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Zynga's Losing Bet to Not Pursue Gambling

NEW YORK ( TheStreet) -- Zynga (ZNGA - Get Report) actually managed to beat Wall Street estimates for its second-quarter but its stock tumbled Friday as the company announced it would no longer focus on online gambling in the U.S. That's one bet that Zynga is sure to lose.

Zynga, through its many social games, has built up a community of gamers, though ever shrinking, totaled 39 million daily active users at the end of the quarter, a drop of 45% year-over-year. With just 39 million users and shrinking, the company didn't have much going for it but Zynga Poker, its poker game, was viewed by investors as key to a turnaround.

Shares of Zynga plunged 14% on Friday to $3.01.

Online gambling has been legalized in Las Vegas and Atlantic City though it's still illegal on a federal level. Many bulls were expecting that the company would partner with a casino once the federal government approves online gambling (it almost certainly seems like it will though the timetable remains unclear), given that the company had talked up the prospect so heavily in the past.

As recently as late 2012, Zynga had filed for an application to the Nevada Gaming Control Board.

Cowen analyst Doug Creutz, who rates shares "Market Perform," notes that the decision to jettison online gambling in the U.S. removes a large portion of the "bull thesis" surrounding the stock. "Management indicated that while they will continue the real-money gaming trial they have going in the U.K., at this point they have no plans to pursue a license in the U.S," Creutz wrote in the note. "We think this is probably a wise move, focusing on business verticals they actually have experience in; however, it removes what we think was a substantial part of the bull-hope thesis on shares."

ZNGA Chart ZNGA data by YCharts

It's quite puzzling that the company is going to keep its focus on real money gaming in the U.K., but not in the U.S., where it's arguably more well known. Yes, gaming laws are different in the U.S. than they are in the U.K., (Zynga currently partners with Bwin in the U.K.), but it's not a large distraction for a company that has struggled recently to produce social-gaming blockbusters. King's Candy Crush is now the most popular game on Facebook (FB - Get Report), and was even mentioned on Facebook's earnings call with CEO Mark Zuckerberg.

Credit Suisse analyst Stephen Ju, who rates shares "underperform," noted that Zynga's decision not to enter the U.S. gambling market would "sharpen management focus on what matters most - good content creation." With new CEO Don Mattrick saying he needs the next 90 days to craft a game plan amid volatility over the next two-to-four quarters, the decision to move away from something that seems like a sure thing is a curious one.

If Zynga is going to focus on creating better content, why not be able to leverage that content as many ways as possible? It just doesn't make sense.

You could argue that this might be the right cause of action if Zynga actually had hit content to show. That's not the case, however. Despite the fact Zynga actually beat Wall Street estimates for the second quarter, generating a loss of 1 cent per share on $230.7 million in revenue, versus an estimated loss of 4 cents on $219.2 million in sales, guidance was putrid.

Zynga gave forward bookings guidance between $125 million and $150 million, way below the $193 million analysts were expecting. The company continues to cut expenses, but if there are further layoffs ahead for the company, as it tries to preserve its $1.5 billion in cash on its balance sheet, then it's not clear where this content is going to come from.

It's clear that Zynga is facing an uphill battle, as it tries to regain the confidence of investors and users alike. BMO Capital Markets Edward S. Williams believes that Mattrick, unlike former CEO Mark Pincus, will be able to restore confidence and drive a turnaround. "In our view, Zynga faces an uphill battle to regain its footing as its player base continues to erode dramatically. However, we believe the company's new CEO, Don Mattrick, will be able to help drive a turnaround at Zynga by harnessing the company's development talent and analytics capabilities toward its best opportunities, particularly on mobile."

Dropping real money gambling in the U.S. is not the way to go about helping drive a turnaround at a company that is struggling to regain confidence. Sure, the company has a stellar balance sheet and some of the most coveted real estate in San Francisco, owning its stunning headquarters at 699 Eighth St. However, the value from its balance sheet and assets (roughly $1.90 per share) isn't enough to entice shareholders to give it more money to keep developing games that may or may not be a hit.

Gambling is a proven money maker, not only in the U.K., but around the world. It has been so for centuries. Without the possibility of gambling revenue, Zynga will have to depend on producing hit games for a fickle consumer that has jumped from games such as Farmville to Mafia Wars to Words With Friends to now, Candy Crush.

Without the backdrop of domestic gambling there to support it, that's a risky bet for Zynga. That's one bet that Zynga is more likely than not to "bust" on.

-- Written by Chris Ciaccia in New York

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