How To Play The Video Game Makers

Video-game execs are as exuberant these days as the kids who play their shoot-'em-ups. Sony's three-year-old PlayStation, along with Nintendo 64, just capped off the hottest video-game season ever. Market leader PlayStation racked up more than $2.4 billion in North American sales in 1997, and analysts think the run of good news is nowhere near its end. "We're going to see a longer, more profitable video-game cycle than ever before," says Larry Marcus of BT Alex. Brown.

With all the hype, you'd think now would be a great time to invest in the game biz. But tread carefully. This is a hit-driven industry subject to the fickle cravings of male teens and twentysomethings. Look no further than Sega Enterprises, which has watched sales of its Saturn system disintegrate amid inept software development and poor management. And some analysts wonder if high-speed cable TV or DSL phone modems will spur online gaming and lure video-gamers onto PCs with improved 3-D graphics.

BOTH HANDS. For now at least, gamers aren't ready to abandon PlayStation and Nintendo 64. Indeed, video and PC games have coexisted nicely for years. Even sub-$1,000 PCs are far more expensive than $149 video-game machines, which may fall in price. So one way to get around the PC vs. video-game competition is to invest in software makers that play in both camps. One is Electronic Arts, which develops titles for PlayStation, N64, and PCs. Known for stellar management, a debt-free balance sheet, and strong development teams, EA is expected to post a 22% rise in profits for the fiscal year ending Mar. 30. The increase doesn't reflect last year's acquisition of Maxis, famous for SimCity. On Feb. 19, EA jumped 11%, to 44 3/16, on a licensing deal with golfer Tiger Woods. "They've shown a consistent ability to be in front of technology cycles and gain market share," says Arcadia Investment analyst John Taylor.

Some tech watchers are keen on Activision. It's making a push overseas, and its stock has been languishing around 14 despite solid management and healthy earnings. Traders are worried that too big a chunk of Activision's revenues may come from single hits, such as the bloody Quake II. But Nick Moore, a portfolio manager at Orbitex Management, believes the stock could reach 25 in a year: "Activision is the one with the most upside leverage."

Midway Games could also be in for gains. The company produces arcade games, then follows up with home versions. It has yet to make a big impact in the PlayStation market, but Mike Wallace of UBS Securities expects the stock, now at 20, to hit 30 within the year on a projected 25% earnings rise (before an extraordinary gain).

Betting on the hardware side of the business is tricky. No company has remained industry champion from one game generation to another. Sony is already starting to slip in Japan, where two PlayStations are sold for every N64. Sony is said to be working on blueprints for a game machine using digital video disks that would come out around 2000. Even if you believe in PlayStation's continuing good fortune, the system's hardware and software accounted for only 25% of Sony's group operating income in the quarter ended Dec. 31. To buy its stock, you must also like Sony's other businesses, which happen to be doing nicely at the moment.

NEW DRIVE. Nintendo, meanwhile, plans to unveil in June a disk drive that attaches to N64 and plays games stored on magnetic optical disks. N64 games now come on read-only cartridges, which are more expensive to make and take longer to develop. Masashi Kubota, an analyst at ING Baring Securities in Tokyo, thinks high prices for the complete N64 setup--about $200--could hurt sales. Nintendo's American depositary receipts now trade around 11 1/2, down a couple of bucks since December, and many analysts are pushing them.

You have to believe in long shots to bet on Sega. True, the company has a respected new president, a longstanding arcade business, and a well-known brand name, and it vows to be back in U.S. homes with a next-generation 128-bit console in 1999. But Sega's ADRs are trading at 4 3/4, less than half their level of a year ago. Even if Sega comes up with a new console, it would have to persuade software developers to write games for it, a tall order with competing brands going gangbusters. "Until there are dramatic changes in the company, I will advise investors to avoid Sega," says Kubota. Fortunately, there are other ways to play this game.