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A Good Hand to Enter the Game
Posted by: Damian Illia (IP Logged)
Date: September 5, 2013 05:16PM

In the video game industry no one is playing games. Users are seeking entertainment on all kinds of devices, and companies strive hard to stand out and profit in this shifting field. Competition might be stiff, but it’s a highly profitable business for those that make it to the next level. Electronic Arts (EA), Changyou.com (CYOU) and Activision Blizzard (ATVI) are three game developers with different, but interesting, prospects ahead. Let’s take a closer look at them and see if you’re up for play:

Hit-maker

Electronic Arts, present in the portfolios of famous short seller Jim Chanos, is a world-renowned video game maker, responsible for hit franchises like FIFA, Madden NFL and Battlefield. The firm owns an impressive video game portfolio and has been experiencing strong growth lately, due primarily to a successful fewer-titles/cross-platform strategy. EA’s stock soared over 80% in 2013, and is trading at $26 or 69 times its earnings, a massive premium to the industry average. Is it worth the price? The firm certainly looks solid, but I would wait for a pullback before chipping in.

EA’s first quarter results have beat analyst estimates, mainly driven by strong digital revenues and lower online support costs. The firm has been benefiting from the industry’s profitable shift from physical to digital, which keeps packing costs at a minimum. For instance, EA’s fiscal 2013 digital net revenue showed a 36% year-to-over increase, pushed by robust growth in its mobile business. Moreover, the company holds a dominant position on the lucrative iOS gaming market, which currently provides significant revenues.

In addition, it should be noted that the whole video game industry benefits strongly from the ongoing rise of online gaming. And EA, which, through its Origin platform holds a solid online presence, is in a good position to continue profiting from this growing market.

On the downside: the video game industry is hit driven, and although many of EA’s franchises are performing strongly (FIFA), others have stagnated or are in decline (Need for Speed or Madden). In short, to generate growth EA needs new hits, and competition in the industry is quite high.

One-Hit Wonder?

Changyou.com, once is an online game developer and operator in China. The firm focuses on massively multiplayer online (MMO) games and has developed the extremely popular Tian Long Ba Bu (TLBB) game, which remains the firm’s major revenue contributor. CYOU trades at $29 or 5.3 times its earnings, at a 75% discount to the industry average, and offers industry-leading margins and returns. The valuation looks tempting, but what about the firm itself?

CYOU has been benefiting from the strong ongoing expansion of China’s online gaming market, which is unlikely to slow down in the near term. Although TLBB remains CYOU’s cash cow, the firm has been making advances on diversifying its content portfolio, mostly by acquiring licensed MMO games and popular web games.

Although the firm’s near-term prospects look promising, CYOU is still a small player in the highly competitive online gaming market and, more importantly, it remains uncertain whether the firm might be capable of developing another hit comparable to TLBB. Moreover, if the enthusiasm for TLBB weakens, so will the firm’s revenues, as it is still quite dependent on this game. And CYOU has operated as a standalone for less than years, so its aptitude to handle tough business conditions still remains largely untested. Finance gurus like Steve Cohen, Jim Simons and Bruce Kovner have substantially reduced (or sold out) their CYOU shares this year. My take? I wouldn't rush on buying.

Independent Giant

Activision Blizzard is a major gaming company formed by the merger of Activision Entertainment and Vivendi Games, Blizzard’s former owner. The holding company owns some of the world’s strongest gaming franchises, like “World of Warcraft” or “Call of Duty”, which hold large and fiercely loyal fan bases. Above-consensus Q2 results and recent news about the firm freeing itself from Vivendi have sent ATVI’s shares up recently. At $16 or 13.8 times its earnings, Activision Blizzard is trading close to its highest level since the 2008 merger. However, it holds industry-leading margins and a 1,13% dividend yield. Major investors, like Paul Tudor James and Joel Greenblatt seem to be confident on ATVI, as they have added plenty of these shares to their portfolios lately.

As we said, competition in the gaming industry is though, but the firm is well positioned to continue to generate strong revenues on the back of its industry-leading property portfolio. As a major player in the industry, ATVI is expected to continue profiting from the gaming industry growth, especially in emerging markets, where a rising middle class seeks new forms of entertainment. In relation to this, the firm has partnered with Tencent Holdings, the dominant Chinese gaming company, to focus on this market, and intends to release an online installment of Call Of Duty (Call of Duty: Online) for China’s gamers only.

The firm strength may reside on the strong following of its franchises, but it should be noted that some of them continue to lose their appeal. World of Warcraft, which represents over 20% of the firm’s yearly sales, is getting old and continues to lose subscribers for the fourth consecutive quarter. At the same time, the project that should replace the WoW stream (code-named “Titan”) continues being pushed back: it is now expected to be released no earlier than 2016.

Bottom Line

While the growth prospects of the gaming market makes any of these three companies an attractive investment option, my bet here’s on Activision Blizzard. The current valuation may not be too tempting, but the firm is strong, holds several growth opportunities ahead and seems a secure long-term investment. On the other side, if you were thinking short term, I’d give Changyou.com a closer look.

[b][/b] Disclosure: Damian Illia holds no position in any stocks mentioned



Guru Discussed: Bruce Kovner: Current Portfolio, Stock Picks
Jim Chanos: Current Portfolio, Stock Picks
Stocks Discussed: EA, ATVI, CYOU,
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