How To Play Video Game Stocks

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

As demand shifts from console gaming to Internet and multimedia platforms, companies have an opportunity to go with the flow, innovate it, or rely on "core" traditional revenue streams. Unfortunately, all too many producers have chosen the last option. Nintendo's stock has fallen an incredibly 77.5% over the last 5 years from failing to adapt. The introduction of Wii U, which was released in stores a few days ago, failed to garner analyst excitement. For gamers, it was a "been there, done that" moment. With this in mind, I review several video game stocks to see where they are positioned amidst this industry transition.

Solid Performance For Activision Blizzard (NASDAQ: ATVI)

At a respective 14.6x and 11.2x past and forward earnings, Activision is a great company trading at a discount. Not only does the company offer compelling growth with forecasts for a 19.9% annual rate over the next 5 years (it was 15.5% in the past 5 years), the future looks bright. There is no debt on the balance sheet, but a cash warchest of $3.5 billion. This is only going to increase. Free cash flow for the TTM ending 3Q12 was $1.1 billion, or an 8.7% yield. Analysts are calling it "strong buy", and one of the latest price target has the stock at $16--it's currently at around $11.40.

Fundamentally, the company is also quite strong. Shares rallied 4.8% after Call of Duty: Black Ops II sold over half a billion dollars’ worth of copies in just 24 hours. The result was so strong that many are claiming this as a defining inflection point shifting console gaming towards strong profitability. I also like the company's position in secular changes. According to NPD Group, domestic consumers spent nearly $1 on digit format sales for every $2 spent on traditional video games. These "digit format sales" include subscriptions, mobile purchases, and downloads--markets that Activision is heavily invested in. With third quarter EPS of $0.15 coming solidly ahead of expectations (+7 cents), execution is Activision's chief value driver.

The shorts wouldn't dare get near a stock like this. Accordingly, they only cover 3.3% of the float, and the wind is working solidly against their thesis. Recent releases, like Skylanders Giants, Cabela's Hunting Expeditions, Transformers Prime, and 007 Legends, were well timed to capitalize on movie releases and the holiday season. For this reason, I recommend buying shares.

Electronic Arts (NASDAQ: EA), THQ Inc. (NASDAQOTH: THQIQ) Struggling Against The Wind

EA, and especially THQ, have been on a tailspin. EA has fallen 41.3% from its 52-week high, and THQ is just one-twentieth of the business it was. Both companies have delivered poor title after poor title to destroy the underlying business. Is there anything left that would make either ones takeover plays?

In mid-August, Bloomberg did a piece on this and argued that EA was possibly a takeover play. Reportedly, several PE firms have approached the company, but Slate's Robert Cryan put it in best when he said that a "leveraged buyout would make a tricky video game". From a secular decline in the console business to declining film studio business, free cash flow streams are not enough to justify a premium to today's valuation. Performance--just in general--has been terrible with a miss of 3.9% in 2Q12 and a miss of 16.7% in 1Q12.

By contrast, THQ actually--to its credit--has actually performed above consensus estimates with a beat of 50.3% in 3Q12, 20.2% in 2Q12, and 69.8% in 1Q12. While Electronic Arts has attempted to penetrate social media, THQ hasn't really even made a fair effort. For new investors, this isn't a bad thing. If management changes its ways and there is a corporate shakeup, they should explore this strategy through leveraging current demand. For now, however, I recommend avoiding the stock.

Electronic Arts is forecasted to generate EPS of $1.23 next year and then grow 16.1% annually thereafter. This means 2016 EPS of $1.92, which, at a multiple of 13x, pegs the future value of the stock at $24.96. Discounting backwards by 11% for the uncertainty yields a present value of $14.81. This is not at a large enough premium to the current price to justify making an investment.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Activision Blizzard. Motley Fool newsletter services recommend Activision Blizzard and Electronic Arts. 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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