Stock Investing

This industry has a long runway for growth, but quality stocks are expensive at the moment, Morningstar research shows.
By Vikram Barhat | 18/10/17

 Video games are no longer just a source of downtime distraction. The industry has now come to be recognized as a strong engine for economic growth. Last year, the industry racked up a staggering US$30.4 billion in revenue in the United States alone, according to the Entertainment Software Association, which represents companies that publish computer and video games.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

More than 150 million Americans play video games, and at least one person plays regularly in 65% of American households, the ESA reports. A Canadian study conducted by the same firm identifies more than half of Canada's population, 19 million to be precise, as gamers.

Rapid advances in virtual reality (VR) and augmented reality (AR), and newer generations of VR-enabled smartphones, gaming consoles and other devices will continue to galvanize the video game industry. PwC's 2017 Global Entertainment and Media Outlook projects that global video game revenue will surpass US$120 billion by 2021 from about US$90 billion in 2016. The industry's remarkable growth prospects represent attractive investing opportunities for investors who want to play the video-game market, which a Goldman Sachs analyst recently said was entering the "halcyon days of gaming's digital age." The analyst added that the "video game publishers are in the midst of a renaissance."

It's a closely contested landscape dominated by a few players that are jockeying to gain the lion's share of this massive worldwide market. With highly addictive games, innovative themes and cutting-edge technology, these companies are strongly positioned to capitalize on the latest social and gaming trends, and the market's long runway of growth. However, given their stocks' lofty valuations, investors may want to wait for a market event to create a more attractive buying opportunity, and a wider margin of safety, according to Morningstar equity research.


Electronic Arts Inc.
Current yield:-
Forward P/E:24.5
Fair value:US$90
Data as of Oct. 13, 2017

A leading third-party video game publisher,  Electronic Arts (EA) is one of the largest publishers of games on consoles, PC and mobile devices with more than 300 million registered players worldwide. The company, which owns such popular games as FIFA, Madden, Battlefield, Dragon's Age and Need for Speed, recently signed a 10-year contract with Disney that granted EA the exclusive rights to develop Star Wars games across all platforms.

"The firm will consolidate its leading position by developing compelling new versions of its existing franchises and by creating new experiences with its Star Wars license," says a Morningstar equity report, noting that the firm is well placed to "benefit from the continued growth of the current generation of consoles (Xbox One and PlayStation 4), the ongoing revitalization of PC gaming, and the growth in mobile gaming space."

EA, like other players, has benefited from the deeper chasm within the industry that places major AAA blockbuster titles on one side and smaller independent games on the other.

Morningstar equity analyst Neil Macker says the company will continue using its stable of franchises and licenses to create new games, particularly in the free-to-play, or F2P, space. "The firm is focused on engaging users beyond the initial game sale via extending the monetization window by expanding the use of multiplayer options and releasing downloadable content, or DLC," he notes.

Online multiplayer games lead users to form social networks, which in turn encourages player loyalty through either informal friendship networks or actual teams, says Macker, who puts the stock's fair value at US$90, implying a price-to-2018-earnings ratio of 26 times, and a free cash flow yield of 5%.


Activision Blizzard Inc.
Current yield:0.5%
Forward P/E:26.2
Fair value:US$42
Data as of Oct. 13, 2017

 Activision Blizzard (ATVI) is one of the world's largest video game publishers whose impressive portfolio includes well-known games including US$8 billion World of Warcraft, and Call of Duty.

The introduction of Hearthstone and Heroes of the Storm is proof the firm is capable of maintaining its market dominance supported by compelling new iterations of its existing franchises and by introducing whole new experiences for gamers, says a Morningstar report.

Market trends such as the expansion of the mobile market, the resurgence of PC-based gaming and new generations of Xbox One and PlayStation 4 consoles create a tailwind of financial benefit for the company. The videogame giant is expected to exploit monetary benefits of the large user base it acquired through the recent purchase of mobile game maker King Digital, by inserting third-party ads in the company's mobile games. However, "substantial revenue contribution [through this] could take until 2018 and beyond to appear," cautions Macker, who pegs the stock's worth at US$42, incorporating 2017 adjusted P/E of 45 times, and a free cash flow yield of 5%.

Activision generally targets the higher end of the market and uses its capital to fund the higher budget blockbusters while leveraging its marketing advantage to push its titles across multiple advertising platforms. A dedicated user base allows Activision to offer more of its games through direct digital channels, sidestepping retailers, which helps realize higher gross margins and improve returns on invested capital.

"The firm is focused on engaging users beyond the initial game sale via extending the monetization window by expanding the use of multiplayer options and releasing downloadable content," says Macker.


Take-Two Interactive Software Inc.
Current yield:-
Forward P/E:22.7
Fair value:US$60
Data as of Oct. 13, 2017

Owner of some of the most popular games,  Take-Two (TTWO) is one of the largest independent video game publishers across a range of platforms. The company's portfolio is studded with coveted gems such as Grand Theft Auto (220 million units sold) NBA 2K, Civilization, Borderlands, Bioshock and XCOM.

"The firm is well positioned not only to capitalize on the success of Grand Theft Auto (GTA), but also to continue diversifying its revenue beyond its signature franchise," says a Morningstar report. "The firm has established new franchises such as Borderlands and Bioshock while reinvigorating older ones such as XCOM."

Take-Two, the report says, continues to benefit from industry trends including console upgrades, the rise of digital downloads, widespread adoption of mobile games and the expansion of the F2P business model. The video game behemoth's largest annual franchise, NBA 2K, had its most popular release with NBA 2K15, which shipped 7 million units, versus an average of over 5 million units for the previous four years.

A strong catalogue continues to boost digital revenue as Take-Two ports older titles to new platforms, a trend Macker says will remain strong, "especially for the GTA games, which have demonstrated proven cross-platform demand over the years."

The company is likely to continue to invest in new intellectual property and fund the development of sequels and new games that will boost revenue and help move into faster growing areas such as mobile, says Macker who recently raised the stock's fair value from US$52 to US$60, supported by "a longer tail for GTA V and larger impact for Red Dead Redemption 2."

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