Sunday, January 1, 2012

What Went Wrong for Investors of Zynga, Demand and Pandora

One defining question of 2011’s Tech IPO market was whether Wall Street had the appetite to invest in companies whose financial success is wholly contingent on the collaboration of another, existing business. This question applied to Demand Media whose eHow website depends on Google for survival, Zynga whose games are literally built on top of Facebook’s API and Pandora who is at the mercy of the record label business. 

corporate piggy-backing
It wasn’t the first time investors had to ponder this issue. For instance, back when Netflix was getting started investors had to consider its dependency on the US Postal Service. It paid off well for early investors in Netflix; the DVD by the mail business crushed the brick and mortar model of Blockbuster and Hollywood Video. Still, when one company piggy-backs on top of another, there is inherent risk. Netflix’s dependency on the US Postal Service meant it had to contend with rising rates of postage, cutbacks in service, even theft that’s attributed to the old “lost in the mail” excuse. 

Despite Netflix’s recent woes, investors largely shrugged off its early reliance on the postal service. Yet, when it comes to Demand, Zynga and Pandora who are similarly dependant on another business, investors have not been so forgiving. 

Demand lost 60% of its value in 2011, Pandora was down 37.5% and Zynga was off by 5%. 

So what gives? Demand, Pandora and Zynga are all enjoying considerable growth, why do investors have a double standard?

Consider the three defining characteristics of how the USPS views its relationship with Netflix:
  • Shared Interest:  The more subscribers Netflix gets, the more it benefits the USPS.  The 12 million subscribers who use Netflix’s DVD by mail service translate into an estimated $600 million in postage every year. 
  • Non-Competitive:  USPS has zero interest in launching its own DVD by the mail business.  
  • Incremental Revenue: The revenue USPS sees from Netflix is all incremental. 

In summary, it’s clearly in the U.S. Postal Service’s interest to do business with Netflix.  Now apply those three rules to Zynga, Pandora and Demand’s relationship with its partner and you’ll see why investors have cause for concern.
Zynga - Facebook is one acquisition away from becoming a competitor, instead of a partner, in the social gaming arena.  Zynga already forks over 30% of revenue to Facebook who could further squeeze them if Zuckerberg decides to launch games. Investor’s Best Bet: Mobile.  Zynga can lessen its exposure to Facebook by building games for Android and iOS, like its popular “Words with Friends” app.
Pandora – In the wake of Sean Parker’s digital music revolution, the recording industry went from a $45B per year business into a $12B business. No surprise then, the music business is feeling less than generous - as evidenced by the hefty fees it charges Pandora on a per stream basis.  Those rates are set to rise by 37% in 2015.

For Pandora to even survive that steep increase, it needs to improve the efficacy of its mobile advertising capabilities so it can charge much higher rates. Investor’s Best Bet:  Lobbyists. Pandora can negotiate a better cost per stream rate by proving that the revenue the recording industry makes from streaming is not cannibalizing existing revenue streams like iTunes and terrestrial radio.  As was the case with Netflix, content providers warmed to the idea of streaming once they saw consumers did not “cut the cord” en masse.  However, Pandora seems to be taking aim at radio’s share of the pie.  The music streaming service is coming pre-loaded into cars made by GM, Ford, even some BMW models.   

Demand – Unlike most websites that depend on advertising, eHow is not a “destination site” that consumers check daily.  The only way you land on eHow is through search. eHow has smartly partnered with Google on its new YouTube channel, so that the search behemoth has a vested interest in the success of the eHow brand.  Yet, Google still has no vested interest in driving traffic to the eHow site, which is critical to Demand’s business. Investors’ Best Bet: eHow’s Relaunch.  eHow, which became synonymous with the term content farm, is attempting to become more of a destination site. If it can lessen its dependency on Google by giving viewers a reason to visit the site more regularly, investors will reward. 

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  1. It is very hard for wall street to invest in companies whose financial success is wholly contingent on the collaboration of another, existing business. For Zynga investors, competition is tighter than ever in Facebook.

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