Toy Story III: Fun, Fun, Fun

Battered investors, harassed by an unkind market, might do well to put their money into some home entertainment -- the mindless joystick kind with titles like Chicken Run FunPack Game, Tony Hawk Pro Skater and WWF Smackdown 2.

Sure, the games are fun. But equally cheery right now is the performance of toy and game companies' stocks.

Just take a gander at some of the sector's stocks. Video game publishing, a little-watched sector, seems to have become a real safe haven in this smashed-up market.

At a time when most major indices are cutting a deep groove into the red, the Dow Jones U.S. Toy Index is up 25% on the year, and its major video game publishing components are outdoing the rest. Activision(ATVI Quote), which makes comic book- and motion picture-inspired games, is up 61% this year; THQ(THQI Quote), which makes games based on Disney characters as well as the World Wrestling Federation's gladiators, is up 50.5%; and Electronic Arts(ERTS Quote), the largest third-party publisher of game software for Sony's PlayStation 1 machine, is up 29%. Electronic Arts makes professional sports games licensed by the major sports leagues. Finally, the smallest of the bunch, Take-Two Interactive Software(TTWO Quote) develops, among other titles, games based on MTV shows. And it's up 22%.

It's Electric! Electronic Arts has powered higher

By comparison, the broad market S&P 500 is down 12.5% and the Nasdaq Composite Index is off 25%. Even other noncyclical consumer products sectors, which are seen as immune to a slowing economy, are down. The Dow Jones Pharmaceuticals Index is off 15% year-to-date. The Dow Jones Househould Products, Non-Durable Index is down 16% since Jan 1. And the Dow Jones Consumer Non-Cyclical Index is down 5.7% for the year.

There's actually some very sound logic behind the runup in the sector. A new five-year growth cycle is dawning in the $20 billion industry, earnings "visibility" is great and toy stocks are seen as relatively immune to a recession. Plus, the sector can't help but benefit from a clear shift out of tech stocks and into areas that are seen as safe havens.

An Active Year It's been a year of fun and games for Activision shares

Analysts say sector leaders Activision, THQ and Electronic Arts, in particular, should continue to rise at a steady clip over the next four years, even if they don't entirely keep up with the pace seen over the last three months. In the last growth cycle, stock values tripled. That's great news for investors at a time when there's no bottom in sight for tech stocks or the rest of the market.

"I'm seeing a number of investors looking at the sector because it offers more visibility than some of the other Nasdaq tech sectors," said Miguel Iribarren, video game stocks analyst at Wedbush Morgan Securities. "Relatively speaking, this sector is a safer bet than other Nasdaq tech stocks right now."

The new home video game five-year growth cycle began in the fall of last year, with the U.S. release of Sony's hot new PlayStation 2, or PS2.

Video game growth cycles tend to last five years, but are tough on companies at the end stages of those cycles -- when new hardware is still being developed and the buzz about new technology and cool new stuff starts to rise. At the end of each cycle, customers stop buying old equipment and games. Video game sales slump and so do the stocks. That's what happened to the sector last year. Activision, THQ, Electronic Arts and Take-Two all fell an average of 40% to 50%.

"They go through their own little recession," said Arvind Bhatia, analyst at Southwest Securities.

Fun and Games With Mister Softee

Once the new platforms are launched, growth rates for software makers surge. In the last cycle, earnings growth hovered around 22%. The more bullish analysts are expecting 25% to 35% growth this time around because of Microsoft's(MSFT Quote) entrance onto the scene with the video game platform Xbox. Compare that to forecasts of a loss of 22% this year for the S&P 500 tech universe and a loss of 30% for the Nasdaq 100.

"I believe growth is going to be stronger than in the past because Microsoft is a new entrant to the space. I believe that it's going to revolutionize the industry like the Sony PlayStation did. It will expand the pie, not just recarve it," said Bhatia.

Microsoft will release its next generation Xbox in the fall of 2001, while Japan's Nintendo will release its Game Cube platform this summer. Sega, the third-largest player in the console business, has decided to duck out and focus on developing game networks and games for wireless devices. Sega recently forged an 11-title game publishing alliance with Microsoft for its Xbox.

Meanwhile, demand for the new video game machines, and thus for video games, is seen expanding to a wider audience this cycle as the new platforms are basically multipurpose home entertainment platforms. Apart from their video game capabilities, the new machines allow for high-speed Internet connections as well as the ability to play DVDs and music.

Go Mario!

Nintendo remains the leader of the game software market, with its hit series Pokemon, Super Mario and The Legend of Zelda. But the makers of the video game machines themselves are far riskier investments than are the pure-play software makers, say analysts.

Video game developers typically lose money on the new hardware and profit on the software plus peripheral sales and licensing fees. Microsoft isn't expected to turn a profit on its Xbox for another five years, while Japan's Sony is currently struggling with a massive restructuring. In fact, analysts said they doubt the PS2 will have a positive midterm effect on Sony's earnings.

The other good thing is, video games are relatively cheap and toys are seen as immune to economic slowdowns. Analysts say parents hate to say no to new toys, and will always find money to buy their children gifts. So the video game stocks should be relatively unscathed by what is already looking to some like a recession in the U.S. economy. Whether or not this theory is true, it has at least held up in previous video game growth cycles.

"If you look at the last three cycles, the general economy had very little impact on the fortunes of these companies," said Iribarren. "If it's summer and times are tough, if you're cutting back on spending, instead of going to Disneyland, you get a new video game. Cause it's usually just $30-$50 a pop."

Even those analysts who do worry that a prolonged recession could hurt the video game publishers expect growth of at least 15% for the sector over the next several years.

Wishing Upon a Star THQ has made a mint on Disney-based games

Activision and THQ seem to be the most popular of the video game stocks with analysts. These two stocks are still only trading at 20 times their 2002 earnings, says Michael Wallace, an analyst with UBS Warburg, as much of this year's runup has been just a rebound from the lows of last year. And that multiple should be closer to 30 in historical terms, he says. Electronic Arts trades at more of a premium -- it's at 74 times 2002 earnings -- because of its size comparative to the others.

Still, there's some concern that major investments in internal development will burden THQ with hefty costs in a weakening economy. The company recently expanded its creative team to make more original video games in-house. THQ only derives one-third of its sales from games created internally. Electronic Arts, which has double THQ's market share, gets about half of all sales from in-house games.

I Want My MTV Games Take-Two Interactive makes games with MTV themes

Take-Two is the smallest of the group, and so gets less attention than the three top-tier players. Its valuation is far more attractive than the others, though, at just 11 times 2002 earnings. But Bhatia says he has some near-term concerns about the company, including its relatively aggressive accounting practices and a significant dependence on low-margin distribution business.

Despite a few concerns for the sustainability of these companies' performance, it's hard to trump the kind of visibility and growth analysts seen in this sector at a time when both qualities are severely lacking for tech. The new platform cycle began at an opportune time for the sector's stocks, and more importantly, for the sector's investors.