With the recent news of Zynga (ZNGA) soon to be trading on the block, much has to be said about 2011’s attack of the Internet IPOs. From Linked In’s (LNKD) offering in May to the debut of Groupon (GRPN) and Angie’s List (ANGI) last month, the online social media onslaught has been in full effect. While the recent IPO run has been quite the roller-coaster ride for both bulls and bears alike, investors should be extra weary and tread carefully before buying into the Zynga hype.
Zynga is a social network game developer that publishes free online games accessible to hundreds of millions worldwide. It generates revenue by selling virtual items to be used in the games. As of the close of the first quarter 2011, the company boasted of having 236 million active monthly users (coined “MAUs”) and 62 million daily active users (“DAUs”). Unlike the Internet IPOs that have preceded it, Zynga has recorded net profits for fiscal year 2010 through the first quarter of 2011, $90.5 million and $11.8 million respectively.
According to their SEC S-1 filing, Zynga plans to sell a little over 11% of its diluted shares, or 100 million shares, between $8.50 and $10.00 each. Using a midpoint range of $9.25, Zynga is valuating itself at around 9 billion dollars, quite the hefty price tag. The IPO offering would be the largest by an Internet company since the behemoth Google (GOOG) raised $1.7 billion in 2004. While the company sports an impeccable reputation among its users and a history of actually turning a profit, there are significant pitfalls that lie in the wake.
Only one will be mentioned in this article and that one may be enough to cause serious concern – Facebook. Facebook is no doubt Zynga’s closest ally. Facebook is the primary, if not the exclusive, platform for which users play Zynga games. Through this platform, Facebook also shares critical personal user data with Zynga. Zynga in turns processes, stores, and uses this valuable information to target potential new users within the social network.
Financially, more than 93% of Zynga’s gross revenues come from Facebook. While the games are free, players purchase virtual items from Zynga to enhance their gaming experience. However, to do so, the players must use a form of virtual currency called “Facebook credits.” Facebook keeps 30% of this revenue and delivers the remaining 70% to Zynga.
Without doubt, Zynga would not be where it is today without Facebook. But for those very same reasons, Facebook may soon become Zynga’s worst enemy. In it’s S-1 filing with the SEC, Zynga admits that one of the risks associated with its business is if it is “unable to maintain a good relationship with Facebook.” That is quite the understatement. Facebook controls the platform that nearly all gaming occurs on, the provision of users and information required to expand the business, and the payment scheme to which Zynga is able to stay afloat.
Facebook also has broad discretion to change the terms of service with Zynga at any time. It can terminate any and all contracts in place or change the terms thereof. An example of such occurred in 2010, when Facebook initiated a proprietary policy requiring all applications on its network to accept only its virtual currency, Facebook Credits, as payments from its users. By doing so, Zynga’s profits took a sizeable hit, because it now had to share a much greater percentage (30%) of its proceeds with Facebook than before.
Another example of Facebook’s influence on Zynga occurred in the early part of 2010. Facebook instituted a number of policy changes for application developers like Zynga that inhibited communication channels among users. Zynga noted that because user interaction was integral to the games they offered, the number of users on Facebook declined.
Zynga’s only defense to Facebook’s enormous influence would be to divorce itself from the Facebook platform. While Zynga has planned to create an alternative gaming platform dubbed “Project Z,” it is restricted under a five-year contract from releasing any game integrated with Facebook on another platform. Zynga generates the vast majority of its income on just a handful of games, all of which are played on the Facebook platform.
In summary, Facebook has Zynga by its jugular. It could single handedly put Zynga out of business by altering or discontinuing access to its platform. Before you say that is extreme or unlikely, consider this. It is pretty much a given that Facebook will inevitably come out with an IPO sometime in 2012. Zynga admits that there is very little to no barrier to competition in the online gaming sphere.
If it willed, Facebook could use the new funding raised to develop its own gaming system on its platform and exclude Zynga completely. Or if it decided not to take that route, they could just as easily enter a more financially equitable relationship with a Zynga competitor.
Ultimately, the question becomes what is the more prudent investment: buying shares in a Zynga IPO or a Facebook IPO? The latter seems to be the safer and sure-fire bet.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.