Video Games sector: Where to find winning stocks

Opportunities in the games sector remain vast, and these stocks offer exposure to well-run, innovative businesses that will benefit from continuing digital growth, writes Edison Investment Research.

This content is provided by Edison Investment Research, an investment research, investor relations and consulting firm. Edison Investment Research is a third-party supplier and not part of interactive investor. It is provided for information only and does not constitute a personal recommendation.

Material produced by Edison Investment Research should be considered a marketing communication, and is not independent research.  

Frictionless Borders

The disruption from digital distribution, Games as a Service (GaaS) and the implementation of more capital-light recurring monetisation models have driven the growth of the European games sector in recent years. 

Despite this historic growth, the opportunities in the games sector remain vast with investment in next-generation consoles, streaming, subscription, eSports and VR/AR driving future growth. Increasingly, the games sector is seen to be challenging Big Media (the likes of Netflix (NASDAQ:NFLX) and Disney (NYSE:DIS) etc.) for user screen-time.

Given the levels of external investment we have seen over the last 12 months as the tech majors position themselves with a channel to market, we believe IP owners are set to benefit disproportionately. We therefore believe that IP ownership should be valued at a premium and that the small- and mid-cap European games sector offers exposure to well-run, innovative businesses that will benefit from continuing digital growth.

Opportunity in fragmentation

As a fragmented market, with niche market leaders and few specialist investors, valuation disparities are more likely in Europe than in the US, which is dominated by a few global publishers that are closely analysed.

Relatively small market capitalisations, restricted free float, limited liquidity, language barriers, differing approaches to transparency and corporate governance are all valid concerns, but nevertheless the sector offers an attractive proposition in the search for alpha.

IP strongly preferred

Given the levels of external investment we have seen over the last 12 months in eg streaming, subscription models, digital distribution, VR, and eSports as the tech majors position themselves with a channel to market, we believe IP owners are set to benefit disproportionately.

To justify their investment, there will be an increasing need for the tech majors to differentiate their platform, with IP ownership or exclusivity (potentially by way of M&A) an obvious differentiator.

We therefore believe that IP ownership should be valued at a premium and anticipate continued strong share price growth and potentially further consolidation of leading IP owners.

Global market

Market analyst, Newzoo, estimates that more than 2.2 billion gamers will generate $152 billion of revenues in 2019, larger than the film ($140 billion) or television ($50 billion) industries, with a compound annual growth rate (CAGR) of 9% forecast to 2022, building to a total market size of over $196 billion. Mobile offers double-digit revenue CAGR, while PC and console gaming offer single-digit growth.

Although the games market is more than three times the value of global box office movie receipts and seven times the size of the recorded music industry, it still has a way to go to catch-up with the Pay TV market, which ABI research predicts to reach $295 billion by 2022. Broadcast media firms eg Netflix are becoming increasingly aware of the battle for users' screen time.

The European games sector constitutes 30+ listed companies (a larger investable universe than broadcast media) with a median market cap of US$200-300 million. Western markets are expected to represent around 49% of global revenues and 45% of total mobile revenues in 2019.

Let the streaming battle commence

2018/9 has been strategically active, with a raft of technology and investment announcements likely to support industry growth for the foreseeable future.

Announcements have included Google's (NASDAQ:GOOGL) Stadia streaming service and Apple's (NASDAQ:AAPL) Arcade subscription service for premium mobile games. Off the back of the huge user base of Fortnite, Epic announced its challenge to Steam, the dominant PC distribution platform, offering developers an 80% revenue share against Steam 70%.

Other platforms including itch.io then offered 88% revenue share. Not only did Microsoft (NASDAQ:MSFT) confirm the release date of its next-generation console, Project Scarlett (whereas Sony (NYSE:SNE) leaked a trickle of information on the PS5), Microsoft also released details of its streaming service, Project xCloud, and then the surprise of a strategic collaboration with Sony to address this strategically critical and lucrative part of the market. 

Indeed, streaming investment has been a major theme of 2019: Electronic Arts (NASDAQ:EA) (FIFA, Madden, Battlefields, Apex Legends) announced Project Atlas; Bethesda, the US publisher behind 'The Elder Scrolls' and 'Fallout', announced Orion, software to improve streaming performance and reduce latency; and Ubisoft (EURONEXT:UBI), responsible for 'Assassin's Creed' and 'Far Cry', announced its own streaming platform, Uplay.

Not all plain sailing

Despite the positive outlook for the sector, there are, as always, potential risks that investors need to consider. These include legacy business models, being left increasingly exposed as the sector digitizes including the risk of the narrow "hit or miss" development model.

The second half of 2018 saw a general pullback in technology valuations as investors grew increasingly nervous of the continuing growth story underpinning sector valuations. Games stocks were affected by this with EA, Activision Blizzard (NASDAQ:ATVI) and Take-Two (NASDAQ:TTWO) all back at share price levels seen in 2017. With a subdued near-term outlook, the US stocks have yet to recover lost ground.

In Europe, companies were later to start digitisation and, as such, have further to travel with eg Ubisoft recognising 69% of 2019 revenues as digital, including 32% as recurring investment from players. From an investment perspective, this means that European games companies still have further value to extract from the digital journey.

Investment Opportunities

That said there are a wealth of investment opportunities in the European gaming sector. The first of these is the increasing importance of Intellectual Property (IP). In order for tech majors to justify their recent investments in streaming, digital distribution, subscription models, VR and eSports in the last year, they must differentiate their platform. IP ownership or exclusivity - perhaps through mergers and acquisitions (M&A) - will be an obvious differentiator.

eSports will also have a significant impact on future growth, providing a further way to build a community around successful titles, streamed live to a global audience via Twitch and YouTube.

Mobile gaming has been successful at capturing the casual audience and has the potential for huge scale and penetration.

New business models may make sustainable revenues easier to achieve. Finally, governments remain supportive across Europe, keen to encourage employment in the creative industries, with tax reliefs for the games and broader creative industries now either in place or under consideration across much of Europe.

These help level the playing field and sustain a creative industry in high-cost jurisdictions.

Open-world perspective

When looking where to invest, it may be surprising to hear that there is specialisation in different jurisdictions.

The UK market, for example, is biased towards PC/console gaming, based around AA and AAA game development, but public market mobile and Massive Multiplayer Online (MMO) game exposure is minimal. France's global publisher Ubisoft lacks the scale of EA and Activision Blizzard, nut has been a creative hotbed.

Mid-market publishers Bigben (EURONEXT:BIG) and Focus Home (EURONEXT:ALFOC) are using the digital transition to expand their IP portfolio, whilst in Italy, digital transition has allowed Digital Bros (MTA:DIB) to expand from a regional business to a global self-publisher of premium and Free to Play (FTP) titles.

The Nordics have benefited from a population which embraces new technology. Historically, this has led to the emergence of mobile phone companies Nokia and Ericsson, and this broad-based mobile expertise has in turn led to an ecosystem open to both mobile and PC and console development - with global successes such as Angry Birds and Clash of Clans as well as Eve Online.

The DACH region - Germany, Austria, Switzerland, became a market-leader in browser-based PC games but this market segment is now in decline due to the rise of mobile. Despite Germany being the world's fifth largest games market, there are no quoted games developers in the region.

Eastern Europe was slow to develop as a games region, partly due to its history of piracy, with publishers unwilling to sell physical PC or console games into the region. However, in an era of digital distribution and data-led market testing, this skillset and mindset may in turn have contributed to a technology savvy ecosystem where the region's vast technology skills have allowed it to become one of the fastest-growing games markets in the world.

Poland has emerged as one of the largest European games markets with four substantial quoted companies as well as a number of smaller quoted businesses.

Conclusion: Can you beat the game?

Companies that we believe will do well are digital leaders with world-class IP, usually with a clear sector focus and a focus on delivering games to attract and retain a growing player community.

By considering their domestic market, investors are unnecessarily limiting their investable universe. We believe that a more rewarding strategy would be to take a holistic perspective and select companies on a pan-European basis from a broader pool of businesses, identifying the characteristics and business models that the investor believes will succeed over the next decade, before selecting the best companies.

This article is based on Edison Investment Research's full report, 'European Video Games Frictionless Borders' published August 2019.

Edison Investment Research is a third-party supplier and not part of interactive investor. Neither Edison or interactive investor will be responsible for any losses that may be incurred as a result of a trading idea. 

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Important Information by Edison 

This report has been prepared and issued by Edison. Edison Investment Research’s business model is to charge the issuer a standard fee of £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. Edison never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2019 Edison Investment Research Limited (Edison). All rights reserved FTSE International Limited (“FTSE”) © FTSE 2019. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under license. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.