Will Zynga Inc (ZNGA) Transform Itself Into a Profitable Company?

On July 1, Zynga Inc (NASDAQ:ZNGA) announced that Don Mattrick, a Microsoft Corporation (NASDAQ:MSFT) executive currently responsible for the firm’s Xbox console business and other entertainment activities, will be replacing Mark Pincus as Zynga’s chief executive officer–though Mr Pincus will remain the company’s chairman and chief product officer. This transition in management brings with it a great deal of hope regarding Zynga’s uncertain future.

Some background

Zynga Inc (NASDAQ:ZNGA) is a video-game developer that was founded in 2007 and went public in 2011. If you’ve ever played “Mafia Wars” or “Farmville” on Facebook Inc (NASDAQ:FB), you’ve used Zynga’s products. These games can be addictive. People love playing them. In fact, data-tracking website comScore reports that more users play Zynga Inc (NASDAQ:ZNGA)’s mobile games than the next five mobile game developers combined.

Recently, the company confirmed the layoff of 18% of its workforce, or about 520 employees. The company says that this will result in $70 million to $80 million in annualized pre-tax savings. That’s good news for investors who had witnessed their shares drop 68% from the IPO price level. Despite those savings, its guidance for second-quarter earnings calls for a loss of between $39 million and $28.5 million

A troubled business model

There are a few pending problems with Zynga Inc (NASDAQ:ZNGA)’s business model. The first problem is that users can play for free. You never have to spend a penny to play the company’s games if you don’t want to, and only 5% of Zynga users pay to play its games. It has 63 million daily active users but it still loses money. In fact, the company generated $1.3 billion in revenue and still hasn’t made a penny of profit.

The second issue at hand is Zynga Inc (NASDAQ:ZNGA)’s dependency on Facebook. In its latest annual report, Zynga stated that “We are highly reliant on Facebook Inc (NASDAQ:FB) and the Facebook platform for a significant portion of our revenue.” That’s a minor understatement. The majority of Zynga’s profits comes from Facebook. Even the name “Facebook” is mentioned 313 times in Zynga’s 2012 annual report. In reward for the trouble, Facebook retains 30% of Zynga Inc (NASDAQ:ZNGA)’s earnings generated on its platform, which equates to 15% of Facebook Inc (NASDAQ:FB)’s total revenue. That’s a problematic busines knot for both companies. Microsoft Corporation (NASDAQ:MSFT), for example, generates just 5% of consolidated operating income from the Entertainment and Devices business segment (which includes Xbox and video games). That’s a much healthier diversity in earnings.