Game Stocks Rally Following Weak Data and a Weak Outlook

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

The outlook for physical retail video games turned negative last Friday as data showed significant weakness during a crucial month. As a result, stocks within the sector opened the day lower, but then remarkably rallied to post strong gains. The performance seems a bit strange, and could be presenting somewhat of a value trap for investors.

The Industry at a Glance

The NPD Group is a firm that tracks the sales of physical goods in the video games industry. Throughout the last year sales of video games have weakened as consumers continue to utilize smartphones and tablets for entertainment use. However, the data for the month of December was particularly grim.

According to the NPD Group, video game hardware and software sales for December fell 27% and 23% respectively year-over-year. The numbers are particularly bad considering the launch of several big name games and because it shows the continuation of steep declines. In November, sales fell 13% and 11% for hardware and software, therefore as I said, the declines look to be much more aggressive as of now. Furthermore, sales of the top-selling console, Xbox 360, declined 17.6%, which could indicate weak video game sales for some time to come.

Despite a great fall in sales within the video game industry, the industry still saw sales of nearly $11 billion in 2012. However, there is a rapid shift occurring, and it’s starting to look as though companies who operate in this segment will see significant fundamental declines. Therefore, it’s hard to imagine how the largest stocks in the space could have rallied on Friday. It doesn’t make much sense! However, maybe it’s because these are fundamentally cheap stocks? Perhaps we should take a look at the top three to determine if the valuation suggests that all bad earnings have been priced accordingly.

Is there Upside in a Dying Industry?

Combined, Electronics Arts (NASDAQ: EA) and Activision Blizzard (NASDAQ: ATVI) completely dominate the video game space. These two stocks combined with GameStop (NYSE: GME) rallied to post significant gains on Friday as analysts came to the rescue. The reason that analysts upgraded the stocks is because of valuation, and big-name video game releases for 2013 could overshadow poor sales. However, with Activision Blizzard and Electronics Arts dominating the space, we have to assume that much of the decline in sales is a result of falling sales for each company.

After looking at the metrics for both Electronics Arts and Activision Blizzard I realized that both companies are valued very similarly. Both trade with forward P/E ratios of 11.76, have revenue between $4 and $4.5 billion, yet have completely different margins. Activision has a profit margin of nearly 20% while Electronic Arts’ profit margin is just 0.37% over the last 12 months. Both companies have significantly improved in terms of efficiency and have managed to grow behind top titles such as Call of Duty and Madden. Therefore, it might be fair to suggest that both companies are valued fairly compared to their fundamentals; meaning each stock should perform with fundamental growth or decline.

In the last year, Activision Blizzard has lost just 5% of its value while Electronic Arts has lost more than 27% of its value. Both stocks have greatly underperformed the broader market but have a great presence of institutional ownership. Looking ahead I see three major fundamental issues for these two companies: 1) sales are declining as consumers switch to mobile and social platforms 2) data shows that consumers are not willing to pay more than $5 for games on either mobile or social which means less profit per sales 3) and finally, concerns of either company not having the “next” billion dollar video game.

In relevance of slowing sales and a fundamental shift to mobile/social platforms, no other company might be more affected than GameStop. In the last year it has lost only 6.5% of its value because it’s already incredibly cheap; forward P/E ratio of 6.84 and a price/sales of 0.31. As sales continue to fall as will the fundamentals of GameStop. Earlier this month the stock slipped 7% after reporting that holiday sales fell 4.6%.

Conclusion

At this time it’s hard to identify value in any of the stocks that prosper from video game sales. The bulk of profit in this space is from physical video game sales, but as of now, the bulk of demand is in the low margin low revenue social and mobile platforms. The problem for companies such as Electronic Arts, Activision Blizzard, and even GameStop is that 42% of all new games are being focused on mobile. Therefore, digital revenue is increasing but the attention span of digital users is much shorter due to a larger selection and less revenue per game; which is a reality that this industry now encounters. Therefore, I don’t see the industry being able to evolve and adapt to these new changes. I would watch for declines in the valuation of these companies, as the decline in fundamentals become even more abrupt in 2013 as the shift becomes more relevant throughout the globe.


BrianNichols has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard and GameStop. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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