Consumers Love It, but Should Investors?

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

For someone just getting out of the video game phase I can tell you firsthand how addictive some of these games are. While I was playing these games I would constantly hear about how the Call of Duty, Grand Theft Auto, and Madden  franchises were all doing very well. Due to all this success I assumed the companies making these games were highly profitable and that shareholders were reaping the benefits.

Not so much

As you can see, none of the three companies that make the games above had positive returns for the past year.

<img src="/media/images/user_15482/atvi_large.png" />

What do the financial metrics say?

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Ticker</p> </td> <td> <p>P/E</p> </td> <td> <p>P/S</p> </td> <td> <p>P/B</p> </td> <td> <p>D/E</p> </td> </tr> <tr> <td> <p>Activision Blizzard, Inc.</p> </td> <td> <p>ATVI</p> </td> <td> <p>14.10</p> </td> <td> <p>2.71</p> </td> <td> <p>1.12</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Electronic Arts Inc.</p> </td> <td> <p>EA</p> </td> <td> <p>303.70</p> </td> <td> <p>1.02</p> </td> <td> <p>1.98</p> </td> <td> <p>25.49</p> </td> </tr> <tr> <td> <p>Take-Two Interactive Software Inc.</p> </td> <td> <p>TTWO</p> </td> <td> <p>N/A</p> </td> <td> <p>1.22</p> </td> <td> <p>2.27</p> </td> <td> <p>67.19</p> </td> </tr> </tbody> </table>

Take-Two Interactive Software (NASDAQ: TTWO) develops, markets, and publishes video games and video game peripherals. They own 2K Games and Rockstar Games, and are well known for their Grand Theft Auto franchise. Looking at their valuation metrics one can see that they are not profitable and are highly leveraged, with a debt to equity ratio of 67.19. With that being said, the future looks very bright as talks of Grand Theft Auto Five grow louder as we get closer to the game's release date.

Another expected release in the coming year is BioShock Infinite, part of a popular series that analysts expect to sell anywhere from 5 to 6 million copies in the coming year. With these two games coming out in the next year I believe Take-Two Interactive has the best growth prospects and the potential to outperform its direct competitors. But whether or not these games can live up to their expectations has yet to be seen; moving forward I would like to see a return to profitability. If this is to happen I really like Take-Two going forward, especially if they keep their expenses down and improve their sales. Finally, if these new releases perform up to their expectations and a potential buyout surfaces, I expect the stock price to greatly improve in 2013.

Activision Blizzard (NASDAQ: ATVI) is the industry’s largest company, with a market capitalization of $12.15 billion. They are known for their incredibly successful Call of Duty and Guitar Hero franchises. Taking a look at the valuation metrics we can see they are the least expensive, with a low P/E and P/B. They also have no outstanding debt and a current ratio of 3.02, compared to EA’s 1.14 and Take Two’s 2.37. Having a high current ratio indicates they can pay off debt obligations faster, and that Activision is very efficient at turning their product into cash. Case in point, their newest Call of Duty game, Black Ops 2, reached $1 billion in sales in only 15 days.

So with positive valuations and strong sales, why has Activision's stock performed so poorly this past year? Concerns over the fiscal cliff and a depressed gaming market has Activision facing a tough task going forward. Subscription services are expected to decline in the future for their new World of Warcraft game Mists of Pandaria. On top of that they have not entered the mobile and social gaming like their counterpart Electronic Arts. But I think the biggest problem for Activision has been their declining free cash flows.

<table> <tbody> <tr> <td> <p>Year</p> </td> <td> <p>2008</p> </td> <td> <p>2009</p> </td> <td> <p>2010</p> </td> <td> <p>2011</p> </td> </tr> <tr> <td> <p>Free Cash Flows</p> </td> <td> <p>1.45B</p> </td> <td> <p>1.11B</p> </td> <td> <p>1.09B</p> </td> <td> <p>683M</p> </td> </tr> </tbody> </table>

This table shows that decline in free cash flows, and so far through the three quarters in 2012 they posted only $278 million in free cash flow. Unless they post an impressive 4th quarter, this will be the 5th year in a row we see a decline.

Although this may look bad, I still see the impressive valuations and improving revenues as a positive, and of late there have been reports about subscriptions picking up. Also, with the new hardware expected out of Microsoft and Sony in the coming year it’s possible the quality of games will increase as well. I believe Activision is trading at a discount, and with a positive 4th quarter I would recommend this as a possible buy sometime in 2013.

Electronic Arts (NASDAQ: EA) is another game publisher, and is well known for their EA Sports brand. Games such as Madden and FIFA have been very popular for a long time now. The company is valued at an extremely high P/E and are easily the most expensive of the three, and the company has a moderately high debt to equity ratio. Also, with the low current ratio they will have a tougher time meeting debt obligations.

The company collects a significant amount of revenue through their mobile platform, and they have seen increasing demand for their online-publishing platform. They benefit from developer talent and their vast financial resources. To further their dominance in the market they have had to acquire several smaller companies, including Digital Illusions, Mythic Entertainment, and SingShot, to name a few. The company also increased their share in the online-gaming market by acquiring Neowiz.

EA broke records in sales with their FIFA '13, selling 4.5 million copies in only 5 days. The news has been mostly positive, but once again their share price offered negative returns for the year. They also have had a tough time producing a consistent cash flow; it has fluctuated up and down over the past couple of years. They rank at the very bottom in their industry for free cash flows, and unless this improves their record breaking sales mean almost nothing. For EA to be a good investment going forward, they have to solidify their cash flows and keep producing superior products.

My Foolish Take

With Take-Two being the only non-profitable company, I didn’t see a reason to evaluate them on their financial metrics, especially their cash flows. Instead I took a more speculative approach, which on paper makes them look like a better buy. But there is too much uncertainty that comes along with speculation, and although they have good growth prospects I would avoid this company for the time being. EA and Activision clearly have the revenue growth and the superior product, but what they lack is the innovativeness to really inspire any confidence. I believe that Activision definitely had the best valuations, and with a strong 2013 they could be the best company to buy. EA is also intriguing, but their weak free cash flows and operating efficiency have me worried going forward. Of the three I like Activision the best, but the performances of this coming year will play a huge  role as to whether or not these companies are a good investment.

gomonkies23 has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley Fool owns shares of Activision Blizzard. 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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