Midway Games Toils to Not Fade Away

The video game publisher finally posts a profit, but analysts wonder if it can keep up with rivals.
By Troy Wolverton ,

Midway Games'

(MWY)

latest report may leave investors wondering whether the troubled video game publisher will ever complete its turnaround.

At first glance, the company's

fourth-quarter report might seem to have quieted its critics. On Monday, Midway posted a quarterly profit for the first time in five years as revenue jumped 156%, and it projected that revenue would grow another 40% in 2005.

But other items within the report likely added to investor doubts. The company would have missed the Street's earnings expectations by a long shot, if not for a one-time settlement gain; and Midway warned investors not to get used to it operating in the black. Instead, it projected a full-year loss that was far larger than analysts expected.

Posting a profit after so many years is an important step, said Joe Spiegel, a fund manager with Dalek Capital, who closely follows the video game sector. But the company is still dependent on aging titles, particularly its

Mortal Kombat

series, he said. Additionally, the company's struggles during the boom years of the current console cycle will likely leave it a disadvantage going into the next cycle, he said.

"I think the jury is still out

on the turnaround," said Spiegel, who has no position in Midway shares.

Other investors seemed similarly skeptical. In recent trading, Midway's shares were off 57 cents, or 5.4%, to $9.90.

While the video game industry grew by leaps and bounds over the last five years, Midway quietly collapsed. The company's revenue shrank from $351.8 million in fiscal 1999 to just $92.5 million in fiscal 2003. Over that time period, the company's bottom line fell from a $6.2 million profit to a $115.2 million loss.

The company started to recover last year, seeing its full-year sales jump 75% to $161.6 million and its loss shrink to just $19.9 million.

The improving results came amid a shake-up in the company's ownership and boardroom. Over the last two years, Viacom Chairman Sumner Redstone has steadily

increased his holdings in Midway; he controls more than 70% of the company's shares. Last summer, Redstone

put his stamp on the company by placing his daughter Sherri Redstone on Midway's board and installing Kenneth Cron as the company's chairman.

With the new leadership, Midway also has apparently focused more on the quality of its games. In 2004, according to the company, its games ranked No. 1 in average review score on the site Gamerankings.com.

Those efforts and changes seemed to pay off in the fourth quarter. The company earned $17.6 million, or 19 cents a share, in the quarter on $77.2 million in sales. That was up from the year-ago period, when it lost $28.6 million, or 52 cents a share, on sales of $30.1 million.

But the company's results benefited from a settlement with former parent

WMS Industries

(WMS) - Get Report

. The settlement added $5 million, or 5 cents a share, to its pretax income. Without the settlement gain, the company would have fallen even further short of Wall Street's expectations of a profit of 20 cents a share in the quarter.

Meanwhile, Midway indicated that furthering its turnaround effort is going to be costly. The company projected that it would lose $38 million, or an estimated 42 cents a share, in 2005 as it steps up its development efforts. In contrast, the Street had projected that the company would lose just 3 cents a share this year.

On the whole, analysts found little to get excited about in the company's results. Most reiterated their "hold" or "underperform" ratings and lowered their bottom-line expectations.

"While MWY reported its first profitable quarter in five years in Q4, additional losses expected in FY05 do not give us much to get excited about near term," said UBS analyst Michael Wallace in a Tuesday report. (Midway has been an investment banking client of UBS in the last year.)

But some analysts question whether the longer term will be any better for the company. The next generation of consoles is expected to start debuting later this year.

Rivals such as

Electronic Arts

(NYSE)

,

Take-Two Interactive

(TTWO) - Get Report

and

Activision

(ATVI) - Get Report

are entering this next-console cycle with momentum based on strong sales, earnings and hit titles.

In contrast, Midway has been struggling to keep pace. And with few hit titles to lean back on and development costs expected to skyrocket for the next generation of consoles, its position could get worse.

"They have a good library of games and some brands that once were very strong but have been diluted over the years by poor games," said Spiegel. "They start the next cycle at a disadvantage to the more successful companies."

Still, the company's affiliation with Redstone may well mean that it will be given plenty of time to complete its turnaround. And with some $118 million of cash on hand and only $10 million in long-term debt, it can stand a few more unprofitable quarters.

And some analysts believe the company is heading in the right direction, even if the turnaround is taking longer than expected.

"It is clear that the company's focus on quality will continue to delay the completion of its turnaround," said Wedbush Morgan Securities analyst Michael Pachter. "We believe that the company is making long-term investments that will pay dividends in 2006 and beyond." (Midway has not been a recent investment banking client of Wedbush Morgan.)

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