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Draining Small Gamers' Life Force

By Olga Kharif The video-game industry suffered a direct hit on July 18, when three publishers -- Acclaim Entertainment (AKLM), THQ (THQI), and Activision (ATVI) -- acknowledged that the Securities & Exchange Commission has included them in an investigation "focused on certain accounting practices common to the interactive entertainment industry, with specific emphasis on revenue recognition."

On July 21, Chicago-based Midway Games (MWY), said it's also part of the investigation. Other gaming outfits -- including the world's largest independent video-game maker, Electronic Arts (ERTS) -- have yet to disclose whether they've been contacted. The SEC says "this request for information should not be construed as an indication...that any violation of the law has occurred." But investors, with the recent memory of the Enron scandal, rushed from the sector, sending many of the stocks down 10% in one day.

TOO COMPLACENT? Within days, investors had a change of heart. THQ's shares are up to $17.95, from $17.70 before the company's disclosure of the investigation. Shareholders seem willing to believe widespread speculation that the SEC's probe is no more than an effort to come up with an acceptable revenue-recognition standard for the industry.

Unfortunately, that may be false hope. The involvement of the SEC's enforcement division indicates a real possibility that some in the industry may have violated accounting rules, says Richard Sauer, a partner at Washington (D.C.) law firm Vinson & Elkins and a former assistant director of the SEC's enforcement unit.

If Sauer is right, it would have far-reaching consequences for the industry. The SEC could force a wave of revenue restatements and impose fines on game publishers, which are already struggling with an industrywide slump. That could wreak havoc on the stocks in a sector that's already poised to undergo a sweeping consolidation amid a hardware-sales slump that could last until 2005.

GYRATING REVENUES? The specter of a contracting industry becomes a much more immediate threat to the smaller players under the cloud of the SEC probe. Dependent on the release of new hardware, growth is slowing, since new consoles won't hit the market until 2005.

Changes in the way the industry has been booking sales could greatly increase revenue volatility, says Joe Beulieu, an analyst with investment researcher Morningstar. And if the outfits' revenues begin to gyrate, investors might not be as willing to hold the riskier stocks, says Jeff Thomison, an analyst with J.J.B. Hillard, W.L. Lyons. That could create an environment in which the biggest players in the industry -- Electronic Arts and software giant Microsoft (MSFT) -- could acquire the small fry on the cheap, notes Beulieu.

Microsoft and Electronic Arts are prospering and have hoards of cash. The Colossus of Redmond, sitting on $49 billion, wants to strengthen its foothold in the gaming market. Its Xbox console has shown decent sales, but it's still way behind Sony's PlayStation 2. Perhaps if Microsoft could produce more Xbox-exclusive games for the device, its market share would soar, says Beulieu.

Gaming powerhouse Electronic Arts could benefit from picking up the best of its rivals' titles. During its quarterly earnings call on July 23, its execs said they might use some of its $1.6 billion in cash and equivalents for acquisitions.

"CHANNEL STUFFING"? In the first half of 2003, gaming-software sales grew only 6%, to $2 billion, vs. double-digit growth before, says Rich Ow, an analyst with marketing researcher NPD Group. To spur demand, console makers have cut prices in half -- and are expected to slash them even further shortly. And video-game publishers should reduce prices of their best titles from $49 to $39 sometime this year, likely at Christmas, says Robert DeLean, an analyst with Morgan Keegan & Co.

Many analysts say revenue-recognition changes are overdue. Current practices smell of "channel stuffing," in which publishers push products to retailers and distributors to make a quarterly goal -- only to take the unsold products back later. According to SEC Staff Accounting Bulletin No. 101, channel stuffing is unacceptable, but some analysts say the way a lot of game publishers handle the issue falls into a gray area.

The SEC might be especially interested in how gaming concerns recognize revenue from sales to distributors. Unlike most retailers, distributors often have the right to return the goods. That's an issue analysts suspect is involved in the ongoing SEC investigation, which started a year-and-a-half ago with gaming publisher Take-Two Interactive Software (TTWO). But sales to distributors aren't where the big money is in this industry, experts say. The revenue involved is insignificant for most outfits, since most publishers sell about 95% of their products directly to retailers, says Edward Williams, an analyst with Harris Nesbitt Gerard.

NEW SEASONAL PATTERNS. What's more likely, analysts say, is that the SEC is investigating revenue recognition of sales to retailers. The agency may want gamers to record sales on a sell-though basis, only counting retail sales after they occur and doing away with some techniques used to manipulate revenue and income figures quarter to quarter.

The practice could dramatically alter current seasonal revenue patterns. For instance, Midway Games, whose fiscal year ends on Dec. 31, could see its fourth quarter turn from best to worst. Most gamers send their products to retailers before Christmas, but many of the games are actually sold in the first weeks of January, when kids, who've received consoles as gifts, go shopping, says Michael Pachter, an analyst with Wedbush Morgan Securities.

Over time, if such accounting changes were implemented, businesses and investors would adjust to the new standards, Pachter estimates. He doesn't see the SEC probe as a huge deal. "It might be a wrongdoing with a small 'w,'" says Pachter. None of the gaming concerns would comment on accounting practices or the SEC investigation for this story.

LOWER RATINGS. Yet the probe's timing could hasten the consolidation over the next year. Investors would be wise to be cautious. Arvind Bhatia, an analyst with Southwest Securities, has lowered his rating for the sector from strong buy to neutral, citing low visibility. Adds Williams of Harris Nesbitt Gerard: "We don't know where the investigation could end up."

Even a wrist slap from regulators -- in an increasingly tough environment for video games -- could make a big difference and play into the hands of the industry's heavyweights. Kharif writes for BusinessWeek Online in Portland, Ore.

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