The bulls in the market have been stomping on the bears for more than a year, but history shows that stock prices don't move up in a straight line. Market corrections are par for the course when investing in stocks, but that same history shows these downturns lay the foundation for great returns afterward.
If you've been thinking about buying shares of a video game stock, the next market pullback would be a great buying opportunity. Activision Blizzard (ATVI), Electronic Arts (EA -0.12%), and Tencent (TCEHY 5.23%) are cash-rich leaders in the burgeoning video game industry that can deliver market-beating returns over the long term. Let's find out a bit more about these three stocks.
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1. Activision Blizzard
Activision Blizzard owns eight franchises that have achieved at least $1 billion in lifetime bookings. It's best known for making one of the most-played first-person shooters on the market in Call of Duty. A $1,000 investment in Activision stock in 2003, right after the first Call of Duty title was released, would be worth nearly $30,000 today.
The Call of Duty franchise continues to grow. It's included in the company's Activision segment, which reached a record 150 million monthly active users (MAUs) in the first quarter. With seven other major franchises under its umbrella, Activision Blizzard sees an opportunity to improve those titles to more than double its MAUs to 1 billion.
Making big-budget video game titles does require investing in thousands of employees and can involve significant marketing expenses, but many other aspects of production are not as capital intensive when compared to other industries. This allows top game companies that can sell millions of copies of new releases to produce robust amounts of free cash flow. Over the past four quarters, Activision Blizzard generated $2.8 billion in free cash flow on $8.5 billion in revenue.
It pays out less than a fifth of that free cash flow in dividends, bringing the current dividend yield to 0.52%. There's clearly potential for Activision to safely double or triple that yield by increasing the payout ratio over time.
Activision Blizzard owns several franchises that each have a built-in base of millions of fans, including World of Warcraft, Diablo, and Overwatch. The company is well stocked with cash, with $9.3 billion on the balance sheet, which should provide plenty of capital to continue reinvesting for growth.
2. Electronic Arts
Electronic Arts is known for its EA Sports titles, most notably Madden and FIFA. EA added 42 million new players to its network during the pandemic. It has a total of 230 million players and viewers, but management is targeting 500 million over the next five years.
Most importantly, EA has demonstrated the ability to bring out new hits. The free-to-play shooter Apex Legends launched in 2019 and recently surpassed $1 billion in bookings. EA also revealed plans earlier this year to relaunch its previous NCAA Football franchise under the new title EA Sports College Football, which should be released within the next few years.
EA's success in growing its sports business in recent years has left it with lots of cash to reinvest. It entered fiscal 2022 with $6.3 billion of cash and investments and has already put that to work. So far this year, EA has spent a combined $4.7 billion to buy Glu Mobile, Codemasters, and Playdemic. These studios bring their own game development prowess and popular titles to accelerate EA's expansion into mobile.
In fiscal 2021, EA's free cash flow came to $1.8 billion on $5.6 billion of revenue. EA started paying a dividend within the last year, which signals management's confidence in its growth strategy. The quarterly dividend amounts to $0.17 per share, bringing the current dividend yield to 0.48%. The company's growing sports lineup and willingness to return capital to shareholders makes it a top video game stock to consider buying.
3. Tencent
Tencent is the largest video game company in the world by revenue and also operates the popular WeChat social media platform in China. It owns Riot Games, the operator of one of the top esports titles in the world in League of Legends. It also has ownership stakes in several other companies, including Epic Games and Activision Blizzard.
Gaming makes up 29% of its annual revenue, with online advertising, fintech, and business services composing most of the balance. But gaming is Tencent's largest business segment. It's the diversity of revenue streams across fast-growing markets, including gaming and cloud services, that make it a stock worth keeping on your radar.
Over the last four quarters, Tencent generated $18.5 billion in free cash flow. It has $39 billion of dry powder on the balance sheet, in addition to a portfolio of investees that was worth over $200 billion in the first quarter. That's a lot of firepower.
Tencent compares the current state of the video game industry to the movie business in the 1930s, and it's investing to maintain its leadership status. Last year, management announced a deep pipeline of 40 new titles, including internally developed and licensed games in development. It's particularly focusing on where gamers are spending more time, which is with big-budget, immersive gaming experiences.
"The development speed, scale, range, and depth of information technology is much greater than the last Industrial Revolution," said Senior Vice President Steven Ma. "This brings unimaginable opportunities for games and the space is almost limitless."
However, investors should note the risks of investing in Chinese companies. Tencent has come under scrutiny by regulators that have cracked down on "inappropriate" content in the company's games, but Tencent has been able to navigate through these obstacles and deliver market-beating returns to investors. The stock price has fallen recently, which can be chalked up to regulatory issues and near-term investments in the business that will pressure profitability this year. But I would look at the recent drop in share price as a buying opportunity.
