Midway Between Here and There

A case for or against the video-game publisher must consider big shareholder Sumner Redstone.
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You'd think there would be something about

Midway Games

(MWY)

that would interest institutional investors to play the stock one way or another.

For those predisposed to going long, there are a number of factors to build a bullish case on, not the least of which is that after a decline of more than 50%, Midway's stock is a bargain compared to what it was just two months ago.

But bears, too, could make a case to short the stock, if only for the fact that the video-game software publisher hasn't posted a full-year profit in the last six fiscal years, and looks like it will continue that ignoble streak this year.

For many institutional investors, though, the predominant position on Midway -- if they consider it at all -- is to stay away from the stock.

The sense of those investors is that the stock's price is completely divorced from the company's underlying fundamentals and has depended -- and still depends -- too much on Sumner Redstone's interest. Directly and indirectly, Redstone controls about 90% of Midway's stock.

"It's basically an illiquid security," says Kyle Flynn, a buy-side analyst at TCW, which doesn't have a position in Midway shares. "It's tough to get in knowing that one person owned that much."

Midway's stock has been one of the big winners on the Street in recent years. Over the past two calendar years, the company's stock surged nearly 400%, despite a sharp selloff in the last days of December. Among the company's peers, the best record anyone else could put together over the same period was the 107% gain posted by

THQ

(THQI)

. Shares of industry leader

Electronic Arts

(ERTS)

rose just 11% in the same time frame.

But Midway's rise seems to have had little to do with the company's underlying performance.

Although the company did narrow its net loss in 2004 to $24.7 million from a mammoth $117.9 million the year before, its loss ballooned again last year to $112.8 million. Meanwhile, sales fell 7% last year after spiking 75% the year before.

Over that period, Midway's stock has gotten more than a little assistance from Redstone. From the end of 2003 until the end of last year, the media mogul's direct or indirect stake in Midway jumped from less than 17 million shares, or about 30% of the outstanding stock, to roughly 80 million shares, or 89% of the outstanding stock.

But instead of upping his stake through a tender offer, Redstone

built it through a vast series of market purchases. The net effect was to decrease the available supply of stock and send the stock spiraling ever upward.

At least that's what was going on until the end of last year. Late in December, Redstone

transferred more than half of his personal stake in Midway -- along with $425 million of personal debt -- to a company controlled by National Amusements, of which Redstone is the majority owner.

After the transaction, Redstone still personally holds about 24.9 million shares of Midway, or about 28% of the outstanding stock. But, more importantly, he hasn't purchased any additional shares since the deal. Midway's stock seems to have responded accordingly. Since the day Redstone announced the transfer, Midway's stock price has fallen 49%. Shares are off 57% since topping out at $23.73 in late November.

The stock's decline seems to have finally started to have slowed. Shares have traded up and down within a range of roughly $10 to a little more than $11 for much of the last two weeks.

That shares have seemingly stabilized after a sharp drop would seem enough to lure in some bulls. And there's more that bulls could potentially like in the Midway story.

In transferring his shares, Redstone essentially valued his Midway stock around $13 a share. That's significantly higher than what Midway is priced at now, meaning that, at least in the eyes of the company's most important shareholder, the company's stock could be considered undervalued.

But setting aside the stock's gyrations, bulls could point to the expected upturn in the industry in coming years. Midway and the video-game software sector are now going through a

transition period as the industry moves to a new generation of game technology. Industry experts expect sales and profits to surge in coming years as the new game machines attract a critical mass of users.

Midway may be an also-ran in the industry, but even the also-rans should see their results improve in coming years. And with some well-known franchises, such as the

Mortal Kombat

series, Midway has the potential to cash in.

The company's management is certainly trying to paint just such a bullish picture. The company has bought up several game studios in recent years, and management emphasized in its recent

quarterly report the investments the company is making in next-generation gaming technology.

But Midway has also offered plenty of

fodder for bears, posting just one profitable quarter in the last six years. In other words, Midway was almost completely unable to make money during the last console cycle, even as sales and profits at its rivals surged.

Meanwhile, some analysts fear that the company has depleted the value of its best franchises and that its ability to capitalize on the upcoming console cycle could be limited.

And that's aside from game-development costs in the next console cycle. Analysts have estimated that development costs are likely to run into the $10 million to $20 million range per game.

Those types of costs are increasingly limiting the number of viable competitors in the video-game business to companies that have the resources to develop multiple titles for as many game systems as possible.

Even with the recent selloff, the stock still looks overvalued, says one hedge fund portfolio manager who follows the video-game sector but who asked not to be named.

"Fundamentally, if

Redstone wasn't in the picture, the stock would be below $5, no question," says the portfolio manager. "It's probably a short from here all the way up."

To be sure, many investors seem to be following that line of reasoning into making a bet on the stock. As of Jan. 10, investors were shorting 2.3 million shares, or nearly 25% of the float, according to

Yahoo! Finance

.

But don't count the portfolio manager among those shorting Midway. Like other institutional investors, the portfolio manager is staying clear of it.

"It's hard to follow," the portfolio manager says by way of explanation. The stock's price "depends on what Redstone's doing."

And no one seems to know that except the man himself.