4 ways to play a video-game boom

By Michael Brush

Video-game aficionados will soon have two new excuses to spend even more hours in brain-numbing trances.

Before year's end, Sony (SNE, news, msgs) and Nintendo (NTDOY, news, msgs) expect to roll out new game consoles for the first time in five years. The platforms will offer blazing computing power and make skateboarding with Tony Hawk or storming the beaches of Normandy even more lifelike.

But investors shouldn't plug either of those companies into their portfolios. History shows that it's a better move to buy shares of the companies that make the game software just before a major platform upgrade. The four main pure plays in the space are: Electronic Arts (ERTS, news, msgs), Activision (ATVI, news, msgs), THQ (THQI, news, msgs) and Take-Two Interactive Software (TTWO, news, msgs).

And right now, those stocks are cheap. Their shares are down anywhere from 15% to 50% compared to highs last year -- partly because consumers are holding off on buying new video games before the console launches. Console software sales declined 4% in the first half of 2006 to $1.73 billion, says Todd Mitchell, an analyst at Kaufman Bros. Equity Research.

Game on

Expect even more turbulence ahead of the platform launches as investors worry about possible snafus. But anyone who has the guts to stick it out should be a big winner over the next two or three years. During that time, video-game players will spend lots of money testing the limits of the new platforms and games.

"This is a great time to be looking at these stocks because of the transition," says Norman Young, a Morningstar analyst whose favorite pick at current prices is Activision. "I don't want to try to call the bottom, but right now we are probably close to where the stocks are going to turn."

Sony plans to launch its PlayStation 3 (PS3) in mid-November, and Nintendo says its new console known as Wii (pronounced "we") will come out some time in the fourth quarter. Besides the two new consoles, Microsoft (MSFT, news, msgs) should launch its new Vista operating system around the start of the year. That's another platform upgrade of sorts for video-game companies because many gamers play on their personal computers. (Microsoft is the publisher of MSN Money.)

The last transition played out five years ago, and investors who bought then were ultimately rewarded. "All in all, it feels an awful lot like the summer of 2000, which proved to be a great time to buy video-game publishers," says BMO Capital Markets analyst Edward Williams.

Mitchell, at Kaufman Bros., expects video-game software sales to grow 8% to 12% a year in 2007 and 2008. He thinks this cycle will peak in 2010 and expects next-generation console sales -- including the Xbox 360 launched last year -- to reach as high as 35 million by 2007 and 60 million by 2008.

Console elation

Analysts -- who tend to be video-game aficionados themselves -- offer rave reviews of the two new consoles. "The graphics are unbelievable," says Rudy Torrijos, a portfolio manager at the Delaware Growth Opportunities Fund (DFCIX), which owns shares of Activision.

Frank Gibeau, a video-game creator who is now in charge of publishing at Electronic Arts, says the PS3 is so powerful that it will take code writers three or four years to get to the "golden age" of video games in the new systems. The stocks, for that reason, could have a more sustained climb.

Analysts are equally enthusiastic about Nintendo's Wii. "The Wii is a return to Nintendo's roots. They are all about making games fun," says Morningstar's Young. Its hand-held controls include a gyroscopic motion detector that allows video gamers to aim rifles or nudge another skate border out of the way in a more realistic fashion.

$600 game boxes? No problem

Nintendo's Wii will cost a reasonable $199 to $249. But Sony plans to charge $500 to $600 for the PS3, depending on features. That will make it the most expensive game console ever.

Video-game makers, meanwhile, plan to charge about $60 for the new games to offset rising development costs. That's about a 20% price hike. Bears on video-game stocks think video gamers won't pony up -- especially in the midst of an economic slowdown.

But the bulls on these stocks aren't too worried. Morningstar's Young points out that the gamers are now 33 years old on average, so they have more disposable income. Williams notes that Xbox 360 owners have spent $643 on average for the box and all their games -- proving that video-game fans are willing to open their wallets.

What's more, American Century Ultra Investor Fund (TWCUX) manager Wade Slome believes the heightened realism in the new machines will broaden the user base to include more players -- including more women. BMO's Williams sees room for growth in foreign markets like Germany where only about 10% of households have game consoles, compared to around 35% in the U.S.

New revenue streams

Video-game companies are also developing new revenue streams. Among them:

In-game ads. These can be as simple as brands on billboards in the background or a form of product placement in which play is designed around a particular make of car. Morningstar's Young says males between the ages of 18 and 34 spend as much time playing video games as they do watching television. But out of the $8 billion U.S. advertisers spent in 2003 to target this demographic group, only $15 million went to in-game ads. This suggests there's a lot of room for growth.

Digital downloads. Also known as "micro-transactions," in which players spend $5 to $10 to extend the capabilities of a game, join tournaments or buy new clothes for characters. "These are direct-to-consumer sales so margins are higher," says Williams. Add-ons to games also cost less to produce because most of the work behind creating the game has already been done, says Gibeau at Electronic Arts.

Fantasy games. Role play and fantasy games like World of Warcraft are popular in Asian countries -- and have great potential in the U.S. In these games -- known as massively multiplayer online role-playing games -- players assume characters and play with others on line. Players typically pay $50 for a game and monthly subscription fees of $10 to $15. The online capabilities of the new consoles may open doors here.

Take three, be wary of one

Electronic Arts. The leader in the space, with popular sports games like Madden NFL and NBA Live, Electronic Arts' sheer size gives it an advantage because it can spread costs among more products, says Morningstar's Young. Its recent purchases of Jamdat Mobile and Mythic Entertainment should give Electronic Arts an edge in mobile-device games and online role-playing games.

Activision. Publisher of the popular "Tony Hawk" skateboarding games, Activision is another game producer that's big enough to thrive as production costs mount. The company has licensing agreements with Marvel Entertainment (MVL, news, msgs) and DreamWorks Animation SKG (DWA, news, msgs) to produce games based on movie characters X-Men, Shrek and Spider-Man.

THQ. A leading developer of titles for children, including games based on SpongeBob SquarePants and movies like "Finding Nemo" and "Cars." As a children's game producer, it could benefit from the family budget friendly price of Nintendo's Wii, says Prudential Equity Group's John McPeake. THQ is also moving into the core gamer market and that should boost profits, says Young.

Take-Two Interactive Software. This company's popular "Grand Theft Auto" brand has stirred controversy and calls for censorship because of the game's violence and "hidden" nude scenes. What's more, the district attorney of New York County has subpoenaed documents for a grand jury investigation into the presentation of earnings results and partnering arrangements, and whether directors knew about the nude scenes in advance. So the stock has been hammered to $10.50. But "Grand Theft Auto" alone could be worth $10 to $13 per share, estimates Susquehanna Financial Group analyst Jason Kraft. All the unknowns still make for a risky play. "This is not for the faint of heart," says BMO's Williams.

As of this writing, I'll add all four of these names -- Electronic Arts, Activision, THQ and Take-Two Interactive Software -- to my Expert Picks portfolio and we'll see if they deliver from here.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for The New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.