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The video game sector is one of the hottest spots for investing. And one of the hottest events in the space is the E3 annual conference. This is the place for gaming companies to build hype for their biggest blockbuster games or hardware of the year.

I caught up with Wedbush Morgan analyst Michael Pachter to get his veteran perspective on what he is expecting from E3 2010. In addition to a sneak peek at where the video game sector is headed, Pachter gives us an inside look at some of the companies we should be watching closely: E3 2010 Preview with Michael Pachter.

Prefer to read? Here’s the transcript of the podcast above:

Damien: Good afternoon, everybody, and welcome to the Wall Street Cheat Sheet podcast. This week we have an exciting guest, Michael Pachter, Analyst at Wedbush Morgan who covers the videogame in interactive entertainment space. Michael’s going to be talking to us today about a very exciting conference coming up very shortly called the E3 Conference. It’s out in California. And this is one of the premier events of the year for the interactive entertainment industry where all the exciting new developments are released for videogame fans. And today, Michael’s going to talk with us a little bit about some of the things he expects to see at E3 and how some of these developments and what he’s hearing will be affecting some of the stocks and companies that he covers at Wedbush. Welcome, Michael, and thank you very much for joining us today.

Michael:Thanks, Damien. I’m glad to be here.

Damien: So, Michael, E3 is, you know, one of the exciting events. And I know all my friends and my gamer friends are just absolutely pumped to see what’s going to come out at the event this year. Since you probably get a preview glimpse of some of the stuff or at least hear some chatter, can you maybe share with our listeners some of the things that you expect to be the more exciting developments in this year’s conference?

Michael: Yeah. It appears to me that this year is more of a hardware show than any we’ve had in the last, you know, probably eight or nine years. You know, we had a lot of buzz back in 2001 when the GameCube (OTCPK:NTDOY) and the Xbox (Nasdaq: MSFT) were unveiled. And we had a lot of buzz back in ‘06 with the PS3 (NYSE: SNE) and the Wii. But – because, you know, the other console needs of those cycles was launched the year prior, so you know, PS2 back in 2000 and Xbox 360 back in 2005.

So, we haven’t had a show where all of the hardware manufacturers introduced something at the same time. And this year, we have each of the manufacturers introducing some new variation on the hardware. Sony preempted the spectacle by showing us the Move which is their motion controller at the Game Developer’s conference back in March. But they’re going to now show us a whole host of software that takes advantage of the Move. And they’re going to allow the masses to get their hands on the controller – control mechanism for the first time. So, I think that will be very, very well received.

Microsoft is launching something called Natal which is rumored to have a different street name. I saw something that leaked that called it the WAVE. Today is the first week of June. I’m actually going up there this week to preview it. And I have to sign a non-disclosure, so I won’t be able to [0:02:42] tell you. But I will learn the name this week. It’s going to be called something other than Natal. But Microsoft is a controller-less motion control scheme, so you don’t use anything but your body to control the characters on the screen or the screen itself. And I think people, you know, we all saw it last year, but few of us – I was one – got to actually try it hands on. They’re going to let a lot of people see it. And my understanding is a software right after that thing is just really deep. I know somebody who has some software for it who has to wait until February for a release because he was told that the launch release window is too crowded. There are too many games coming out for it. So, people would be excited about that. And then…

Damien: Michael, real quick, since that’s a pretty interesting topic. Do you think that this is an evolutionary step beyond the Wii? Is this going to be the first step into virtual reality?

Michael: Well, I think – I think that’s, you know, certainly, Microsoft’s intention is to evolve game play beyond, you know, what Nintendo did. And if you look at, you know, the Nintendo Wiimote and the controller mechanism, it’s a controller with an infrared light and an accelerometer built into it. You point it at a status bar that sits in front of your TV, so that you can calibrate it. Sony actually copied that exactly with the Move. It’s just that instead of using a status bar that’s an infrared sensor, it uses a camera, but it absolutely works the same way. And the only difference is that Sony’s camera will allow you to put your character, your actual physical presence into the game if you’d need to, if there’s a reason to do that.

But Microsoft went in a different direction, so there is no control or there’s no accelerometer. And again, it’s using hand motions and voice activation. And they really downplayed the voice activation a year ago. I think that’s going to be the big surprise of the show that you can talk to the screen and you can actually make things happen. And those of us who are, you know, far less creative than most, which is me, all I can think of is, you know, Xbox on or Xbox off. But clearly, you can, you know, theoretically, you could talk to your, you know, other players, you can play a multi-player game, coordinate action. That’s pretty obvious. If you could actually bark at your character and say, “Duck,” and he did, that would be kind of cool. I’m not sure what they’re going to do, but I think we’re going to see some games to take advantage of the voice activation as well. And…

Damien: And since this has been a development for so long, do you think that we should expect it to work flawlessly and not have a massive amount of, you know – speaking from the stock and business side – having a massive amount of problems or glitches that are going to cause refunds or returns?

Michael:Well, I think you just spoke in extremes, flawless, unlikely, and massive flaws, unlikely, so somewhere in between.

Damien:Okay.

Michael: I’d say modestly flawed. I mean, they’ve been testing this thing. You know the thing that I saw back in – I saw it in May of ‘09 – worked very well. And they really haven’t shown it since, I mean, they demoed it at the first week of June, it’d be three year ago. No one had seen it since. So, they’ve kept it so close with us because they wanted to make sure it was as near flawless as they could make it. And the trip I’m taking, you know, this first week of June, I was scheduled to take the thing back in February and they cancelled on me because they said they weren’t happy with the way it was working. And they wanted the experience to be as close to flawless as possible. And they’re now very excited to having this up. So, I have a hunch it works pretty damn well, but I’ll know more in a week.

But my guess is yeah, there’ll be things. The gamers are hyper critical bunch. I mean, they tend to think that everything needs to work flawlessly and that everything should be free. So, you know, well, truthfully, everybody – you know, I’m sure that you can come up with great examples outside of the gaming world, but in my experience, I’ve never seen the degree of entitlement among any consumer group that you see among gamers. They want more and more and more for less money every year. It’s amazing. And, you know, I think the poster chapter of that is Call of Duty Modern Warfare (Nasdaq: ATVI) online play, you know, the idea that 1.75 billion hours are spent on an Xbox LIVE for the first five months. It means that roughly 8.5 million people play 10 hours a week for 20 weeks.

And just the hint that Activision would never charge for that has people open arms, you know, it’s like, it’s crazy. People think that “Hey, I bought a game for 60 bucks. I should be able to play it, you know, 40 hours a week for the rest of my life.” Well, if it’s got that much value, it’s not going to be 60 bucks anymore. And I think that that’s kind of the case with Move and Natal, people want it to be, you know, free and all games just instantly work flawlessly. And Microsoft spent a lot of money on this thing. And Sony spent a lot of money on theirs and they’re going to charge for it. And the games are going to have features in them we haven’t seen before. And, you know, I think that if they don’t work well, well, that’s probably – you’ll get good enough for what you pay.

Again, I think that Natal, we’ve seen rumors that it’s going to be 149. I think that would be a mistake. But the idea that Microsoft actually potentially believes its worth that much, suggest that they’re very confident that it works. So, you know, we’ll find out. I mean, I would be personally shock if the thing didn’t work. I mean, I have a feeling people are going to be blown away by it. So, the third guy in – of the console manufacturers is Nintendo. And obviously, they already have the motion control scheme. And the other two guys are trying to take a lot of the wind out of the Wii sales by saying we’re just as good.

So, Nintendo’s going in a completely different direction as they always do by introducing the – what they’re currently calling the 3DS. It’s a three dimensional handheld gaming device. And no one seen it, so nobody knows exactly what they’re going to do and there’s a lot of excitement I think building around that. I’ve seen – I’m sorry, screwed up – I’ve seen photo cameras that are currently only sold in Japan. I’ve only seen two of them, but I know they exist. We have a 3D screen built in, so that require glasses. The screen is a thick piece of some kind of crystal that, you know, that allows for multiple layers of display. And the cameras have two lenses in them, so they take, you know, the proper depth to display in 3D. They look pretty sleek. And again, you have to look at them pretty much straight on. You can’t angle it too much or you’ll see the image split into two. But it’s a very, very nice-looking, you know, three dimensional image. It’s much like wearing those, what they call those little view graph glasses. Remember those little things used to click the button and the circular slideshow we display in 3D. We all have those when we were kids. I can’t remember what it’s called.

Damien:The old school.

Michael: Yeah. But it does look like that. I mean it’s got that kind of two-eyed thing and the lens is really full view into seeing a 3D image. I’m pretty confident that’s what Nintendo’s doing. And I think that’ll be really well received. And since our focus is on the consoles, you know, for – from Microsoft and Sony, I think Nintendo is actually very smart to be taking the different direction of D3. So, I expect a lot of excitement about the three hardware reveals. And then we’ll see what kind of software is there to support them.

But all of that is pretty additive to what we normally get out of D3 which is just a giant lineup of new games that people haven’t seen. And, you know the ones – there are some big names everybody’s excited about, you know, the Halo Reach. And I’m not sure we’re going to study StarCraft and D3 other than the Activision of that. I don’t think they’re going to have it on the floor.

Damien: Do you think – is the new Halo going to be – and I saw – I followed it up with – on the – I followed it a little on the beta launch that they were having. Is the new Halo something that enlist or anticipating to be maybe one of the biggest blockbuster videogames of all time again?

Michael: Well, I think certainly it will sell, you know, as many units as anything that comes out this year. I mean, the, you know, the crazy thing is that two of the biggest games of the year are single platform games. So, Super Mario Galaxy which just came out a week ago or 10 days ago, and Halo Reach are each console exclusives and though each sell, you know, quite easily 8 to 10 million units with a bias that Mario could do more.

The bigger games out there, if there are any, you know, maybe the Call of Duty: Black Ops game which will probably sell about the same 10 million or 11 million multi-platform. So, we at Halo, certainly one of the top two or three games of the year and possibly the number one game, you know. It’s funny how, again, the freaking, you know, gamer community, they’re bitching about Halo Reach because Master Chief is not in it, you know. So it’s like, to me, the same game but their beloved Master Chief who like – it’s no, just – it’s still so funny that they, you know, how people are. But yeah, maybe, you know, maybe that was one of the selling points.

And I think Microsoft really is delivering something pretty meaningful. You know, we’ll see Gears of War 3 which is another big-selling console exclusive. That will get people excited. I’m sure that Sony has a couple of games that we haven’t heard about coming out. There could be another inFAMOUS, some of these games like that. Nintendo’s going to very likely show us Zelda, coming out in just a couple of months so they’ll show that. So, there’s a lot of new content that people haven’t seen. Electronic Arts (Nasdaq: ERTS) is going to focus on Medal of Honor, I think that’ll make a good showing. We’ll probably see the Star Wars MMO.

And, you know, the Ubisoft is showing Driver which I think will get people excited. There really are a lot of games, so we’re going to see a lot of footage out of, you know, Activision is going to focus on Call of Duty: Black Ops. So and then Take-Two (Nasdaq: TTWO) who probably has the most anticipated game of any with Grand Theft Auto Next probably won’t show it because they’ll show it when the Rockstar guys decide it’s time to show it. But they’re fortunate because they currently have one of the bestselling games of the year in Redemption, you know, in the market place. So, it’s out, so they can’t talk about it, you know, can’t show anything that will surprise us. But I think that the buzz from that game helps the stuff they have coming out later in the fall, Max Payne 3, Mafia II, and possibly L.A. Wars. They should show some of those games because they are close to being out.

Damien: So, can you share a little bit into how this affects these companies in so far as, you know, for investors to consider, is Take-Two something that you like here going forward with their fall lineup and with their currently high selling game? And how do you feel about some of the other companies in the sector?

Michael: You know I like Take-Two a lot as a trade because I think that Take-Two will – the shares will go up when they announce the Grand Theft Auto. And I think that’s fair. I mean, Grand Theft Auto throws up just an enormous amount of profit. And I think that Take-Two has a potential of going up if their large minority shareholder makes any noise about how they need to do things differently in the company.

My long term view on the stock is, you know, I’m officially neutral. And my bias is, my only negative at this price. I mean, I have a $10 price target stocks at $11.60, so it’s not like I think it’s, you know, sell them to zero. I think it’s slightly over valued. And my $10 target, you know, we’re not trying to get too scientific about it, is just a commentary on the fact that they’ve lost $3 in fiscal ‘06, ‘07, ‘08 and ‘09 combined and there’s a full Grand Theft Auto in there. So, net, they lost $3 a share and yes, I think the next Grand Theft Auto is worth a lot and I’d say it’s probably worth about $1 to $2 of share.

So, in the next four years, they’ll lose $1 if they’re lucky. And that’s just not a great investment. I mean, the way that it’ll become a great investment is to turn that dollar of loss into something that, you know, some profit. And clearly, when their baseball contract rolls off, they’re more profitable by something, you know, in the order of 50 cents a share per year. So, the negative one, if the, you know, pie in the sky number could be positive one, if they do things right. But what do you pay for a company that makes a dollar every four years? You don’t pay $11.50 or $15. The way to get that number up to a dollar or $2 a share sustainable every year is to get their games out more frequently.

And I think what everybody misses on Take-Two is that as good as Red Dead Redemption is, and it is a great game, it took six years to make. And nobody takes six years to make games. And when I say nobody, I mean you really cannot name a game franchise that comes out every six years, but Take-Two has six of them. That’s the problem. The Mafia is a six-year development cycle. Max Payne is a six-year development cycle. L.A. War was announced five years ago, so, you know, at least a five-year cycle. And they just have too many of their good games that take too long. And, you know, I think that the problem of the company is that the developers always believe if we take an extra two or three years, we can take the game score from an 85 to a 95. And I actually think Red Dead Redemption is, you know, reveals the flaw in the way the companies run because they allowed the developers to take the extra few years. They did it. The game got a great review and everybody’s patting themselves in the back on how well it’s doing. But that creates unacceptable risk because if Max Payne hasn’t reviewed that highly and doesn’t sell that many units, they’re going to lose money on it. And, you know, investors don’t want to buy a company that loses money on its big franchise. So, I’m not a huge fan until they start getting games out on the two or three-year cycle. They can do that, then I will really, really like them. Again, great quality games just don’t come up frequently enough.

Damien: And is there – are there any other companies in the space that you think are doing well? You know, Activision, obviously, has been a huge focus for the average investor to play the videogame space. Do you think Activision can still maintain its sort of leadership in the space? Or is it one of those deals where it’s better to pick some of the other up and coming companies now that it’s just established itself as a leader, there’s not as much growth opportunity there.

Michael: You know, I think that’s really a fair question. And this industry is constantly surprising us. I mean, years – you know if we were talking five years ago, we would have said, “EA is the one to own because they’re dominant.” And Activision, you know, was kind of just afterthought. And in fact, in fall of ‘05 Activision has a terrible, terrible holiday and the stock hit, you know, probably five-year in row and has gone up a ton since.

So, you know, the bet, you know, five would have been ignore the industry leader and play the up and comer. And that would have been the right thing to do. I tend to actually really like Activision right now because I think the industry is evolving into, you know, where the winner is going to win based upon having the biggest franchises with the largest recurring revenue streams. And Activision, without question, has that in World of Warcraft. It looks to me like they have something real with the Call of Duty franchise. And, you know, I’m hopeful that they don’t mess it up the way they messed up Guitar Hero. And again, in fairness to them, I’m not sure Guitar Hero really had, you know, kind of a 10-year staying power. I think that it was quite a bit faddish game. You know its fun, but once you have your, you know, two or three versions of it and you have your 150 songs, how many do you really need?

So, I’m not sure that’s got the same kind of recurring revenues. But I do see the online game play of Call of Duty is presenting a real opportunity for Activision. The idea of that on Xbox LIVE, my number 8.5 million people played 10 hours a week for the first 20 weeks, that’s incredible. And if Activision could figure out a way to charge for that, it doesn’t really matter if only two million of those people pay. Activision’s going to make a lot more money. So, I think that’s coming. And I think that where investors are going to decide they really love Activision the next two or three years is when they have a Call of Duty online multiplayer subscription business, and a Bungee online multiplayer subscription business and a StarCraft online multiplayer subscription business. And we add it all up, you’re going to see that, you know, Activision’s generating two thirds or three quarters of profits from recurring subscription revenue. And that makes the stock worth a lot. That makes – that takes multiple up.

So, my bias is they’re in the midst of a transition, not necessarily a way from package goods, but supplementing package goods by introducing online monthly subscriptions. And I don’t think it takes very many people. It takes two or three million people for each of the services paying somewhere between $5 or $15 a month to throw off crazy amount of profits. Now, that won’t make the, you know – I said 8.5 million on Xbox LIVE, so probably 12 or 13 million between Xbox 360 and PS3 that are playing online. If only 2 million of them get, you know, can afford to pay for the subscription, 10 million of them are going to be angry.

But what are they going to do? You know, I don’t think they’re going to just go over to EA and play Battlefield or Medal of Honor for free because if Activision can demonstrate that 2 or 3 million people will pay 10 bucks a month, EA is not going to give away Battlefield and Medal of Honor for free. They’ll charge 10 bucks a month, too. I just think that’s just reality. And as we see, the publishers come up with models to monetize online game play. I am confident that the stocks are going to go up. Consumers may not be happy because, back to the sense of entitlement, they think everything should be for free in perpetuity.

The fact is that either they’re going to stop playing games and go spend their money on something else or they’re going to grudgingly spend their money, you know, to continue to do what they like to do. My bias is that there will be a pricing model that strikes a balance between what consumers are willing to pay and what the publishers are willing to charge and I think everybody wins. So, then consumers are going to spend more money, but they’re going to get a lot more game play for that money. And I think the publishers that benefit are led by Activision, followed by EA because I think they have the content, EA with Stars Wars MMO and Battlefield and Medal of Honor, they have the content that people probably are willing to pay for. And EA is going to probably do the same thing on the sports side.

So, subscription multiplayer I think is the way – the wave of the future. And I think that EA and Activision are positioned best to capitalize on that, followed by Ubisoft. I don’t think THQ (Nasdaq: THQI) and Take-Two yet have a line up of games that are really great multiplayer experiences. GTA multiplayer pretty much fell on its face. I mean it’s a single player game. We’ll see how Red Dead Redemption multiplayer does, but I just don’t see why I want to be in a game with cowboys shooting, you know, six shooters and other cowboys. So, ultimately, you know, I really think because of the military theme, shooters win. And Activision with its Bungee deal, you’re going to get some kind of a Halo-like space shooter out of it. EA with its production M&A deal probably the same thing. So, these guys are very much focused on that online multiplayer market. They haven’t announced plan to charge on subscriptions, but its coming.

Damien: Well, Michael, this has been extremely interesting and exciting especially if someone who – I, myself, a casual gamer and also have invested very heavily in the videogame sector for probably the past decade. And I know a lot of our listeners are very interested. I want to thank you very much for taking the time today to give us a little bit of a preview on E3. And I really hope that you and I can catch up again after the conference, maybe a week after or something. And you can maybe, once again, for our audience, give them a little bit of a thought process on what you liked about the conference and what you see going on going into the end of the summer and the fall.

Michael:Happy to do that and nice to be here. Thanks for having me, Damien.

Damien: Thanks so much, Michael. I really appreciate it. And thanks, everybody, for listening.

Source: E3 2010 Video Game Conference Preview: Gaming Analyst Michael Pachter