Microsoft ( MSFT) introduced the XBox 360e last year, but the video-game world is still waiting on the PlayStation 3 to debut later this year. Sony's ( SNE) PlayStation has been the world leader in video gaming since 1994, shipping over 200 million units worldwide. Nintendo also introduces its next-generation box -- Nintendo Wii -- later this year. I know a little something about video games. I grew up playing Pong, and later Pacman, yet I don't think I ever really dreamed that one day I would be a character in a game myself. When I was last in Afghanistan, I noticed a couple of soldiers playing a video game. When I saw the pigeon-toed character, I realized they were having fun with the new THQ ( THQI) WWE video game in which I am a character. While it is quite an honor to be a character in a popular video game, they could have at least straightened out my feet and took a few pounds off my hindquarters -- way too realistic for me. (Full disclosure: I get a portion of revenue from the sale of the THQ video game.) There is a normal deferral period when gamers are waiting on the new consoles. I believe the delayed launch of PS3 is the reason for slow sales in video games. With PS3 scheduled to be in stores just before Christmas, this could mean a fantastic year-end for game makers. A new console cycle has helped increase sales by 30% on average. Up until this past year, game makers were flying high. Activision ( ATVI) grew net earnings annually on an average of 61% from 2001 to 2005. Activision had increased margins every year and had a return on invested capital of 45%. However, then came the delay in PlayStation 3. To view John Layfield's video take of this column,
click here .
Activision showed a mere 4% increase in revenues from 2005 to 2006. I believe this trough is something that will be corrected when the PS3 and the Nintendo Wii are introduced. While the handheld gaming market is growing rapidly, consoles still generate the bulk of revenue. Activision has shown it can build brands. The Tony Hawk franchise is a $1 billion revenue generator, and the Spider-Man and X-Men games have produced over $750 million worldwide. Activision has an agreement with DreamWorks ( DWA) to produce games based on its movies, such as Shrek, Madagascar and Over the Hedge. Activision is expected to earn 50 cents next year based on consensus numbers; this would give the company a PE multiple of 20, with a long-term growth rate of around 20 as well. However, I feel these numbers don't take into account the resurgence in game buying that will occur when PS3 and Wii come to market. Finally, Activision still has $944 million in cash and no long-term debt. This is an $11 stock with $3.40 per share in cash, a perfect balance sheet. I believe buying ATVI right here is a good investment. Another company that will benefit from an upgrade cycle is Gamestop ( GME). Gamestop holds a virtual monopoly on used games and consoles, but also sells new video games and consoles; so either way, with the new consoles on the way, Gamestop will have all sides covered. The company had sales growth of 68% last year and is forecast to grow at 65% this year. Compared to the video-game makers, consensus numbers for Gamestop have risen significantly, to $2.66 per share next year. With a PE of around 19 times for this year's projected earnings and earnings growth estimated at over 30% for next year, this stock is cheap on a PE-to-growth basis.
Elsewhere in the sector, Take-Two Interactive Software ( TTWO) produces the Grand Theft Auto video-game series, which has taken a hit lately. The New York County District Attorney's office issued the company with subpoenas just after it had settled with the Federal Trade Commission regarding "hot coffee," a term used to refer to hidden sex scenes in GTA: San Andreas. I would wait on Take-Two to see if this plays out in its favor; if so, the stock will be a steal at this price. It, too, is a game maker with cash -- approximately $2 per share -- and no debt. THQ and Electronic Arts ( ERTS) are also both awash in cash, with no debt. Electronic Arts has almost $8 per share in cash (at a recent share price of just under $42), and THQ has almost $6 per share in cash (at a recent share price of just under $21). All of the video-game makers have a terrific balance sheet, none has any long-term debt and all have plenty of cash. I believe they are set for a terrific run when the console cycle is complete later this year. Remember, being poor is bad, staying that way is stupid.