2 Video Game Producers To Buy, 1 To Sell

by: Takeover Analyst

As game developers gear up for the holiday season, shareholders must place a keen focus on the macro trends. While recent employment figures were better than expected, the unemployment rate still rose to 8.3% - well above what is necessary for a healthy economy. In such a climate, investors should be pickier about their consumer good picks. In my view, Microsoft (NASDAQ:MSFT) and Activision Blizzard (NASDAQ:ATVI) are undervalued while Electronic Arts (NASDAQ:EA) is overvalued. Below, I review the fundamentals of each.

Activision Blizzard

Over the last 12 months, Activision's stock price has gone nowhere while the NASDAQ has gained by more than 18%. Valuation is still closer to the 52-week lower than the 52-week high, and volatility is very limited at a beta of 0.58. Analysts are bullish on the stock and rate it a 1.8 out of 5 where "1" is a "buy." Risk/reward is overall fairly compelling given that the company trades at a respective 16.1x and 10.7x under a 11.1% 5-year annual EPS growth forecast.

During the second quarter, Activision beat expectations with $1.1B in revenue. Even still, the market understandably reacted negatively to the earnings call for several reasons. First, revenue has been very volatile. Third, it is rumored that largest shareholder Vivendi is looking to sell its $8.1B position. Second, earnings has fallen $150M to $185M from the same quarter last year. With that said, I see a large future for the company in the international sphere. Activision Publishing's agreement with Tecent (TCEHY,PK) to introduce Call of Duty to China represents a major catalyst and a step in the right direction towards higher growth. Shareholder have become disillusioned by World of Warcraft churn and a shift to emerging markets could help eliminate some of the anxiety. In any event, the company plans to unveil World of Warcraft: Mists of Pandaria to excite back disillusioned investors.

What attracts me to Activision, in particular, is that the company has succeeded in generation a fan base around and beyond WoW. Skylanders and Call of Duty have both been major hits with the former gearing up to be the next $1B title. Bears argot that competition is getting intense from free game operators like Zynga (NASDAQ:ZNGA), but I believe there will always be a place for paid-for console games. I recommend buying shares to capitalize off of these low prices.

Electronic Arts

As I correctly predicted some time ago, EA has continued to stumble. Over just the last year, more than one-half of shareholder value has been lost. After such a fall, the company is only valued at 9.8x forward earnings. Analysts expect 17.4% annual EPS growth over the next 5 years. While this may be reason enough for some investors to buy a stake, I believe that EA is not worth the risk at such volatility. Moreover, ROA, ROE, and ROI are all in the low single-digits.

During the first quarter, management beat expectations with revenue of $491M, which was still down approximately $30M off of the same quarter one year ago. A loss of $0.41 per share was stymied by strong returns in digital, which positions the company to become the largest entertainment company in the video game market. Smartphone and tablet sales soared 86% followed by nearly identical 65% growth in Consoles and PCs. While the emergence of online video game producers may make EA attractive in the sense that it has inroads into this market, I believe that the mobile and online craze will die down. 9M of EA's 21M Origin users, for example, are on mobile, and shareholders are pricing in large future returns that I don't believe will materialize as expected.

I am, however, bullish about some of the initiatives that the company has taken to diversify in niche fields. The Ultimate Fighting Championship gaming license is now being run by EA, but THQ Inc. (THQI) will still produce games up until the end of 1Q13 in return for cash payments. Mixed martial arts is the fastest growing sport in the world, and the sports video game market has generated significant returns in the past from Madden and FIFA titles.


Microsoft may be most well known for its software and OS products, but it is also a video game developer through Xbox. No matter, diversification in a variety of different mediums - search, mobile, tablets, consoles, etc. - will enable the company to survive unpredictable consumer developments. The new console, dubbed Xbox 720, for example, has been speculated to possibly run Windows 8. If video games truly head to, say, the mobile and Internet space, Microsoft has the arsenal to transition consumers from one segment to the next.

Perhaps nowhere can Microsoft's synergistic value for video games be best seen than through Kinect and Bing. These 2 mediums enable users to easily find content before browsing competitor options. The newly-unveiled Xbox SmartGlass will also help to make gaming more interactive and take away traction from the upcoming Wii U. Xbox SmartGlass connects phones, tablets, and PCs to Xbox 360, thereby directly bringing together different mediums in a way that peers simply cannot.

Despite a weak console industry, Xmarket retrained a near majority share of the domestic market. Xbox LIVE membership grew north of 15%, largely as a result of Kinect and Bing's improvements on discoverability. It should be noted that Microsoft's video game business should never be considered in isolation to the software, OS, mobile, and internet operations. They work together and, as such, offer much to the growth story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.

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