Video game companies saw their businesses supercharged by the COVID-19 pandemic lockdowns. With many people stuck inside, money that could have been spent on traveling or experiences was instead spent on at-home entertainment like TV, movies, and console games in 2020 and 2021.
Now, with the pandemic in the rearview mirror, investors are getting pessimistic as gaming industry sales are set to fall by 1.2% in 2022, causing many video game stocks to decline in value. If you are a long-term investor, these price declines can be buying opportunities for companies with multiple long-term tailwinds.
Here's why now is an opportune time to buy video game stocks.
The ending of console supply chain woes
One of the main ways people play video games is through dedicated console hardware. In late 2020, Microsoft (MSFT 1.65%) and Sony (SONY 0.31%) -- two of the three leading console makers -- released next-generation hardware for consumers, the most significant update for the industry since the last console cycle in 2013. While gaming demand was on fire at this point in time, the timing of the launch could not have been worse because of the growing semiconductor shortage around the globe.
Game consoles are essentially just computers optimized for video game playing, and they require high-end computer chips and semiconductor equipment to work properly. With semiconductor supplies running low, both Xbox and Playstation have not been able to manufacture enough console supplies to meet consumer demand. Today, almost two years later, it is still extremely difficult to buy a new Xbox or PlayStation console. Without the new hardware, consumers are likely to delay purchases of new console games, driving down sales in the near term.
It is unclear exactly when the semiconductor shortage will fully end. But when it does, it should accelerate game sales across the industry as 100 million+ people around the globe get new hardware from Xbox and Playstation. For companies with huge portions of their revenue coming from console games, this will be especially beneficial and should be an easy tailwind to ride over the next three to five years.
Cloud gaming will be a game changer
But what if gamers didn't need to buy a $500 console to play state-of-the-art games? That day may be closer than we think with the investments companies like Xbox are making into cloud gaming.
What is cloud gaming? It is the ability to have all the computer processing needed to play a game done on an outside server connected through the internet instead of dedicated gaming hardware. Xbox/Microsoft is experimenting with cloud gaming through its Game Pass subscription service. Investors should expect other companies like Sony to invest in cloud gaming technology because once it goes mainstream it should drive more gamers to play console-level video games. Why? Because if you remove the barrier to entry of needing to spend $300-$500+ just to have the ability to play popular games, more and more casual gamers will likely start playing them in their free time.
Third-party analysts are optimistic about the growth of the cloud gaming market this decade. By 2029, the market is expected to hit $41 billion in annual spending and grow at a compound annual growth rate (CAGR) of 43% from now until then. Those are phenomenal growth numbers and a large amount of new revenue for gaming companies to capture this decade.
So what are the best gaming stocks?
The video game industry is clearly in a good spot, even though the market is set to stagnate in 2022. Two high-quality stocks specifically set to benefit from the ending of console shortages and cloud gaming are Electronic Arts (EA 0.02%) and Take-Two Interactive (TTWO 1.26%). Both are gaming publishers with large exposure to the console market and have great franchises that have endured the test of time.
For EA, it has sports titles like FIFA and Madden NFL along with other games like Apex Legends and the Sims with huge fanbases across the world. Take-Two owns the incredibly popular publisher, Rockstar Games which created Grand Theft Auto, Red Dead Redemption. Take-Two also owns NBA 2K, which, like EA's titles, have huge and dedicated customers that have spent time with the franchises for many years.
EA has a price-to-earnings (P/E) of 38 and Take-Two has a P/E of 80. Both look expensive, but given the weird accounting gimmicks of gaming revenue recognition and the lumpy sales for game publishers, trailing P/E ratios are not the right metric to look at when evaluating these stocks. It is all about the gaming pipeline and future cash flows these businesses will generate.
For EA, it has cash cows with its sports gaming franchises, is set to add back its popular NCAA Football game next year, and has over a dozen different non-sports titles in the works. Take-Two is set to release the next title in its Grand Theft Auto game sometime within the next few years. Its previous title -- Grand Theft Auto V -- is the best-selling individual game ever. Add on the proliferation of cloud gaming, and I think both EA and Take-Two are set to grow their cash flows tremendously over the next 10+ years. Regardless of what P/E the stocks trade at, that makes both companies a buy right now.
