Got Game?

A recent New York magazine article declared 2005 a “golden age for video games,” and anyone who has played Resident Evil 4, Madden NFL 2005 or Grand Theft Auto: San Andreas can agree.

What remains to be seen is whether this golden age extends to the shares of the companies behind these games. It might seem like kids' stuff, but these games produce grown-up numbers: $10 billion in sales in the U.S. alone in 2004, according to the marketing research firm NPD Group. The vast majority of that money — 70 percent — is generated by Electronic Arts and Take-Two Interactive, which publish the Madden NFL and Grand Theft Auto series of games, respectively.

The sector has been remarkably profitable and resistant to the forces that have battered the tech sector, including the dot-com meltdown four years ago. Over the past seven years, an index of six game software publishers kept by Michael Pachter of Wedbush Securities produced a 20 percent compound return, as compared to 6 percent for the S&P 500.

A Time to Sell?

Of course, periods of extended prosperity in a given sector often give way rather quickly to cyclical downturns, and the coming of new game hardware (Sony's PlayStation 3 and Microsoft's XBox specifically) suggests that such a backlash might be in the offing for gamemakers. Hardware transition periods in the past have hurt sales at software publishers, especially if the publishers chased early adopters and lost sight of their installed base. For instance, during the 2000-01 transition to 128-bit consoles, software sales fell about 16 percent. But Pachter does not expect sales to be hurt by the current hardware transition, and he sees gaming stocks continuing their strong performance for some time to come.

“We expect this year to be different,” he says. He notes that both Electronic Arts and Activision, which makes Doom and the Tony Hawk series of games, plan to harvest current-generation platforms through 2010 to ensure a smoother revenue stream. Further, the fundamentals look solid, given a packed software release schedule over the coming months and the imminent launch of the Sony PlayStation Portable, which will likely boost the size of the portable market that is currently defined by Nintendo's Game Boy.

Pachter sees “software stocks appreciating throughout the first half of the year,” but advises investors to buy the lower price-to-earnings-growth ratio stocks.

“Electronic Arts, Activision and Take-Two are all going to grow earnings between 15 percent and 20 percent,” he says. “But with Activision and Electronic Arts, you're paying multiples in the 20s and 30s for earnings, and with Take-Two, the P/E ratio is under 20.”

Pachter has buy ratings on Activision and Take-Two because, “I believe they have more upside over the next 12 months, but you have to take Pepto-Bismol with them because the stocks move all over the place,” he says. (There is no Institutional Investor category for gaming software, but in both 2003 and 2004, Pachter was No. 1 or No. 2 among all software analysts in terms of earnings accuracy out of 104 overall, as measured by StarMine.)

So far, the software publisher outperformance continues. Pachter's six-stock index (comprised of Atari, Activision, Electronic Arts, Midway, THQ and Take-Two Interactive) rose 15 percent from June 2004, compared to the S&P 500's 5 percent over the same period. Atari is down 4 percent; Activision is up 31 percent; Electronic Arts is up 27 percent; Midway is down 9 percent; THQ is up 23 percent; and Take-Two is up 20 percent. (The index is price-weighted. Had it been capitalization-weighted, it would have given Electronic Arts more impact, making the outperformance of game publishers even greater.)

Last year's best-selling games were Microsoft's alien-fighting Halo 2 and Take-Two's Grand Theft Auto: San Andreas. Both are sequels, as is common in the industry. In 2003, of the top 30 software titles, 26 were sequels, and of the four new titles, three were licensed properties, with just one game representing brand-new intellectual property.

An Acquired Taste

The steady stream of revenue makes the gamemakers attractive acquisition targets. In mid-February, The New York Times reported: “Wall Street is rife with speculation that media companies are on the hunt to acquire a video game maker like Activision or Electronic Arts.”

Absent such a deal, one of the big gamemakers is a less appealing buy right now than the others, according to Pachter: Electronic Arts. Last quarter it slipped a notch on both top and bottom lines and offered 2005 guidance that sounded cautious. Pachter sees shares, now trading over 30 times forward earnings, as “approaching full valuation.”

More alluring is Activision, which recently beat analyst expectations and provided better-than-expected forward guidance. The company reported third-quarter earnings per share of 63 cents, against consensus expectations of 53 cents, and raised guidance for fourth-quarter revenues to $150 million from $128 million. For fiscal 2005, it increased earnings per share to 87 cents a share from 81 cents. The company's future growth is undervalued, Pachter argues, given that shares trade for an earnings multiple 30 percent below that of Electronic Arts.

Hot titles from Activision include Spider-Man 2 — the only game based on a movie tie-in that reached NPD's Top 10 in 2004 — and Shrek 2: Beg for Mercy. Both are sequels, though Activision's most sequelized title Tony Hawk, an extreme sports game in its sixth version, also ranked among 2004's Top 10.

As Electronic Arts owns sports and Activision extreme sports, Take-Two Interactive owns the “edgy” space by virtue of the runaway success of the Grand Theft Auto series. That single-franchise dependency raises flags, however. Notes Pachter, “With Take-Two, it's a bit like looking at Mattel. Are you impressed with Mattel's Barbie? Everyone seems to think Mattel should have 10 Barbies, but they really have only one Barbie.”

Still, as with all the players in this sector, Take-Two stands to benefit from the general perception that games are improving at such a rate that real fans must have them. As long as that feeling remains, the future looks bright for the sector as a whole.