Zynga's IPO: Myths and truths

Here's the skinny on the video game company as it prepares to go public.

By TheStreet Staff Jul 6, 2011 11:50AM

By Eric Jackson, TheStreet


A lot has been written about Zynga in the past week since it filed its S-1 last week, revealing more details about its financials and future IPO plans.


Overall, most folks in the press have described the company positively because it appears to be making money compared with Groupon.


The company does have a number of strengths, but the general view of the business press is badly misinformed because of a lack of familiarity with the gaming sector.


Here are some myths and truths about Zynga:


Myth: The company is cheap relative to Facebook and LinkedIn (LNKD).


Fact: Facebook and LinkedIn are going to be trading at 40 times their 2011 revenues this year, while Zynga is going to trade at "only" 20 times its revenue. Therefore, it's cheap. The reality is that there's a reason Zynga will trade at a discount: It's in a "hits" business, where your valuation is only as high as your last hit game.


Post continues below:

Myth: Its profitability in the future is assured.


Fact: Again and again in the IPO coverage, you get articles that refer to what Zynga did in net profits last year and in the first quarter of this year. The assumption is that you will see it continually build from there, that whatever its revenue and profit ramp has been so far, the trend will continue. These are the same basic math skills and unquestioned assumptions that caused us to drive the U.S. economy in a ditch because of housing.


Zynga is more vulnerable to a disruption in future profitability because it's a gaming company. Look at the quarterly earnings of any gaming company: it's lumpy over a three- to five-year period. Nobody's figured a way out of that one. And just because they sell their games on Facebook doesn't change the basic industry structure they operate in.


Myth: It is in a weak position because it relies on a few core gamers for most of its revenue and profit.


Fact: This was listed as one of its risk factors in its filing. (By the way, news flash to the media: All companies making filings with the SEC include risk factors. It's not a sign that the company is about to go belly up. Their lawyers write this section.) All gaming companies are in the same boat. Usually 80% to 90% of the users play the game for free. The real money is made off the small number of addicted users who play.

Myth: It holds a dominant position in gaming in North America.


Fact: Most American press mention few, if any, other U.S. gaming companies when discussing Zynga. If anything, they might refer to Electronic Arts (ERTS). The reality is that the U.S. gaming market is still small relative to Asia. There are dozens of gaming companies out there all looking for the hot new games and competing for the same technical talent to build those games. It's crazy to think that Zynga is dominant in the U.S. for gaming. It is a good strong company, but it will continue to have to build great games or it will fall behind. Zynga is raising IPO money now to have more resources so that it can keep going after talent.


Myth: Mark Pincus has used some nefarious techniques to grow the company to date.


Fact: Pincus has apparently OK'd techniques like signing people up to some service they didn't specifically request. Has anyone over here covered some of the practices some of the Chinese gaming company CEOs have used to build their businesses? Whatever Pincus has done, it's pretty modest by those standards.

Myth: Facebook might pull the plug on Zynga one day.


Fact: Theoretically Facebook could do this, but why would it? Facebook now is taking 30% of Zynga's profits (in a deal through 2015). Would it seek to raise its cut to 50% of Zynga's profits then arbitrarily? It might drive Zynga off the Facebook platform, which might be a better thing for Zynga shareholders in the long run, so why would Facebook do this? Again, this is a lawyer's risk factor that the media is getting too worked up about. Zynga hopes hiring Facebook's former number two (Owen Van Natta) will help with the ongoing discussions with Facebook.


At the time of publication, Jackson had no positions in the companies mentioned.


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