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Time to play a game?
EA's struggles have tainted the entire video game software industry. But rivals are good values.
May 3, 2005: 12:32 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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Wall Street hopes Sony's new PSP handheld device will lead to strong video game sales in the second half of the year and in 2006.
Wall Street hopes Sony's new PSP handheld device will lead to strong video game sales in the second half of the year and in 2006.
Industry leader Electronic Arts has lagged the performance of its smaller rivals during the past year.
Industry leader Electronic Arts has lagged the performance of its smaller rivals during the past year.

NEW YORK (CNN/Money) Like many of the teens who are among their biggest customers, video game software companies have reached that dreaded awkward phase.

Business has been booming for the past few years but sales are starting to slow as the major console makers -- Sony, Microsoft and Nintendo -- get ready to launch new systems.

Microsoft's Xbox 2, for example, is due out later this year while Sony is widely expected to start shipping PlayStation 3 in 2006.

That's not to say that new software titles for existing consoles won't continue to be hits with the gaming cognoscenti but the average video game consumer may not have as ravenous appetite for older games.

And that's reflected in a fairly tame outlook for industry leader Electronic Arts (Research), which will report its fiscal fourth-quarter results on Tuesday.

EA stunned Wall Street in late March when it said that revenues and earnings would be lower than expected for the quarter, mainly because sales of new releases were not enough to offset declines in sales of older games.

As a result, analysts now expect earnings to plummet 62 percent from a year ago on an 8 percent year-over-year sales decrease. Since the warning, EA's shares have plunged more than 20 percent.

EA's bombshell sent shock waves throughout the sector. Shares of competitors THQ (Research) and Activision (Research), which will also report fourth-quarter results this week, have fallen 11 percent and 13 percent respectively. Take-Two Interactive (Research), which makes the popular Grand Theft Auto series of games, has dropped 12 percent.

Smaller is better...and cheaper

So is this a buying opportunity? After all, video game companies have been solid performers, holding up well during the economic slowdown and tech stock crash earlier this decade.

In fact, the four major video game software companies are all trading higher now than they were five years ago. That's not something you can say about most tech companies.

For longer-term investors, this could be a good time to jump in. The smaller publishers look particularly attractive. But be forewarned, there will be bumps along the way.

"EA's guidance put a scare in the market -- console transitions can be a rough time," said Geoffrey Mogilner, an analyst with Soleil-Decatur Jones, an independent research firm

"People look at the stocks on a quarter-by-quarter basis but there's a lot of volatility and that could remain for the next year and a half."

EA remains the king of the industry but analysts say it's probably not the best bet right now since it still commands a steep valuation premium to its rivals. The stock trades at 30 times earnings estimates for fiscal 2006 (ending next March) even though earnings are expected to increase by just 1 percent.

"Why pay 30 times earnings for little growth?" said Mike Hickey, an analyst with Janco Partners.

Hickey see better value in Take-Two, trading at 17 times estimates for this fiscal year, which ends in October. Earnings are expected to increase more than 50 percent thanks largely to the success of its latest "Grand Theft Auto" game.

Mogilner said he'd also be wary of EA at these levels. He thinks Activision is a good investment though, trading at 21 times earnings estimates for fiscal 2006, adding that Activision has a better chance of pleasantly surprising Wall Street due to strong sales of its "Doom 3" game.

What's more, Mogilner thinks Activision's guidance for the next few quarters could be decent because the company has two games coming out in the next few months tied to summer movies, DreamWorks Animation's (Research) "Madagascar" and "Fantastic Four," the latest film adaptation of a Marvel (Research) comic book.

PSP could boost sales

And there's another possible positive catalyst on the horizon for the patient investor.

Sony (Research) appears to have a hit on its hands with is handheld PlayStation Portable (PSP), which debuted in the United States in March.

Sales of games for this device probably won't have a major impact on companies like EA, Activision and THQ in the immediate future but could help lift results towards the end of this year and into 2006.

"PSP is important but keep in mind, but the installed base is still small. It's more important for Christmas of this year and next year," said Arvind Bhatia, an analyst with Southwest Securities.

Meanwhile, short-term investors probably will find little to like in the video game software industry. The next few quarters should be characterized by relatively unexciting growth rates. For this reason, Bhatia thinks investors should stay on the sidelines.

Furthermore, momentum investors may have started to bail on the group due to a belief that the companies are no longer likely takeover targets for larger media firms, like Disney (Research) and Time Warner (Research), which is the parent of CNN/Money.

Merger talk had picked up after Disney announced last month that it was buying a small privately held game developer and Time Warner's Turner Broadcasting unit said it was partnering with several publishers to launch an online network for video game downloading.

But the good news for the long-term investor is that takeover fluff may no longer be factored into the stocks, which makes them less risky now.

"Valuations are based on core long-term fundamentals, not the likelihood of an acquisition," Mogilner said. "So a lack of speculation shouldn't weigh heavily on the stocks going forward."

For more coverage of video games by Chris Morris, click here.

For more personal tech news, click here.

Analysts quoted in this story do not own shares of the companies mentioned and their firms have no banking ties with the companies.

The writer of this story owns shares of Time Warner through his company's 401(k) plan.


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