Game On for Gamemakers

The sector heats up as investors await earnings reports and the annual E3 confab.
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Over the last several months, the thrill has been gone from the video-game industry.

The hype surrounding the launch of

Microsoft's

(MSFT) - Get Report

Xbox 360 game console last fall has been followed by disappointing shipments of the new device and poor holiday sales for the industry.

But despite the crummy environment, investors haven't been able to go bargain hunting; instead, the shares of the biggest publicly held game software publishers have largely held steady, thanks to long-term holders betting on future returns.

However, excitement could return to the sector over the next two weeks -- with good or bad results. On the potential down side, three of the top four independent game publishers --

Electronic Arts

(ERTS)

,

Activision

(ATVI) - Get Report

and

THQ

(THQI)

-- report earnings later this week. None of them are expected to do particularly well, and because recent reports have disappointed, there's some fear on the Street that these could as well.

On what could be the positive side, the industry's annual E3 confab gets under way in Los Angeles next week.

Sony

(SNE) - Get Report

and

Nintendo

are both expected to give more details on their own upcoming game machines, and that should spark some excitement from gamers and possibly investors.

The industry is in a "lull," says one buy-side analyst who covers the sector. Investors are "really kind of trying to game when the sentiment is going to improve," says the analyst, whose firm manages $60 billion in assets and holds stakes in several publishers. "Arguably, we're getting much closer to that time period, but people are still in a wait-and-see mode."

That attitude has been prompted by the ongoing console transition, which Microsoft inaugurated with the launch of the Xbox 360. In the past, similar transitions have resulted in slumping sales and earnings for game publishers as demand for older-console games slackens and companies rev up development of new-system titles.

But many analysts and industry figures had expected that things would be smoother this time. Publishers had planned to keep sales up by continuing to roll out games for older consoles over a much longer duration than they had in the past. Meanwhile, sales of games for new handheld systems such as Sony's PSP were supposed to pick up some of the expected slack in demand.

Things didn't turn out as expected. While handheld games have proved popular, they haven't been able to fully replace sales of older-console games, which have fallen off a cliff in recent months. Sony waited longer than expected to cut prices on the PlayStation 2 and PSP, possibly hindering demand for related games. And, facing supply constraints, Microsoft shipped far fewer Xbox 360s than expected, limiting the number of games that could be sold for that console.

The result: a console transition that was supposed to be better than those of the past has proved more difficult. Even if they meet earnings expectations this week, EA and Activision -- the two largest independent game publishers -- will post full-year fiscal results far below the guidance they gave a year ago.

That said, investors have largely rolled with the punches. Over the last year, shares of all three publishers that report earnings this week are up -- THQ's most dramatically, with a 45% gain.

That resilience has left the stocks with fairly expensive near-term valuations. EA, for instance, is trading at more than 50 times its expected earnings for fiscal 2007, which ends next March. Activision is trading at nearly 90 times expected fiscal 2007 earnings.

Those heady figures have left at least some investors skeptical that the stocks will give much of a return, even if they do start rising again in coming years as sales of -- and earnings from -- new console games pick up.

"The appreciation potential in the space right now is OK, but not compelling enough to be heavily invested," says Tony Ursillo, a buy-side analyst at Loomis Sayles, which holds small long positions in Activision and EA.

Indeed, many analysts are still hoping for an entry-point selloff. And some believe that the earnings reports this week -- EA, Activision and THQ report Wednesday, Thursday and Friday, respectively -- could provide the impetus. While long-term holders of the stocks likely expect bad news, the news could be even worse than they are prepared to absorb, says one hedge fund analyst.

"People tell themselves that they are willing to wait. The problem is, they've been waiting for a while. Some funds are getting a little tired of waiting," says the hedge fund analyst, who asked not to be named and whose firm has long stakes in Activision and

Take-Two Interactive

(TTWO) - Get Report

. "If they get pushed too far, they may say they don't want to wait anymore."

On the flip side, news out of the E3 confab could potentially shore up belief in the sector's future -- and convince skeptical investors that the low levels for the publishers' stocks are about to be a thing of the past.

A number of the publishers' stocks saw a bump last fall as excitement built over the Xbox 360. And that's for a platform whose predecessor was a distant second behind the PlayStation 2 during the past console cycle. Any positive news from Sony about when exactly it will ship the PlayStation 3, how much it will cost and how many units it will have available at launch could get gamers and investors amped up about its upcoming launch.

News from Microsoft that might indicate strong future sales and excitement around the Xbox 360 or from Nintendo about its own upcoming Wii console also could help stocks.

E3 could provide a "catalyst" for the stocks, says the buy-side analyst. But it's more likely that investors will continue to have to wait for the thrill to return.

"All these companies have laid it out pretty clearly that calendar 2006 is going to be a real transition year for them," the analyst says. "There isn't much exciting now,

but we may be getting some buzz going into the holiday season."