Editors' Pick: Originally published Feb. 11.
Despite the uncertain global economy, the gaming industry is seeing remarkable growth.
Stocks of gaming companies such as Electronic Arts (EA - Get Report) and Activision Blizzard (ATVI - Get Report) have zoomed over the past few years, outperforming the S&P 500. The trend is expected to continue this year, as these companies and their peers join the vanguard of innovative companies that should "beat the bear" in 2016.
Demand for online games continues to be strong. New products and innovations, most notably the growth of virtual realty will fuel further expansion. The end effect: There will be a number of good opportunities for investors in the near future.
Below, are three promising stock opportunities and some context on the gaming industry.
The Evolution of Gaming
Detailed analysis indicates that mobile gaming is the fastest growing segment in the gaming industry and is only set to grow larger.
Looking back, mobile gaming took flight in 2007-08, prior to which gamers raided stores for games and played in consoles. Today's mobile games mean a high level of interactivity and constant updates, in a bid to keep the user hitched. That's why it pays to invest in companies that always stay ahead of the tech curve.
With $80 billion in revenues recorded in 2015, digital gaming growth is expected to hit $104 billion by the end of 2018. Exponential growth in Russia's mobile gaming industry and China's growing user base of over 115 million paying mobile gamers are key drivers of this growth.
As mobile gaming exponentially expands, game developers big and small have flooded the market. With so many players vying for the user's attention, companies are naturally stepping on each other's toes, leading to mergers and acquisitions (M&A), and ultimately, consolidation in the space. Larger cap companies are scouring the landscape for smaller, highly innovative companies to gobble up.
It isn't too late to jump on the bandwagon for investment gains, as advancements and disruptions in the space are only set to give a further impetus to gaming stocks. Here is what you need to watch out for.
Consolidation to Continue
In 2012, consolidation in the gaming industry crossed $4 billion. To put the growth since then into perspective, only the first quarter of 2014 crossed that figure, crossing over $5 billion in M&A activity.
One such recent deal occurred when SGN, the fastest growing major U.S. mobile games studio, bought independent gaming studios Fat Rascal Games and Kiwi. Other high-profile buyouts of 2015 included Activision's $5.9 billion acquisition of King Digital Entertainment (KING) , which is credited with making the blockbuster game Candy Crush.
Since 2013, GigaMedia has put in place a turnaround strategy to become leaner, sustainable and profitable. Looking for diversification and identifying potential synergies, it had even signed an agreement to acquire 70% equity interest in Strawberry Cosmetics, a global cosmetics e-commerce company in 2015. But the company had to terminate the contract due to the unfavorable global economic climate.
Over the past two years, the stock is down close to 50% at $2.89. Last November, CEO Collin Hwang increased his ownership in the company to 4.2% by purchasing more shares, because he believed that the stock was undervalued.
Now, the company's market cap has diminished to $32 million with $5.78 million in debt and a trailing price-to-earnings ratio (P/E) of mere 2.81. With close to $75 million in cash the company's enterprise value of -$36 million makes it an attractive takeover target for a bigger company with deep pockets. In this consolidating industry, an established gaming company with sophisticated strategies could very likely see GIGM as a valuable proposition.
Zynga is another company that has more cash than it needs but has seen its market cap wiped out over the last few years. While Zynga is debt free, it has total cash of $1.07 billion and would be of great value to larger players with more innovation. With shares down an alarming 55.5% over the last two years, its market cap is currently at $1.94 billion and enterprise value at $880.19 million, exposing it to takeover threats.
Even in Japan, which commands the largest share of the mobile gaming industry at $6.2 billion, ahead of China's $5.2 billion and the U.S.'s $3.1 billion, consolidation is the next phase. Budgets are expanding to build the next big "Flappy Bird," a game which earned its Vietnamese developer $50,000 a day, to appeal to a maturing market. Sales are closely dependent on smartphone penetration, and with more than 75% of the Japanese owning a smartphone, growing will not be as easy as it was once.
Virtual Reality is Getting Closer to Reality
With the official shipment date of Facebook's Oculus Rift VR set for March 28, the new face of gaming will appear. The trend is just beginning, with $600 for the Oculus Rift and $1,500 for a PC compatible with Oculus VR content, being major "costly" barriers. However, it is clear that there is immense potential in the space as pointed out in a July 2015 Business Insider report which says that VR headset shipments will grow at a 99% compound annual growth rate (CAGR) between 2015 and 2020.
Apart from the Oculus, expect to see headsets debuting from companies like Sony, HTC, and Microsoft.
What You Should Consider Buying
Let's take a look at the three best stocks in the gaming space:
Buoyed by robust sales of Star Wars Battlefront, Electronic Arts reported third quarter adjusted revenue at $1.8 billion, up 26% from a year ago but slightly below the Street estimates. For the fiscal year, EA raised its adjusted revenue outlook by $17 million to $4.52 billion. While this means conservative growth of 5%, investors might wonder if EA is worth its trailing P/E of more than 30.
However, Thomson Reuters consensus has a median target of $82 in the next 12 months, representing a more than 40% upside to the stock. A 9.2% drop over the last month, thanks to pessimistic market sentiment that wasn't the company's fault, has made the stock even more attractive. This gaming company is among the stock market's "game changers" that should outperform the broader indices this year.
After beating estimates on earnings per share (EPS) for the last four quarters, investors are hopeful that Activision will continue its winning streak in the 4Q results to be announced on Feb 11. With help from Call of Duty: Black Ops 3, the company most likely will do so. Activision has already raised its 2015 outlook.
Analysts and investors have given a thumbs up to Activision's widening portfolio and innovation and expansion efforts. Analysts have a 12-month median target of $42.5 on the stock, representing a more than 42% upside.
Muted fourth guidance and delays in the release of CSR2 and Dawn of Titans aren't exactly helping Zynga. However, its $200 million stock buyback program and cost-cutting efforts may provide some respite to investors. Even in the event that Zynga attracts an acquirer, shareholders stand to profit considering the sheer potential of the mobile gaming market.
With the rise in mobile gaming, should you be worried about the traditional gaming console industry? If sales numbers are anything to go by, Sony's PlayStation 4 and Microsoft's Xbox are not going anywhere.
PlayStation 4 sales have crossed 35 million units to become the best-selling console ever while Xbox has sold 15 million units too. With price reductions expected this year for both, expect sales, and stock prices, to receive a fillip.
Over the longer term, these companies along with HTC and Facebook are poised to gain with their entry into virtual reality.
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