Caution big part of games theory

Sector analysts urge congloms to take deep breath before playing

Publishers of video games will see 10% revenue growth over the next several years as the next generation of consoles enjoys a long adoption cycle, but it's too soon to expect much merger and acquisition activity in the sector, according to Wedbush Morgan Securities.

In one of Wall Street's more ambitious critiques of the video game industry, analysts Michael Pachter and Edward Woo are bullish on the sector but caution entertainment conglomerates not to overplay their opportunities.

While "major media companies appear to covet the profits that are generated by video game publishers," they might be better off licensing their properties to those with a proven track record for creating games that people will buy.

Walt Disney Co. CEO Robert Iger, for example, has indicated a desire to bring more video game development in-house, a strategy that hasn't worked yet, the analysts argued.

The video game based on the Disney/Pixar movie "Cars," for example, was made by THQ Inc. and was a much bigger hit than was the game based on "The Chronicles of Narnia: The Lion, the Witch and the Wardrobe," which was created in-house, they said.

"The Disney experiment with games will come to an end before the company makes a large-scale effort to compete," the analysts predicted. They also forecast disappointing sales numbers for the next "Pirates of the Caribbean" game, which they guess "will be the poorest seller out of the crop of summer blockbuster movie-themed games," losing out to the likes of "Spider-Man 3," "Shrek the Third," "Ratatouille," "Transformers" and "The Simpsons."

"It's not that we think Disney can't make a great game; rather, our view is that THQ is particularly good at developing and marketing games based on Pixar licenses," the analysts said. "We feel the same about other media companies."

Warner Bros. forming alliances with European publishers SCi and Codemasters, the analysts said, "is a prudent approach" because they believe Warners "has negotiated favorable terms." They also praise Warners for going to industry giant Electronic Arts Inc. for such franchises as "Harry Potter" and "Lord of the Rings."

"Ultimately, we think that the media companies will learn their lessons quickly, and will again return to the licensing model," they said.

They also discourage media conglomerates from outright purchasing video game publishers, at least in the near term.

"It is premature for an acquisition of a U.S. publisher by a media company, primarily due to the uncertainty involved in choosing winners and losers in the next generation," according to the analysts.

The 205-page Wedbush Morgan report says that investors can make money in the video game sector -- historically a tough thing to do -- because the console-upgrade cycle will last longer than similar cycles, a conclusion UBS Investment Research also reached in a recent 92-page video game report.

Investors should use caution though, the Wedbush Morgan analysts said. Shares of EA, Activision Inc. and THQ have returned 26%-39% annually to investors over the past decade, but shares of Atari Inc. lost 42% year over year for five years and Majesco stock has lost 90% of its value in two years.

The analysts also give props to Sony Corp. by declaring that its handheld PlayStation Portable product "is not quite dead, yet."

The Nintendo DS has been such a phenomenon (23 million units sold just in the most recent fiscal year), the analysts said, that it has "made the PSP's performance appear poor, when in fact, the PSP is actually performing quite well." By the end of its third full year, they expect 25 million PSPs to have sold, and that PSP software sales will rise from $1.5 billion in 2006 to $2 billion this year.

The analysts, though, acknowledge that UMD movies "are quite disappointing, with many studios withdrawing support," and that the "evolution of Sony's music-download service has been quite slow." Nevertheless, they "do not expect Sony to curtail support for the PSP."

After exhaustive analysis, Wedbush Morgan recommends that investors looking for exposure to the next-generation video game cycle buy shares of Activision, EA, THQ, Ubisoft Entertainment, Blockbuster Inc. and GameStop Corp.

The only video game stock they rate a "sell" is Take-Two Interactive Software Inc., with their report expressing doubt that the new executive team of chairman Strauss Zelnick and CEO Ben Feder will improve the company's fundamentals as quickly as Wall Street expects.