Will Zynga be the next IPO winner?

Groupon could be a tough act to follow.

By Motley Fool Pick of the Day Nov 8, 2011 5:02PM

By Tim Beyers

 

Shares of Groupon (GRPN) are already up more than 30% from the IPO price of $20 apiece. Will Zynga, which is valued at just under $11 billion (according to data from private-equity exchange SharesPost), enjoy a similar pop when it comes public before the end of the year?

 

How to get paid for publicity
My guess is yes, but only because IPO engineering is the new "it" strategy for companies coming public. The game is simple. Limit the amount of shares available -- as Groupon, LinkedIn, and Zillow all did -- and you guarantee a significant pop on the first day of trading.

 

Will Zynga follow a similar strategy? I think so. Per its own filings, the company sees an IPO as a PR event. What better way to build buzz than by engineering a massive initial spike in the stock price?

 

After all, Zynga doesn't need the money. According to the latest S-1 filing, the company had more than $926 million in cash and zero debt as of Sept. 30. Impressive, right? Sure, but there may also be more to this story.

 

Checking on the cash flow data shows that cash from operations fell 16% year over year in the first nine months of 2011. Meanwhile, capital expenditures quintupled in the June quarter, suggesting that Zynga still needs plenty of investment in order to capitalize on the opportunity ahead of it.

 

After all, Zynga is largely beholden to Facebook now. Any attempt to build on alternatives such as Google's (GOOG) Google+ network or its own sites could dramatically increase the capital needs of the underlying business. CEO Mark Pincus may need a war chest in order to reduce his company's dependence on another Mark (i.e., Zuckerberg).

 

Stuck for stickiness
Pincus may also be raising funds to hire developers to build new games, since his company's newest, Adventure World, hasn't caught on. Researcher AppData shows a 1.7 million-user decline in daily average users of the game over the past seven days. Empires & Allies, a recent success, has also suffered a modest decline in the days after Facebook adjusted the way it counts active users of social games.

 

At the same time, alternative games are rising. Electronic Arts' (ERTS) The Sims Social is now solidly in third place on the AppData leader board. The shift is notable in that, while Zynga's CityVille remains the top dog among games, The Sims Social has 7 million more monthly active users than FarmVille, the game that arguably put Zynga on the map even as it caused fits among Facebook users tired of seeing crop-related status updates from their friends.

 

To be fair, The Sims Social has also endured declines, which may say as much about the attention span of Facebook gamers as it does about the fortunes of Zynga. Either way, it's becoming clear that Pincus and his team face precisely the same problems as EA, Activision Blizzard (ATVI), and Take-Two Interactive (TTWO): The pressure to publish new winners is just as intense.

 

"In order to develop new games and enhance the content and features in our existing games, we must invest a significant amount of engineering and creative resources. These expenditures generally occur months in advance of the launch of a new game or the release of new content, and the resulting revenue may not equal or exceed our development costs," Zynga says on page 52 of its S-1 filing.

 

Why Zynga?
With so many similarities to other game companies, it's tempting to ask why Zynga should command a premium -- on SharesPost it trades for roughly 11 times its $1.02 billion in revenue produced over the trailing 12 months. By comparison, Activision Blizzard and Electronic Arts trade for 3.25 and 2.16 times sales, respectively. Take-Two commands just 1.26 times revenue.

 

Bulls will rightly point to outrageous growth. Revenue more than doubled in the June quarter and rose 79% in the third quarter. Yet even with that growth has come unpredictable profitability and substantial but not always sufficient cash flows.

 

As with Groupon, I've little doubt Zynga will be the next short-term IPO winner. I'm just not sure it should be. Do you agree? Disagree? Please weigh in using the comments box below.

 

Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Google at the time of publication. The Motley Fool owns shares of Activision Blizzard, Google, and Take-Two Interactive Software. The Fool owns shares of and has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Take-Two Interactive Software, Activision Blizzard, Zillow, and Google. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

 

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