Zynga woes: Once a social network darling, it’s now a cautionary tale.
Zynga, so recently trumpeted as San Francisco’s fastest-growing startup and a poster child of the social media age, is now a cautionary tale.
In early April, Zynga Chief Executive Officer Mark Pincus dumped 15 percent of his shares for about $198 million, in an unusual secondary stock offering that came almost two months before the official selling lockup for insiders ended. It turned out to be spectacular timing — at least for Pincus and other executives and early investors. They unloaded big portions of their holdings for $12 per share. By the end of July, after the social gaming company whiffed on second-quarter analyst expectations and sliced forecasts for the year roughly in half, the stock had dipped below $3.
Earlier that month, a flush Pincus reportedly closed on a $12 million, seven-bedroom mansion in Pacific Heights. In sharp contrast, anyone who bought in at Zynga’s initial public offering price had by that point lost about half of their money. Likewise, many rank-and-file employees who logged brutal work hours on the promise of Internet riches were — and are — staring at restricted stock worth far less than what had been expected. It’s at least another glaring example of a financial system rigged in favor of executives and venture capitalists at the expense of average investors and employees. And if Zynga doesn’t stage a remarkable turnaround, it could end up as one of the most high-profile flameouts of the Web 2.0 era.
Analysts have turned incredibly
negative, shareholders have filed insider trading lawsuits, and the market is betting the company has almost no long-term value.
Shares plummet
On Friday, Zynga’s market cap stood at $2.28 billion. That’s less than the company’s assets, including cash, receivables and real estate, which totaled $2.7 billion at the end of the second quarter — and only marginally higher than its assets minus liabilities, which stood at $1.86 billion.
A company spokeswoman didn’t make anyone available for this story before press time.
Zynga, the maker of popular Facebook games such as “CityVille” and “FarmVille,” went public at $10 a share in December. Shares peaked at almost $16 in early March but have traded downward since.
Shares went into free fall in late July, after the company announced deeply disappointing quarterly results. Its 1-cent earnings per share missed analyst estimates by a nickel, and the company came up $12 million short on revenue.
The core problem is user fatigue: People are playing Zynga’s premier games less and spending less on virtual goods such as digital tractors, guns and cows when they do.
Drastic revision
But the extent of the company’s challenges was laid out most clearly in its outlook for the year. Zynga slashed its socalled EBITDA projections (earnings before interest, taxes, depreciation and amortization) from a range of $400 million to $450 million, to $180 million to $250 million.
Zynga said the drastic change reflected delays in new games, declining engagement with existing games in part because of changes in the way Facebook promotes apps, and reduced expectations for “Draw Something.” Zynga acquired that flash in the pan with its purchase of New York’s OMGPOP for $180 million in March, managing to buy at the peak of the game’s popularity.
The revised 2012 forecast was particularly troubling to analysts because it came after the company had raised annual expectations in its first-quarter announcement. In fact, Zynga emphasized at the time that most of its growth would happen in the second half of the year.
The wildly different assessment in a threemonth period revealed a stunning lack of insight into the state of the business — or something worse.
‘A disaster’
Analysts pounded the company, using language of a sort rarely seen on Wall Street.
Sterne Agee’s Arvind Bhatia and Wedbush’s Michael Pachter both called the July announcement
“Zynga misrepresented or failed to disclose material adverse facts about its business, operations, and growth prospects.” Shareholders’ lawsuit against Zynga
a “disaster.”
“It was a big aboutface,” Bhatia said. “It was revealing to us that the communication from management was not very clear — or straight.”
Richard Greenfield of BTIG took the rare step of apologizing for having recommended the stock and immediately cut his rating from “buy” to “neutral.”
“We are sorry and embarrassed by our mistake,” he wrote in a note to clients.
A few days later, Greenfield took Zynga to task for failing to disclose the restructuring of its senior management team in the days ahead of the quarterly announcement. In turns out the company stripped Chief Operating Officer John Schappert of his game development duties and handed them to two other executives. Those developments came to light only through reporting by Bloomberg.
Schappert has since resigned.
“They were released out of a lockup that underwriters normally wouldn’t have allowed,” Greenfield said in an interview. “They raised guidance and reorganized management without telling anyone. Then they cut guidance by 50 percent. It’s a very shocking chain of events.”
Shareholders sue
It seems the offering underwriters released the executives and early investors from the normal lockup obligation in exchange for committing to hold remaining shares for longer periods. Zynga has said it did the secondary offering to facilitate an orderly transfer of stock, by allowing the shares to hit the market in waves instead of all at once.
But many shareholders saw things differently and responded with lawsuits accusing the company of insider trading.
“While Zynga insiders were able to sell their holdings at $12 per share before Zynga’s second quarter financial results were announced, Zynga’s non-executive employees and other public shareholders suffered colossal losses on their investments,” reads a suit filed by the San Francisco office of Kessler Topaz Meltzer & Check, in the U.S. District Court of Northern California.
“Zynga misrepresented or failed to disclose material adverse facts about its business, operations, and growth prospects,” the suit alleges.
A handful of other firms have filed suits or announced investigations in the matter, including Schubert Jonckheer & Kolbe, Wohl & Fruchter and Levi & Korsinsky.
For good measure, Electronic Arts just sued Zynga for copyright infringement, saying the company’s new game “The Ville” is a blatant knockoff of EA’s “Sims Social.” Zynga has been dogged by copycat allegations throughout its five-year existence.
100-hour weeks
Zynga’s precipitous decline looks all the worse for the pains it took to cling to as much of the IPO upside as possible.
Last year, the company threatened to leave San Francisco if it wasn’t granted a sizable break on its payroll tax, which applies to the stock-based compensation that kicks in after an IPO. Mayor Ed Lee and the Board of Supervisors pushed through a cap for startups that limits the bill on such compensation to $750,000 or the figure the company paid in 2010, whichever is greater.
Whatever the public policy merits, the deal allowed Zynga executives and its investors to hold onto what could be millions of dollars — the exact amount is still unclear — that would have otherwise flown into city coffers. The only company that filed for the exclusion last year — its name wasn’t disclosed publicly, but it had 1,975 San Francisco workers, roughly the number Zynga employs — saved $1.5 million, according to San Francisco’s Office of the Treasurer and Tax Collector.
Rank-and-file Zynga employees also feel they’ve missed out on riches. On the questionand-answer site Quora, anonymous users who said they were Zynga workers vented their frustrations over working long hours for years only to wind up with restricted stock that tumbled in value before their lock-up period ended.
“I worked 100 hour weeks,” one wrote. “Week, after week, after week. I hated the management. I hated the culture, but we all knew the IPO was right around the corner, and once it came, as long as the s— organization could keep it together for the lockout period, I’d have made bank, and in some way, that would have made my three and something miserable years there worth it.”
At least one poster blasted Pincus for selling shares in the secondary offering.
“This was in my opinion the event that broke Zynga’s back,” the person wrote. “Anybody that knows how traders think knows that this was a signal to every single hedge fund in the world to short Zynga into oblivion.”
The Chronicle could not independently confirm that these people worked at Zynga.
After the second-quarter announcement, Bloomberg reported that the company offered stock options to all fulltime employees in a bid to keep them from jumping ship. Options give employees the right to buy shares at a preset price, usually set below the current market value, so that owners can sell for a gain.
Planning new games
On the investor conference call, Zynga managers insisted they are tackling the manifold challenges.
They stressed the company had introduced several new games for mobile devices, where more and more people are looking to play. Zynga is also rolling out new titles such as “ChefVille” and “FarmVille 2.” Finally, the company said it’s planning to start gambling games that allow players to bet with real money in overseas markets.
“We are the most optimistic long-term believer in the opportunity for social gaming and play to be a mass-market activity, as it’s already becoming,” Pincus said on the call. “Today, we have the leading position on Web and mobile, and we will continue to pursue that strategy and keep investing in building the best social game mechanics that drive the next generation of engagement.”
‘Treading water’
So can the company turn things around?
Every analyst contacted for this story said what Zynga needs to do is deliver another hit.
It’s become crystal clear that social games aren’t gifts that keep on giving, as some proponents once argued. People grow bored and move on. The only way to succeed is to deliver hit after hit, a monumental challenge, as any movie studio or traditional gaming company can attest.
Merely being a “social” game is no longer a novelty. Zynga must deliver products that stand out in a crowded sea of rival offerings inspired, largely, by its own early success.
“Until then, they’re going to be treading water,” Bhatia said.