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Where's the Growth in Video Games?

Travis Hoium, The Motley Fool

There's an odd discrepancy taking place in the video game industry today. Most investors would view it as a growth industry with exciting advances like esports and digital in-game purchases. But the reality of video games today is that it's become hard to find growth. 

Activision Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA) haven't grown much in a decade, and Take-Two Interactive (NASDAQ: TTWO) has had huge ups and downs depending on game releases. There's a shift going on in video games, and consistent growth may continue to be hard to come by for the biggest names

A man, a woman, and a young girl playing video games together

Image source: Getty Images.

Where growth comes from

The chart below shows the growth in revenue for Activision Blizzard and Electronic Arts over the past decade. In 2016, Activision Blizzard acquired King Digital for $5.9 billion, which is the only real growth spike we've seen. 

ATVI Chart

ATVI data by YCharts.

For perspective, Electronic Arts' growth amounts to an annualized rate of just 2% over 10 years. Activision Blizzard's rate isn't much different if we pull out the King Digital acquisition. Any way you look at it, growth is anemic for video game makers. 

Where's the growth? 

There are a number of reasons video game revenue hasn't increased significantly over the past decade. A big one is the trend toward free games, with monetization coming on the back end for developers. Instead of an up-front purchase of $50 or more, gamers on PCs and mobile devices can spend what they choose over time. If a game has millions of users, the freemium model can be great, but if the user base is small, the add-ons may not be enough to make the game profitable. 

We're seeing this trend in blockbuster games like Call of Duty, which is still one of the most popular games in the industry. But Activision Blizzard has seen sales in opening weeks fall over the past decade. The premium video game market may actually be contracting right now. 

Esports was supposed to be the big growth engine for video games in 2019 and beyond, but that hasn't shown up in the numbers yet. Franchise fees are bringing in millions in cash for league owners like Activision Blizzard, but ongoing revenue from esports will be shared with franchise owners. There may be incremental sales of games because of interest in esports, but that hasn't fueled significant growth either. 

Without a new console or technology (like smartphones), there aren't any easy growth options for video game makers. 

The good news in video games

I showed above that revenue hasn't been growing in video games, particularly for Electronic Arts and Activision Blizzard -- but net income has. And that's really what's helped drive video game stocks higher. 

ATVI Net Income (TTM) Chart

ATVI Net Income (TTM) data by YCharts.

A big reason net income is up is because of rising gross margin. Digital sales, which are very low cost, are key to this earnings growth. Another reason is the focus on blockbuster games that are refreshed year after year. For example, Activision Blizzard's results are driven by World of Warcraft, Candy Crush, and Call of Duty, which are usually refreshed each year. Electronic Arts has tentpole titles like FIFA, Madden, and Battlefield to lean on. Take-Two relies on Grand Theft Auto to drive its business. 

A risk for video game investors

Video game stocks have been on a hot streak for the past decade, with Activision Blizzard, EA, and Take-Two rising 164%, 338%, and 1,270% respectively. But growth has been hard to come by, and there may be headwinds coming if consumers are spending less up front on games. 

Business models will adapt and change to freemium offerings, but this may not be the growth market that investors expect. And if the top line isn't rising, that will eventually manifest with slower gains on the bottom line, which investors should keep an eye on in 2019.

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Travis Hoium has no position in any of the stocks mentioned. The Motley Fool recommends Activision Blizzard, Electronic Arts, and Take-Two Interactive. The Motley Fool has a disclosure policy.