More Lives Left for Game Makers

Despite a recent rough patch, 2004 could be a banner year amid price cuts and the PlayStation Portable.
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Video game makers have lost some of their luster in recent weeks amid worries over weak holiday sales. But investors shouldn't write off the sector just yet. A few developments stand to help video game makers in 2004, including a likely console price cut and the debut of the PlayStation Portable.

To be sure, the latest selloff seems justified given recent numbers tracking video game sales. NPD Funworld recently estimated that North American video game retail sales -- excluding sales at

WalMart

(WMT) - Get Report

-- grew a modest 2.5% year to date through November. NPD has yet to report December sales.

Accordingly, shares of market leader

Electronic Arts

(ERTS)

have fallen 6.7% since mid-November,

Take-Two Interactive

(TTWO) - Get Report

-- also hit by an ongoing

Securities and Exchange Commission

investigation -- is down 28.7% and

THQ

(THQI)

is down 8%. By contrast, the Goldman Sachs Software Index edged up 1.4%, and the

Nasdaq Composite

rose 1.9% during the same period.

Activision

(ATVI) - Get Report

, which preannounced stronger-than-expected holiday sales, bucked the trend with an 11.5% bounce.

The November sales numbers may not seem encouraging, but company comments suggest December may not have been the disaster many feared. Furthermore, lower valuations resulting from the sector's weakness prompted U.S. Bancorp Piper Jaffray senior analyst Anthony Gikas to raise his ratings in mid-December to outperform from market perform on several names, including THQ, ERTS and Take-Two. U.S. Bancorp has done investment banking with all three companies.

Meanwhile, Viacom CEO Sumner Redstone got regulatory approval this week to buy more shares of troubled

Midway Games

(MWY)

.

One likely reason for unspectacular holiday sales is the refusal of console makers

Microsoft

(MSFT) - Get Report

and

Sony

(SNE) - Get Report

to cut console prices this holiday season -- in contrast to the past -- and instead bundle games or peripherals with consoles.

But the absence of a price cut on consoles before the holidays all but guarantees there will be one next year, a crucial step to attracting a more mainstream audience and thus boosting software sales. The question is when.

Most observers expect cuts will come around the E3 video game convention in May. But Wedbush Morgan Securities analyst Michael Pachter believes Sony will cut the price of PlayStation 2 in January or February to boost sales before its fiscal year ends March 31.

As console prices fall, Pachter believes video game software prices should also fall 5% to 7% next year. On the surface, a drop in average software prices may look like a bad thing, resulting in lower profit margins for game makers. But the decline can ultimately result in higher overall sales if enough people buy more games at the lower prices.

Declines in both software and console prices are normal at the midpoint in the console cycle -- the period between the launch of video game consoles -- and are not necessarily a negative, according to NPD analyst Richard Ow. "It may spell double-digit volume increases," depending how the mass market responds, he said.

Until prices drop, only hardcore gamers buy consoles and games. But with console prices expected to drop to $149 or even $129 from their current price of $179, the mass market is expected to start playing games, too.

While Gikas forecast a 15% drop in average software sales prices next year, Pachter says that's too steep. He believes video game makers will be careful to avoid repeating past mistakes, in which they suffered losses as profit margins declined while research and development costs rose.

If and when the mass market jumps in, family-friendly games become more popular. That's why P.J. McNealy, an analyst with American Technology Research in San Francisco, is most bullish about THQ, whose lineup includes such titles as

Finding Nemo

and

Scooby Doo

. THQ is the only stock McNealy has currently rated buy.

"Anyone that's aligned with a family demographic stands to perform well in 2004 and 2005," McNealy said. (His firm doesn't do any investment banking.)

Nintendo

(NTDOY)

, with its popular GameBoy handheld and lower-priced GameCube console, also falls into the family-friendly camp. "Nintendo has had a tremendous holiday season in North America," noted McNealy, who does not cover Nintendo.

Nintendo was the only console maker to cut prices before the holidays, boosting sales. Nintendo's

Mario Kart: Double Dash

game for the GameCube was also the top-selling game in November, ringing in an estimated $27.5 million in sales in North America, according to NPD.

A couple of wild cards could further boost sales in 2004: the launch of Sony's PlayStation Portable (PSP) handheld device and Take-Two's

Grand Theft Auto 5

.

Sony's PSP is expected to launch in Japan and possibly North America in the second half of the year. If Sony achieves its goal of selling 10 million PSPs worldwide, that would translate to a 3% jump in U.S. software sales, says Wedbush's Pachter. But the PSP's price tag will be a major determinant of whether Sony achieves that goal, and Sony has yet to disclose it, he noted.

Meanwhile,

Grand Theft Auto 5

, the latest release of the top-selling franchise, could be a game changer when it comes out before the 2004 holiday season, reigniting hardcore gamers' excitement.

It's also one major title among a stronger lineup in 2004 vs. 2003, which includes sequels of

James Bond

from Electronic Arts and sequels of

Shrek

and

Spiderman

from Activision, Pachter said.

Pachter expects overall video game software sales dollars to grow in the mid- to high-teens next year, driven by 20% to 25% growth in game units sold. Such unit growth does not appear unrealistic: The bright spot in NPD's November numbers was a 19% year-over-year jump in unit sales for the month and a 12% jump in year-to-date unit sales.

All that means video game makers may be a good play after all, despite the year-end jitters.

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