Analysis: Video Game Stocks - At A Tipping Point?

[How might the latest industry decline in September's NPD U.S. game retail results affect video game stocks? Gamasutra editor-at-large Chris Morris, a financial journalism veteran, examines the plight of the major public-traded game firms in the wake of the disappointing U.S. retail numbers.] I’m not a stock market analyst. And I’m not a psychic. So seeing as I’m writing this before the market opens on Friday, I’m obviously venturing out on a limb when I presume that video game stocks are getting hit. It’s not a bad guess, though. Thursday’s NPD numbers were down yet again – and investors who were hoping for a little good news in what has been a gloomy year are likely to lash out. It’s not hard to see why. 2009 was bad all around. And since the U.S. retail game industry has not had two consecutive years of negative growth before, investors were betting on a rebound. (Yeah, yeah… “past performance is not indicative of future behavior.” I know, and so do they. But it’s investing advice precious few pay attention to.) So were some analysts. Wedbush Securities’ Michael Pachter in January forecast sales growth of 10 percent for the public-traded companies and retail elements that make up his area of the industry this year. He wasn’t alone. The numbers varied from brokerage firm to brokerage firm, but several analysts generally felt that the strong lineup of titles, expected lower console prices, addition of the PlayStation Move and Kinect and easy comparisons to 2009 sales would ensure robust growth. The warning bell was chimed loudest, ironically, by Electronic Arts – which said it expected the retail industry to be down mid-single digits. Many people – gamers and industry observed alike – pooh-poohed this, calling it a ‘worst case scenario’ and accusing the company of trying to set a low bar after a crummy 2009. Only Lazard Capital Markets’ Colin Sebastian seemed to agree, saying he expected “flattish” console software sales. Now we stand with the easiest monthly comparables behind us – and the U.S. retail console and game software industry remains 8 percent behind last year’s pace. And, while Call of Duty: Black Ops seems a guaranteed blockbuster and Kinect pre-orders are going well according to Microsoft, there don’t appear to be any other catalysts on the horizon to drive share prices. Here’s the trick to investing – from a guy who has covered the world of finance for over 20 years. The Wall St. herd moves on short-term news. (Look no further than Electronic Arts’s performance this week.) And too many investors look only as far as the next quarter’s earnings. If you’re patient and know the games industry, it can pay off. Investors, at present, are wary of video game stocks. The industry hasn't had a lot of recent success with retail sales and it hasn't seemed able to pivot quickly enough to adjust to new competition. This includes a number of things, like the threat of social networking and mobile platforms (both of which are sucking up time that used to be spent playing) and the growing strength of digital distribution. That has added to the group's instability - and could keep things shaky for a while. But for long-term investors, it opens a door, especially if companies like EA can build digital revenue and get its retail game-centric costs under control. In the meantime, while most investors focus on glowering at packaged goods companies, there are a limited number of digital-only game companies that are traded as well, some of which sport some impressive numbers. For example, Chinese-headquartered firms Perfect World and Shanda both still have share prices that top any third-party U.S. retail-centric publisher. (Perfect World, for example, is trading at 2.5X what Activision closed at Thursday.) To be fair, both are getting hammered YTD – off 27 and 24 percent, respectively - but still, it makes you wonder how Steam would do if Valve decided to spin it off publicly. So what of the future for the public-traded behemoths? “Until we see a reversal of the negative trend, we expect investors to remain on the sidelines,” said Pachter in a note to investors earlier this week. “We think that 2011 has the potential to be a bright year for the publishers, but we think that investors will have to be patient to see evidence of a rebound.” Here’s the odd thing, though. While the retail-centric industry as a whole is suffering, with Ubisoft and THQ both down closer to 25 percent so far this year, shares of the other major third-party publishers aren't doing as bad as some people assume. Sure, they’re trailing the Dow and S&P indexes, but amidst all the fear mongering, disappointing sales numbers and unease about the future, they’re basically holding their own. Electronic Arts is down 9 percent thus far this year, but that’s a bit exaggerated as investors were recently spooked by middling Medal of Honor reviews. Activision’s up two percent for the year, so far, and Take-Two Interactive Software has climbed four. It’s nothing to celebrate, but the way analysts and investors have carried on, it’s better than many might expect. And even if those companies do take a hit based on the latest NPD results (and the more complete mid-year numbers, which include digital, subscription and used game sales, don't offer stability when they're released Friday morning), there is clearly a bright digital future for games -- and big gains for firms that do things right. But the billion-dollar question - one that some investors are hanging their hats on - is whether the big, public-traded firms can ride digital revenue up past the decrease and/or stall in retail revenues. [Chris Morris does not own shares of any companies mentioned in this story. Simon Carless contributed to this analysis.]