Zynga: Riding a Tiger
Zynga is the latest in a long line of IPOs slated for 2011. Famous for Farmville and a corporate culture that would make Enron blush, Zynga is distinctive from the likes of Groupon (GRPN) and Pandora (P) in that it is already profitable, carries about $900M in cash on its balance sheet and boasts a line-up of experienced and savvy management executives.
Investing in Zynga is in reality a bet on the success of Facebook since the company derives all of its revenue from the FB platform and it dare not dismount or anger the world's largest social platform.
Business Model and Financials
The Virtual goods market is a $9B business out of which Zynga will make about $1.1B (12% market share) in revenues this year, while gaming as a whole constitutes a $49B industry. 95% the company’s revenue comprises the sale of virtual goods within the games that it operates, with the rest coming from in-game advertising. The company relies almost entirely on Facebook for revenue generation with FB taking a 30% haircut on all revenues earned on its platform.
Being a hit-driven business, Zynga has to continually develop new games as users get tired or bored with existing ones – the decline of World of Warcraft and Guitar Hero, two of the most popular games ever, comes to mind. The top 3 games are expected bring in 58% of revenues and as of September 2011 the top 3 by revenue were:
1. FarmVille - $223M - (27%)
2. FrontierVille - $132M - (16%)
3. Zynga Poker – $124M - (15%)
Mafia Wars, the top game in 2010 fell to 4th position in 2011 after revenues declined by $12M (9%) from $128M for the 9 months ended Sept 2010 to $116M as at September 2011.
International revenue comprise 35% of total revenues up from 32% in 2010.
The company is on track to make $1.1B in revenues and bring in about $41MM in before tax profits (a decent 10% net margin) this year, down from $90MM in 2010 which is mainly a result of a five-fold increase in SG&A costs due to increased hiring within the infrastructure teams. Revenues and margins have grown at 202% and 73% CAGR respectively in the last three years as virtual goods and currency gained wide acceptance.
The numbers game
As of September 2011, Zynga boasted 227M Monthly Average Users (a measure that double-counts a user if they play two different games on the same day/month or if they play the same game on two different platforms). Out of this, Zynga will have 7.7M actual paying users for the year, spending an average $154/year. That is, 3% of Zynga’s players actually pay for virtual goods.
To put things in context, more than 500 million people use an app on Facebook or interact with the FB platform on other websites every month. This means that Zynga is already at just fewer than 50% of FB users or that 1.5% of FB users pay for virtual goods on Zynga.
Assuming that everything else remained constant and Zynga captured FB’s entire monthly active users, this would generate 2-3 times current annual revenue run-rate or $3B at the top end of the range.
One thing to note is MAUs declined in the last 3 quarters from 236M in Q1-2011 to 227M in Q3-2011, a 3% decline.
Zynga amortizes its bookings as revenue over the average life of its virtual goods. For the 9 months ended September 2011, bookings stood at $850M, revenues at $828M and the average life of virtual goods was 15 months, down from 18 months for the same period in 2010. Revenues as a percentage of bookings was 98% in 2011 compared to 78% in 2010 - What all this means is that Zynga’s pipeline is actually drying up and the company will eventually have to change its revenue recognition approach in order to make the numbers.
Zynga, under the Nasdaq ticker ZNGA, aims to sell 100MM shares (or 11% of total common shares outstanding) at an average $9.25 aiming to raise $925M, making it one of the biggest IPOs of the year. This would value the company at about $9B, slightly less than half the market capitalization of Activision Blizzard (ATVI) which boasts 4 times the annual revenues.
According to Renaissance Capital, the $9.25 price point represents an enterprise value of roughly $6.4 billion (vs. $9B market cap – a 40% mark-up) and a 5-6x 2011 sales multiple, compared with 7x for Pandora (P), 12x for LinkedIn (LNKD) and 7x for Groupon (GRPN).
Mark Pincus, the CEO owns about 16% of class B shares which carry 70 times more voting power than the common shares that the company intends to sell.
The issue will be led by Goldman Sachs and Morgan Stanley which makes it worthwhile for potential investors to look closely at how issues led by these two banks - Delphi, Groupon, LinkedIn- have performed in the recent past.
A number of shareholders cashed out earlier in the year including:
CEO Mark Pincus — $110 million
CTO Cadir Lee — $3 million
Chief creative officer Michael Verdu — $3 million
Kleiner Perkins Caufield & Byers — $6 Million
Institutional Venture Partners — $22.4 million
Union Square Ventures — $45.8 million
Foundry Venture Capital — $22.6 million
Avalon Ventures — $20.8 million
Management and Culture
Mark Pincus, a graduate of both Wharton and Harvard Business School, is a former banker who successfully transitioned into a serial entrepreneur. He espouses a highly competitive and almost ruthless workplace culture where he is said to maintain an MIA list of executives targeted for equity reduction, reassignment or dismissal. His first company support.com went public in 2000 and he sold another, Tribe.net to Cisco in 2007 just before starting Zynga.
John Schappert, COO, is a veteran of the gaming industry and is formerly COO of Electronic Arts
According to a recent article in the NY Times, the culture encourages an intense laser-like focus on data and metrics with performers lavishly rewarded and underperformers punished severely. This has led to a number of insiders openly declaring their intention to leave the company after the IPO (more likely after the lock-out period). To the management’s credit however, steps like 360 degree feedback reviews are being instituted to encourage self-awareness and increased communication between Mr. Pincus and employees.
Risk factors and dependencies
A decline in FB traffic, a failure to agree on terms in the future or the entry of FB into the gaming space would all adversely affect Zynga. FB has already flexed some muscle when in 2010 they adopted a policy requiring applications on Facebook accept only its virtual currency, Facebook Credits, as payment from users.
Zynga relies on Amazon Web Services for approximately 50% of its traffic – this is not a dependency you want to have – it would be like Google depending on AT&T for 50% of its traffic.
The corporate culture seems to be attritional - a number of smaller plays have rejected acquisition offers from Zynga due to its policies and culture - In July 2011, Zynga lost a bid for PopCap, a mobile game company after offering $950 million in cash and Rovio, the maker of Angry Birds, rejected a deal worth $2.25 billion in cash and stock for the same reason.
Zynga is a profitable market leader in its industry niche and is well run. The IPO seems reasonably priced relative to other IPOs this year and the price point is quite attractive. I am however concerned about the long term viability of the business model, which like that of Netflix is has inordinate levels of dependency on other companies. In addition, there is no way to predict that Zynga will continue to generate blockbuster hits failure of which would lead to a very fast reversal of fortunes and at this point I am only slightly concerned about the decline in average monthly users.
As a medium to long-term investor focused on fundamentals and defensible business models, this one is at the margins and I will wait until the lock-out period expires and the company announces earnings to get a better feel for what action to take.
For those looking to cash in on the IPO on the first day, it may behoove you to do your diligence around Day One price movements and to realize that you will only really be taking a turn at the roulette wheel.
Sources: Zynga S-1 Filing, Roadshow presentation and IPO prospectus, News Articles.