Gaming Your Way to Prosperity?

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

It may be the best time to get in the video game market--and not because the holidays are nearing. Rather, I see the industry facing wide-spread consolidation as the largest producers seek to leverage their cash flows to secure leading brand portfolios. Several notable game makers, even the once invincible Nintendo, have fallen in recent years. Below, I put the spotlight on three companies under this theme.

Why Activision Blizzard Is A Good, Undervalued Company

Having returned 56.5% plus dividends to shareholders during a period of industry turbulence, Activision Blizzard (NASDAQ: ATVI) is one of the strongest game makers out there. From 1Q08 to today, R&D grew by 75%, yet free cash flow nearly quadrupled (283%) to $1.15 billion, or a strong 9% yield for a tech firm. Return on invested capital has been 10.4%, or 81 bps greater than the industry average, and the stock still manages to trade at only 1.2x book value versus an industry average of 2.6x. Going forward, the company is expected to have a 3-5 year EPS growth rate of 15.5%, which is 360 bps and 900 bps greater than what is expected for the toy industry and consumer goods sector, respectively.

Boasting strong growth, an excellent balance sheet, value creation, a track record of successful R&D, and compelling multiples, Activision appears to be both an undervalued and good company. What are its main catalysts and fundamentals? Though slowing growth in Call of Duty: Black Ops II has caused Sterne Agree to downgrade to "neutral," sales surged over half a billion in just 24 hours of hitting the market. GameStop reported that it sold over 1 million copies within the first day--probably the biggest launch of all time. By contrast, Microsoft's Halo 4 has only been guided for $300 million in the first week--still a ton, to be sure, even for a popular title.

In addition, some have argued that the console market is dying, but the recent report that Microsoft sold over 750,000 Xbox 360 units during holiday sales last week helped to buoy confidence. Consoles have had a tough year, but the resiliency of Activision through it all is a testament to the brand's strong present-day appeal. It should be of no surprise then that 3Q12's top-line of $751 million came in $42 million above consensus.

Going forward, the future looks bright. Activision guided for $2.41 billion in revenue, which was $70 million above consensus. They are expecting online subscription sales, which include the World of Warcraft and Call of Duty franchises, to rise 26% y-o-y. Even the PC and Other category is guided for 273% growth.

Take-Two Interactive, Electronic Arts Both Buyout Targets

Take-Two Interactive (NASDAQ: TTWO), the struggling producer of Grand Theft Auto, has fallen 33.9% in the last 5 years. By 3Q11, free cash flow plunged to negative territory on a TTM-basis and now stands at $169 million. Worse yet, over the past decade, R&D has gone up 250% to $66 million while free cash flow has fallen 221%. Even Electroninc Arts (NASDAQ: EA), which many have taken for "dead in the water" wasn't nearly that bad. They grew R&D by 214% to ~$1.2 billion while generating only a 35.5% decline in free cash flow to a still-positive  ~$350 million. Put differently, management has been much more reckless in spending shareholder's cash at Take-Two.

It should not be surprising then that Billionaire activist investor Carl Icahn, who made his fortune from taking on the corrupt boards of beleaguered companies, has scooped up a 10.7% stake in the game maker. If he could raise takeover speculation for the company, which is in a very vulnerable status against thriving Activision, it would drive tremendous value creation for tag along investors. Even though Icahn filed a 13D form to disclose his stake, it doesn't mean, however, that he will be as activist as he has been in previous investments. Ultimately, I don't see Icahn making this just a "passive" investment, because there is a catalyst from agitating what is, again, a very vulnerable board.

EA may similarly be in a position of being taken over. The $4.5 billion game maker trades at only 12.1x forward earnings and 13.1x free cash flow. Stifel Nicolaus is calling it a "buy," and there have been several reports speculating that it is indeed a buyout target. If more serious proposals surface, it would surely drive up interest in Take-Two, so Icahn may not even have to make a tender offer himself. Only time will tell.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Activision Blizzard and Take-Two Interactive. Motley Fool newsletter services recommend Activision Blizzard and Take-Two Interactive . 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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