Threats and Opportunities for 2 Leading 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.

Both Activision and Electronic Arts are leading gaming companies. They are, however, confronted by several challenges. I recommend looking particularly at company diversification in Internet gaming and performance. This is because, first, the console gaming industry has been on the decline, and, second, the recent collapse of THQ has put many investors on edge. Gaming is without doubt going to change. The ability to understand the shifting demand will determine the success or failure of any company in this industry. Below, I review Activision and Electronic Arts with this in mind.

Activision's (NASDAQ: ATVI) Opportunities & Threats

Activision Blizzard is one of the leading developers of video games, and it ranks second in the world after Nintendo. What really impresses me about the game maker is its ability to release one hit title after the next. The release of Call of Duty Black Ops II reached the $1 billion mark within 15 days. The results of the third quarter were made a little better by reduced tax rates. Revenues of $751 million was $42 million more than what had been predicted.

While Activision's performance has impressed me, the company should look towards Nintendo as a case study of what may come. At its peak around the end of 2007, Nintendo was an $84 billion company. In a half decade, the company erased nearly $70 billion in value, a staggering sum for what was long regarded as an invincible market leader. Zelda, Mario, Donkey Kong, and Metroid--all Nintendo. Nintendo really brought us to modern gaming, so to see it fall like this is a strong indication that trends come and go.

Activision has seen a lot of momentum in connecting users to Internet options, but it faces significant competition, particularly in the area where tablets and mobile phones are concerned. The last rumor--not really a rumor anymore, since technical data has been leaked--is that Microsoft (NASDAQ: MSFT), the owner of Xbox, is developing a tablet that is primarily focused on gaming. It will be called "Xbox Surface" and feature a 70'' display on a 720 HD resolution. This tablet is also likely to have some sort of connectivity with the upcoming "Xbox 720" system. So, while you may be tempted to cast aside "Xbox Surface" due to poor Surface sales, you should also consider the other part of its name that has been anything but a failure: "Xbox."

Though the market for console games is certainly not stable, Activision has the advantage of scale and many years of experience. Activision must adjust to the new trends in the market and reconsider the $12 or $15 charged for WoW monthly access. Even still, the introduction of mobile and tablet games on shareholder value in at least the short-term should not be underestimated. 

A Look at Electronic Arts (NASDAQ: EA)

Electronic Arts ranks third among the world largest gaming producers. The company’s growth can be attributed several acquisitions it has made in the past. For the financial year ending March 2012, EA generated $4.1 billion in revenues. But the gaming industry has faced challenges that have led to a general decline in sales. Hardware sales have dropped by 30% while those of software have dropped by 23% in 2012. 

Digital gaming is EA’s key opportunity for expansion because of the large margins and the attractive double-digit growth momentum it has already shown. But the Street isn't exactly optimistic, as evidenced by how 19 of 25 reporting analysts rate the stock a "hold" or worse. I'm mixed on this consensus.

Here's why I agree: The metrics look awful. Return on invested capital of 3.2% is below the industry average of 10% and the weighted average cost. Profit margins are razor thin at 1.8 and made worse by high volatility (beta 1.22).

Here's why I disagree: The risk has already been factored into the stock price. EA now has a free cash flow yield of 7.8% and a forward price-to-earnings ratio of 12x. Assuming the company meets expectations, 2016 EPS will come out to around $26.91 at a 15x multiple. Discounting backwards by 10% yields a present value of $16.71, which is at a 15.6% premium to the current market assessment. So, the stock looks slightly undervalued when adjusting for the risk.


TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard and Microsoft. 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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