Wall Street Analyst Breaks Down Zynga’s Secondary Offering

Before the market open on Wednesday, Zynga (NASDAQ:ZNGA) filed an S-1 for a $400 million secondary offering.  Zynga did not specify any details (the offering’s price per share, the number of shares to be sold, or the date that the Class A shares would be delivered). However, at yesterday’s closing price of $13.38, the offering implies ≈ 30 million shares. In addition, it did not specify selling stockholders, although non-executive employees will likely be included. We expect that Class B stockholders will be the sellers in the offering once their shares have been converted to Class A, Zynga’s publicly-traded shares. We note that Class A stock has one vote per share, Class B stock has seven votes per share, and Class C stock has seventy votes per share. Class B stock and Class C stock automatically convert to shares of Class A stock upon sale or transfer.  Class C stock is held entirely by Mark Pincus, Zynga’s CEO, and does not appear to be included in the offering. Class B and Class C stock will still hold the vast majority of voting power after the offering. Zynga will not receive any proceeds from the offering.

The secondary offering has the potential to be a positive, as it addresses the staggering of the expiration dates of lock-up agreements. According to today’s S-1, substantially all of the company’s outstanding shares are subject to lock-up agreements that expire on May 28, 2012. However, in order to facilitate the secondary offering, the selling stockholders have been released from their lock-ups to sell a certain number of shares. In return, they have agreed to new lock-up agreements that will allow them to make shares available in the public market on July 6 and August 16, well after the initial lock-up expiration date of May 28. In our view, the selling stockholders likely agreed to new extended lock-up periods for the majority of their shares in return for the ability to sell a much smaller portion of their shares before the expiration of the lock-up. If such a situation has occurred, investors can expect fewer Class A shares to be sold immediately upon the expiration of the earlier lock-up (May 28), positively impacting Zynga’s share price on that date and the month or so that follows through less supply. We believe that the staggering of lock-up expiration will help mitigate any potential of flooding the market with shares for sale.

Zynga remains well-positioned for long-term growth. The company is expected to grow revenues in 2012 due to multiple social game launches and continued expansion on smart phone platforms. Zynga.com will help growth in the second half of 2012 as well. We believe that many investors are under the misperception that revenues track growth in monthly active users (MAU) and daily active users (DAU); we believe that revenues from Zynga’s games grow over the first year or more, notwithstanding the inevitable attrition of MAUs and DAUs.  As such, we expect Zynga to show revenue growth from games launched in 2011 over the back half of 2012, and expect further revenue growth after 2012 from games launched this year.

Maintaining our OUTPERFORM rating and our 12-month price target of $17. Our price target reflects an EV/EBITDA multiple of ≈ 23x our estimate for 2013 adjusted EBITDA, or an EV/EPS multiple of ≈ 34x our 2013 EPS estimate. We acknowledge that such a lofty multiple suggests an extraordinary growth rate, but think that the company’s market dominance and rapid recent user growth make it likely it will continue such growth for the foreseeable future.

Risks to the attainment of our share price target include changes to game release timing, decreasing interest in Facebook and other social networks among the general public, changes to the terms or economics of its Facebook agreements, the inability to create popular mobile games, increased competition from other social gaming companies and the traditional video game publishers, greater-than-expected consumer demand for video game hardware and single purchase software, and changing macroeconomic factor.

Michael Pachter is an analyst at Wedbush Morgan.

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