This note describes the strategy of Zynga one year ago and shows the importance of getting your strategy right. Rarely has a quoted company showed such disregard for strategy.
Business unit strategy. Zynga's business-unit strategy is as follows: Social games played on the Facebook platform. The gameplay involves competing with the player's friends, typically by building something in virtual space. Most of the games are using the same format, but vary in their details. The games are free to play, but the company sells points (Zynga dollars) to its users if they want to get ahead in the game. 94% of revenue is coming from customers and the reliance on advertising is minimal. Typically, a player would get ahead in the game by spending many hours with the game, but by buying points the player does not need to spend hours playing the game. The player will beat his friends without putting in the effort! Less than 5% of users are converted to customers.
Problem 1: No sustainable source of revenue. The gameplay in Zynga's games is very simple, e.g. you grow crops and animals in Farmville and constant effort will pay-off. There is hardly any skill component in the games, which means that game fatigue will occur relatively quickly. Zynga has understood this so they frequently introduce new games. However, what they have not understood is that the users may be fatigued with the whole category of these simple games. Once you have built a farm, a hotel, a mafia, and a restaurant using the same principles you are not likely to find another similar game as appealing. I have a friend in private equity who was crazy about playing MafiaWars and maybe he bought a lot of points, but he never built a farm or anything else. So if you are a paying customer, you are not likely to buy points for each individual new game. Cycling through customers and not generating repeat business is not a good strategy.
Problem 2: Dependence on Facebook. Zynga is buying distribution services from Facebook and nobody else. In fact, the social network nature of the games makes it necessary to use a social network site, without which you would not be able to include your friends in the game. Facebook largely has monopoly in this market. Thus, Zynga is buying distribution services from a monopolist. As long as Zynga is not making a lot of money, it is not in Facebook's interest to change a high fee for providing the distribution services. In fact, Zynga's games increase the usage of the Facebook platform. However, once Zynga starts to make money, Facebook will start to charge higher fees. This is standard microeconomics; a monopolist will charge higher prices.
Problem 3: Corporate culture of imitation. The company is present in a fast moving industry in which technology is important. Such an industry requires companies to be at the forefront of the changes. Typically this would have been accomplished by a sizeable R&D unit that looks into new game design (to mitigate problem 1) as well as new distribution channels (to mitigate problem 2). Zynga did a genuine innovation in social gaming and then thought it would be sufficient. CEO Pincus made it clear in 2010 that he was not interested in more innovation. According to sfweekly, he infamously said to a game developer: "I don't fucking want innovation". It is all right to copy games from competitors, but that does not invalidate the importance of R&D. Furthermore, this attitude blinded the company to the importance of the smartphone as a new gaming platform.
Side note on the equity analysts in the big banks. The analysis above is taken from a student group project, written before the collapse of the share price. At the same time, the track record of the professional equity analysts was less than stellar. According to IBES, 50% of the analysts had a buy recommendation for the company in January 2012 and this went gradually down to 35% in April. If you thought that the analysts had understood the strategic context by then, you would have been gravely disappointed. In mid-July, the company had an all time high in buy recommendations (55% of analysts) and not a single sell recommendation. Later that month, the share price went down with around 50%. Only after this spectacular fall were the buy recommendations largely changed to hold (14% buy recommendation in August). While the consensus recommendations turned out to be less than useless, there were a few individual analysts that understood the precarious position of the company.
What will happen? This is a historical analysis and I am not familiar with the company's current position. It seems that the company has dealt with Problem 2 to some extent (reduced dependence on facebook by entering the smartphone space and set up their own social network), but has not dealt much with Problem 1 (find a sustainable source of revenue). The advertising share of revenue is increasing, but it is still only 12%. Problem 3 deals with corporate culture and I think it would be difficult for the CEO to change the culture. However, people can change after having a near-death experience.
Thanks to Eldora SIM, Florence WANG, CHU Xue Jun, Wendy NEO, LEONG Ai Kuen and PHI Minh Thuy of Singapore Management University for the original report.
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