Online gaming's room to run

Most industry observers believe the game software industry is on the cusp of its strongest growth cycle in years.

Sony expects to have more than 30 million PlayStation 2 consoles sold by the first quarter of next year; the latest version of Nintendo's Game Boy unit is selling briskly; and Microsoft and Nintendo plan to launch their new gaming machines in time for this year's holiday season.

"Retailers are very pleased with the way the summer is progressing and the way the holiday season is shaping up," Credit Suisse First Boston analyst Heath Terry wrote Tuesday. "Most retailers are working to add additional floor space for the interactive entertainment category."

But the stocks, already seen by a few observers as expensive a couple of months ago, haven't gotten any cheaper.

Investors in the game software industry typically buy shares ahead of an expected industry surge, and this year hasn't been any different. While most of the technology market languished amid fears of a U.S. economic recession, most entertainment software stocks traded at or near their highest levels in years. Companies like Activision, THQ, The 3DO Co. and Midway Games more than doubled or tripled in market value.

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And there's room for more gains, some analysts believe. First Call has an average consensus recommendation of two--equivalent to a "moderate buy" rating--for a sextet of game software stocks, including the four aforementioned companies, Electronic Arts and Acclaim Entertainment.

"Barring any new platform launch delays or problems, we believe the group can move higher, as we move toward the introduction of the new platforms from Nintendo and Microsoft, and momentum builds toward the holidays of 2001 and 2002," U.S. Bancorp Piper Jaffray analyst Anthony N. Gikas said last week.

However, Gikas noted that the sector has "made a tremendous run" over the past year. Although Gikas raised his 12-month price targets for several stocks, he added that many of those issues have already achieved 80 percent to 85 percent of their gains for 2001.

That would seem to leave little room for growth over the next six months. But even a 10 percent gain from current levels sounds pretty good compared to the rest of the technology industry, which remains clouded with doubt about the timing of an economic recovery.

And game stocks aren't likely to get any cheaper anytime soon, Terry said. "While some investors may choose to wait on the sidelines for better opportunities, they will likely be rare," he wrote.

That's because the industry is still early in its run of new machines. Video-game platforms tend to run in six-year cycles, Gikas said. "In general, we estimate valuations are strongest in years six, one and two, as investors anticipate the next cycle, as visibility improves, and the hyper-growth period (years two to four) are still in front of the companies/stocks," he said.

This is still the first year for 128-bit game consoles, so the industry shouldn't peak for at least a couple of years, assuming it follows historical patterns.

Growth could be even stronger than previous console cycles with the entry of Microsoft into the fray with Xbox. Most Wall Street researchers predict 20 percent to 25 percent growth for the game industry over the next few years, but that could be underestimating the market, according to the latest analyst to start covering game stocks, Southwest Securities' Arvind Bhatia. He sees 30 percent to 35 percent compound annual growth for games over the next four to five years.

"Current market expectations...do not fully reflect potential market penetration potential of PlayStation 2, Xbox, GameCube and online platforms," said Bhatia, who formally began covering industry leader Electronic Arts last month.

Online gaming could be an unexpected boost to the sector. Several companies plan to expand their Internet game offerings, which give game companies the chance to establish a reliable subscription business. Many online games, such as Sony's EverQuest and Electronic Arts' Ultima Online, cost a monthly fee. EA plans at least one major online launch this year with its Majestic title, a mystery/thriller game slated to cost $10 a month.

Internet games not only provide a predictable source of revenue, but also tend to have relatively fat operating profits. Ultima Online, for instance, has operating margins of about 30 percent, Credit Suisse First Boston's Terry estimates.

For game investors, that would be a bonus. Meeting their console goals would be enough.