Facebook Points To Strong Zynga EPS

| About: Zynga (ZNGA)

The rumors about Facebook's IPO registration got my attention a few weeks ago, but not in the same way most took to the big news. You see, I was contemplating an analysis of Zynga (NASDAQ: ZNGA) for publishing, and so I was aware of the fact that Zynga would be reporting earnings just two weeks later. Nobody had put the two events together, but I expect they may in fact be linked. You see, a strong earnings report from Zynga would serve Facebook's IPO momentum well, though Facebook (NYSE: FB) does not really need any help.

Still, considering that the two companies have a lot in common, perhaps including investment bankers, I had a feeling a short-term prospective long bet on the odds of a positive Zynga report had a good chance of paying off. Now, I realize this is going to be hard to believe, and I do apologize for not publishing my views earlier despite my start of this report two weeks ago. However, I'm still looking for a strong EPS report from Zynga today (February 14). Given the shares' steep incline since Facebook's registration, a lot of those gains have already been captured though, so the report has a higher bar to surmount.

Zynga's stock action since the announcement seems to confirm that something is afoot, except for the important fact that other relative internet plays also saw significant lift on the Facebook registration rumor and reality. For instance, Renren (NASDAQ: RENN) was up 26% on the Friday of the first news break on potential registration, and another 20% the following Monday. Quepasa (NASDAQ: QPSA) soared 33% that Friday. LinkedIn (NASDAQ: LNKD gained 5.9% that Friday, but gave back some ground soon after.

Groupon (NASDAQ: GRPN) gained 2.6% on the day of the first rumor, but shed 2% on the following Monday. Zynga almost immediately moved higher on the Friday of the Facebook rumor and closed 5.6% up on the day. ZNGA was up another 3.4% on the Monday that followed. After some of the numbers became public regarding the strength and interdependence of the two companies through Facebook's S-1 filing, Zynga found fuel to keep climbing and has accumulated an approximate 42% gain now since January 26.

Despite the group movement, Renren seems to have followed Zynga's lead before speculatively soaring further. I point this possibility out as a clue to perhaps Zynga's gaining on more tangible information or fact-based speculation. The internet plays generally gained on investor bets that similar plays might find better valuation in sympathy. In truth, it is Facebook's superior operation that demands a better valuation; the others only gain on the opportunity they could someday exploit. Zynga, however, has a direct tie with Facebook, and so has benefited from the information that has become available and better understood through Facebook's release.

Zynga shares have obviously already taken some of the ground they might score on a good earnings report. Still, there could be more gained by the shares when the company reports earnings, should it produce a positive surprise of enough significance. This will be the company's first earnings report, though we have the data for previous quarters in its S-1 filing. I expect Zynga's management team has set its earnings bar low, guiding the consensus of analysts' estimates to a beatable level. The actual earnings report and conference call is set for today, perfect for the romancing of its business partner. Given that Facebook has its IPO schedule set now, it could have a strong report from Zynga to benefit from, if it needed it. Clearly it does not.

Zynga, of course, is integrally tied to Facebook, as its 'Risk Factors' within the company's own SEC filings indicate. For this reason, I have concerns about the growth prospects of the company over the five-to-10-years forward. While it should benefit from its brands' expansion into other mediums outside of Facebook, and it is desperately seeking to spread its risk beyond the social media behemoth, it should find tougher competition within Facebook as well, as seasoned game-makers like Electronic Arts (NASDAQ: EA) and others gear up to compete on the new and rich playing field.

ZNGA's valuation was already looking lofty before the latest gains, and so when comparing the current price of $13.60 to the existing estimates, which are likely understated, the stock looks expensive. With a P/E ratio of 62x the 2012 consensus estimate for $0.22, based on data at Yahoo Finance, it compares to Electronic Arts' P/E of 15x its FY 2012 (Mar.) consensus estimate. Activision Blizzard (NASDAQ: ATVI) trades at 12.7X its FY 2012 (Dec.) consensus estimate. One has to wonder if perhaps the valuation gap might narrow here, with Electronic Arts gaining on opening market opportunities for the top game-makers. Note that Electronic Arts' gaining might not cost ZNGA's price, while its valuation may close toward the industry; that's due to the growth opportunity that continues through its rich distribution channel at Facebook.

However, keep in mind that ZNGA's estimates are likely going to be revised upward after its earnings release this evening, in my view. In fact, just over the last 30 days and likely driven by information and speculation tied to Facebook's release, Zynga's consensus estimate for 2012 improved 22%, rising from $0.18 to $0.22. Again, according to data at Yahoo, analysts have ZNGA's long-term growth projected at 24%. The relative PEG ratio based on those two probably low estimates is upward of 2.5, a point most investors would shy from. Again, I expect both the numerator and denominator of that PEG ratio will improve on the earnings release. This would give the stock-gains scored of late some justification.

What I will want to hear from the company on its earnings day is how well its expansion is going outside of Facebook, and what new revenue streams it is developing tied to Facebook. I would hope it is not sitting idle, and is instead making tangible inroads to expand opportunities. Zynga has an amazing channel to exploit within Facebook, where creative new revenue streams can amount to significant wins. Therefore, I expect its shares should continue to benefit short-term. However, its long-term outlook of five-to-10-years forward will depend greatly on operational strategy and savvy, and how successfully established game-makers break into the social media arena. So, despite the latest short-term gains, I would "hold" ZNGA heading into the release. I apologize again to investors for not publishing this report two weeks ago when it was begun.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.