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Wall Street, California | SECTOR SPOTLIGHT

To Play Video-Game Stocks, Look for Hit Machines

June 09, 1998|JAMES PELTZ

Picking a winning video-game stock is about as easy as Sonic the Hedgehog's struggle to wind through his ever-changing 3-D maze.

This year is no exception. A look at the field shows that some of the stocks are up nicely this year, while others have been big disappointments. And although the industry overall is expected to enjoy a strong holiday selling season in 1998 after slumping in the mid-1990s, analysts by no means think all of its players will share the spoils.

That's because video-game companies are only successful if they "have consistently good" games, said Robert Fagin, analyst at CIBC Oppenheimer in New York. "It's a title-driven business," and video-game fans are a notoriously fickle bunch.

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Even so, unit sales of games in the U.S. market this year will jump 31% to 84 million, and the dollar value is expected to surge 32% to $3.7 billion, according to DFC Intelligence, a research firm in San Diego.

The games are mostly played on four "platforms": personal computers and three console--the Sony PlayStation, the Nintendo 64 and machines made by Sega Enterprises. The growing market for sub-$1,000 PCs is giving sales a lift, and there's widespread speculation that console prices, which now range from $129 to $149, will drop this holiday shopping season, generating more game sales.

But like the movie, compact disc and book industries, it's not easy to know which video games will be hits. That, in turn, makes it tough for investors to find game makers with predictable earnings growth.

So which stocks to pick?

If there's one that analysts like for its sustained performance, it's industry powerhouse Electronic Arts Inc. (ticker symbol: ERTS). For its year ended March 31, Electronic Arts' profit surged 41% from the prior year on a 35% jump in sales, to $909 million. Wall Street is looking for fiscal 1999's diluted earnings per share to reach $1.61, up from $1.19.

The San Mateo-based company has zero long-term debt and "remains the best-managed software company in the group," said analyst Michael Stanek of Lehman Bros.

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Fagin likes Electronic Arts for another reason. About 60% of its business comes from sports-related games--"John Madden NFL Football," for instance. Because the player rosters of sports teams keep changing year after year, consumers keep buying the newest versions. "Sports acts like an annuity for them," he said.

Notably, though, two of the four best-selling games for PCs last year--"Myst" and its sequel, "Riven"--came from struggling Broderbund Software Inc. (BROD), Fagin said.

With its overall business sagging, Novato-based Broderbund's main attraction is the constant speculation that it's a takeover candidate. But most analysts are neutral toward the stock, which has plunged 32% in 1998 alone to a recent $17.50 a share.

Another game maker that's struggled is Santa Monica-based Activision Inc. (ATVI), whose stock has plunged by nearly half in just the past six months. With the help of acquisitions and such hit games as "Quake II" and "Nightmare Creatures," Activision's revenue in its fiscal year ended March 31 soared 68% to $260 million--but net income dropped 37%. That prompted analyst Stewart Halpern at Furman Selz Inc. to downgrade the stock from "buy" to "hold."

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What gives? Activision has been expanding its business of distributing games developed in-house and by others worldwide, said James Lin, analyst at Wedbush Morgan Securities in Los Angeles. That's a smart move long-term, but in the interim it's eroded the company's earnings because distribution carries much thinner profit margins than publishing games.

"When investors looked at [the decline in] Activision's gross margins . . . it was a difficult pill to swallow," he said.

Nonetheless, Lin calls the stock "an attractive buy at these prices"--it trades around $9.50, or 16 times its expected fiscal 1999 earnings--not only because the wider distribution will eventually pay off, but Activision is stepping up development of new games. One example: It just signed a deal to make an X-Men game for the PlayStation under license from Marvel Comics.

Lin also recommends another Southern California-based game maker, THQ Inc. (THQI) of Calabasas, even though its stock has sagged lately after more than doubling last year. The shares got a particular drubbing this spring when THQ lost its licensing agreement with World Championship Wrestling to Electronic Arts.

THQ runs "a very low-risk" business by largely avoiding high-cost development in-house and instead distributing licensed games in the U.S. market that "have been proven in other regions," he said. With development costs reduced, THQ can sell a modest number of games and still turn a profit, Lin said.

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