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Video game stocks have been red hot for the past five years.
During that stretch, Activision (NASDAQ: ATVI ), Take-Two (NASDAQ: TTWO ), and Electronic Arts (NASDAQ: EA ) have all rallied more than 300%, with TTWO stock leading the way with 600% gains. The drivers? A secular uptick in video game play - thanks to new technology, more engaging games, and the mainstream emergence of eSports. Plus, these video game publishers have figured out a way to boost monetization rates through micro-transactions.
But, aside from eSports, these tailwinds are slowing. Nintendo Switch hype has come and gone, and a lot of these companies are already bringing in most of their revenue from recurrent consumer spending. As such, video game stocks have stalled out over the past three months. Particularly, ATVI stock is up just 2% during that stretch.
What's next? The next big catalyst for ATVI stock is cloud gaming, which is essentially code for video game companies adopting the Netflix (NASDAQ: NFLX ) model. But, that catalyst is still a few quarters to several years out. And, at current levels, ATVI stock is already largely priced for upside from that catalyst.
Thus, while I think cloud gaming will propel ATVI stock higher over the next three to five years, I also don't think there is any reason to rush in and buy the stock now.
Here's a deeper look.
Cloud Gaming Could Be Huge
When it comes to the video game market, the next big leg of growth will come from cloud gaming.
Put simply, cloud gaming is the trend that will emerge as a result of over-the-top technology converging on the traditional video game world. The video game industry will start to adopt the Netflix model. Video games will be played over the top of any device and won't require a video game console. In this sense, you remove the bulky hardware, reduce friction, and likely increase player adoption rates.
This future isn't here yet. But, Activision and EA are flirting with it. And it will one day be here. When that day comes, the gains could be huge.
Netflix has proven that the over-the-top entertainment model works. Over the past several years, it has grown to 130 million subscribers paying around $10 per month to watch movies on demand and from any smart screen.
The same will be true in the video game world - just at a smaller scale. Roughly 63% of U.S. households have at least one frequent gamer, and that rate is presumably lower -around 50% - on the global stage. Moreover, back in the day when video games went head-for-head against DVDs, video games commanded a higher price. Thus, it isn't unlikely that an Activision cloud gaming platform grows to tens of million of subscribers paying around $15 per month over the next several years.
This cloud gaming platform will presumably displace the current console model. Thus, in three to five years, Activision will look a lot like a smaller Netflix. Netflix has a market cap of $153 billion. Taking the 50% video game play rate and applying it to market cap, then it is reasonable to assume Activision's market cap hits $75 billion in five years.
Investors Can Afford to Wait on Activision Stock
If Activision gets to $75 billion in five years, then you are a talking about 40%-plus gains in the long run.
But, that doesn't mean you need to buy ATVI stock here and now. Take that $75 billion five-year price target. Discount it back by 10% per year. You arrive at a year-end market cap of $51 billion. The current market cap on Activision is $53 billion. Thus there is reason to believe ATVI sock is slightly overvalued here and now.
Moreover, the cloud gaming catalyst is still a few quarters to several years out. And the company's other big catalyst, eSports, is still nascent and not really in hyper-growth mode just yet.
Thus, ATVI stock doesn't really have any catalysts on the immediate horizon which imply a higher stock price in a few months. That is why the stock has stalled out recently, and also why the stock will remain stalled out into the foreseeable future.
Bottom Line on ATVI Stock
Patience will be rewarded when it comes to ATVI stock. This is a long-term winner trading at a near-term premium. Big-time catalysts won't kick in for at least a few more quarters, so "wait now, buy later" seems like the right strategy.
As of this writing, Luke Lango was long EA.
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