More Slow Times Ahead for Video Game Stocks?

It has been an interesting and generally very tough year for stocks related to the video game industry, and yesterday’s guidance from game-maker Electronic Arts (ERTS) cast more doubt on the near term future for the industry. Electronic Arts is one of the titans of the game industry with arguably the most successful franchise of sports games, such as Madden. These games are hugely popular and attract scores of gamers to buy each new edition on an annual basis. EA reported earnings for the fiscal third quarter of $.33 per share or 2 cents better than Wall Street expected. However, analysts have greatly lowered their estimates over the last few months due to weakness in the sector.

More importantly, Electronic Arts issued guidance for the next half year (fiscal fourth and first quarters) that was far worse than analysts had expected. For the current quarter, EA expects earnings of 2 to 6 cents, much lower than the 13 cents anticipated by Wall Street. Furthermore, they see sales coming in well below expectations and forecast a loss of 35 to 40 cents in the first quarter of 2011, as analysts’ expected a loss of only 4 cents. Not surprisingly, many analysts have downgraded the stock and lowered estimates and price targets in reaction to this disappointment, and the stock has fallen nearly 10% in this afternoon’s trading. We think that the company is probably being overly conservative, but with the softness in their guidance we are only reaffirming our Fairly Valued rating on ERTS.

In addition to the disappointing outlook from one of the industry’s top game producers, the top video game retailer GameStop (GME) is down nearly 5% after it suffered a downgrade on Tuesday. An analyst at Credit Suisse (CS) cut GME to Neutral from Overweight and he called the stock a potential “value trap” with little room for multiple expansion. We happen to disagree with this analysis, as the current multiple is 8.3x this year’s earnings expectations (fiscal year ended last January). Furthermore, earnings per share are expected to grow by 16% next year, which yields a PEG ratio (five-year earnings growth) of .64x.

There are concerns that GameStop’s model may be in trouble with the possibility of digital downloads grabbing an every larger slice of market share, which makes many fear that GameStop may go the way of Blockbuster (BBI). Being tied to bricks-and-mortar stores can be a menacing prospect, but as for right now they are still doing great business. We think that at this price point many of the risks are priced-in and there could be an opportunity for value investors. Of course, the potential for downside still exists, but the fundamentals continue to improve and the multiple cannot get too much more depressed. We are maintaining our Undervalued rating on GME and will not be deterred until the analysts’ fears over threats to long term earnings potential start to show in the company’s actual results.

Video game stocks are some of the beaten down stocks in the current market, and we believe this may present an opportunity for long term investors. Obviously, these investments would be somewhat speculative, but it is reasonable to assume that the worst is behind this industry. An interesting article in today’s New York Times shows that most American families are increasing spending on entertainment and leisure technologies at a much fast rate than inflation. Some will read this as greater competition to video games for consumer’s disposable income, but we read it as a change in consumer behavior that will benefit game makers and retailers. Americans are choosing to entertain themselves at home more often these days, often with video games. We have our doubts that video game industry will see a year as bad as 2009 again for the next few years, and these stocks are priced attractively relative to many other stocks in the current market environment.

More Slow Times Ahead for Video Game Stocks?

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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