3 Reasons I'm Not Buying Zynga

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Well, it appears that the Zynga (NAS: ZNGA) IPO was a dud. After reaching $11.50 per share in early trading, the stock promptly sank below its $10.00 offering price, finally closing at $9.50. Some investors may see the failed IPO as an opportunity to get in on the biggest player in social gaming at a reasonable price, but I can think of three reasons why investors might want to stay away.

1. Virtual goods = virtual profits?
Back in October, The New York Times took a closer look at Zynga's financials and made a startling discovery. If not for a little bit of accounting sleight of hand, the company wouldn't have been profitable.

Before I explain the Times' findings, let me take a moment to explain Zynga's accounting methods. The company uses amortization to calculate revenue. Basically, if you pay $4.00 for a horse or whatnot for your virtual farm, the company will record the transaction under bookings. It will then take the dollar amount of the transaction and amortize it -- or divide it up -- over the course of what Zynga considers the useful life of the object to calculate the revenue.

The problem with this style of accounting is you can boost your revenue by shortening the amortization schedule, which appears to be what happened in Zynga's case. After the company announced that its bookings for the first half of the year had declined to $275 million from $287 million the previous year, it said that it had shortened the useful life of its goods from 14 months to 11 months. This move gave Zynga an extra $27 million in revenue and converted a second-quarter loss of a few million dollars into a small profit.

2. The CEO has total control
According to its S-1 filings, Zynga has three classes of shares. Class A common stock -- which is what you would buy -- has one vote per share. Class B common stock gets seven votes per share, and the Class C shares have an astounding 70 votes per share (only CEO Mark Pincus owns these). The class B and C shares hold 98.2% of the voting power, while Pincus alone holds 38.5%.

Now, having dual share classes isn't unprecedented. Both Linkedin (NAS: LNKD) and Zillow (NAS: Z) gave some shareholders 10 times the votes as IPO investors. However, Zynga's structure completely disenfranchises the average shareholder and all but assures that no matter what happens, Pincus will remain in control for as long as he likes.

I could almost be OK with this arrangement if Pincus was an innovative visionary like Steve Jobs, but he's not even close. As I've written before, Pincus doesn't appear to believe in innovation and has admitted to putting revenue generation ahead of customer satisfaction. Furthermore, if he's willing to put revenue ahead of the customers, then I have a hard time believing he'll act with the shareholders' best interests in mind.

3. This field's been over farmed
Most of all, I think Zynga's days of stellar growth are behind it. The company's total monthly active users remains around the same levels seen in the first quarter of 2010 and its bookings have remained flat for three quarters. It's possible that the flat growth was because the company didn't release a new game during the first three quarters of the year, but as it turns out, new games aren't really growth drivers. A recent report by the game-tracking service Raptr found that when Zynga releases a new game, 90% of its users will come from its old games.

In order to spark growth, the company will have to find a new audience, either by releasing a game that breaks from the EndlessTediumVille formula and attracts a new demographic, or moving onto new platforms like mobile gaming. I don't think either strategy will work because as the company freely admits, social and mobile gaming have low barriers to entry. In addition to major players like Electronic Arts (NAS: ERTS) and Disney's (NYS: DIS) Playdom, Zynga also has to fight smaller independent developers for Facebook's gamers.

I wouldn't hold out much hope for mobile either. Glu Mobile (NAS: GLUU) , which relies on a similar free-to-play revenue model, has struggled to turn a profit. Again, Zynga has to contend with the same low barriers to entry and competition from larger and more experienced developers. With an anti-innovation CEO at the helm, I just don't think Zynga will be competitive in the long run.

Foolish takeaway
I consider any one of the issues I mentioned here a serious red flag. All three of them bundled into one company is an absolute deal breaker. As a result, I've given Zynga an underperform CAPScall. You can see this and my other picks here.

In the meantime, if you'd like to know about better opportunities to profit from the growing mobile market, then I invite you to check out this special report: "3 Hidden Winners of the iPhone, iPad, and Android Revolution." It's free, so click here to download it today.

At the time this article was published Motley Fool newsletter serviceshave recommended buying shares of Walt Disney and Zillow. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.Fool contributor Patrick Martin holds no positions in any of the companies mentioned here. You can follow him on twitter @TMFpcmart03. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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