Take-Two Interactive (NASDAQ: TTWO) and Ubisoft Entertainment (OTC: UBSFF) (OTC: UBSF.Y) have been two of the top-performing stocks among the top game producers for console and PC platforms. Over the last five years, Take-Two and Ubisoft's share prices surged 414% and 240%, respectively, trouncing the returns of Activision Blizzard (NASDAQ: ATVI) and Electronic Arts (NASDAQ: EA).
Here's why Take-Two and Ubisoft could outperform again over the next five years.
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Take-Two: Undervalued relative to its peers
Take-Two looks expensive with a high P/E of 42. But investors are potentially undervaluing Take-Two's ability to improve its profit margin and grow earnings when we look at the price-to-sales (P/S) ratio. Take-Two trades at a lower P/S ratio than Activision Blizzard and Electronic Arts, signaling that the former could be undervalued relative to industry peers.
It's common for companies with high margins to trade at higher P/S ratios than companies that produce a low profit margin. As a result, the P/S ratio can be very helpful in spotting a stock with potential upside, if the underlying business can improve its profitability.
Take-Two's profit margin currently stands at 13%, but it has gradually improved over the last 10 years. Likewise, the multiple-to-sales ratio that investors are willing to pay for Take-Two stock has more than doubled to 5.5 over the last five years.
By comparison, Electronic Arts and Activision Blizzard generate a profit margin of 26% and 34%, respectively. If Take-Two can continue improving its profit margin in line with Activision and EA, it makes sense that investors will gradually bring Take-Two's P/S ratio in line with its peers.
Take-Two is pursuing the same opportunities as its larger rivals to grow profits, such as investing in esports, mobile games, and digital distribution, which generate a higher gross margin than physical goods. Digitally delivered net bookings grew 35% in fiscal 2020, marking a new record for Take-Two while comprising 82% of total bookings.
Take-Two expects bookings to be lower in fiscal 2021, but management is investing in a deep pipeline of new games that is expected to grow revenue. The long-term goal is to build greater scale throughout the company and expand margins.
Strong engagement during the pandemic accelerated the trend toward digital distribution, with total bookings up 136% year over year in the June-ending fiscal first quarter. This was driven by growth in digital net bookings of 139%.
Over the long term, management expects the trend toward digital purchases to continue. The new consoles launching this holiday serve as a major catalyst for further growth in digital bookings. The new consoles will bring cloud gaming features into the mainstream. Microsoft and Sony are both offering digital-only versions of their consoles, as more gamers are increasingly ditching game discs in favor of digital purchases and subscriptions to services like Microsoft's Xbox Game Pass.
Another catalyst for higher margins is the price increases for next-generation games. Take-Two is raising the price for NBA 2K21 on the Xbox Series X and PlayStation 5 from $60 to $70 and will announce future increases on a title-by-title basis. The price increase will offset the higher costs to develop games (which have been rising for several years) while padding the bottom line.
The stock's lower P/S multiple lays a foundation for continued outperformance, as Take-Two continues to pursue digital revenue opportunities through in-game spending and mobile games.
Ubisoft: Expecting to capitalize on the shift to digital distribution
Ubisoft doesn't get the attention of its U.S.-based counterparts, but it makes some of the industry's biggest franchises. During the current console cycle, 11 of Ubisoft's titles sold more than 10 million units each, including Assassin's Creed Odyssey, The Division, Far Cry 5, Tom Clancy's Rainbow Six Siege, and Watch Dogs.
On the next-generation consoles, Ubisoft expects to capitalize on the shift to digital distribution, driven by the increasing popularity of multi-player titles and social gaming experiences. Gamers tend to stick with the same games for months at a time, which naturally leads those players to spend more money on additional content for their favorite titles. Last year, Ubisoft generated 82% of its revenue from digital sales, but there is more to come.
Ubisoft experienced record levels of new players in the most recent quarter. For the full year, Ubisoft expects bookings to grow between 53% to 73% year over year. This stellar performance is expected to push Ubisoft's adjusted operating margin up to 17% to 23% for the full fiscal year ending in March. This is a significant improvement from the 12% margin reported in fiscal 2016.
The stock trades at a P/S ratio of 6.2, below EA's P/S of 6.5 and Activision's P/S of 9.1. Over the last decade, Ubisoft's P/S multiple has narrowed the gap with its competitors, but the digital trends that will carry over to the next console cycle could see the gap close completely, providing more returns for Ubisoft investors.
Overall, Take-Two and Ubisoft have the most to gain from the industry's ongoing shift to digital distribution. Both companies generate a lower profit margin, providing more headroom for margin improvement and profit growth.
If you're looking for the best gaming stock in terms of potential returns, Take-Two and Ubisoft are worth considering.
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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. John Ballard owns shares of Activision Blizzard, Electronic Arts, Microsoft, and Take-Two Interactive. The Motley Fool owns shares of and recommends Activision Blizzard, Microsoft, and Take-Two Interactive. The Motley Fool recommends Electronic Arts and Ubisoft Entertainment and recommends the following options: long January 2021 $85 calls on Microsoft, short January 2021 $115 calls on Microsoft, long January 2022 $75 calls on Activision Blizzard, and short January 2022 $75 puts on Activision Blizzard. 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.