Despite the ongoing debt crisis in Europe, more initial public offerings (IPOs) are expected to price this week than in any other week in the last nine months.
If there’s one deal garnering the most attention, it’s social gaming juggernaut, Zynga (Proposed Ticker: ZNGA). Is it deserved, though? I wanted to find out, so I took the time to dissect the company’s 202-page IPO prospectus, instead of just relying on the hyped-up headlines and blindly jumping in. Here’s what I discovered…
On the Plus Side
For those unfamiliar with the company, Zynga is the world’s leading social game developer with 227 million average monthly active users in 175 countries. It’s behind the popular social games like CityVille, FarmVille, Mafia Wars and Words with Friends.
All of its games are free. The way the company makes money is by selling virtual goods – like houses, poker chips and other items for use in its games – and to a much lesser extent, via in-game advertisements.
On the plus side, the company does possess several hallmarks of a hot IPO… It’s growing rapidly. Sales zoomed from $19 million in 2008 to almost $600 million last year. It’s reinvesting the IPO proceeds back into the company to fund even more growth. Insiders are retaining a meaningful stake – about 30% post-IPO. And the company’s already profitable, which isn’t something many IPOs can claim. But that’s where the good news stops.
On the Negative Side
There are seven potential problems with Zynga’s business model, in my opinion:
1. Too Young: Typically, the older and more established a company is when it goes public, the better the stock tends to perform. But Zynga’s a youngling. It was only founded in 2007, which makes it about the same age as many companies that went public during the dot-com boom. If you don’t recall, most of those young companies ultimately crashed and burned. If social gaming proves to be just a fad, watch out below!
2. Too Friendly With Facebook: Over 90% of Zynga’s sales are generated from Facebook. I’d say that qualifies as overreliance on a single partner. And it’s not about to change anytime soon, either.
As the prospectus states, “We expect to continue to derive a substantial portion of our revenue and to acquire a substantial portion of our players from the Facebook platform for the foreseeable future.” Such a setup leaves Zynga with virtually no bargaining power when its addendum with Facebook – the one that specifies that Zynga gets 70% of the face value of Facebook credits purchased by its players – expires in 2015. It’s not hard to imagine Facebook playing hardball and demanding a slightly bigger cut than 30%. Even a few percentage points would dramatically alter Zynga’s revenue and profitability.
3. Whale Chasing: Despite an average of 227 million active players each month, Zynga only makes money off about 3% of them. Finding and retaining “whales” becomes harder and more expensive as a business matures.
4. Hit Me With Your Best Game (Again): Zynga earns the bulk of its revenue from a handful of games. In fact, the company’s top three games accounted for 93%, 83% and 78% of online game revenue in 2008, 2009 and 2010. In other words, it’s a hit-driven business. If Zynga doesn’t keep the hit games coming, its sales are destined to fall off precipitously.
5. Public in Namesake Only: Zynga is going public with split share classes, which isn’t uncommon. Visa (NYSE: V) and LinkedIn (NYSE:LNKD) are two other companies with split share classes. The difference here is that Zynga’s CEO, Marc Pincus, is going to retain an inordinate amount of control.
His class C shares carry 70 times more voting power than regular A shares, compared to a 10-1 ratio for LinkedIn. So although he’ll only own a 12% equity stake in the company post-IPO, he’ll control 37% of the voting power. So much control is great for shareholders if Pincus is a visionary like the late Steve Jobs, who kept finding ways to increase sales and profits. Not so much if he doesn’t deliver.
6. Overzealous Management: In addition to having too much control, Pincus is also too enthusiastic. He’s reportedly telling investors in roadshow presentations that the company is working on its biggest-ever pipeline of online games.
Silly rabbit. Doesn’t he know that overhyping your growth potential, especially before actually going public is a recipe for a falling stock price? You’re supposed to under promise and over deliver on Wall Street.Groupon’s (Nasdaq: GRPN) CEO learned this the hard way. Zynga’s CEO could be next in line.
7. Valuation: Zynga plans to sell about 100 million shares for $8.50 to $10 each, which would value the company at about $7 billion or roughly 6.8 times sales. That’s more than triple the valuation of game maker,Electronic Arts (Nasdaq: ERTS), according to Bloomberg. Such a premium valuation leaves little room for error. Much like Groupon, any missteps could be met with a rapidly declining share price.
Bottom line: I’ve previously evaluated – and warned you about – the prospects for other seemingly “sure-thing” IPOs, including Zipcar (Nasdaq: ZIP) and Groupon. And it’s time to add Zynga to my “Not So Hot” IPO list.
Shares are expected to begin trading this Friday. I won’t be lining up at the open with other investors for a piece of this IPO. I hope you don’t, either.
COMMENTARY: I agree with Lou Basenese's assessment of the Zynga IPO, and I wish to add a few pluses and negatives myself:
PLUSES:
- Zynga had 10 game titles in Top 25 Facebook Games by Monthly Active Users for December 2011, compared to 8 games titles in the Top 25 in December 2010.
- Zynga's new game CastleVille, released in November 2011, was the biggest gainer ranking No.5 with 20.8 million monthlly active users, and No 2 with 7.3 million daily active users. CastleVille is Zynga’s latest and so far fastest-growing game ever on Facebook. The new game help offset losses in both daily active users and monthly active users in Zynga's other games.
NEGATIVES:
- Zynga's older games are definitely suffering from player fatigue when compared by monthly active users between December 2011 versus December 2010.
- Farmville - December 2011 (30.9 mil) versus December 2010 (53.7 mil).
- Texas Holdem Poker - December 2011 (29.6 mil) versus December 2010 (34.7 mil).
- Frontierville - December 2011 (Not ranked) versus December 2010 (29.3 mil)
- Mafia Wars 2 - December 2011 (11,3 mil) versus December 2010 (20.0 mil - Mafia Wars 1)
- CafeWorld - December 2011 (6.5 mil) versus December 2010 (16.9 mil)
- Zynga’s Mafia Wars 2 technically suffered the “biggest loss” of Daily Active Users between November and December 2011 as it dropped out of the Top 25 list in December 2011. On November 1, it would’ve been in the top 10 in terms of DAU.
- 7 out of 10 games Zynga games in the Top 25 list suffered a drop in total Monthly Active Users between November and December 2011.
MONTHLY ACTIVE USERS
December 2011
December 2010
Zynga is definitely a hit-driven business, but it has so far has been able to deliver the goods. The biggest problem that Zynga has is its reliance on Facebook for customers, and having to pay Facebook 30% of all virtual goods sales for the previlege. Mark Pincus is no dummy and he plans to breakaway from Facebook sooner, rather than later, to pocket that 30% and improve its bottomline, something that has been severely hit by the present arrangement.
Zynga must also find ways to increase advertising revenues (now only 5% of total revenues). The explosive growth in mobile devices should help increase ad revenues. Fortunately, they get to keep all the revenues from the advertising.
There is always gonig to be investor exhuberance and a whole lot of hype with startups like Zynga. Although they are a young company, they have delivered hits and consistent revenue growth, and the company has really benefited greatly from the full "Facebook Halo Effect" due to their unique tie with Facebook, which is in the midst of planning its own IPO in 2012.
Like Facebook, Zynga faces the prospects of losing some key executives and staffers after the IPO, when those employees can finally cashin their fully-vested shares. How this will affect the company's ability to create hit games remains to be seen.
Courtesy of an article dated December 14, 2011 appearing in Seeking Alpha
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