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Zynga (ZNGA) reports that its mission is “to connect the world through games.” For the most part, the company does that using the Facebook (FB) service as its primary delivery platform. Wedding itself to that dominant social network has been a good decision so far, as the company has “customers” in more than 175 countries and over 240 million monthly active users (MAUs, which is a key metric for Zynga).

The term “customers” has to be put in quotes because, like so many other products in the digital space, Zynga’s games are predominantly free. It develops, markets, and operates its online social games, including CityVille, FarmVille, and Words with Friends, as live services played over the Internet. This includes on social networking sites, predominantly Facebook, and other mobile platforms. As noted, the games are accessible to players worldwide. Games are continually updated with new content and features, such as holiday themes.

The company generates revenue by selling advertising within its games and in-game virtual goods. The latter item may not make much sense to people who have never played one of the company’s games. While Words with Friends is a pretty run of the mill Scrabble clone, allowing users to play against friends as well as strangers, many of the other games the company offers allow for the purchase of virtual goods. This can include such things as tractors in FarmVille or special buildings in CityVille.

While the value of buying virtual goods can be argued, the allure of growing a special plant or growing more crops at one time is apparently large enough to generate significant revenues for Zynga (its top line was over $1 billion in 2011). The company is, essentially, creating an ecosystem into which customers can freely participate and then providing goods for sale that can make that ecosystem more enjoyable for individual players. The leverage in the model should be obvious, since the items it sells are coded one time and sold multiple times. This model, however, requires several things to work well.

First, Zynga needs access to a large population of potential customers. So far, the company has ridden the popularity of Facebook to gain access to that company’s users. This has worked well, but has resulted in a disturbingly large percentage of Zynga’s earnings being dependant on that one relationship. Although Zynga has games on other platforms, any problems with Facebook would take a material bite out of revenues. The success of the company’s other ventures may or may not be enough to materially offset that dominant relationship. Growth could also slow if using Facebook were to become less desirable (or contract if users actively sought out alternatives to Facebook). Broadening beyond Facebook, however, is likely vital for long-term success. So far, the company has made games available on Apple (AAPL) and Google (GOOG) devices and has recently launched access through its own website.

Second, the company must create games that appeal to users. This is an important factor for any computer game maker. That said, Zynga’s focus on less complex social games, primarily geared to the casual gamer, likely makes its products less difficult and less costly to create and maintain. Still, consumer tastes can be fickle and fleeting, and the company has to spend a great deal of effort in making sure that its games keep up with the times. Moreover, in order for its business to grow, it will need to continue to develop, or purchase, new titles. Those titles also need to lend themselves to the sale of in-game products, as noted below. New games may allow it to expand its share of its current customers’ discretionary spending, generating top-line growth. Though new games may also result in sales shifting from one game to another, which would be less beneficial to the top line.

Third, it has to successfully market to its customers. Since the games Zynga offers are free to use, it must make revenue by selling other things. Advertising space is a fairly simple business model that can work well, but has limited potential. Selling in-game virtual merchandise has materially more potential, but is also more complicated. Not only does the company need to create desirable games, but those games must revolve subtly around a sales platform (few users would stick around if its games were blatantly about product sales). In fact, there is little benefit to Zynga in making a hit free game if it can’t sell to the game’s users.

Selling in-game virtual merchandise is very much like selling consumer goods. The products must be appealing, constantly updated, and attractively priced. In this regard, it is a similar model to a teen apparel retailer—only with virtual goods. This requires a staff to constantly create and update the products in a game and to effectively market those products. Pricing issues, scarcity, product design, time to market and other factors not typically considered with video games become very important.

Zynga shares went public in December of 2011. The company has grown rapidly in recent years by piggy backing on the success of social networks, particularly Facebook. Zynga is at a crossroads and continued top-line growth likely depends on its ability to move into new delivery channels. Interested subscribers should monitor Value Line’s quarterly coverage of the company, while keeping an eye out for Supplementary reports highlighting late-breaking news.


At the time of this article's writing, the author did not have positions in any of the companies mentioned.