Image Source: steamXO
Adapting to consumer consumption trends is a necessity for video game makers, and rapidly improving technology standards are impacting the industry as producers work to deliver high-quality entertainment effectively. Long-term demand trends are generally bright, but continual innovation and adaptation will be necessary.
By Kris Rosemann
Key Takeaways
Video game companies compete with all forms of entertainment for discretionary spending, and competition has never been greater.
Business models aimed at driving recurring revenue have disappointed with respect to their ability to reduce lumpy financial performance. Evolving delivery methods cannot reduce the hit-based nature of the industry.
We’re not interested in adding exposure to the space, but operators within it do have some attractive qualities, not the least of which is the generally low capital-intensity of the businesses.
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Video game companies are constantly competing will all forms of leisure-time activities, and keeping the attention of consumers with high-quality products is their only chance at continuing to earn a share of discretionary spending. The proliferation of mobile devices and improving mobile connectivity are enhancing the opportunities and challenges within the gaming industry, but demand for high-quality games remains as strong as ever. As EA (EA) CEO Andrew Wilson succinctly stated on the company’s fiscal 2019 third quarter earnings call, “And above all else, great content continues to be the lifeblood of our industry.”
The current evolution of the gaming space, however, has companies sorting out how to best deliver the high-quality content its customers demand. We recently saw Sony (SNE) report disappointing performance from its PlayStation business as it works to drive sales of its PlayStation 4 console despite strength in games software sales. Top-notch consoles are becoming increasingly less necessary to deliver a high-quality gaming experience, and this is a trend that is not going away. Investors need look no further than the rapid adoption of mobile computing devices and the impact it has had on the PC market for evidence of what may be coming, or is already happening, in gaming. A similar parallel can be drawn to rapid change in video consumption to streaming.
The coming implementation of 5G could accelerate this trend for game makers. Relative to competing entertainment sources, video games have a far lower tolerance for latency on wireless networks due to the heightened sensitivity of outcomes and user experiences to even split-second lags. In this sense, video game companies are reliant upon outside sources to develop reliable infrastructure that can be used to deliver products. Passive media such as video and music streaming are not as sensitive to these factors, which can make a meaningful difference when it comes to consumer time-based competition. Competition for consumers’ time has never been greater.
The dynamics of the mobile gaming market are also changing as the industry ages, and it is made up of a small number of very successful games with a large number of far smaller games that struggle to remain economically viable franchises. EA estimates that the average age of top 20 game titles is currently more than three years, which is making it increasingly difficult for new games to gain a foothold. Despite changing delivery methods, the gaming space may very well remain hit-based for the foreseeable future.
The shift in gaming away from consoles, PCs, and physically delivered games is causing operators to redefine their business models. Subscription-based revenue and cloud gaming are expected to be significant growth opportunities as we move forward with improving technology, and subscription offerings are already growing. Tech giants like Alphabet (GOOG, GOOGL), Amazon (AMZN), Facebook (FB), and Microsoft (MSFT) will also play a role in the future of gaming as widespread hyperscale data centers will be necessary for streaming technology to improve on a large enough scale. The potential for vertical integration within the video game space may be a possibility moving forward as the combination of content creators (game publishers) and distribution provides (streaming providers) is not without precedent in other industries.
Shares of video game publishers had benefit materially from expectations that business models emphasizing recurring revenue would reduce the potential lumpiness of quarterly results, but significant competition and an innate reliance on fickle consumer tastes have made realizing these benefits more difficult than expected.
Yet another avenue that aimed to remove some of the lumpiness from quarterly financial performance is the free-to-play model with in-game purchases. Social-gaming leader Zynga (ZNGA) has had success with this model with franchises such as FarmVille, and the massively popular ‘Fortnite,’ created by Epic Games, in which Tencent (TCEHY) owns a 40% stake, has had success with a free-to-play model that incorporates in-game purchases for upgrades. EA recently launched ‘Apex Legends,’ a direct competitor to Fortnite using the same kind of revenue model, and the company reported that it had 10 million user sign ups in just 72 hours. Demand for in-game purchases are still hit-driven to a large degree, as consumers must be willing to invest time and money in the games.
At the end of the day, consumers will be willing to pay for high-quality games, regardless of the revenue model incorporated. The key objective for game publishers remains the quality of their games, and the space is not commoditized in the slightest. Differentiation occurs in the quality of the product. Delivery methods are changing, and producers must adapt to consumer preferences in that regard. However, the highest-quality games will continue to rise to the top.
EA lowered its guidance for fiscal 2019 (ends March 2019) in its third quarter report, released February 5, as a result of a launch delay and significant levels of competition impacting the performance of big-name releases, and its reduction of expectations was felt across the space as investors extrapolated the difficulties in its business to peers Activision (ATVI) and Take-Two (TTWO). After initial selling pressure following the release, shares of EA have bounced back due to optimism over the future potential of ‘Apex Legends,’ but we’re not expecting this kind of volatility to disappear any time soon.
Activision is expected to announce a material round of job cuts to address profitability issues, which suggests the challenges for the space are far from ironed out. Shares of Take-Two have experienced notable selling pressure since the February 6 release of its fiscal 2019 third quarter earnings despite strong demand for ‘Red Dead Redemption 2’ and increased guidance in a number of metrics. Expectations for a deceleration in recurrent consumer spending in its fiscal fourth quarter may be weighing on shares as outperformance in this area in its fiscal third quarter was driven by special editions of ‘Red Dead Redemption 2,’ and ‘Grand Theft Auto Online’ sales are expected to remain lower on a relative basis in fiscal 2019.
We are not interested in adding exposure to video game creators at this time due in large part to the number of challenges the space currently faces and the inherent volatility found in hit-driven demand environments, but there are a number of attractive qualities found in some industry constituents. The low capital-intensity of the group facilitates free cash flow generation, provided high-quality content is being produced, and the resulting cash-rich balance sheets help offset some of the inherent uncertainty the group faces.
At the end of calendar 2018, EA held no debt on the books compared to nearly $5.2 billion in cash, cash equivalents, and short-term investments, and Take-Two also boasts a debt-free balance sheet with $1.6 billion in cash, cash equivalents, and short-term investments. Activision reported a net cash position of $638 million (comprised of $3.3 billion in cash and $2.7 billion in debt) at the end of the third quarter of calendar 2018 as it has been active in M&A in recent years.
EA and Take-Two are our two favorite ideas within this near-term challenged space, but shares of both companies are currently trading with our respective fair value ranges as of this writing. Investors should note the larger-than-average fair value ranges we use with these companies, as it reflects our thoughts surrounding heightened levels of uncertainty facing the group.
Software – Graphics: ATVI, AVID, EA, GLUU, RST, TTWO, ZNGA
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.