Recent gains aside, game makers have become far too reliant on existing commercially successful franchises to drive profit and prop up other lines of business. This has led to an all-out effort create additional game franchises. Such efforts are loaded with risk, increasingly costly and have the potential to exhaust hard earned cash from successful franchises and dragging down the valuations of video game production companies for years to come.
The appeal of building a successful franchise is obvious. Consider Madden, Electronic Arts' hugely popular and best-selling football series that will release its 25th edition later this summer to coincide with the opening of the NFL's upcoming season. Each year, EA makes improvements to the game-play settings, updates the rosters and refines the playbooks to reflect the makeup of each NFL team, but for the most part Madden utilizes the same code and graphics over and over. That enables production at a fraction of the cost required to develop a new franchise (Though expensive licensing agreements with the NFL Players Association have eaten into the game's profits in recent years). A successful franchise is a financial gift that keeps on giving to any video game production enterprise.
For every Madden there are hundreds of video game projects that flop, and at great cost to the production companies, ala 38 Studios. The upshot for the industry is that you have very few hits funding bloated and largely unimaginative management teams that continually churn out a series of highly unprofitable and unsuccessful ventures.
In many ways, it mirrors Hollywood's approach to movies: Invest lavishly in one project and hope it will yield a hit that will generate enough income to cover for other missteps. And as with the video game industry, if the large enterprise fails, the entire company suffers. It almost goes without saying that – as with the old school Hollywood film studios – it's increasingly an inadequate business model.
With this in mind, let's consider how some of the major players in the video game industry today measure up:
- Activision Blizzard– Activision has been buoyed in recent years by Call of Duty, a war-simulation series that has sold over 100 million copies worldwide. Call of Duty's highly anticipated tenth installment will be in stores in November, just in time for the Christmas shopping season. Considering that Call of Duty: Black Ops grossed over $500 million in the United States within 24 hours of its release Activision appears to be in an enviable spot moving forward. Still, the company's fortunes, in many ways, are tied to this franchise, and should it become stale or disappoint in stores it could spell doom for Activision.
- Electronic Arts Inc– Though Madden has been a reliable money maker for the company for more than two decades in the United States, the best-selling sports franchise of all-time is actually another EA offering, FIFA, a soccer series that enjoys strong global support. But like Madden, FIFA is becoming more costly to produce due to exclusive licensing contracts with various soccer leagues. While the company also has high hopes for Battlefield 4, which is set for an October release, it does not change the fact that EA is spending far too much to protect their franchises. Overall, expenses remain out of line with their revenue, hurting profits.
- Microsoft– Microsoft has sold over 78 million Xbox 360 game consoles since 2005. With the much-anticipated release of its predecessor Xbox One set for November, the company is optimistic about its future gaming revenues. The problem is that while Microsoft is a pretty strong and growing player in the gaming industry, the rest of the company continues to struggle, which drags down any attempt to play Microsoft from a purely video game industry standpoint. The Surface tablet was a flop, Windows 8 was not well received and its foray into the smartphone market has been mixed at best – all of which is on top of a continued drop in PC sales. An investment solely in Xbox would be a good bet. Unfortunately, that's not possible, and because the rest of Microsoft's parts are fraught with problems it is ultimately an unattractive company.
- Sony– Sony's stock has performed well this year, but it is confronted many of the same issues currently plaguing Microsoft. Sony's gaming console, the Playstation 4, is expected to launch sometime in the fourth quarter and much like the Xbox One it will likely be a huge hit. Yet, it's improbable that a big hit in the video game industry could offset the score of other problems hovering over the parent company, including lackluster sales of flat screens and other electronics, as well as poor management.
Each one of the above companies has its share of pros and cons. While Microsoft and Sony both have thriving entertainment divisions that continue to produce innovative offerings, each is shackled to larger parent companies that continue to take significant losses on other products and services. Meanwhile, Activision and EA have succeeded in delivering entertaining game franchises, but they are increasingly running the risk of being too reliant on them.
Based on all of this, we feel there is only one video game company that provides attractive, long-term upside opportunity in the markets today:
GameStop– GameStop's stock has skyrocketed over the last year despite plummeting video game sales, which are down more than 15% from last year. GameStop is the top retailer of video games with over 3,800 stores. The company stands to greatly benefit from the release later this year of the Xbox One and Playstation 4. New product lines should drive increased revenue and jumpstart the moribund video game market. Also, the company has been shareholder friendly over the years, paying out 100 percent of their cash flow in dividends or stock buybacks. GameStop will greatly benefit from the new consoles and games driving customers back into their stores. Expect lines out the door this holiday season.
Equity investors – my friend included – need to remember that it is very important to carefully consider companies individually versus making decisions based on a broader view of a particular sector.
Often, once you pull back additional layers you are likely to find things that are surprising. Despite appearances, the video game industry is not as attractive as it seems, with one possible exception. Otherwise, it's not all fun and games for investors.
Ross Gerber is CEO and president of Santa Monica, Calif. based Gerber Kawasaki, an independent investment advisory and wealth management firm with approximately $200 million in assets under advisement. Gerber Kawasaki clients and employees may own positions in various companies mentioned in the article.