Video games: still a long term growth story

For a few years now the video/computer games sector has looked attractive as an investor. 

As most people would now be aware video games have passed movies in terms of gross revenue and there are a bunch of  factors which make them extremely interesting as a long term growth story.

For example:

1. increased availability of high speed broadband
2. increased availability of large, high definition screens in the home
3. the growth of whole new genres which are different from the traditional shoot-em-ups such as edutainment titles which teach children far more effectively than any human teacher could, and gaming physical fitness titles exemplified by the Nintendo’s Wii Fit series which have redefined the user interface so that physical activity forms a strong component of the game
4. social gaming systems such as World of Warcraft (owned by Activision) with 11m players
5. new generations for whom gaming is not a marginal activity such as the under 20s and increasing numbers of women gamers

At the same time as a sector it’s pretty damn scary. 3-5 year console cycles cause stock prices to fluctuate like a yo-yo and it perhaps bears a passing resemblance with large title production costs and big marketing budgets to the movie business (not a business that looks tempting as organisations like Vivendi and Sony have learned to their cost). Equally there is the argument that, like the music business, titles can be pirated with high speed connections. Looking at all this you just have to keep reminding yourself equity investors really get returns for taking on risk…

However something that has significantly changed is that the multiples on all these gaming stocks have fallen over the last couple of years which is what makes them more interesting at the moment from the perspective of a value investor in what used to be regarded entirely as a growth stock play.

The big cap pure-play video games companies

The three big (pure) players are Activision, Electronic Arts, and Nintendo (given the risk levels on individual titles the smaller companies seem to be significantly riskier). None of these companies have any debt and all have significant cash on the balance sheet (in Nintendo’s case net assets excluding intangibles accounts for over a third of its market cap – about US$8bn of which is cash).

Whilst Sony and Microsoft are of course large in the games industry as well they also have other priorities and it looks hard on the surface of it to disentangle their games activities and the resulting impact on their stock prices from their other businesses.

Long term (see chart here) Activision seems to have tracked Nintendo (both of which are generally thought to have excellent management teams) up until the beginning of 2009, whilst comparatively Electronic Arts has languished in the last 2 years (EA focusing heavily on sports titles compared to the other two).

Comparative valuations for Activision, Nintendo and Electronic Arts

Some comparative valuation metrics for all three stocks are listed below:

There is some degree of fear out there on these stocks – see “Can Nintendo Rebuild?” for example in Businessweek. Generally video game sales have not been good recently (Nintendos’ sales fell for about 8 months straight this year and it expects annual revenues to fall for the first time in 6 years), there is nervousness about the impact of social gaming via systems like Facebook, and the rise and rise of iPhone games has made people wonder what impact that might have on dedicated handheld devices like the Nintendo DS or Sony PSP.

Nintendo, for example is trading at half its price in 2007:

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 and even Activision with the recent success of its Call of Duty: Modern Warfare title is trading at $10 or so from a high of $18 back in 2007 (but not an apples for apples comparison given its 2008 merger with Blizzard and their World of Warcraft franchise). 

Of these 3 stocks it is Nintendo that seems to jump out (although both Activision and Electronics Arts are trading below Morningstar’s fair value estimate and it would probably be entirely reasonable to take a diversified bet on all 3).

The case for investing in Nintendo?

As a US$34bn company with the majority market share in many areas (Sony has sold about 9m PS3 units in the UK with Nintendo selling 25m Wiis)  Nintendo is surprisingly hard to find investor coverage on – Morningstar in the USA for example does not provide analysis on it.

If the reason is concerns about the way that some Japanese companies are run, these don’t seem warranted in Nintendo’s case.  At current stock prices they even pay a 5% dividend – the only company of these three to do so and a rarity in the games industry generally.

Nintendo is however definitely a long term bet. Their revenue has halved in the last 6 months compared to a year ago and a chartist probably wouldn’t touch them with a bargepole.

However they are still busily shipping units of the Wii (with a price cut) and the portable DS (with roughly 10% of the all time entire total sold in the last 6 months) and if you look at their geographical revenue split what happens in the US is both very important but equally very impacted by US dollar weakness (the USD having fallen against the Yen by about 20% over the last 2 years).

As the activity type table above suggest Nintendo is not just a hardware company with revenue over this period (during which not many new titles were released) being split about half software, half hardware. Recent falls in revenue reflect a lack of new compelling titles or hardware launches but the company’s franchise with casual gamers places less stress on coming up with radical new cutting edge consoles (as is the case perhaps with the Xbox or Playstation). Their Mario Brothers franchise is still going strong and the title was released in 1983!

The concerns about the iPhone seem to be overrated to me. The iPhone lacks gaming controls so you have to use your fingers on the screen (reducing its visual area), it comes with data charges, and to argue that gaming apps are cheaper for the iPhone is a little like arguing  that nobody is going to go to the cinema because they can watch movies for free on television (the better movie experience still counts for the consumer).  Just on that minor point $10 for  cinema ticket for a one-off 2 hour’s enjoyment still seems to be outranked by potentially weeks of enjoyment in sharing a game with your family at home.

Neither, if you look at Nintendo’s R&D spend, does it look like Nintendo intends to stand still with a high definition Wii supposedly in the works as well as link-ups with organisations like Netflix. Yes, motion-sensing controllers may well be on the way from Sony and Microsoft but this is a company with a history of innovation.

Nintendo’s management has successfully broken into whole new areas – with a market share for example of up to 80% of US female gamers and almost singlehandedly created a new genre, the fitness/exercise game.

Nintendo’s profitability and track record makes their US ADRs look like a buy (US: NTDOY) and the rumours of a stock split would make them more attractive as well. However looking at their chart averaging in looks warranted – this is not for the faint-hearted.

Posted under individual stocks