Monday Morning QB: The Curious Case of Zynga’s IPO

After months of hype and speculation, Zynga officially went public last Friday with a most curious offering.

Zynga raised $1 billion in one day, for the biggest tech IPO in the US since Google raised $1.9 billion in 2004. Zynga started as a company 4 years ago and now has a valuation of $8.9 billion (for perspective, Electronic Arts is valued at $6.9 billion). That’s the good news.

The bad news is that Zynga priced its IPO at $10/share and ended the day at $9.50/share in what can best be described as a lackluster opening day. Which begs the question — what happened on the road to IPOville?

Part of the answer is that other high profile social tech companies like Groupon, Pandora, etc all went public with a “pop” but are now trading below their initial IPO price once the hype died down.

It’s not fair, because Groupon’s business is a mess (high acquisition costs, no competitive barriers, a loss of over $400 million in 2010 alone) and Zynga is actually profitable. But, such is life. Having been burnt on the likes of Groupon, Wall Street was extra careful about Zynga and when investors peered beyond the impressive numbers, they were concerned by current and future trends.

For example, Sterne Agee analyst Arvind Bhatia giving Zynga an “under-perform” rating days before its IPO. Despite Zynga’s huge profits, hit games, and revenues in the past, he raised reasons to be concerned about the future:

• FarmVille’s traffic has peaked and its latest hit game, CityVille is tracking 50% lower than FarmVille at the same period in its product life cycle (and CastleVille, though a hit, is tracking 50% lower than CityVille).
• Unlike EA and the console game business, there may not be a sequel opportunity in social games since they always update. Mafia Wars 2 has been a disaster, declining from 28 millions DAUs (basically, players) to 1 million in less than 2 weeks) and most likely, destroying the Mafia Wars franchise.
• Though its made recent inroads in mobile (growing to 13 million players per month), Zynga is overly dependent on Facebook (93% of its revenues are tied to Facebook), a company that now takes 30% of Zynga’s micro-transactions revenues and with a history of changing policies quickly.

With Zynga’s stock price dropping even further down today, the bears seem to have won the day over the bulls so far with Zynga.

Of course, it doesn’t matter how the price fluctuates on a daily basis. It’s highly likely that come January, when Zynga releases 4th quarter numbers, they will be good because the company has released a lot of new games and 4th quarter is always good for games companies.

Over the long term, however, now that Zynga has gone public, it has a lot of challenges ahead if it wants to grow its public value and grow as a company.

During the IPO road show, Zynga CEO Mark Pincus predicted that Zynga could double its number of paid users, from current 3% to 6% of total users in the future.

There are four possible scenarios that this could happen:

1. Facebook doubles in traffic: If Facebook grows, Zynga’s revenues would grow since it is the number one social game company on Facebook by a long shot. However, the converse is just as true (Facebook could lose users if it releases a product feature that users do not like, for instance…Timeline).
2. Zynga successfully releases its own social games network, Zynga Direct. Based on what I have seen so far, however I think this is a very long time coming.
3. Zynga releases new hit games on Facebook. I think its upcoming HOG, Hidden Chronicles, will be a big hit. But the number of paying players from new games has to exceed number of players leaving older titles for it to be a net gain.
4. Zynga becomes a major player in mobile gaming.

Mobile is Zynga’s biggest opportunity and they must make this happen. It’s also their biggest challenge.The problem is that Zynga’s “playbook” for success does not work on mobile. On Facebook, Zynga wins by out-spending their competitors on development, marketing, and data analysis. With mobile, Zynga faces competitors with more money (Asian companies like DeNA and Gree), larger development teams (Glu, Gameloft), and no clear marketing strategy to pay for players as on Facebook. Moreover, the Apple and Android markets have very little barriers to entry.

Zynga has scored a hit with its latest game, Dream Zoo. But, Backflip Studios, a small games company, has done just as well with their game DragonValewith a much smaller staff and less marketing budget.

On Facebook, there are only a few “FarmVille” like successes. On the iPhone or Android, there are hundreds every month.

Surely, Zynga could buy their way into mobile through a series of acquisitions. But it’s a catch-22. Either their stock price needs to increase in value for anyone to be acquired, or Zynga is going to have to spend a lot of the $1 billion it just raised by going public to buy a good mobile company. The days of paying a penny for a social games company going out of business are over.

Final thought: There has been a lot of negative press around the fact that Zynga’s IPO was less successful than expected. Part of the reason is that bloggers and journalists love to write headlines and stories with puns, especially if you can add a clever “Ville” or “stock not growing like a weed in FarmVille” reference. Here are a few samples:

Forbes – Zynga IPO goes Splatville

CNET – Oopsville. Was Zynga’s IPO a mistake?

AllthingD – Zynga’s Stock keeps withering on day two (Farmville reference)

Joel Brodie