How to Level Up Your Portfolio With These Gaming Stocks

Nearly a decade ago, the teens of the world were glued to their consoles and wired controllers, leading Mario and Luigi on an epic adventure.

With mobile device sales increasing at an astounding pace, one might question how the power could shift and make console providers paranoid. Games like Candy Crush Saga from King Digital (NYSE: KING) or Kim Kardashian: Hollywood from Glu Mobile (NASDAQ: GLUU) dominate the mobile gaming space, but what does that mean for console juggernauts Xbox and PlayStation? Find out as Sean O'Reilly and Vincent Shen take us to the next level on this episode of Industry Focus. 

A full transcript follows the video.

 

Sean O'Reilly: We're leveling up on gaming on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from Fool headquarters in Alexandria, Va., on a very rainy day, south of the nation's capital. I am joined by the one and only Vincent Shen. How are you today, sir?

Vincent Shen: Hey, Sean. I'm really pumped for this show.

O'Reilly: This is -- I don't know if you guys can hear it in our voices, we have an hour and a half to prep for this one and we're all geared up and want to go play video games now.

Shen: Yeah. Well, I think it helps that both of us have spent half an hour here and there the past couple weeks playing GoldenEye.

O'Reilly: Yeah, bad.

[crosstalk]

O'Reilly: Plus, I spent a decent chunk of my childhood playing Super Nintendo and N64, then Xbox. Then I realized I wasn't good at video games anymore. So, first and foremost, just to give everybody a quick outline: We're talking about where video gaming has been, the current dynamic of the Xboxes and the PlayStations of the world. Then we're going to go into those wonderful online games that all of our children are playing on our phones.

So, first and foremost, how big is the video game market, Vince?

Shen: I think that's what really surprised me because when you're a kid you only think about it as this context. Then now, here at the Fool, we look at it like, "Wow. So, global PC and console game revenue is $90 billion. So, it's a huge market." That's a lot of money to be made in this industry.

O'Reilly: Yeah, that's like Coke's revenues, or something. That's quite large.

Shen: Even in more mature markets like U.S., Western Europe, they're still seeing pretty good growth. Some of that is through newer platforms -- like mobile, that we'll talk about later. The sales for the newest generation of consoles have been pretty robust.

O'Reilly: Yeah. So, the PlayStation 4 has been outselling the Xbox, and then Nintendo -- and it's obviously family friendly and it has a purpose there for Wii sports and all that -- but it's losing to these guys.

Shen: Yeah. The issue there is -- I think in the beginning Microsoft (MSFT -2.45%) made a small blunder. Well, not that small. They were pairing their newest console -- the One -- and trying to get it out with certain accessories -- like the Kinect. Whereas Sony (SONY -0.33%) was pushing it with games included with the consoles, more attractive package, the price point was better -- it was about $100 cheaper. That kind of gave Sony some real strong momentum in the beginning.

Microsoft shifted gears around the holiday season, seeing "Our sales are lagging." I think it helped them catch up a little bit, but overall I think Sony has still outsold the Xbox by a pretty good margin.

O'Reilly: Got it. OK. So, just to give our audience some perspective if you aren't aware; there are three studios the make all of the traditional console and PC games in the world.

Shen: The biggest ones, yeah.

O'Reilly: The biggest ones. Yeah. There's obviously a lot of side players and this, that, and the other thing. We can't invest in them anyway so it's fine. First of which is Activision Blizzard (ATVI), then you've got EA Games (EA -0.65%), and bringing up the No. 3 spot is Take-Two Interactive (TTWO 0.42%).

So Vince, I've got a quiz for you. Which of these has the best return on equity? For our listeners that don't know, that is net income divided by book value, and it is a rough measure of how much a company earns every year on what's been invested in the business up to that point.

Shen: My guess is EA Games, though I wish it was Take-Two because they make my favorite one.

O'Reilly: Well, of course. Will you share with us what that is?

Shen: Grand Theft Auto.

O'Reilly: Atta boy.

Shen: Though I haven't played the newest one, but the originals -- a lot of good times on that when I was a kid.

O'Reilly: Terrible. What are you willing to wager on this?

Shen: $1,000 gold.

O'Reilly: OK. I'm not, because you're right. Yeah. Last year, for fiscal year 2014, the return on equity of Activision was 12.1% -- meaning they earned $0.12 for every dollar that had been invested in the business up to that point. EA crushed it with 28%. That is -- the average S&P 500 company earns 10 or 12. That is awesome. And Take-Two was a negative number so it doesn't even work.

Interestingly though, the forward P/Es -- and for our listeners, all of our estimates and numbers are coming from Standard & Poor's Capital IQ. Their forward P/Es are pretty similar. Activision's is 23, EA is 22, and then Take-Two -- they're assuming they're going to earn a buck a share next year -- so it comes at a 27.

Shen: OK. Wow. Those are actually pretty reasonable valuations.

O'Reilly: It's obviously not like "That's so cheap" and Benjamin Graham is all over this, but that's not crazy.

Shen: Well, assuming the market average for S&P 500 is usually around 20 times, right?

O'Reilly: Yeah.

Shen: So these aren't mind-blowing expensive.

O'Reilly: Bananas, yeah.

Shen: Like some of the other companies that we're going to talk about.

O'Reilly: Yeah. I cannot wait for later in the show. I do just want to throw out, they are expected to grow their earnings out the next five years. So, out to 2019 Activision's going to grow about 15% -- we hope -- EA's going to be about 12%, 13%, and Take-Two, nobody knows. They didn't even bother estimating out that far because it's just too variable.

What's interesting to me is EA. That ROE number -- they've done this for years. EA is crazy profitable, and I have to think it's because of the multiple franchises they just keep churning them out on. They've got the FIFA series, you've got all the Madden games. How long have they been making Madden games? Twenty years?

Shen: That's true.

O'Reilly: This is...

Shen: Well, when I first saw this I thought that Activision would be the leader just because...

O'Reilly: They've got -- we'll get to that in a second. Yeah.

Shen: They have some really big titles I think about like the Call of Duty series, they have the World of Warcraft series, but...

O'Reilly: What do they have? Eight million people that pay money every month to play it online?

Shen: Yeah.

O'Reilly: That's crazy numbers.

Shen: It's a nice revenue stream for them. But then with Electronic Arts you mentioned that they had a lot of these sports franchises. Those are very regular money makers.

O'Reilly: They've got the NCAA Football series. I remember playing one of the original versions of that with my dad on Super Nintendo in the '90s. Good old 16 bit, it's a very consistent -- they don't get crazy. Now, in more recent years they've got Titanfall and all the Star Wars games and stuff. So, they're doing OK.

Shen: It looks like they have a very strong portfolio of games.

O'Reilly: They do. On the other hand, with Activision, we mentioned they've got the World of Warcraft thing going for them and the StarCraft, and Diablo, and all that stuff. What were you telling me about Destiny? All the money they spent on this thing? This is dragging their ROE number down.

Shen: Yeah. There's been a lot of talk. Destiny was a huge title for them. There's been numbers thrown around that the game cost $500 million to develop over the past decade. OF course, the company's come out and said "It was nowhere near that. The $500 million encompasses the entire franchise because there's likely to be sequels." A lot of people were basically complaining, "You spent that much money on the game and..."

O'Reilly: It cost $200 or $250 to make The Avengers movie.

Shen: The initial reception was lukewarm, mixed. So, there's been talk about that in the industry.

O'Reilly: Their big cash cow though -- in addition to all the people that pay to play Warcraft online every month -- seems to be the Call of Duty series. That thing has been going on for 10 or 15 years. Total sales for the series were over $10 billion, and that is bigger than all the Iron Man movies, all The Avengers movies; this is a big business.

Shen: Yeah. The original titles, like you said, they've been coming out for so many years...

O'Reilly: You're talking about my middle school career right now. This is like "Aw, man." Back in time.

Shen: Then in more recent years they had a string where every new Call of Duty game was their record best-seller.

O'Reilly: I remember, I did a show a year ago for -- it was with Mark Reeth -- we were doing over and unders on what the Call of Duty -- was it Black Ops that came out last year? I can't even remember. But I was like, "Yeah, I don't know." I didn't know how big a business it was at the time. It brought in $800 million or something. These are blockbuster numbers, and they're just video games. So, they are definitely not playing around.

Shen: Huge business. Yep.

O'Reilly: Then of course you've got Take-Two. They aren't nearly as profitable, but I just want to throw out they've got the BioShock games and of course they have your favorite -- their big cash cow -- the Grand Theft Auto series. I was actually surprise they aren't a profitable. That thing was a huge seller.

Shen: Yeah, but I don't think it comes out quite as consistently as a Call of Duty does, or some of these sports franchises.

O'Reilly: Yeah.

Shen: So, it's going to be a little choppier for them.

O'Reilly: They have tried to get in on the sports games. So, instead of the NCAA Footballs, or the Maddens they've got NHL 2K for 2000 -- because they can't have 2000 -- it is what it is. They're trying to get their piece of the sports action. So, moving on, we'll obviously make our stock picks later on.

Now, we've got this advent of, ever since we all got a smartphone -- mobile gaming and the success of the Candy Crushes, and the Kardashian game. This is -- I could never have imagined this five years ago.

Shen: Yeah. So, in the past I always thought of it as either being console games, PC games, you had some handhelds like the -- Nintendo does very well with their handheld systems.

O'Reilly: My smartphone is now my Game Boy, or whatever.

Shen: Yeah, but Nintendo -- even recently -- has done very well with their handheld. It's outsold even the newest generations of the Xbox and the PlayStation.

O'Reilly: In terms of unit sales, obviously.

Shen: Yeah. But in the grand scheme of things, to put it in perspective, you can talk about a base of -- I pulled these numbers from a recent report where they think that even if the Wii has traditionally sold 100 million units, the original PS3 has sold 80 million, and then some of these newer consoles have sold upwards of 15 million units combined -- how does that really compare when there was 1.3 billion smartphones shipped last year?

Every smartphone -- which is often, even in the developing countries -- the first device that these people get to connect to the Internet. They start gaming on it.

O'Reilly: Right. And playing Candy Crush.

Shen: So, all of a sudden -- exactly. The mobile gaming market has just -- over the past few years -- has absolutely exploded. So, even -- in Southeast Asia and China they think annual growth is somewhere around almost 90%. Even in the U.S. and Europe its' close to 50% every year. In North America, we have about $24 billion of that total pie for gaming revenue. Mobile's a good, solid $7 billion of that.

Ultimately you have these four platforms now possible for games. You've got your TV, you have your PC, your tablet, and your phone. A lot of people in the street think that split's going to become pretty even where you divide your time between those four. Whereas right now, in the U.S., about 44% of people are still playing on TV, about one-fourth of them are on the PC...

O'Reilly: So, I'm sorry to interrupt; back in the day it was 100% N64, or whatever.

Shen: Exactly, or the PC. So, it was...

O'Reilly: 60/40.

Shen: In the U.S. the remaining 30% gaming share is split between tablets and phones. Whereas globally, I think Americans are just more -- they prefer the console games on the TV, whereas globally PC has a bigger share. It's 40%, but the tablets and the phones have a bigger piece, too. Close to 35%.

O'Reilly: So, we're investors here. What do we think about these companies?

Shen: The big three public companies for mobile companies are King Digital, Zynga (ZNGA), and Glu. The issue is -- especially with King Digital and Zynga --they've had their rocky performances since their IPOs. King's trading at $15, they priced at $22.50, Zynga -- I don't even want to talk about them.

O'Reilly: We're not going to. Move on. Glu Mobile.

Shen: They've gone down approximately 70% since their highs, and they've had a very rocky history with their CEO as well.

O'Reilly: Even King and Glu, they're trailing P/Es. King's at 8, Glu's 76 -- which is just crazy, they've barely made any money -- and then the other thing that was interesting to me was; Glu mobile, obviously -- I have an idea of why they're not nearly as profitable. They do mobile versions of popular titles like Monopoly and Call of Duty. The problem is, when you make a mobile version of Call of Duty, Activision wants their cut.

It is not an original title to them. That cuts into your margins a bit.

Shen: Yeah. I think, of the three companies, I think Glu Mobile has a very...

O'Reilly: It seems to be more replicable. We'll get to that in a second.

Shen: I really like their long term strategic vision that their CEO has mentioned. He's got this view of having a really strong portfolio of titles. You can't always bank on getting a Candy Crush Saga.

O'Reilly: Right. Well, this serves as an interesting contrast with King because their trailing P/E's 8 and the Wall Street is not pricing in any growth at all because they have a huge hit with Candy Crush, and "can you repeat a one-hit wonder?" The hopeful '80s bands say "no."

Shen: Yeah. Candy Crush Saga, Pet Rescue Saga; they're trying to build franchises off that core idea, but they're not nearly as successful as Candy Crush at a year or two ago. So, they've traded down. They're at about $15. Sean, like you mentioned, they've turned around 8x current year earnings, which seems cheap, but when you factor in what people are expecting for the growth, and the trajectory of the business, you're basically banking on them being able to replicate that success.

O'Reilly: Right.

Shen: It's pretty risky.

O'Reilly: They're not pricing it -- this is probably one guy on Wall Street guessing -- but they earned $1.80 last year per share and 2019, at best, they'll probably earn $1.61 per share. This is a total guess. It's not like I would trade on or invest on anything at this at all. It's really hard -- when you talk about Activision Blizzard -- they've got a huge portfolio, 20 years of success, cash cows, and they've got Candy Crush.

Shen: I do think what King has going for it, it's got a massive player base.

O'Reilly: They do.

Shen: The monthly active users is very impressive at 550 million. That's gone up 14%.

O'Reilly: And it is pretty addictive. I was talking to one of our super sharp newsletter analysts down here earlier, and they just wanted to find out what happened to Candy Crush if you leveled up and actually paid them money. So, every time you get offered the opportunity to level up, and pay for -- I've never even played it before. Like, coins, or the ability to move up. They wound up spending a couple hundred dollars.

Shen: Oh, yeah. These in game purchases for these mobile companies are their bread and butter.

O'Reilly: Right. And that only happens 2% of the time, but man.

Shen: There's talk now in the mobile gaming industry about the whales -- people who spend hundreds of dollars a month on their mobile games.

O'Reilly: Like a casino.

Shen: Yeah, essentially. You commonly see this in a lot of industries, basically, where a small group of your customers are making up the line to share your revenue because some of these people really like their games. They have discretionary income to spend and they choose to spend it on this stuff.

O'Reilly: Do they get comped like at casinos?

Shen: I doubt that. So, Glu Mobile has this vision of their portfolio games. They've had a lot of success lately with the Kim Kardashian: Hollywood game. Otherwise, it's definitely a bit riskier play. But that's actually, probably my pick for mobile games. Glu Mobile. Specifically it's like picking from three questionable ones.

O'Reilly: Yeah.

Shen: I like the long term vision for Glu and I think that's the most Foolish pick.

O'Reilly: Going forward. Okay. I'm going to be super conservative. I'm going to go with EA Games. That forward P/E of 22 compared really with Activision. They're going to see growth, they've got amazing portfolio titles, and I think it's probably a layup.

Shen: I'd take that too.

O'Reilly: Yeah, but if you want a home run. ... Very good. Well, thank you for your thoughts, Vince. Have a good one.

Shen: Thanks, Sean!

O'Reilly: I'll see you in the gaming room. And that is it for us, Fools. Before we go, I wanted to make our listeners aware of a very special offer. If you've found this discussion informative and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We're offering the lowest price out there for all of our Industry Focus listeners. It is $98 for two a two year subscription to Stock Advisor.

You will get two stock recommendations every month with insights from our team of analysts. Just go to focus.fool.com to take advantage of that deal. Once again that is focus.fool.com. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!