The new pinball wizards transforming gaming

Video games have already come a long way from their humble origins, and they are about to progress to the next level. Smart investors should get in on the act, says Stephen Connolly.

In 1982, winning the licence to launch the video game of the Universal Pictures blockbuster ET The Extra-Terrestrial the highest-grossing film of the 1980s looked like a fantastic coup. Director Steven Spielberg was unstoppable, audiences loved the film and video games were so hot that they made Time magazine's cover in January that year, with the headline: "Video Games Are Blitzing the World". US games group Atari, then an industry giant, felt it couldn't go wrong, and bet heavily on it.

Unfortunately, time was tight, and Atari slapped ET together in a little over five weeks in order to catch the Christmas sales season. The resulting game is still considered one of the worst ever made: customers fled and sales cratered. Atari flipped from being a go-go growth business to a deep lossmaker almost overnight, and ended up literally burying hundreds of thousands of unsellable copies of the game and others in the ground.

In the film, ET the alien is finally rescued and heads home to some distant part of the universe. In the game, ET doesn't get farther than an industrial landfill somewhere in the New Mexico desert. So began one of the industry's worst slumps, triggered by a glut of terrible games and too many poorly supported, competing consoles to play them on.

A changing business model

Video games have come a long way since. Businesses are more robust, technology and graphics capabilities have advanced and games are played online and across continents. But for all the bells and whistles, the core business model was still much the same until just a few years ago: each game sold was a one-off (there were no add-ons, in-app purchases, or extra characters and content to buy), and the product was a physical item that wasn't cheap to make. Every launch was about sales volumes, which meant "blockbusters" were crucial, and sales had to build as quickly as shelves were stacked. Luck played such a big role that forecasting was tough to impossible, and the resulting volatility kept many mainstream investors away.

But this is changing. Big hits are still important, of course, and many physical copies of games are still sold. But major improvements in communications technology including faster download speeds and larger computer memories have revolutionised the way in which the industry engages with its customers, sells and delivers games, and exploits rapidly growing markets on new platforms, such as smartphones. Selling to gamers more regularly, and in different ways across lots of platforms, over the course of a core product's multi-year lifespan, should help to smooth the once-haphazard financial results of games publishers.

This in turn means more reliable forecasts and a new audience of potential investors. In short, to think of the industry as it was even just one economic cycle ago is to miss out: it has reinvented itself, creating a compelling investment opportunity. Global video-game sales are set to hit $116bn in 2017, up 11% on last year, says consultant Newzoo, which recently upgraded its forecasts sharply, due to "even stronger performance than anticipated". By 2020, sales are expected to reach $143.5bn, an annual growth of 8.2%.

A key driver is "digitisation", which is about squeezing more out of each game. The company sells the game, then offers extra features (downloadable content) online for further payment. To drive digitisation, firms need to get their customers to play for longer and return to the game more often, which in turn increases their commitment and makes it more likely that they'll pay $2 for a new weapon, $20 for a better character or $30 to change a landscape, say. These micro-transactions where one click and a credit-card number means an instant sale are now the holy grail of the gaming business.

Of course, it's a fine line between selling experience-enhancing extras and ripping people off. Electronic Arts (EA) recently found this to its cost: early sales of its new Star Wars Battlefront II game appeared to soften after gamers criticised the publisher for offering too little in the initial game and expecting them to pay too much for more features. An apparently chastened EA temporarily pulled micro-transactions before the official launch. Yet overall, it works.

Between 2014 and 2016, Activision Blizzard's (ATVI) digital revenue rose from 46% of sales to 79%. EA's rose from 45% to 55%, and Take-Two Interactive's from 11% to 39%. Indeed, one day all sales are likely to be digital beyond technology constraints for the hardware, there is little to prevent this. That's good news for investors digital makes costs plummet and margins soar. Activision Blizzard's operating margins for game downloads and add-ons, for example, are over 60%, as opposed to 20% on physical games console sales. That's a lot of profit to hit the bottom line.

The rise of the smartphone

Established publishers are also exploiting their intellectual property and expertise to secure a bigger share of the world's largest, fastest-growing games platform the smartphone. Barclays Research sees mobile-gaming revenue rising from $32bn last year to $49bn in 2020, and while different analysts offer different figures, they all have one thing in common: sales predictions for mobile gaming keep being revised higher. With a billion devices worldwide, and ten mobile gamers for every console gamer, the smartphone represents a huge opportunity.

China in particular and Asia generally make the most mobile gaming revenue, and performance is beating expectations, with Chinese groups Tencent and NetEase leading the way. Yet for Western games publishers, mobile revenue represents only 13% of sales, whereas globally, mobile accounts for 40% and is on its way to 50%. So this is a huge potential growth area for them ATVI in particular now has a decent mobile presence after buying King, the developers of Candy Crush, a multi-billion-dollar mobile game. Meanwhile, mobile users in both Asia and the US show great interest in the live streaming of eSports games (more on that in a moment).

Mobile provides opportunities for companies to exploit existing franchises that are already popular on other platforms (for example, ATVI is launching its popular Call of Duty military-game franchise on mobile). The mobile-games market is also highly fragmented, with lots of games from small publishers, which gives dominant publishers in other formats the opportunity to secure meaningful market share via acquisition and consolidation.

Video games as a spectator sport

Another major part of the video-gaming theme and one drawing growing interest across the globe is eSports, the buzzword for competitive gaming. Interest is strong and growing from the US to China, with popular games, live events and tournaments supported wholeheartedly by the industry, which realises only too well the rewards on offer if eSports can garner even a fraction of the popularity of "real" sports.

Fans already spend hundreds of millions of hours each year watching tournaments and events via streaming services such as Twitch.TV, Steam and MLG.TV, with Facebook and Twitter in on the act too (if you ever grew up watching over the shoulder of the local pinball wizard or Pac-Man champ at your nearest arcade, then you have some idea of the appeal of these services). Twitch.TV, which is largely dedicated to video gaming, was bought for $970m in 2014 by Amazon, its third video-game streaming acquisition. Marketing demographics are attractive (ie, young), with the industry's revenue so far mostly coming from advertising and sponsorship.

A lot rests on eSports replicating the traditional sports business model event and online ticket sales, advertising, media rights, sponsorship deals and retail merchandising (as well as game sales and micro-transactions, of course). It's ambitious but it seems far from fanciful when you watch an eSports tournament being streamed live from the Staples Center in Los Angeles: bright lights, loud music and general razzmatazz surround the paid, professional league players who compete on stage in front of crowds of cheering fans, with eye-catching multi-million-dollar cash prizes (nearly $100m-worth in 2016) that show no signs of peaking as yet.

Having said that, with a market value of $750m, eSports is still niche nowhere near the $120bn-$150bn (depending on who you ask) estimated size of the traditional global sports market. But Newzoo, an industry analyst, reckons that revenues for the games industry overall could overtake global sports within the next three or four years. If eSports grows quickly as a part of that, then optimism for the niche doesn't seem misplaced. Newzoo sees eSports as moving into phase two of its development, before maturing into a viable business segment by 2020. It reckons enthusiasts currently number around 191 million. This is set to reach 286 million by 2020, which could drive sales of as much as $2.4bn in the best case, or $1.5bn in the base scenario.

Spectators certainly seem keen so the evolution of the niche depends very much on where publishers try to take it. ATVI is perhaps the main one to watch here. The company is investing in homegrown tournaments its team strategy game Overwatch boasts city-based professional teams and paid players as far apart as London, Los Angeles and Shanghai in its league. It's also behind other popular multi-player games such as card game Hearthstone and science-fiction strategy game StarCraft. Interestingly, ATVI recently announced that the lead sponsors of the Overwatch league are household tech giants Intel and HP. It has even built its own Blizzard Arena in Los Angeles as a venue. Given this commitment to the business, it seems quite possible that the industry could grow a lot faster than expected, which would be good news for those who invest now.

Earlier this year, US venture capitalists Kleiner Perkins calculated that out of the daily number of minutes spent on digital platforms, video gamers on consoles came in top at 51 minutes, overtaking the time spent by the typical Facebook user. In other words, games publishers are clearly keeping their customers happy.

We are not at the beginning of the transformation of the games business but nor are we at the end. A lot of progress still lies ahead. As the industry charges beyond the $100bn-a-year sales mark, the trends remain positive and forecasts are being raised. Given the fundamental nature of the changes, the sector's stocks are well worth tucking away for the long run. We look at some of the most promising options in the box below.

The six stocks to buy now

Despite a strong year, all the companies mentioned above continue to have sound long-term growth prospects. Activision Blizzard (Nasdaq: ATVI) is the largest pure US games company, with a solid portfolio of $1bn-plus titles. It's enjoyed success in China and the Far East, has a decent mobile presence and is an enthusiastic driver of eSports. Take-Two Interactive (Nasdaq: TTWO) has popular franchises, but a narrower overall portfolio than ATVI's. It's a good play on the digitisation/margin expansion theme. Analysts expect high long-term annual earnings growth and have an average $127 price target, roughly 20% above current levels. China's Tencent (Hong Kong: 700) has the largest revenue from games in the world, and has a good development record. It is well placed to gain from expansion in China, while also pushing globally. The shares have done very well, but profits are rising and it can go on beating expectations.

For those who prefer mid-sized businesses and a bit more risk, look at Zynga (Nasdaq: ZNGA), a credible turnaround play with a diverse mobile portfolio. Floated in 2011 at $10 a share, the price fell as low as $2 as mistakes were made and the company lost its way. Now about $4 and with new management from Electronic Arts onboard, its latest results were the best in years, and the outlook is good. Zynga has cut costs, made solid acquisitions and has new launches in the pipeline. Not all investors are sold on the turnaround, and memories of the flotation flop linger, but profits are back, forecasts are upbeat and sentiment is warming.

In the UK, the adventurous should check out Frontier Developments (Aim: FDEV), which was founded in the mid-1990s. Frontier has developed successful games and has a major new launch due. At first glance, the shares aren't cheap. However, it raised £18m this year from global giant Tencent, which now owns 9% of the company and has joined the board; founder, chief executive and industry veteran David Braben still retains 37%. It's been performing well and some directors have been buyers of the shares even at current levels. Forecasts for earnings growth are punchy, while Tencent should boost its access to new markets and also brings top-class expertise, which could have a major positive impact.

Finally, for those who like taking risks, there's Gfinity (Aim: GFIN), which hosts its own eSports competitions and has deals to organise events with leading names such as Formula 1 and Microsoft. Although it's loss-making, it hasn't struggled so far to raise funds for growth, and profits are expected in 2019. Buying a small, young company in a fast-evolving sector is a leap of faith, and where Gfinity will eventually fit in is hard to say. It's an early mover in an exciting segment and could well carve out a niche that pays off but at this stage it's only for the brave.

Stephen Connolly writes on finance and business, and is a retained investment consultant to various high net-worth investors (sc@plainmoney.co.uk).