Why You Should Not Buy into Zynga's Rally

Facebook filed a highly anticipated five billion dollar IPO last night, which has made the entire social media sector boom today. LinkedIn LNKD is up nearly 6% and Groupon GRPN is trading up almost 7%. As a result, the Global X Social Media Index Fund ETF SOCL, in which aforementioned stocks have a significant weight is up 2.5%. The biggest mover, however, is a social game developer Zynga ZNGA. The company's biggest titles, such as FarmVille and Mafia Wars, gather millions of players every week on Facebook's platform. The stock is up 18% today, as Facebook's IPO filing mentioned that 12% of Facebook's revenue comes from Zynga's games. So, should you buy into this rally? Sterne Agee analyst, Arvind Bhatia, who has an Underperform rating on Zynga, told Benzinga that Facebook's IPO filing did not change his opinion and that it did not offer any new information that would be positive for Zynga. Bhatia said that today's rally in Zynga is caused by the false impression that Zynga's valuation should be 12% of Facebook's valuation because it accounts 12% of Facebook's revenues. Bhatia points out, for instance, that Zynga's growth rate is currently half of Facebook's and that the company is highly dependent on Facebook, as a staggering 94% of company's revenues come from Facebook's platform. Thus, there is the looming threat that Facebook could demand a bigger share of Zynga's revenues and significantly hurt the game developer's earnings. When asked about Zynga's ability to diversify by releasing games on different platforms, Bhatia was not optimistic. He said that in the foreseeable future at least 90% of Zynga's revenue would come from its Facebook games. Thus, continued success on Facebook is vital for Zynga, a social games company that went public less than two months ago. Overall, the high level of dependence on Facebook is clearly a risk factor for Zynga and the company also brought up this fact in its IPO filing. Additionally, investors should be concerned about Zynga's negative growth rate, which indicates that the Facebook users might be becoming less interested in improving their farms and spending money to equip their mafia soldiers. You can follow me on Twitter @TuomoKallio