I Was Right About this IPO Flop, but Now it’s Time to Buy

New IPOs (initial public offerings) offer the promise of huge upside as investors speculate on a young company’s impressive growth potential. Yet just as often, this potential is more hype than reality, so you should only stand on the sidelines as investors’ enthusiasm obscures their ability see real challenges.

#-ad_banner-#For online gaming firm Zynga (Nasdaq: ZNGA), I laid out the stark reality in December 2011, a few days before the company went public.

At first blush, I might have seemed too pessimistic. Shares moved above the $10 IPO price and into the low teens by the time I revisited this stock in February 2012. 

In that look at the social media stocks, I concluded: “Zynga may be the most dubious long-term business model. Not only does the company need to keep coming up with winning games (as existing popular games can have a fairly short shelf life), but the company is vulnerable to consumers deciding they want to spend their time on other leisure pursuits than Facebook games.”

Well, this stock chart tells you what happened, as reality finally set in.

Shares now trade for just $5, or half the IPO price, and nearly two-thirds lower than levels seen at the end of the first quarter. This makes Zynga one of the worst-performing stocks of the second quarter.

Yet even as I’m not a huge fan of this type of business model, I have to concede that $5 is just too cheap for this broken IPO.

The end of a fad?
A few quarters ago, I felt like the only person that wasn’t spending hours on Facebook (Nasdaq: FB) playing games. Gaming holds little appeal to me in light of all of the books I still need to read and movies I need to watch. Yet for millions of Americans, games are a part of life. Zynga’s real trouble stems from the fact people may have grown bored with playing games on Facebook. A research report from Cowen & Co. notes that Zynga’s roster of daily users fell 8% sequentially in May, perhaps due to a waning interest in Facebook itself. 

But simply put, to declare Zynga as dead-on-arrival is quite premature. Even if it’s true that Facebook as a platform has peaked, interest in gaming has not. And Zynga still has plenty of resources to find new ways to capture the interest of consumers.

This will always be a company in search of the next hot thing. In 2011, that was Farmville, which was wildly popular and helped shape interest for the late 2011 IPO. The number of people playing Farmville on a daily basis has now fallen 70% from last summer. Cityville, another popular Zynga title, has seen similar drops from the peak. That’s typical for many gaming titles, even those offered by console- gaming companies like Electronic Arts (NYSE: EA), Take Two Interactive (Nasdaq: TTWO) and Activision (Nasdaq: ATVI).

Zynga is now banking on newer titles such as Hanging with Friends, Scramble with Friends, Words with Friends and Draw Something. There’s a good chance that few or none of these titles will be big hits. But this doesn’t mean the Zynga business model is broken. Even with a recent slump in traffic, Zynga still is a major player in this space. Analysts at Baird, who recently upgraded shares to “outperform” with a $13 price target, note, “Zynga generates more engagement than the next five social game developers, combined.”

Analysts now anticipate an aggressive launch of new games later this summer and fall, perhaps in the company’s planned “Zynga Unleashed” event. (The date has not been set, but last year’s event took place on October 11.) 

How far has this stock sold off? Consider that Zynga ended the first quarter with $1.52 billion ($1.80 a share) in cash, which equates to 40% of its entire market value. That’s a lot of dough for the company’s developers to use to churn out new titles. Many of the company’s new games won’t make a dent in the marketplace, but just a few successes would quickly restore this stock’s luster. 

Risks to Consider: Shares of Zynga have been heavily pressured by the “lock-up” expiration, as insiders have been free to sell shares 180 days after the Dec. 16, 2011, IPO. Roughly 115 million shares were freed up in late April, another 330 million in late May, and another 200 million will be released in July and August. As a result, shares could stay under pressure until then.

Action to Take –> Despite the recent bungled IPO, obituaries for Facebook may be a bit premature, and Zynga still stands as the pre-eminent games provider on that platform. Indeed, Facebook is looking for ways to make it easier for partners such as Zynga to monetize revenue and drive growth.

Though it’s hard to get a clear read on how Zynga’s sales growth — both on Facebook and mobile phone platforms — will play out, it’s clear that the company’s stock price plunge now heavily discounts potential success. Though I think this stock will be hard-pressed to move back into the teens this year, a relief rally could easily bring it back to $7 or $8, good for as much a 60% gain for investors willing to take a flyer on this stock.