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2HRS2GO: Game stocks already priced for growth

COMMENTARY--Game software investors provide the ultimate example of early action.

The second half of this year looks great for entertainment software. Sony (NYSE: SNE) has solved the production problems that prevented it from reaching its targets for shipments of the PlayStation 2 console; and Xbox and GameCube are coming in the fall from Microsoft (Nasdaq: MSFT) and Nintendo.

"We expect the holiday season to be very big and very loud," Electronic Arts CEO Larry Probst said during his company's quarterly conference call last night. "We think that everyone will benefit from that."

Actually, everyone has already benefited from that.

All major game companies are poised to do well now that PlayStation 2 console installations are in the double digit millions. Industry titan Electronic Arts (Nasdaq: ERTS) and its nearest competitors, Activision (Nasdaq: ATVI) and THQ Interactive (Nasdaq: THQI), should lead the pack. During their fourth-quarter conference calls this week, Electronic Arts and Activision radiated confidence. Activision even raised expectations for fiscal 2002. The leaders are looking muscular.

But so are the stocks. Compare their Wall Street performance to the Nasdaq composite index over the last six months:

Investors didn't wait for software sales to pick up in the fall. They anticipated a boost. They moved early.

Maybe it's appropriately impulsive behavior for shares of companies largely reliant on finger-twitching products. "There's the target, hit the turbo boosters and grab the flag before anyone else does so we can declare victory: All Your Base Are Belong To Us."

The phrase is tired, but so is the investment philosophy. Buying ahead of a growth cycle sounds great, but then there's nothing left to gain once earnings and revenue really start moving up.

"The only issue is valuation," Lehman Brothers analyst Felicia Kantor said last night. "No matter how strong or solid the ship is, I find it hard to recommend a purchase."

Kantor doesn't reflect the majority view among her colleagues. Today's First Call notes following EA's earnings report included reiterations of three "buy" ratings and two "strong buy" advisories.

Yet most of the optimistic analysts cut their estimates a bit after Electronic Arts executives noted that online gaming is taking a bit longer to perfect than expected, which is an especially surprising admission coming from the company that rolled out the first major subscription-based franchise more than three and a half years ago with Ultima Online.

And those consoles that fuel the bulk of game companies' revenue aren't a sure thing either. PlayStation 2 set hardware sales records, but software sales for Sony's latest platform haven't been great; more than a year after the console's Japanese release, PlayStation 2 had just one game that sold a million copies in Japan.

Meanwhile, GameCube and Xbox still have to prove themselves. Nintendo and Microsoft have release dates in mind, but the former has already blown its original target launch, and the latter has no experience at all in doing this.

"I think most of us now have the attitude of 'I'll believe it when I see it,'" Jefferies analyst James Lin said.

Game publishers are captives of a hardware market still feeling its way through. Those uncertainties have Lin agreeing with Kantor.

"Electronic Arts is a great company, but we just think the stock's a little ahead of itself, given the risks around all these console launches," Lin said.

One of the few analysts to raise earnings estimates slightly on Electronic Arts was Deutsche Banc Alex Brown's Justin Post. But he stuck to a "market perform" rating. "Stock continues to be in what we view as an appropriate trading range," Post wrote.

Some game software companies probably will get a boost next week from the industry's flagship trade show, the annual Electronic Entertainment Expo in Los Angeles. That's a short-lived pop, though.

More relevant than E3 are the stocks' current prices: Activision has been hitting all-time highs; THQ hadn't traded at these levels in nine years; Electronic Arts sits near its 52-week peak.

Wall Street already expects powerful strides from the game industry. Long-term value already has been built into the stocks. Companies can only try to live up to the demands. 22GO

• 2HRS2GO: Wall Street looks to EA's long-term future
• 2HRS2GO: Activision 1Q hints at better times ahead for games
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