What To Expect From Zynga

| About: Zynga (ZNGA)
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Zynga (ZYNG) is now expected to have its IPO after Thanksgiving due to recent stock market volatility. The company is expected to raise about $1 billion, floating between 5 and 7 percent of the business. If you do the math, this would value the company at $15 to $20 billion which is right around where the market currently values Groupon (NASDAQ:GRPN). In this article, I explain why Zynga's valuation is more justifiable despite it posing a high risk for future shareholders.

The one upside that Zynga brings that LinkedIn (LNKD), Pandora (NYSE:P), and Groupon can't offer is that the company is actually profitable. Zynga reported $90 million in profits in 2010 and grew YOY profits in Q1 of 2011 by 84 percent. It's incredibly hard to value a company with this kind of growth because companies like Zynga haven't been floating around in the open market for decades on end. Valuing Zynga at $15 to $20 billion pins a P/E ratio of about 195 using 2010's earnings and a P/E ratio of 105 assuming 84 percent growth in 2011. When comparing these multiples to Amazon (NASDAQ:AMZN) and salesforce.com (NYSE:CRM), this is a bargain for such a high growth company.

The downside to Zynga is that the video game industry as a whole is not profitable. Pricing Zynga between $15 and $20 billion would make it more valuable than Electronic Arts (ERTS), Take-Two Interactive (NASDAQ:TTWO), THQ (THQI), and Konami (NYSE:KNM) combined. All of these competitors have better technology and higher quality games than Zynga as well as a lot more experience in the industry. Electronic gaming is a very difficult industry to profit in since the consoles control the supply chain and there is such intense competition. Zynga will face similar challenges to these video game developers as Facebook will ultimately control Zynga's fate. Only $13 million of $235.4 million of Zynga's first quarter revenue was derived from online advertising and $222.4 million came from online gaming revenue. If Facebook decides to up its cut of Facebook credit revenue from 30 percent to 50 percent, Zynga stock can drop by 80 percent overnight.

The most surprising aspect of Zynga is that the company offers very basic games in an almost perfectly competitive marketplace, yet the company produces four of the top five games on Facebook and many top games in the App Store and the Droid Market. Despite having a potentially overpriced stock, Zynga deserves a lot of credit for having such a large presence in an industry that didn't exist 10 years ago. Zynga is the first of the new age tech stocks where I can see actual value. The database and networking technology behind their games is actually quite innovative and I expect the company to continue its rapid growth in the near future. Since the IPO is going to have such a small float like Groupon and there is still very high demand for these new age tech stocks, I wouldn't be surprised if Zynga has a similarly successful IPO. The main attribute of Zynga that will keep me away from the stock is how dependent the company is on its distribution channels and how major video game companies can start moving in on Zynga's territory if the company starts getting very profitable. Windows wasn't the first operating system and Google wasn't the first search engine, yet they still put the first movers out of business. The risk of Zynga becoming a name of the past will be prevalent until the company can become big enough to become a tech leader in and of itself.

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