DFC: The High Flying Video Game Companies of 2007

Author: by DFC Intelligence

In a new report from DFC Intelligence, the analyst group has given its look back at the games industry's stock performance, noting Asia's stagnation compared to the U.S., and adding that the newly merged Activision Blizzard will become "a gauge for industry growth." The full text of the report sent follows: "Once again it is December which means it is time for DFC Intelligence to look at the stock performance of the video game industry. This year there is more attention than ever being paid to video game market valuation. Nintendo’s market value has soared to unbelievable levels and, as we indicated last month, merger seems to be in the air. Of course, when we wrote that article we had no way of knowing that the largest merger in industry history was just days away. Given all the hype, now is a good time to take a look at the big picture of investing in the video game industry. For the past two years, DFC has discussed how the transition to new game systems could lead to some interesting market fluctuations. In December 2005, we described how, based on historical trends, there was a chance game company stocks could soar in 2006 with the launch of new systems, followed by a cool down in 2007 as the hype wears off. Last year we reemphasized that point but stated that sales for 2006 turned out much better than expected. This year we would state that 2007 was clearly a stellar year. The worldwide video game and interactive entertainment market is on track to smash all records. In the recent DFC Intelligence forecast report we estimated that worldwide sales would exceed $40 billion for 2007. Of course, much of this increase is due to consumer spending on expensive hardware. However, software spending is also keeping up at record paces. Despite the good news in the video game market, several high performers have clearly broken out from the pack. Comparing stock price increases over not only the past year, but also the past five years, four companies standout: Activision (ATVI), Nintendo (NTDOY), Ubisoft (UBI) and GameStop (GME). The interesting thing to note about each of these companies is that they serve very different segments of the market. It seems that these four companies have become favorites of investors that want to play the full gamut of growth in the video game food chain.

Company Symbols Activision (ATVI); THQ (THQI); Electronic Arts (ERTS); Take-Two (TTWO); Midway (MWY); Konami (KNM); Atari (ATAR); Nintendo (NTDOY); Sony (SNE); GameStop (GME); Ubisoft (UBI)

What do each of these companies represent: 1) Nintendo represents the historical hardware/software video game model where hardware is sold at low cost and profits are made via software 2) Activision represents the historical publishing/distribution model of getting a diversified product lineup released for multiple platforms across North America and Europe. 3) Ubisoft represents the focus on building high quality original intellectual property that can build long-term value. 4) GameStop is of course all about the essential physical retail distribution of getting products into consumer’s hands. Five years ago, or even one year ago, an investor looking to capitalize on video game industry growth would have done very well buying into the market with just Activision, Nintendo, Ubisoft and GameStop. However, most other video game stocks have lagged behind. More importantly, past success is no guarantee of future success. One issue is that none of the large publicly traded companies represent a play in one of the fastest growing market segments, namely online games for the PC. As the game market has grown on an international basis and become increasingly fragmented among different platforms, the online connected personal computer has emerged as the leading worldwide game platform. Furthermore, the PC platform has been the pioneer for emerging business models such as digital distribution, virtual items, subscription models and advertising. However, for investors there are limited options for publicly traded companies that are strong in PC online games. Of course, there are several large PC online game companies that are publicly traded. However, all these companies have been very regionally focused on Asian markets. Global reach is key and the Asian game companies have yet to prove they can have successful long-term expansion outside their domestic market. As a result, the stock price of Asian online game companies has fluctuated significantly over the past three years. As the charts show, in that time period, none of the Asian companies have had anywhere near the upside of the top traditional video game companies.

Company Symbols Shanda (SNDA); The9 (NCTY); Netease (NTES)

That brings us to the Activision merger with Vivendi Games. Obviously, as the name of the new company implies, this merger is all about Activision and Vivendi’s Blizzard game division. No one has come close to Blizzard Entertainment’s success in PC online games. Furthermore, Blizzard proves how profitable new game industry models could be. For 2007, Vivendi expects Blizzard to have operating income of over $500 million. The highest reported operating income for Activision was $180 million in fiscal 2005 (Activision expects to exceed that for fiscal 2008). Prior to the merger, Blizzard Entertainment was buried away in the media giant that is Vivendi Universal. With the new Activision Blizzard, investors will have a single company that, on paper, has its hands in most of the major international growth areas in the video game market. Of course, in reality it is not so simple. With mergers of this size one plus one does not always equal two. Some of the key concerns about Activision Blizzard include: 1) Both Activision and Blizzard are having record years in 2007. This leads to the question of whether these companies are merging at their peak. In our recent report on MMOG Subscription Business Models, DFC analyzed how revenues and profits for a product like World of Warcraft can be expected to peak in year three only to decline slowly in future years. 2) Can the companies successfully consolidate and merge such disparate organizations. Games are a creative product and the track record of such mergers is not positive. There is often a tendency for top talent to leave after such a merger. 3) Will Vivendi’s controlling stake hamper growth? Even with all the questions Activision Blizzard remains a fascinating combination. There has been a great deal of talk about how other companies will react to the merger. Speculation is that it could lead to further consolidation. The problem is there are simply no other companies that have had the recent success of Activision and Blizzard in their respective fields. The video game business is going from a packaged goods business to a packaged goods/service business. The new Activision Blizzard will represent the first established pure play investment opportunity for a company that is dominant in both areas. As such, Activision Blizzard is, at the very least, likely to become a gauge for industry growth. The company will have leadership positions in console games, PC games, online games and a strong presence in North America, Europe and Asia. It is clear that any company that wants to play catch-up will have a long way to go."