Zynga IPO: Virtual Goods, Very Real Profits

• Posted by Tech Insidr
• on July 5th, 2011

I have been following the tech IPO scene very closely and so far it’s been a pretty successful run.  I took a pass on Pandora ($P) due to concerns about their underlying fundamentals and profitability.

I did pretty well on both LinkedIn ($LNKD) and Fusion-IO ($FIO), however the company that *really* intrigues me is Zynga Inc.

Zynga is an innovative company that brought casual gaming to the masses using outlets like Facebook and Mobile Apps.  Some of the most popular Zynga game franchises include Farmville, Frontierville, Cityville, Mafiawars, Zynga Poker, and Words With Friends.

Instead of catering to the hardcore gamers, Zynga takes the opposite approach and creates game franchises that appeal to casual gamers.  The games are available to play on platforms like Facebook, Yahoo, and others.  Anyone can pick up a Zynga game, invite their friends, and start playing almost immediately.

As far as their business model, Zynga gives their games away for free, but charges gamers for “virtual goods” that can be purchased inside of a game.  These “virtual goods” allow gamers to experience new capabilities and access new features that were previously locked down.   While this may sound like somewhat of a gimmick, this “virtual goods” business model has been extremely lucrative for the company.

Last week, Zynga filed their S1 Form with the SEC and it provided a glimpse into an extremely innovative business model.  Unlike most Web 2.0 companies who are still searching for profitability, Zynga is already extremely solid financially and was profitable during 2010.

During 2010, Zynga delivered $597 million in revenues,  EBITDA of $392 million, and net income of $90 million.

According to research from GreenCrest Capital LLC,  Zynga is expected to see roughly $1.46 billion in revenue this year–roughly 80% of which will come from the sale of virtual goods in its games and credits, and about 20% from online advertising.

AppData, a third-party service that tracks the market share of Facebook apps, shows Zynga to be the largest developer by far on the platform, with nearly 272 million monthly average users.  The second largest developer has only 34.3 million monthly average users.

“At first we didn’t realize how big social gaming could be, but once we launched our first game and we saw how viral it could be and that people wanted to play games together, we started to see how big the audience could get..”
Mark Pincus, CEO Zynga

Clearly, the Zynga business model is already working, but it does not come without some concerns.  In the early stages of Facebook App development, Zynga took some liberties in the privacy department in order to get their product out the door.

Gamers were offered virtual currency in exchange for clicking on adds or installing phony software. Some individuals complained that “Farmville” posts on Facebook were beginning to take over their news feed.

Although these concerns are legitimate, I think Zynga has made great strides in the privacy area and I have no long-term worries in this area.  The single biggest risk factor for Zynga is their longstanding relationship with Facebook.  Since all of Zynga’s games are primarily distributed using the Facebook platform, a strong working relationship with Facebook is essential.  If the Zynga/Facebook relationship ever broke down, it would reduce Zynga’s reach in a huge way.

Facebook  gets a 30% cut from all revenues that Zynga generates through the Facebook platform, so it’s a lucrative partnership for both sides.I think both of these companies need each other and I am confident they will find a way to work together over the next few years, but it remains a huge risk.

One area that really intrigues me about Zynga is their relatively high level of profitability.  Since Zynga primarily sells “virtual goods”, their margins are much higher than their other competitors in the gaming industry.  For a pre-IPO tech company, their 70.5% gross margin during 2010 is definitely quite impressive.

Even though their profitability metrics are solid, Zynga’s revenue growth is even more impressive .  For the quarter ending March 31, 2011, revenues were $235M, which represents a 133% increase year over year.  With cash of $966M, Zynga is extremely financially secure and has plenty of resources to fund new projects or acquisitions.  The company is clearly executing very well both from a strategic and a financial perspective, which is what you love to see from a pre-IPO company.

Zynga represents an exciting opportunity for investors who want to gain exposure to the growing market for casual gaming, social media, and virtual currency.  It’s extremely rare to find a company who is clicking on all cylinders heading into an IPO, but I think Zynga definitely fits that bill.  The company has a great product that continues to grow and they’re already extremely solid financially.  Zynga is definitely a buy.

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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