Are you a fan of Activision Blizzard's (NASDAQ:ATVI) World of Warcraft, or do you prefer a relaxing game of Madden NFL from Electronic Arts (NASDAQ:EA)? Whichever camp you belong to, there's good news today from the analysts at investment bank Morgan Stanley: Both companies are great, and both stocks are buys.
That's the upshot of a note just out from Morgan Stanley this morning, and reported on StreetInsider.com. Whether you've been considering an investment in Activision Blizzard stock, or in Electronic Arts instead, both stocks are undervalued at today's prices. According to Morgan Stanley, Activision Blizzard stock that costs just $44 and change today could soon sell for $56, while Electronic Arts stock that costs $84 could be worth as much as $101 a year from now. Accordingly, Morgan Stanley rates them both overweight.
Here are three things you need to know about that.
1. Out with the physical, in with the digital
Sales of physical video game discs are on the decline, a trend that has been evident for some time now. Considering that Morgan Stanley is publishing a recommendation on two companies that sell such games, you might think that would worry the analyst -- but it doesn't. In fact, says Morgan Stanley, it sees the traditional "units sold" metric for measuring success in the videogames world as increasingly irrelevant, and is shifting its focus instead "to a model based on users, engagement, and digital monetization."
"We are bullish on the digital gaming shift," says Morgan Stanley. "We see digital in-game offerings leading to recurring and growing user bases, higher per-game engagement (time spent per user), and more monetization opportunities."
2. Get in the game -- or at least get "in-game"
Specifically, Morgan Stanley is vesting its hopes for Activision Blizzard stock and Electronic Arts stock outperforming the market on the prospect of gamers spending more money on in-game purchases. Such sales of "expansions, new challenges, new characters, etc." could potentially help grow the active user base at Activision 11% a year over the next five years, and Electronic Arts, 5% a year.
Revenue, too, should grow nicely with this shift in business model. Morgan Stanley predicts 16% annualized revenue growth for Activision and 15% for Electronic Arts over the next three years. In fact, says the analyst, "digital rev," or "in-game purchases + full game downloads," has the potential to drive literally "all of ATVI/EA forward rev growth."
3. These margins are terrific!
Yes, you read that right. What Morgan Stanley is predicting, in essence, is zero growth in physical game sales going forward, and only growth in digital sales -- of full-game downloads, and in-game purchases.
If that sounds like a big bet to be making on the game makers, well, Morgan Stanley thinks it's a bet worth making. After all, it doesn't cost a lot to create an in-game item -- and it costs even less to reproduce it, and nothing at all to ship it. Morgan Stanley sees Activision Blizzard's and Electronic Arts' decision to focus on this market as giving a potentially huge boost to profit margins: "We see op margins heading ~650 bp higher between now and '18 for both names," says the analyst, resulting in five-year earnings growth rates of 17% for Activision, and 14% for Electronic Arts.
The most important thing: Valuation
So assuming Morgan Stanley is right about all the above, what does all this mean for owners of Activision Blizzard stock, and what does it mean for owners of Electronic Arts stock as well?
Well, that's where the bad news comes in. Priced at 44 times earnings today, Activision stock looks a mite pricey even if you assume Morgan Stanley is right about the 17% growth rate. Electronic Arts, selling for 22 times earnings, looks less overpriced based on 14% projected growth -- but is still pricey.
Viewed from the perspective of free cash flow meanwhile, the conclusions are reversed, but still similar. Over the past year, S&P Global Market Intelligence data show Activision generating $1.5 billion in positive free cash flow, which was more than twice the company's reported net income, and enough cash to give the company a price-to-FCF ratio of just 22. That's still a bit expensive for 17% growth, but less expensive than the P/E ratio makes it look.
Electronic Arts, on the other hand, generated just $937 million in FCF over the past 12 months, or only $0.81 in real cash profit for every $1 claimed in GAAP net earnings. Result: EA's P/FCF ratio of 27 is a bit more expensive than its P/E ratio makes it look -- and probably costs too much for 14% growth, in any case.
So long story short? Once again, we're facing a case of two strong companies, and two great stocks, which both unfortunately cost more than they are worth. While I commend Morgan Stanley for giving us a glimpse into the future of gaming, I have to take issue with its assessment that these two stocks are cheap enough to buy.
Because they simply are not.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he currently ranks No. 280 out of more than 75,000 rated members.
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