This Is How Zynga Slowly Strangles Itself

Last week, a former Zynga (NAS: ZNGA) engineer -- who calls himself mercenary_gamer -- hosted an "IAmA" thread on Reddit, in which he answered questions about the eight months he spent at the company. For the most part the thread confirmed a lot of what we already know about the company's standard operating procedures. However, it did shed a little more light on just how Zynga uses all of that data it collects from players to fine-tune its games. If what mercenary said is true, then the company's data obsession may lead to its downfall.

The $10,000 virtual farm
Zynga collects huge quantities of data, but according to mercenary, it focuses on the habits of the most popular players and those who have spent at least $10,000 on in-game purchases -- also known as "whales." Most of the changes and updates you see to existing games are meant to encourage the big spenders to spend even more.

Mercenary also claimed that the company will sacrifice fun to maximize profits. He recounted an incident in which a game's quality-assurance tester complained that a particular item's low drop rate made the game less fun, so mercenary made an adjustment but was ultimately overruled by the product manager, who changed the game back to the more profitable version.

What's wrong with profitable?
I'm not arguing that video-game companies shouldn't seek profits, or that they shouldn't find new ways of pleasing their existing customers. However, I see two problems with Zynga's strategy. First, the average player and the player willing to spend $10,000 on virtual corn are two very different people. Focusing on the high spender runs the risk of alienating the less obsessive gamers -- which is the larger market. Second, by sacrificing fun, the company also drives away new players long before they begin to consider opening up their wallets.

In short, rather than spur growth, Zynga's strategy actually limits it. You can already see the effects. When the company launches a new game, 90% of the players come directly from an old game, so its audience really isn't growing that much. Eventually, even the company will find the upper limit of what its whales are willing to spend. When that happens, we'll see the company's declining bookings and revenue growth rates shrink even further.

The better way to play
The more I learn about Zynga, the less appealing I find the company. It will ride the Facebook IPO for a while, but eventually the market will turn on it. If you're looking for a better play in video games, I'd go with Activision Blizzard (NAS: ATVI) . Although it hasn't entered social gaming yet, the company is also looking to generate more revenue from its players, but it has taken a smarter approach. Its new subscription service, Call of Duty: Elite; the Skylanders figurines; and the real-money auction house launching with Diablo III all add value to the games, but without alienating new players.

You could also take a less direct approach and invest in the booming smartphone and tablet PC markets. The mobile industry's growth potential absolutely dwarfs even the rosiest outlooks for companies like Zynga. If you'd like to learn more and find out about three companies quietly cashing in, then check out our special report, "3 Hidden Winners of the iPhone, iPad, and Android Revolution." The report is completely free, so access it today.

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