It's Game Time: Game Console and Software Stock Update

by: Todd Mitchell

A roundup of recent news relating to game console makers and gaming software publishers:

• There is significant evidence of slower-than-expected PS3 deployment. KBRO Retail [Consumer Electronics] Analyst SooAnn Roberts' channel checks indicate that Sony (NYSE:SNE) would need to dramatically increase its shipments of PS3 to retailers to reach its goal of one million by year-end. There is also evidence of low initial PS3 tie-ratios, due to the robust secondary market prolonging the time before many PS3s reach the end consumer.

• Total displaced PS3 sales are greater than the hardware shortage. We estimate that for every 100,000 PS3's, Sony is short $70 million and unsatisfied consumer demand is created. In all likelihood, the shortfall versus consumer expectations is probably much higher than Ms. Robert's estimates for Sony's shortfall, as Sony could never satisfy initial demand, so the actual number of disappointed PS3 consumers is likely much greater than this shortfall.

• The primary beneficiary of lower-than-expected PS3 sales is Sony. Not only will it cut its losses on the heavily subsidized PS3, we believe relatively few disappointed PS3 customers are opting for an Microsoft (NASDAQ:MSFT) Xbox 360 or Nintendo (OTCPK:NTDOY) Wii instead. We think that displaced PS3 dollars are going first to purchase more PS2 software, and then out into the broader CE market. In particular, we think the handhelds are receiving a fair amount of displaced PS3 consumption.

• The Xbox 360 is reaching critical mass regardless of the PS3. We believe lower PS3 sales are having a marginally positive impact on Xbox 360 sales, particularly in Europe where the PS3 is not yet available. We think Microsoft will have 10 million Xbox 360 deployed by year-end, which would create a market with sufficient depth to support $100 million in Xbox 360 releases.

• Nintendo's success is independent of PS3 market dynamics. Some disappointed PS3 consumers may buy a Wii this holiday season, but we do not think this is the overriding dynamic. The success of the Wii stands on its own. We suspect the larger impact of displaced PS3 sales on Nintendo will be higher DS volumes to go into the stocking next to the extra PS2 titles.

• PS2 and Xbox 360 titles will be the dominant sellers. The soft launch of the PS3 has reinvigorated PS2 software sales and the Xbox 360 is reaching critical mass. With Nintendo dominating initial software sales for the Wii, the PS2 and Xbox 360 offer the biggest markets for third-party publishers. At this stage of the cycle most PS2 users have an extensive library of games, so hit titles are likely to dominate sales disproportionately.

• Activision (NASDAQ:ATVI) and THQ (THQI) are best positioned for a PS3 shortfall. Activision has a focused release slate that is likely to do well in the PS2 and Xbox 360 markets. THQ has WWE and heavy exposure to handhelds, and both have established a toe-hold on the Wii. This holiday season EA (ERTS) looks overextended and in the wrong areas, while Take-Two appears to be all but absent.

• Heavy investment in PS3 development is not likely to pay off this year. Lower-than-expected PS3 hardware sales mean lower PS3 software sales. If the secondary market for PS3 does not cool down and tie ratios don't start to improve, we believe the total market for PS3 software this year could be well under $100 million. EA is the most exposed to the PS3 at launch, while Take-Two's valuation is built on its future success.

• Extrapolating 2007 gains misses full dynamic of PS3 shortfall. The recent sell off in EA and run up in Activision's and THQ's shares tells us that investors are extrapolating market share shifts into 2008. This is also implicit in both company's guidance. However, we believe share gains are reflective of dynamics specific to this market, specifically a deep, but narrow market for PS2 and Xbox 360, that is resulting in a winner take all market for a few hit titles.

Completive Dynamic of Fewer than Expected PS3s