The Game's On at EA

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Things are finally starting to heat up for video game publishers, now that the latest consoles are on the market. Electronic Arts (Nasdaq: ERTS) generated some jubilance on Wall Street today, beating analysts' expectations in both earnings and revenues despite lower third-quarter profits.

Third-quarter net income dropped 38% to $160 million, or $0.50 per share, including an after-tax stock-based compensation charge of $28 million, or $0.09 per share. Revenue increased 1% to $1.28 billion, which the company attributed to successful titles such as Need for Speed Carbon, FIFA 07, The Sims 2: Pets, and Madden NFL 07.

Electronic Arts' ability to generate cash remains impressive. EA generated $195 million in free cash flow for the quarter. That's down 21% from the same period last year, but it's still an enviable number, especially considering the company's lack of debt.

Electronic Arts' digital revenue, which includes microtransactions and digital downloads, was a highlight as well, increasing 50% to $37 million in the quarter. In its conference call, Electronic Arts' management said it's pleased with early performance of its titles for Sony's (NYSE: SNE) PlayStation 3, currently commanding a 32% segment share.

In another noteworthy move, Electronic Arts will start deferring revenue for online-enabled games, amortizing it over the length of a service period that the company currently estimates at six months.

The games publisher has plans for future growth against rivals such as Activision (Nasdaq: ATVI), Take-Two Interactive (Nasdaq: TTWO), and THQ (Nasdaq: THQI). While continuing its emphasis on PS3 and Microsoft's (Nasdaq: MSFT) Xbox 360, it's also planning to step up development for Nintendo's new hit console, the Wii, as well as the Nintendo DS, planning 15 titles for both. That's certainly a good move, given doubts about whether the PS3's high price will prove a stumbling block for many gamers. In addition, Wii is actually attracting more everyday consumers, as opposed to hardcore gamers, providing new and exciting opportunities for gaming to reach the mainstream.

Furthermore, the digital area seems ripe for growth. EA believes that in fiscal 2008, digital revenue could increase by nearly 60%. The growth will be driven by digital downloads, in-game advertising, microtransactions, its online Pogo games site, and Warhammer, a game its Mythic unit is developing for the massively multiplayer online role-playing space (or MMO for short). That space has earned recognition from the wild success of Vivendi's (NYSE: V) World of Warcraft, developed by Blizzard Entertainment.

Investing in video game publishers can be feast or famine. It's a cyclical industry, and shares can appear deceptively overvalued during downturns. Although the new round of consoles should make sales and profits easier to come by, thanks to the new round of consoles, EA and the other game publishers still have their share of challenges -- particularly in providing innovative new titles that will catch gamers' attention. Gamers are beginning to grumble that developers should add more originality to their lineup of tried-and-true franchises. Fools should keep an eye on EA in the year to come, to see whether it can meet that challenge.

Electronic Arts and Activision are Motley Fool Stock Advisor recommendations, while Microsoft has been recommended by Motley Fool Inside Value. Whatever your investing style, the Fool has a newsletter for you.

Alyce Lomax does not own shares of any of the companies mentioned.