Video games have been the blockbuster story in the software world, defying the market downturn and joining other areas of tech in an impressive run this year. Just this week, the biggest star of them all,
, hit a new all-time high of $86.30, representing a staggering 65% ascent since the beginning of this year.
Given such performance, is it too late to make a video game play? Not necessarily. Video games are heading into what many call the sweet spot in the industry's cycle, which lifted software-gaming companies despite the market's downturn.
Now at about the midpoint of the console cycle, which typically spans four to six years, developers have had enough time to create better games. And console prices have had time to drop to levels more attractive to the mass market, spurring even more game sales. A price cut is widely anticipated in the fall among at least one of the top three models (
GameCube), when a raft of new games will also debut in advance of the crucial holiday season.
Electronic Arts remains the popular pick among sell-side analysts, but there are other choices for investors hoping to capitalize on such recent industry trends. However, before exploring such options, investors should realize a few basic points about the industry, as noted by U.S. Bancorp Piper Jaffray senior research analyst Anthony Gikas in a recent note on trading in both the seasonal and cyclical video game field.
Gikas noted that multiples are highest in the years directly before and after console cycles. Gaming stocks, he said, tend to decline in the first quarter, go flat until August, then ramp up, peaking in the fourth quarter, making a company's holiday lineup crucial.
Securities and Exchange Commission
recently launched an investigation into the industry's revenue-recognition practices, which many believe would be more likely to lead to new standards for the industry rather than surprise restatements by individual companies.
Go G Rated
One area that is drawing less attention but could offer some investment opportunity is Nintendo's successful Game Boy Advance handheld system, which launched in March, said Joe Spiegel, an analyst at New York-based Spinner Asset Management.
He said retailers say it's impossible to keep on the shelves, and six of the top 10 video games sold in June were for Game Boy. "It is on fire," Spiegel says.
Given that Game Boy appeals to a younger demographic than the Xbox and PlayStation 2, Spiegel decided to look at the children's market for games rather than the sexier adult blockbusters, which are more expensive to produce. "As the console cycle enters
years three, four and five, that's where family oriented games do better," Spiegel says.
, with its family friendly titles such as
, is one of Spiegel's picks. In its latest quarter, first-quarter fiscal-year 2004, THQ beat earnings guidance and the consensus estimate by a penny on higher-than-expected revenue, driven in part by several Game Boy Advance titles.
On the small-cap side, Spiegel points to
, whose releases scheduled for the fiscal year ending in March 2004 include
The Haunted Mansion
. The company, however, posted a net loss of $7.7 million, or 34 cents a share, on $3.1 million in revenue for the quarter ending in June, down from a net loss of $2.7 million, or 13 cents a share, on $3.6 million in revenue in the year-earlier period.
On the other extreme in the gaming world is
Take-Two Interactive Software
, whose violent
Grand Theft Auto
franchise has set all-time records for unit sales on a single platform.
Take-Two has largely sat out the rally, its shares climbing only 11% since the beginning of the year and short interest at a sizable 20% of float. The problem: Many believe it's a one-trick pony, and it has had an SEC investigation hanging over its head since February 2002. An internal investigation ultimately led the company to restate results.
But its valuation -- trading at only 10 times 2004 earnings -- has prompted Wedbush Morgan Securities analyst Michael Pachter to recommend that investors "aggressively accumulate" Take-Two, which is on his firm's focus list. His firm hasn't done any banking with Take-Two.
Although riskier than Electronic Arts and THQ, Take-Two could reward for a couple of reasons. "The company has a top-secret Xbox project planned for Q1 release, and is rumored to be planning the release of one or both
games on the Xbox during the quarter," Pachter wrote in a note Tuesday. The company's first quarter ends in January. One buy-side analyst from Philadelphia who owns shares of Take-Two said he expects that rumor to be resolved this month.
The analyst also said he is optimistic about some upcoming Take-Two releases, including
Max Payne 2
, a view echoed by Pachter.
Another riskier play that could pay off is
, which is trading at 14.5 times 2004 earnings (excluding the company's sizable cash balance of $4.43 per share). In July, Activision lowered earnings guidance for fiscal year 2004 by 4 cents. W.R. Hambrecht analyst Bill Lennan has a sell rating on the stock because of product delays and his fear that the company will suffer another dismal holiday season with unproven titles in a cutthroat market.
But others are more upbeat about Activision, which they say could deliver to investors willing to wait at least a year. The Philadelphia fund manager, who owns Activision shares, cast hopes on the company's new release of
True Crime: Streets of LA
, whose graphics duplicate actual Los Angeles city streets. And Wedbush's Pachter moved Activision to his firm's focus list due to its valuation.
And for a safer play, of course, there is always Electronic Arts, the largest third-party video game software vendor, although its story may be changing.
No one can argue with EA's well-rounded portfolio of games, ranging from
to James Bond, from
World Cup Soccer
Just this week, Banc of America Securities analyst Gary L. Cooper made a particularly bullish call on Electronic Arts, setting a 12-month price target of $95, representing a 10% appreciation in value. "EA's shares may trade above $100 this fall based on product momentum, of which there will be much," wrote Cooper, whose firm expects to receive or intends to seek compensation for investment banking services from Electronic Arts in the next three months.
However, James Lin, founder of video game industry consultancy The Simba Group, advises that investors wait for a little bit of a pullback. "I would be a little selective to the entry point," Linn said. "If you are looking at investing vs. trading, it's certainly not too late to get into Electronic Arts."
Lin, a sell-side analyst covering the video game sector for eight years before starting his own firm, noted the summer period has historically been slow for the sector, but is then followed by a pickup in August and September as kids head back to school.
Enough Is Enough
On the bearish side, meanwhile, Ned Klingelhofer with the hedge fund San Francisco Sentry Investment Group is short Electronic Arts. His thinking: The gaming industry is moving from a growth to a cash flow story, which could disappoint growth investors and prompt selling.
His is a contrarian view; short interest in EA was only 4% of float as of July 8. But Klingelhofer could have a point: EA's revenue is expected to grow 16.5% this fiscal year, down from nearly 44% last year. And the industry itself has grown only 6% year to date vs. double-digit growth last year, according to The NPD Group. That number, however, excludes the all-important holiday season, which accounted for half of EA's sales in its last fiscal year.
The other reason Klingelhofer has become less enamored with the sector is that games have become increasingly tied to movies and, as with that industry, more hit-driven than ever before. During 2002, about 22% of sales of video games in North America came from about 20 games of the thousands published. Klingelhofer's only advice for anyone who wants to venture a guess on what will be the next hit: "Good luck."