Video Game Champs

S&P's Jim Yin discusses his outlook for game developers Electronic Arts, Take-Two, Activision, and THQ, as well as the sector as a whole

SyndicateCategory: Investing, Mergers & Acquisitions, Software, Stock Recommendations, Technology, Video Games

While the battle rages on, video game maker Electronic Arts (ERTS) is likely to win the fight to take over Take-Two Interactive Software (TTWO), says Jim Yin, who follows entertainment software companies for Standard & Poor's Equity Research. He believes EA's $26-per-share offer for Take-Two is already high, given the company's "lumpy" earnings and reliance on one franchise: Grand Theft Auto. Still, he thinks EA will have to raise its bid before declaring victory.

On Mar. 26, Take-Two rejected EA's offer, saying it was inadequate, and adopted a poison pill—a move Yin says was expected. Then, on Mar. 28, EA extended its tender offer to Apr. 18 from Apr. 11. Last month, Yin downgraded EA shares to sell from hold, saying he thinks EA would have difficulty keeping key Take-Two employees and achieving synergy if the merger goes through. He has a hold opinion on Take-Two shares.

In the meantime, Activision (ATVI) looks like a real winner to Yin. On Mar. 28, he upgraded Activision to buy from hold. He likes the company's game franchises, and its deal to merge with Vivendi Games will boost earnings, he says.'s Karyn McCormack spoke with Yin about his view of the video game software industry (for more, see our special report). Edited excerpts of their conversation follow.

Do you think the EA/Take-Two deal will ultimately get done?

I do think, eventually, EA will acquire Take-Two. The main reason is its offer of $26 is substantially higher than what Take-Two was trading at prior to the announcement. And I think it will be difficult for another buyer to come up with anywhere near the $26-per-share it is offering. It's a slight discount to the industry in terms of price-earnings. However, Take-Two's earnings are lumpy, because they're tied predominantly to one franchise: Grand Theft Auto.

Take-Two plans to launch the latest version—Grand Theft Auto IV—on Apr. 29. This is the best-selling game franchise, and we expect it to be very profitable. For Take-Two, I project earnings per share of 91¢ for fiscal 2008, ending in October. This fiscal year will include most of the revenue from Grand Theft Auto, but beyond that we expect earnings to drop off.

So, I think the price EA is offering for Take-Two is fair. I don't expect another company to match EA's offer. Take-Two is playing hard to get. When shareholders have a chance to vote, I think they will accept it. Without this offer, the shares could drop off to somewhere near the level before the bid—around $18.

I think Take-Two wants to extract a higher value by seeing initial sales of Grand Theft Auto IV, in hopes EA might raise its offer. EA already raised its bid by a dollar, and it could go up another dollar or two to close the deal. That's why I have a $28 price target for Take-Two.

Do you see more deals in the group?

I think THQ (THQI) could be a potential takeover target. The stock has rallied a little, to 22 from 18 earlier this year.

Activision already announced it is in process to merge with Vivendi Games, a division of Vivendi (VIV.PA). We expect this deal to close soon.

What are your favorite stocks?

I upgraded Activision to buy from hold on Mar. 28. I downgraded it to hold from buy several months ago when it announced the deal to merge with Vivendi Games, thinking that the deal will limit near-term upside potential since Vivendi will be acquiring a majority stake at $27.50 a share.

However, I like the combined company after the deal closes, which I expect to happen in the first half. For one, Activision owns the intellectual property of two of the best-selling franchises: Call of Duty and Guitar Hero. The best thing about owning intellectual property is you don't have to pay license fees for the right to use someone else's brand, such as a celebrity's name or movie title. Vivendi owns Blizzard Entertainment, which develops World of Warcraft, which is a cash cow with 8 to 9 million users subscribing on a monthly basis. So combined, the company controls more intellectual property, which should help sustain long-term profitability.

I estimate EPS of $1.14 in the fiscal year ending March, 2009, and expect the deal to be synergistic and add to Activision's earnings after the deal is closed.

What's your overall outlook for entertainment software companies?

I'm neutral on the group. The industry is still growing—driven by improvement in graphics, high-definition TV, and increased sales of next-generation consoles. I think sales will grow in the low to mid-teens in 2008. There are a couple of key titles coming out, including Grand Theft Auto IV, for the next generation of game consoles, and sales of Nintendo's (NTDOF) Wii, Sony's (SNE) PlayStation 3, and Microsoft's (MSFT) Xbox 360 are rising.

On the negative side, we're concerned about a slowdown in the U.S. economy and higher development costs. Developers didn't anticipate the Wii selling this well, and they need to allocate resources to Wii. For example, I estimate Activision has only 12 games for Wii and EA has about seven—that's far less than for other platforms. Finally, I see increased competition from the hardware manufacturers. For the Wii, Nintendo is building games for its own console. And we think the valuations are a little high.

Do these stocks look more attractive after this year's weakness?

EA is down quite a bit since October of last year, while Activision is up. I think the stocks in this sector on average are still somewhat expensive based on earnings potential. For example, EA is trading around 40 times forward 12-month earnings. Despite having faster growth rates than companies in other software industries, I still think valuations are high.

One main reason I'm more cautious on the industry than other analysts is that I think [video game developers] are not like traditional software companies, such as Microsoft and Oracle, where you have economies of scale and expanding operating margin as a company gets bigger. I think the business model is more similar to that of movie studios, where development costs depend on the quality of the products, in this case video games, and not on the size of the company.

Every time they have a new release, they have to rewrite much of the program code. The quality of a video game keeps improving and they need more developers, which drives up development costs. With the exception of some franchises, most games have a short life, requiring a lot of advertising and marketing expenses to promote them. Developers also need to pay license fees and royalty, which often goes up as sales increase.

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