The video game industry has been picking up steam in recent years. Market researcher Newzoo recently increased its 2020 revenue estimate for the industry to $143 billion, which represents a growth pace of 8.2% per year. Millennials are spending more time playing games, as game companies are not only producing compelling games, but they are also finding new ways to attract new players through spectator gaming, such as esports and game streaming sites like Amazon.com's (AMZN +0.81%) Twitch where millions of viewers watch others play games online.
There are several trends driving the video game industry's growth, which we'll review below.
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New technologies are pushing the industry forward
The most fundamental factor that drives sales of video games over time is the ongoing advancement of graphics processing technology. Chip makers, NVIDIA and Advanced Micro Devices, continue to release new graphics cards each year that make games look more lifelike, and allows game creators to make games more immersive. Above all else, this serves as great marketing to attract both hardcore gamers and those who only have a casual interest to play games.
The growth of mobile platforms is also having a big impact on industry growth. The graphics capabilities of tablets and smartphones are starting to approach the processing power of traditional game systems like PC and console, which will only continue to fuel the $50 billion mobile game market -- the fastest growing category of game sales.
There's also new technologies emerging, such as virtual reality and augmented reality. You might remember Nintendo's (NTDOY 0.87%) mobile game Pokemon GO making headlines a few years ago for its use of augmented reality. These emerging technologies will create entirely new ways to experience games, which will help the industry continue to grow.
Video games generate high margins
Another reason to consider a video game stock is that gaming is becoming more of a service. Over the last 10 years, game companies have shifted to a digital distribution strategy in order to lift margins and generate year-round revenue, as opposed to relying on annual new game releases, which sometimes produce inconsistent revenue performance. Because it costs these companies much less to distribute digital content than selling physical game discs, this strategy has made game companies much more profitable and lowered their risk to investors.
The three largest U.S.-based game companies -- Activision Blizzard (ATVI +0.00%), Electronic Arts (EA +0.00%), and Take-Two Interactive (TTWO 0.01%) -- generate around half of their annual revenue from sales of digital content that players purchase while playing the game. With more revenue coming from digital content, Activision and EA are generating high margins that you typically only see among software technology companies that have low capital requirements like Microsoft (MSFT +0.15%). Activision's operating margin has been hovering around the mid-30s in recent years, and EA has seen its margins steadily rise, as well. Take-Two is smaller than its larger peers, and has struggled in the past to generate consistent annual free cash flow, but that has changed with the growth of in-game spending.
Gone are the days of selling a $60 new game, and then waiting another a year for the next release to make money. Game companies are completely focused on growing in-game spending, and that's why these companies are pursuing adjacent growth opportunities like esports, consumer products, and cinematic experiences; these are ways to drive higher awareness and enthusiasm for specific games which can lead to more time spent playing games and, therefore, higher spending by players.
Where to start
The trend to digital and spectator gaming, such as esports, is causing the video game industry to experience dramatic change -- and for the larger companies, that's a good thing. While the big companies that make the blockbuster games are winning, there have been losers.
Over the last few decades, smaller companies like THQ and Atari who couldn't keep up with the big boys went bankrupt. However, companies like Activision, EA, and Take-Two have continued to thrive. These larger companies consistently turn out blockbuster titles which provide the profit to reinvest in not only new games, but also acquire smaller companies in order to broaden their revenue stream, as Activision did in 2016 by acquiring King Digital Entertainment -- the maker of the hit mobile game Candy Crush -- for $5.9 billion.
These larger game makers are also starting to invest heavily in building an esports ecosystem around its biggest games. The most ambitious effort so far has come from Activision with its Overwatch League which has already attracted sponsorships from major global brands like Toyota Motor, Intel, and T-Mobile.
Nintendo has gone through ups and downs, but is currently on a upswing with strong sales of its Switch game system. Take Two is seeing success from the massively popular Grand Theft Auto V, with other initiatives underway to keep its momentum going, such as new games and an esport league based on its bestselling NBA 2K franchise. Activision, EA, and Paris-based Ubisoft (UBSFF +3.85%), make some of the biggest, best-known games in the industry, which attract millions of viewers on game streaming websites, including Amazon's Twitch, Microsoft's Mixer, Twitter's Periscope, or Alphabet's YouTube.
By owning one of the larger video game companies, investors have the broadest exposure to all the trends impacting the growth of the industry, and that's where I would focus. New emerging technologies, as well as the growing popularity of esports is creating new ways for game companies to reach new audiences. Because of these trends, there's never been a better time to consider investing in video game stocks. However, with these stocks trading at high P/E multiples, it would be wise to start small if you decide to invest in one of the video game stocks mentioned.
