Summer is here, but with many households confined indoors due to COVID-19, video game stocks are doing well. In fact, while the S&P 500 remains down 6% year to date, all the largest U.S. video game studio pure-plays are up. Activision Blizzard (ATVI +0.00%), the largest of the batch, has gained 29% so far in 2020, trailing only small mobile gaming outfit Zynga's (ZNGA +0.00%) 56% runup.
Video games are important entertainment outlets these days, and e-sports continues to grow in popularity around the globe. Some estimates say annual spending on the interactive entertainment medium will increase from some $150 billion in 2019 to over $250 billion by 2025.
Activision Blizzard is one of the largest game creators around. That makes the stock a no-brainer, right? I'm not so sure.
Image source: Getty Images.
Plenty of growth, but plenty of disruption too
This game developer, which has some 400 million players worldwide, is famous for Call of Duty, Overwatch, World of Warcraft, and Candy Crush, to name just a few franchises. It's the result of two major deals: A merger with Vivendi (former parent of Blizzard) in 2008, and the acquisition of King Digital (maker of Candy Crush) in 2016. The combined studios have churned out hit after hit for years, becoming the largest video game pure-play around.
There's been growth, but the industry has been evolving rapidly, too. The shift to downloaded games has been a good thing, as less packaging and less physical inventory management mean higher profitability. Rising mobile gaming has also been a boon, as it has opened up a whole new set of consumers. King's monthly active users increased 10% to 273 million worldwide in the first quarter of 2020 from the end of 2019. And e-sports leagues have turned Activision Blizzard's Overwatch and Call of Duty into professional gaming staples.
New consoles and PC hardware are also arriving. New chips from NVIDIA featuring AI-enhanced graphics and ray tracing helped pave the way for a new generation of games. Sony's Playstation 5 and Microsoft's Xbox Series X, both of which offer similarly impressive graphics advances, will be arriving in time for the 2020 holiday season.
New hardware is always good news for the episodic nature of the video game release business, and Activision Blizzard is ready with a new World of Warcraft expansion and Call of Duty game set for release in the second half of the year. It also has a couple of classic sequels and remakes in the Tony Hawk's Pro Skater and Crash Bandicoot series.
There has been ample disruption, though. Games that are free to play (think Fortnite) have forced studios to rethink monetization. Rather than generating sales by creating new games, Activision now must figure out how to increase the longevity of a title and monetize it via smaller transactions over time.
The very infrastructure powering video games is also changing. Tech giants like China's Tencent Holdings, Alphabet's Google, and NVIDIA have launched new subscription-based video game streaming services. Between free-to-play and streaming, these two new formats are quickly transforming the industry and will make it look very different five years from now.
A steep premium for a decent outlook
All that change that has me approaching this video game stock with caution. Game sales are heating up amid shelter-in-place orders, and Activision Blizzard is forecasting a 21% increase in sales year over year for Q2 2020 and a 5% increase for full-year 2020 off of a 2019 slump.
However, given the rally in share price so far this year, I think the expected growth is already baked in. The stock trades for a premium 41.3 times trailing 12-month free cash flow (revenue less cash operating and capital expenses) and 28.8 times 2020 expected adjusted earnings per share. Meanwhile, smaller and faster-growing studios like Take-Two Interactive (TTWO 0.03%) and aforementioned Zynga trade for similar valuations.
Thus, at this junction, I can't call Activision Blizzard a buy. The video game industry is set for explosive growth and change in the coming years, and I think this top studio will benefit. But I think there are better purchases at the moment given the hefty price tag this one carries.
