3 Problems Hiding in Zynga's IPO filing

[I'm not a lawyer nor an accountant. My opinions are mine and not my employers, etc, etc]

Zynga's S-1 filing is really interesting reading. Tech Crunch has a (rather short) post on it here, and VentureBeat has a better post looking at some of the details here. Hit the bullet points on the VB post if you want the TL;DR version, but most of this will leap out at you from the S1 filing anyway. Short version:

• 600M revenue in 2010, almost 4X 2009. $235M revenue Q1 this year alone.
• Profits growing, with revenue (Q1-Q1: 135%), but...
• R&D up sharply (160%)
• marketing costs up (130%)
• but on the plus side, Cost of Revenue (mostly operating costs) up 110%, suggesting they are getting efficient, or benefits of scale, or both

So, all in all they are doing very well, and it certainly looks like a better investment than GroupOn or any of these other crazy IPOs that have people crying bubble.

But hang on a second. It still smells funny. Look at it from 10,000 feet. The company is HIGHLY dependent on one platform/vendor (Facebook), they don't have nearly the revenue or war chest that the incumbent publishers have, etc.

So, I thought I'd read through some of the fine print. I think the S1 doesn't address three important areas:

1. Allocation of R&D costs: Details on R&D are sparse, and the statement just cites increases in headcount, etc. What it doesn't say is whether that's because of a broadening portfolio of games (that would spread risk) or whether individual game title budgets are growing, which would suggest an increase in risk, as each title becomes a bigger gamble.
2. Risks posed by entry of EA and other incumbents: As the major publishers awaken to social games, this could have a three-sided effect on Zynga: (i) R&D costs go up to compete on product quality, (ii) possible loss of MSS as the publishers bring major titles to market, and (iii) user acquisition costs go up as the competition drives CPMs on FB's ad network up.
3. Terms of Facebook credits agreement. To Zynga's credit, they DO call out the move to the Facebook credits system that took place last year, where they went from giving up 2-10% of revenue for payment processing to giving up 30%. However, they didn't just move to Facebook's credit system. They did so after a bit of a fight, and they signed a five year agreement. What are the terms? I'd like to know, for example...

• Do they get preferential ad pricing and/or placement as a result?
• Although signed in July 2010, the S1 states the migration was only completed April 2011, so how much of the revenue from 2010 and 1Q11 was earned at 95 points on the dollar vs 70 points?

With any company, it'd be possible to ask infinite numbers of questions to learn or infer more. In this case though, I think there are at least a couple key things that investors should consider.

Food for thought over your long weekend...

Riffing on the Popcap acquisition rumor

Yesterday Techcrunch broke this story:

Popcap to be acquired for $1+B, which started a rumor mill going. Who could it be? Story points to potential buyers as: Zynga (discounts them as not having stomach for the price & multiple, EA, DeNA, Tencent.

I tweeted about it saying I thought EA just as a gut call. Later though, I started wondering why no one had asked if it could be Google, or even more credibly, Microsoft.

Techcrunch added a story about rumors that it was likely EA.

And then today, VentureBeat had this story pointing to EA (nothing new, just citing the techcrunch article), but being skeptical about it and pointing at other potential buyers: Zynga, DeNA, Media companies like Fox, Activision/Blizzard, and throwing water on any "stingy" chinese companies.

(WTF, why is VentureBeat also not mentioning Microsoft? Does everyone assume they are broke after buying Skype?)

The interesting thing about these pieces is that they are looking at the market rather naively. Techcrunch refers to Popcap as a startup while at the same time mentioning that they've been in business since 2000. VentureBeat mentions their social games but barely mentions mobile let alone all the other platforms they are on.

Anyhow, I believe the EA rumor is most likely accurate (though I still have a side bet on a surprise that it's Microsoft, but I'm crazy like that).

Just for grins and giggles though, here's some alternate takes on the headlines made possible by this acquisition, which I think make it more apparent that this isn't such a bad buy. Allow me my editorial liberties:

If it's EA:

• #1 iPhone games publisher buys #2(3?) iPhone games publisher to further cement leadership
• #2 Facebook games publisher buys #3 facebook game publisher in bid to take lead position away from #1 FB games publisher
• Leading western games publisher buys another entry ticket in race for China gaming market (Popcap has social games/portal play in China, a shanghai studio doing original IP, etc)
• EA buys leading casual games dev, "Popcap is the Valve of casual games" says Someone.

If it were to be Microsoft

• MS buys publisher of popular iPhone, iPad games in bid to secure exclusive content/features for MS phones/tablets
• MS buys publisher of social games in bid to catch up in that race
• See same two above points about traction in Asia and Popcap's production abilities, quality

In any case, my point is that there's a lot more value to Popcap than just "Plants vs Zombies on Facebook or iPad". They are a force in the mainstream games market with recognizable IP, real revenue, good distribution, top notch development talent, international portfolio of games and distribution, etc. You can play their games on almost every platform under the sun - even play bejewelled on airplane headrests!)

$1B is a lot of money, but Popcap is an awesome crew, and likely worth it. I sure hope whoever it is doesn't screw the magic formula.

Shh!! 3 Unspoken Lies About Social Games

The inimitable Greg Costikyan wrote an excellent piece for Gamasutra, lambasting Social Games, and claiming that they are in fact not very social at all.

I agree, and thought I'd add two more topics that came up in conversation at Login recently, and in conversations with a couple social games developer friends.

So let's give Greg Credit for calling out the first lie on my list:

Lie #1. Social games are social games. (Truth - they aren't very social at all)

And to this I'll level two more accusations.

Lie #2. Social games are viral. (Truth - they aren't)

Social games are often cited as "viral", or having the opportunity to be so, because of the social network on which they reside. However, short of the early days in which FB allowed apps to spam a user's friends list, this just isn't the case.

Companies like Zynga are rumored to spend many millions on advertising within FB to acquire users, but if the games were truly viral, they would spread on their own, being recommended whole-heartedly by friends via word of mouth.

The fact that few social games have been able to exceed the virality of the average dog-on-skateboard Youtube video - let alone the virality of an Angry Birds - is proof that they aren't viral. (Some examples do come to mind though. Parking wars and Cow Clicker certainly got a lot of watercooler talk.)

Lie #3: Social Game Publishers are building Games, not Products. (Truth - most have little respect for the medium other than as a revenue generator).

I'll cut to the chase: To my knowledge large publishers in this space, like Zynga and Playdom, don't have developer credits listed in their games.

I wasn't able to find them anyway. I had a couple developer friends lament about the fact that there were no game credits and that when they'd asked management at these companies, they'd been told no.

I think that speaks volumes about those publishing these games and what they think of the people working on them, and of their contributions. "It's just a product, and you are just a cog".

There are a few companies out there doing the right thing (I'm looking at you Brenda!), but I fear these are the exception.

With all the excitement around 'Social Games' these days, it's important that we don't delude ourselves about some of the lies being told.

//rant off

A couple VC Gems

I have a few of the better (I think they are, anyway) VC blogs on my feed reader, and just recently did some catching up.

A few snippets caught my eye:

1. Ben Horowitz, on "How we picked our first cloud investment" makes this point:

...the first attempts to build applications in the cloud from companies such as Corio simply fork-lifted the leading on premise software and moved it into the hosted environment. While this sounded like a good idea to many VCs at the time, it turned out to miss important details and advantages of the cloud...

Reading this should spin your gears if you are thinking lately about OnLive, Gaikai et al. (And thinking about it further, you might see why I was saying early on that MMOs are a really good customer for these services - Already architected for the cloud, just the network stack sits at a different point in the pipeline). Regardless, key point is that content that is ported is always second-rate compared to content authored from the outset for a platform.

2. Lightspeed Venture Partners has this post (2 months old now) estimating Zynga revenue at ~240M for 2010, down slightly from 2009.

a) It's a fairly thorough model, and they have the spreadsheet shared on google docs if you want to tinker with it.

b) The graph of Zynga's revenue over time sure made me think of Dave Edery's inevitable misery pitch.

Anyhow, something to noodle on.

Slush(y) Fund: Piggybacking Bits on Atoms

Someone put this on my radar on Facebook today:

Zynga and 7-Eleven partner to bring game content to ice cream, Big Gulps

Short version is: Buy ice-cream, comes with a code, redeem code in-game for virtual items.

Gimmicky, right? Wrong. Brilliant. OK, why?

I wrote some time ago (wow, 3 years ago!) about how kids "connected toy" products like Webkinz and other entrants were bundling services with a toy.

The most brilliant thing about this is not that "you get a game with the toy!" or vice versa. The way to view it is that the physical product allows the virtual item sale/subscription/etc piggyback on a channel that the customer understands. And if that gets you over the hurdle of a massive number of customers not having credit cards or being afraid to type them into a browser, then it's well worth the cost of the plushy (or in this case slushy).

I'll bet that we're going to see piggy-back revenue models like this (you can call it a promotion, or a bundle) are going to grow significantly.

One way to accelerate it would be to think about ways to remove the friction of having to enter a lengthy code while in front of the PC. Maybe it's texting the code from your mobile to automatically credit your account, or a unique bar code you hold in front of your webcam?

Anyhow, it will be interesting to see how well this does for Zynga. I'm betting it's going to be copied a lot