In the past 12 months, some of the best-performing stocks on the market are video game producers, with Activision Blizzard (ATVI) being the No. 1 performer in the S&P 500, up a staggering 60%.

In this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann look at the industry overall, and dive into the three biggest players that make up the vast majority of it: Activision Blizzard, Electronic Arts (EA -4.31%), and Take-Two Interactive (TTWO 0.01%). Find out how each company has accomplished such incredible growth, how things like microtransactions and mobile games have affected the industry, and some of the biggest risks and opportunities for each company.

A full transcript follows the video.

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This video was recorded on May 26, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 26, and we're grabbing our controllers to navigate the red-hot world of video game stocks. I'm your host, Dylan Lewis, and that is David Kretzmann hmm-ing on the side.

David Kretzmann: This is why we pay you the big bucks, Dylan.

Lewis: I thought you might like that intro. Sometimes I try to not give you a heads-up about what I'm going to come in with, and see if I can catch you on surprise like that.

Kretzmann: I was impressed. Nicely done.

Lewis: David, I had you on last week. We talked about two tech names that were not doing so hot, Twilio and Yelp. Today, we're flipping it over. You're back with me this week to talk about a sector and a couple companies that have just been on fire so far in 2017.

Kretzmann: Yeah, some of the best-performing stocks of the year, including Activision and Electronic Arts, essentially that video game space which, as you mentioned, over the past year, and certainly year to date, they've been some of the best performers so far.

Lewis: And I know that this is a category that I think some investors dismiss. It's either something they can't really wrap their head around, because it is, in a way, new media. But, like you said, Activision Blizzard is actually the best-performing stock in the S&P 500 year to date, up over 60%. Take-Two Interactive, which we'll also touch on today, and Electronic Arts, both up over 40% year to date. So, this is certainly a category worth paying attention to if you're an investor.

Kretzmann: Yeah, not too shabby at all. I think Activision Blizzard was actually the top-performing stock in the S&P 500 in 2014 or 2015 as well, so it isn't just this year. Over the last three to five years, all of these have been incredible investments.

Lewis: And when you hear about those types of gains, I think a lot of investors have to look at it and say, "Is it too late to build up a position? What does this market look like? We've already seen a huge surge; are games going to look this attractive moving forward?" We will try to answer that today, at least a little bit. Why don't we start out with the big fish in the space, Activision. I think a lot of Fools are probably familiar with this company. It's been a recommendation for quite some time, as you mentioned, going back to 2014. But, I think it's been involved in the premium services for over a decade.

Kretzmann: Yeah.

Lewis: And gamers might know this company for its Overwatch and Warcraft franchises, among some others. Recent quarter, the company hit new records for revenue, EPS, and cash flow. David, what's been fueling all that growth for them?

Kretzmann: You teed that up nicely. The company, essentially, has three different segments. You have Activision, which is probably best known for Call of Duty and Destiny, those shooter action games. Then, you have Blizzard, which is best known for the online multiplayer games like World of Warcraft and Overwatch. Then, a couple years ago, they acquired King Digital, which is mobile gaming, most famously Candy Crush.

Lewis: I feel like you can see someone playing Candy Crush on any metro commute, it's always there.

Kretzmann: It has some incredible staying power, we can talk about that. The main highlight for me this quarter, that Blizzard segment is really doing well thanks to Overwatch, which is now the eighth billion-dollar franchise in the company's overall portfolio of game franchises. That's pretty incredible for just a year. And it's Blizzard's fastest-growing new franchise ever. It's reached over 30 million players globally in less than a year after launch, it launched in spring of last year. That Blizzard segment, thanks to Overwatch, is doing really well. You're seeing their monthly active user count continue to tick up steadily thanks to Overwatch.

Lewis: This is, in some ways, kind of like the social media platforms we talk about, where there is that MAU number you can look at an addition to some of the more financial metrics, and get a sense of how these platforms and games are doing.

Kretzmann: Yeah, absolutely. One of the things to keep in mind with these video game companies is their quarter-to-quarter results and year-to-year results will be lumpy depending on the timing of a game release. Call of Duty, I'm not sure what sequel they're on, probably seven or eight at this point, but that's obviously huge. Pretty much anything that has Call of Duty on [it] will sell well, even if the reviews aren't all that great. So, that is something to keep in mind. Depending on when you have these new games developed and launched, you will see those numbers ebb and flow. But all in all, you do want to see that user count and overall user engagement continue to tick up over time, because that usually leads to pretty good financial results.

Lewis: In some ways, it's kind of like the movie studio business. You find something that resonates with your audience, and you milk, you keep putting out titles in that franchise, because you know it's a story, or the characters, or a storytelling approach, or something like that, that people just love, and they can't get enough of. So, you see that yearly releases or every other year releases for a lot of these titles.

Kretzmann: Yeah. That's been an overarching theme and revolution of the video game space. If you go back five or 10 years, primarily, you would go into the store and buy the physical disc of the game. In that case, the shelf life of the game wasn't necessarily that long. You needed to get that physical disc in front of customers, whether it was at Wal-Mart or GameStop or wherever. And if you didn't do well at that initial launch, then the shelf life of that game probably wouldn't be too long. But, the shift toward digital, where people are downloading the games, they're able to do microtransactions within the games, they're able to download extra maps or levels of the games over time, then all of the sudden you can buy a game in 2014 and still be playing it today, still be paying money as a player and a user of that game. That's part of the reason why you're seeing the profitability of all of these companies we're talking about today continue to tick up over time, because that digital revenue is high margin. Once you get those users and you're able to continue to engage with them over time, it doesn't cost a lot to sell another map to them digitally, where people can just download over the internet.

Lewis: And you can push updates to those users, too, right?

Kretzmann: Yeah, you're seeing a lot of live events and live updates and things like that. These games are very much a living entity. It's not like you're just buy one physical disc and then that's the only edition you have going forward. It will continue to evolve over time.

Lewis: And you see that in the company financials, too. Looking at the most recent quarter for Activision, online sales were up 50% year over year, and they now make up 80% of revenue, which is crazy. And some of that is the transition to digital away from physical with those games. I think some of that is also the acquisition of the King Digital property, and everything they have under their umbrella. One of the things that is interesting with Activision is, particularly relative to these other video game publishers, they actually have a surprising amount of goodwill on their balance sheet. About half their assets are in goodwill. For people who might not remember, goodwill is an intangible asset often tied to the difference between what you can actually tie value to and what you pay for something in an acquisition. Other times it's brought in with brand value and things like that. They bought King Digital for $6 billion a couple years ago, and that is part of that huge goodwill number. And I think a lot of people are wondering how that acquisition looks and what the property is doing for them.

Kretzmann: Yeah, to me that's the biggest question mark still with the company. When Activision acquired King back in late 2015, and that acquisition was announced, King had about 475 million monthly active users, almost half a billion, which is more than Twitter and a lot of these other social networks, so that's an incredible number. But that slow and steadily ticked downward each quarter up until now, where now it's at about 350 million monthly active users. But there are some bright spots there. The ratio of daily active users to monthly active users, so, essentially, the hyper-engaged users, is at a record high. And the people who are paying for the games are paying more each quarter. So, it's kind of like you have this small but growing base of really engaged people who are just playing Candy Crush like crazy, and they're paying a lot to upgrade through the game, and different things like that. Those people are paying more. That's how management will spin it. But I think overall, the question there is, how easy is it for them to replicate that success with Candy Crush, or is that all it's about. One thing that was interesting in the conference call this quarter was, they mentioned that Activision and King will be partnering up, and they'll look to build a Call of Duty mobile game. I think that could justify the acquisition to me even more than just bringing Candy Crush under your umbrella. But if they're able to use King's expertise in developing mobile games, and transition Call of Duty into the mobile space, that could be really interesting, and I could see that justifying the premium that they paid. Hopefully that would help them avoid having to write down that goodwill and admit that they paid too much for King. So, some things to like there, but for me, that's probably the biggest question mark with Activision, still to be determined.

Lewis: Looking over at one of the other big players in the gaming market, Electronic Arts is something that sports fans probably know very well, are very familiar with. They make some of the most popular sports games out there, including FIFA and Madden. They have tons of other franchises. Like Activision, EA is really enjoying the fruits of that transition to digital. You see it in their margins.

Kretzmann: Oh, yeah, absolutely. Their total sales in this most recent quarter was up 17%. Their digital sales up over 30%. And now their digital sales are over 60% of revenue. You're seeing their margins over the past few years, it's so clear, and it's a nice trend to see those margins on the top and bottom line, trending up. And the biggest contributor to the digital sales is what they call "Ultimate Team." This is within their sports franchises, whether it's Madden, NFL, FIFA, NHL, NBA Live. And Ultimate Team is kind of the combination of fantasy sports games like fantasy football or fantasy basketball and collecting trading cards. So, you're essentially building a team, and you get these different packs with players and other things. Over time, you're building a team, you're able to trade players, and it takes into account all sorts of things. If you're building a team, a FIFA Ultimate Team, it takes into account the demographic of the player. So, will a Brazilian soccer player get along with an Italian player? It takes into account all these different chemistry items. Last year, management said there were 2 million trades happening in FIFA Ultimate Team every second. So, the level of engagement of people who step into Ultimate Team is staggering.

Lewis: And the idea there, to clarify for listeners, is, I have an Ultimate Team, you have an Ultimate Team, and we have players who are looking to optimize the rosters, or maybe you have a player that I'm a particularly huge fan of and want.

Kretzmann: Right, exactly. You can trade and try to upgrade your team over time, and then you can buy the virtual currency, and maybe acquire certain players or certain packs or something. And you're competing against other players. In the sense of fantasy football where you draft your team and you're following those players, you're trying to fine-tune your team and you're competing against other people, this takes fantasy to a live-action level, where you're actually able to physically play the game, you're able to manage your team over time, and that's something that's really resonated with the players of these games. So that now makes up about 30% of their total digital revenue, that Ultimate Team segment. So, I really like how they're focused on that competitive gaming aspect, e-sports, is actually something that comes up a lot. Activision wants to become the ESPN of e-sports, and really focus on that elite level of players who are literally getting paid to play video games, and people will watch people play video games. Electronic Arts is more focused on individual players competing with one another, and I think they've done a really nice job of creating a really compelling, live, constantly updating experience where you're competing with tens of millions of people around the world, whether it's in FIFA or Madden. And so far, that's been a huge driver of their digital success.

Lewis: And you look at that, and you're like, well, this is something that they just could not have done before the internet enabled gaming to really take off. Back in the model of 15 years ago, where people were buying discs and they weren't on consoles that were connected, you were playing with your friends in your house. And it was nice because people had to buy the discs, but they didn't have all of these additional purchases that people could be making. The microtransactions, it seems, are becoming a growing and growing segment for a lot of these video game producers.

Kretzmann: Yeah. In the case of Ultimate Team, I think it launched in 2009, and initially it was an add-on feature that you needed to pay more for. So, you would buy the disc, and then you could buy access to this feature. But now with something that comes free initially, so anyone can join. But once you're in, you tend to be locked in, and you stick with it. And then I think a good amount of people end up spending money there. So, obviously, with Electronic Arts, that sports area is where they dominate. I also really like what they're doing to expand into the action and shooter genre, which are the biggest genres within the video game space. They have Battlefield 1, which was a huge hit last year, and that's performing better than the sequel to Battlefield 1, which is called Battlefield 4, which is a little confusing, I'm not sure how they came up with the names there. But, essentially, they're seeing higher engagement with Battlefield 1 than they were seeing with its predecessor over a comparable period. So, that's always nice to see.

They also have, essentially, a decade licensing agreement with Disney to pump out Star Wars games. Coming up this year you have Battlefront 2, which looks like a very compelling game. The first Battlefront reboot that Electronic Arts did a couple years ago, it got kind of timid reception from fans, but it looks like they've incorporated a lot of the feedback, and people are really excited about that game, so I think that will be a big hit for them. And, obviously, as you have more Star Wars movies coming out over the next few years, I think that puts them in a golden position. That also goes to mobile. There's the Star Wars: Galaxy of Heroes mobile game, which is sort of a similar concept to Ultimate Team, where you're able to trade the different characters and collect the characters, kind of a collecting fantasy game. The average user spends 162 minutes a day playing that game, and that number has steadily ticked up over the last year. I mean, that's about two and a half hours a day for the average user on that game. I don't know what that means for productivity in the world. 

Lewis: I would love to see that metric for Fools. [laughs] 

Kretzmann: I know. We could count it as research, though, so we have that perk. But, just, the level of engagement that they've been able to create just shows that they're producing some incredibly compelling content. By comparison, I think the average power user of Candy Crush is spending more like 35 minutes a day. In the case of this Star Wars mobile game, be careful when you download that, because you might lose a lot of time out of your day.

Lewis: Yeah, I don't know if I can afford that kind of time-suck. David, last but only least in the sense of market cap, we're looking at Take-Two Interactive. This is the publisher behind the Grand Theft Auto series, the NBA 2K franchise, so they have some sports exposure there. Take-Two is currently a fraction of the size of these other publishers. I think they're about a quarter to a fifth of the size of EA and Activision Blizzard. So, they're a little bit smaller, the profile is a little bit different there. I know the company recently announced a minor roadblock in the delay of its release of Red Dead Redemption 2 title. Can you talk little bit about what's going on with the company, and whether or not that's something people should worry about?

Kretzmann: Yeah. Red Dead Redemption 2 was originally supposed to come out late summer, early fall this year, 2017. They've delayed that release until spring 2018. Initially, that would raise a yellow flag, but taking a step back here. Take-Two Interactive has two major studios. They have 2K, does a lot of the sports franchises like NBA 2K, WWE. Then, they have Rockstar, which is the studio behind Grand Theft Auto and Red Dead Redemption. And Rockstar has a history, going back 15 years or so, of delaying virtually every major game that it comes out with, so this is really just par for the course. So, it's nothing to me that's very concerning. They're basically saying, we want to make sure this is the best we can possibly make it. And part of the reason they're delaying it is more and more people are getting the latest generation of consoles. So, you have PlayStation 4, Xbox One, that hardware is a significant upgrade from the previous generation of gaming consoles. So, they're saying, we can make this game even better to adapt to that later hardware.

So, for me, I would much rather they delay it six months or even a year, and make sure the game is as good as it can possibly be, rather than putting out a product that they feel is subpar. I think that's part of the reason why Grand Theft Auto has been an incredible franchise. Speaking to the power of this transition to digital, the last Grand Theft Auto was released in 2013, Grand Theft Auto V. But it still makes up 38% of the company's total sales today. That just shows you, more and more people are continuing to buy the game and play the game, and management says, Grand Theft Auto online, that online experience, continues to surprise us and beat our own expectations. With Take-Two Interactive now, about a quarter of their revenue comes from what they call recurrent consumer spending. I feel like they could come up with a better phrase than that.

Lewis: I have to ask you what it means.

Kretzmann: That's not a surprise. It's made up of the money that players will spend on virtual currency within the games, downloadable add-on content within the games, and microtransactions. Essentially, any money that players are spending in the game once they own that game. That's 25% of the revenue now. Again, that's very high margin, sticky revenue.

Lewis: It's all digital, right?

Kretzmann: Right, it's all digital. That just shows that, once players do download or buy these games, they're staying very engaged, and they're spending more money over time. In the case of Grand Theft Auto, you have a four-year separation between when the last title came out, but it's still contributing over a third of your total revenue. That's pretty astounding, and I think that's part of the reason that Take-Two is a little bit riskier. They still have a lot of dependence on Grand Theft Auto. But I don't see that drifting down at any point. There have been over 80 million units sold now of Grand Theft Auto V. So, it has an incredibly long shelf life as a franchise. In the meantime, you have Red Dead Redemption, which, the first one got rave reviews, there's a lot of anticipation for Red Dead Redemption 2, and since they're delaying it a few more months to make sure it's really the highest quality it can be, it'll probably be a pretty successful game. NBA 2K continues to have incredible engagement each year when they come out with a new NBA titles. Again, all these companies are excelling at finding ways to make really compelling games that are engaging over a long period of time. I think as you're transitioning to this digital area, that's really the key. All three of these companies are doing a really nice job at that.

Lewis: I get the sense in this conversation that, really, there's room for all of these companies to succeed, they all have their separately carved out niches. There's obviously going to be competition, particularly with sports licensing, for games, with Take-Two and EA, as those contracts come due. But, the sense that I get is, there's room for all these players to play.

Kretzmann: I think so. This is a global game as well. I don't know the exact breakdown for all the companies. But in the case of Electronic Arts, well over half their revenue comes from outside the U.S. FIFA is really a global phenomenon.

Lewis: It's huge abroad.

Kretzmann: Huge, yeah. That also means that can make it even more compelling if you're directly competing against literally tens of millions of players around the world. So, it makes it really interesting as a player to have that kind of opportunity to engage with players that way. I forget what your question was.

Lewis: It seems like plenty of room to operate for all of them.

Kretzmann: Yeah, the global market is huge. And as the economy worldwide improves, and steadily over time, the world economy is becoming more productive, people will have more leisure time. So, really the main competition for any of these kinds of companies are Facebook, Twitter, Netflix, YouTube, wherever you spend your leisure time, that's really the competition there. I recently watched an interview with Reed Hastings, the founder and CEO of Netflix, and he said the biggest long-term threat for Netflix is if, at some point, there is some content that's just so compelling that people get bored sitting down watching just something, dormant. That gives you a sense for how these media companies should be thinking about the long term. But I think people love being entertained, they love the chance to compete and connect with friends and other people around the world. I don't see this slowing down anytime soon. And, in the meantime, you have stuff, which, this is hard for me to wrap my mind around, but e-sports. You actually have people watching other people play video games. And that's something that's that was especially popular in Asia, but now in the U.S. and Europe, you're also seeing that on the rise, and more and more companies looking to sponsor, advertise at e-sports tournaments. So, I certainly see a long-term runway for this space, to continue doing well.

Lewis: I know that I was certainly guilty of thinking of e-sports as being more of a niche, novelty phenomenon. And it's clear that it has staying power, and it will be a huge tailwind for a lot of these businesses. It seems like a lot of things are moving in the right direction for these companies. Not surprisingly with the run these stocks have gone on, they're not cheap by any means on a typical P/E basis for valuation. All of them above market multiples right now. I teased that I would have to ask you if you had a favorite among the lot. Is there one that you particularly like, or think is a little bit better positioned right now, maybe a more attractive valuation, something like that?

Kretzmann: I'll probably give you a long answer here. The short answer is I like all three, I personally own all three, full disclosure there. Take-Two Interactive is really interesting if you're looking for a little bit higher-risk, high-reward situation. As you mentioned, they're quite a bit smaller than EA or Activation. They don't have quite the breadth of franchises that those two leading companies do. But, what I'm really impressed with is, even though they delayed Red Dead Redemption 2 to essentially the next fiscal year, they're still guiding for record profitability for this coming year, even though they don't have any other major titles slated to be launched this year. I think that's really impressive. And based on the guidance that management gave, they're only trading in about 18 times forward earnings. So, that's one that I'm taking a closer look at, because based on today's numbers, it does look a little bit pricier, but despite that major game delay to next year, they're still looking to do just fine. Activision is really interesting. I would look more and more at Activision as a miniature Disney, the way that they are approaching it. They want to become the ESPN of e-sports, so they have a new e-sports segment that's about a couple years old now. And they actually brought on the former head of the NFL Network and ESPN to head up this new e-sports segment under Activision Blizzard's umbrella. They recently launched a consumer goods segment, so, trying to bring that intellectual property to toys and --

Lewis: Merch.

Kretzmann: Yeah, stuff like that. So, really following Disney's footsteps there. They see opportunities for advertising, especially with those 350 million monthly active users on the King Digital mobile games. And they also have a movie and TV studio. So, they're trying to build out a cinematic universe for Call of Duty, which might be in the works over the next couple years.

Lewis: They've tried doing that a little bit with Warcraft, right?

Kretzmann: A little bit. That Warcraft movie wasn't under their own studio, that was an external studio, so they can't be blamed too much for that. It got kind of poor reviews. But, they do have a kids show, Skylanders Academy, based on their Skylanders game. The first season launched on Netflix last October, the second season is launching this year, and Netflix signed it on for a third year, so that's a promising start. But, with all those different segments, you can see that Activision probably has the biggest vision of all these different companies, just in terms of seeing their IP extending well beyond just the video games themselves.

So, if I had to pick one of them, it would probably be Activision. But I like the position that all of these are in. Take-Two, higher risk, high reward, I would probably make that a smaller position. EA, I love what they're doing with Ultimate Team, that competitive gaming aspect, especially with the sports games. I think having the access to that Star Wars IP and being able to pump out those games, I don't see how that doesn't do really well over the next few years as more Star Wars movies come out. And Activision has a whole breadth of different opportunities for them, and how they extend that IP beyond video games. So, I like all of them, but I think if you forced yourself to pick one, Activision would probably be the one. They pay a small dividend since 2010. They're just the bigger idea of the three. And why not just go with all three?

Lewis: Get a basket of video game stocks?

Kretzmann: Why not?

Lewis: David, anything else on video games or the industry before I let you go?

Kretzmann: No, I think that does it. I think this is a really attractive space. I personally don't play a whole lot of video games and I certainly don't watch other people playing video games, so I can understand, especially if you're not a younger investor, this might be a little bit more of a foreign industry to you. But, this is something to watch. I think these companies, these game franchises are going where customers are headed. People want engaging, compelling content, and these companies are delivering that. So, it's well worth the look as an investor.

Lewis: That's a nice thing to end on there. Listeners, that does it for this episode of Industry Focus. A little housekeeping note before we wrap up: I hope everyone has a good, long weekend. Take some time to think of all the individuals who have died while serving our armed forces on Memorial Day. We will be posting an IF episode on Monday, but it isn't going to be your standard stock-focused show. It's a little bit more of a bonus episode. We wound up getting all the hosts in the studio to hang out and talk about life at the Fool, and offer up some fun, behind-the-scenes type stuff. If you want to get to know us a little bit better, give it a listen. If you just want some stock-focused discussion, it might be an episode to skip. Of course, if you have any feedback or questions for the show, you can shoot us an email at [email protected] or tweet us at @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!