E-sports is a rapidly growing industry, and media companies across the board are taking notice.

In this episode of Industry Focus: Consumer Goods, Motley Fool analyst Vincent Shen and Fool.com contributor Danny Vena look at some of the most exciting parts of e-sports, including hundreds of millions of viewers, massive prize pools, and billions in potential revenue.

The cast also answers a listener question about a recent rash of headlines for iRobot (NASDAQ:IRBT) and investigations from law firms. Find out the most important things to keep in mind when any company or big-name investor publicly calls out a company.

A full transcript follows the video.

This video was recorded on Aug. 29, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and I'm in the Fool HQ studio again this week, getting this listener Mailbag edition ready to air on Aug. 29. I'm excited to welcome a very special guest today, Fool.com contributor Danny Vena, who's joining us via Skype from San Diego, California. Hey there, Danny! Welcome to Industry Focus!

Danny Vena: Hey, thank you! I'm glad to be here! How's it going?

Shen: I'm doing well. I know this isn't technically your first time on the podcast. Dylan had you on for the Tech edition, I believe, not too long ago. But this is your first time with me talking consumer and retail, and I'm very much looking forward to tackling some of these listener questions together.

Vena: Exciting business.

Shen: Listeners, remember that you can write to the Industry Focus team at any time and that you'll hear back directly from one of the hosts. Our email is industryfocus@fool.com. Our first question comes from Tom Gaffner. He asked early last month, "What's going on with iRobot, ticker IRBT? It's a bit unsettling when headlines are dominated by Shareholder Alert: Law Firm XYZ Announces Investigation Into the Firm. Is this an ordinary instance executed by bears or shorts, or something to really be worried about?"

If you go to Yahoo Finance and scroll through the major news headlines for iRobot from the past few months or so, you'll see a lot of examples of what Tom is talking about. Before we dive into the question, a really quick look at the company. iRobot is a $2.5 billion market cap company. You can likely guess from its name, they generate revenue by building and selling robots, about 18 million of them in the past 15 years. The company leads the consumer robotics industry, and its devices are designed to make its customers lives easier. iRobot offers four major product lines, and they're all robots that can either help vacuum your floors, mop them up, clear your gutter, or clean your pool. So overall, this seems rather harmless. But Danny, kicking it over to you, what's with the legal scrutiny the company is facing?

Vena: First of all, one of the things that investors will find after they've been doing this for a little while is that shareholder lawsuits are essentially just something that comes with the territory. There's a particular type of law firm that, this is their bread and butter, this is how they make their living, by basically exploiting a loophole in securities law. 

You'll oftentimes hear these lawsuits referred to as a Milberg. The way it got its name was based on the infamous firm of Milberg Weiss, who gained notoriety back in the seventies. They would file lawsuits against companies supposedly on behalf of the little guy. It turns out, later on, they were prosecuted for kickbacks, racketeering, bribery, so basically, they were doing it to line their pockets. Now, the problem with these lawsuits is, once one of these lawsuit is filed, really the only one who makes any money is the attorneys involved. What you'll see is, the companies will spend a lot of money either pursuing these lawsuits or settling these lawsuits. Most of the money goes to the attorneys. And the people who are hurt are the shareholders. So it's not a good situation -- it's damaging to the present shareholders. In fact, the U.S. Chamber of Commerce has calculated that shareholder lawsuits cost companies about $39 billion every year, but they actually only recover about $5 billion. So the additional $34 billion, guess where that goes? To the lawyers. 

Shen: Yeah. So it seems in this case, then, that it's not as alarming as an issue that Tom needs to be worried about. But let's get specifically into this example with iRobot. What are the law firms here investigating then? What are they bringing up exactly? Because there has to be some basis for their investigations, no?

Vena: That's true. What has happened is, there's a research report that was issued by a short selling company called Spruce Point Capital Management. Now, that company is headed by a guy by the name of Ben Axler. And actually, that's the only person that works for the firm as far as we know. He made his name by uncovering fraudulent Chinese reverse mergers, which is essentially a Chinese company that wants to enter the U.S. stock market. What they'll do is buy up a shell company in the U.S., and then do a reverse merger so they can basically cheat their way onto the stock market. So he made his name finding those types of situations and exposing those fraudulent companies. 

Since then, once he's gotten beyond that, it's a little more difficult to continue in that vein. You're only going to find that many companies for a certain amount of time. So what happened thereafter is, he started issuing short reports on companies for a number of different reasons. In the case of iRobot, he said there were several points, the first being that the stock performance -- the stock is up some 150% over the last year, and he said those gains are a result of the supply chain being restocked from the company divesting its military robot division, and also an acquisition of a Japanese distributor. Now, there's not necessarily a problem with any of those things, and what he says is the stock has run too far, too fast and there's going to be a reversion to the mean, they're not going to be able to keep up with those, that once it comes time for them to report earnings in the future, it's going to be difficult to meet those comps, and as a result of that, the stock is going to fall.

Shen: Yeah. It seems odd to me, what you mentioned in terms of this basis for some of these investigations in this report. This is an issue that will come up for plenty of stocks on the market. Things like hype do play into some of these bullish runs we see for these companies. And, overall, iRobot is followed quite closely here at The Fool, and some of the things that you mentioned, I understand the risk of having potentially flown too high, but there's nothing fraudulent here so far that we can see.

Vena: That's right. They didn't make any type of accusations, they merely said that because of these issues, he also pointed out that competition from SharkNinja, which is a competing vacuum company, they could potentially release a product to compete with the iRobot. SharkNinja released a product that competed and stole market share from the Dyson vacuum people. Also said that companies that have acquired their related party distributors have oftentimes run into issues that weren't apparent when they made the decision to do that. So they're saying there's potential for these types of problems. Not necessarily saying that there is any issue, but that there could be.

Shen: Sure. And I understand that you have some background here for Spruce Point Capital, in terms of some other instances where they've written reports and tried to leverage some of the market response in that. Could you share that with the listeners?

Vena: I'd be happy to. Let me first start by saying, anybody who wants to, all this information is publicly available. I went to Spruce Point Capital's website, I looked at the number of companies that they have written short reports on going back about two years. I eliminated the ones that were done most recently just because, whatever their thesis was hasn't had a chance to play out yet. So I want to look at my figures here for a second. Over the last two years, eliminating the reports from the last six months, the stock performance for the companies that were the subject of these reports, four of the 10 did significantly better than the market, three of them had single-digit percentage price moves either up or down, meaning they were essentially unchanged or even with the market, and three of them were down significantly. So what that shows is, out of these 10 reports that I've reviewed, Spruce Point Capital was right about 30% of the time. And if you take all 10 of those companies and compare the performance from the time they issued the report to the current day, and you compare that to the S&P 500 over the same time frame, the differences in total is less than 2% overall.

Shen: So not really that much there, as the reports and the legal response would seem to indicate.

Vena: Right. So it's one of those things that shareholders have to be able to and ready to deal with. These things happen, there are some companies that will be the target of these types of short sellers. And how they work is, they'll do a report, they wait until the stock runs up or until there's an issue, and then they will release this research report after they've sold the stocks short. Then, the stock will fall and they'll cover that short and pocket all the money.

Shen: Sure. That's really helpful background, and I think it's a very good reminder in this instance to be wary of this kind of research. When it comes down to it, even some of the most well-known investors that we follow and really respect here at The Motley Fool, think, even a Warren Buffett, will have their own reasons for calling out companies, good or bad, so you have to keep their motivations in mind and make sure you perform your own due diligence before you take any kind of action. I know, Danny, that you've done some additional research for iRobot specifically in this case. Really quick, what is your take? They make these consumer-focused robots, what's your take on the company's outlook?

Vena: I'm an accountant by trade, so I prefer to think in terms of metrics. If you look at, for instance, the recent sales on Amazon (NASDAQ:AMZN) Prime Day, they doubled year over year from the prior Amazon Prime Day. In their most recent quarter, revenue was up 45% year over year. They beat guidance for both top and bottom line for the year, and the stock jumped to an all-time high. So that's probably part of what made it a target. What's exciting about the company is that their robot, the Roomba, the most recent model uses something called spatial awareness, which basically gives the robot the ability to determine where it is in a confined space. Now, what they're doing is using this technology to map the room that the Roomba is in, and from that, they're pursuing an entry into the smart home market. Now, the smart home market was $10 billion in 2016, and it's projected to increase about 60% this year alone. So it's a hot market, and they're looking to get into that market. What they're doing is asking Roomba owners if they will opt into the program to basically map their home, and they're using that information to hopefully help consumers better move into the smart home products that are out there.

Shen: Yeah. With that information, the idea is, it could help homeowners, and also the creators of smart home technology, get the most out of the experience and convenience that smart home tech can offer. And management at iRobot is really focused on this. Keep in mind, this is a consumer products company in terms of what they sell and how they generate the revenue. But they hold dozens of patents, they spend $100 million every year on research and development, so they're very focused on the tech behind this. I think that is ultimately, with some of the smart home and the mapping and the opportunities to branch out of that, the main thing to watch for this company going forward.

Let's move on to our next question. It's one from Will in Chicago. He wanted to know, "What is the business model and future for e-sports, especially since Amazon owns Twitch?" The last time we covered e-sports was at the beginning of the year, and there have been some pretty big developments, including new partnerships with professional sports leagues, some licensing deals, and other investments from media companies and game publishers. But Danny, when we were chatting earlier this week, you had some really impressive updates that you shared with me that put the scale of the e-sports industry in perspective. Can you give Fools listening some of the bigger highlights?

Vena: Sure. I found some of these metrics to be pretty astonishing. I've only been following e-sports for a short time, but here are a few bullet points to whet your interest. The largest prize pool ever for e-sports is for DotA 2. DotA is Defense of the Agents, for the uninitiated. That prize pool for players was over $20 million. The top winner of that competition was, in 2015, Peter "ppd" Dager, he won more than $2 million himself in prize money. The E-sports League, which was the largest e-sports company that was broadcasting on Twitch at the time, was recently acquired by a company called Modern Times Group for $87 million. There are currently around 300 million people that tune into e-sports, and that number is expected to grow to over 500 million by the year 2020. Then, to give you a couple more specifics, the League of Legends World Championships that was held in Berlin's Mercedes Benz Arena, tickets to that event sold out in three minutes.

Shen: Wow!

Vena: Three minutes!

Shen: Yeah, that's crazy!

Vena: Like it was a Bruce Springsteen concert!

Shen: [laughs] Elsewhere in this industry, you have a lot of players from traditional sports like ESPN, professional sports teams buying in. I think that adds a lot of legitimacy to this opportunity as well. Just this week, there was the creation of the Madden NFL Club Championship. That's through a partnership between Electronic Arts (NASDAQ:EA), which is a huge video game publisher, and the NFL. Players basically will sign up to compete online, and eventually the top 32 players will end up each representing an actual NFL pro team, and they'll compete against each other in the finals, and those finals will actually be coordinated with the actual NFL Pro Bowl and Super Bowl games. The prize money is supposed to amount to several hundred thousand dollars. So you've given a pretty good context and background of the scale for the e-sports business. A word that you used to describe it, and how it's similar to traditional e-sports when we were talking about the show previously, you used the word "ecosystem", and how the different stakeholders come in. In this case, you have game publishers, you have console manufacturers, broadcasters, players. Will called out Twitch specifically in his question, and Amazon spent $1 billion acquiring Twitch three years ago. What is the story there? 

Vena: With Twitch, they will charge users a monthly fee to be able to stream on their platform. Twitch is a wholly owned subsidiary of Amazon, it's the leading video game streaming site for gamers. It currently has about 10 million daily active users. Now, users on that platform will watch about 106 minutes of video per day. Just to give you a comparison, if you look at YouTube, YouTube is about an hour of video per day that users watch. So this far exceeds usage that YouTube enjoys, and YouTube is one of the world leaders.

Shen: Yeah, they're known for their engagement.

Vena: Absolutely. Amazon also offers, through Twitch, tools for developers so that they can include game broadcasting services into their apps. I think this is only going to get bigger from here. I think, currently, Amazon will charge, I believe the fee is $5 a month for these streamers, and people that are watching it will pay $5 a month, and the people who are actually streaming and playing the games will collect about half of that.

Shen: I think what's really special with the Twitch platform is the potential here for two-way interaction. That means between the players who are broadcasting their gameplay, and also the viewers. I know there are plenty of athletes out there, tennis players, golfers, basketball players, who love to play the sport and love watching professionals do it the best in the world. But now imagine being able to connect directly with the players, in this case, who are potentially the best in the world. An example in Twitter is, you can see how powerful it can be to have that connection between the viewers and the content creators. 

Other than Twitch, there are also some traditional media companies that are taking the plunge with e-sports, and that includes, as I mentioned earlier, ESPN, NBC, TBS, and others. So if you read about what industry insiders have to say about the e-sports opportunity, a lot of them will mention a point in the future where e-sports eventually reaches mainstream audiences, and then the revenue potential that comes with that. But I actually think we're already at the point where we're talking about millions of viewers in the U.S. You mentioned something like 300 growing to 500 million viewers worldwide. Among younger consumers, e-sports viewers, the viewer base is already enough to rival established sports like hockey and baseball. So I think it's only natural that cable networks want to test the water to find out what the advertising potential and revenue potential is for this kind of programming.

They'll just ultimately have to compete with the likes of Twitch and YouTube and other digital alternatives for it. The thing is, Hollywood right now is kind of squaring off against tech companies like Netflix and Amazon, as well, for content and talent. These Silicon Valley companies and tech companies have very deep wallets, and they're willing to invest a lot to build out that viewership, to build up the market share in the industry. Let's talk about the business model a little bit for the content creators in this industry, the game publishers. How are they monetizing and leveraging these huge audiences?

Vena: There's a couple of different ways. The easiest way to think about this is comparing it to professional sports. Professional sports teams will make their money by selling media rights, advertising, players will have sponsorships from major corporations, you have tickets sales, and of course the game publishers themselves. So what's happening with the game publishers is, first of all, they're going to make money by not only collecting those fees for these channels to be able to use their games, but also, as the games become more popular, they get out there in the limelight, people say, "Wow, I've been meaning to pick up this game and I haven't," so they're going to sell more games. But then, in those games, there's also -- and this is where some of the big money is -- microtransactions, virtual currency, downloadable add-on content, where you can buy more weapons or buy specialized items within the game. So game publishers make a lot of money doing that.

Shen: I really don't think it's possible to overstate how important it is now for game publishers to essentially maximize what is the shelf life for their most popular titles. In the past, it used to be, the main revenue stream for these companies was the initial sale of the game. So it was great to have a blowout first week or first month where you're setting a record for the number of sales. Even now, the more copies of your title that you can sell, the better. But now, you also want as many players as possible playing and being engaged because there's so much money to be made with those in-game purchases and the downloadable content that you mentioned. These add-ons, like weapons, special items, maybe new levels or gameplay modes, they amount to billions of dollars. So for Activision Blizzard (NASDAQ:ATVI), for example, the company reported a record $3.8 billion of in-game purchases in 2016. That doubles their tally from 2015 in just one year. Digital revenue now makes up the majority of the top line for companies like Activision, Electronic Arts, and most other competitors in this industry. So if e-sports can essentially help these games reach wider audiences, recruit new players, the publishers will naturally want to grow this opportunity as much as possible. I think that's why we're seeing a lot of the publishers establish specific teams and segments within their corporate structure that are focused on the e-sports opportunity.

Will, I think we've covered most of the business model for e-sports. I'd like to close out the conversation talking about the players who are cashing in. You don't have to be a pro, necessarily, at these mega tournaments to be making money enjoying your favorite video game. Danny, can you tell us a little bit else about the opportunities if you're a good player and you're interested in getting into this? What's out there for the gamers?

Vena: The best example that I found was with the company Riot Games, which is owned by Tencent Holdings. They are the sponsors of the League of Legends championship series. What they've done is provide each team with several players with a stipend, and they require that team to pay each player a minimum of $12,500 for their participation. Now, it might not seem like very much, but that's also the minimum. I was able to find one instance in Dec. 2015, a North American Challenger team that went by the name Ember. They became the first professional e-sports team to pay their players as employees rather than as contractors. They released their players' salary figures, in which case that each of their players received compensation between $70,000 and $92,000 per year. They also provided them with housing, office space, healthcare. So there's a lot of opportunity there. When you're the big player in the DotA league or Riot Games, you could make millions. But for the average player who's just really good, you can still make five or six figures just by doing what you love, playing video games.

Shen: Yeah. It's really an incredible growth in this space. Right now, the thing is, we're still in the early stages. However you think it pans out, we're getting a glimpse of it now with these licensing deals, these partnerships with professional leagues. But even on the small guy level, if you want to call it that, there's still a lot of opportunity out there. Overall, it's a really cool space. I very much intend to follow it going forward, hopefully with your help, Danny. But otherwise, that's all the time we have for today. Thanks again, Will and Tom, for your questions. Danny, it was great having you on the show!

Vena: Thanks for having me, I appreciate it.

Shen: People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

Danny Vena owns shares of Activision Blizzard, Amazon, and Netflix. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard, Amazon, iRobot, Netflix, and Twitter. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.