‘Tis the season of the IPO. So far, 2011 has seen companies like LinkedIn, Pandora, Yandex, Zillow, and RenRen come to market. As you’ve heard, Groupon and Zynga are next up in the IPO pipeline, with both companies arriving on public markets within weeks of each other. Groupon, barring some catastrophic event, will begin trading publicly on NASDAQ November 4th, with shares set at $20 a pop at a valuation of $12.7 billion.
Zynga, too, is expected to trade on NASDAQ beginning the week before Thanksgiving, and according to its revised S-1 filing with the SEC, a “third party” has valued the company at approximately $14 billion. In the same ballpark as Groupon.
So, the question becomes this: Notwithstanding their potential overvaluations at the time they go public, which of the two companies stands to be the most successful and the most valuable in the long run, post-IPO?
Both Zynga and Groupon have become lightning rods of late for criticism over their inflated valuations (among other things), especially as being representative of the high valuations across the industry. (Some attach the dreaded “bubble” label, some don’t, but there is anxiety brewing here no matter what you call it.) There are a lot of questions that need to be answered in short order if the public markets are to become comfortable with the $10+ billion valuations of Zynga and Groupon.
That being said, both companies have waited out the stumbling IPO market and remain (far and away) the market leaders in their respective neighborhoods. In spite of the naysayers, these companies are going to go on to make a lot of money and will be around for the foreseeable future.
THE BIG PICTURE (I.E. THE SPIN)
Zynga is arguably the most popular social/casual game developer in the world, with 232 million average monthly active users in 166 countries and it’s generated over $1.25 billion in cumulative revenue since its inception in 2007. Groupon is running ahead of Zynga in revenues, but not on profits.
For those bullish on group buying, Groupon owns 54 percent of the daily deal market, is the largest local commerce platform with scale effects, counts 143+ million email subscribers in its ranks, and is building on its lead in daily deals by moving into complementary markets, like events, goods, travel, and is attempting to close the redemption loop by merging daily deals, instant mobile offers, and loyalty rewards.Of course, everything sounds picture perfect if you put a full stop there. Hell, give ‘em $30 billion! But there are some downsides. Oh yes, there are some downsides.
WHO HAS THE TECH?
For starters, both Groupon and Zynga count themselves as technology companies. But, in the case of Groupon, if you’re in Rocky’s camp, then the company may not even be worthy of the title, in spite of CEO Andrew Mason’s repeated assertions during the roadshow to the contrary. As Agrawal points out, only 5 percent of Groupon’s more than 10,000 employees are in technology. That’s probably less than some of the local merchants it “represents”.
Groupon’s growth is indeed decelerating, cutting back on marketing and sales expenses to become more profitable (or to dress up its financials for the IPO). Blodget was quick to identify a precedent in Amazon, comparing Groupon’s current status to Amazon’s painful transition from growth to profits between 1997 and 2001.
Both companies waited three years to go public, and while Groupon is generating lower revenue per employee and has been spending more on marketing than Amazon did, the e-commerce giant continued to grow over its first four years as a public company, even though its growth rate slowed. Much like Groupon in the present. As to the technology comparison, in juxtaposition today, Amazon has a far more diverse set of traditional “tech assets” with its innovation in cloud computing with EC2, S3, and other Web services, some of which support the ever-improving Kindle.
Groupon’s lofty IPO (and sale of $700 million worth of stock) brings up comparisons with Google. But Groupon is a sales and marketing (or services) company. The 5 percent of its employees involved in technology are there mostly to maintain the infrastructure. Groupon’s on the Web, but that doesn’t make it a tech company.
If you want to use Google as a comparison, the search giant spends 14 percent of its revenues on R&D. It has Google Labs. Apple’s the same way. Tech companies spend money on R&D, they hire as many engineers as possible (see Facebook), there are barriers to entry, and they develop intellectual properties. Groupon not so much.
As for Zynga, the gaming company’s R&D spend (in Q1) was up 158 percent from the same time last year, and it spends an enormous amount (proportionally) of its revenues on servers. In comparison to Groupon the “sales company” (it has over 4,800 employees in sales), Zynga proudly calls itself an “analytics company masquerading as a games company”.
What that means is that Zynga believes that it will beat traditional gaming companies by taking an alternative route to customer acquisition and retention. It releases free games on Facebook and then obsessively studies the data it collects on how users are playing the game, leveraging that data to tweak the game’s formula to make the gameplay more addictive, increase playability, etc.
Using Facebook as a sharing and marketing platform to tell friends about the game and get them to buy more virtual goods is one thing, but Facebook also provides Zynga with a more robust picture of who their users are and what they’re doing online. This allows the company to take advantage of the platform’s ready-made ability to invite new users to try the game, something offline gaming companies have to work much harder to accomplish.
Zynga just smells more like a tech company.
In spite of all that’s being said, I’m still optimistic about Groupon because of its redemption loop trifecta. The company has long been criticized for not providing merchants with the necessary tools to retain the new customers they see when offering Groupon discounts. But with Groupon Now, the mobile app that lets local merchants offer deals when business is slow to yield retention, and Groupon Rewards, the tool that will allow businesses that offer discounts to later follow-up with another reward after a customer spends a certain amount of money — Groupon is showing that it can offer valuable products to close the gap. (And, hey, with high-end deals of Groupon Reserve, discounts on electronics in Groupon Goods, these could all add up to something retailers can’t ignore.)
Considering the fact that merchants can set the spending level required to achieve the new deal with Groupon Rewards, it should put their collective minds at ease. And for the daily deal behemoth, which already has millions of credit cards on file, it enables them to essentially turn these credit cards into the buy 10 get one free punchcards, and with each visit to a local coffee shop, Groupon can push them mobile or email notifications telling them that they’re just $10 away from the reward. Its new rewards program can actually track what customers are spending at their local merchants, giving them better insight into the success of their core business, daily deals. And merchants will get a dashboard so that they, too, can track customer spending.
Zynga’s true value, on the other hand, comes from its innovation around in-game rewards. Adding virtual enhancements to its games to convince people to spend real money on virtual play money is what has turned it into a multi-billion dollar company. A few years ago, that was a far more difficult proposition than it sounds today.
If Zynga can develop full control over the virtual money supply, it can be huge. There is a bright future around virtual currency, and if Zynga could use its self-controlled platform to institute a virtual currency that is widely circulated and has real inherent value, it could be a serious game changer.
Groupon may be valued at $12.7 billion at its IPO, but Trefis currently estimates Groupon fair value at about $7.9 billion, 54 percent of which emanates from North American featured deals. Trefis arrived at this valuation by collecting the sum of the values of its divisions, plus cash, minus debt.
Blodget’s formula has similar results. Taking the fact that Groupon’s North American business had a 12% operating profit margin in Q3, he projects that it could see a 10% operating profit margin in 2012 and a 15% operating margin in 2013, with earnings of about $300 million in 2013, giving Groupon a $6 to $9 billion valuation, with an average of about $7.5 billion. Comparable to Trefis.
While I do believe Groupon will be a profitable company with a big market cap, its valuation is seriously inflated.
The fact is that Google Offers, Amazon Local, and LivingSocial all pose significant threats. Without a single patent and little to no significant barriers to entry in the space, Groupon has a ways to go before it convinces investors (and now the public) that there’s enough differentiation and value in its model to warrant a high market cap.
As for Zynga, unlike Groupon, the social games giant is already profitable. However, the company saw its net income fall to $1.4 million in the second quarter, down from $13.9 million over the same period last year. It, too, has some serious downsides. The company’s filings show that its revenues come from less than 5 percent of its users and from a small group of games. While the company is working on deploying games on other platforms, most of the company’s business is still generated on Facebook, and it still heavily relies on the social network for sales and the delivery of its major services. (Facebook also takes a significant chunk of the sale of virtual goods.)
In the land of social gaming, Zynga must continuously churn out new games to keep users interested, as casual games have the tendency to become stale quickly. As Industry Gamers points out, Zynga’s new titles are hitting peak daily active users inside of three weeks of launch and the majority aren’t sustaining that activity (with Words With Friends being the one exception). Instead, the new releases have only succeeded in cannibalizing gamers from other Zynga titles, rather than attracting new customers.
Relying on in-game purchases and rewards to encourage gamers to keep users engaged with its titles has been successful thus far, and while investors aren’t happy about its reliance on Facebook, the public perception that its fate is largely tied to Facebook isn’t all bad. Zynga has been receiving lofty valuations in part because it is basically seen as a proxy investment for Facebook. Even Zynga’s Project Z, which is supposed to be the company’s big play at cutting its umbilical cord, will require users to have a Facebook account to log on.
But I think there is huge opportunity for Zynga on mobile and tablets, and if it can keep game development costs low while drawing new users in with Project Z and some new, original titles, profit margins could grow significantly with scale. Some (optimistic) analysts have even put its long-term operating margins at 50 percent.
Zynga expects to see about $1 billion in revenue for 2011, compared to Groupon’s expected revenue of $1.6 billion for the year, but it’s profitable with net incomes north of $19 million for the first nine months of 2011. Zynga is nowhere near its original target of a $20 billion valuation with its revised S-1 and SEC scrutiny over Zyngametrics, but it deserves to be priced above Groupon.
Although EA’s market cap is currently around $7.8 billion, if one is comfortable saying that Zynga can hit $4 billion in revenues by 2014 with 40 percent operating margins, we would have to be generous to give them a 13 to 16 multiple on operating profits, but this could easily justify a $15 billion valuation.
In the end, both Groupon and Zynga are currently valued at prices that are far higher than what I think they’re reasonably worth. I have no stake in either company, but if I were buying, I would choose Zynga over Groupon. I think there’s a greater upside to Zynga and as gamification is poised to seep into everything we do, Zynga is poised to be at the forefront of this transformation. Groupon is here to stay, but there’s just way too much to be concerned about.
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