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Zynga's virtual items may turn into real cash for investors

Regular readers of Vox know this column has been, shall we say, skeptical of stocks with sky-high valuations, particularly those from the social media set. LinkedIn? Overpriced at $35 (U.S.), much less the $120 it traded at on its first day. (Oops.)

But Vox also recognizes the temptation to buy in to this phenomenon may simply be too great for many. So we offer this piece of advice: If you simply must buy one overpriced, over-hyped Internet stock this year, consider Zynga Inc.

Zynga, which filed last week for its public offering on the U.S. markets, is the proprietor of a host of games played on Facebook, such as FarmVille. If you're on Facebook, you know how popular they are; until I figured out how to block my friends' game updates, my News Feed was a constant stream of "Scott planted soybeans in FarmVille – play now!" and "Melissa just burned the meatballs in Café World!"

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Zynga's prospectus enumerates the phenomenon, and the numbers are staggering: 60 million daily users in 166 countries, with 2 billion minutes of play per day. Every second – second! – Zynga's users create 38,000 "virtual items."

Virtual items? They are crops planted in FarmVille, sidewalks paved in CityVille, dishes prepared in Café World and military units deployed in Empires & Allies. How intangible can you get?

Well, while many people can and do play Zynga's games for free, many other pay real-life dollars to get extra currency in these games and advance to higher levels, faster. (As part of my research, I yielded and started playing FarmVille Tuesday. The game wouldn't let me plant rhubarb because I had not yet attained "Level 11," as if growing rhubarb is harder than growing soybeans.) FarmVille offered me a range of options, from 7,500 "farm coins" for $5 to 70,600 coins for $40 – the "best value," it noted.

It's ingenious. Imagine if your competitors in Monopoly could get extra cash in the bank by paying real money to get it. Except that Zynga's customers play these games every day, because they require commitment and near-constant attention, like those Tamagotchi handheld digital "pets" that "died" if you didn't feed them. (My FarmVille strawberries wilted some time Tuesday night while I was sleeping.)

The Zynga users' commitment is adding up to some real money. In the first quarter, Zynga had $235-million in revenue (up from just over $100-million in the prior-year quarter) and profit of $11.8-million, smaller than it could have been because Zynga spent $71-million on research and development. Operating cash flow was a shocking $104-million.

The full-year 2010 numbers are similarly impressive: operating cash flow of $326-million on revenue of just under $600-million. Zynga answers that trick question in microeconomics class: If the cost of selling one additional unit is zero – then, omigod, marginal revenue is equal to marginal profit!

Now, of course, the valuation warnings. Since Zynga's filing is just a preliminary prospectus, and the offering is weeks or months away, the company didn't have to value itself. But news reports suggested the company will price its shares at a $20-billion market capitalization.

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That implies a multiple of 27 times trailing sales (or 14 times 2011 sales, if you presume this year's first-quarter performance will continue.) The trailing price-to-earnings ratio is 208. Trailing price-to-operating cash flow is a mere 59, though. Cheaper, but not as cheap as the virtual soybeans, to be sure.

And while Zynga has a huge lead in social gaming – it's the dominant fun-time provider on Facebook, and its user numbers speak for themselves – its future growth is going to require a steady stream of games that are just as addictive as the last batch.

Still: While we speculate whether LinkedIn, Pandora, Twitter, and Groupon can ever fully monetize their user bases, Zynga is stuffing its pockets. It now has $1-billion in cash, no debt, and a user base increasingly willing to pay to play. If you're willing to play "SocialMedia MarketVille," Zynga may indeed be your "best value."

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