a short reprise of the Zynga (ZNGA) IPO

King Digital Entertainment, PLC  is the maker of the fabulously successful mobile-centered game Candy Crush Saga.  The firm has filed a form F-1 in preparation for an IPO.  King (proposed ticker: KING) intends to raise around $500 million.

Not surprisingly, the KING offering has reawakened bad memories of the 2011 IPO of ZNGA, which was led by Morgan Stanley and Goldman (no shock, either, that neither of those firms has a role in the KING IPO).

I haven’t yet read the KING offering document.  It’s possible that I won’t.  But I still thought it might be useful to look back at the characteristics of ZNGA that, in my view, made that stock an unattractive investment from the start.

1.  Virtually all the traffic coming to ZGA’s games was generated by Facebook.  This made it difficult to tell whether ZNGA’s games were successful because they were great games, or because they were being featured on FB.  If the latter–which subsequently proved to be the case–FB held the economic power in their partnership.  Any lessening of FB’s marketing efforts would quickly translate into a reduction in ZNGA’s profits.  A big weakness of ZNGA, not a plus.

2.  A reasonable way of assessing social games is to measure:

–the time needed to reach the peak number of players,

–the number of peak users, and

–the rate at which the number of users fades from the peak.

Even prior to the IPO, ZNGA offerings launched after its signature game, Farmville, were peaking faster than Farmville, and at lower numbers of users than Farmville.  In addition, they were as fading from the peak more quickly.  In other words, none of them had anything near the oomph of Farmville. This was all bad news.

3.  The actions of  the lead underwriters, both before and after the ZNGA IPO were quite odd, in my view.

For one thing, according to the New York TimesMorgan Stanley mutual funds bought  $75 million worth of pre-IPO shares of ZNGA in February 2011 at $14 a share.  Some have suggested that this was done to help persuade ZNGA to choose Morgan Stanley as a lead underwriter.

For another, the underwriters released the top management of ZNGA, as well as some venture capital investors, from IPO share “lockup” agreements that prevented their sale of stock prior to May 29, 2012.   Instead, a sale of 49,4 million shares at $12 each raised close to $600 million in early April for these high-profile holders.  By the original lockup expiration, the stock was trading at little more than half that level.

My overall impression is that the underwriters (incorrectly) thought that the heyday of tech investing was over.  This would imply that they and the companies they were moving to initial public offerings had only a short time to cash in before the rest of the world figured this out.  As a corollary, the traditional rules of trust and fair play between underwriter and professional portfolio manager/wealth management client no longer held–because there would be no follow-on business that once-burned clients would shy away from.

relevance for KING?

Again, I should mention that I haven’t yet analyzed KING.  Candy Crush Saga may well prove a fleeting fad and KING a one-trick pony.  On the other hand, the underwriters are different this time.   And I don’t sense the same IPO-before-it’s-too-late urgency that was in the air in 2011.

Greater Fool Theory (II): Zynga (ZNGA)

ZNGA

Zynga (ZNGA) is a maker of casual social games played principally on Facebook.  The most famous of them is FarmVille.

The company follows in the footsteps of the Korean smash hit Kart Rider, which showed how immensely profitable “free” casual online games can be if they charge money for items players need to succeed (microtransactions).

going public

ZNGA went public in mid-December 2011–before GRPN shares began to give up the ghost–at $10 a share.

Shareholders weren’t as lucky on day one as GRPN IPO participants, however.  The stock opened at $11 and rose to $11.50.  It then faded back to $9, before closing the day at $9.50–below the IPO price, despite presumably the best efforts of the underwriters to “stabilize” the price at $10.

The stock did have a brief renaissance in February, when it reached almost $16 a share, before beginning its downward journey to the current $2.78.

 ZNGA as a “greater fool” stock

two investment variables

To my mind, the most important investment issues surrounding ZNGA were/are:

–whether it could follow the success of Farmville with other, hopefully bigger, games, and

–its relationship with Facebook.

on the first count,

It’s pretty easy conceptually to figure how much a given game is worth.  Games have a lifecycle that’s a function of:

–how many users it has

–how often, and for how long in each session, they play

–how long the game remains at/near peak popularity before players become interested in something else and fade away.

The detailed data may be difficult to come, but this is a straightforward discounted cash flow problem.  Figure out the value of a game–let’s say $3 a share–and that tells you how many successful games are already being presupposed in a given stock price.

Long before the IPO, industry sources were indicating that ZNGA was having trouble finding a follow-up success to Farmville.  Its subsequent games were attracting fewer players–who were playing them less intensely than Farmville, and losing interest more quickly.  Therefore, on all DCF counts, they were (much) less profitable.

To my eyes, ZNGA had all the earmarks of a one-trick pony.  Yet, to me the $10 IPO price presumed a parade of new hits.

on the second point,

experience, common sense and basic microeconomics all suggest that symbiosis can be a fragile thing in the business world.

From FB’s perspective, the fact the ZNGA games were a significant source of its revenue had to start it looking for other game makers to feature.  That would hedge against the possibility that ZNGA was a flash in the pan.  And it would diminish the leverage ZNGA would otherwise be gaining over FB if the hits kept on coming.

From ZNGA’s perspective, the fastest way for it to grow would be to tap non-FB gamers by establishing a platform separate from FB.  That, of course, would be potentially bad for FB.

The issue has two facets:

1.  Was ZNGA successful because FB steered traffic to it?; or was FB successful, at least in part, because it had preferred access to ZNGA games?  The more important partner should get the lion’s share of any profits from the partnership.

2.  The FB/ZNGA relationship had become profitable enough that the question of the respective profit shares came up.

Here again, the issue was settled pretty decisively over a year before the IPO.  ZNGA is successful because of  FB, not the other way around.

why subscribe to this IPO?

What must the subscribers to the IPO have been thinking?    …all I can see is the thought that “greater fool” had worked once with GRPN, so it would likely work again.

And, if you flipped the stock into the early strength on the first trading day, it did.

Tomorrow:  what were the underwriters thinking?

Zynga close to $3–what’s happened?

Zynga

Social games maker Zynga (ZNGA) came public last December at $10 a share.  Its stock rose to an intraday high of almost $16 in early March, before beginning a swoon that has taken it down to less than a third of its initial offering price today.

What’s going on?

There are certainly Zynga-specific factors involved.  But it’s also important to note, I think, that the relative performance of ZNGA parallels almost exactly that of Groupon (GRPN), another flawed investment concept whose stock price has also cratered.

GRPN came public early last November at $20 a share.  It reached an intraday high on its debut day of a bit more than $31, but fell quickly to $15 late in the same month.  From there, GRPN rose again, to reach almost $26 in February before falling away to the current $6.50 or so.

The businesses of the two companies have almost nothing to do with each other.  Yes, both have weak competitive positions; both companies have eyebrow-raising management practices.  But one distributes discount coupons, the other makes games.  Yet, the stock market is treating them in identical fashion.  This suggests to me that the mood of the market has a lot to do with how the stocks have traded.

What’s surprising about them both, to my mind, is not their weak stock market performance itself.  Instead, it’s the fact that both initially got such a warm welcome from Wall Street.

ZNGA’s potentially wobbly foundation

Two potential issues with ZNGA were evident long before the IPO:

–the company’s almost total dependence on FB to distribute its offerings, and

–its reliance on a small number of games for its profits.  Even more worrying, reports I read before the IPO indicated that ZNGA’s newest games were attracting fewer users, and had shorter shelf lives–therefore, were making less money–than its existing hits.  So even maintaining operating profit might be a struggle.

ZNGA’s dilemma

It seemed to me to be basic microeconomics that if ZNGA tried to strengthen itself by developing distribution apart from FB, the move would bring a competitive response from FB that might be harmful.  This appears to be what has happened during the June quarter.  ZNGA established its own game portal and began to direct users to it;  FB responded by making it easier for its users to find new games instead of just playing ZNGA’s.  The result has been a sharp drop in ZNGA’s audience.

wide stock market effects

One slightly head-scratching consequence of the release of ZNGA’s weak June quarter financials has been a subsequent worldwide selloff in smaller consumer-oriented internet stocks, especially those with any social networking associations.  This makes no sense to me.  ZNGA’s problems are mostly unique to it, in my view.  FB appears to have been caught napping by the switch to mobile use in the US.  Its woes may well be temporary.

Anyway, the fallout on other internet stocks looks to me to be a case of throwing the baby out with the bath water–an emotional reaction that may mark as extreme a negative reaction as we are likely to get, and which may the the market equivalent of 4Q11’s buying frenzy.