Still on the Fence About the Future of Video Games?

By Matthew DiLallo - June 3, 2012 | Tickers: ATVI, EA, GME, TTWO, VIVHY.PK | 0 Comments

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Video game sales have been mired in decline for the past few years and with that the industry has suffered from poor investment returns.  Despite excellent free cash flow leading to massive cash balances many of these companies are priced for death.   While I think the market is vastly undervaluing several names in the space, I know that the market can keep depressing the values of companies until it changes its mind.  The problem is that it is just too hard to predict when that change will happen, so if you can’t beat them, join them, or at least try to profit in spite of them.  Today I am recommending an options income trade for my “No Drip, No Mess” portfolio to take advantage of the current market sentiment.  So if you are like me and still on the fence about the future of the gaming industry why not "Straddle" it and make some money. 

The Company

As the industry has struggled to perform up to Wall Street’s expectations, shares of companies like Electronic Arts (NASDAQ: EA) and Take Two Interactive (NASDAQ: TTWO) are both down over 20% the past three months thanks to game sales sliding 42% in April compared to last year as well as the general concern about the economy here and in Europe.  Not only are the publishers suffering, but game retailer GameStop (NYSE: GME) has also been in a free fall as its shares have also fallen over 20% in the same time frame.  Each of these companies has issues that the market has every right to be concerned about, however, they also have underlying business strength and intellectual property values that the market is overlooking.  One company that hasn’t been hit as hard is Activision Blizzard (NASDAQ: ATVI), home to the top selling entertainment franchise of all time, Call of Duty.  Of all the companies in the space they are performing much better than their peers and they also have the least concerns going forward.  While EA is focusing on social gaming and Take Two is working on trying to stay profitable when there isn’t a Grand Theft Auto title, Activision has a very diverse model that has been generating consistent cash flow.  GameStop meanwhile is doing its best to fend off the threats from digital downloads while waiting for the next console cycle to kick in with the rest of the publishers.   The following chart gives a quick snapshot of each firm:

One of the reasons I feel that Activision’s stock remains compressed is due to the general uncertainty about Vivendi’s majority ownership.  They have recently been selling some of their shares and it is unclear what their long term plan is for their shares.  Until that is resolved and the market for games picks up, it’s unlikely shares of Activision will take off.  Given the unlikelihood of a Vivendi resolution any time soon and the moribund nature of the stock, I think there is a good way to profit if we consider all our, ahem, options. 

The Trade

With Activision generating over a billion dollars of cash each year and having another three and a half billion in the bank, the downside here is very limited.  While I think they have a lot of upside, I am willing to give that up to get paid today.  For this particular trade I am looking to write a covered straddle on Activision which might sound complex but really is just combing three simple strategies.  We are going to buy 100 share lots of the stock while simultaneously writing both puts and calls at the same strike price.  Specifically in the “No Drip, No Mess” portfolio we are going to buy 200 shares at around the current market price and write two November $12 puts and two November $12 call contracts  for a total allocation of about 5% of the portfolio.  If you are following along in the paper trade account or at most brokers you can submit this all on one order. 

What we are looking to do is collect the nearly $400 in premiums on our approximately $4,800 of capital at risk for a yield of about 8% which we will set aside along with the dividends collected in order to invest in a more growth orientated stock.  I’m more than willing to buy the additional 200 shares than obligated by the written puts as well as sell the 200 shares we own via the calls.  The downside is limited by the over 25% of net cash on the balance sheet as well the aforementioned billion dollars of annual free cash flow, most of which they are returning directly to shareholders via both share repurchases and dividends.

Looking Ahead

I went with the November expiration because that’s about the time Call of Duty: Black Ops 2 should release and therefore a reason the options pay well.  If shares of Activision are over $12 per share I’ll likely let them be called away and look to write puts to get them back if they are attractive.  If the release doesn’t perform up to expectations and shares stay below $12 so that we are put more shares we’ll likely keep them and look to write calls on the full position for income while we collect the 1.5% dividend. I plan to use options to generate income on the stock until it is no longer an option.  If you have questions about the trade please leave me a comment below. 

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