Could investing in the video games sector be a recession-resistant play that reaps rewards?

It’s no secret that the video games sector has been growing quickly in value for a number of years now. There are a number of factors behind the growth. The statistics company Statista forecasts the international value of the video games sector to grow from an estimated $208.52 billion this year to $304.64 billion by 2027. That’s total growth of 46% and represents a forecast average CAGR of over 9% over the next five years.

Source: Statista

The various business models in the video gaming sector

There are different ways to take on investment exposure to the video gaming sector as not all companies in the space make their money the same way.

The most obvious is an investment in the biggest games publishers such as:

• Activision Blizzard (currently in the process of being acquired by Microsoft subject to regulatory approval).
• Bandai Namco (the Japanese games publisher behind titles including Super Smash Bros).
• Electron Arts (titles include the popular FIFA franchise, Battlefield, The Sims and Star Wars franchise)
• Take-Two Interactive (titles include Grand Theft Auto, Red Dead Redemption, Borderlands).
• Tencent (Chinese gaming and technology giant, titles include PUBG Mobile, Honor of Kings, League of Legends).

There are also hundreds of smaller games publishers, including Team17, the AIM-listed publisher behind Worms. However, while the spate of acquisitions in the industry could see an investment in a smaller publisher pay off if it’s bought up by one of the bigger fish, the chances are it would be a hit-or-miss approach. The lion’s share of the money in video games publishing is also gobbled up by larger publishers.

Research conducted by Joost van Dreunen of the New York University Stern School of Business found that the top ten titles in each video gaming genre (eg. Battle Royale shoot-em-ups, strategy games, sports simulators etc.) accounted for around 90% of revenues generated. FIFA 18, for example, made $723 million, which represented 28% of consumer spending on sports games. The $190 million generated by Super Smash Bros was 57% of the income made by the top-ten titles in the fighting genre.

As an investor with a mid to low risk profile, that means the bigger games publishers with a history of generating steady, growing revenues year-on-year is probably the pool you want to fish in. Developing video games is a capital-intensive process and there is a gap between putting the money in and realising a return on investment.

That means smaller games developers and publishers with fewer titles can often have revenue boom and bust cycles that coincide with the release and tapering off in popularity of successful games. These cashflow cycles are smoother for larger companies that own several successful titles or franchises due to more regular releases and the spread of capital risk between them.

There are other companies like Microsoft, Sony and Nintendo that make money from the video gaming sector in a more diverse and diluted way but on a bigger scale. These 3 companies also produce the gaming console hardware, the Xbox, PlayStation and Switch respectively, that games are played on.

They sell the actual consoles, specialist computers designed specifically for gaming, at a loss and make their profits by taking a cut from all the games that run on them sold. They are also all publishers themselves with Microsoft owning titles and franchises including Minecraft, Halo and Gears of War among others. Sony’s stable of titles includes the Spiderman games franchise, the Grand Turismo franchise and The Last of Us and Nintendo’s Super Mario Bros, Pokemon, DonkeyKong and The Legend of Zelda.

Microsoft has publically stated it sees the future as console-free with games streamed to any device and the computing capacity needed taking place in the cloud and a subscription business model comparable to Netflix. That belief is behind the tech giant’s move to buy Activision Blizzard and also why it is having a hard time convincing regulators to allow it to.

Other companies provide products and services to the gaming industry such as game engines that developers use to create the 3D worlds their games are set in. The Unreal Engine developed and owned by Epic Games, which is in turn owned by Tencent, is one of the most popular, as is the Unity engine owned by NYSE-listed Unity Software.

Dublin-based and AIM-listed Keywords Studios provides services such as localisation, QA testing and marketing to 23 of the top 25 games publishers by revenue and all of the top-ten mobile games publishers.

How recession-resistant is the video games sector?

How resistant a sector is expected to prove to an inflationary environment and now expected global recession is a factor investors should consider when diversifying a portfolio in any new direction.

Of course, there is an argument that investors with a long term investment horizon do not have to concern themselves too deeply with short term economic conditions if convinced about the overall value proposition of an asset. However, there is also a convincing case to hold off on taking positions in assets that could have a challenging year or two ahead while consumer spending is constrained.

Studies have shown that returns have historically been better when a stock is acquired within 6 months of a new bull market starting compared to buying it during a bear market. That means there needn’t be any rush for investors to “buy the dip”.

This also means that there is a case to focus investments made during a bear market on assets that will perform well amid the storm. Do video game stocks fall into that category? Opinions are mixed despite the fact the sector faired very well during the last recession in 2008. While banks were being rescued by huge government bailouts or collapsing alongside the housing market, computer games and consoles were going strong.

However, there are a number of new factors at the onset of the recession that is expected to grip most developed economies in the coming months that lead some analysts to believe the videogaming sector will not get off as lightly this time.

Consumers typically cut back their discretionary spending during a recession and video games are not immune to that. However, the hours of entertainment that a video game can provide over many months often means the £40 to £70 a popular game for a PC or console typically costs means they tend to be seen as very good value. That’s a strong selling point when consumers are carefully monitoring their discretionary spending.

But the video games sector far from relies on the sale of games alone for its revenues and profits. Microtransactions now form a big part of revenues, or all of them in the case of free-to-play games like the hugely popular Fortnite and are likely to take a hit during a recession. The most expensive games have also risen in cost over the past few years and their price elasticity will be put to the test.

Some kinds of hardware, like VR headsets, have also risen in price as components have, which may put off buyers sticking to a tight budget. In August, Meta, formerly known as Facebook, raised the price of its Quest 2 VR headset, from $299 to $399.

Another factor is that after a couple of boom years during the pandemic, video game sales showed their first contraction during the last quarter. The end of two years of pandemic restrictions has heightened the appetite for outdoors and social forms of entertainment to the detriment of time spent at home playing video games.

We also have unusually high levels of employment as we head into the forecast recession. That could mean more consumers still be able to afford forms of entertainment that involve leaving their homes and be inclined to take advantage after the pandemic, even as belts are tightened.

There are signs video games companies are tightening their belts too in preparation for a potentially more fallow period. Pokemon Go creator Niantic has laid off some staff, as has the games engine Unity while Ubisoft confirmed the cancellation of 4 new games during its July earnings call citing a “changing financial environment”.

Chris Kramer, Tencent Games’ head of North American communications recently commented for the Washington Post:

“Budgets are going to become tighter with every company across the board, which means it will be tougher to get new projects approved unless they have a rock-solid chance of being successful. Publishing efforts will be scaled back as budgets shrink, so game companies will have to do more with less and really examine where the best return on investment is on dollars spent.”

Serkan Toto, chief executive officer of Tokyo-based games consultancy Kantan Games Inc., is “in the camp that the industry is recession-proof indeed, at least to some extent.”

Commenting for Bloomberg in late July, he says he can’t remember a recession in the last four decades that had a significant impact on the games industry. In fact, he points out, during the Great Recession of 2007-2009, Activision merged with Vivendi Games as part of a $18.9 billion deal–and picked up World of Warcraft publisher Blizzard in the process.

What’s the secret to the gaming industry’s history of riding out recessions healthily? Toto believes it’s because playing games is a relatively inexpensive hobby compared to other entertainment options and that the evidence shows that people who lose their jobs still consume plenty of entertainment products.

Where to invest for video gaming exposure?

If you are confident the video gaming sector will weather the expected recession well, which companies look like the best investments? Unless you are willing to take on a significant amount of risk, the industry’s bigger players would look the safest bets.

Analysts for CFRE Research, pick out these 7 video gaming stocks as ones for investors to consider:

Nvidia: the chipmaker produces the high-end graphics cards required for the most advanced video games and also operates a data centre business considered to hold great growth potential. The analysts have a price target of $350 for the stock and it currently trades at just $137.14.

Advanced Micro Devices: Advanced Micro Devices is a semiconductor producer and one of the world’s largest suppliers of PC microprocessors and GPUs. The CFRE analysts have a price target of $120 for a stock trading at $79.61.

NetEase: NetEase is a Chinese tech stock that specializes in PC and mobile gaming, which accounts for more than 70% of its revenue. It’s valuation has been hit by the crackdown on mobile gaming by the Chinese authorities by CFRE rates it as a buy with a $110 price target against a current trading price of $87.22.

Electronic Arts: Electronic Arts is one of the world’s largest independent video game publishers and owner of key franchises such as Madden, FIFA and Battlefield. The company’s fiscal fourth-quarter numbers were particularly impressive given the recent “spending lull” for video games. The analysts have a price target of $184 and the stock currently trades at $125.55.

Sea Ltd: a Singapore-based consumer internet company, Sea’s subsidiaries include its Shopee e-commerce platform, its Garena digital entertainment business and its SeaMoney financial technology operations. There was impressive revenue growth in the first quarter, including 45% growth for Garena, 64% growth for Shopee and 360% growth for SeaMoney. The company’s game Free Fire was the most downloaded mobile game in the world in the first quarter and 43% revenue growth has been predicted by analysts for 2022. CFRA has a buy rating and $160 price target for SE stock, which is currently valued at $58.83.

Roblox Corp: Roblox is an online entertainment platform that allows creators to develop games. It is also a video game that has 54.1 million daily active users, its own digital currency and a range of unique virtual experiences. CFRA analysts are convinced daily active user growth, improving demographic trends, 5G network upgrades and growing interest in coding will help Roblox maintain at least 20% annual revenue growth in the long term. Digital training, education and fitness are seen as potential new growth areas.

CFRA rates the stock a “strong buy” and has a $56 price target against a current trading price of $39.94.

Take-Two Interactive: Take-Two Interactive Software is the publisher and owner of popular video game franchises including Grand Theft Auto, Red Dead Redemption and Borderlands. The company also has what looks like a strong pipeline of new content, and its stock has an attractive valuation. Currently trading at $120.58 and CFRA has a price target for it of $171.

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