November 5, 1999
How to Play Video Games
By Paul R. La Monica
A LITTLE REMINDER: There are only 50 shopping days left until Christmas.
And if any of you have young kids living at home (or hey, even grown-up
children like me with a severe Peter Pan complex) odds are that a video game
or two is going to wind up on their holiday wish list. According to estimates
from market-research firm NPD Group, sales of video games during last year's
holiday shopping season (from the day after Thanksgiving until New Year's)
were $2 billion.
This Christmas, sales are likely to be boosted for many game publishers
because Sega introduced a new hardware console, Dreamcast. NPD
estimates that sales will reach $2.4 billion during the holiday season. For the
whole year, NPD predicts that video-game sales will reach $7.1 billion, up
slightly from last year's $7 billion record year.
And looking ahead to next year, there's cause for even more optimism. Sony
(SNE), which makes the industry-leading PlayStation, will start selling the
PlayStation 2 in the U.S. sometime in the fall of 2000. And Nintendo is set to
unveil its latest system, which as of now is going under the code name
Dolphin, in time for Christmas Y2K as well. And even Microsoft (MSFT) is said
to be considering getting into the hardware business with a system that is
being vaguely dubbed the X box.
You may be wondering, dear readers, why all this is interesting. This is, after
all, SmartMoney.com, not Electronic Gaming Monthly. Well, the reason I'm
opining on this subject today (besides the fact that I still enjoy playing video
games) is that there are several publicly traded gaming-software companies for
investors to look at. It's pretty much a given that the holiday season is going to
translate into big bucks for many of these companies, so it's reasonable to
wonder whether any of the stocks look appealing as an investment.
As with any sector, you need to be selective. There do appear to be some
definite winners in this group — but some stocks I'd avoid as well. Many have
performed strongly this year but are still pretty cheap. And the sector has
taken a hit in the last month along with toy manufacturers, thanks to Mattel's
(MAT) earnings bombshell related to its acquisition of educational software
maker, the Learning Company. Bobby Kotick, the CEO of video-game maker
Activision (ATVI), says the fact that a toy giant like Mattel is having problems
with a software division has had a bit of a psychological effect on investors.
Activision, for one, is down about 14% in the last month, but it's still up more
than 30% since January. And I think there's a really good chance it will have a
monster fourth quarter. The company previewed some of its new releases for
the holidays in New York last month and could have several big hits on its
hands.
Activision is releasing a game tied to the upcoming movie "Toy Story 2" and
also has a new "Star Trek" game. But the overwhelming crowd favorite at
Activision's event was "Wu-Tang: Shaolin Style," a kung-fu fighting game
featuring members of the rap group Wu-Tang Clan, such as Method Man and
Ghostface Killah, as characters. The game, set on Staten Island (which is
known as Shaolin in Wu-Tang mythology), even features previously unreleased
music, which is likely to create an even bigger demand for it. Personally, I'd be
stunned if this isn't one of the best-selling games of the season. (I'd also like to
proudly point out that I beat my SmartMoney.com colleague Ian Mount every
time we played this game.)
OK, enough bragging about my video-game prowess. Should you buy the
stock? Despite Activision's gain this year, the stock still looks pretty cheap,
trading at just 14.6 times estimated earnings for 2000. Analysts expect
earnings to increase 25% next year and 27% annually over the next three to
five years.
Another company that looks attractive right now — if a bit riskier — is 3DO
(THDO). The company, which was started by Trip Hawkins, the founder of
video-game kingpin Electronic Arts (ERTS), has taken a circuitous route to
becoming a software developer. When Hawkins left EA in 1993 to start 3DO,
his original goal was to produce a new hardware system that could rival Sega
and Nintendo. But the 3DO gaming unit failed miserably mainly because it was
overpriced. Hawkins returned to what he does best, and 3DO has made a
remarkable turnaround.
The company's strategy of building brands for its games seems to be working.
Instead of relying on licensing (i.e., making games tied to sports leagues or
movies), 3DO has taken a similar approach to Nintendo, which made its
internally developed video-game characters Donkey Kong and those wacky
Italian brothers Mario and Luigi into pop-culture icons. 3DO has a long way to
go before its characters are as ubiquitous as Nintendo's, but the company has
been successful so far with its Army Men and BattleTanx line of games.
And Hawkins has also been astute enough to recognize the dominant
presence that Sony has in the hardware market. 3DO has spent most of its
time focusing on production of new PlayStation games, and isn't making any
games for Sega's Dreamcast. "Sony is in an incredibly strong position, so we
decided to build our business around them," Hawkins says. The company
should benefit immensely once the new PlayStation hits stores.
3DO stock is up more than 66% year-to-date, but cooled recently after 3DO
announced in its third-quarter earnings report last month that it would delay
shipping one of its anticipated games until after Christmas. Even though
earnings were ahead of expectations, the stock has since slipped 20%. And
that's the sort of thing that makes this stock a bit of a risk. Obviously, a
continued pattern of delayed shipments would not be a good sign. Still, I think
investors overreacted, and now the stock looks to be very reasonably valued,
trading at just 11.5 times 2000 earnings estimates. Earnings are expected to
increase at a 32.5% clip over the next three to five years.
THQ (THQI) is another relatively cheap software company that has some
momentum. The company makes World Wrestling Federation (WWFE)
licensed video games and a line of games based on the popular Nickelodeon
cartoon Rugrats. Earnings are expected to increase 20% next year and about
21% for the next three to five years, but the stock trades at a multiple of just
14 times 2000 earnings estimates.
But as I said, you don't want to buy every game company. Take a look at
Acclaim (AKLM). The company was a huge success in the mid-1990s with
hits such as Mortal Kombat and NBA Jam. But it was slow to adapt to the new
hardware systems, and its inability to meet the demand for new games for
these systems handed the company some horrendous earnings problems.
Profits fell in 1995, and the company lost money the next two years before
returning to the black last year. As a result, the stock is trading at about 7,
well off its five-year high of 27 1/4.
And Acclaim's problems don't appear to be behind it just yet. The biggest red
flag is that the company has a huge amount of debt, 63% of capital. The
software industry is not typically one where a lot of leverage is needed.
Activision and 3DO sport debt loads under 40%, and THQ has no debt
whatsoever. So even though Acclaim is cheap, trading at about 10 times
earnings, I'd stay away from this one.
Another stock I'd be wary of is Eidos (EIDSY), a British software producer that
trades in the U.S. as an American depositary receipt. The company is best
known for making the Tomb Raider series of games, which feature the
incredibly lifelike, not to mention, uh, well-endowed, cyberbabe Lara Croft
character. Lovelorn gaming freaks may think Lara is a hottie, but that's not
enough to justify the big premium the stock gets to other game manufacturers.
Eidos hit a new 52-week high today and trades at about 27 times next year's
earnings estimates — even though its estimated long-term earnings growth
rate of 20% is lower than Activision's, 3DO's and THQ's.
Finally, we have Electronic Arts. There's no disputing that EA is the king of
this market. This company has made a name for itself by making licensed
sports games that feature the names and official stats of popular athletes. I
can personally attest to the fact that these games are among the best sports
games…and highly addictive as well. They were a major abetter of
procrastination in college.
Of all the publicly traded video-game makers out there, EA is the one to buy if
you're looking for a well-known name. With sales of $1.2 billion last year and a
market cap of $5 billion, Electronic Arts is the closest to a large-cap blue chip
in this sector. (All the other video-game makers have sales and market values
in the hundreds of millions range.) But the problem is that an investment in EA
comes at quite a price. The stock trades at a P/E of 32 times estimated
earnings for next year. Earnings are expected to increase 14% next year and
23% over the next three to five years, about in line with the growth rates for
smaller rivals that trade at sizable discounts.
I wouldn't go as far to say that EA is overvalued, but I think some of the smaller
players out there are better bargains. And I think that if the PlayStation 2 is as
big a hit next year as everyone expects it to be, current estimates for the
smaller companies could wind up being on the conservative side, which would
make them even more attractive.
Now I know you may scoff at the notion of buying video-game stocks — leave
it to me to find something frivolous to write about on a Friday. But let's be
honest: How much of a difference is there between clicking the buy button at
your online broker's Web site and playing the Wu-Tang Clan game? You could
argue that investing is just one big video game these days anyway.
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