The Starting Line: Midway rises from the ashes

Shares of Midway gained more than 16 percent Tuesday after UBS Warburg analyst Michael Wallace upgraded the stock to a "strong buy" rating, but the company has seen this before. As recently as the end of April, Midway enjoyed a two-week stretch that saw the stock climb to $10.30 from $6.75--but then it fell on a combination of worries about revenue growth after a disappointing quarterly report and fears of dilution stemming from a private stock sale announced a week ago.

Analysts at brokerage firms typically concentrate on company fundamentals rather than stock technicals, so in their research notes released following the $42 million private placement they applauded the move as a good way to raise cash. Combined with a solid showing a couple of weeks ago at the game industry's annual showcase event, the Electronic Entertainment Expo (E3), the placement gave industry observers a reason to be hopeful about Midway's future.

And hope is all this stock needs to get a lift. It couldn't get much worse.

The achievement is unique. Not many technology stocks can lose half their value in a four-and-a-half year span since going public and still remain viable investments.

Midway has suffered over the years as its traditional business of coin-operated games has declined. For the last several years, the advanced graphics and sophisticated game play on home PCs and game consoles have matched or exceeded almost anything you can play in an arcade. Why stand in a mall to pour quarters into "Mortal Kombat" or "Gauntlet" when you could sit in the comfort of your own home for "Quake" or "The Legend of Zelda" in lively 3D colors?

The company's revenue reflected the trend, as Midway's coin-op video sales fell every fiscal year since 1996. That wouldn't be terrible if home video game sales increased markedly at the same time; unfortunately, Midway's home revenue in 2000 was actually lower than it had been two years earlier. Analyst conference calls turned into quarterly exercises in depression as Midway bled money like a small-market NHL team. Until last week, Midway was in real danger of running out of cash later this year, said Edward Williams, analyst with Gerard Klauer Mattison & Co.

Williams officially had a "neutral" rating on Midway as of Tuesday, but in recent weeks he has qualified that negative-sounding description, going so far as to declare in a report earlier this month that Midway was "turning the corner" even though analysts were cutting earnings estimates for the year following a disappointing third quarter.

Perhaps not coincidentally, Gerard Klauer Mattison was Midway's adviser for last week's stock placement. But there's no doubt that many analysts' view of Midway improved after E3 and the cash infusion. Not that it took much to paint an improving picture.

"It's a matter of expectation," Williams notes. "Going into E3, a lot of people didn't have many expectations for Midway."

Even Wallace's "strong buy" doesn't call for a huge jump in price. UBS Warburg set a 12-month price target of $18, or about 25 times Wallace's earnings estimate for Midway's fiscal 2002.

By contrast, industry leader Electronic Arts ended Tuesday's regular trading at $58.72, or about 93 times the consensus analyst forecast of 63 cents per share for EA's fiscal 2002, according to earnings tracking firm First Call.

Midway publicly previewed eight titles at E3, including the latest versions of "NFL Blitz" and "Ready 2 Rumble Boxing," the latest installment of "Gauntlet," and a 21st century version of an '80s classic, "Spy Hunter." They may not have the cachet of Nintendo's "Zelda" or "Mario" franchises, but they're still well-known names--the key to success for all publicly traded game companies these days. New titles and cutting-edge games may be the most exciting part of the industry, but the profit comes from established brands.

Much of Midway's appeal may not come from individual games, but from the launch of Nintendo's GameCube console later this year. Of the 31 titles planned by Midway for 2001, nine--or nearly one-third--are targeted for GameCube. Larger companies such as Electronic Arts will have more GameCube titles overall, but as a percentage of new games, no one is relying more heavily than Midway on Nintendo's next-generation unit.

"I think some of the titles will do very well," Williams said. "But the main point is that you have visibility now, coupled with the financing now in place, meaning Midway can finish its projects...The comfort level has increased dramatically."

It's a marked change from the last console shift, with the first PlayStation and Nintendo64. Midway's revenue sputtered even as that cycle peaked in the late '90s. This time, the company is focused entirely on the new hardware.

Midway has stopped making games for older consoles. And for all intents and purposes, Wall Street analysts' financial models no longer include any revenue from Midway's coin-operated arcade unit, which cut 60 employees in April.

On paper, it can only get better.

But Midway proponents have said that before also. "Spy Hunter," "Gauntlet" and Midway's other big names didn't stop the company from falling short of its peers in the past. "Execution is a big deal," Williams admitted. "Right now, Midway is a concept story."

The concept is so unproven that Midway's rise in late April brought doubters out of the woodwork. More than 15 percent of Midway's shares were being shorted earlier this month.

Short-selling is a way to profit when a stock falls, by borrowing shares to sell them immediately in the hope that the loan can be covered by buying back shares later at a cheaper price. Shorts can create illusions of optimism about a stock, with a rash of buying following a steep drop; a heavily shorted stock could suddenly rise as short-sellers lock in their profits and purchase shares to cover their loans.

Midway's latest gains came after the stock plunged following the private placement a week ago.

"I think there could be some short-covering, but I don't think there was a lot," Williams said. "I think a lot of it was actual buying."

A short-covering rally rarely lasts more than one day, but Midway now has shot higher two sessions in a row on relatively heavy volume, Williams noted. And the stock price finally has poked above its upper limit of the past year; Tuesday's final price of $10.93 represents a 52-week closing high.

"The company should be back on track and should have a strong year in 2002," Wallace wrote.

No one expects Midway to turn into a game software giant. But with a market capitalization of scarcely $412 million--or less than Midway's expected sales for a full year--the company doesn't have to be gigantic to justify its stock price. With the video console market just taking off on its latest generation of hardware, it shouldn't be too hard for Midway to have a good year.