Think You'll Make Money in Video Games? Fat Chance.

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

I LOVE video games. 

Right now, as I am writing this post, I am fighting the urge to go play Activision’s wildly successful Modern Warfare 3 with my best friend who lives on the other side of the country.  But I am fighting that urge for good reason.  If just one person reads this post and gets my message, it will have been worth the lost hour of game time.  Even though I should probably put it at the end, here's what you need to get out of this post: 

Gaming companies make awful investments.  Mostly.  But not all of them. 

Just look at the share price of a few of the usual suspects in the industry over the past five years, plus a behemoth that plays a critical role to the gaming universe:

 

<img src="http://media.ycharts.com/charts/99e16d8129301556418041e42aaf8a4e.png" />

 ATVI data by YCharts

Just for fun, I've added Microsoft (NASDAQ: MSFT) to the mix.  After all, whether most realize it or not, the future of Mister Softy is tied to the video game market.  I'll discuss that later.  But as far as pure video game companies, with the notable exception of Activision Blizzard (NASDAQ: ATVI), this segment is clearly a great place to lose money. But let’s take a look at making a decade-long investment. Long-term investing is the way to go, right? 

<img src="http://media.ycharts.com/charts/513ca8fee68a0dc7835d160ab75f8975.png" />

ATVI data by YCharts

Well, not so much, this time.  Long-term, and quality companies.  That's the key.

So unless you are investing in Activision Blizzard. It’s just not even close. Even Microsoft's share price has at best only kept up with inflation, returning less than 18% over the time-frame measured above. 

In all fairness, we need to include the dividend yield to get a full picture.  As the chart below shows, Microsoft becomes a much better investment, adding another 30% to your ten-year return.  To paraphrase Warren Buffett, reinvesting dividends "gives you the magic of compounding interest!"  Activision is about two years into a steady dividend payout, while the others have shown no ability to return profits back to investors.

<img src="http://media.ycharts.com/charts/5190b3a7fba7d235b69c66392cbfa91c.png" />

Dividend Yield data by YCharts

With that said, I'm not going to type another word about why the deadbeats above are bad investments.  Let's focus on Activision a little bit, what the real challenges are, and who the real challengers are -- because frankly, it's not the other video game publishers.

Game unit sales and revenues are down.  Why am I even still reading this?

While there has been a dip over the past year, and that short-term trend has investors disconcerted, industry revenues are significantly higher than where they were a decade ago, and the historical growth trend should return.  And with distribution moving away from physical sales and delivery at traditional brick-and-mortar retailers such as Best Buy and GameStop, trending to online direct distribution, gross margins are also increasing, and this trend should be sustainable. 

Breaking sales records again? Meh.  Cash-flow super-franchise?  Well, how are you gonna replace it?

Activision's Call of Duty franchise has consistently been a best-seller, entering territory previously reserved for Hollywood blockbusters.  With the Elite premium subscriber offering for the current iteration, MW3, there are now about 2 million paying subscribers kicking in good money above and beyond the initial game price.  As nice as that incremental revenue is, it hasn't offset what is probably the biggest concern investors have:  What's going to replace WoW?

Nearly 8 years after its initial launch (which was actually on the 10th anniversary of the original Warcraft game launch) World of Warcraft is still going strong, with over 9 million paid members.  If you think about it, that's amazing staying power.  We are talking about nearly 20 years of success for this franchise, and close to a decade for WoW itself.  After many attempts by competitors, nobody has ever really come close to knocking the king off the hilltop.  Honestly, that's part of the problem with making a future investment in Activision, and why it may not be a smart long-term investment going forward. 

Say what?

Okay, so think about it this way:  WoW subscribers, about 9 million strong, at a monthly rate of around $10 each on average.  That's over a BILLION dollars a year.  Think about that.  We are talking about essentially hosting access to a video game online, and generating a billion bucks.  Let's put this numerically:  $1,000,000,000.00.  That's a LOT of zeros that are essentially profit. 

And nobody else has been able to replicate this, on even a small scale.  The only thing that has been able to reduce membership in WoW is time.  Eventually people will lose interest, even with updates and additions.  It's just a matter of time, and investors fear that the company won't be able to catch lightning in a bottle twice, replicating the success of the WoW franchise, thereby recapturing some of the players that have left, and grow another MMORPG that reaches the same level of sustained success.  The rumored "Titan" project has some really big armor to fill. 

But that's not the whole story.  There's a bigger risk, and that risk to the success of Activision Blizzard actually may be where you should put your investing dollars to work. 

It’s the Trends, Stupid!

Margins are climbing, every new title shatters sales records, and the market yawns. What gives? It’s pretty clear, as I see it.

Blame it on Apple (NASDAQ: AAPL) and Facebook (NASDAQ: FB), with a little bit of angst at Google (NASDAQ: GOOG) for good measure.  “Say what?” you ask again?

I’m serious, here.

Unless you’ve been hiding under a rock for the past half-decade, I can understand your confusion. The bottom line is that there has been a major shift in the way consumers interact with and access electronic entertainment, and how we use technology for social interaction. If you had been smart enough to have invested in Apple, ever, or in Google since the IPO, you have done well.  But your profits have been at the expense of what many investors, and lots of consumers, have voted on with their wallets -- the death of the PC and of the video game console. 

As tablets and smartphone sales have skyrocketed, PC sales have flattened.  The console platforms are dated and with so many new mobile technologies and "social" games competing for eyeballs, many people see the console as destined for the graveyard.  Simply put, it is losing its place in the living room. 

So when your business, no matter how profitable, innovative, or popular, is attached to what investors see as a declining technology, don’t expect the market to respond in a positive manner. When it is attached to two declining technologies, that’s really painful. Throw in the fact that Activision has so far eschewed the “social” gaming platforms (despite how wise that choice has been so far. Zynga, anyone?), you have a triple-whammy happening. 

So is it time to get out?

I don’t think so. If there’s anything that investing in technology-heavy businesses should teach us, it’s that the trends can change quickly.  Activision's current lull in revenue growth isn't so much a product of the video game market as it is their internal development cycle.  I would be more concerned if there were a pattern of declining sales figures to new releases, but that's not the case, as we discussed above.  Activision continues to generate great big piles of cash, as consumers have shown a willingness to spend their hard-earned money for quality content, while Zynga has demonstrated since its IPO how fickle consumers can be about ponying up for something that starts off free.  The trend of growing sales revenues should pick back up in 2013, as Activision has a strong lineup of releases scheduled. 

But there's still downside, and Microsoft is at the center of it.  The folks in Redmond are at what is likely the most important crossroads the company will face in the next decade.  Windows 8, Surface, and SmartGlass are all right at the middle of it, as the company is making an effort to become relevant for consumers again. 

Using a powerful console to help integrate the "Ecosystem" of the mobile devices and the home could really give it a leg up over Google and put it on a more level playing field with Apple in the battle for consumers.  If Microsoft makes the decision to cede any of this, then that could hurt Activision's ability to put great content in front of consumers.  Additionally, Sony's ability to create a viable console in the future is very much in question.  These are real concerns to consider. 

But on the positive, eventually Activision will adapt to tablet computing.  There was a time when people complained that Activision’s games were too powerful for laptops, that they needed to make "dumbed-down" versions.  They didn't --  eventually laptop computing technology caught up to the games, and that's what will happen with tablets.  As processing power and storage capacity increases, along with the ability to easily connect your device to a larger screen and input device, more complex and enriching gaming options will become available on the tablet and smartphone.  And you can bet the farm (or at least a cow or two) on ATVI being at the leading edge of that occurrence. 

"Social" gaming is another story.  There is market opportunity and Activision is taking the time to explore this.  I like to think that the approach being taken is one of identifying financially viable gaming content that can predictably generate revenue in the "social" arena.  Remember that CEO Bobby Kotick isn't a gamer and will not be caught up in any technology bias.  Rest assured that if it's a segment that can be profitable, Activision will be there in time. 

So how long before I can actually make money?

Heck, I have no idea.  All I can point out is that the trends over the past several years have been clearly against the entire gaming industry in general.  Throw in the guilt-by-association factor, and it’s been a frustrating half-decade.  But I see the trends slowly turning in Activision’s favor.  Will I be right?

You didn't think I actually knew, did you?  But seriously, I have put my money where my mouth, or at least my typing fingers are, and am holding my ATVI shares for the long-haul!


elihpaudio owns shares of Apple, Activision Blizzard, and Microsoft. The Motley Fool owns shares of Apple, Activision Blizzard, Best Buy, Facebook, GameStop, Google, and Microsoft. Motley Fool newsletter services recommend Activision Blizzard, Apple, Facebook, and Google. 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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