It’s the dirty secret of Wall Street. That report on a newly-public company tends to look a lot like the investment-banking pitch investors saw during the pre-IPO (initial public offering) roadshow. Those bankers come up with lofty projections to help sell the deal, and the analysts that ultimately follow the company simply copy and paste many sections of the bankers’ reports and issue a similarly glowing outlook.

That’s why investors seek out opinions of analysts who had no involvement in the IPO. These folks carry no hidden agendas, must do their research from scratch, and are often closer to the mark when it comes to forecasts and price targets. Better still, they can weigh in right away, and aren’t subject to the lengthy “quiet periods” that the banking-related analysts are constrained by.

So it should come as no surprise that Sterne Agee’s Arvind Bhatia holds a fairly critical view of social-gaming developer Zynga (Nasdaq: ZNGA), which is perhaps the biggest IPO of the month. Sterne Agee wasn’t in on the deal, so when Bhatia warns that investors should avoid this stock like the plague, they need to pay attention. His $7 target price is a far cry from the current $10 IPO price.

The numbers don’t lie
Bhatia took a deep look at Zynga’s financial metrics and spotted real problems. “Zynga’s growth is slowing even faster than what is obvious at first, its margins are under pressure, and free cash flow has been declining recently,” he wrote in a Dec. 13 note to clients. I’ll dig through these key points in a moment, but first let’s look at why this IPO has been so eagerly anticipated.

If you are a fan of Facebook, then you’re likely familiar with Zynga. The company has developed the most popular games on the world’s most popular social network, and most impressively, made plenty of money from one game in particular: FarmVille — the game that put Zynga on the map. Launched in 2009, the game enables users to help run a virtual farm by plowing land, planting and growing crops, and raising livestock. Nine months after its launch, FarmVille had 29 million daily active users (DAU — meaning users played the game at least once a day). The number of players logging on at least once a month (MAU) peaked at an impressive 49 million. Today, FarmVille’s DAU stands at less than 10 million.

Zynga’s second foray into Facebook gaming came with CityVille, which focused on building up an urban area. A year ago, CityVille got off to an even faster start than FarmVille, but peaked faster as well: DAU maxed out at about 21 million and now stands at about 10 million. Zynga has subsequently launched a slew of other gaming titles, but none has even reached the 10 million mark for DAU.

The lack of follow-on hits is already negatively affecting sales trends. Quarterly growth, as reflected by new bookings, was stunning in 2009 and 2010, but has slowed to a crawl in 2011, as you can see in the chart below. Actual stated revenue growth is likely to look more impressive as the company places much of the bookings into deferred revenue. But this deferral can only help for so long.

 
Source: Company reports

To be sure, Zynga will have plenty of cash to develop many more games. The company already had nearly $900 million in the bank before the IPO, and raised another $1 billion with this deal.

Still, competition is rising, so Zynga needs to figure out how to come up with blockbusters like FarmVille and CityVille. FrontierVille and Adventure World, which were recently launched, just aren’t doing the trick. Traditional video-game developers such as Take Two Interactive  (Nasdaq: TTWO) can at least count on strong demand for updates to existing hot titles such as Grand Theft Auto though, as Sterne Agee’s Bhatia notes, “sequels in social gaming are not a guaranteed success.”

In 2012, Zynga will be launching two new games on Facebook — Hidden Chronicles and Zynga Bingo. If they don’t gain major traction, then this stock may be in real trouble as investors come to perceive Zynga as a steady — but not spectacular — growth stock. After growing 156% in 2010 and a projected 35% to 40% in 2011, Bhatia says Zynga’s bookings growth could cool to 20% in 2012 and 17% in 2013. (Again, this is not to be confused with actual revenue growth, which will likely be more robust in 2012 as still-strong levels of deferred revenue move from the balance sheet to the income statement).

Could Bhatia be too bearish? After all, the company is just now branching out beyond Facebook (which currently accounts for 94% of sales) onto other platforms such as Google’s (Nasdaq: GOOG) Android. In addition, Zynga has only scratched the surface in terms of international penetration.

But the Sterne Agee analyst has a second bone of contention: Profit margins are falling fast. He notes that EBITDA slumped 24% from a year earlier in the first nine months of 2011, to $235 million. I disagree this is a red flag, as the company has spent heavily on staffing and management compensation (so executives can load up on pre-IPO stock that must be expensed). This heavy spending growth will presumably cool in 2012; hence, any revenue growth at this point will likely quickly flow to the bottom line.

Still, this stock will ultimately trade on perceptions of growth, and Bhatia thinks Zynga’s growth is slowing down meaningfully. He comes up with a $7 price target after comparing Zynga with other recent social media IPOs and existing publicly-traded Internet companies. Bhatia says the stock could be worth about three times his projected 2012 bookings forecast of $1.388 billion, which works out to be $7 a share. 

Risks to Consider:  If you’re contemplating shorting this stock, then think about this: Zynga spent $149 million on research and development (R&D) in 2010, and is on track to spend $400 million this year. That’s a lot of dough, so it may well come up with the next FarmVille, and grow a lot more robustly than Bhatia anticipates.

Action to Take –> It will be interesting to compare Bhatia’s financial projections with those issued by analysts who worked at banks that underwrote Zynga’s IPO. These underwriting analysts are bound to be quite bullish, which makes it risky to short this stock when the quiet period ends a little more than a month from now. Still, it’s hard to argue with Bhatia’s math. It increasingly looks as if this stock will be trading in the single digits in 2012.