2HRS2GO: Playstation wait holds down game stocks

5 min read

Investors easily forget about game software nowadays.

Over the last two months, shares of market leader Electronic Arts (Nasdaq: ERTS) slid more than 35 percent in the last two months, Midway Games (NYS: MWY) lost 35 percent, and Take-Two Interactive Software (Nasdaq: TTWO) gave back 17 percent. Since late September, Activision (Nasdaq: ATVI) and The 3DO Co. (Nasdaq: THDO) have been running treadmills.

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The industry has grown 20 percent or better annually for the last five years and comes off a reasonably strong holiday season, but you can't expect much in 2000 because everyone is waiting for Sony Playstation 2 to make waves. Presumably console gamers, who generate the majority of game software sales, will restrain themselves until the next hot platform arrives.

So with the next 128-bit platforms not slated to hit the United States and Europe until fall, Wall Street is restraining itself as well.

Some companies have other reasons for stock doldrums. Acclaim Entertainment (Nasdaq: AKLM) and Eidos Interactive (Nasdaq: EIDSY) tumbled on disappointing financial results. Long-time Wall Street dog GT Interactive (Nasdaq: GTIS) is ceding control to Infogrames, a French company that isn't publicly traded on U.S. markets.

And a couple of firms, THQ Interactive (Nasdaq: THQI) and Interplay Entertainment (Nasdaq: IPLY) are actually gainers as of late.

Those are exceptions. But maybe the broader spectrum of game companies also deserves more attention.

Take Activision as an example. During its third quarter conference call last week, the publisher of the popular first-person, shoot-em-up Quake franchise said it's planning for flat revenue this year. In spite of that, the company expects to boost earnings by 25 percent; Activision plans to lift margins by focusing on proven, winning brands.

Activision foresees 70 percent of 2000 earnings will be generated by established brands, versus 35 percent last year.

"The problem with this industry historically has been, very few companies have been able to have stability and predictability in their financial results," Activision CEO Robert Kotick said in an interview with ZDII. "The way that you overcome what has been a historical problem for investors in this sector is have a very high percentage of your forecasted earnings coming from proven properties."

Every major game company is moving toward a focus on well-known franchises, because it not only reduces marketing costs, but also means lower R&D expenses and shorter time-to-market, because you rely on previous technology and character development.

That's why industry analyst James Lin is bullish on the field. Lin, a former Wedbush Morgan analyst who just resurfaced at ING Barings, yesterday began coverage of eight game software publishers, six with "buy" ratings and one, 3DO, with a "strong buy" recommendation.

Because the game audience has grown so much, technology transitions won't be as painful as they used to be, Lin believes. "This time, sales won't go down 40 percent like it was during the last transformation five years ago," he says. "The video game software installed base will get larger and larger with every cycle."

Just as important, gaming companies are just starting to break into the Internet-based subscription games, which repesent a huge source of revenue. Among publicly-traded firms, 3DO and Electronic Arts broke the ice with Meridian 59 and Ultima Online; Sony -- which is developing a massively multiplayer Star Trek game for Activision -- raised the bar by publishing Verant Interactive's EverQuest; and now Microsoft (Nasdaq: MSFT) has Asheron's Call.

Not only do these games typically command fanatical audiences (Trust me, I play EverQuest. If someone knows of a 12-step program for EQ customers, please e-mail me), but they ultimately can provide phenomenal boosts to the bottom line because companies not only charge for the initial box software sale, but also a monthly fee that runs roughly around $10 a month. One industry insider estimates these Internet virtual world games carry operating margins at least double those of traditional offerings, even factoring in the network and customer service support required for Internet games. And subscription revenue brings more earnings visibility.

Activision believes between 20 and 30 percent of its operating income will come from Internet games within 5 years. The company conservatively expects 300,000 And all the major game companies are planning to jump onto the Net. Lin believes that the Internet will buoy these stocks.

And once Playstation 2 hits in the fall and Nintendo's Dolphin perhaps in time for the holiday season, game software makers will get a renewed charge. In the meantime, business might be flat overall, but this is not like the DRAM implosion of 1998.

"All fundamentals of the business continue to be terrific, short of what I would consider a transition period," Kotick notes. "You've got more microprocessors being incorporated in more devices than ever before. You have continued consumer fascination with the Internet, which I think is driving consumption of better price-performance PCs and new gaming experiences. You've got Nintendo coming out for the first time with a non-solid state, optical or quasi-optical delivery device (Dolphin) which will lower cost of goods. You've got the largest installed base to sell to than we've ever had before. You've got a smaller number of competitors with better economics."

Yet the industry trades at a discount to the S&P 500, let alone the high-tech Nasdaq. And even when Electronic Arts shares are blazing, most game software companies stay deflated.

They'll probably stay that way until Playstation 2 materializes in the global market, but it never hurts to get a cheap head start.

Other issues:

  • Advanced Micro Devices
  • (NYSE: AMD) The company keeps looking brighter, with chairman and CEO Jerry Sanders telling a Goldman Sachs conference that AMD now sees flat to slightly higher first quarter revenues on a sequential basis. That's impressive coming off a holiday season and marks another happy surprise for the company. I guess if Wall Street lets a company hang around long enough, it's bound to iron out its problems at some point. It also demonstrates how fragile technology leadership can be; Intel basically committed one stumble with the Coppermine chip and that's all AMD needed to become a visible player again. 22GO>