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How to Play the Social Gaming Trend Before Zynga’s (ZNGA) IPO

Yesterday, our Chief Investment Strategist, Louis Basenese, revealed his seven reasons why Friday’s much-hyped Zynga (Nasdaq: ZNGA) IPO [1] might not be so hot.

One reason he cited involved Zynga’s dependence on “whales” to keep the company afloat. Whales refer to a small percentage of users who are responsible for a large percentage of Zynga’s revenue.

For the record, I agree with Louis’ assertion.

You see, Zynga relies on the “freemium” business model popularized by the recent uptick in social gaming, meaning that the games are free (or at least cheap). Users then have the option to make purchases within the game itself.

Three percent of Zynga’s users presently buy these virtual goods – the company sells upwards of 38,000 virtual items every second [2]. More impressive still, of the company’s $598 million in sales last year, 96% came from in-app purchases.

The trend is catching on, too. Earlier this year, mobile analytics firm, Flurry, reported that “65% of the revenue generated from Apple’s (Nasdaq: AAPL [3]) App Store’s] top 100 grossing games came from freemium applications.”

Social gaming developer, PopCap, predicts that the trend is only going to get hotter, saying, “One year from now, 95% or more of iOS game downloads might come from freemium games… The freemium model is extremely powerful because it allows developers to reach the biggest possible audience, and it allows players to choose if and how to pay for content, after having tried it out.”

But the real question is whether this model is actually sustainable.

Our opinion is an emphatic, “No!” As Louis mentioned yesterday, “finding and retaining ‘whales’ becomes harder and more expensive as a business matures.”

But that doesn’t mean the freemium business model doesn’t have upside appeal to investors. It does. We just need to adjust the lens a bit…

A Growing Presence in the Social Space

Electronic Arts (Nasdaq: ERTS [4]) has quietly been elbowing its way into the social gaming and freemium space.

Here’s a quick rundown of its current efforts:

Like Zynga, EA is making the model work. The company reported that revenue from social and mobile games hit $234 million in the last quarter – a 45% increase over the same quarter last year. And its social gaming studio, Playfish, has seen its average revenue per user climb for the last six quarters in a row.

So EA is certainly holding its own in the social and freemium space. In fact, according to Helix Investment Management, “While Zynga may have control over social gaming on Facebook, it’s Electronic Arts that has the widest overall presence in the social/mobile world.”

And while that’s all well and good, here’s where Electronic Arts sets itself apart from Zynga, providing our airtight investment rationale…

Still a Killer Premium Game Competitor

Electronic Arts doesn’t depend completely on the revenue generated from its freemium games. EA continues to be a solid competitor in the console gaming race, too.

Its Battlefield 3 game, for instance, might not be as insanely popular as Activision’s (Nasdaq: ATVI [5]) Call of Duty: Modern Warfare 3. But it’s sold a respectable eight million copies since October.

During the last quarter, EA’s soccer game, FIFA 12, also sold nearly eight million units. And its football game, Madden NFL 12 sold over three million.

In short, with 76% of its revenue still coming from its premium content, its social gaming endeavors are just a bonus at the moment.

Not to mention that the company has some promising games in the pipeline. Like the launch of its upcoming online game, Star Wars: The Old Republic, which has already attracted more than enough subscribers for EA to turn a profit.

Bottom line: Zynga might have popularized the freemium business model, but it’s not sustainable on its own. Electronic Arts, on the other hand, is perfectly positioned to reap the benefits of the freemium and social gaming trends, while continuing to profit from its successful premium games, too.

Good investing,

Justin Fritz