EA is in the game. Yes, there's little use in denying the market dominance of Electronic Arts (Nasdaq: ERTS) in the realm of home console and computer gaming. It's the one with the franchise sport titles with a built-in audience upgrading every year to get the latest batch of players. It's the one with The Sims as the faux-community smash with 8 million copies sold. It's the one that dared to earmark well over $100 million in its online endeavors.
But even the most forgiving of value investors would have to hit the pause button when it comes time to jog the company through even the most passive of valuation metrics. Is EA really worth 30 times earnings and six times its revenue run rate?
The case for buying into EA is compelling because of the dynamics in the video game industry. Sony (NYSE: SNE) has sold more than 40 million PlayStation2 consoles. Software sales are growing every year and should continue save for a pause before the company rolls out its next-generation home gaming system. That shouldn't be until around 2005.
While Nintendo's GameCube and Microsoft's (Nasdaq: MSFT) Xbox systems have found smaller audiences -- each had sold 4 million machines before the holidays kicked up in earnest -- the fact that the industry has thrived even in this lackluster economy is impressive.
So why EA? If the $10 billion video game industry is gaining ground, shouldn't all software developers float in tandem? The hottest game of the season belongs to a much smaller company trading at just 11 times this year's profit guidance. Two other major players who have scored smash hits in the past are now trading for a little more than twice the value of the cash on their balance sheet.
But EA has never backed down from buying a worthy rival. Because the market has granted the stock a hefty premium, the company can buy any upstart at a fair markup and the transaction will still be accretive to earnings -- meaning that the deal will actually help improve earnings per share. No one should buy into a stock for the lonely hope of a buyout, but it's always there as a potential catalyst for capital appreciation. The reasonable valuations seem to indicate that the downside is rather limited, too.
Who are these companies? Glad you asked. Let's get into the game.
Take-Two Interactive (Nasdaq: TTWO)
Grand Theft Auto: Vice City was high on the collective holiday wish lists last month. As the fourth installment in the golden Grand Theft Auto franchise, the visual immersion into a life of crime that would make even Winona Ryder wince has been a best-seller mainstay for the PS2 platform. Few know that the company behind the game is Take-Two Interactive. With a sixth of the lucrative PS2 software market over the past year, Take-Two has lived up to its moniker -- taking the second position in the world's most popular console format behind the titans at EA.
Take-Two closed out fiscal 2002 in dramatic fashion. With sales bolting 77% higher to $794 million on earnings of $1.81 a share, it helped shatter the myth that gaming was just kid's play. The company has no plans to relinquish the throne for its adult-geared game content. Upcoming releases won't be holding back any punches, with licensed games devoted to everything from MTV Celebrity Deathmatch to the cult fave gang-on-the-run flick The Warriors.
Last month, it announced that it was looking to earn $2.20 a share this year (which ends in October) on $950 million in sales. How does that stack up to EA's rich multiples? Well, how about a P/E of less than 11 and a market cap that matches the company's fiscal 2003 top-line guidance based on the stock's Thursday close of $23.25? I'd close with the obvious play on words -- to Take-Two and call your broker in the morning -- but it's worth noting that a lot of its success has been hanging on that one franchise.
Activision (Nasdaq: ATVI)
You'll get a much wider variety of feast and famine when you check out Activision. A household name for decades, the software pioneer had a big hit early last year with its Spider-Man game across all the major platforms. Unfortunately, it wasn't able to have the same kind of sticky webbing over its audience that Peter Parker had. Gamers moved on over the holidays, and now Activision is in the process of being lapped by Take-Two in claiming the industry's No. 2 spot behind EA.
Unlike last month's cheery outlook at Take-Two, Activision had to hose down expectations last month. With earnings looking to fall from $0.88 a share this fiscal year ending in March to $0.80 come fiscal 2004 on flat sales growth of $823 million, why like Activision beyond a childhood addiction to Pitfall on the Atari 2600? Well, you do have that beauty of a balance sheet with roughly $8 a share in cash and marketable securities. That was more than half what the stock was trading for last week. Back out the cash to arrive at the company's enterprise value and you have another set of bargain multiples, with the stock trading at less than 10 times earnings and a little more than half its annual sales. From personal computer staples like Doom and Quake to dibs on the video game treatment for the can't-miss Spider-Man sequel, maybe Activision has some of that keen spider sense after all.
THQ (Nasdaq: THQI)
Then we have THQ, which, beyond its slate of wrestling games that once thrust the software house into prominence, is basically at the other end of the Take-Two spectrum with its Nickelodeon-inspired games. Absent a major hit given the waning popularity of the World Wrestling Entertainment (NYSE: WWE), the company also bet on the wrong horse when it devoted too many of its resources in catering to the GameCube market. While the move may have made sense in that Nintendo's audience is younger than that of the two other platforms, SpongeBob SquarePants and Jimmy Neutron couldn't save the day for THQ.
Days after Activision's warning, THQ followed suit. Its watered down forecast for 2003 now stands at earnings of $0.90 a share on $540 million in revenue. Like its software brethren, THQ is yet another cash-rich, debt-free gem with more than $5 a share in cash and marketable securities. Back the greenery out and you have a company trading for less than nine times forward earnings and 0.6 times its projected top line.
Having enjoyed David Gardner's perspective on the video game industry in the new Stocks 2003, I have every reason to believe that, digging beneath the crust of the behemoth that is EA, you will unearth some precious gems. Then again, this is also a very unforgiving industry. Acclaim Entertainment (Nasdaq: AKLM) was once a world-beater and now a buck will buy you a share, with spare change for the arcade. 3DO (Nasdaq: THDO) even had its own gaming console, but now it's turning to its CEO for financing.
It's for these iffy situations that I relish the fact that Take-Two, Activision, and THQ are all flush with cash. Money will always come in handy for the spells when the pipeline runs dry. So, yes, EA is in the game. The only thing is, it's not alone.
Rick Aristotle Munarriz managed to duck out to play a few video games while writing this piece. He'll challenge you next time he sees you. His stock holdings can be viewed online, as can the Fool's disclosure policy.