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By Brian Sozzi

At this time last year, I wrote a less than enthusiastic piece on the videogame sector. While I was excited about the prospects of new technology to move the industry further away from packages goods sales, I approached the stocks with a sense of caution. The basic premise for such tempered enthusiasm, despite my affinity for playing videogames (that love affair has waned as adulthood has set in) since receiving a Nintendo (OTCPK:NTDOY) Entertainment System for Christmas in 1987, was etched in:

  1. Inability to hold launch prices very long on current generation titles;
  2. High development costs for consoles with greater memory capacity; and
  3. Difficult Nintendo Wii hardware/software and music genre sales comparisons.

In the aggregate, I fancied these items would lead to a topsy turvy environment for quarterly earrings and by extension, stock performance. The prescient forecast by yours truly played out for the most part. Earnings warnings were in vogue from many third-party publishers in the first half of the year as NPD data softened, in turn sparking another round of cost-cutting measures ranging from headcount reductions or the pruning of titles in development. Shares of Electronics Arts (ERTS) (-9.7%), THQ (THQI) (+11.9%), and Take-Two (NASDAQ:TTWO) (+18.3%) all lagged the gains logged for the consumer discretionary sector (about 26%), which was a market leader in 2010.

Some Points of Interest From the Year That Was 2010:

  • Publicly traded publishers paid handsomely for upstarts and established companies in the social media gaming sphere.
  • Little movement in pricing for the three entrenched home-based consoles, despite being five years into the start of the cycle.
  • Greater fight for the lucrative used videogame pie that GameStop (NYSE:GME) still dominates (Target (NYSE:TGT), Wal-Mart (NYSE:WMT), Best Buy (NYSE:BBY) now in the mix).
  • Rise in the prominence of bundle packs to get hardware units in the hands of the masses.
  • Launch of the wireless Kinect (Microsoft (NASDAQ:MSFT)) and Move (Sony (NYSE:SNE)) technologies, which represent the typical peripheral add-ons when a console cycle is nearing a conclusion.
  • Inability of non top tier titles to hold launch pricing for an extended period.
  • Rise of the iPad (NASDAQ:AAPL) as a credible gaming platform.
  • Continued shift online by gamers whether it's for expansion packs, character upgrades, or the download of entire games.
  • Another year of no innovation on the Nintendo Wii.

With an installed base of consoles well on its way to touching 200 million, the Kinect and Move gaining acceptance (when combined may have notched 15 million in unit sales by 2011 end), iPad games experiencing an upswing, and online gaming in social media apps or console networks as drivers are there legitimate reasons to be long software stocks in 2011? Are we set up for another year of overhype and relative underperformance?

Although I am concerned on packaged goods pricing and production costs, and unsure when a new stream of consoles will arrive that will require steep development costs ahead of future revenues by publishers, I think there are reasons to be optimistic on the sector.

  • The likes of Electronic Arts, Activision Blizzard (NASDAQ:ATVI), THQ, and Take-Two are sitting on $3.7 billion in cash and zero to manageable debt positions. If a company cannot publish its way to growth internally, it will acquire growth that helps to support revenue and earnings.
  • I think core operating expenses are contained. Costs continue to rise to publish AAA titles on platforms with greater memory, but headcount and discretionary expenses are under wraps.
  • Easy sales comparisons are now in the fold.
  • Excitement is returning to the sector, with a wave of tablets hitting the market in 2011 that opens the door for game sales on iTunes and Android.
  • Publishers have shown success in upselling gamers. Pricing on console games may be under pressure, but expansion packs and other downloadable content has proven to be a nice offsetting mechanism.

I think the best way to take advantage of my broader sector call is with Electronic Arts, the only stock that did not appreciate in 2010 from the major publishers. The company's product slate is as targeted as I have seen in years, expenses are being well managed, the balance sheet is poised to fund further acquisitions in mobile/social media, and consensus is down on the name (hence raising the upside earnings probability). A leadership on Apple products and some interesting titles in 2011 (Bulletstorm, Shift 2 Unleashed, Dead Space 2, and Star Wars online) have the opportunity to reawaken the top line, complementing what Electronic Arts has done on the gross margin (shift to mobile/online) and operating expense lines.

Disclosure: No positions

Source: Videogame Sector Analysis: Time to Get Into the Game?