Don't Play Games With Your Portfolio

Video games are changing the world. Generations that have grown up playing games have developed a culture that's a seismic shift from earlier times, with its own language, thought patterns, and behavior. But that hasn't necessarily led to the jingly, valuable kind of change investors crave. Even Activision Blizzard (NAS: ATVI) , video gaming's 800-pound Tauren (the large cow-like race in World of Warcraft), has been a bit disappointing following its post-merger pop. Can investors expect long-term gains in this hotly contested industry? Perhaps not, for a variety of reasons.

Digital businesses with analog business models
Despite all the innovations in gaming software and hardware -- from virtual-reality goggles to the Kinect -- modern game developers live and die by content. In that respect, they're no different from the film industry, which is dominated by a few large studios and which maintains relatively steady revenues by offering broadly diverse content for many different tastes. In either case, a company is only as good as its next hit. If big releases don't catch the public's interest, it's a huge setback.

There's one critical difference, amplified by the mobile shift toward simplistic games: Scale doesn't really matter. It used to, and for consoles it often still does, but a tiny two-man operation can reap windfalls if it designs a great mobile game. In that respect, game developers present similarities to the biotech industry, which has a few major players and a number of smaller companies whose stock movements are dependent on binary events. One hit game can change everything, but fickle gamers can just as soon make a company yesterday's news.

Making the connections
Activision and Electronic Arts (NAS: EA) , as the two biggest game publishers (outside of the console producers themselves), most closely resemble the large studios. Zynga (NAS: ZNGA) , as another large-scale game developer, also fits in this category, though its business model has some differences that I'll explain a bit further down. And how have those studios performed?


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Keep in mind that these companies still have far more diversified businesses than our large-scale gaming standard-bearers. There's no WoW theme park, and you can't buy toys (at least not that I know of) based on The Sims or FarmVille.

Too big to succeed
Ubiquity can be as much a drawback as it is an asset over the long term. It's not easy to replace millions of subscribers, but Activision Blizzard will have to find a way to do that as World of Warcraft ages and suffers further subscriber losses. Think the upcoming release of Diablo will make up for further declines? Think again. Starcraft II's release in July 2010 doubled the company's PC segment revenues, but that segment only accounted for 7% of total sales. Starcraft II sold 4.5 million copies that year. The WoW segment (it gets broken out independently) made $1,320 million, or 28% of total company revenue.

Analysts at Cowen & Company project that five million copies of Diablo III will sell in its first year, so the impact may be similar. To put things in perspective, last year Activision Blizzard's entire PC segment made about as much as the company generates from 2 million standard WoW subscriptions over the course of a year. Two million, incidentally, is about the number of subscribers no longer playing from WoW's peak in late 2010.

The rise of EA's Star Wars MMO now closely parallels WoW's decline, as the former game reported 1.7 million active subscribers in March, the "vast majority" of whom are now past their free trial and thus paying to play. The problem with switching your loyalties is that EA's got a much rockier history of profitability. There's also no guarantee those 1.7 million will hang around -- WoW's last "big threat," Aion, peaked within months of its 2009 launch and has shed subscribers since.

Keeping players interested is much more challenging for Zynga since its games are free to play, but aimed at hooking "whales," which is a nice euphemism for people with far more money than common sense. The company's combined user base has been flat for a year, and thanks to my Foolish colleague Evan Niu's excellent graphs, it's easy to see that this strategy is producing rapidly diminishing returns.

Zynga, like Activision and EA, suffers a problem of scale. When 250 million users are playing your games, you're not likely to reach too many more. The MMO makers, like their film-industry counterparts, need blockbusters just to keep moving forward. One tactical misstep can undo years of progress.

Glorified gambling
Let's get back to the smaller gaming stocks for a second. There aren't many. Gluu Mobile (NAS: GLUU) and Perfect World (NAS: PWRD) are two of only three companies whose market caps are worth less than a billion. That's an opportunity, but it's also a gamble. With Gluu, you have to hope that its next game will be a blockbuster, since the incremental approach hasn't had much effect on either the top or bottom line. Perfect World is even trickier, as its games are China-centric. The American news media will let you know when there's a new hit game in town, but will you be able to find out if something goes supernova in Shanghai?

Investing in smaller game developers is very much a leap of faith. At least with biotech companies, there's usually advance warning of what might happen. No one can predict where the next big hit will come from, and with freemium games, there's little assurance that popularity will translate to profitability. And when it does come along, odds are the big hit will be made by a non-public company! How frustrating.

What's an investor to do?
The games industry has always been a source of intense competition, and although Activision is the top dog now, there's no indication its future product slate can do much more than make up for diminishing WoW returns. Most other game companies are a roll of the dice. Depending on your time horizon, game publishers can be highly worthwhile investments -- but remember that every company's only as good as its next hit.

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At the time thisarticle was published Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights. The Motley Fool owns shares of Activision Blizzard. The Fool owns shares of and has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Activision Blizzard. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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