Analyst: Zynga’s Valuation Now Closer to $5.5 Billion (Updated)

Public market investors who once hungrily awaited the IPO of Zynga keep receiving more to digest about the company. It’s not clear how the confusing array of data will settle with them, either.

While Zynga’s July 1 S-1 filing was met with much fanfare, some worrisome numbers have emerged since, including in a September amendment that highlighted the company’s second quarter stats. It was then, for example, that Zynga reported that its daily active users slipped to 59 million in the second quarter of this year from 67 million in the first quarter of 2010, that its costs more than doubled to $266.1 million in the second quarter up from $116.7 million a year earlier, and that its profit dropped to just $1.4 million in the second quarter ended June 30, up from $14 million in June 2010.

Earlier this week, the company made strides in countering growing concern around its financials by inviting reporters to its San Francisco headquarters and unleashing a torrent of new announcements. The company talked of new products, including games that include Mafia Wars II, CastleVille, Hidden Chronicles; it talked mobile strategy; and perhaps most important,  Zynga announced its own gaming network. Dubbed Project Z, the standalone property may finally see the company grow its revenue base beyond Facebook’s platform — an absolute necessity, given that last year, Facebook began collecting 30 percent of whatever Zynga makes from the sale of its games’ virtual goods, via its Credit payments system.

Still, it’s not clear how long that good will might last. Late yesterday, Zynga released yet another amendment, and it “doesn’t smell good,” according to analyst Sam Hamadeh of the New York research firm PrivCo.

Hamadeh has become widely known for his bearish pronouncements about numerous Internet stars, including Groupon and Facebook. But Hamadeh sees red flags, for example, in the filing’s “stock repurchases table,” which spells out how Zynga acquired Class B Common shares from two employees in January for $6.43 per share, then paid founder Mark Pincus himself $13.96 per share for his Class B Common shares just two months later. (That’s a 117% price increase.)

While some might argue the jump reflects the company’s growing strength over that period, Hamadeh thinks it “smells of trying to pump up the price” for the sake of both Zynga’s IPO as well as its secondary market sales. (According to the amendment, insiders including Institutional Venture Partners, Kleiner Perkins, Union Square Ventures, and Foundry Group collectively cashed out hundreds of millions of dollars worth of shares last March.)

For his part, Web analyst Lou Kerner of Wedbush Securities, who hasn’t seen the newest S-1, points out that a “a motivated seller often gets a different price then a seller with a motivated buyer.” Kerner also says that the “price at which private transactions occur tend to have minimal impact on the pricing of an IPO.”

A request for comment from Zynga has not yet been returned. (Update: a source close to the company says the price for Pincus’s shares was “based on a valuation of the company’s stock by a third party for 409A purposes.”)

Will all the news — good and bad — ultimately affect appetite for Zynga’s IPO? Yesterday, over the course of two short calls, I asked Hamadeh and analyst Nick Einhorn of Greenwich, Conn.-based Renaissance Capital. Because we could easily talk about Zynga all day (and none of us had the time), we stuck to three issues: Zynga’s valuation, when the ideal time might be for it to go public, and whether it needs to drop a controversial, three-tier voting structure to get there.

First, what’s your valuation estimate for the company?

Sam: Well, comparable gaming companies to Zynga include Electronic Arts, with a market cap of $7.58 billion – or about 2.2x its revenue – and Activision Blizzard, the largest gaming company with a market cap of  $14.5 billion, or about 3.1x its revenue. If we apply a 3x revenue multiple to PrivCo’s estimate of Zynga’s revenues this year of $1.2 billion, that gets us to about $3.6 billion. However, Zynga is growing faster than traditional game companies, so far, so an aggressive valuation might be as high as 7x revenues, which would bring its valuation to $8.4 on the high end. Either way, we don’t see how it can reasonably get to $25 billion or $30 billion as in IPO valuation.

We also have to discount for the risk that Electronic Arts, Activision and others are now attacking Zynga’s core market of the Facebook platform.  In less than 2 months EA’s Simm Social now has 66 million users, higher than Zynga’s 59 million users, and they’re growing while Zynga’s are falling.   Zynga itself has seen that its core market is now under attack by developers of far more sophisticated games, thus this week’s “Project Z” event to attempt to diversify away from Facebook and try to regain lost momentum for its IPO with by dangling the hope of new markets.  Unfortunately, Zynga largely has tied itself to Facebook contractually for 5 years, limiting its ability to substantially diversify away from Facebook in the near future. Factoring in these risks, that might bring a fair risk-adjusted valuation of Zynga closer to $5 billion or $6 billion.

Nick: There are a lot of ways you can look at valuation. The difficulty with looking at the EA model is that it’s just so different from Zynga. I know the boundaries are getting blurred a bit. EA has made meaningful process in social gaming. But it’s mostly still a traditional, legacy business with very different margins. Over the last 12 months, Zynga’s EBITDA margin is 27 percent. If Yahoo Finance’s numbers are right, it’s 4 percent for EA. Certainly, because Zynga is just much more profitable, it should get a higher sales multiple.

And then, just in terms of growth, there are lots of different estimates regarding how quickly it will continue to grow. Has it lost its monopoly position on Facebook? Maybe. But even if you think its window of opportunity is closing a little bit, its recent growth has been very strong at least through June, so it hasn’t slowed them down too much yet. Is it possible that [a slowdown] is coming? Yes, but it’s hard to say how likely that is.

Second question: The three-tier stock structure that Zynga has incorporated into its filing is unusual, to say the least. Will it slow down this deal or can Wall Street stomach it?

Sam: We hear it’s causing investor resistance, understandably so in our opinion, as it’s unheard of. I’m a lawyer and I’ve never seen anything like it.

Nick: We certainly see a lot of companies go public with dual class voting structures and others with complicated structures in place, but if people like the company and where the business is going, it’s not necessarily a deal breaker. It comes down to whether you trust whether the people who have those votes know what they are doing. I think from a public investor perspective it would be better if it weren’t skewed [the proposed way], but I don’t think it will make the difference between a successful or unsuccessful IPO.

Last question: There’s apparently still no road show planned for the company. Best guesses as to when it will go public?

Sam: When a company files to go public, it has to file an amendment every 90 days if it doesn’t go out. Zynga’s [third quarter numbers] will have to be disclosed by November 15 in another amendment. That means they have 45 days to price, or to file again. If they file again, they’ll have to get recommitments on pricing because the numbers will be very different and every investor will have to agree or disagree to take so many shares at a certain price; they’ll need a chance to absorb the new figures. [I’d say to get out during that window.] There’s no benefit in waiting. There are only risks involved.

Nick: From my perspective of the IPO market, if a company needs to get its deal out before it shows another quarter of numbers, I think that’s definitely a problem. If Zynga’s September numbers aren’t good, they shouldn’t be coming out. It’d be worse to come out and report disappointing numbers weeks after its IPO. It’s hard to regain investors confidence after something like that happens. When a high-profile  company goes public, investors want to be confident that at least the next quarter will be good and ideally the next several quarters.

Obviously, I don’t know what its September numbers will look like, but I do think public market investors will want to see them before they invest given that there has been a lot of debate about the company in general. In fact, I don’t know that going public before then is really an option.