Video Game Stocks: Beyond the Economic Slowdown

This weekend, I looked at an ugly chart showing the 6-month stock performance of the so-called “Big Four” video game publishers in North America (performance may not be the right word). Activision Blizzard (ATVI) has fallen 14.48% in that timespan. Meanwhile, former industry leader Electronic Arts (ERTS) has fallen 51.92%, Take Two Interactive (TTWO) has fallen 56.49% and THQ (THQI) has fallen 64.68%. What has happened?

I’ve been looking for answers beyond the obvious economic downturn and recently asked some managers of Gamestop (GME), a game-retailer whose stock has also fallen hard. The word was that the economic slowdown hasn’t drastically affected video game sales at all -- a fact confirmed recently by earnings reports from Microsoft (MSFT), Sony (SNE) and French publisher Ubisoft. So are these recent stock discounts simply a result of indiscriminate selling by hedge funds with margin calls?

With that in mind, I’ve been trying to figure out what, among this group, is the best competitive value. If the economy eventually hits interactive entertainment, I want to be a buyer in the one who has a competitive advantage.

First, let’s look at Electronic Arts. What immediately sticks out is the failed $25.74 bid for Take Two Interactive. From the beginning it was interpreted by some to be a desperate move to increase earnings because bullish analysts were expecting significant earnings increases of over 50% for the next fiscal year while Electronic Arts was refusing to give forward quarterly guidance. That, along with the fact that Electronic Arts was going to partially finance the Take Two deal, appeared to me as a major red flag. But now the stock has dropped in half, so let’s take a new look.

EA has about $8.50 in cash and is trading at about $25.00, meaning 34% of its value is cash. They had forecast $1.30-$1.70 in July and analysts forecast $1.43. That results in a P/E of 17.5 with 34% of the current value being cash. Meanwhile, let’s look into their 4.9 to 5.15 billion revenue forecast and compare it to today’s Amazon international video game charts. EA has 9 out of the top 100 games in Amazon U.S., 12 out of 100 in U.K., 12 out of 100 in Germany, 16 out of 100 in France and 1 out of 100 in Japan. Highlights: EA’s new intellectual property Dead Space and Spore are doing well, but probably not exceptional since they are tracking in the middle of the top 100s worldwide. In fact, most of their top 100 titles are out of the top 25. EA’s soccer games are doing well in Europe and DS games are performing well in France. Overall, EA’s performance at the moment looks strong but doesn’t appear to be ground breaking.

Contrast this to Activision Blizzard, whose P/E of about 18.5 is based on analyst earnings estimates of about .63. The combined entity will likely end up with approximately 30% cash once the updated balance sheet is revealed. So despite now having a market capitalization twice as big as Electronic Arts, Activision has a similar P/E – and that, in spite of the fact that their revenues are probably less than EA. Let’s see why that might be: ATVI has 10 out of the top 100 games in Amazon U.S., 8 out of 100 in U.K., 11 out of 100 in Germany, 9 out of 100 in France and 0 out of 100 in Japan. The numbers are similar to EA but there is a major difference: Activision clearly has three very high profile brands worldwide: World of Warcraft, Call of Duty and Guitar Hero. World of Warcraft’s extension game is the top selling game worldwide and Call of Duty looks to be not far behind. Guitar Hero may be seeing some signs of slowing down, especially given that the prices on this brand’s games and accessories is relatively high. But overall, it is clear that Activision is the current market leader due to these specific brands.

The next two publishers combined together represent about 6% of the total market capitalization of the “Big Four” based on recent trading - which leaves me wondering whether it has really become the Big Two …”and the rest” (like the Gilligan’s Island theme song). Take Two is trading at about $11.50 recently with $4.50 in cash with forward earnings estimates of $1.37. That’s a P/E of about 8.4 with nearly 40% of that represented by cash. THQI is trading at about $7.50 with about $4.25 in cash and a .73 average earnings estimate through March 2009. That’s a P/E of about 10 with a remarkable 57% of that represented by cash.

Wow. Somebody call an ambulance. Let’s see what we can tell from the charts:

THQ may be having a problem in the U.S.: they have 0 out of the top 100 games in Amazon U.S. But they have 4 of 100 in U.K., 2 of 100 in Germany, 2 out of 100 in France and 0 out of 100 in Japan. Some of those are older discounted titles. Saints Row and de Blob do not appear to have become big hits according to any charts and THQ’s WWE title may be showing signs of weakness – not that THQ has ever had a reputation of being a hit driven publisher like the rest. But that may be precisely the problem. With higher development costs today, it seems as though they have not evolved sufficiently with the rest of the industry. At today’s remarkably low enterprise value, I don’t think it would surprise anybody if THQ were acquired or merged given their current price and cash on hand.

Meanwhile, odd ball Take Two Interactive appears to be doing alright, considering its relatively small size: TTWO has 4 out of the top 100 games in Amazon U.S., 6 out of 100 in U.K., 6 out of 100 in Germany, 8 out of 100 in France and 2 out of 100 in Japan. Their mega brand GTA4 is on the very top of the charts in Japan – nice timing given the rise of the Yen – while Carnival Games and Bioshock seem to also be selling well internationally. Midnight Club appears to be getting slow traction in the U.S., but is charting high in Europe.

In taking a look at international revenue growth for Take Two, I was surprised that while the other publishers have been fairly consistent with nearly 50/50 domestic/international sales, TTWO had only 24% international revenue in 2007 and was up to 35% in the recent year. The charts seem to be showing a trend and indeed recently Take Two has been emphasizing their international expansion efforts. Of course, there’s also that matter of TTWO turning down $25.74.

At these prices I would go with TTWO, THQI, ATVI, ERTS, in that order, with particular emphasis on TTWO, which seems to be charting very well given how it is growing in size, growing its cash, expanding its sales internationally and even brushing off a buyout offer that was well over twice its current price. It seems that the combination of the financial crisis and the dropped bid has created a particularly unusual buying opportunity in this stock.

If I were hedging my bet, I’d go against EA. But with these levels of cash on hand, I wouldn’t be hedging my bet at all.

Disclosure: Author holds long positions in GME, TTWO , ATVI, ERTS and THQI

Comments

[Risky Business:]

"So are these recent stock discounts simply a result of indiscriminate selling by hedge funds with margin calls?" It sounds like you're saying yes... but what if you look forward to a potential global recession/depression. Cash may be king but in a severe downside scenario, P/Es would adjust current levels to be more consistent with historical averages and the market would be appropriately valuing future cash flows.

2008 Oct 27 10:40 AM

[stocks:]

nice analysis marty

2008 Oct 27 10:53 AM

[Yupp:]

Big Four? I think in a year it will be the "Big Three" ! I agree that TTWO is probably undervalued right now, but I think THQ's days are numbered. Nintendo has killed off THQ's role in the game market and many have learned not to depend on GTA rip offs ..THQ is way behind the times. Yes, half their value is cash but I would still recommend getting rid of that one.

2008 Oct 27 11:11 AM

[byrnemm:]

IMO:

Great pick
ATVI - WotLK comes out in 3 weeks, CoD was/is awesome.

Good picl
TTWO - GTA IV shows they have the ability to create quality games

Not so good picks
THQI - unless they have something good up their sleeve
ERTS - thank god they have Rockband

It's not public, but Bethesda Studio Games is gonna be a winner of the video game world after Fallout 3 is released.

2008 Oct 27 12:49 PM

[User 286790:]

Any comment on Midway Games? Their TNA Impact game had much hype prior to its release but has sold horribly.

2008 Oct 27 02:21 PM

[User2122:]

If you look beyond the earnings for EA, you will see they're going to have major battles in the legal front in the coming months. There have been 4 class-action suits filed against the company in Federal court in California about the Digital Rights Management program, Securom, being used in their games.
If I were a stockholder, I'd be more concerned about their cash flow out to the legal sections of their company than their earnings. If they lose just one lawsuit, it could mean millions in compensation or damages. If they lose all four of them, they will be paying out millions to millions of very unhappy customers who have had significant issues with Securom, the DRM of choice for EA.

2008 Oct 30 11:37 AM

[Gaucho420:]

ERTS is a loser stock and will be for a while...a doubling of the loss from last year? In a growing industry?

As far as THQI, it is a buy at these levels, as is TTWO. But TTWO to me, could be the next ATVI as the quality of its games are tough to beat. Nothing can hold a candle to GTAIV and one can only hope they reinvest the money towards more franchise. The release of GTA Chinatown DS should further drive sales, even if the DS isn't exactly a hard core machine, it will see simply due to how many DS are out there.

I would rank all the Cos. in this order:

1. ATVI- Top of the game, but again, it cannot fall into the EA trap of doing sequels year after year, as you end up killing franchises with over-saturation. Guitar Hero will be the next big ATVI franchise to fall, the same way Tony Hawk fell.

2. UBISoft-up & coming, beats all forecasts and has a nice wide array of games. Its partially owned by ERTS. I could see this company merging at some point.

3. TTWO- Truly, the talent here is vast. Can they resign the Houser Twins? That is the biggest question at TTWO and expanding its lineup. I rank them 3rd based on potential.

3. ERTS- Puts out a lot of games, but the quality isn't quit there yet, although progress is being made. If Rock Band leaves EA and MTV publishes it on its own, it would be a big loss. Its sporting business also needs help or simply a breath of fresh air, as most games feel like cut & paste from the previous version. The losses and missed earnings estimates is great cause of concern.

4. THQI- barely any debt and tons of cash...they just need to put out better quality games.

5. KNM- Konami...big company, but not so big in the west. DDR franchise will get competition from ATVI's eventual Dance Hero. Its rock game is not very good...I could see a merger with a western partner.

6. Capcom- Said to be looking to merge with a western partner...TTWO? THQI? UBISoft? I'm sure the current financial mess is puttingt those plans on hold, althought the strength of the Yen vs. other currencies could facilitate this. But I doubt it.

Anyways, ERTS missed earnings today, while NTDOY reports no slowdown on its end the very same day (outside of effects of the Yen's strength), shows that customers look for value and quality games...I'm not so sure EA offers either at this point.

2008 Oct 30 05:13 PM

[Runescape P...:]

Well. i just think the EA will be the best game designer for mmorpg. because i'd readed my Runescape Powerleveling at mmonice.com, so i just think their give us value and quality games.

2008 Nov 19 05:46 AM

[User 403942:]

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Apr 28 10:44 PM