Gamemakers Lost in Transition

Electronic Arts' earnings report may shed light on when next-generation games might revive the sector.
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With the video-game sector going through a rocky period, some investors think the best bet right now is not to make one.

Traders will get an update on the industry's health over the next several days as three of the leading players report results for the just-completed holiday quarter. But don't expect these reports to spark investor interest -- or lift share prices.

"We're on the sidelines right now," says one hedge fund analyst whose fund has invested in the sector in the past. "It's still a little early get back in."

What's discouraged investors is the transition underway to a new generation of video-game technology.

Microsoft

(MSFT) - Get Report

released its Xbox 360 last fall, initiating a new console cycle;

Sony

(SNE) - Get Report

and

Nintendo

are both expected to release their own new game boxes later this year.

As has happened in past cycles, the launches depress demand for older-generation games and boost costs for game developers as they build titles for the new systems.

While most analysts have been expecting the transition to weigh on results, game sales held up much longer than many expected. But the bottom finally seemed to drop out of the industry in recent months.

Electronic Arts

(ERTS)

and

Activision

(ATVI) - Get Report

issued an earnings warnings last month.

Take-Two Interactive

(TTWO) - Get Report

, which last month

reported disappointing results for its quarter ending in October, also warned of disappointing results for the holiday period and for its full fiscal year.

THQ

(THQI)

has

reiterated its own guidance, but that forecast called for results that are significantly down from those of a year earlier.

EA reports Thursday, THQ reports Friday, and Activision releases its numbers on Monday.

Meanwhile, industry research firm NPD has been reporting

disappointing game sales results for months.

Those issues have started to weigh on share prices. EA, for instance, is down 4% over the last three months and Activision is off 9%. Shares of Take-Two,

Midway Games

(MWY)

and

Atari

(ATAR)

are each down more than 20% over that period, although all three companies have specific problems on top of the industry's overarching troubles.

For many investors, though, the issue isn't the fact of the shift but determining how long it will last. The thinking is that stock prices won't really rally until investors gather some sense of the transition's finality.

And that's really up in the air. Although Microsoft has released the Xbox 360, the company has shipped fewer units of the new console in the holiday quarter than many analysts had expected. And it lowered its forecast for the number of units it will ship the first 90 days after launch.

That's a concern for publishers, because software sales are closely tied to hardware sales. Gamers typically purchase several games when they buy their new systems. The larger the number of consoles already in users' hands, the bigger the potential market for individual titles later in the cycle.

But the problem is bigger than Microsoft. Neither Sony nor Nintendo has said exactly when their machines will launch, in what areas of the world or how many units they plan on shipping. Meanwhile, Sony has declined to cut the price on its PlayStation 2 console, which dominated the last console cycle, for more than a year. Many analysts think that a price cut could juice sales of both the console and the related games.

"There's not a lot of visibility," says the hedge fund analyst. "It's a little bit tough for us to figure out right now."

And then there's the issue of game pricing. Companies such as Activision are trying to push the standard price for next-generation games up to about $60 a title, but there's some question about whether that price hike will stick. Meanwhile, there's concern that pricing for current-generation games are going to fall precipitously. EA, for instance, recently slashed prices on a number of its top titles for the older consoles.

"We're still concerned about the sector overall," says Evan Jones, managing partner at Brightleaf Partners, noting the pricing and other issues. Though Jones follows the sector, Brightleaf has no current positions in the game publishers.

Electronic Arts, which is the dominant player in the industry, finds itself at the center of these concerns. While many analysts and investors think the company will maintain its dominance, its recent track record leaves them worried about how long it will take the company to get back on track.

For the last five straight quarters, EA has given guidance below analysts' estimates, and twice in the last year, the company has issued midquarter earnings warnings. Its first-half results this year are well below that of a year earlier. That poor result follows a decline in earnings in the last fiscal year.

Steve Monticelli, who follows the video-game publishers as president of Mosaic Investments, wonders "how much longer the Street will tolerate repeated earnings warnings without punishing the stock." Shares of EA are off 12% over the last year, but have found a base level of support at around $55.

That support may hold because many investors and analysts are bullish about EA's longer-term prospects. The company dominates the market for sports games and has some of the most important licenses in the business. And unlike most of its peers, EA recognizes all development costs as it incurs them. That hurts the near-term as the company invests in next-generation games, but it should benefit the company's results down the road.

"Everyone who owns this stock owns it for calendar 2007. They don't own it for this year," says one hedge fund portfolio manager, who asked not to be named.

But like many others investors, he's on the sidelines, waiting for a better opportunity to buy EA and other stocks in the sector.

"The stock starts to work and gets out of its range when it starts to beat numbers," the fund manager said.

Investors can only hope that happens soon.