After sitting on pins and needles for over a year now, it appears our wait may soon be over. In a highly anticipated move, according to CNBC Facebook is expected to file paperwork with regulators today to take its company public in a deal that could be worth up to $5 billion and value the company somewhere between $75 billion and $100 billion.
Not so fast …
Don't rush to hit the buy button, however -- it will probably take months to settle on a proper price for the social media giant. Likewise, don't take this opportunity to blindly fall in love with some of the companies who have ridden Facebook's coattails to success -- especially Zynga (Nasdaq: ZNGA )
There's a lot to like about Zynga if you appreciate the hours of entertainment its social media games Farmville and Mafia Wars have provided consumers over the past few years. But looking at this purely from a fundamental economic perspective, Zynga has the potential to take all its shareholders down with the ship and should be avoided at all costs.
Reasons to be wary
First, its reliance on Facebook for revenue just isn't healthy. Most sources cite that a whopping 95% of Zynga's revenue is derived from Facebook with much of the remaining 5% coming from its relationship with Google (Nasdaq: GOOG ) . This exhibits a staggering imbalance where Facebook essentially controls the puppet strings of Zynga and makes it increasingly unlikely that Zynga will have any pricing power when it comes time to renegotiate its contract with Facebook.
Another scary fact about Zynga's 240 million unique gamers is that less than 3% actually pay for the service! Yes, I am aware that this leaves a huge pool of potential paying customers left to solicit, but let me catch-22 this and point out that this leaves 97+% that flat-out are getting Zynga's products totally for free -- and the company can't do a darn thing about it.
Then there's the slower-sequential-growth bug that seems to eventually plague all social media companies. Based on its most recent S-1 filing in November, Zynga's quarterly revenue grew just 10% sequentially, down from 15% in the second quarter, and net income fell by 50%. The company is still profitable, but like many other gaming companies which are currently suffering, the expenditures that go into developing and marketing new games can be exorbitant.
Let's look at Take-Two Interactive (Nasdaq: TTWO ) , for example, known most famously for its Grand Theft Auto series. Wedbush Securities estimates that production of Grand Theft Auto V, due out in 2012, will be around $80 million. Similarly, Electronics Arts (Nasdaq: EA ) vice president Jeff Brown recently opined that he expected video-game development costs to rise by as much as 200% for next-generation consoles. In short, development costs are rising and Zynga is going to have boom-and-bust cycles just like its gaming counterparts.
Finally, I'm not too fond of the control that Zynga CEO Marc Pincus wields over the company. Obviously you want a CEO to present a strong and confident public image, but Mr. Pincus has set aside his very own class of C shares which give him 70-to-1 voting rights. Other insiders are privy to B shares, which offer 10-to-1 voting rights. With such a large controlling interest, I'm concerned that (pardon the terrible analogy) Ahab may blindly chase the whale despite the differing opinions of his crew.
There are just too many question marks to support buying into Zynga here, even with hype peaking regarding Facebook's imminent IPO. In short, Zynga, I do not plan to water your crops, so stop asking me! Instead of chancing your wealth on the boom-and-bust cycle of the gaming sector, I invite you to download our latest special report, "3 Hidden Winners of the iPhone, iPad, and Android Revolution." Not only is this report completely free, but it will give you the scoop on three names quietly raking in the dough in the mobile and tablet market. Don't miss out!