How The Cloud May Boost Video Game Stocks

The cloud computing revolution is boosting the future prospects of leading video gaming stocks, such as Activision Blizzard Inc. (ATVI), Electronic Arts Inc. (EA) and Take-Two Interactive Software Inc. (TTWO), according to Barron's. By hosting games in the cloud, rather than having users download the software to their own devices, video game companies have the opportunity to offer a quantum leap in the sophistication of games, often without the need for users to upgrade their own hardware. Despite recent pullbacks for many of these stocks, their 5-year gains are still stratospheric. Moving the action into the cloud may be the recipe for another big growth spurt.

Source: Yahoo Finance; based on adjusted close data through the open on Sept. 5.

Electronic Arts has endured a particularly rough patch recently, partly on news that its Battlefield V game release has been delayed from late Oct. to Nov. 20, InvestorPlace reports. From a 52-week high reached in intraday trading on July 13, the stock has fallen by 25% through the open on Sept. 5.

Video game companies already are enjoying increased profit margins as a result of a secular trend away from sales of physical game disks and toward downloads of gaming software through the internet. As a result, for example, Electronic Arts has seen its operating profit margin triple in the last 5 years, from 10% to 30%, Barron's notes. But there is still a long way to go.

According to Tim O'Shea, a video game sector analyst with Jefferies & Co., only 40% of new console game software is downloaded today, per Barron's. He projects that downloads will be 75% of this market by 2020, and he estimates that every 10 percentage point increase in the market share of downloads increases gross margins by 3 percentage points. The availability of more sophisticated games in the cloud promises to hasten the demise of physical game disks.

The future path of video games has much in common with the experience of the music and movie business businesses, which went from distribution via physical CDs and DVDs to downloads onto the purchaser's device to the current standard, real-time streaming off the internet. The music business, however, endured a downturn in sales by taking too long to make the transition from downloads to streaming, a lesson that game makers should heed, Barron's warns, while noting that Electronic Arts has taken a early lead in the migration.

The move to streaming of video games promises the ability to pause play on one device, such as a TV, and resume it on another, such as a smartphone. Also, customers who pay monthly subscription fees for video games have proven to be bigger revenue generators than those who buy individual games, Barron's indicates.

There already are between 300 million and 400 million households worldwide that own either a console or high-end PC dedicated to use for video games, Barron's reports, adding that there are several billion additional casual players, including those who play on smartphones. The migration of gaming to the cloud promises to expand this universe of users even further, including new users who are attracted to the expanded possibilities for interactive gaming with other players, in other locations, that cloud-based gaming facilitates.

A rapidly expanding sector of the video gaming market is eSports, in which either teams or individuals compete against each other for prize money. Some of these competitions have made their way onto cable sports channels and draw paying spectators to watch in person. The cloud revolution should spur even further expansion of eSports. Activision Blizzard, Electronic Arts and Take-Two all see significant profit potential from sponsoring eSports competitions and leagues.

For cloud-based video games to reach their potential, users must have fast, reliable and low-latency access via the internet or their mobile phone networks. Latency is the amount of delay in data transmission. If planned network upgrades, such as the rollout of 5G cellular service, take longer than expected or end up being choked by increased traffic, the alllure of cloud-based gaming will be diminished. Moreover, game sellers probably will need to host their software in multiple physical locations, reducing latency through close proximity to users, and building backup in a case of local outages or delays. This, of course, will add to their costs.