With information coming at investors a mile a minute here in the thick of earnings season, it's easy to draw conclusions about a group of stocks simply based on the results of one company. Case in point? Electronic Arts Inc. (Nasdaq:ERTS) got trashed on Tuesday (9%) after worries over a weak outlook took hold. The dip took other big game-makers like Konami Corp. (NYSE:KNM) and Activision Blizzard, Inc. (Nasdaq:ATVI) down with it.
Though those two other stocks didn't take anywhere near the hit that Electronic Arts did - they didn't deserve a hit at all, and certainly didn't deserve to miss out on the market's bullish action that day.
But isn't guilt by association just part of investing? Unfortunately, a handful of investors were savvy enough to not let mere association pull the rug out from some of the game-maker names. Specifically, many of the smaller stocks in the industry posted solid gains in the face of heavy selling. Better still, most of them deserved to make those gains.
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In light of the fact that the ATVI, KNM and ERTS are all in the red for the year, the bullish spotlight needs to be directed at some of the smaller brothers in the family - picks of the litter, if you will.
Two interesting players come to mind right away: Changyou.com Ltd. (Nasdaq:CYOU) and Majesco Entertainment Co. (Nasdaq:COOL).
Changyou.com may be one of the market's best-kept secrets. It's a cash-generating machine with four straight quarters of bigger top lines, and four straight quarters of income growth. It's almost as if the recession didn't happen.
If you're wondering how the company did it, it's the nature of the business model. (Learn more about business plans, see: Getting To Know Business Models). Changyou.com isn't just a conventional designer and developer. The company operates a subscription-based (read 'recurring revenue') online gaming site, which forces it to come up with something new every few months. Either way, with profit margins of more than 50% (yes, you read that right), coupled with reliable growth, the projected (2011) price-to-earnings multiple of 8.4 doesn't seem out of reach at all.
Even though Changyou.com is so successful, not many people have heard about it, mostly because it's a Chinese-based company. A few more huge-margin quarters from the company, though, and a few more troubled outlooks from the likes of Electronic Arts, and investors will discover CYOU.
Majesco Entertainment Co.
As for Majesco Entertainment, once again we can attribute potential success to doing something in addition to designing and selling games for video game consoles or desktop computers.
The numbers don't look good right now. Majesco took some big and unexpected losses over the last two quarters, which certainly casts doubt on the fiscal 2010 EPS forecast of 5 cents, and 2011's EPS estimate of 15 cents. The company's still interesting though, because if it can pull off those profit figures, the forward-looking (2011) earnings multiple of 5.6 is almost comical.
And what will pull Majesco Entertainment out of the red and into the black again?
Like Changyou, a shift in the business model here may help. Majesco has started to design games specifically for mobile devices. And, the business could be viable. The company just needs to cut expenses and/or increase sales to the tune of about $5 million per quarter. While that's a challenge, it's doable for this company that's been generating revenue between $17 million and $33 million per quarter recently.
The best thing COOL shares have going for them is the explosive growth in sales of mobile devices, each one of which is a potential paying customer.
The 39% year-over-year increase in smartphone sales during the fourth quarter of 2009 implies that users are doing more with them, and for non-communication purposes. That Q4 growth also means another 39.2 million more customers now have a better reason to shop for a Majesco game. Even a fraction of that growth trend, however, could send a steady supply of new potential customers Majesco's way, and soon fill in that $5 million quarterly gap.
It's still very early in the COOL game, but forward-looking investors can see where it can be going.
The Bottom Line
None of this is to say the big, console gaming giants are dead in the water, nor is it to say other video gaming small caps can't do well. The point is, it's time to start thinking outside the Xbox.
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