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Video Game Makers Are Battling Sinking Stock Prices

Call of Duty 2 is made by Activision, whose shares have fallen 17 percent this year as the industry moves to a new generation of consoles.Credit...Activision

Correction Appended

The video game industry has been taking a beating.

While air has seeped steadily from the stock market, it has poured from the four major publicly traded game publishers. Since May 1, they have lost a collective $6 billion in market capitalization, about a 25 percent drop, compared to declines of 8.3 percent for the Nasdaq and 4.2 percent for the Standard & Poor's 500-stock index.

The sharp decline reflects a realization by investors that the game industry will recover considerably more slowly than expected from the transition to a new generation of consoles, the Xbox 360 from Microsoft, the Sony PlayStation 3 and the Nintendo Wii.

So, too, analysts said, the game publishing industry is being disrupted by the growing cost of development, as well as uncertainty and opportunity created by the growing popularity of online game play.

"There are more industry concerns than ever, and that's what you're seeing in the stock prices," said Justin Post, an industry analyst with Merrill Lynch.

And yet, underscoring the complexities of assessing the industry, Mr. Post has a buy rating on shares of two of the major publishers, Electronic Arts and Activision. Like many stock analysts, he argues that given long-term trends, the game business is destined to boom, and that the only question is when.

Evidence of trouble started growing last November after Microsoft introduced the Xbox 360, marking the transition to a new generation of game consoles more powerful and graphics-rich than previous models.

Production delays left Microsoft unable to meet demand, leaving some customers unable to buy an Xbox and, in turn, the publishers' games. Highlighting the troubles, Electronic Arts said in early May that its 2007 fiscal earnings could be as much as 70 percent lower than analysts had projected.

Several days later, the industry convened in Los Angeles for its annual convention, the Electronic Entertainment Expo, a neon-lighted extravaganza of self-promotion.

But rather than providing momentum, it seemed only to complicate matters. Sony said it would release its own next-generation console, the PlayStation 3, in November and sell it for $499, the highest price ever for a console.

Since January, Wall Street analysts have dropped their estimates of the industry's total revenues for 2006 by 60 percent, said Daniel Ernst, an analyst with Soleil-Hudson Square Research. Many analysts now say that publishers will not see significant growth until well into 2007.

Mr. Ernst said the most optimistic view is that by the end of this year, consumers will own 15 million consoles of the new generation — 12 million Xbox 360 consoles and the rest PlayStation 3 and Wii machines. There are about 150 million machines of the preceding generation.

Past transitions have been painful, too; consumers, awaiting new systems, tend to hold off on purchases of games for the old systems. The video game industry is highly unusual in that every three or four years, in sync with new consoles, publishers hit a trough of earnings but one historically followed by a boom.

That is what the game executives are expecting this time.

"More people are playing games than ever before," said Bobby Kotick, chief executive of Activision, whose franchises have included Doom, Quake and Tony Hawk. "People who were in their teens in the 80's are now playing games with their kids. When I look at the next 10 years as compared to the past 10 years, I just see better prospects."

He said that the powerful new consoles and richer games would attract consumers, that publishers had a chance to profit by making games for a range of different machines (not just consoles, but also hand-held devices, like the Sony PSP), and that a consolidation of smaller publishers in recent years could leave greater shares for those remaining.

But Mr. Kotick acknowledged that there were challenges, including a growing need to produce games more efficiently. He said the industry would probably also focus more narrowly on games with hit potential (selling several million copies) as opposed to a scattershot approach of creating numerous games that sell one million copies or less.

What is becoming clear to analysts, they said, is that this transition includes some particular facets complicating how soon the industry rebounds and how far. One aggravating factor is a 30 percent to 50 percent increase in the cost of making top-tier games — now $10 million to $15 million to make games for the new consoles and their more powerful processors.

The expense is expected to cut into profit margins, which may have hit their peak at some companies, notably at Electronic Arts, analysts said.

A potentially counterbalancing force is the emergence of revenue from gamers playing over the Internet — which the Xbox 360 allows and the PlayStation 3 is also expected to allow — and using the consoles to download games. If so, that could allow publishers to markedly cut the cost of distribution.

On the other hand, that prospect may be one reason for the fall in the share price of GameStop, a game retailer, analysts said. Since early May its stock has fallen to $39.43, from above $48. Mr. Kotick, for one, says he does not think that players will be routinely downloading games any time soon, given bandwidth and hard-drive limitations.

"The idea of full downloadable games is so far in the future that it's almost incomprehensible as an opportunity," Mr. Kotick said. But he added that there were more immediately plausible revenue opportunities from selling downloads of supplemental game levels or "characters, new weapons, new missions, or auctioning off places" in a virtual world.

The wariness of game industry investors is heightened by concerns that inflation will drive up interest rates, cutting into consumer spending. "People go to Wal-Mart less, and fewer video games are sold," said Evan Wilson, a video game industry analyst with Pacific Crest Securities. "There's a pall cast over every stock that touches consumer spending."

But Michael Pachter, an analyst with Wedbush Morgan Securities, says that a retrenchment in consumer spending could assist game makers if people abandon higher-cost entertainment in favor of stay-at-home entertainment. "A bad economy is good for video games," he said.

Over the long term, analysts said they were bullish, citing the increasing popularity of games and the growing ranks of adults who have been playing video games for years.

"I would be buying these stocks with both hands," Mr. Wilson said. Within the industry, he ranks Activision and THQ as the better current opportunities, seeing them as having a chance of winning market share away from rivals like Take-Two Interactive and Electronic Arts.

To be sure, the analysts see these stocks as a group only to a point, advising that investors look at the long-term prospects for each company. Since May, Electronic Arts' shares have fallen to $42.30, from $56.80; Activision to $11.58, from $14.19; THQ to $21.49, from $25.63; and Take-Two to $13.10, from $17.05.

Particularly rough news came two weeks ago for Take-Two, which announced that in its second quarter it had losses of $50 million, compared with a loss of $8 million in the same period a year earlier. Mr. Pachter of Wedbush Morgan said some analysts continued to be skeptical of the company as possibly a "one-hit wonder" supported by its wildly successful Grand Theft Auto franchise.

The publishers' stocks were up slightly on Thursday and Friday, but analysts did not see the beginnings of a turnaround. "The move the last two days doesn't do anything to offset the material decline of the stocks," Mr. Wilson said. "Relative to the total move that's happened since the beginning of May, it's not that big."

Mr. Ernst, from Soleil-Hudson, said there might be one upside to continued investor disappointment this year.

"If 2006 stinks, 2007 on a comparable basis is going to look pretty incredible," he said.

Correction: June 20, 2006

An article in Business Day yesterday about the problems facing the video game industry misstated a figure from a report by Soleil-Hudson Square Research on analysts' financial forecasts for the industry. The report estimated a 60 percent cut in 2006 in the industry's total earnings, not its revenues.

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