Shares of social gaming company Zynga (ZNGA) are up better than 45% over the last ten days, piggybacking on the hype surrounding the Facebook (FB) IPO. While some of the gains can be written-off to the rampant speculation in shares of anything that may have even a distant connection to Facebook, the 20% rise in Zynga's shares on February 2nd most likely occurred for one very specific reason. Investors learned, via Facebook's S-1 filing, that Zuckerberg's social networking giant derives 12% of its total revenue from the fees it collects from Zynga. Everyone knew Zynga relied upon Facebook for virtually all of its revenue, but few people suspected Facebook depended so heavily upon Zynga.
So why should this matter for Zynga's shares? Presumably, the fact that Facebook depends on Zynga for a substantial portion of its revenue means that Zynga's relationship with Facebook will remain amiable for the foreseeable future, or at least until Facebook's revenues grow enough to make the amount of money it gets from Zynga a smaller percentage of the total. In other words, Facebook likely has little choice but to continue its relationship with Zynga for now-- which means Zynga gets to stay in business. If Facebook stopped hosting Zynga's games, Zynga would not survive.
In light of this, buyers of Zynga's shares must ask themselves an important question: is it wise to buy simply because the company might stay in business for another year or two? Zynga investors would be wise to recall that outside of its relationship with Facebook, there is absolutely nothing to like about the company. Zynga's operating margin is 28%, well below the 40% many analysts have pegged as desirable. By comparison, "Activision Blizzard has a 50% operating margin with...World of Warcraft," according to Reuters.
The company is very unfriendly towards shareholders as it repeatedly insists it will prize innovation over earnings (read: it will value make-believe farm animals over profits) and it recently asked several employees deemed 'not valuable enough' to return their shares or risk being fired. This is in addition to the fact that CEO Mark Pincus owns a (very) special class of shares, which carry 70 times the voting power of shares sold to the public. So, as a shareholder, your opinion is exactly one seventieth as important as Pincus's.
But these concerns aren't what will sink Zynga. The real concern is that less than 3% of Zynga's users are paying customers. In the long-run, that is just not sustainable. Put options are available for Zynga as far out as September, and they got a whole lot cheaper over the last few days thanks to the rally in Zynga's shares. I would look to buy the September puts with slightly out-of-the-money strikes. There are no fundamentals to back the rally in Zynga's shares-- and once the Facebook hype dies down, so too will the demand for shares of Zynga.
As a final note, It would be worth rolling-out any bearish position you do take on Zynga as more monthly contracts become available. Once the market gets a look at a few quarterly reports from Facebook, I'm willing to bet they show a declining percentage of revenue derived from Zynga's games. Zuckerberg is too savvy to keep Facebook inextricably linked to a company that sells virtual farm animals to virtually no one.