By Jonathan Rudy
Video-game companies and their customers descended upon Los Angeles for the Electronic Entertainment Expo (E3) May 22-24 to get a peek at the next generation of games. But the buzz started well before the show. On May 14, Sony announced that it would cut the price of its highly successful PlayStation 2 game console to $199, from $299. Archrival Microsoft, which had been expected to announce a price cut for its Xbox console at E3, matched Sony's markdown the next day. Then Nintendo chimed in, reducing its GameCube platform $50, to $149.
While such moves were anticipated, they came sooner -- and with steeper discounts -- than many had expected. Aggressive price cutting can boost sales, but it can also take a bite out of profits. However, we at Standard & Poor's believe that the independent software providers will be the true beneficiaries of this price war.
Among the stocks we cover in that segment, we continue to like Electronic Arts (ERTS ), currently rated 5 STARS (buy), our highest recommendation. Another favorite is THQ (THQI ), which has a 4-STAR (accumulate) recommendation. As the hardware price cuts expand the gaming market as a whole, the earnings potential for these two software companies is substantial. Let's take a closer look at their prospects.
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Electronic Arts, the leading video-game software provider (based on its $1.7 billion in revenues for fiscal 2002, ended March) creates, markets, and distributes software for all three platforms. It also has a significant investment in online gaming through EA.com. A highlight of E3 was EA's online demonstration of Madden Football 2003, the latest version of one of its biggest hit games. Other significant title in EA's library are FIFA Soccer, The Sims, James Bond, Harry Potter, and The Lord of the Rings.
This strong, well-diversified list puts EA in a position to benefit significantly as the entertainment software market continues to grow over the next four to five years. EA will also benefit from a deal with AOL that makes it AOL's exclusive provider of online gaming and entertainment.
We anticipate that revenues will rise about 18% in fiscal 2003 as operating expenses remain well-contained. The shares recently traded at 39 times our fiscal 2003 earnings-per-share estimate of $1.61, and with a long-term growth rate estimated at 25% to 30%, we would continue to recommend purchasing this financially strong market leader.
THQ, the No. 4 independent video-game publisher (based on $379 million in revenues in 2001), also develops entertainment software for all three platforms. Its specialty had been its line of WWF (now known as World Wrestling Entertainment) wrestling games. However, thanks to THQ's efforts to diversify its product portfolio, the wrestling line now accounts for only about 20% of its revenues -- a significantly lower percentage than in prior years. THQ's other strong titles include various adaptations from Nickelodeon and Marvel, as well as Hot Wheels, Scooby Doo, Red Faction, and Summoner.
We expect that THQ's revenues will increase in the low double-digits in 2002. Operating margin should widen to the mid-teens during the year. Despite the fact that earnings will be divided over a larger base of shares outstanding, we anticipate that EPS will increase approximately 23%, to $1.24, in 2002.
THQ's shares recently traded at a discount to its peers, but with a recent price-earnings-to-growth rate of 1.2, a strong balance sheet, and an increasingly diversified game portfolio, we expect that THQ will outperform the market over the next 6 to 12 months.
Analyst Rudy follows software stocks for Standard & Poor's