The Secret Champion of Video Gaming Stocks

What's the most popular video game in the world? You might think it's Angry Birds, with over a billion downloads since it was first released. That makes it the most widely distributed game of all time, but it rarely holds players' attentions for long. Maybe it's Activision Blizzard's (NAS: ATVI) World of Warcraft, which recently bounced back over 10 million subscribers, or Activision's Call of Duty franchise, which claimed 40 million monthly players across all games earlier this year.

You're close, but not quite. A few days ago, Riot Games, the developers of League of Legends (or LoL) released statistics that blow Activision's best out of the water. The competitive team-based PC game most non-gamers have never heard of claims 12 million daily players, of which up to 3 million may be online at the same time. Compare that to Modern Warfare 3, the latest Call of Duty game, which had 3.3 million daily users, with 1.4 million concurrently active, at the peak of its popularity.

Legendary success
Every month, LoL players invest over a billion cumulative hours into the game, which makes it, in Riot Games' assessment, the most-played video game in the world. Not bad for a game that's only been active for three years, which began as an outgrowth of a popular multiplayer map for Blizzard's Warcraft III. In a way, Warcraft III could be responsible for creating both Activision Blizzard's biggest cash cow and its biggest threat. Earlier this month, over 7,000 LoL fans gathered in Los Angeles for the game's world championships, an event not unlike the StarCraft tournaments in game-crazy South Korea, to see a Taiwanese team take home a $1 million grand prize. Blizzard, on the other hand, canceled this year's BlizzCon, despite its potential to stage similarly intense StarCraft tournaments.

Riot Games was bought by Chinese online giant Tencent (NASDAQOTH: TCEHY.PK) last year for $400 million. The Chinese company earned just over half its $1.7 billion in second-quarter revenue from its games division, with much of its growth coming outside of China. LoL proves that the freemium business model can work if it supports the right type of game. Players aren't pressured to buy anything to speed up their experience, which usually becomes frenetic anyway as players progress through a typical half-hour game. Still, the unique powers of a new character (which are regularly added to the game), or the bonus of additional skill points, are compelling propositions for competitive players.

Where the model breaks down
Premium sales for otherwise free games don't always work as a long-term business strategy. Zynga's (NAS: ZNGA) an ideal case study here. It continues to revise key estimates lower. Its games don't capture gamers for long, resulting in rapidly dwindling player counts from a very early peak. Executive after executive has already jumped ship. Why is that?

Maybe it's because, when it comes down to it, Zynga's products are more chores than games. Kirk Hamilton's review of FarmVille 2 (which now has over 50 million monthly active users and nearly 9 million daily players since launching a month and a half ago) on Kotaku had a lot of great descriptions of what it feels like to play a Zynga game. They all boil down best into this sentence: "Now that I've got everything unlocked, the game has lost any sense of discovery and become a grind of busywork." Zynga's business model has little room for fun, as evidenced by VP Tim LeTourneau's comments in another Kotaku article. Here's some snippets:

• "[It's] not that you win FarmVille, but that you feel like you're making progress."

• "I'd say first and foremost, in most social games, what you're really combatting is time."

• "It's not about somebody pushing the button. It's about somebody pushing the button again."

Push the button again! "A grind of busywork" is the perfect expression of what it feels like to play a Zynga game, and the only ways to push past that grind are to harass your Facebook friends or buy in-game things. Its games exemplify the "Skinner box" design standard of many low-end freemium games, both on Facebook (NAS: FB) and on smartphones. Instead of creating an engaging play experience, these games "play on deep-rooted psychological impulses to make money from their audiences," in the words of an Atlantic article published shortly after Zynga went public.

A Skinner box, by the way, is simply a psychological testing tool that examined addiction in rats. Push the button, get a food pellet. Push the button again. And so on.

Some will fall into this button-pushing cycle and will add to Zynga's coffers, but the strategy has diminishing returns as the same exact format gets recycled into newer titles and gamers become familiar (and bored) with it. According to a Playnomics social-gaming engagement study, 95% of social gamers who joined a new game at the beginning of this year's third quarter were gone by the end of it, and 85% of social gamers got bored after the very first day.

Franchise potential
Does this mean LoL will outlast Zynga? It may, and it may very well not. All games get old, even World of Warcraft. That's why there are sequels and expansion packs (or new characters, in LoL's case). One of the reasons why Activision's withstood the steep drops hitting most of its American video game peers is that it's been remarkably successful at maintaining interest in its sequels and expansions. However, I've pointed out several times that interest in Call of Duty seems to be in decline, and a fumbling Diablo III launch resulted in big player losses after a huge number of early sales.

Public perception can quickly turn against a franchise that wears out its welcome. Activision knows this, as it was forced to retire the Guitar Hero series after a flood of underwhelming sequels and spinoffs caused franchise sales to collapse.

What other gaming company can still wring growth out of its biggest properties? Electronic Arts (NAS: EA) has several notable franchises, but over the past few years none have been enough to take its finances to the next level. Take-Two Interactive (NAS: TTWO) is all about Grand Theft Auto, but the latest installment has no official release date, leaving investors waiting for the long development cycle to wrap up.

Tomorrow's entertainment empire?
Let's consider Ubisoft (NASDAQOTH: UBSFF.DL.P), the French developer behind the Assassin's Creed series and Prince of Persia. Its ADR shares, at a 16.9 P/E, are right in line with Activision's current valuation. It's had remarkable success with Assassin's Creed, which has sold 39 million copies across all titles so far , a number which will soon increase dramatically with the release of the hotly anticipated Assassin's Creed III sequel at the end of the month. In comparison, Prince of Persia, which was turned into $335 million global blockbuster in 2010, has only sold 12.5 million cumulative copies.

The lessons of the Prince of Persia movie (a disappointment despite its take) led Ubisoft to form its own film studio last year, primarily to develop an Assassin's Creed film franchise. Blizzard properties World of Warcraft and Starcraft have been stuck in hypothetical-movie development limbo for years, and the track record of video game movies is spotty at best. However, Ubisoft is perhaps the best-positioned game studio in terms of making the transition to a Disney-style (NYS: DIS) strategy of taking beloved characters from a smaller medium and blowing them up on the big screen for blockbuster returns.

The Prince of Persia film already ranks as the highest-grossing video game adaptation of all time, and the Assassin's Creed series has both a more globally recognized game universe and a storyline that lends itself very well to a film franchise. With Prometheus and X-Men: First Class star Michael Fassbender already attached to a tightly controlled Assassin's Creed film project, Ubisoft has a lot riding on the success of a single franchise -- but it's also releasing a third Far Cry game at the end of the year, which could establish a second path for film success, as that series is also a more story-driven game than most.

Game over, press start to continue
Investing in game companies rarely works out very well for long-term investors. However, there are rare developers here and there that exist at the intersection of attractive valuations and tremendous franchise growth potential. Ubisoft comes closest to that, as League of Legends is already so massive that there may not be much growth left. Its road from game studio to entertainment powerhouse won't be easy, but empires have been built on the back of a single franchise before. Disney, after all, started with a black-and-white cartoon mouse.

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The article The Secret Champion of Video Gaming Stocks originally appeared on Fool.com.

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 Facebook. The Fool has bought calls on Facebook. The Fool owns shares of and has written calls on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Activision Blizzard, Facebook, Walt Disney, and Take-Two Interactive Software. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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