On this tech edition of Industry Focus, analysts Dylan Lewis and David Kretzmann talk about the video game industry, focusing on the two biggest names in the space: Activision Blizzard (NASDAQ:ATVI) and Entertainment Arts (NASDAQ:EA).

Listen in to find out just how big this industry is, some of the major trends offering a tailwind for both companies, and how each business is positioning itself for the future.

A full transcript follows the video.

This podcast was recorded on June 10, 2016. 

Dylan Lewis: This episode of Industry Focus is brought to you by Harry's. For guys who want a great shave experience for a fraction of what you're paying now. Just in time for Father's Day, get $5 off the limited edition Father's Day set by entering the code "Fool" when you check out at harrys.com.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 10th, and we're talking tech and video games. I'm your host Dylan Lewis and I'm joined in the studio by Motley Fool premium analyst David Kretzmann. David, how's it going?

David Kretzmann: It's great to be here, Dylan. Thanks for having me.

Lewis: Nice to have you on the show. I don't think we've ever done anything together.

Kretzmann: No, I'm a big fan and a big listener. Thanks for having me on. It's an honor.

Lewis: We're going to be talking video games today. Before we dive into the companies, I have to ask: Did you have a favorite video game growing up?

Kretzmann: Growing up, my family didn't have any of the fancy consoles, so I never had a PlayStation or an Xbox. I would have to go over to a friend's house to play that. On our Windows 95 computer and we kept this computer specifically for these two games. I played Road Rash and then Warcraft II special edition, Tides of Darkness. Those were the two games I played in my own house on a somewhat regular basis.

Lewis: I was raised in a very similar household, where my parents told me, "We're not buying you a video game console. If you want one, you have to buy it yourself." Eventually, I saved up and got enough for the PS2. That was my console. That was my baby as a kid. When you're young, you're just like, "Boy, I really hope I have a sleepover sometime soon. I really want to go to that guy's house who has the Xbox."

Kretzmann: Yeah, some popular friends on the block.

Lewis: That Warcraft reference is a nice transition into one of the companies we're going to be talking about. Before we get too far into the stocks that we'll be discussing on today's show, I figure we'll set a little groundwork here for what the gaming industry looks like. I'm just going to throw out a couple different estimates of market size I've seen lately.

Digital gaming was a $60-plus billion market last year. That was actually led by PC gaming, which is surprising. You hear all this about the death of PCs, or the rise of the tablets, or the multicapable devices, switchover to mobile. PC gaming is still leading the charge there.

The worldwide mobile gaming market is a high-$20 billion market. I've seen projections that that will hit $45 billion by 2018. Just to give you an idea of where this market's going, some big growth expected and not necessarily from the areas that you might be expecting.

Kretzmann: Yeah, absolutely. There is a lot of different growth arenas in this space. To give some additional context, 10 years ago there were 200 million players, 200 million gamers. Five years ago, that increased to 1.5 billion. Most recently, the most recent number I have seen is 2.6 billion gamers worldwide. You're seeing more and more gamers, more and more platforms that people can play the games on, so a lot of growth happening in this space.

There have been a lot of great investments in it over the past five, 10 years. I think some of the names we'll talk about today, there's a lot of potential there for investors going forward as well.

Lewis: The two big names, at least as far as I'm concerned in the video game market, Activision Blizzard and Electronic Arts. These are both video game publishers. Activision's made shareholders pretty happy over the last couple years. They've got some big time franchises under their belt, World of Warcraft, Call of Duty.

Electronic Arts, most of the people know them for their sports games. They're trying to move beyond that a little bit right now. You want to start out with Activision. Talk a little bit about what they're doing?

Kretzmann: Let's do it. Yeah. As you mentioned, Activision, they have the number one console franchise which is Call of Duty. This is a franchise that's been out for about a decade -- I think a little more than a decade. I think 12 years. Each year or so, they'll issue a new iteration of that franchise, an extension, a different version. It's been just an amazing seller for the company.

Similarly, with PC Gaming, you have World of Warcraft, which has been just a juggernaut of a game. It's actually a subscription model. You pay a monthly subscription and you can play in this online fantasy world with your friends and other players around the world. Warcraft, the most recent numbers I saw, there are still more than 5 million players with Warcraft.

Activision, a massive company in this space. It's the largest video game software publisher in the world. Last year, we'll talk about this more I'm sure, they acquired King Digital, which is a large mobile game operator.

By bringing King Digital under its umbrella, Activision now has more than 500 million monthly active users through all of its different games and platforms. That's a user base that's rivaled by only a few companies out there like Facebook, [Alphabet's] YouTube, some juggernaut brands out there. Activision has a huge audience.

To give you another pretty staggering number, over the past year, audiences spent 42 billion hours playing and watching Activision's games. They have a lot of people paying a lot of attention to their games.

Lewis: I think one of the key things to hone in on there is watching, hearing you say that. Something that some of our listeners might not be as familiar with is the rise of what we're calling eSports now. There is the conventional gaming market where you have people buying titles either physically, or digitally, playing them. They're in-game purchases in some cases.

There's also this transition to a space in the industry where there's money to be made by selling video game experiences as sporting events.

Kretzmann: This is a concept that's popular internationally. It's becoming more common domestically as well, but especially in China and Asia, and Europe. eSports has been a rising phenomenon. You're even seeing dedicated stadiums built for people to watch the elite gamers play a video game. It's really the idea like you have the NBA, the National Basketball Association where you see the elite gamers, the elite basketball players play.

In a similar way eSports is this league, or this platform where you can watch the top tier gamers play. Some pretty amazing statistics here. In 2015, the second most viewed sporting event in the world, only behind the super bowl was the League of Legends world championship, which had 36 million viewers. That's ahead of game six of the NBA finals, which had Steph Curry and LeBron James, the best basketball players in the world, they had 29 million viewers.

The world series final game last year had 17 million viewers. 36 million people watched a world championship with League of Legends, a video game. That gives you an idea of just a staggering global audience for people who are actually sitting down and watching elite gamers play. It's still something I'm personally still trying to wrap my head around.

We have some gamers at the Fool who do spend time watching these tournaments and watching the elite players play. This is certainly a driving force with the industry. You have both Activision Blizzard and Electronic Arts, then other players even like Amazon with Twitch, with the acquisition they made a couple years ago. YouTube is spending more time streaming these gaming tournaments.

You're seeing a lot of big players make a concentrated concerted effort to dive into eSports and really drive that movement. It's certainly something to watch.

Lewis: I think one of the things that's particularly compelling with eSports is whereas with live sports, you are in a lot of ways selling tickets. There are instances where you're at a stadium and there are probably tens of thousands of people watching something.

This is a very scalable and online production for the people that are putting it on. It's a digital pass type approach. That's something that scales incredibly well when you're talking about porting it out online, or trying to sell some sort of a subscription service to it.

Kretzmann: Absolutely and you even are seeing some traditional networks like ESPN and TBS broadcasting some of these gaming tournaments. By and large it says something that's happening online, so it's still a question of how do you gain advertisers and sponsors for something like this? There hasn't been anything quite like this that we've seen.

I think a great example of the resources that companies are putting behind this; let's go with Activision Blizzard. In October of 2015, less than a year ago, they announced that they're creating an independent eSports division. The person they brought on to head up that division is Steve Bornstein, who was formerly the head of ESPN and the NFL Network. He's someone who knows a thing or two about sports broadcasting. They're bringing in a big gun from ESPN and the NFL network to head up eSports.

Bobby Kotick, the CEO of Activision Blizzard, he says he wants Activision to be the ESPN of eSports. We're still in the early phases of this happening. That eSports division, again, was only created less than a year ago, but then two months after that, Electronic Arts announced that it's launching a competitive gaming division, a similar division to what Activision is doing.

Like I said, you have Amazon with Twitch, where a lot of these games and tournaments are live-streamed and similar with YouTube. You're seeing a lot of big companies put a good amount of resources behind this space and bringing in talent from the traditional sports broadcasting role into this eSports world. You're seeing a blurring of the lines there.

Lewis: One of the other major catalysts I see for both of these companies is the idea of extending their existing franchises, possibly even licensing out their franchises. We've definitely seen Activision Blizzard do this a bit in the past with World of Warcraft. It sounds like their strategy might be shifting a little bit with that.

Kretzmann: Yeah, so backing up a little bit, 10 years ago when you bought a game, you would pick up the case off the shelf. You would install it on your computer, or your console, and then you would play it maybe five or six months. You get tired of the game, you move on. Now, both for Activision and Electronic Arts, they make more than half their revenue through digital sales. Rather than going to the store and buying the copy, often times you can just download a game online on to your console, on to your PC, play the game.

The life of these franchises is now being extended thanks to these digital purchases, or micro transactions within the game. It's no longer just a case where a customer is making a one-time purchase of a game. You might buy the game and then after you accomplish so much within the game, suddenly you have the opportunity to pay maybe $3 to open up another map in the game you're playing, or maybe you want to buy a certain jersey for your NBA team, or your FIFA team.

There are all sorts of these different micro transactions. You're seeing, with these video game companies, it's no longer the one time purchases, but they're stretching out the life of their franchises. It turns out that digital revenue it's higher margin for the company. It stabilizes their cash flow production. It's appealing for investors and it's appealing for gamers, too. You're able to really engage with the game in a new way.

You have these companies; Electronic Arts has especially made a concerted effort. They're almost releasing daily, or weekly updates to some of these games, not just on mobile, but on other platforms. The game is really a living entity now. It's not just this one-time thing that you purchase. It's something that you can engage with for a very long time. That's certainly an important shift that's been happening in the space. It's likely to continue going forward.

Lewis: One of the things that we've seen on Activision side, at least, is the idea of these properties having value outside of the game themselves. We look at the World of Warcraft movie which Activision...

Kretzmann: We'll see how that does. It's coming out.

Lewis: The idea that they are able to take what was a game and was on a gaming platform and bring it out to a mass audience in the form of a movie.

Kretzmann: Right. Video games, up to this point, they have been infamous for not transferring well to the movie screen. In the case of Warcraft, which has received mixed reviews up to this point, that wasn't actually created in-house by Activision. It was licensed out, I believe to Universal.

Similarly last year Activision actually created a movie and TV production studio. They have a guy heading it up who spent nine years at Disney (NYSE:DIS) as a senior vice president. The guy heading it up, Nick van Dyk I believe is his name. He was a key player at Disney for the acquisitions of Marvel, Pixar, and Lucasfilm.

Activision, they're making an effort again, similar to what they're doing in eSports, they have a new division for movie and TV production where they're acknowledging that they have this extensive library of intellectual property and these very vibrant game franchises that have done very well for more than a decade like Warcraft and Call of Duty.

One of the early projects for this production studio is creating a cinematic universe for Call of Duty. We'll see if this studio can break the curse that's fallen on video games when people try to make a movie out of them. It's a similar approach to what you've seen Disney take. Activision, in a lot of ways, is becoming mini Disney with what they're doing. They're trying to have the broadcasting platform with eSports. Obviously they have the games, the core franchises there. Now they're trying to extend those franchises to movies and TV shows.

When you look at Activision, I see them as taking a similar strategy to maybe what Disney was doing 15 years ago. It doesn't mean that Activision will be as successful, or as big as Disney, perhaps one day. I think it's interesting to compare Activision's strategy to what we saw from Disney years or decades ago.

Lewis: The franchises in eSports, two major catalysts to watch for gaming stocks. You mentioned the move to digital. I think that actually poses a little bit of a risk for some of these video game companies. We're going to talk about that on the second half of the show.

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Kretzmann: It's glorious. It's like a question mark on your face.

Lewis: Yeah, like an upside down swirl question mark?

Kretzmann: Right. It's great. Glorious.

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David, back for the second half of the show talking video game stocks. You mentioned in the first half the idea of this transition to digital, that there is not the physical case and disc that you're picking up at your GameStop, or something like that to be able to play these games. That leads this to being, in some ways, a very high margin business to be in. You're eliminating all the physical stuff that goes into the product. I'm a little worried that that lowers the barrier to competition a little bit.

Kretzmann: No, that's certainly right. I think that's a great way to put it. Another way to frame is that the switching costs for customers is much lower than it was ten years ago when it comes to a game. Ten years ago, again, you go to the store. You pick it up off the shelf. You have the game on your shelf. You'll play it. You would have to go back out to get a game if you want to switch to a different game to play.

Especially with mobile and then this digital transformation in general, if you're on your phone, it takes you what? 30 seconds to download a game. You can play it. You can fiddle around with it for maybe 20, 30 minutes if that. If you're not happy with it, worst case scenario, you just leave it on your phone. You don't open it for six months. You forget, "Oh I downloaded Bejeweled a year ago."

It's painless to just uninstall that game and just install another game. Certainly, the switching costs are very low for customers. Especially on that mobile platform, you're seeing a trend where it's really a freemium experience. You're not even paying anything necessarily up front to play the game.

That mobile model is more challenging because you recognize that the majority of people who play a game on a mobile app are not going to pay anything. You're betting on that small fraction, maybe 1% or 2% of the really power users who are going to be spending half the day on the game. They're going to be buying different credits and stuff to progress through the game.

That's a more challenging model. There has certainly been a lot risks that come with that. Yeah, that transition to mobile and digital, I agree. It does have more risks. It pressures the companies like Activision and Electronic Arts. They have to engage with their users much more regularly than launching a game every year or two, which is what they were doing maybe 10 years ago. Now, as I said, with Electronic Arts, it's not uncommon for them, with their popular games to be releasing daily, or weekly updates.

Companies that can make that transition, they should do well. It's on them to maintain that engagement with customers. Companies that don't do that are probably going to have a difficult time. Competition can swoop in much more easily now than 5 or 10 years ago.

Lewis: Yeah, and on the note of staying relevant, I think another one of the major risks with these types of businesses is that being a video game publisher is a lot like being a movie studio. You need to keep pumping out hits. Luckily, for both of these companies they have very established rooted franchises that they have been able to milk for quite some time. It's amazing the grapple that EA has had on sports games.

Kretzmann: Even so, obviously EA, they've done a great job, especially with their FIFA and Madden franchises. They have other sports franchises that have done really well, but then within the past five years or so, you have this smaller company, Take-Two Interactive, which comes out with an NBA 2K, which is now the dominant game for basketball video games, at least for the NBA.

Even in a case with EA, you have a dominant market position. They control the vast majority of that market share of sports video games. Even them, if they get complacent and they're not putting the energy into a game and making it player friendly and making it what players want, that opens up the door for competitors. For EA and Activision, certainly they have these dominant franchises, so long as they can continue to update them and keep them relevant for people, they should do well.

Going back to mobile, and just an example of Electronic Arts, they've managed to do pretty well with some of their mobile games. They have Madden NFL mobile games. They also have a lot of the... Disney licensed their Star Wars games to Electronic Arts. The Star Wars mobile game that Electronic Arts has, in the most recent quarter, the average player of that Star Wars mobile game spent two hours a day on that game. That's the average player. That's not just the top tier. That's the average player. Electronic Arts, they have found different ways to really break into that market.

Monetizing it is another story, but as least having that engagement, that's the first step. Anytime you go to a new platform, you want to have that engagement. The monetization will come after that. The engagement is the first step, then monetization will come. It's an interesting space to watch. So far, both these companies, in their own ways have found ways to transition nicely to that digital model. Anytime that your margins are ticking up, like both these companies, your inevitably going to attract new competitors. That'll be the thing to watch in the coming years.

Lewis: Was it Jeff Bezos that said, "Your margins are my opportunity?"

Kretzmann: Exactly. There's a big, growing target on the backs of both these companies. It'll be interesting to see how they fend off competitors, whether they acquire new games, or acquire new companies to better reach customers on these platforms, or license new games and franchises, they have different opportunities. Both these companies are flush with cash and producing a lot of free cash flow and their margins are very strong. They have the resources.

It's really just a matter of how effectively they allocate that capital to strengthen their competitive position, invest in the games, invest in that player engagement. If they can do that effectively, they should be able to grow for a long time, but if they get complacent and just sit on their cash and put their feet up on the table and sit back, they could lose that competitive position pretty quickly.

Lewis: Yeah. The two giants in the space, Activision and EA, a little bit different as company profiles. A little bit more growth priced into Activision at the moment. They also have a .7% dividend yield?

Kretzmann: Yeah.

Lewis: Yeah, so it's there. It's not big, but it's there. EA is a little bit more moderate growth expectation. one in particular that you like more?

Kretzmann: I honestly like both these companies. I personally own shares of both of them. I think if you were only going to pick one, Activision would probably be the one I'd lean toward, just because I like how they're making these different efforts with mobile games, eSports, and that movie and TV studio. I think they have more growth avenues beyond just the game franchises.

That's more of the model that EA is focusing on. They've done a good job with that. They've really turned that company around over the past three to four years. The new CEO at Electronic Arts, he's a young Aussie, Andrew Wilson. He's in his 40s. He's done a great job turning around that company and the culture.

I think if you had to pick one, Activision just has a more diversified line, not only of franchises but also of different divisions with eSports, movies and TV, all those things. It's run by Bobby Kodick, who has just been a wonderful CEO. I think it's hard to go wrong with either of these companies, but if I had to pick one, I would probably lean toward Activision at this point.

Lewis: Awesome, David. Thank you for your thoughts!

Kretzmann: Thanks for having me, Dylan. It's a pleasure.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say "Hey," shoot us an email at industryfocus@fool.com, or you can tweet at us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes. You can also check us out on Spotify or go and access the Fool's family of shows at fool.com/podcasts.

As always, people on the program may own companies discussed on the show. The Motley Fool may have formal recommendations for or against stocks mentioned. Don't buy or sell anything based solely on what you hear. For David Kretzmann, I'm Dylan Lewis. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. David Kretzmann owns shares of Activision Blizzard, Amazon.com, Electronic Arts, Facebook, Take-Two Interactive, Twitter, and Walt Disney. Dylan Lewis owns shares of Alphabet (A shares) and Walt Disney. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (A shares), Alphabet (C shares), Amazon.com, Facebook, Take-Two Interactive, Twitter, and Walt Disney. The Motley Fool has the following options: short July 2016 $28 puts on GameStop.  Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.