While many investors are rightfully worried about a double dip, investors should also make sure to hedge against bearish predictions. The video game and toy industry is well positioned to take off if full employment materializes quicker than expected. What follows is a list of companies that operate, partially or completely, within this sector. In my view, Activision, Mattel, and Microsoft all look healthy in the short- and long-terms. On the other hand, I recommend selling Electronic Arts until greater certainty emerges. While EA is a strong brand in the long-term, I do not see it outperforming in the short-term.
To value Mattel, I employ a DCF model. In this model, I make several assumptions: (1) 9.1% per annum growth over the next half decade or so, (2) operating metrics stay at historical levels, (3) a 3% perpetual growth rate, and (4) a discount rate of 8%. Based on these assumptions, I find that the fair value of Mattel is $45.06, implying stellar upside.
Perhaps most attractively, Mattel is just a safe stock. It is 10% less volatile than the broader market and offers an impressive dividend yield of 4%. With the S&P 500 trading above 22x past earnings and Mattel only trading at 14.4x past earnings, however, the company is more of a value play than what the market appreciates. The Barbie-maker is sustainable, undervalued, and cheap. Emerging market potential adds yet another layer to this compelling risk/reward story.
While Microsoft is known for its software, Xbox 360 still remains a heavy catalyst due to various value levels elsewhere. Unlike other technology companies, Microsoft has done well in not becoming a mess of a conglomerate. With that said, it has not done the best in optimally unifying various products. This is starting to change with the emergence of cloud computing.
The stock currently trades at just a respective 10.8x and 9.8x past and forward earnings. With the stock worth around one half of Apple (AAPL), considerable value is being under-appreciated. Technology has few barriers to entry and Microsoft has excellent capability in mimicking Apple's success regardless of what the bulls say. If Google (GOOG) is any indication, it is never too late for Microsoft to make a meaningful impact in mobile. From a gaming standpoint, however, Microsoft is best positioned among peers.
Activision Blizzard (ATVI)
Activision trades at a respective 14.7x and 11.3x past and forward earnings with a dividend yield of 1.5%. Assuming a multiple of 16x and a conservative 2013 EPS of $1.05, the stock would hit $16.80 for double-digit upside.
The main headwind for Activision continues to be the apprehension towards World of Warcraft churn. With that said, the company can still experience churn in this leading brand and still have terrific revenue. Skylanders has already been a huge success and demonstrated that Activision can succeed even without its flagship titles. In addition to yielding a record number of sales within the first five days after release, Call of Duty: Modern Warfare 3 had 1.6B hours of game play registered since March 31. Yet again Activison has showcased its powerful brand.
Electronic Arts (EA)
In many respects, Electronic Arts is like the unloved version of Activision. FY2012 free cash flow of around $105M was dismal while the firm offers no dividend yield to compensate for poor momentum and slightly-high volatility. Since the beginning of the year, the stock has lost more than 30% of its value while Activision has held roughly flat.
Unfortunately, recent performance has done little to dissipate investor fatigue. Star Wars: The Old Republic embarrassingly revealed losing 400K players. While the company is planning 2 expansion packs for the game, gamers have shown a milder response to the launch than expected. Regret-ably, guidance for 2013 was lowered well below consensus. I recommend holding out from an investment for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.