Game Makers' Turnaround Tease

Hopes for a good holiday season ignore the sector's cyclical history.
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Don't worry, we'll make it up to you later.

That was the mantra of the video-game software industry this past week. In reporting generally lackluster results for their just-reported quarters,

Electronic Arts

(ERTS)

,

Activision

(ATVI) - Get Report

and other leading players all warned that they expect weak results in the coming two quarters. But the companies promised improvement, with each projecting much better results in the holiday quarter and the first quarter of next year.

Because this is a year of transition, and new hardware is expected to debut later in the year, short-term troubles aren't all that surprising. Once the transition is over, most analysts believe that the industry can flourish.

But the idea of a turnaround come the December quarter may be too good to be true.

"Whenever you push revenue or earnings out, there's always going to be risk," says P.J. McNealy, who covers the video-game software sector for American Technology Research, which does not do investment banking.

The publishing companies are ultimately dependent on the hardware manufacturers' decisions about the release and roll out of their machines, and on consumers' choices in the marketplace. "Those are issues that, at the end of the day, the publisher can't control," McNealy says.

Later this week,

Microsoft

(MSFT) - Get Report

will unveil its new Xbox console, which is expected to be on store shelves later this year.

Sony

(SNE) - Get Report

and

Nintendo

will debut their new game machines next week.

In the past, the changeover from one console generation to another has been a double whammy for software publishers. Typically, companies see their costs rise as they develop new tools and games for more complex new systems; at the same time, they see sales fall or stagnate.

Often in the first year of the new console cycle, the installed base of new game consoles is too small to counterbalance declining demand for games made for the outgoing generation of game systems.

How the software publishers navigate the coming transition period could go a long way toward determining which ones are successful in the next cycle -- and which stocks will be rewarded. While history might suggest a different outcome, publishers right now seem to be sounding the same positive note.

The publishers may have good reason for optimism. Sales of software in the holiday quarter last year were dominated by Microsoft's

Halo 2

and

Take-Two Interactive's

(TTWO) - Get Report

Grand Theft Auto: San Andreas

. So far, no similar blockbuster titles are slated for this year's holiday period, which may open the way for less-hyped titles to do well.

Software sales are often linked with hardware sales. People who buy a game machine will often spring for a couple of software titles to go with it. And a large base of console users can make it relatively easy for a publisher to have a hit title.

With the new Xbox likely out in time for the holidays, publishers could see some incremental sales. And a number of analysts are expecting Sony's PlayStation Portable handheld to be a hot seller this holiday season, which could also juice software sales.

"This Christmas is going to be another big software year," predicts one fund manager who closely follows the video-game software sector and whose firm is long both EA and Activision.

But not everyone's convinced. Any number of things could derail the publishers' happy holidays -- and their predicted results, note some analysts.Even though the first and fourth calendar quarters are typically the biggest periods for the video-game business, the companies may be expecting more than they can deliver.

Over the last three years, for instance, about 48% to 50% of total video-game software sales have come in the fourth quarter, and another 18% to 20% in the first quarter, according to data from NPD. EA and Activision, though, are expecting sales to be stronger than the market in those two quarters.

For EA, at least, that could be a stretch. In the past three years, the company has never had 50% or more of its revenue from the holiday quarter and only once has hit 70% of revenue for the second half of its year. Yet its guidance suggests that the company expects to best both of those figures in the second half of this fiscal year.

Likewise, the second half of Activision's fiscal year has accounted for more than 70% of revenue only once in the past three years. But the company expects to exceed that target again this year.

But there may be more than historical reason to be skeptical of the publishers' plans this year. While hardware sales may help sales of some software, they could also detract from them. Consumers are already seeing higher energy prices eat into their disposable incomes, and hardware purchases may take another big chunk of change out of their wallets.

The PSP, for instance, costs around $250. That same amount would buy about five premium-priced games, notes David Cole, president of DFC Intelligence, an industry research firm. While each dollar spent on hardware does not necessarily detract from software spending, there are likely to be some tradeoffs if hardware spending picks up this year.

"Even if they're not buying new game systems, they may be saving up money for new game systems, knowing they're coming out," Cole says.

Indeed, that may be the larger risk this year. Microsoft's announcement this week could stall software sales as consumers await the launch of its new console, said Joe Spiegel, a portfolio manager with Dalek Capital, who is effectively long both EA and Take-Two, shorting put options of both companies. Sony might put a bigger damper on such sales by promising its new PlayStation earlier this year.

"There's a significant risk overall that spending is going to be frozen by consumers," he says.

Even if consumers open their wallets, there's a question about what they will be buying. Not only will new handhelds such as the PSP and the new Xbox be competing for their dollars, but so also will software for the various platforms that will be available. The publishing companies that succeed this holiday season will be those that do the best job of forecasting which platforms will see the bulk of software sales.

"There's a lot of natural uncertainty in the market," says Cole.

How much? We'll find out likely sooner than later.