Electronic Arts: Shock Therapy

Loyalists say value will emerge at the hammered-down game maker.
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Earnings have fallen two straight years at

Electronic Arts

(ERTS)

, and the company expects things to get worse. But that hasn't shaken the faith of many long-term holders -- nor dissuaded others from buying in.

EA's shares fell as much as 14% on Thursday after the video-game software provider offered an extremely disappointing outlook that called for earnings as low as one-third what analysts were expecting.

Despite the slide, many analysts and longer-term holders are willing to continue giving the company the benefit of the doubt and chalk up the company's recent problems to transition troubles as the industry moves to a new generation of hardware. As the largest video game publisher, EA stands to benefit as a mass market starts to develop in coming years for new game consoles and the software for them, bulls say.

"Despite where we are in the cycle, the fundamentals are strong," says Darren Chervitz, a research analyst at Jacob Asset Management. "Over the next couple of years, I think

video-game-publisher stocks are good investments." Chervitz' firm is long EA and

THQ

(THQI)

.

Bulls such as Chervitz back up their case with a number of arguments. First and foremost, they note, are overall trends in media usage. Consumers are spending more time playing games or surfing the Internet than watching television or reading newspapers, they note. Meanwhile, while games continue to have their stronghold in the teen and pre-teen set, the average game player continues to get older as the overall demographic appeal of video games has broadened, they say. The new consoles, which have robust graphics engines and online capabilities, should help extend those trends, they say.

"The gaming experience is going to be significantly better

on the new consoles," says Kyle Flynn, an analyst at investment firm TCW, which is long EA. "The big picture is the trends haven't changed. People are going to continue playing these games. As they get more intense and rich, they will appeal to a broader audience."

But aside from the industry argument, there are specific reasons to be bullish about EA, investors say.

True, the company offered disappointing guidance for every quarter last year, notes Flynn. With its earnings report Wednesday, EA predicted that it would earn between 35 cents and 65 cents a share, excluding certain costs, while the Street had been predicting earnings of $1.07.

Essentially, the company has learned its lesson, Flynn argues. Instead of having to continually disappoint investors, the company has lowered the bar so far that it is unlikely it would have to again, he says. For instance, the company's revenue estimate, which calls for sales, excluding those for mobile phones, to be down more than 10%, seems "somewhat unrealistically low," Flynn says.

"I wouldn't be surprised if there's upside from here," he says.

Regardless of whether there is, many investors are perfectly ready to write off 2006. Microsoft's Xbox 360 still not out in large quantities, and new consoles from

Sony

(SNE) - Get Report

and Nintendo likely won't be available in large numbers until sometime next year. So, sales of next-generation games likely won't pick up until sometime in 2007, they say. Sales troubles in the interim should be expected.

Indeed, some investors were surprised by the market's reaction on Thursday.

"It was pretty widely known that this was going to be a tough year," says Matt Kelmon, a fund manager at Kelmoore Investment, which is long EA. "I thought that was somewhat in the stock."

It wasn't. But bulls aren't about to cash out of EA now. The launch of Sony's upcoming PlayStation 3 this fall is likely to give a lift to video-game stocks, they say, as investors and the market start to get excited about sales of next-generation games. As sales of games start to increase in coming years, EA's earnings should start to rebound, sending its stock higher, they say.

Many investors have been waiting for an entry point into EA, hoping to cash in on the growth over the next technology cycle. And some found it amid the selloff. Steve Monticelli, president of Mosaic Investments, for instance, had been waiting for months to buy EA, but had found it too expensive.

"I finally own some ERTS now," he said, following the post-earnings selloff.

EA's returns this fiscal year are being held down in part by investments the company is making in a variety of new technologies -- not just next-generation game machines, but games for mobile phones and handheld systems and online games. Those investments may be depressing earnings now, but investors are expecting them to pay off down the road.

"They have the largest resources of any interactive game company," notes Flynn. "They're deploying them now to make sure they maintain that leadership position."