Beneath the Game Sector Hype

More often than not, yours truly is doing one or all of the following:

• Thinking about work
• Doing work
• Thinking about doing more added work
• Hitting the weights (gym that is, not those on the fishing pole)
• Trying to improve upon an already majestic baseball swing

There are time slots allotted to consuming food and water, and the occasional shut the door/turn off the phone decompression moment, but on balance these are kept to a minimum (why wage a battle with the Crackberry organizational calendar, after all). As a result of the feedback loop that is my existence, a passion to sit down and play videogames has fallen by the wayside. It’s an unfortunate outcome of adulthood I suppose.

What’s more unfortunate is the dust collecting on the Xbox 360 (MSFT) I purchased in 2006 in the hopes of becoming an Xbox-Liver (online service) to essentially join forces with other gamers across the world to pick off a bad guy sniper in the latest shooter. The games for the Xbox 360, Playstation 3 (SNE), and to a lesser extent the Nintendo Wii (NTDOY.PK) have steep learning curves and require too much time to obtain the trust mastery required to make the experience fun.

So, why invest $59.99 in the latest iteration of Grand Theft Auto when the title is likely to stay in the wrapper? I know you heard much about the “staycation” amidst the onset of the recession, where families sit at home, order in food, and rock out to Guitar Hero (ATVI) until the wee hours of the morning.

Although this trend has materialized to some form or another, the fact is that lifestyles are more hectic than, say 1985, when the first Nintendo console was released to a curious crowd (I admit, mom and dad bought me a powerpad).

Touching upon hype, the current game hardware cycle has been a colossal bust from an investment standpoint. When these consoles were introduced in 2005/2006 (first with the Xbox 360, then the Playstation 3 and Wii), the analyst community was simply Ga-Ga for the videogame sector as a vehicle to earn super investment returns (ok, I admit, I had my moments as well). The consoles were to usher in a new interactive environment in game land, rife with online content, rich graphics, and unparalleled processing speeds (say goodnight to load times).

Of course, third-party videogame publishers were to be the prime beneficiaries, despite the clear and present danger to future earnings from increased per title development costs and consumer adoption risk. Companies such as Midway Games, Electronic Arts Inc. (ERTS), and THQ Inc. (THQI) raced to purchase game design studios with “hot” engineers and development technologies. Premium prices for the console titles were supposed to lead to strong earnings growth, and Electronic Arts in many respects was said to become the next Microsoft (MSFT).

However, the current console cycle has brought anything but good tidings to the publisher sector. Midway Games, for instance, filed for bankruptcy late last year (is selling assets as we speak) under a burdensome debt load and a product pipeline that just plain stunk.

Now, publishers are shedding the same design studios that they paid premium prices for just to make an earnings number and stop some series cash outflow. The data provided (which is on a GAAP basis rather than the non-GAAP numbers used by the publishers) serve as illustration to my points.

Electronic Arts

• Share price since the start of 2005: -63.0%
• Development expenses: +114.0% since FY05 (total spent is $4.9 billion, which excludes licensing costs, marketing expenses, and other outlays)
• Revenues since FY05: +35.0%

THQ

• Share price since the start of 2005: -69.6%
• Development expenses: +36.34% since FY05 (total spent is $509.0 million, which excludes licensing costs, marketing expenses, and other outlays)
• Revenues since FY05: +9.6%

Final Thoughts

I bring this tale to the forefront on the eve of the E3 Expo starting in full swing. You will hear the hype of new hardware attachments, potential price cuts for all systems in the market, and long-term health of the industry.

But, as an investor, it’s critical to not be fooled by the hype machine and make one’s own judgments (especially on a highly cyclical, low barrier to entry industry as videogames). Four years into the current console cycle, game publishers have shot a hole through shareholder value and are not earning their cost of capital. The notion that publishers could dump a premium-priced title on the market, one with sub-par graphics and plot structure and expect to drive volume is pure nonsense.

I have already seen price cuts on current generation console games of the second tier quality, which has started to spread to “AAA” franchises post launch. Gamers are very savvy, and are tuned into chat rooms and ratings agencies to see which titles are the most compelling. If the game flat out sucks, it will sit on the shelves and the retailers will put the units back to the publisher (publishers mark the inventory down). It’s that cut and dry.

And, long-term, say around 2011, one could conceivably begin to hear about new consoles which will cause additional development expenses. Unlike the entrance into the current console, publishers will likely have leaner resource pools.

Authored by Brian S. Sozzi, an Equity Research Analyst for Wall Street Strategies, Inc. (www.wstreet.com) covering companies in the Retail (hardline and softline) sector.

Disclosure: None

Comments

[holderofumpq:]

ATVI (Modern Warfare) up 225% since Jan 1 2005
SNDA (China online gaming) up 69% since Jan 1 2005

There's no point in making selective arguments against a sector; you have to look at the sector as a whole.

Jun 04 08:00 PM

[Michael Comeau:]

It's a bit unfair that you selected just two stocks to make your point.

Jun 05 11:57 AM

[Wall Street...:]

Hi Mike. Check out my update


On Jun 05 11:57 AM Michael Comeau wrote:

> It's a bit unfair that you selected just two stocks to make your
> point.

Sep 17 12:51 PM

[Wall Street...:]

SNDA=Not a traditionally game publisher


On Jun 04 08:00 PM holderofumpq wrote:

> ATVI (Modern Warfare) up 225% since Jan 1 2005
> SNDA (China online gaming) up 69% since Jan 1 2005
>
> There's no point in making selective arguments against a sector;
> you have to look at the sector as a whole.

Sep 17 12:52 PM