The Valuentum analyst team talks the latest and greatest trends in the video game entertainment industry from tried-and-true titles to the financial positions of the largest players to retail big box and beyond. ~9 mins.
Kris Rosemann:
Welcome to Valuentum’s podcast. I’m Kris Rosemann and joining us today is Mr. Chris Araos. Chris, you have a strong background as an observer of trends in the video game entertainment industry. How would you say the world of gaming is shaping up these days?
Chris Araos:
Well, Kris — a lot has changed in video gaming in just the past five years thanks to the emergence of more-advanced mobile phones, which are just great devices to play games on. Unlike PCs or game consoles, smartphones are much less expensive to use and, of course, they’re portable, so you can play anywhere.
Incredibly, the market for mobile phones is 8 times the size it was five years ago and is expected to grow at a 60%+ clip over the next five years. Thanks to microtransactions and consumer purchases of full games via digital channels, digital gaming revenues for the interactive entertainment industry are advancing at a robust ~20% clip, but sometimes much faster.
For example, at Take-Two (TTWO), digital-delivered net revenue grew more than 50% during fiscal 2016. And this revenue stream has a higher gross margin relative to packaged goods sales revenue to boot. Activision Blizzard’s (ATVI) November 2015 deal with King, which owns Candy Crush, speaks to how important mobile is for traditional video game companies, EA Sports (EA), the number 1 publisher on Sony (SNY) PlayStation 4 and Microsoft’s (MSFT) Xbox One, is committed to digital, and how can we forget about what just happened with Nintendo’s (NTDOY) Pokemon and consumer’s fascination with augmented reality!
Kris:
Yes, I remember — Pokemon Go was quite the phenomenom! People were outside everywhere trying to catch a Pokemon…
If I recall, the augmented reality game was just launched in July, and it was a huge hit, even though it has fallen from the newsflow a bit of late. From some of the stats that I came across, there were as many as 20 million daily active users in just a month after its launch, hundreds of millions of downloads, with as many as 10% of all Android phones having Pokemon Go installed on them. Incredibly, Pokemon Go had more first week downloads from the Apple (AAPL) App Store than any other app in history. Its revenue contribution hasn’t been a needle-mover per se, but I can only imagine how important augmented reality will be for the video game space in the future. Facebook (FB) has been investing a lot there with virtual reality with its Oculus initiative.
Good points Chris, but how would you say traditional video gaming is doing? Is it now a dinosaur because of mobile?
Chris:
Well, not quite.
As you know, industry sales continue to revolve around new console upgrades, as gaming sales are often reduced in advance of the latest and greatest upcoming platform. So this industry is still quite cyclical in that respect. To give you an idea — Activision’s revenue in 2015 was below that achieved in 2011, while EA’s revenue in fiscal 2016 is only modestly above its mark in 2012. Get this — Take Two’s revenue hit $2.3 billion in 2014, but now it has fallen to $1.4 billion as of 2016. The big drop had to do with a huge year in 2014, which included the release of Grand Theft Auto V on Sony’s PS3 and Microsoft’s Xbox 360.
Though it may be cyclical to a degree, traditional console gaming is not down and out by any stretch. Looking to the future, Nintendo will be rolling out the Switch in 2017, and we’ll be monitoring how that impacts the PlayStation/Xbox One rivalry. The PlayStation 4 has pretty much outsold the Xbox One by a factor of 2 to 1, but Microsoft is working on Project Scorpio, the next iteration of the Xbox One, and Sony’s PlayStation Neo could be very exciting, too.
Kris:
Yeah, I can’t wait to see the next-generation gaming technology. But would you say that even with these new and exciting gaming consoles, there are a lot of risks out there for video gaming stocks?
Chris:
Yes, absolutely. This industry will almost always be a hit-or-miss one when it comes to the individual games. Competition is intense, and many publishers only roll out a few titles each year!
According to The NPD Group, the top 10 titles accounted for 33% of the retail sales in the U.S. interactive entertainment industry in 2015. Another example to illustrate such concentration is that for Activision Blizzard, Call of Duty, World of Warcraft, Skylanders and its Destiny franchises combined to account for about 75% of revenue, on average, during the past three years, and even a higher percentage of its operating income. The three largest franchises at EA Sports account for ~55% of revenue — and for Take Two, Grand Theft Auto alone accounted for nearly 55% of its revenue! As you can imagine, should one of those franchises fall out of favor, these companies would face considerable pressure.
Kris:
Whoa –that’s something investors definitely need to be aware of. But what about financial risk?
Chris:
That’s more mixed, I’d say.
Activision Blizzard holds a sizable net debt load, as one example, so these entities can sometimes have both considerable operating and financial risk.
EA’s balance sheet, however, is in much better shape, with a rich net cash position. Take-Two also has a decent net cash position.
What we do like about the video gaming companies, however, is that free cash flow is extremely robust, averaging about $1 billion in each of the past 2 years at EA and about the same over the past 3 years at Activision Blizzard. Take Two is also free cash flow positive.
Kris:
Great stuff. So very strong cash flow generators with asset-light business models. Lots of potential for economic-value creation if they do things right.
Okay — maybe you can give us your thoughts on the future of the most important franchises. How about Call of Duty and World of Warcraft for Activision, Fifa 17 and Madden NFL 17 for EA Sports, and maybe NBA 2K17 and Grand Theft Auto and for Take-Two.
Chris:
That’s a great list and you nailed some of the heavy hitters, Kris.
We think all of those you mention will be relevant for years to come. Call of Duty Black Ops III continues to be the top-selling current-gen game, according to NPD and World of Warcraft Legion was recognized as one of the fastest-selling PC games ever. FIFA 17 has been revolutionary, and engagement has never been better thanks to the introduction of story mode, “The Journey,” for soccer fans across the globe. Get this — Madden NFL 17 players spent more time playing the game in the third calendar quarter of this year than in any Madden title in the past 5 years! As for Take-Two, NBA 2K17 had record-breaking results and performance for Grand Theft Auto remains solid, despite its more controversial backdrop.
Kris:
Awesome. So we don’t expect too many surprises there with the strong cash-flow-generating titles… what about some up and coming new games that should be on investors’ radar screens? How’s the pipeline?
Chris:
Pretty good. The Legend of Zelda on Nintendo’s Switch looks to be highly anticipated for 2017. Microsoft’s Scalebound and EA’s BioWare are others, and the list is quite long. So pipelines are healthy, but so is the competition for consumer dollars. But you never truly can tell what will be the next big hit. Case in point — Pokemon Go. Some publishers may be able to catch lightning like that but the next iteration of some of the tried and true games, especially the sports franchises like FIFA, Madden and the like, will be recurring winners, in our view.
Kris:
Excellent — so lots of new titles for gamers to choose from. Another theme I wanted to get your thoughts on, perhaps a more ominous one — What would you say about the growth in digital and the impact on retailers like Best Buy (BBY) and GameStop (GME), for example. Are these brick-and-mortar retailers in a lot of trouble?
Chris:
Great question — and this has been on our minds for years, but Best Buy seems to be able to reinvent itself each year, even as it faces incredible competition from the likes of Amazon (AMZN). The console will still be an important part of gaming in the near term, but growth in digital is not something that plays into the hands of either Best Buy or GameStop.
We’re most concerned about GameStop’s relevancy over the long haul. What if Sony or Microsoft completely cut out the physical game sales out of the supply chain and switch completely to digital distribution, for example? Same store sales are already plummeting at GameStop and with about half of its gross profit coming from profits related to used (pre-owned games sales), a huge part of its business is at risk over the long haul. The company remains incredibly profitable, for the time being, however.
Kris:
Wow — that is quite something. Big box retail seems to be facing pressure from almost every direction in this increasingly-digital economy. With all of this considered, how are we playing “video games,” per se? What’s our favorite idea?
Chris:
Well, while not a pure play, we like the total package at Microsoft. We don’t include it in the Dividend Growth Newsletter portfolio because of its exposure to this channel, but we do so for a large number of other reasons, not the least of which is its cloud business opportunity, reasonable valuation, strong dividend growth prospects and fortress-like balance sheet.
Some of the players in the video game supply chain could be big winners, but it’s difficult to handicap with precision, again pointing to the immediate and unexpected success of Nintendo’s Pokemon Go. We also think Facebook will become a major player in the space, particularly as it relates to virtual reality. Facebook is included as an idea in the Best Ideas Newsletter portfolio. One thing is clear — the video gaming entertainment space is one exciting area to follow!
Kris:
Thanks for your thoughts Chris. I’m Kris Rosemann with Chris Araos for Valuentum Securities. Thanks for joining us today.
Software – Graphics: ATVI, AVID, COOL, EA, GLUU, KZ, ROVI, RST, TTWO, ZNGA