Three video game publishers riding the esports wave

The growing popularity of mobile gaming, faster internet speeds, rapid advancements in virtual reality and graphics technology will continue to draw new audiences to competitive gaming.

The leading players of the industry have been quick and aggressive in cornering the lion's share of the market. They are well positioned on a long runway of growth as the market continues to expand. However, the run-up in their stock prices so far this year has wiped out their margin of safety, and investors wishing to play this market may want to wait for a meaningful pullback before hitting the buy button.

One of the biggest video game publishers,  Take-Two (TTWO) owns some of the best-known video game franchises including Grand Theft Auto (220 million units sold) NBA 2K, Civilization, Borderlands, Bioshock and XCOM.

"The firm is well positioned not only to capitalize on the success of Grand Theft Auto, but also to continue diversifying its revenue beyond its signature franchise," says a Morningstar report, noting that the gaming behemoth has evolved from being dependent on GTA "into a publisher with multiple franchises across consoles and PCs with recurring revenue streams."

The company continues to benefit from the tailwind created by the growth of the current generation of consoles and ongoing recalibration of PC gaming. "Over the past 10 years, the video game industry has undergone a number of changes, including two console generation transitions, the rise of digital downloads, widespread adoption of mobile games and the expansion of the free-to-play business model," says Morningstar equity analyst Neil Macker. The firm, he adds, is focused on engaging users beyond the initial game sale by expanding the use of multiplayer options and releasing downloadable content (DLC), thus driving greater monetization.

The company is expected to continue to invest in new intellectual property and to fund the development via sequels, says Macker who puts the stock's value at US$114, implying a price/earnings ratio of 25 times 2019 earnings, and a free cash flow yield of approximately 6%.

Pursuing newer growth avenues, Take-Two has partnered with the National Basketball Association (NBA) to create a professional esports league, based on its popular basketball series, NBA 2K. The deal, considered the biggest yet between traditional and digital sports, paved the way for similar partnerships, reinforcing the notion that esports could grow far beyond the US$1-billion-a-year market it is today.

Leading video game publisher  Activision Blizzard (ATVI) owns an impressive franchise portfolio including such blockbuster names as World of Warcraft (US$8 billion of lifetime sales) and Call of Duty, which has sold over 175 million copies across 14 titles over 12 years.

"The firm is well placed to consolidate its leading position by developing compelling new versions of its existing franchises and by introducing new experiences, such as Hearthstone and Heroes of the Storm," says a Morningstar report. The company, the report says, benefits from a tailwind of conspiring forces including the proliferation of smartphones, the resurgence of PC gaming and newer consoles.

That Activision generated strong results without the benefit of a major release in the recent quarter highlights the strength of its core franchises. Its quarterly report revealed other key areas of growth including the mobile segment, which grew 13% in the quarter as King Digital (maker of the Candy Crush game, which Activision acquired in 2016) had two games in the top 10 of U.S. app stores for the 19th quarter in row. "We expect Activision to monetize the user base at the recently acquired King Digital by inserting third-party ads in the company's mobile games," says Macker, who recently raised the stock's fair value from US$62 to US$69 to reflect the impact of esports.

As well, increased revenue from higher-margin digital sales and microtransactions boosted operating margins for the last quarter to 26.4% from 20.8% last year.

Activision consistently develops new revenue streams through innovative value-added methods. The publisher recently inked a deal with Disney's ESPN for live TV coverage of the Overwatch League, an esports league.

 Electronic Arts (EA) is the one of the largest game publishers on consoles, PC and mobile. The firm's popular franchises include Madden, FIFA, Battlefield, Mass Effect, Dragon's Age and Need for Speed. A leading player in the sports genre, the company accounts for nearly half of all sports game sales.

"The firm will consolidate its leading position by developing compelling new versions of its existing franchises and with its Star Wars license," says a Morningstar report, noting the firm will continue to benefit from the rapid advances in consoles, as well as PC and mobile gaming.

As a large publisher on mobile platforms, the company is able to continue to exploit its stable of franchises and licenses to create new games, particularly in the free-to-play space. "Its portfolio of long-running successful franchises allows the firm to monetize its intellectual property year after year by delivering content via sequels, expansion packs, and DLC, exemplified by the annual versions of Madden and FIFA," says Macker who recently upped the stock's fair value from US$103 to US$115, prompted by microtransactions growth and gross margin expansion.

Having built a dedicated user base, the company's franchises allow EA the ability to bypass retailers and push its content through direct digital channels, thus generating higher gross margins and improving returns on invested capital.

EA intensified its push around esports by striking a multiyear deal this year with Disney-owned ESPN and the NFL to broadcast the Madden NFL 18 Championship Series. This is in addition to a partnership with ESPN that Electronic Arts forged last year to broadcast the FIFA 17 Ultimate Team Championship.