Zynga Shareholder Outlook: Wall Street Analyst Issues Caution

We are initiating coverage of Zynga (NASDAQ:ZNGA) with an OUTPERFORM rating and a 12- month price target of $12.50. We believe Zynga is well-positioned for revenue growth due to its dominant market share among social game publishers, its track record of releasing very popular and durable games of the highest quality, and its myriad opportunities to expand beyond Facebook with its increased focus on advertising and the migration of its social games to mobile platforms.

Zynga is the world’s leading social games developer and publisher. By virtually any metric, it is clear that Zynga is the dominant developer of social games, claiming six of the top ten most popular games on Facebook by DAUs. We believe that Zynga’s dominance is its key strength as the company leverages its large installed base of players each time it launches a new game.

Well-positioned for long-term growth.  Zynga is expected to grow revenues in 2012 due to the 2011 launches of Adventure World in September, Mafia Wars 2 in October, and CastleVille in November, plus continued expansion on smart phones. We modeled Zynga revenues to grow to $1.53 billion in 2012, with 24% growth in virtual items revenue and better growth from mobile, advertising and China.

Emergence of smart phones creates a strong mobile growth opportunity.  In order to mitigate its dependence on Facebook, Zynga is expanding to mobile platforms such as Apple (NASDAQ:AAPL) iOS and Google (NASDAQ:GOOG) Android. The company grew DAUs on mobile platforms more than ten-fold from November 1, 2010 to September 30, 2011, reaching 9.9 million DAUs in Q3 and 11.1 million in October 2011.

Zynga has the ability to drive advertising revenue growth. Given the unobtrusive nature of Zynga’s current advertising practices and the strong value proposition presented by its free-to-play gaming, we think that a small increase in advertisements would likely boost revenues without alienating users.

Our 12-month price target of $12.50 reflects an EV/adjusted EBITDA multiple of 9.5x our 2013 adjusted EBITDA estimate, or around 16x our 2013 adjusted EPS estimate. We arrive at a 9.5x multiple of our adjusted EBITDA estimate given the 93% adjusted EBITDA growth we are projecting in 2012 and 25% growth in 2013, offset by the risk that is at a higher level than we have contemplated.

Michael Pachter is an analyst at Wedbush Morgan.