Why You Should Buy Groupon Over Zynga

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It seems like just yesterday that every investor was hot on "social media." Now the market is starting to realize how inflated their initial expectations were. Ironically, however, the market has over-corrected for its poor starting assumptions and caused one stock in particular to become undervalued…

The Case For Groupon (NASDAQ: GRPN)

After falling 87% from its 52-week high, Groupon has been even more of a loser than Facebook. Yet the company still generates a 10.8% free cash flow yield and trades at a reasonable 12.8x forward earnings (reasonable for a high-growth stock). While analysts still rate the company a 2.8 out of 5, where "5" is a "sell," they were also forecasting 27.1% annual EPS growth over the next 5 years. That kind of growth would easily be enough to make the stock undervalued. So, what's the "deal" with Groupon?

In my view, the stock is worthy of a speculative "buy" after the sell-off. Keep in mind that its revenue skyrocketed from $312 million in 2010 to $1.6 billion in 2011. The company is only worth $2.9 billion and, though operating margins are razor thin at 3.5%, there's room for improvement. Bears have argued that competition will squeeze the firm even more, but I find that this talking point has been more than factored into the stock price, given that it is currently valued as if earnings will nearly be offset by margin erosion. The industry average is nearly double Groupon's level; but, then again, Groupon is a one-of-a-kind stock.

While the company missed expectations with a surprise of -166.8% in 4Q 2012, results since then have been fairly strong. Revenue and EPS has consistently trended upwards, and I do not expect this trend to reverse any time soon. If anything, add-on programs like Groupon Payments and Breadcrubs will help to not only sustain the business beyond initial expectations through building brand loyalty among retailers, but also through expanding margins. If Facebook (NASDAQ: FB) is able to trade at a premium valuation for what it can "do," then it is likely investors will eventually value Groupon at some point. Your goal should be to buy now and sell at the peak of investor enthusiasm, which shouldn't take much to drive up the valuation.

Zynga (NASDAQ: ZNGA): CEO's Words at 3Q 2012 Call Should Be Considered Revealing

Zynga has similarly slid around 87% since its 52-week high. Valued at around its 52-week low with a "sell" rating on the Street, but holding little debt and an under-book-price valuation, Zynga appears to be your class value trap. Perhaps the Chairman & CEO, Mark Pincus, best articulated this in the last 3Q earnings call when he said, "The last several months have obviously been challenging for us."

While Pincus then followed by saying how "a series of steps" have recently been made to "drive long-term growth and profitability," it's not exactly clear what the company can do to turn the tide. My thesis on Facebook is that the company is a fad that is already seeing decreased use from its earlier active users. Nearly every month I hear references to people being "done" with that histrionic network. And if Facebook goes, so does Zynga's "long-term" potential. It is humorous then that Facebook keeps referring to how many users it has when that bears no relevance to how active original users have become. If they are either plateauing or decreasing use, it's a good sign that the fad is dying.

It should not be surprising that the company has failed to meet growth estimates. CityVille and CastleVille have "found it more challenging to maintain historical levels of player engagement." Management suggested that this was due to a failure in "creat[ing] enough heat for our players by innovating on content and features" and mobile, tablet, and smartphone alternatives. But, Pincus explains, "We've got more great games coming".

At the same time that management wants to create more "great games," it also plans on initiating a $60 - $80 million cost reduction program. If your company is already in the position where it needs to act as if turnaround mode is necessary, it's a good sign that the fundamentals are inherently challenged. I thus recommend avoiding the stock, despite how beaten it has been.

Interested in Additional Analysis?

Zynga's post-IPO performance has been dreadful, and investors are beginning to wonder if it's game-over for this newly public company. Being so closely related to the world's largest social network can be a blessing and a curse at the same time. You can learn everything you need to know about this company and whether they're a buy or a sell in The Motley Fool’s new premium research report. Don't even think about picking up shares before you read what the Fool’s top tech analyst has to say about Zynga. Click here to access your copy.  

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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