It's been a rough year to be in the market, but it's been a particularly rough year to be in big gaming (except for Nintendo). In this episode of Industry Focus: Tech, host Dylan Lewis and Fool.com contributor Evan Niu look at two of the biggest companies in the industry -- Activision Blizzard (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA) -- and the lackluster performances they've put up in 2018.

EA's loot box controversy continues to cast a pall over the business, and that's on top of some weak guidance for what should be an explosive quarter. Meanwhile, Activision reported discouraging trends in active users. Neither company was quick to the battle royale trend, but they're finally stepping up to the plate. Is it too late to get in? Find out more below.

A full transcript follows the video.

This video was recorded on Dec. 21, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into different sector of the stock market every day. It's Friday, December 21st. We're talking about a class of beaten-up tech stocks. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, how are you feeling going into the holidays?

Evan Niu: Man, the market's been wild these past few months. It's nonstop volatility. It's getting crazy. You have to really buckle up.

Lewis: Yeah, that's been the story of 2018. A lot of big market moves. Certainly a good time to be a long-term, Foolish investor. But what I really meant, Evan, was how are you feeling going into the holidays? What do you have on your plate for holiday plans? What kind of stuff are you going to be getting up to with celebrating Christmas and stuff like that?

Niu: My parents are coming over for the holidays, so they'll get to spend some time with the grandkids. That's about it. Nothing too exciting. 

Lewis: Producer Austin Morgan, what about you? What are you getting up to for the holidays? 

Austin Morgan: There's so many holiday parties this weekend. It's crazy! Hopefully, come Tuesday, everything will see settle down a little bit and I'll just be relaxed.

Lewis: So, Tuesday, the true holiday is going to be your downbeat.

Morgan: Hopefully, that's my downbeat. That's the plan.

Lewis: You're living large, man. You're living larger than either of us.

Morgan: Gotta do what you gotta do.

Lewis: I'm going to peak on Monday and Tuesday. That's when I'll be having the most festive, most fun time. Are you returning to your Mimosa breakfast that you had last year? Our listeners seemed to really enjoy that.

Morgan: We are. Yeah, my mom liked it a lot, so I guess we're doing it again. It's fine by me because she's buying.

Lewis: Alright, you can't beat that. I mentioned the holidays because, just as a heads-up for listeners, this will be our last show prior to the holidays. We won't have any new episodes going out Monday or Tuesday of next week. We'll come back on Wednesday with something special that we've taped. It's a roundtable discussion with all the hosts of Industry Focus recapping 2018, looking forward a little bit in 2019. That's something to look forward to. Unfortunately, if you're driving on Christmas Eve or Christmas Day, there won't be any new episodes for you to listen to. You're going to have to just talk to your family, I guess. [laughs] That's the sheer truth.

But before that happens, maybe you can just save this episode. You can enjoy this episode as you drive for the holidays. If you're doing that, we're going to be talking about gaming. That's what we're getting into today, Evan. This is a piggyback on what Dan Kline and I talked about last week. It's a hot topic for gifts, something that a lot of people focus on. We mentioned Take-Two (NASDAQ:TTWO) last week. This week, we're going to be talking about Activision Blizzard and Electronic Arts. A lot of the same issues plaguing all these companies. EA down over 25% year to date, ditto for Activision Blizzard.

Why don't we kick things off talking about Electronic Arts? What's been the story for them this year?

Niu: Most of these companies have been up, actually, most of the year. They only really started tanking in the past couple of quarters. There were a couple of bad earnings releases. Of course, there's a little bit more context to it than that that we'll get into. Both companies, in essence, issued really soft guidance for holiday shopping season. As you mentioned, holidays are a pretty big time for buying video games as gifts. They had a bunch of blockbuster releases. So, it's a busy time for them, and you'd expect them to be doing more, but their outlooks were not that great.

Lewis: For EA, you backtrack to the summer, shares are down about 45% since then. I think a lot of investors are probably surprised to see this. Over the past couple of years, especially the past five years, the chart for this company has just been up and to the right. It's been one of the most consistent performers in a space that a lot of people have a lot of expectations for. E-sports is a trend that we continue to hear about.

Niu: For EA, the big thing for them was, they delayed the launch of Battlefield V, which was one of their core franchises. They said had to make some last-minute adjustments, but they also wanted to distance themselves, there's a few other AAA titles that released in October, including Black Ops 4, Red Dead Redemption 2, which you probably talked about when you were talking about Take-Two. Also, there was Ubisoft's Assassin's Creed Odyssey. All those games came out in October. It was a jam-packed, really competitive month in terms of these releases. I think they wanted to distance themselves from that. But then that inevitably leads to lower guidance, because they're not going to be making as much money during the quarter. 

​Lewis: I think that's what really rocked the stock, is the look-forward for their financials weren't looking as rosy as maybe investors had expected. When you're talking about releases of what should be a pretty hotly anticipated title, it comes down to maybe more a matter of timing than actual revenue. Unfortunately, the market is going to ding the stock because they have to go with what management's giving them as guidance. 

This title, Battlefield V, is pretty important for them. You look at EA over the past year or so, there's been a bit of controversy with this publisher. There are a lot of purists in the video game space that aren't super thrilled with them.

Niu: Right. They've been grappling with the fallout from this loop box controversy all year long. It's been this overhang. As a quick refresher, they released Star Wars Battlefront 2 last November. That game relied very heavily on micro-transactions, where players were expected to buy these loot boxes with randomized virtual goods in them to progress in the game and unlock all these things. The whole situation even attracted attention from regulators and lawmakers around the world because a lot of people think it's essentially a form of gambling, and you have a lot of kids playing these games. It's predatory, in a way. The whole situation even led Apple to implement a new policy on iOS where developers are required to disclose the odds behind loop boxes in mobile games, and in-app purchases are a pretty huge part of mobile gaming, so it had pretty broad effects there. 

It's just created this massive backlash among gamers, and it really hurt EA's brand. They've basically been apologizing for it all year long. Then, ironically, they still put loot boxes in a different game, FIFA 19, a soccer game they released in September. So, not really sure if they're learning their lesson. But they are now under criminal investigation in Belgium over the practice, because the country considers loot boxes to be a form of gambling, and EA isn't complying with the local laws around gambling.

Lewis: I think a lot of investors probably look at something like micro-transactions and digital sales, and they say, "This is something I want to see. I know this is high-margin business." I think the reason that many gamers push back is, it kind of ruined the skill-based and experience-based elements of the game. It allowed for progression in a way that could be bought rather than earned through gameplay.

Niu: Right. There's also a pretty big difference. Most people are pretty familiar with it in the context of mobile or the freemium model, companies like Zynga took off. They offer the game for free, then monetize it through in-app purchases. Maybe only 2-5% of your players will actually end up paying, but they'll end up paying quite a bit. The big difference is, on these big console games, you're paying $60 for the game up front, and then they're also expecting you to pay all this money out of pocket for these virtual goods. And some of these things are crazy expensive. You can easily spend multiples of $60 buying the stuff in the game. That compounds the perception issues with why gamers really don't like the practice when these console developers are trying to implement the same type of strategy that mobile developers can get away with.

Lewis: You mentioned the books. Looking at how management has been treating this delay, for this upcoming holiday quarter, they indicated sales would be about $200 million lower than analyst estimates. The story with management's guidance and the company's performance throughout 2018 has been, management lowers guidance, then ultimately winds up beating it. And I can understand why the market is concerned with all these blockbuster games. Take-Two has Red Dead Redemption, Activision has Call of Duty. But when I see this huge slate of video game releases, I think this is just par for the course. I think this is what people should expect. There's no mutually exclusive element to that.

To my point earlier about it being more a timing element of revenue than anything else, I don't know that I'm super worried about how crowded this space is. I think that the company getting over the hurdle of micro-transactions and restoring gamer faith is a little bit more important.

Niu: Right. I definitely agree that a small delay isn't going to be a deal-breaker. At the same time, there are other cracks that investors are worried about. EA's been really trying to push their digital revenue, which is also, as we mentioned, this in-app stuff, all these virtual things. That all contributes to their digital revenue. Digital revenue is growing, but the growth is decelerating quite a bit. Net bookings were up like 11% last quarter, but that was... I forget what that was down from, but the point is, growth is decelerating. They're also having a little bit of trouble getting players to sign up for these live services. A lot of games nowadays try to be this online experience all the time, but then they also want you to subscribe to these different types of services. They did reduce their guidance for live services revenue, and now only expect it to be flat to up 5%. They said on that FIFA game that players have been slow to sign up for the services there. So, there are definitely some other challenges that they're facing.

Lewis: There is one ace in the hole for this business. That's this upcoming release of this title Anthem. This should be debuting in early 2019. If you're looking for a good sign -- obviously, Battlefield V sales are super important for this stock. But, if Anthem is a hit, that gives them another tentpole franchise to work off of. Seeing the lifetime value that some of these video game franchises have, that to me is such a big boost to the stock looking at 2019. And given the company's track record, that there could be something strong there.

Niu: I think Anthem looks really good. I'm actually planning on buying it, assuming that they don't botch the rollout or launch with crazy in-app purchases. [laughs] 

Lewis: Yeah. And hopefully, they won't. Although, to your point earlier, maybe they haven't learned their lesson quite yet.

Turning our gaze over to Activision Blizzard, also down about 25% year to date, and down over 40% since highs hit in October. This is a pretty precipitous fall that's happened pretty recently. The story isn't super different. It has to do with their financials. The slump for Activision was really brought on by earnings that missed expectations, rather than providing poor guidance in the case of Electronic Arts. 

But, I don't know that the revenue and earnings misses are huge deals when you look at the more concerning problem of user declines. This seems to be how this company is being judged now.

Niu: Right. I think the overarching challenge for Activision here is, a lot of their core franchises are seeing user numbers going down. They report monthly active users. They have three different segments. They have King, an acquisition they made back in 2015 for $6 billion, the maker of Candy Crush. They have Blizzard, and they have Activision. All three of those segments are seeing their user numbers decline a little bit. I think investors are a little worried there. This company, historically, had World of Warcraft -- I mean, they still have World of Warcraft, it's one of the things that they're known for, it's a hugely successful subscription-based online gaming business. But of course, now there's a lot more other stuff in the mix.

Lewis: To put some numbers to that, the company had 345 million engaged users compared to 384 million a year ago and 352 million in the previous quarter. A lot of those losses, like you said, are coming from the King segment. I've never been a huge fan of that segment, personally.

Niu: I've never been a fan of King in general. [laughs] I didn't really like the acquisition because I thought it was quite a bit of money for a mobile game publisher that was really concentrated on that one Candy Crush game. I mean, they do have a bunch of other games, but it's really all about Candy Crush. Mobile gaming platforms in general are so intensely competitive, and users are fickle that they move on to the next thing so quickly. It seemed like a lot of money, in my opinion. To be fair, Candy Crush is now five years old, and the company did say that users of Candy Crush are still stable and up. But, you're seeing other signs of player fatigue. Their total user numbers are coming down. It shows that their other games are not really doing that well.

Lewis: Yeah, and that's a big, big chunk of that overall monthly active number. King is 262 million. It's a huge chunk. I have a lot of the same feelings about mobile gaming that you do. I think the switching costs are a lot lower. People generally aren't paying for games up-front. That makes it a lot harder to build these really flagship franchises that so many of these gaming companies have built their business on. I just don't like that business quite as much. 

The good news if you're looking at Activision Blizzard, though, is Overwatch, one of its main titles, is still incredibly popular, although it isn't growing the way it used to.

Niu: Right. On the last call, they said that players were flat quarterly. Earlier this year, they had said they have about 40 million players. That's about where I would expect the player base to be. But it's not really growing. Even though it's still a pretty popular game in the grand scheme of things, investors like to see growth.

Lewis: Yeah. Where I think a lot of people probably had some expectations, too, is with their Destiny 2 expansion. That doesn't seem to be going particularly well.

Niu: Right. They launched an expansion for Destiny 2 during the quarter. And they admitted, "It has not achieved our commercial expectations." They're still working on trying to reengage with that core fanbase around the game. Even though Destiny players were up on a sequential basis, it's pretty clear that overall sales, in terms of how much money they're making, is not meeting up to the expectations.

Black Ops 4 was also released in the quarter and helped create some user growth there. They had a pretty strong launch in October. The launch weekend did about $500 million in sales.

Lewis: There are some signs to be positive about, to be optimistic about. Particularly, also, if you look over at some of the user metrics. While the total count might be dipping, the engagement looks pretty good. They hit a new record with 52 minutes per day, up from 50 minutes per day as a past record. There's some stuff going in the right direction for this business. Maybe running into some of the same snags that EA is. 

The thing that we haven't really talked about yet with the gaming space is the fact that over the past 12 months or so, we've seen this emergence of a type of game that neither of these businesses immediately had an answer for, and that's the battle royale segment.

Niu: Right. The battle royale genre has exploded. Fortnite is the big one there. It now has 200 million registered players. Epic Games, who makes Fortnite, said in August that they had about 80 million monthly active users. That's double the size of Overwatch already. Fortnite was launched about a year ago. There's also other games like PlayerUnknown's Battlegrounds. These games are becoming so incredibly popular. For example, I have a fifth grader, and even she tells me how popular it is at school. These elementary school kids, they're all obsessed with it. It's blowing up everywhere. 

EA and Activision have been slow to get on that bandwagon. Now, to be clear, both Black Ops 4 and Battlefield V have these battle royale modes. But that was literally just launched over the past couple of months. It's really too early to call on whether or not they're going to see success by getting on that bandwagon.

Lewis: I've had a very similar experience. My cousin's kids are about the same age as your kids, Evan, and all they talk about is Fortnite. It's either they're playing Fortnite or they're watching someone play Fortnite on YouTube, because their mom, my cousin, has decided that they aren't allowed to play any more Fortnite. It's this all-consuming thing. For any listeners out there that maybe haven't seen or heard or interacted with this, this is the stuff that you see, all these dance moves that are coming out, all these NFL players, all these soccer players, doing these dance moves as a celebration for scoring, those very often are Fortnite dance moves.

Niu: They're getting sued now over the dance moves. [laughs] 

Lewis: Yeah, so they've cribbed some dance moves from some very popular -- I think Carlton from Fresh Prince of Bel Air. [laughs] 

Niu: That was the recent one, yeah. 

Lewis: So, it's this very weird way that video games have entered pop culture. And it's been unavoidable. Fortnite has been absolutely everywhere. I know Activision Blizzard is making some efforts to create battle royale versions of some of the games, and allow for that type of gameplay, because if there's a story from 2018, it is the way that battle royale has taken over the gaming space.

Niu: Yeah, it's a total cultural phenomenon right now. Like you mentioned, it's everywhere. Whether or not that proves to be sustainable, a long-term trend that people really love, or if it becomes a fad, we'll just have to wait and see.

Lewis: We'll have to wait and see. I play video games a little bit. Evan, I know you play video games a little bit. But I think, of the three people currently in the studio -- I'm going to include Austin Morgan in here -- our producer, Austin Morgan, probably plays video games the most. When you look at the video game landscape, what are you most excited by? And how do you feel about our more academic discussion of these video game publishers?

Morgan: I don't know anything about the backstory of the publishers and companies or anything. I just know that there's like four games I buy a year. It's either any Rockstar game -- GTA or Red Dead -- I buy the new NHL game, MLB The Show, and whatever Battlefield game comes out. 

Lewis: I think that speaks to the value of these franchises. These are repeat purchases for you, Austin.

Morgan: For sure. Definitely. I haven't bought the new Battlefield V yet, and that's because I was playing Red Dead. I didn't even realize it came out because I was just playing Red Dead. But I got an email to buy it for 50% off, so that might be a sale for me.

Lewis: Oh, Merry Christmas to you! Look at that! I think it's really unbelievable, the value of these properties and the way that they continue to pay dividends. Similar to the value of these sports contracts in the cable space, the value of creating sports games in the video game space is there for these publishers because these are recurring purchases. You get the updates with the new players, new logos, teams, everything. It's something that the people that are in the know want to have every year.

Niu: I will say, the one game I'm particularly excited about, that hopefully will come our next year, is Last of Us 2. Last of Us is by far my No. 1 favorite game of all time. They're working on 2. They haven't announced when they're going to release it. Hopefully, if it does come out next year, that'll be another big storyline in video gaming.

Lewis: I'm going to play the ignorance card here. I have no idea what that is, Evan. [laughs] 

Niu: [laughs] Google it. It's worth a google.

Lewis: [laughs] Alright. What's on your holiday list? What's the gift that you hope for this year, Evan?

Niu: We actually do Hanukkah and Christmas, so my wife I don't give each other a lot of gifts. We just focus on the kids, and we already had Hanukkah, so they already got all their big stuff. I got my daughter an iPhone 8. We got it on a promotion for T-Mobile. That was her big gift for the year. [laughs] 

Lewis: Man, I wish I was your kid! [laughs] That's better than anything I'm going to be getting. I'm getting all these practical gifts. Austin, what about you? Anything you're expecting under the tree? 

Morgan: I have no idea. It's a surprise. 

Lewis: Oh, you're going in blind?

Morgan: Yeah. They were like, "What do you want?" And I was like, "I have no idea, surprise me." It's more fun that way.

Lewis: I was going to ask you what you got Kara, but I realized that we're taping before Christmas, and I don't want to reveal --

Morgan: There's no way she listens to the show. Nothing.

Lewis: [laughs] Even if, by some off chance, she does listen, I don't want to ruin the surprise. 

Morgan: That's fine. She does not listen.

Lewis: Then she's like my girlfriend and almost everyone in my family. [laughs] 

Well, I hope both of you guys have awesome holidays! Listeners, I hope all of you guys have awesome holidays, too! Like I mentioned, we'll be back with some episodes Wednesday, Thursday, Friday of next week after Christmas. Then, I believe Jason Moser is going to be taping a show on Monday of the following week. We'll be taking New Year's Day off, and then back with our regularly scheduled programming after that. You can look forward to Industry Focus in 2019.

Evan, thanks for hopping on today's show, man!

Niu: Thanks for having me! Happy holidays!

Lewis: Austin, thanks for all you did in 2018!

Morgan: ... I was trying to think of something clever to say.

Lewis: [laughs] You know what? You have the power to decide whether or not that makes it into the show. But I really hope that makes it into the show.

Listeners, that does it for this episode of Industry Focus. If you want to reach out to the team, questions or comments, you can find us at industryfocus@fool.com, or @MFIndustryFocus on Twitter. If you want more of our stuff, you can subscribe on iTunes. Or, you can catch videos of the podcast over on YouTube. 

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 in 2018. He's been an all-star. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!