Zynga may have a great IPO, but beyond that--look out

In 2007, people around the globe used the Internet to learn, engage with friends, and entertain themselves. But serial entrepreneur Mark Pincus wanted to add another activity to their daily mix.

"We founded Zynga in 2007 with the vision that play--like search, share and shop--would become one of the core activities on the Internet," Zynga wrote recently in a filing with the Securities and Exchange Commission (SEC).

Mission accomplished! At last count, Zynga's many popular games, including FarmVille, CityVille, and others, have attracted 227 million monthly active users. Each day, 54 million people from 175 countries around the world load up the company's titles on the Web or mobile devices and play for a whopping 2 billion collective minutes. Through Zynga's titles, social gaming hasn't simply become a part of people's daily lives, it has become an obsession.

And that obsession is about to make Pincus and many other people at Zynga extremely rich. Even if it's not clear how long that will last.

Early tomorrow, Zynga will go public on the Nasdaq under the ticker symbol ZNGA. The company hasn't yet priced its shares, but in an SEC filing earlier this month it set a range of $8.50 to $10 a share and planned to offer 100 million shares to investors and up to 15 million more as an overallotment. All told, the company could raise as much as $1.15 billion.

The road to its IPO has been a long one for Zynga. The company filed its Form S-1 registration statement with the SEC back in July in the hopes of going public in September. However, in August, the SEC took issue with Zynga's "non-traditional" accounting methods and forced it to recalculate earnings based on accepted principles. To make matters worse, the stock market at the time was in a state of turmoil, making any IPO less desirable than it had been earlier in the year.

In response, Zynga decided to delay its IPO until after Thanksgiving in hopes that things would quiet down.

The move might have been a good one. Over the last month, the market has stabilized, and many stocks are starting to regain some ground. More important for Zynga, the IPO market has turned around, as evidenced by daily-deals provider Groupon's strong showing when it went public last month. That stock started its opening day at $20 per share and saw its stock soar in early trading. By the end of the day, Groupon was up 30 percent to $26.11.

Groupon's strong opening day followed similarly impressive IPOs for other online giants this year. LinkedIn, for example, opened its first trading day in May at $45 per share. When the day was up, its shares closed at $122.70. Pandora, Yandex, and several other online companies also had strong first-day showings.

But what about Zynga?
Sterne Agee analyst Arvind Bhatia sees a strong first day for Zynga. Speaking to MarketWatch in an interview published earlier this week, he said that he expects "the company to get a pop on day one," but didn't say how high the shares might go.

However, that's about as positive Bhatia is on Zynga. In a research note to investors earlier this week, Bhatia said that Zynga is actually going public at a price that's too high, based on its implied value, and will likely see shares fall after its IPO.

"While we believe in the potential for social games, we think Zynga's growth is slowing even faster than what is obvious at first, its margins are under pressure, and free cash flow has been declining recently," Bhatia wrote to investors. "Thus, we believe the implied valuation in the IPO is not justified."

Financially, Zynga isn't looking quite as golden as it once did.

During the first nine months of this year, the company generated $829 million in revenue and posted a $30.7 million profit. In the year-earlier period, however, Zynga's net income was more than half again as high: $47.6 million, on revenues of $401.7 million. That is, to put it mildly, not the profit trajectory most investors would prefer to see.

There's also Zynga's unhealthy dependence on Facebook. During its last-reported quarter ended September, Zynga revealed that Facebook accounted for 81 percent of its accounts receivable. What's worse, 94 percent of the company's revenue comes from the world's largest social network, according to Bhatia.

"Zynga is overly dependent on the Facebook platform," Bhatia told investors. "A slowdown or disruption in the growth of Facebook, or Facebook policy changes, will negatively impact Zynga."

For its part, Zynga admits that Facebook is a concern, saying in its SEC filing that "any deterioration in our relationship with Facebook would harm our business and adversely affect the value of our Class A common stock."

Given all those issues, Bhatia believes Zynga is really only worth $7 a share, and will likely fall to that after initial excitement over the IPO subsides. Morningstar analyst Rick Summer is similarly bearish on Zynga, saying the company's stock is worth $6 a share.

Such a post-IPO decline wouldn't be unprecedented. Over the last several months, all the top Web IPOs have been hit hard by the difficult market and unwarranted excitement in their shares. LinkedIn hit a high of $122.90, but is currently trading at about $66 per share. Groupon is down to just $21.77, and looks likely to drop below its IPO price before long.

What about the employees?
But there's more to Zynga's concerns than just its stock price.

Last month, several former and current Zynga employees spoke out to the New York Times, saying that they "work long hours, are held to performance metrics that their CEO obsesses over, and are in fear of being demoted or terminated if they don't do a good job." Those conditions have prompted many employees tomake plans to leave the company as soon as they can cash out their shares--180 days after the IPO, as mandated by SEC regulations.

After Google went public in 2004, more than 900 employees reportedly became instant millionaires, including a chef and masseuse. But just four years after the IPO, nearly one-third of Google's first 500 employees had left the company for new ventures. That brain drain hasn't slowed much, if at all.

A similar outflow of talent could have a profoundly negative impact on Zynga. To date, it's been able to attract top employees with the promise of getting rich off stock options. Now that it's about to fulfill that promise, employees are considering other opportunities, and Zynga will need to find a new team that can carry the torch.

In short, Zynga's future remains a question mark at best. To justify its (likely) lofty IPO valuation, the company will have to find a way to:

• Grow more, not less, profitable;
• Keep the employees it needs;
• Successfully manage its symbiotic relationship with Facebook;
• Fend off a number of aggressive social-gaming rivals, including 800-pound gorilla Electronic Arts

That would be a tall order for anyone. We'll have to see if Pincus & co. are up to the task.

Zynga declined to comment for this story, citing its "quiet period" prior to the IPO.