Zynga — 3 Pros, 3 Cons

This IPO will be red-hot

   

When Mark Pincus founded Zynga in 2007, his mission was to connect the world through games.  He thought it would become a significant activity on the Web.

It turned out to be a huge idea – and his team has executed extraordinarily well.  Zynga is now the dominant player in social games.  In its short history, the company has generated $1.5 billion in bookings with franchises like CityVille, FarmVille, Mafia Wars, Words with Friends and Zynga Poker.  The company also generates substantial net income and cash flows. 

In fact, more than 90% of revenue comes from selling digital items.  These include castles, animals, farm equipment and so on.  It’s a tantalizing business model.

Despite all the success, there are certainly some issues as the company intends to go public after filing for an IPO last week.

To get a full picture of things, let’s take a look at the pros and cons:

Pros

Unique business.  Zynga’s games leverage the power of social networks, like Facebook.  This allows friends and family to play games, which creates high levels of engagement. And since Zynga creates high-quality games, its users often encourage others to play them.  The result is that most players come from unpaid channels. 

As a result, with large audiences, Zynga is in an enviable position to cross-promote new games.  For example, within the first 50 days of the launch of CityVille, it attracted 61 million monthly average users. 

Analytics.  Every day, Zynga’s players generate more than 15 terabytes of game data — this is incredibly valuable.  Zynga mines the data to help create new features and enhance the player experience.  It has also been extremely helpful in generating more demand for virtual items.

Stellar team.  Zynga’s board is a who’s-who of the world’s best managers.  Some of the board members include William “Bing” Gordon, who is the co-founder of Electronic Arts (Nasdaq:ERTS); Reid Hoffman, the co-founder of LinkedIn (NYSE:LNKD); and Jeffrey Katzenberg, who is one of the masterminds behind DreamWorks (NASDAQ:DWA).

Cons

Dependence.  Zynga gets “substantially all” of its revenue from Facebook.  In fact, it has been a testy relationship.  Yet Facebook has not been afraid to use its negotiating power.  Keep in mind that Zynga is required to use the Facebook Credits payments system, which takes a 30% cut of the gross revenue.

Interestingly enough, Zynga is also highly dependent on a small number of users who pay for virtual goods.  In some cases, players will spend more than $1,000 a month on such things.

Hits business.  So far, Zynga has had a hot hand when it comes to creating popular titles.  However, the social gaming space is still nascent and there may come a time when the company will lose its Midas touch.  Consider that most of Zynga’s revenue comes from two to three popular games at any given time.

Slowdown.  During the past year, the number of daily active users fell from 67 million 62 million – and it fell as low as 48 million in the fourth quarter.

Why?  It’s tough to say.  One reason may be Facebook, which has tightened its requirements on user acquisition. 

Verdict

According to IDC, the worldwide video game software market is about $50 billion.  It does seem reasonable that a growing chunk of this will move to social games – as well as mobile.

In light of Zynga’s strong platform, it should continue to benefit from this trend for at least the next several years.  The estimate is that revenues will hit about $1.4 billion to $1.5 billion in 2011.

Given the strong receptions of other Internet IPOs – such as LinkedIn, HomeAway (Nasdaq:AWAY) and Yandex (Nasdaq:YNDX) – it seems all but inevitable that the Zynga offering will be red-hot.  The pros outweigh the cons on this soon-to-be-public company.

Tom Taulli’s latest book is “All About Short Selling” and he has an upcoming book called “All About Commodities.”  You can find him at Twitter account @ttaulli.  He does not own a position in any of the stocks named here.


Article printed from InvestorPlace Media, http://investorplace.com/ipo-playbook/zynga-3-pros-3-cons/.

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