Why Sticking With the Leaders Is the Best Option in Gaming

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

Zynga (NASDAQ: ZNGA) has fallen hard since the fanfare of its IPO. After searching in different directions to find a workable business model, the company has decided to “get back to basics.” That may be a good choice, but investors should still stick with companies like Electronic Arts (NASDAQ: EA) and Activision Blizzard (NASDAQ: ATVI).

Zynga was among the first casual game makers in the social space, spreading its wares free through Facebook and charging for in-game purchases. That model worked great for a while, particularly while that social network's dominance grew. However, as Facebook faced its own troubles, Zynga's unhealthy dependence on Facebook became clear.

The game maker tried to build its own website, build standalone mobile games, and was looking to latch on to real money online gambling, too. While none of these are particularly bad ideas, Zynga has continued to struggle and has resorted to cost cutting via layoffs and office closures.

Still, revenue has been falling and the company continues to lose money. The first half of 2012 hasn't seen any improvement. Now, the company is shifting gears again, dropping plans for real money gambling. Most investors should stay away from this struggling company.

Acquisition fodder

That said, more intrepid types might like the prospects for a Zynga acquisition following Hasbro's $112 million purchase of a controlling stake in Backflip, a casual game maker. The only problem with this scenario is that Zynga's market cap is close to $3 billion. That's a lot more to digest than $100 million. While an acquisition might be a possibility, it won't be Hasbro since it already bought a casual game maker and sports a market cap of about $6 billion. Zynga is just too big.

Mattel's $14 billion market cap suggests it won't bite either. That leaves the big video game makers, but they aren't really big enough to swallow Zynga. A giant technology company could step in, but that seems like a stretch, too. It looks like things will have to get a lot worse before Zynga becomes someone's target.

Stick to the leaders

Investors interested in the social game space should probably look to Electronic Arts. The company has a powerful collection of game titles, spanning the massive multi-player, action, and sports genres. And it has been more aggressive than competitor Activision in its efforts to expand in the casual game market.

For example, Electronic Arts purchased game makers PopCap and Playfish to quickly build a presence in the emerging casual space. It has created popular casual games like The Simpsons: Tapped Out, but the longer-term appeal is likely to be its efforts to bring its hard-core game titles to the casual market. Such titles as Need for Speed and FIFA are good examples.

After a string of four years of red ink, EA turned a profit in fiscal 2012. Although its top line fell in fiscal 2013, profit margin expansion led to a bump in earnings. Things are going in the right direction, with new game consoles from Microsoft and Sony likely to push sales up later in the year and beyond.

And with a broad reach, there's serious potential for cross pollination that attracts more casual players to its hard-core titles. That said, now is a good time to consider the company's shares since they have been rising on anticipation of the PlayStation 4 and the Xbox One.

If you are interested broadly in video games, Activision Blizzard might be a good option. The company just agreed to buy the bulk of Vivendi's controlling stake in the company for just over $8 billion. That could put a financial damper on growth initiatives for a little bit at Activision, but with a new game console cycle about to take hold, that shouldn't be too much of a problem. In fact, there's top-line growth pretty much baked in the cake as customers step up to the new game machines.

Activision owns popular titles like the World of Warcraft, Call of Duty, Diablo, and Skylanders. Its top line has been growing steadily, and the bottom line has grown from about a dime a share four years ago to around a dollar a share last year. Although it's the better positioned of the two big game makers, its shares rose sharply after the news that it was buying its freedom. Still, despite the advance, the shares are still trading at a reasonable price to earnings ratio of around 15, about six points below its five year average.

A gamble...

Zynga shares are a gamble right now. It either has to figure out how to go it alone, or crumble enough that a buyer comes in. Either way, you shouldn't wager on it. Activision is well positioned in the game space, and is still a good value even after its shares ran up on corporate actions. EA, on the other hand, is more focused on social games, which positions it well for the long term. That said, it's still in turnaround mode.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. 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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