As Facebook IPOs, Are Zynga And Groupon Takeover Targets Or Also-Rans?

by: Dividend Kings

One of the most anticipated IPOs is on the way. Internet giant Facebook (NASDAQ:FB) filed its S-1 with the SEC for an IPO of class A shares this week. You would think that in the current conditions an IPO would not be attractive, but several new companies have made an IPO-- and headlines-- in the past month or so.

Zynga (NASDAQ:ZNGA) is one of interest. It was the hottest IPO of 2011, rivaling Google (NASDAQ:GOOG)-- but at an initial value around $925 million. This stock was seen as a proxy for Facebook and a gauge of the social media market. While the IPO got a lot of attention, to date, shares of Zynga have not performed as well as expected. Other big name IPOs from 2011 are also down from opening day. Online retailer Groupon (NASDAQ:GRPN) has been able to maintain itself around its IPO price near $25. The IPO market in 2011 had its ups as well. Global retailer Michael Kors (NYSE:KORS) has performed remarkably well in its first month and a half of trading.

These stocks are hard to value in comparison to their competitors. A deep look into their financials is warranted. The financial data is not as transparent in the period before public sale. Zynga is set to release its first statement on February 14th. The analysts have a wide range of ideas about how the company is going to perform. The low estimate is a loss of $.01. The high water mark is a gain of $.48, making the average estimate about $.19 for the year. I have not been able to find much guidance.

In my opinion, Zynga is more likely to come in on the lower end of the range, set expectations, and permit itself a lower hurdle for subsequent quarters. Investors should give the company a free pass if results are weak because it can promise growth. Indeed, many investors are banking on Zynga. It is the world's largest supplier of online social gaming, a growing market segment. Zynga has over 227 million monthly users and is growing its base. The company has been able to capitalize on the growing use of social media and smart phone technology to span the globe. I know I'm a user, and not afraid to admit it. The games are fun and addictive, captivating audiences and providing ample space for advertising.

The business model does have some flaws. Aside from advertising, the company relies on users purchasing virtual items in the games to derive revenue. In my view, this model has the potential for a razor-and-blade model exemplified by Gillette. Without the blade, the razor is worthless. Likewise, without the virtual items, the game is much less playable. Profitability, however, is an entirely different issue. The company is profitable but has unstable results. Zynga is constantly spending on new games and upgrades but has only been able to convert about 3% of its users to paying customers.

Zynga does not gain much revenue from its advertising sales. It is estimated that advertising sales in social media games will grow 35% over the next five years. Other game makers Activision Blizzard (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA) are valued at $14.2 billion and $7.7 billion each, which demonstrates that-- with maturity-- Zynga could be sizable in the gaming market. This growth opportunity makes it a viable takeover target, and Facebook would be a likely acquirer because Zynga's products are heavily intertwined with Facebook's applications. Few investors realize that Facebook is an avid acquirer, particularly on the design front. Zynga would likely be earnings accretive as early as this fiscal year. Zynga would give Facebook a more interactive platform with which to work ,and potentially spawn opportunities for virtual avatars of real people on Facebook.

Online discount retailer Groupon is expected to release its results February 8th. The retailer has not been very profitable, and is not expected to impress investors now. The flaw in the business model is revenue stream. The revenue stream of one retailer is discounted and then split in two. Groupon receives about 50% of income from the deals it sells. By offering huge discounts and then splitting remaining revenue with Groupon, retailers are seriously impacting their own bottom lines. Retailers must see some benefit to using the discount service or else they would not. I also do not see any reason why a business can not advertise its own discount and save the trouble and the money. Daily deals are a fantastic way to liquidate over stocked items but if Groupon can't make money now, it won't make money in the future. Increased competition from Living Social and OpenTable (NASDAQ:OPEN) on the restaurant front will eventually force it to lower its cut-- and hurt margins by several basis points, incrementally.

The stock is currently trading at around $25, down more than 25% from its IPO price. The first official release of financial information will not help share price move higher. Current average estimates for the current year are a loss of $.29 per share. A positive surprise will still be a negative number and will not help Groupon. The average estimate for next year is a profit of $.39 per share, with a low estimate of $.08.

Groupon is much less likely a takeover target than is Zynga. I think that next year we will see a positive earnings per share figure out of Groupon, but it will not be enough to support its current valuation around 80 on a forward price to earnings basis. Facebook is in head-to-head competition with Groupon through its Deals service, and I anticipate that due to its virtual proximity to Facebook users it can be a significant competitive advantage for Facebook. The Deals service highlights Groupon's underlying weakness which is that it lacks any competitive moat. Its business is easily reproducible. It only retains first-mover advantage, which-- with the bevy of competitors around-- will likely be fleeting.

Facebook makes money through advertising, applications and virtual goods. It combines several online revenue streams into one business. Facebook has mastered the art of connecting advertising to the public. It currently has over 800 million registered users, a number that is growing daily and helped the company double its income in 2011. Facebook has been estimated at generating over $4 billion in revenue this year, with about $3.8 of it coming from advertisers. Facebook has a unique way of tailoring the ads on each page to the user. I know you've all experienced this, you get on Facebook and notice that ads are being aimed at you directly. Ads on my page are for middle thirties, bike riding single guys who like good beer, fishing and cooking. My friends have described the same phenomenon. Facebook has become one of the best ways to reach target markets.

Facebook has a much better business model than Groupon and could very well put the site out of business. Commercial use on Facebook is growing as social media gains broader acceptance. Facebook could easily provide the platform for retailers to market their own discounts. Groupon could be a buying target for Facebook in the future, or simply a competitor to brush past. An integration of the infrastructure would enhance Facebook's reach and may prove the only way for Groupon to make profits.

As for Zynga, it will continue to ride the coat tails of its bigger cousin. Zynga is dependent on social media for access to its customers. It is a valuable part of the Facebook experience, and may also become part of the Facebook empire. The stock will be in high demand and could surpass internet IPO legend Google.

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