Considering the Zynga IPO

Brittney Barrett |

After a fall season that saw the number of IPOs dip well beneath expectations, the hunger for initial public offerings from buzzed-about tech outfits has returned. The latest firm entering the spotlight is the social game maker Zynga Inc., which makes the wildly popular FarmVille and CityVille, which have become favorites on Facebook.

Beyond their successful forays on facebook, Zynga has announced a number of new online contests, in addition to their plans to develop their own gaming platforms for use on both the web and mobile platforms. While expansion always sounds like a good thing, the impetus for the greater growth and independence is an integral part of the Zynga story and may influence whether or not investors snap up shares.

While Zynga, thanks to the prevalence and addictive nature of their offerings, has been the most lucrative of all similar outfits on facebook; its reliance on the platform presents a major impediment for its initial public offering.  Facebook generates the large majority of Zynga’s traffic and the introduction of new and stringent rules, the requirement to use Facebook’s universal currency within all games, for instance, has negatively impacted profit generation. Facebook’s policy requires that Zynga forfeit 30 percent of all payments made over to the platform. As a result, with roughly 150 million users per month, Zynga’s revenue reached$306.8 million for the quarter that ended Sept 30, from $170.7 in the year ago period, while net income declined by 54 percent to $12.5 million. Profit slipped an immense 90 percent to $1.4 million.

This negative trajectory is largely the result of the company’s increased focus on improving its offerings and the fees incurred by facebook. The intense focus, aggressive development and growth spending devoted to expanding their offerings, which now consist of MafiaWars, FarmVille and CityVille, also raises another question: when will Zynga release another hit that will help compensate for the rising costs and ward off the number of approaching competitors?

The latter is especially a cause for concern as the IPO approaches, as Electronic Arts (ERTS) recently acquired PopCap Games, the makers of Planets Vs Zombies and BeJeweled, in an effort to invade the current space occupied by Zynga. Zynga had wanted to buy PopCaps itself, perhaps recognizing that its own social games might become stale or at least wanting to prevent, EA, which is coming up on its heels, from acquiring the company. Electronic Arts has already launched Sims Social on Facebook, which has become the second most popular game on the social network behind CityVille. Sims' already has 8 million daily active users and 40 million monthly users, threatening to bite into Zynga’s market share.

Beyond Sims', the company said that it has a competitive advantage over Zynga as a result of the strength of many of its console brands, like Battlefield and Need for Speed. Should the company take these and other popular names, like Madden, into the social media space, it could continue to detract from Zynga’s relevance. Zynga’s latest introduction CastleVille, will have to make a big splash if the company can be expected to compete with the wealthier EA, which has set a $3 billion revenue target for its online offerings.

The potential triumphs of the EA titles represent an active threat for Zynga long-term, but it’s unlikely to impact the initial strength of the company’s IPO. The eagerness for investors to involve themselves in social media and tech IPOs is well documented. The strength of Groupon’s (GRPN) IPO in spite of the intense criticism for its failure to produce profits, demonstrates this. Groupon, even in light of harsh market views, has added 31 percent growth in a week-long period. Investors are bullish in this sector, perhaps blindly, as we’ve seen with the sky-high valuations, so Zynga will most certainly climb in the near-term. Investors should keep a close eye on the stock's price and the developments among competitors if they want to exit shares richer than they came in.

The Zynga IPO is also scheduled for around Thanksgiving, having been delayed as a result of the massive market volatility. Given that EA is not expected to debut their popular console games onto the social media space between now and the 25th, investors may not concern themselves with how their release will impact Zynga’s userbase initially. If EA continues not only its aggressive strategy but its open and vocal assault on the company, investors will soon become aware and may choose to exit at highs.

The Thanksgiving date is also critical in that it relieves Zynga of the pressure to prove its success in diversifying delivery methods outside of Facebook. Investors have expressed concern with the company's dependence on facebook, but they seem placated by Zynga's recognition of the problem and the company's plan to address it via Zynga Direct.  The long-term importance to Zynga of expanding onto its own platform is critical to growing its user base and staying relevant in the face of new games planned for the social media space. It's difficult to determine how they will fare in their attempts to expand their user base outside of the platform when Facebook members are presented with a bevy of new options from other gaming companies within the confines of a familiar and convenient platform.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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