The gaming industry at large has seen massive growth over the last year coinciding with consumers being forced to spend extra time indoors related to the effects of the global pandemic. That development has some investors looking for opportunities to buy in on the usage surge.
Many are focusing their attention on exciting new gaming-related companies like Unity Software (NYSE: U) and Roblox (NYSE: RBLX) that have been hitting the public markets of late. Which makes it easier to see how investors might be overlooking some of the older legacy gaming companies.
While these legacy producers have experienced plenty of growth already over the years, there are at least three video game stocks that are worth a closer look right now because they have bright futures and growth potential.
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1. Electronic Arts
Widely known for its "games for non-gamers," Electronic Arts (EA -0.33%) is home to the most popular sports-based video games. Led by its hit games franchise FIFA, EA has generated roughly $6 billion in net bookings over the last 12 months -- 8% more than the prior year. Additionally, as more and more users have opted to purchase their games digitally, EA has incurred lower manufacturing and distribution costs, leading to an improved operating cash flow margin.
Despite this success, the market appears to be ignoring EA's recent financial performance. Granted, the following comparisons aren't exactly apples to apples given that each company has a different expected growth rate, below is EA's valuation in relation to its peers.
Since traditional accounting standards force video game companies to recognize bookings over an extended period of time, instead of at the time of purchase, net income doesn't always properly reflect the true cash that a company is generating. So, in addition to earnings multiples, I've also included each company's enterprise value (market cap minus net cash) versus free cash flow. The lower the EV/FCF ratio, the faster a company can generate cash to reinvest in its business.
| Game Producer | Enterprise-Value-to-FCF Ratio | Price-to-Earnings Ratio |
|---|---|---|
| Zynga | 26 | 146 |
| Activision Blizzard | 31 | 32 |
| Take-Two Interactive | 18 | 50 |
| Electronic Arts | 17 | 31.5 |
FCF=free cash flow. Sources: SEC, Koyfin.com.
Even though new development studios continue to be on the rise, the durability of EA's hit franchises shouldn't be understated. Thanks to its exclusive licensing agreements with various governing bodies, EA can simply create new iterations of the same game concept every year, leading to much more reliable revenue. Some competing publishers, on the other hand, have to originate new game concepts from the ground up every time in hopes of a big hit.
While EA might not see astounding growth in users or revenue due to its sheer size, it should benefit from overall gaming tailwinds. As available users grow, game purchases transition even further into digital downloads, and next-generation gaming consoles hit the shelves, EA should see continued free cash flow growth over the coming decade.
2. Activision Blizzard
Gaming conglomerate Activision Blizzard (ATVI) just wrapped up its greatest financial year ever. Driven by its leading Call of Duty franchise, Activision Blizzard generated more than $8 billion in revenue in 2020, 25% more than the year prior. While there aren't any known major new catalysts for growth in 2021, Activision has made a structural change that should help expand profits with each coming year.
Traditionally the Call of Duty franchise has been based on the success of individual games, but thanks to the introduction of its free-to-play model, Activision can release new software updates to its existing user base every season. Additionally, this style has introduced a recurring revenue element as users pay for the "Battle Pass" subscription every time a new season is introduced. Since each new user requires fewer variable costs, this has led to more sustainable profit growth across the board.
Though the Activision segment's Call of Duty stole the headlines, the King and Blizzard Entertainment segments both also performed impressively. Driven by Candy Crush and World of Warcraft, all three franchises under the Activision Blizzard umbrella generated greater than a 35% operating margin in 2020. With each business now humming along, Activision looks well-positioned to deliver more cash flow to its shareholders over the next several years.
3. Nintendo
Nintendo (NTDOY -2.30%) is one of the oldest video game companies around. But now, nearly 50 years after its first foray into the gaming industry, Nintendo seems to have finally built a sustainable console -- the Nintendo Switch. The Switch has been the best-selling console for the last three years, and the company has already introduced a successful follow-on console, the Switch Lite.
With roughly 80 million units in total now in people's homes, game development has become more lucrative for Nintendo as well. Since development costs hardly change and Nintendo has a wider audience to sell to, Nintendo's profits continue to grow. Over the last 12 months, Nintendo has generated $5.5 billion in operating profits -- a 107% increase from the 12 months before.
But the party isn't over yet. Despite trading at a market cap that is only 12 times operating profits, the future looks bright. Rumors have floated around that Nintendo's third iteration of the Switch is planning to release this year. If three consecutive consoles are able to sell successfully, it should wake the market up to the idea that the Switch is here to stay.
With its Disney-like collection of intellectual property to capitalize on and a clear underappreciation from the market, Nintendo shareholders should be in for a fun ride in the years ahead.
