This Just In: Upgrades and Downgrades

Wall Street offers up some reviews of hot videogame ... producers.

Rich Smith
Rich Smith
Mar 21, 2013 at 10:28PM
Technology and Telecom

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Who's hot, who's not -- in videogaming stocks
With Sony, Microsoft, and Nintendo all in the process of updating their gaming consoles, and apps developers coming out with new "casual" games for smartphone users just about daily, it's been a busy week for investors in the videogaming arena. Analysts are busy picking the next round of winners and losers and, already, we've seen three notable ratings changes this week. Here's how they look:

The most recent ratings switcheroo of note was Bank of America's downgrade of social gamer Zynga, which came out yesterday. Pointing to a Zynga's 42% run-up since the year began as evidence that pretty much everything good that could happen for Zynga has already been priced into the stock as if it had already happened, B of A cut the stock to neutral.

At this point, the banker says only "a hit new social PC game" could really add value to the stock, and that's both "unlikely and difficult to predict." Perversely, the risk of rivals attacking Zynga with new real-money poker-playing products is almost certain to arise, and that could hurt investor enthusiasm for the stock.

Long story short, with no profits to recommend it, and no profits likely before 2016 at the earliest, there's really no reason to rush out and buy this one today.

Electronic Arts (NASDAQ:EA)
Also getting the sharp end of the downgrade stick this week is Electronic Arts, which suffered a downgrade to "hold" at the hands of Needham & Co. Tuesday.

Needham worries about the timing of CEO John Riccitiello's departure, coming as it does right after a sales warning -- and, indeed, after a whole "series of setbacks [that] underscores the industry's difficult transition to new platforms, business models and genres." The analyst is cutting its earnings outlook by $0.15 in 2013, and by $0.10 more  in 2014, to $0.80 and $1.15, respectively.

Now, granted, that still suggests we could see EA double its per-share earnings over the course of the next two years. On the other hand, though, based on what EA is actually earning today, the stock looks expensive at 32 times earnings, and a 13% projected growth rate. Fact is ... even if you take EA's earnings double as a given, I'm not sure the stock would be a buy even at the implied price of 15-times 2014 earnings.

Result: Shareholders might not like the fact that Needham cut EA to "hold." I think they did EA a favor by not going the next logical step, and cutting the stock all the way to "sell."

Glu Mobile (NASDAQ:GLUU)
Finally, and in the only good news of the week, Northland Securities announced Monday that it's raised its price target on mobile gamer Glu to $4.50, nearly doubling its previous prediction of $2.50 a share. Needless to say, with Glu shares currently costing only $3.16, Northland thinks you should buy the stock.

But I disagree.

Sure, Northland could be right about Glu producing more "hit" games, and making more sales than it was expected to make on smartphone apps. Problem is, no matter how many games Glu is selling, it's still not profitable today -- and, just like Zynga, not expected to become profitable anytime before 2016. And when you get right down to it, that's really the key to why we invest in companies: We want to earn actual profits, because you can't pay the mortgage with "accelerating sales."

A better way to invest
Are there any gamemakers out there that are earning these actual profits, and earning enough of them to justify an investment? Actually, yes, I can think of one.

Paris-based mobile and social gamer GameLoft SA (OTC:GLOFF) earned $22 million last year, and generated so much cash from its business that it's free cash flow number was even a bit higher than that ($23.5 million).  At roughly 25 times earnings, and 23 times free cash flow, the stock's not obviously cheap. But if it can achieve the kind of 20% to 30% profit growth that analysts are projecting for Zynga and Glu -- and it does operate in the same industry -- the price looks fair.

Right now, there aren't enough analysts following GameLoft to establish a good consensus number for how fast GameLoft will actually grow. That makes the stock a bit of a guessing game. Guess right, though ... and you could make a bundle.