We’ve written several times this year on themes related to videogames — trends we believe show that the 2017 outperformance of many domestic and foreign videogame companies are not a flash in the pan, but the beginning of a period of secular growth. This week we’ll provide a brief summary of these trends. Videogames remain one of our favored industries.
As the current bull market continues to mature, many investors of our mindset have found it more and more difficult to locate “growth at a reasonable price.” One industry where we see such inexpensive growth is biotechnology, where several major U.S. companies have projected earnings growth in excess of their current price-to-earnings multiple (i.e., a PEG ratio below one). Now that this industry is emerging from the shadow of potential price controls, investors are responding favorably and there is room for multiples to expand. Many of these stocks are cheap compared to their near-term growth and cheap compared to their historical norms.
The situation with videogames is slightly different. Although they too as a group have an attractive PEG ratio, they are tending toward the higher end of their historic price-to-earnings multiples. But there are powerful secular tailwinds behind them that will likely fuel earnings growth for many years.
Videogame Companies Ready to Press Start on Earnings Growth and Margin Expansion
For many years, videogames were not an attractive industry for investors, partly because of their intensely cyclical nature and the unpredictability of earnings surrounding the launch of new hardware platforms and new games. But technological shifts are beginning to even out those uneven earnings… and the same shifts will lift margins and provide new opportunities for revenue generation.
The Big Trends That Will Help Videogame Companies Keep Outperforming
First, companies are moving away from console and hardcopy sales as their sole revenue drivers, and are growing earnings from in-game purchases and digital downloads. Soon, in-game purchases will generate a majority of revenue. This in-game monetization is being driven by micropayments and content expansions to enhance gameplay; what has enabled a shift to more digital downloads is the ever-increasing availability of high-bandwidth internet connectivity. Downloadable content is increasing the lifespan of players’ engagement with a game. By reducing dependence on the cycle of consoles and games, videogame companies are increasingly presenting a more reliable revenue growth picture for investors.
Second is a potential wave of mergers and acquisitions. On average, the big game companies hold cash equivalent to 11% of market capitalization. This makes the industry ripe for a period of consolidation that will benefit the industry’s major participants.
Third, as we have written about several times, is the rise of e-sports, which videogame companies have only just begun to monetize. E-sports, we believe, will eventually capture a global audience larger than that of any traditional sport; this audience is already larger than that of the NHL and major-league baseball. Not only will e-sports provide direct revenue through new leagues, it will also increase the value of existing intellectual property franchises by encouraging deeper player engagement (providing a virtuous circle with the rise of in-game micropayments and content enhancements noted above).
We believe that these trends will continue to support revenue growth and moderate multiple expansion for videogame companies — particularly the major U.S. and Chinese firms.
Investment implications: In the U.S., investors should consider Electronic Arts [NASDAQ: EA], Take Two Interactive [NASDAQ: TTWO] and Activision Blizzard [NASDAQ: ATVI]. In China, investors may consider Hong Kong-based Tencent [Hong Kong: 700HK], NetEase [NASDAQ: NTES], and Changyou.com [NASDAQ: CYOU], as well as social networks YY.com [NASDAQ: YY] and Momo [NASDAQ: MOMO] and internet behemoth Alibaba [NYSE: BABA]. (We note that in China, many major firms, including MOMO, YY, and BABA, include games and game-related social media as elements of an aggressively diversified coverage of many internet-related sub-industries.) The KraneShares China CSI Internet ETF [NASDAQ: KWEB] is one of several U.S.- and China-based ETFs with significant exposure to Chinese videogame firms. Videogames remain one of our favored themes within the U.S. and Chinese tech sectors, and we recommend any seasonally or geopolitically induced weakness as an opportunity to establish a position. Please note that principals of Guild Investment Management, Inc. (“Guild”) and/or Guild’s clients may at any time own any of the stocks mentioned in this article, and may sell them at any time. Currently, Guild’s principals and clients own KWEB, YY, MOMO, and BABA. In addition, for investment advisory clients of Guild, please check with Guild prior to taking positions in any of the companies mentioned in this article, since Guild may not believe that particular stock is right for the client, either because Guild has already taken a position in that stock for the client or for other reasons.