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3 Video Game Stocks Down 40% or More That Can Battle Their Way Back to Growth

Motley Fool - Mon Mar 20, 7:04AM CDT

The bear market of 2022 has been brutal on video game stocks. As measured by the Global X Video Games & Esports ETF (NASDAQ: HERO), these software businesses are down nearly 50% from all-time highs and have nearly given back all their early pandemic gains.

Video games are only growing in popularity, though, and businesses in this industry still hold tremendous long-term promise. Nintendo (OTC: NTDOY), Unity Software (NYSE: U), and Take-Two Interactive (NASDAQ: TTWO) are three stocks down at least 40% from all-time highs that could return to growth soon. Here's why.

Nintendo: A new console will be great, but how about the "jump" to theme parks?

Nintendo's incredibly successful Switch gaming console is now six years old, and gamers (and investors, too) have been anxious for a refresh from the classic game platformer company. But the Mario creator has set no timer for itself -- at least not publicly. It's cheekily stated a new game system (perhaps a "Switch 2") will be released sometime in "20XX."

In the meantime, Nintendo's revenue has been falling steadily from its record score. The stock price has been following suit, and is now down over 40% from all-time highs.

Remarkably, though, Nintendo's operating income has remained quite consistent even as revenue has fallen, resulting in a rising operating profit margin. This is thanks in large part to the company's focus on software and subscription sales that don't rely on a hardware refresh.

Chart showing rise in Nintendo's operating margin since 2014.

Data by YCharts.

In the meantime, the company has been exploring new lands. The Super Mario Bros Movie, made by Comcast's (NASDAQ: CMCSA) NBCUniversal subsidiary Illumination Studios, comes out in April 2023. NBCUniversal's theme parks have also opened two Super Nintendo Worlds, one in Japan and one in Hollywood, Calif., with a third under construction in Singapore. That should generate some stable licensing revenue for Nintendo in the future (since the parks' actual construction and operation are being handled by NBCUniversal).

Given the present situation of stable profit generation, and potential new hardware on the way in the coming years, Nintendo could be a top stock right now. It has lots of cash and investments ($13.2 billion), has no debt, pays a dividend yielding 1.2% a year, and trades for just under 13 times trailing 12-month earnings. Nintendo could be a great power-up for a long-term portfolio of video game stocks.

Unity: Hitting reset and starting a new chapter

Cloud software company Unity was a darling stock after its 2020 IPO. But after soaring in price through the end of 2021, Unity's stock has been stuck on a particularly tough level. Turns out, even a software-as-a-service business can go through down cycles. Growth was negatively affected by internal missteps with its monetization platform for game and application developers, and a general slowdown in video game playing after a boom early in the pandemic. The stock is down nearly 90% from all-time highs.

Investors sped up the clock on high-growth but no-profit company expectations to ramp up to robust cash generation. Though it was a fast-moving business, Unity was sorely lacking in this department and needed a refresh. The company ended 2022 with a total net loss of $919 million, or negative free cash flow of $117 million. The primary difference between the two metrics was a huge employee stock-based compensation expense of $550 million, and an additional non-cash depreciation and amortization expense of $212 million on the year.

The result has been highly diluted shareholder returns (as far as revenue goes, since Unity isn't profitable yet) on a per-share basis since 2020.

Chart showing Unity's revenue and revenue per share rising since mid-2020.

Data by YCharts.

But Unity has hit the reset button and believes it is starting a fresh new chapter. It finally completed its dramatic merger with fellow app monetization company ironSource in November 2022. In combination, the two entities think they have a fully fledged video game development and app management platform that can collect lots of coins. Management thinks it can generate an adjusted EBITDA margin (earnings before interest, tax, depreciation, and amortization, which will more closely follow free cash flow than GAAP income) of at least 11% in 2023 on revenue of about $2.1 billion to $2.2 billion, with plenty of room to run higher in the years following.

As for shareholder dilution due to the issuance of new stock to employees, Unity has said it will repurchase stock in the coming years with its newfound profit abilities. It already completed a $1.5 billion stock repurchase in 2022.

I believe this will continue to be a highly volatile stock in 2023. Shares currently trade for 6.4 times trailing 12-month sales, and a messy balance sheet ($1.6 billion in cash and short-term investments, total debt of $2.7 billion) complicates things. However, the risk-to-reward payoff looks promising at this fork in the road for Unity. I'm considering adding to my small existing position here.

Take-Two Interactive: Two classic gaming companies in one

Microsoft (NASDAQ: MSFT) is currently battling to get its mega-acquisition of video game publishing powerhouse Activision Blizzard (NASDAQ: ATVI) across the finish line. But it's not just Microsoft that has seen value in merging video game development efforts to create a super team. Take-Two finished its purchase of mobile game maker Zynga in late spring 2022 for a total price of nearly $13 billion.

Before you lament the $70 price tag on new console and PC games these days, Take-Two might like you to know its profits have gone to minimal (or negative) since the merger with Zynga. Its guidance for current fiscal year revenue was also lowered to $5.24 billion to $5.29 billion in February, down from $5.41 billion to $5.51 billion before. Shares are down nearly 50% from all-time highs last set in early 2021.

Chart showing Take-Two's revenue and free cash flow rising since mid-2022, and its net income falling.

Data by YCharts.

Take-Two-plus-Zynga should be fine over the long term, though. This is a top collection of video game studios that can drive deep engagement with its fan base. Take-Two's financials will remain a bit cyclical -- relying heavily on new hit title releases to generate positive momentum. The company is also beginning a renewed emphasis on cutting costs during its present slump. Profits should begin rallying in fiscal 2024 (the 12-month period ending in March 2024) as costs associated with the Zynga takeover get lapped.

What I don't like: Take-Two's balance sheet is a bit out of sync after the Zynga purchase, with cash and short-term investments of $1.1 billion offset by debt of $3.1 billion. What I do like: Shares trade for 22 times expected one-year forward earnings, and any surprise game hits (and positive progress in cleaning up expenses) might not be fully priced in.

Of these three video game stocks, I think Take-Two's immediate-term outlook is the most cluttered, but don't be quick to put it on the shelf. The stock could still offer compelling long-term value. Keep this top game studio on your radar.

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Nicholas Rossolillo and his clients have positions in Comcast and Unity Software. The Motley Fool has positions in and recommends Activision Blizzard, Microsoft, Take-Two Interactive Software, and Unity Software. The Motley Fool recommends Comcast and Nintendo. The Motley Fool has a disclosure policy.

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