Personal Finance

What Investors Are Getting Wrong About This $135 Billion Industry

An illustration of a person playing video games.

The video game industry's impressive run hit a rough patch last year, and turbulence has continued early in 2019 for many of the sector's top players. Slowing growth and new roadblocks to expansion sent valuations tumbling, and headlines like Is It Game Over for Video Game Stocks? have started to pop up in articles and broadcasts following the pullback. At the same time, the hugely popular free-to-play game Fortnite seems to be presenting new challenges and sucking up all the air in the room -- or at least most of the media coverage.

The market is trying to shake out what's next for previously high-flying game companies. And with industry leaders getting dragged through a valley, it's a good time to look at some of the dynamics that will shape what's next for interactive entertainment. The risk factors that have recently been getting increased attention are worth monitoring, but there are also instances where it seems like narratives have skewed overly negative on companies including Activision Blizzard (NASDAQ: ATVI) , Take-Two Interactive (NASDAQ: TTWO) , and Electronic Arts (NASDAQ: EA) .

An illustration of a person playing video games.

Image source: Getty Images.

Understanding the Fortnite phenomenon

Without a doubt, Epic Games' Fortnite has been the biggest sensation to hit the gaming world in the last five years. The title has been dominating the sector's investment conversation as well -- and it's worth exploring what the game is, where it came from, and what it means for the industry.

Fortnite is a free-to-play entry in the "battle royale" genre that's recently taken the video game industry by storm. Players battle one another to be the last character standing in large virtual environments. It's available on mobile, console, and PC platforms, and the title's battle-royale mode quickly took the gaming world by storm after launching in 2017. Epic's opus now has over 200 million registered players -- an incredible achievement and a milestone that highlights its global reach. The game's success has also highlighted other publishers' recent shortcomings.

A narrative has emerged that Fortnite is crushing the competition and destroying the business models of its competitors. The game is undeniably a phenomenon, and one that's worth studying for investors in the video game space -- but that means cutting through hype. Some investors seem to be treating the game's incredible success as if it came out of nowhere. And they have concluded that the barriers to entry in the video game space have been dramatically lowered, thereby creating problems for the likes of Activision, EA, and Take-Two. But the concern seems to be off base.

Before it made Fortnite , Epic developed hugely successful franchises including Unreal and Gears of War . It also developed the Unreal Engine -- a graphics development suite that serves as the backbone for a huge number of games.

Epic is far removed from being a plucky upstart in the video game industry. It's a storied developer that started working on Fortnite in 2011, fell off many people's radar, and steered the project to blockbuster status years later after overcoming a series of hurdles. In other words, a game from one of the most influential and respected development houses in the industry got off to poor start, but the fact that the title had enjoyable core gameplay and was able to be updated to tap into the exploding popularity of battle royale led to the creation of an industry sensation.

A screen shot from Epic Games' Fortnite.

A screenshot from . Image source: Epic Games.

A screenshot from Fortnite . Image source: Epic Games.

The digital transition is still underappreciated

The video game industry's big shift to digital isn't a secret. Games are increasingly being sold as downloads instead of at retailers like GameStop or Walmart , and the resulting margin improvements have been a big part of the bull case for video game stocks in recent years. The rise of in-game purchases (virtual goods, currencies, and content expansions) as earnings drivers has also been central to the gaming industry's growth story. But there are aspects of the digital trends that still aren't fully appreciated.

In a conversation I had with former Activision Blizzard senior vice president Mike Sepso last year, he laid out a view on the digital transition that seems salient amid the current video-game stock shake-up:

I think from my perspective, having started my career at the beginning of the commercial internet watching what happened to the music industry and the movie industry, the video game industry is performing a nearly flawless digital transition. Piracy is not an issue. There's all these other kinds of big issues that don't really affect the video game business.And in fact, it appears that the digital transition is going to lead to higher margins and more recurring revenue streams. You're moving away from the big opening-weekend, hit-driven business to an ongoing monetization pattern and recurring revenue that maybe won't be a subscription in all cases, but it starts to look a little more like a subscription.

Game companies have great bulwarks against piracy because of protections at the hardware, software, and network levels. And rather than suggesting that most publishers will suffer from new, digital-centric game distribution models, Fortnite 's big success paints a bright picture for the global games market. The game is actually a validation of a shift that many of the industry's biggest players have been moving toward for a long time.

Failures aren't because of Fortnite or industry collapse

In 2013, the president of the PlayStation business for Sony (NYSE: SNE) , Shuhei Yoshida, said that he hoped that consoles and games from Nintendo (NASDAQOTH: NTDOY) would be very successful. The comment was notable because the two companies are ostensibly competitors, but the rationale behind his statement was simple and sound: Nintendo brings in new gamers and plays an important role in expanding the overall market. Remarking on the ways that the presence of competition actually benefited his company, Yoshida said, "We need each other, I think, to create a bigger story."

Fortnite is surely sucking up player hours and spending, but one long-term effect of its success will be the broadening of the total gaming audience. In the short term, however, the game is being incorrectly blamed for the underperformance of other titles.

EA's Battlefield V and Star Wars Battlefront II underperformed because of content issues and design elements that put them out of touch with what their audiences were asking for. The same can be said for Activision Blizzard's Destiny 2 . The popularity of Epic's battle-royale game has been wrongly put forward by company executives and industry analysts as an explanation for why some recent high-profile titles have underperformed.

Focus on Fortnite has even somehow managed to turn the incredible success of Red Dead Redemption 2 into a much quieter affair -- another sign that battle royale is dominating the headlines and one that might indicate Take-Two has been unfairly punished in the recent industry sell-offs.

A screenshot from Take-Two Interactive's Red Dead Redemption 2.

A screenshot from . Image source: Take-Two Interactive.

A screenshot from Red Dead Redemption 2 . Image source: Take-Two Interactive.

Red Dead 's success confounds the narrative that Fortnite has upended the industry and stomped all over growth avenues for other players. Take-Two's hit western has shipped more than 23 million copies just a few months after release, a performance that has crushed most sales estimates and set retail records. The game is also seeing strong engagement online even in the midst of the Fortnite phenomenon.

Similarly, Activision's latest entry in its long-running Call of Duty franchise put up strong numbers last year, and Nintendo and Sony each set sales records for their first-party game franchises.

You don't have to look hard for other success stories. Earlier this month, EA launched Apex Legends -- a free-to-play battle-royale game that some have hailed as the next Fortnite .

Claims that it's "game over" for video game stocks are misplaced. And while unpredictable twists and challenges may hit the industry, companies that deliver high-quality experiences still have clear paths to big success. At the end of the day, the video game market is growing at a fast clip and still has a long runway for growth.

Newzoo estimates that the global video game industry will be worth nearly $175 billion in 2021, up from roughly $135 billion in 2018, and that backdrop suggests a lot of opportunity for the top competitors in the space. Games are still a growth industry. Investors will have to embrace the possibilities of shake-ups on volatility that come with that territory, but the promising long-term outlook has not been derailed.

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Keith Noonan owns shares of Activision Blizzard and Take-Two Interactive. The Motley Fool owns shares of and recommends Activision Blizzard and Take-Two Interactive. The Motley Fool owns shares of GameStop and has the following options: short July 2019 $18 calls on GameStop. The Motley Fool recommends Electronic Arts and Nintendo. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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