Zynga’s New Toy: A Look Under the Hood

Zynga (NASDAQ:ZNGA) announced the acquisition of social game developer OMGPOP, the creator of the highly popular game Draw Something. Since its founding in 2006, New York-based OMGPOP has developed over 35 social games. The financial terms of the transaction were undisclosed. Zynga’s financial resources, large customer base, and deep experience in monetizing social games should improve the monetization and gameplay experience of the titles acquired.

OMGPOP’s most successful asset is Draw Something. The game, which is available on iOS, Android, and Facebook, has been downloaded over 35 million times in the six weeks since its launch. According to AppData, a service that reports traffic data for games and other apps on Facebook, Draw Something has 22.4 million monthly active users (MAUs); it is currently the most popular non-Zynga game on Facebook prior to the acquisition, and sixth most popular game on Facebook overall. In particular, we think that the game has tremendous appeal internationally, as it is primarily a drawing game easily localized into many languages. It is the #1 word game in 84 countries according to the Apple App Store. Through the acquisition of OMGPOP, Zynga should be able to increase its mobile and international revenues meaningfully in the nearterm. Although Zynga grew daily active users (DAUs) on mobile platforms to 15 million DAUs in Q4:11 from 9.9 million DAUs in Q3:11, mobile revenues continued to significantly trail Facebook revenues, which likely accounted for over 90% of total revenues.

Although financial terms were not disclosed, we believe that the OMGPOP acquisition is likely the largest in Zynga’s history. Technology news website TechCrunch reported a rumored purchase price of $180 million in cash plus a $30 million earnout. The reported cash paid represents ≈ 10% of Zynga’s cash balance at the end of 2011 of ≈ $1.8 billion (including short-term marketable securities). We believe that Zynga’s largest acquisition prior to OMGPOP was Newtoy, a mobile games developer, in November 2010 for $53.3 million ($44.3 million in cash and $8.9 million of convertible preferred stock). Many social games generate at least $1 of revenue per year per MAU (Zynga’s average is much higher), so at 25.55 million current MAUs, OMGPOP’s annual revenue run rate for Facebook alone is likely at least $25.55 million, and the game is likely still growing. We believe that under Zynga’s stewardship, OMGPOP’s Facebook business could generate 2 – 3x this amount, suggesting that the rumored price is not excessive. OMGPOP’s CEO Dan Porter recently disclosed that the company has generated revenue in the six figures on a daily basis, implying an annual revenue run rate of at least $36.5 million, adding credence to the notion that the OMGPOP purchase price is significantly larger than Newtoy’s.

Zynga remains well-positioned for long-term growth. The company is expected to grow revenues in 2012 due to multiple social game releases, continued expansion on smart phone platforms (accelerated by the OMGPOP acquisition), and the launch of Zynga.com. We believe that many investors are under the misperception that revenues track growth in monthly active users and daily active users; 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 factors.

Michael Pachter is an analyst at Wedbush Morgan.

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