Why Video Game Stocks' Hot Streak May Get Hotter

Video game stocks Activision Blizzard Inc. (ATVI), Take-Two Interactive Software Inc. (TTWO) and Electronic Arts (EA) have soared in 2017, with year-to-date gains through Friday of 70%, 112% and 51%, respectively. Meanwhile, explosive growth of so-called in-game spending, rather than the introduction of new games, should be the key driver of more gains during the next two years, according to research by Goldman Sachs Group Inc. (GS) cited by Barron's. In-game spending often generates considerably more revenue than initial sales of the games themselves, and a particularly lucrative category includes virtual goods, called items, that are used by characters in a game. (For more, see also: Investors May Love the Fast Action in Video Games.)

To be sure, the video game stocks have their skeptics. Analysts at Cowen & Co. recently downgraded Activision, Take-Two and French game publisher Ubisoft Entertainment SA (UBSFY) from outperform to market perform this week, pulling down these shares. In their report, Cowen analysts found growth expectations for these companies to be "highly unrealistic."

Revenue Shift

In-game spending, including mobile purchases, should reach 50% of industry revenue by 2019, up from about 35% last year, according to projections by Goldman Sachs reported by Barron's. Meanwhile, the fastest growing revenue source for Activision and EA is in-game spending, as Timothy O'Shea, an analyst with Jefferies LLC, told Barron's. Take-Two last released a new version of Grand Theft Auto in 2013, but annual in-game sales related to it are about $500 million, Barron's says, or roughly 26% of total revenues, per Investopedia data.

Bigger Margins

These trends promise to send game makers' profit margins yet higher. The virtual goods called items typically have very small development costs, and thus represent almost pure profit, per Barron's. As a result, it is much more profitable for the game makers to extend the lives of old games by adding opportunities for in-game spending, than it is to introduce new games. New games can have high development and marketing costs, meaning that a flop can be a financial disaster.

Another profit-enhancing trend is the move towards downloads of games over the internet, which do not have the manufacturing and distribution costs associated with sales of games on physical discs. In the second quarter, Activision derived 80% of its revenue from low-cost digital sales, Barron's adds. Mobile gaming is another growth area. EA produces roughly $650 billion of annual revenue from mobile, Barron's indicates, about 13% of total revenues, per Investopedia data.

Operating margins for these companies during their most recent fiscal years are, per Investopedia data: Activision, 23%; Take-Two, 11%; and EA, 28%. O'Shea tells Barron's that EA is on track to exceed 40% in the next few years, up from 10% in fiscal 2013.

Move or Die

There probably are limits to how much extra profit game makers can milk from old games through in-game spending. Eventually, game players will demand not only new games, but games with advanced features such as 3D displays, virtual reality, and/or machine learning based on artificial intelligence (AI). This means continued spending on research, development, programming and marketing is necessary to stay competitive.

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