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A War on Social Media

April 11, 2012

Introduction

I’d like to consider myself a very sensible person, often a little too much so.  I ask obvious questions to make sure I’m not misunderstanding, I make obvious statements to make sure I’m not misunderstood.  I’m no good over text message, my sarcasm is “of a rare breed” (as I’ve been told), and I will call you out on your non sequiturs.  People, by and large, are typically the exact opposite.  For that reason my market perspective (and my entire life) has most often been pretty contrarian, and my process has been dictated by tried-and-tested logical strategies.  When I look at a company whose stock I want to invest in, I’m looking for a firm that’s in an industry with solid economics that make sense for the long-term.  I need to see a company with competent management willing to make a career out of running and growing their company.  I need to be confident that 10, 20, or 50 years from today, there should still be a logical reason why this company’s product should be demanded.  And I’d definitely prefer to see them sustain margins through some sort of durable competitive advantage.

This post is mostly aimed at identifying one company where, to my knowledge, there is absolutely no durable competitive advantage, in an industry whose economics don’t logically suggest long-run success.

Social Media and the ZNGA Haterade

  The social media industry is popular, gaining momentum, and I’m using it right now.  So why hate it?  I never did until a few months ago when I was staring at my Facebook news feed and said (out loud), “what the hell is all this shit?”  I had already had friends take “a break” from Facebook – some returning and others actually enjoying their new-found freedom – and decided it was time to do the same.  I deactivated my account (i.e. deleted it) and haven’t felt the need to log back on since.  Okay, well I’m lying, I logged back on twice to watch UFC fights.  But that’s not an issue anymore, as UFC has moved on from Facebook and back to the real world: television.

I wonder… Had anyone else?

The short answer is yes.  New user growth rates for Facebook have fallen, but, given their explosive growth, this was never a surprise.  Facebook’s interface, which used to be celebrated for its simplicity and sharp image, has become cluttered with useless junk and photos from acquaintances that “friended” us sophomore year of college to make sure they weren’t too far behind the social scene.  

All this shit, I decided, had to end. 

In the long run, I don’t see Facebook making out like the next Microsoft.  There’s no computers here, no great new product, no food, and maybe not even any new technology.  For lack of a better word (since there is no better way to describe it), it’s a fad.  And being born in the 90s, I know what happens to fads.  

Any business model that relies on being “cool” to achieve success is destined to go the way of the Pet Rock.  

Unfortunately, this logical approach to evaluating Facebook’s long-run economics isn’t very helpful to us in the short run, and it’s like that Facebook will be able to do a whole lot better than companies in the same industry that are far from “top dogs” in their respective space.  Speaking of top dogs: that’s where I found Zynga.

Given my thoughts on Facebook, I went sniffing around for other social media companies that relied on being “cool,” but to a more amplified extent.  I had seen these “fad games” several times since I first joined Facebook: first there was FarmVille and Mafia Wars, then (for me, anyway) Family Feud, and most recently we have seen games like Words with Friends and DrawSomething.  The funny thing about most of these games is they’re all owned by the same company… which, conveniently enough, recently went public on the NASDAQ under the ticker ZNGA.  This was something to take a look at.

After beginning my research around the IPO date in December, I started developing an investment opinion on ZNGA.  I will try to summarize for brevity, but the following facts, with some details, helped me arrive at my decision to short the stock.

  • ZNGA primarily receives revenues through Facebook users who play their games for free.  Users can purchase “Facebook credits” from Facebook and spend them on in-game items, but the games themselves have no cost.  These Facebook-related revenues generate about 93-94% of ZNGA’s total revenues.
  • For every $1 of “Facebook credits” spent in ZNGA games, Facebook pockets 30% and ZNGA gets 70%.
  • ZNGA typically spends large amounts on Research and Development, which cost the firm 25% of revenue in 2010 and over 60% in 2011, though that was due to many employees’ stock payments being vested.  Thus, the 25% number is higher and the 60% is most likely lower.  
  • Despite spending so much in-house for game maintenance, improvement, and new game creation, ZNGA spent a whopping $210 million in total to purchase a competing game called DrawSomething.
  • DrawSomething, like any other Zynga-owned game, experienced (and is still experiencing) a quick and sharp burst in popularity.  It is unlikely that it will be able to maintain this popularity, based on what typically happens to games in the social media space, though this is simply my speculation.
  • ZNGA had 2011 revenues of about $1.1 billion, and if we simplify and assume this all came from Facebook credit purchases, results in users of its games having spent over $1.57 billion for in-game items and customization. 
  • The CEO, Mark Pincus, who I will be the first to say is a Wharton undergrad alumni, has already unloaded stock valued at 9-figures, and is in the process of dumping even more along with some other large insiders in a secondary offering of 42 million shares.  When announced, the secondary offering was at a price essentially $1 lower than ZNGA’s approximately $13.00 share price that day.  

I could go on, but I’m already worried this post will be too long for many uninterested parties to read.  So to draw these facts to a conclusion, I wanted to ask myself the following: Do people really spend $1.5 billion on little trinkets and small in-game character improvements, and who are these people?  Even if they do, how long will they continue to do that before they get bored and move on to the next thing? (see: World of Warcraft)  How much longer until there are enough competitors in this market for nobody to turn a significant profit?  

Oh, and… what about all this cashing in?  Sure, it’s great for these “entrepreneurs” to finally see their payday, and they get glorified in the media, but if they thought they had legitimate businesses on their hands worthy of holding on to, wouldn’t they be squeezing onto their shares for dear life?  And why overpay for a popular game when you can develop a competitor and already spend so much on your existing games?  Are you admitting they can do better than you?  Doesn’t sound good for the long-term to me.  Coca-Cola can get away with buying small beverage companies that are popular in niche markets because those same customers still love Coke and aren’t fully sacrificing their Coke-drinking for this niche product.  However, people tend to jump around from game to game, especially in the social media space, and games “die out” very quickly once something else becomes more popular. You don’t see anyone still playing Hangaroo, do you?  

One last point before I cut myself off: The company is currently valued at about $9 billion.  To give you an idea of what that compares to in terms of businesses one can easily see value in, it’s about 70% of the value of Chipotle Mexican Grill.  Think of it this way: if you bought out Chipotle using Facebook credits, they’d probably be willing to trade you straight up for Zynga stock.

What About Now?

We made the decision to go ahead and short ZNGA at $13.49.  Since then, there has been the announcement of the company’s secondary share offering and a bearish trend.  We have seen a string of bad days for ZNGA yet still have no plans of closing out the position.  In my eyes, there’s no reason for this stock to be worth even 50% of what the market is currently giving it credit for.  For that, we will stay short until the market recognizes the company’s true (hopefully, and in our eyes) lesser value.  

I want to echo one thing I mentioned earlier before I end.  I am bearish on social media in general and don’t see it as something that will be profitable and lasting in the way that industry staples like KO, COST, or IBM are able.  However, I think the industry has a place in our lives and will be around for a decently long stretch of time.  I aimed specifically at Zynga because I believe this to NOT be the case for them.  

Simple logic tells us that today’s Smurfberries are just tomorrow’s Sega Dreamcasts.

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