Let’s start off with the general industry where Zynga operates. While it might have all the hot buzzwords attached to it like “social,” “cloud,” “Facebook,” “Web 2.0,” and “apps,” Zynga is at its core a video game company, and the video game world is brutally competitive. Although the content delivery mechanism for Zynga’s games and target audience might be different from other gaming companies, it still faces the same problem every game company faces. They need to continually produce hit game after hit game. That means a lot of money needs to be sunk into R&D as well as marketing.
The table below shows Return on Invested Capital (ROIC) for four large US video game developers; Electronic Arts (ERTS), THQ Inc. (THQI), Take Two Interactive (NASDAQ:TTWO) and Activision Blizzard (NASDAQ:ATVI).
As you can see, the median ROIC is terrible. If a company releases a hit game, then its ROIC swells. If it has a few misses (and all companies will eventually have them), then it drops back down. The general unattractiveness of the industry is one reason Zygna does not deserve a premium multiple.
The second red flag is that R&D spent as a percentage of revenue is increasing. This is the newer, shinier, better "treadmill to hell" on which every game company finds itself. Companies must continually produce new, exciting products or consumers will switch to a competitor who does. Additionally, there is not much preventing consumers from switching, especially given the casual nature of most of Zynga’s games. Contrast this to a business model like Coca-Cola (KO) or Philip Morris (PM) where the formula behind Coke or Marlboro cigarettes hasn’t changed much, if at all, for decades.
Zynga R&D Spend
The IPO price ranges bandied about value the company at around $15 billion. This means Zynga will trade at a PE of 318, giving the company every benefit of the doubt, that is, annualizing the net income reported for first quarter 2011 and before any special dividends or other payments to preferred securities holders.
The insatiable appetite of investors for these high-priced companies and the focus on the new paradigms of Web 2.0 reek of the dot-com bubble. My guess is that Zynga does well and grows fast, but just not quite as fast and as profitably as needed to justify a PE of over 300. Even with all the shiny new social media-isms attached to the company, it still won’t be able to escape the intense competition that pervades the video game publishing industry.