The Zynga IPO - A Winner or a Zinger?

Before I start talking about the Zynga IPO (ZNGA), I have a disclosure to make: I regularly use a Zynga app on my iPhone. It’s called “Chess With Friends.” I started playing it a few months after I got hooked on Zynga’s “Words With Friends.” In fact, right now my wife thinks I’m addicted to Chess With Friends, and she may be right.

Here’s some background on Zynga. The company is the gaming app leader on Facebook, recently registering 227 million active users. In late November Zynga launched a new game called “Castleville,” which has already attracted 20 million Facebook users in two weeks. That offering follows in the footsteps of Zynga’s “Farmville,” which is pretty much a household name among gaming apps.

In what’s being touted as the biggest internet IPO since Google hit the market in 2004, Zynga is offering of up to 10% of the company, priced in the $8.50 - $10 per share range. If shares price at the high end of that range, the company would be valued at $7 billion. (Prior to the pricing of the IPO, some analysts estimated Zynga’s value at up to $20 billion!)

So with lofty expectations already the order of the day, can Zynga really make a go of it at these valuations, or is the share price destined to crumble under the weight of sketchy market conditions and an uncertain long-term earnings outlook for the company?

One big thing Zynga has going for it is that the company is already profitable, and gross earnings are robust. For the most recent nine months, Zynga reported a profit of more than $30 million on revenue of almost $829 million. Compare those numbers to money-losers Groupon (GRPN) and Pardora (P), two recent web IPOS that are struggling, and at least on the surface it makes Zynga look like a bargain.

But Zynga may have a skeleton or two in its closet. In the most recent quarter the company reported earnings that were down 54% from the same period last year. And competition on the mobile and gaming app front is fierce, with users’ tastes morphing faster than the most skilled Power Ranger.

Right now, Zynga’s two biggest insiders, CEO Mark Pincus and company financiers Kleiner, Perkins, Caufield & Byers, won’t be selling any of their shares in the IPO. However, industry heavyweights Morgan Stanley and Goldman Sachs—the lead brokers of the deal— have an overallotment option to sell an additional 15 million shares of Zynga if demand is there.

I’m not a big fan of highly-hyped IPOs, especially of the internet variety, but I have a strong feeling that the debut performance of ZNGA will present market participants with a good opportunity for some short-term trading value to the long side. It’s got a sexy story, brand name appeal and solid institutional support, so I wouldn’t be surprised to see the stock price quickly accelerate to the upside right out of the gate, and continue heading north, especially if shorts take premature aim at the shares.

After the dust settles, however, I believe that Zynga will have to generate solid and consistent earnings over time for the underlying equity to offer and sustain long-term upside—just like any other stock. And if overall market conditions continue to be unfriendly to inherently riskier issues like Zynga, any misstep on the performance front could ultimately spell disaster for ZNGA’s stock price.