Video-Game Stocks Played Out

BOSTON ( TheStreet) -- Video games will be hot gifts this holiday season, judging from Black Friday sales.

With freshly cut prices for three major consoles, Nintendo's Wii, Sony's ( SNE) PlayStation 3 and Microsoft's ( MSFT) Xbox 360, and a slate of new games, there's plenty for kids to clamor for.

Still, brisk sales don't make video-game makers surefire picks for your portfolio. Recent history hasn't been kind to those companies, and now isn't the time to jump back in.

Game developers' returns have been dismal over the past year, when the S&P 500 Index rose 29%. Activision ( ATVI) and THQ Inc. ( THQI) fared better than most, with increases of 4.6% and 22%, respectively, but THQ's position seems to be highly suspect as investors representing 12.7% of its shares outstanding are betting the stock will fall.

Take Two Interactive ( TTWO) has gained only 2.9%, while Electronic Arts ( ERTS) and Konami ( KNM) have fallen 8.9% and 24.7%, respectively. The culprits for these poor performances have been returns on equity and net margins. High fixed costs due to game development and massive selling expenses owing to fat marketing budgets have eroded profits.

In fact, those costs have outstripped revenue increases, which have been buoyed by new titles. While most of the developers operate debt-free, surprisingly, there's little to justify they can be satisfactorily profitable despite impressive offerings.

Sales figures for some games are quite compelling. Activision's latest, Call of Duty Modern Warfare 2, was released earlier this month and sold over 4 million units on the first day alone, generating an astonishing sales estimate of $310 million.

That's the most successful single-day sale for any media release, including box-office hits such as The Dark Knight and Twilight.

The problem with those sales results is that they're sporadic. Smash hits like Call of Duty or Guitar Hero may only be released once a year, or less, as the remaining roster of games is released to middling success. Development costs for games is becoming an increasing burden. Now a major Hollywood production level has found its way to video games, with Hans Zimmer providing the score to Modern Warfare 2 and 50 Cent lending his voice.

Despite the disadvantages of video-game stocks, if an investor still wanted to own one company, it would have to be Activision. With powerhouse franchises like Call of Duty, Guitar Hero and Tony Hawk, the company likely will roll out at least two strong releases a year. Also, it has managed to stay out of the red, unlike most of its competition in recent quarters.

Video-game companies are breaking sales records. Yet, as investments, they don't look like smart bets. The companies need to prove they can be profitable and pass earnings on to shareholders.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.

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