Investing in the Next Generation of Video Game Consoles

The launches of Microsoft's Xbox One and Sony's PlayStation 4 have started another generation of the battle for sales of video game consoles and, by extension, the battle for your living room. It's a big industry, but it's impossible to predict from a console's launch how successful it will be. That uncertainty can scare off investors, but there are ways to invest in the latest console boom without trying to pick a winner.

Making the systems
To sell millions upon millions of consoles, a lot of things need to happen. First, they need to be made and two companies are heavily involved.

The first, Advanced Micro Devices (NYSE: AMD  ) makes the processors for both Sony and Microsoft's offerings, so whether it's a PlayStation or an Xbox under the Christmas tree, there is an AMD processor at its core. Whether both consoles continue to compete for market share with relative parity or one dominates the other, AMD wins.

AMD's primary business is in making processors for computers and between that and their sudden domination of the console market, they are extremely well positioned for a turnaround. Analysts are predicting a return to profitability, and a big gain from the console ramp-up could easily make this the turnaround story of 2014. Stiff competition from Intel on the PC side of things has given them some lean years, but with over $1 billion in cash on hand, there's every reason to bet on this success.

But all those AMD chips and high-end components don't just put themselves together, and that's where Foxconn comes in. The consumate Chinese manufacturer of other peoples' gadgets is involved in the manufacture of both consoles, and that's a nice position to be in. I'm not a huge fan of Foxconn's incredibly low profit margin business style, but there's no denying they're good at what they do.

Games
Out of the box neither an Xbox One or a PlayStation 4 can do much. These are video game systems, and they need games to be worthwhile. While both Sony and Microsoft do make some of their own games, the lion's share of the game market is third-party developers.

While some of the software companies, like Japan-centric Konami and Square clearly would benefit more from PlayStation 4 becoming the worldwide standard, most of the major software players will take advantage of the internal similarities of the two systems, and release their games for both.

Electronic Arts (NASDAQ: EA  ) and Take-Two Interactive (NASDAQ: TTWO  ) are both going to benefit, as their respective sports and action games get reboots on new systems.

The benefit is not just novelty, it's price. The last couple of years of this generation, and indeed any generation, the "new" games fall out of favor quickly and end up in bargain bins well below launch price just a few months out of the gate. On the new systems, there is no competition from used games yet, and the prices will stay higher for longer, helping margins. Higher production costs will offset this somewhat, however.

While earnings will be improved for both in the near term, that makes me nervous and I'm not sure either is a buy at current levels. By contrast, Activision Blizzard (NASDAQ: ATVI  ) sports much better margins, a much higher current ratio (over 5 versus over 1 for the others), and even a small dividend.

Activision isn't as pure a play on the consoles, with its Blizzard division almost exclusively focused on PC gaming, but Blizzard's knack for long-term successful titles will provide the Activision division with a cash-flow cushion that will allow them to take risks the others may not be able to afford. In the last generation that meant some huge hits, and there's no reason to doubt that again this time.

Buying it all
One last play, lost in all of this, is the retail play. Lots of places sell games, from Wal-Mart to Amazon, but the pure play is what it's been for years, GameStop (NYSE: GME  ) , and its worth considering.

People have been predicting the death of GameStop and the rise of digital distribution for years. Buying games on the console and downloading them is an option for some of us, but while broadband is more and more common nationwide, the high speeds needed to download huge, Blu-Ray-sized games are still comparatively expensive and uncommon. Even where they do exist, download caps at Internet providers mean dedicating tens of gigabytes of bandwidth to downloading a single game is not an option for many.

GameStop still has a valuable niche in gaming retail, and there's a lot to like about the cash-rich, debt-free company, with its consistent earnings and its sub-1 PEG ratio.

With everybody predicting a big win for either Sony or Microsoft, there's a lot of temptation to think you have to gamble on one or the other to play the game market. But whether you're into the hardware side with AMD, the software side with Activision, or the retail aspect with GameStop, some of the most compelling plays in the sector don't depend on either side winning outright.

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  • Report this Comment On December 17, 2013, at 3:33 PM, KenLuskin wrote:

    >>>"For Andrew Feldman, microservers and System-on-Chip (SoC) are a lot more than just another variety of compute. The man in charge of AMD’s server business expects nothing short of a revolution, and a big reason for that revolution, he says, will be ARM Holdings, the UK company that licenses its low-power processor-core architecture to chip makers. ARM chips power most of the world’s smartphones, but many vendors in the data center IT food-chain are working around the clock to crank out servers, storage and networking devices with low-cost and low-power ARM-based SoCs instead of the expensive network silicon or powerful and even more expensive x86 processors."<<<

    Both he and Feldman say growth of the segment will, to a great extent, depend on growth of the ecosystem around it – the ecosystem of hardware makers, software developers and customers. Feldman expects this ecosystem to grow very quickly because it is so much cheaper and less time consuming to build an ARM server than it is to build an x86 one. “It takes four years and $350-400m to make an x86 server,” he says. This is why there has not been a successful startup in the x86 server market in 20 years. “On the other hand, it takes $30m and 18 months to build an ARM CPU.”

    This is important because it means companies can make custom chips for big internet companies, who are expected to be the first major microserver users. “What that means is we can do a custom one for Facebook; we can do a custom one for Amazon; we can do a custom one for Baidu – each individually and separately – that has their IP in it, that embed advantages [for] their particular technology,” Feldman says.

    He expects ARM to win not because the end products will have slight advantages on key metrics. “They will,” he reassures us. “They win because it’s a fundamentally different approach to delivering a product.” ARM Holdings amortizes its R&D over its 250-300 licensees, while Intel amortizes its R&D over itself, and that is what makes it so much fun to watch, Feldman says.

  • Report this Comment On December 17, 2013, at 3:35 PM, KenLuskin wrote:

    The reasons the big internet companies will be the first to adopt microservers, he explains, are that their businesses are extremely sensitive to cost of computing, and that they write their own software and have no allegiance to an instruction set. “They’re writing in PHP. They absolutely don’t give a hoot about special instructions or optimizing. They’re writing at a layer of abstraction so high, that they don’t even know what the CPU’s doing.”

    That is the opposite of the enterprise market, where one virtualized server is running 30 or so software packages on 30 different virtual machines. This is an extremely conservative market, where IT is expensive by design, and it can take as long as five years for the concept of microservers to take hold in this space. We have already seen examples of technologies developed by the likes of Google or Yahoo! – Apache Hadoop is a good example – making their way into the enterprise data center a few years later.

    The big internet companies with massive data centers “want an ecosystem’s worth of alternatives,” and that ecosystem is bound to develop very quickly, Feldman says. “Right now, you’ve got fundamental changes. You’ve got demand going through the roof on one side. You’ve got customers being smart and innovative on the other. You’ve got a threat from the ecosystem against an installed giant. A lot of things happening, and that’s cool.”

  • Report this Comment On December 18, 2013, at 6:49 AM, bluesky64 wrote:

    Ken,

    Thank you for sharing these compelling facts.

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