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Zynga: The worst may be yet to come

Zynga: The worst may be yet to come Exclusive

August 1, 2012 | By Chris Morris

Last week was an ugly one for Zynga. An earnings shortfall and reduced guidance for the coming fiscal year resulted in a 40 percent drop in the company's stock, which brought out the doomsayers.

Those corporate obituaries are premature, but the company is likely to face some even rockier times before there's much chance of things getting better.

Zynga is facing a tremendous series of hurdles as it struggles to course correct. The social gaming space is slowing down -- and player numbers for the company's flagship games are declining. Investors know this, and they're rightfully worried, but the most looming hurdle is the coming expiration of a new round of employee stock options.

On August 16, the lock-up period on 150 million shares will expire, meaning employees will be able to exercise their shares. While the stock is hardly a windfall for anyone these days, some money is better than none. And it's a safe bet some employees will cash out.

Zynga used stock options as a major recruitment tool in its pre-IPO days. Developers were lured from the traditional console industry not so much because they believed in the company's future (though that was certainly part of the appeal), but because of the temptation of sudden wealth when the company went public.

At the time, a Zynga stock explosion seemed a sure thing. Things change, though. And employees who are thinking about another career shift are likely waiting for the chance to cash out some of those options before they go.

Complicating things is Zynga's float -- and forgive me a little finance gobbledygook here. A stock's float is the number of shares that are available for trading. When Zynga went public, there were only 100 million shares available. Between a secondary stock offering and the expiration of three lock-up periods since then, the number has jumped to over 600 million. When the latest lock-up period expires in August, that will bring the float to nearly 800 million shares.

Larger floats tend to make a company less volatile in general, but at Zynga, it's starting to look like the supply for company shares is outstripping demand, and that could batter the stock price even further.

And make no mistake, the stock is being hammered. Alarmists point out that Zynga shares are now trading at a price that's nearly half of THQ's stock. That's an unfair comparison, though, since THQ just completed a 10-for-1 reverse stock split. But Zynga is getting very close to the territory of Majesco, which hasn't topped $4 per share in over five years. (By mid-day Tuesday, the stock was trading at $1.83 per share, versus Zynga's $2.92.)

Beyond the new options about to hit the market, the poor results are bringing about the usual lawsuits. A California firm is seeking class action status in its accusations that the company failed to disclose the decline in users and revenue. These suits rarely go anywhere, but they're a distraction and tend to weigh down the stock.

And Tuesday's baffling decision by the company to yank game oversight from chief operating officer (and EA/Microsoft vet) John Schappert may be the company's most bone-headed move in years -- and could cause even more stock turbulence. Investors may want a scapegoat, but Schappert is one of the most game-savvy executives the company has. Mark Pincus, who will now oversee game development, doesn't have the experience, and should things slip further, it will further undermine confidence in his leadership abilities.

Zynga's tailspin isn't entirely its fault. The company was dragged down by Facebook's IPO (which pretty much put a halt to all public offerings after the social network landed with a thud). And until Zynga finds a way to become less dependent on its biggest partner, the stock will suffer. It's in the process of building up and is actively recruiting development partners for the site, but it's going to take a while for that to bear fruit.

The mobile market is another source of revenue, but Zynga hasn't quite learned the trick of mastering it. And after the bloated acquisition of OMGPOP earlier this year (and the subsequent underperformance of Draw Something), investors are going to be skeptical of any buyouts in that space.

Zynga is a company in transition, one it didn't expect to go through quite this quickly. (And investors certainly weren't planning on having to weather this so soon after the IPO.) Assuming it doesn't suffer a major talent drain and it's able to course correct, especially in the mobile space, it could once again be the powerhouse it was a short while ago. But until then, investors -- including those developers who hope to see their options bring them a windfall -- are likely to be in for a bumpy ride.

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