Method To The Zynga Madness

In the last 10 days, Zynga (ZNGA) managed to go from $8.53 to $13.34, for a full 56% return. Given how overvalued the stock seemed even before rallying, it's hard to see why it would go up so much.

But there's a method to the madness.

You can actually rationalize the climb. It has to do with Facebook's IPO. Facebook will certainly get a $100 billion valuation right out of the gate, and will then add several tens of billions to that when it trades.

Now, through Facebook's S-1, we got to know that it:

• Had revenues of $3.71 billion in 2011;
• 12% of those revenues came from Zynga;
• 17.6% of Facebook's revenues are from virtual goods and payments and that is the fastest growing segment.

We also knew that Zynga had $1 billion in TTM revenues and is growing about as fast as Facebook itself, which is expected to continue.

In short

The method to the madness is that if Facebook is going to be worth north of $100 billion, and Zynga should be around one-fourth Facebook's size, and present in the fastest growing of Facebook's segments, then Zynga can be worth as much as one-fourth of Facebook, which would put it at least $35 per share, given 700 million outstanding shares.

What do I think about this?

A huge bubble is forming all around Facebook. Investors are once again throwing caution to the wind and buying anything that smells of tech, be it Amazon.com (AMZN) after some more horrid earnings, Zynga on the relative scale, Netsuite (N) on very dubious earnings or even Groupon (GRPN), which has already shown to have a much lower margin business than Facebook due to the hordes of salesmen it requires.

Valuation and other things

My take on these stocks is not just based on valuation. Granted, they are all very expensive, but each has issues that go beyond valuation.

Zynga trades at a 2012 P/E of 60 times, and while it has some franchises inside Facebook like Farmville, Cityville and MafiaWars, nobody really plays Zynga's games because they are Zynga's. Anyone can come in and make a better game, while these franchises already seem mature. Still, of these stocks, Zynga is the easiest to be speculated higher for the reasons stated before (the method to the madness).

Amazon.com is the most impressive for not having fallen further. After all, not only does it trade at 136 times its estimated 2012 EPS, but its earnings are now back to 2004 levels, and it has had two entire years of lower earnings and downward EPS revisions. Hardly the stuff high multiple stocks are made of. Worse still, Amazon.com has been buying revenues through a low price, low margin, no sales tax strategy, even while not having a cost advantage and soon being forced to apply sales tax in the remaining states (namely California). Only a powerful internet bubble could make this stock not crash soon enough.

Netsuite simply has no earnings. Those "earnings" Netsuite reports come about only by ignoring cost paid in stock. Even then, it trades at 227 times those fake, estimated earnings for 2012. And even the "earnings beat" that was just reported was fake in itself, because estimates after the quarter had ended were for a $0.05 EPS, and only downward revisions toward $0.04 after the quarter had ended, managed to produce the earnings beat. The dilution that Netsuite is undergoing just to show "earnings" is also incredible, with diluted shares increasing 5.8% during the last year. Here, I'd recommend my article "Salesforce.com: Not All Cash Is Born The Same" to see how 5.8% dilution per year simply turns the equity to mush.

Finally Groupon: Groupon trades at 78 times its 2012 estimates. These are going up, but Groupon's business is not like the other "pure web" companies like Facebook or Google (GOOG). No, Groupon is labor intensive, needs an army of salesmen to handle the local businesses that provide it with coupons. It will thus not scale incredibly well, and is as such, not really worthy of the huge premium it carries. And that's even ignoring the fierce competition that the local deals business industry attracts, the lack of barriers to entry, and the lack of any differentiation (people will chose deals according to the discount and not whatever company sets up the deal).

Disclosure: I am short AMZN.