NEW YORK (CNN/Money) – When it comes to video games, there's Electronic Arts and then there's everyone else. At least that's what Wall Street seems to think.
EA, the clear leader in the gaming software world, has a market value of nearly $18 billion. Its closest rival, Activision, has a market value of less than $3 billion. EA (Research) trades at nearly 30 times earnings estimates for fiscal 2005 while its top rivals have P/Es of about 19.
Of course, investors often are willing to pay a premium for a stock that is number one in its industry. But as I pointed out in a column last May, most of the major players are benefiting because gaming is a solid business with healthy long-term potential.
And several analysts think that the rest of the group is getting too little respect. Michael Pachter, an analyst with Wedbush Morgan Securities, said his favorite picks in the sector are Activision (Research), Atari (Research) and Take-Two Interactive (Research) -- the maker of the popular, yet controversial, Grand Theft Auto series of games.
Atari and Take-Two are particularly intriguing, he said, because they trade for just 14 times and 15.6 times 2005 earnings estimates, respectively.
"Take-Two is cheap and Atari is really cheap. Investors mistakenly look at the group as either being big and going to thrive or small and going to go broke," said Michael Pachter, an analyst with Wedbush Morgan Securities.
Activision isn't exactly a bargain, trading at 26 times estimates. But the company clearly has momentum on its side with strong titles such as its Spider-Man series of games, Call of Duty and Doom 3.
"I think Activision has one of the strongest breadth of franchises. Last year was strong for them and this year should be as well," said Jennifer Jordan, an analyst with Wells Fargo Securities.
Is EA paying too much for sports?
But isn't EA the 800-pound gorilla? Why should investors buy its smaller rivals, especially now that EA has signed exclusive contracts to make sports games using the National Football League and ESPN brand names?
Well, there are some concerns about how much EA will have to spend for these licensing agreements. In fact, Knox Fuqua, manager of the AAM Equity fund, said he recently sold his stake in EA at $61 because he's worried that increased expenses could put a dent in profit margins.
"How much did EA have to spend to get these contracts? If you're giving away the farm to make this work, it's not worth it," Fuqua said.
EA will report its fiscal third quarter results after the closing bell Tuesday and Fuqua said he would be keeping a close eye on the company's profit margins. He adds that he still likes EA as a long-term investment, calling it an "awesome" company, but that he would not buy the stock again unless it dipped back into the low $50s. Shares currently trade around $58.
So it all comes back to valuation. Sometimes investors have to take a chance on companies that don't have as strong fundamentals as industry leaders but trade at more compelling prices.
"EA and Activision are clearly the gold standards but given their most recent moves, I'm favoring the underdogs, THQ and Take-Two Interactive," said Mark Argento, an analyst with ThinkEquity Partners. THQ, (Research) known mainly for children's video games, trades at 20 times estimates for fiscal 2005. And Argento notes that THQ and Take-Two are decent takeover candidates.
Big media may want to play this game
Betting on mergers is always risky, but Jordan thinks there is a good chance that some of the gaming companies could be bought out this year by larger media companies like News Corp (Research), Walt Disney (Research) and Time Warner (Research), which owns CNN/Money.
Sumner Redstone, chairman of media giant Viacom (Research), is a majority holder in struggling video game publisher Midway Games (Research). Redstone made several purchases of the stock last year. That led to increased speculation that other media companies might want to buy a video game software firm to juice revenue growth prospects.
Many younger consumers -- who advertisers covet -- are increasingly spending more time playing games instead of watching television and Jordan thinks that the media companies need to do something to combat this trend.
"We will see consolidation in the gaming industry and major media companies will look at these businesses," Jordan said. "Ad revenue is so important to them and their viewership is going down."
And as long as there is takeover scuttlebutt, this could lift the valuations of the perceived targets, which includes pretty much everyone not named EA.
None of the analysts quoted in this story own shares of the companies mentioned. Wedbush Morgan has performed investment banking for Atari but ThinkEquity and Wells Fargo have no banking ties to the companies mentioned.
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