Skip to main content

Next Generation's Software Growing Pains

A new console cycle has typically meant short-term pain for game software makers.

With three new game machines expected in the next year -- and two new handheld game devices already on the market -- this is a great time to be a gamer.

What remains to be seen is whether it will be a great time to be a game maker -- or an investor in such companies.

The launch of


(MSFT) - Get Free Report

Xbox 360 this week will inaugurate the latest console cycle, a ritual that begins every five years or so. Each successive cycle has eventually led to bigger sales, bigger profits, and surging share prices for the top players.


this week also looked at how Microsoft's

rivals will

cope with the ballyhooed rollout; how far Microsoft will make it into consumers'

living rooms; and what a

game is worth.)

But in the short term, the transition to new machines typically means trying times for makers of game software: slowing sales, rising costs, and stumbling stocks. Worse yet, the transition can also be the beginning of the end for weaker companies that just can't afford to keep up.

For investors, then, making money off the transition becomes a game of timing and educated stock-picking.

Count Joe Spiegel, a hedge fund manager at Dalek Capital, among those who believe it's too early to invest in the game software companies based on hope about the next-generation consoles.





won't come out with their new machines until next year and Microsoft will sell only a limited number -- likely fewer than 2 million -- this holiday season. That's too small a base of users to really boost software companies' results, or their stock prices, he argues.

"People may be getting too excited too soon," he says. "If you're looking at making investments based on next-generation for results this year, you're making a mistake. You're being blinded by hype."

But other investors say the time to jump on the next-generation train is either now or soon approaching. Even if sales of next-generation games won't be meaningful until sometime next year or beyond, stock prices will likely soon reflect expectations of those sales, if they haven't already, says one fund manager, who asked not to be named.

"You can't be thinking, 'I'll buy them next November,'" says the fund manager. "The stocks are going to be a lot higher then unless something crazy happens with the consumer."

No less important than the debate about when to buy is what to buy. The fund manager, for instance, likes -- and is long -- both

Electronic Arts




(ATVI) - Get Free Report

, saying both companies have a strong lineup of hits for the current game machines.

For his part, Spiegel likes -- and is long --

Take-Two Interactive

(TTWO) - Get Free Report

, arguing that the company is poised to do well whenever it releases the next version of its flagship franchise,

Grand Theft Auto


Still others ask, why choose? "You could buy a basket of them, and you will make money," says Steve Monticelli, president of Mosaic Investments, which has no current positions in the sector. "They will move as a group."

But before that taking-off point, investors may need to endure some pain. As EA CFO Warren Jenson told investors and analysts earlier this month at the Harris Nesbitt Media & Entertainment Conference in New York, "This is a transition. Expect the unexpected."

That's certainly the lesson of past console cycles, particularly if by "unexpected" Jenson means "unpleasant."

Overall game software sales flatlined during the last console transition. Companies such as EA and Activision saw their bottom lines dip deep into the red. And during the last two transitions, many software publishers saw their stocks hit bottom within months after the new consoles launched.

And those were often the success stories. At the opposite ends were companies such as




that, instead of riding the next generation to new prosperity, instead were ridden off the rails and eventually forced to close shop.

A Slow Start

During transitions, game companies often come under pressure on both the top and bottom lines. Typically, sales of next-generation games don't ramp up quickly enough to make up for the decline in sales -- and prices -- of old-generation games. At the same time, companies take on increased development costs as they try to get up to speed with and master the new game-machine technology.

On the cost side, things look much the same. Game development costs are going up for the new consoles, according to most analysts. If the average game could be made for less than $10 million for the current generation of consoles, the run-of-the mill next-generation games will cost more than $10 million, says John Goldman, CEO of

Foundation 9 Entertainment

, one of the leading privately held game developers. And, depending on who you ask, per-game costs for top-of-the line titles could run into the $20 million to $30 million range.

But things were supposed to be different on the revenue side. Acknowledging past mistakes, most major software publishers have pledged to support Sony PlayStation 2 and other current consoles far longer than they supported previous machines, such as the original PlayStation -- the idea being that there's still a huge market for those machines.

In the meantime, high-powered handheld systems such as the PlayStation Portable and the Nintendo DS, launched in advance of the console transition, were supposed to help bridge the gap between cycles, helping bring in sales -- at a relatively low cost -- that publishers didn't have before.

But so far, many publishers seem to be experiencing some of the same transition-year trouble that they've experienced in the past. Shares of EA, for instance, were

hammered in March when the company announced a big earnings miss. It has predicted flat sales and earnings this year, but recent price cuts on current-generation games could hamper results.

Other companies are also starting to feel the pressure.

Midway Games



Take-Two recently slashed their guidance. Activision expects earnings to essentially stagnate this year, while



predicts its profits will plummet on flat sales.

Despite these near-term troubles, investors have continued to have faith. Despite EA's problems this year, its shares are up 22% over the past year. And Activision and THQ are both up around 75% over the same period.

That's left all of the major U.S. publishers trading at a pricey 28 times or more their estimated earnings for the current year. And all except Take-Two are trading more than 20 times expected earnings for next year also.

Still, the longer-term outlook for the sector is bullish, most analysts believe. PricewaterhouseCoopers, for instance, forecasts that the worldwide market for video games will grow from about $22 billion in 2003 to about $55 billion in 2009.

"In my mind, there's no question that the entire category will be strong stocks in '06. The tougher question is, strong stocks from what point?" says Monticelli.

For those who answer that question right, the console transition will truly be a great time.