The Starting Line: Wall Street scoops up game makers

"If you're covering the other tech sectors, it's pretty depressing," said James Lin, entertainment software analyst for Jefferies. "It's hard to ignore something that's hot."

Wall Street warmed to game software earlier this year, but now investors are practically sizzling for the field. After a summer lull and a brief plunge along with the entire stock market after September's terrorist attacks in the United States, several game stocks have taken off in the past month, including the top three independent sellers of game software. Leader Electronic Arts is up 24 percent since Oct. 1, No. 2 Activision is up 52 percent, and No. 3 THQ is up 24 percent. Also rising were Take 2, up 113 percent, and Acclaim, up 72 percent.

Research firms are riding the trend.

The past week alone saw Bear Stearns and Goldman Sachs formally begin coverage of Activision and THQ, with Goldman also picking up Electronic Arts. Acclaim, whose stock price until recently had been in a gradual decline since 1995, received new coverage from Jefferies' Lin, and an upgrade from UBS Warburg analyst Michael Wallace. And Activision and Electronic Arts are two of the six stocks in the "software" portion of UBS Warburg's latest Global Tech Focus list.

Timing explains some of the new attention.

Microsoft's Xbox and Nintendo's GameCube are scheduled for launch this month, and Sony's market-leading PlayStation 2 is finally reaching enough households to make it worthwhile for game companies to produce many PS2 titles for the holiday season, analysts say. Sony expects to have more than 20 million PS2 consoles shipped by year's end.

Most of Wall Street's attention is focused on the gaming industry's biggest companies: Electronic Arts, Activision and THQ. Not only does size improve economies of scale in marketing, back-office operations, and development processes, it also gives a publisher more muscle when it comes to getting shelf space. And it lets companies concentrate resources for particular niches; thus, Activision dominates in "extreme sports" games with brands like the Tony Hawk skateboarding series, Electronic Arts has a grip on "traditional" sports franchises like Madden NFL football, and THQ lords over WWF-branded pro wrestling games.

A large company can rely on established, standardized methods to produce games.

"Process and scale are sort of key components to...success," said Activision's chairman and CEO, Robert Kotick, who has argued for the past few years that companies with less than $500 million in annual revenue will have a hard time gaining market share. "Ultimately, institutionalizing the product process so that you have a higher percentage of highly rated, high-quality, market-appropriate products, is, I think the difference between success and failure in this business."

But Lin believes there's room for smaller companies, especially at the beginning of a new cycle for consoles. When a new platform is launched, there simply aren't as many games on the shelf, so anyone can grab attention with a smash hit.

"It really levels the playing field for all publishers, big or small," Lin said.

The upcoming introductions of Xbox and GameCube, as well as the relative youth of PlayStation 2, could be the ticket for "fallen angels" such as Midway and Acclaim, Lin said. Acclaim and Midway have languished in recent years, with the former weighed under by debt and the latter trying to shed its legacy as a company reliant on coin-operated arcade machines. Both companies have done well to restructure and improve their balance sheets, Lin said.

Yet the industry's improvements, by themselves, aren't the only reasons for investors' attraction. This year's console launches have long been expected, and many of the biggest software titles are merely extensions of previously successful franchises. They're not surprises.

The biggest reason for Wall Street's new fascination with games might have less to do with the industry itself, and more to do with the rest of the tech world's weakness. The technology world looks bleak these days, especially after the Sept. 11 terrorist attacks, so any niche poised for strong growth in a poor economy will draw attention.

"Anything that's even remotely tech-related, there's no visibility whatsoever in earnings, there's no growth, there's no operating margin expansion; it's just bad news," Kotick said. "And we're in a category where there's nothing but good news. You've got five years of great growth ahead for the next video game cycle. You have companies that continue to overperform expectations and continue to raise guidance, ourselves included."

No segment of technology expects more expansion in the near future than the game software industry. For instance, First Call's analyst consensus predicts Electronic Arts will earn $1.15 per share in the second half of 2001, compared with 57 cents in the last two quarters of 2000. Analyst consensus calls for Activision profits of 93 cents per share in the third and fourth quarters combined, or a 27 percent year-over-year improvement. Goldman Sachs analyst Jessica Kourakos estimates the game software market will grow to $18.9 billion by 2003, which requires a compound annual growth rate of 12.2 percent from $13.3 billion last year.

It would be a decent performance in any kind of economy. Now it looks like a tremendous one, especially considering the overall, corporate-driven tech industry wont start recovering from its doldrums until the second half of next year, if most analysts are correct. Corporations' chief financial officers are still reducing their information technology budgets.

"We believe the political winds are not likely to change soon and spending will keep dropping until profits improve," wrote Pip Coburn, UBS Warburg's chief technology strategist.

Meanwhile, the game industry requires no approval from any CFO--just games that consumers like.