Three Video Game Firms with Long-Term Tailwinds

Console transitions are difficult times for video game publishers such as  Electronic Arts (ERTS) and  Activision . Gamers will spend several hundred dollars to buy  Microsoft's (MSFT) Xbox 360 or  Sony's (SNE) PlayStation 3, which leaves them with less money to buy games. In addition, people tend to delay purchasing new games until they can get their hands on a new console. Unfortunately for the game publishers, supplies of the Xbox 360 have been tight and the introduction of the PlayStation 3 has been delayed. As if slowing sales were not enough, publishers must spend significant sums to develop games for the new consoles, which further pressures profit margins.

As you can imagine, 2006 will be a forgettable year for the video game industry. However, if you're willing to take a longer-term view, console transitions provide an opportunity to buy excellent businesses at reasonable prices.

We think the trends that have shaped the industry over the past decade will continue to drive growth in the years ahead. First, the people who began gaming as children in the 1970s and 1980s are now adults with more disposable income to spend on video games. In addition, innovation in game content is capturing a wider-demographic audience. According to EA, women account for 60% of The Sims players and have helped make that game one of the most successful titles of all time. Furthermore, there are a growing number of gaming platforms. Sony's PlayStation Portable (PSP) handheld gaming device has sold millions of units, and video game margins for the PSP are the highest of any platform.

Another wild card that we think could be a huge positive for the game publishers is in-game advertising. According to Nielsen, males aged 18 to 34 spend as much time (30 billion hours annually) playing video games as they do watching television. However, of the $8 billion U.S. advertisers spent in 2003 to target this lucrative demographic group, only $15 million was directed toward in-game ads. Clearly, we're in the early innings of what could potentially be a long growth phase.

With the market focused on the difficult short-term results, here are three video game companies that will have the wind at their backs over the long term. Keep them on your radar screen, because you might get a chance to buy them on the cheap.

Take-Two Interactive (TTWO)
Economic moat: Narrow
Business risk: Above Average
Morningstar Rating for stocks: 4 stars
The crown jewel of  Take-Two's game portfolio is the blockbuster Grand Theft Auto (GTA) series. Between fiscal 2003 and 2005, the GTA series generated roughly $1.2 billion in sales, making it one of the top-selling franchises of all time. The next major release in the GTA series is targeted for the 2007 holiday season. However, poor corporate governance is an ongoing issue for the firm, as illustrated by the recent executive turnover. A hedge fund, Glenview Capital Management, has purchased an 11% stake in Take-Two and recently converted to a 13D filing status, which means the fund may take an activist stance. There is a reasonable argument to be made that Take-Two trades for a modest premium over the value of its GTA franchise alone, so a corporate event may help realize value for shareholders.

Activision 
Economic moat: Narrow
Business risk: Average
Morningstar Rating for stocks: 5 stars
 Activision is a stock owned in the Morningstar GrowthInvestor portfolio, which I manage. We believe that Activision's size and intellectual property arm the firm with durable competitive advantages. As the cost and complexity of game development increase, scale becomes an important differentiator. Not only can Activision enjoy cost savings by leveraging common technologies (such as a physics engine) across multiple titles, but the firm also has the revenue base to support nationwide advertising campaigns. Another key for Activision is its ability to develop game franchises from exclusively licensed content and internally developed intellectual property.

Electronic Arts (ERTS)
Economic Moat: Wide
Business Risk: Average
Morningstar Rating for Stocks: 3 stars
Electronic Arts' rock-solid balance sheet, healthy free cash flows, and exclusive licenses place the firm in a competitive position that is the envy of rivals. The firm is consistently one of the top three providers of games to the console and PC markets, and more recently it has been the market-share leader in the PlayStation 2, Xbox, and PC segments. With the nearest pure-play competitor having one third of EA's sales volume, we believe that the firm leverages its size to ensure wide distribution of its titles and to attract the top developers in the industry.