Playing the Gaming Giants on Wall Street


Ladies and gentleman, welcome to the ultimate Wall Street smackdown. Let's get ready to rumble! Tonight we bring you a serious Steel Cage grudge match between the two behemoths of the $6 billion electronic-games publishing biz, Electronic Arts (ERTS) and Activision (ATVI).

Weighing in with a hefty market capitalization of $9 billion is Electronic Arts, the reigning dominator and the biggest company in the sector. The maker of the Harry Potter video game and the wildly popular John Madden NFL Football series, EA is having a stellar holiday season with boffo sales. Still, its online gaming arm, EA.com, has been bleeding buckets of red ink and has caused EA to break its long string of profitable years. And these days, EA faces a resurgent challenger in Activision from sunny Santa Monica, Calif.

With roots going all the way back to the original Atari days, Activision has turned on the afterburners in the past two years and sent sales growth vertical on the back of hot titles such as the Tony Hawk Pro Skater series. Activision expects to book revenues of $725 million in 2002 (it just raised its estimate by 17%) and earnings per share of 73 cents. It finally has enough corporate girth and sufficient economies of scale to compete in the superheavyweight class. Activision has also expanded its product base, so that it receives 75% of its revenues from other titles other than its original winner and still champion, Tony Hawk (for a Q&A with CEO Robert Kotick, see "Pushing the Right Buttons at Activision").

MADDEN RULES. Too bad for Activision that it gets no respect from investors, which have kept its market cap at less than one-sixth that of EA's. Can the upstart overcome the powerful EA and win Wall Street's hearts? Or will EA knock down the challenger in its own backyard with an array of new action-sports games -- and maintain its market cap hammerlock? Let the grudge match begin.

In the relatively splintered video-game software business, EA has surged to the lead over the past five years. Its notable hits include The Sims, a PC game that has remained popular for more than a decade and is still going strong, plus football masterpiece Madden NFL. But EA has managed to spread its revenues well, with no more than 10% coming from any single title. Company revenues have more than doubled in half a decade, from $624 million in 1997 to $1.3 billion in 2001, according to Standard & Poor's.

With operating margins in the 14% range for its primary console-game business, EA has historically been one of the most profitable game makers -- before the losses from EA.com kicked in. EA's track record shows the signs of solid management, says Edward Williams, an analyst at investment bank Gerard Klauer Mattison. "I think their management team is extremely strong," says Williams. "These guys have been in place for many years, and they know their stuff." Add to that a deal to serve as the exclusive seller of games for America Online and of the hot-selling Harry Potter console game, and EA looks sure to continue turning in strong results.

NOT ENOUGH SUBS. The one dark spot is its losses in online gaming. The EA.com unit, which builds subscription-based multiplayer strategy and action games played over the Net, drove EA's overall operating income $30 million into the red in fiscal 2000, ending March, 2000, the first time it didn't post an operating profit since at least fiscal 1992. Losses for EA.com during fiscal 2001 totaled $99 million, not accounting for acquisitions and special charges.

Those losses will continue in fiscal 2002 as Web surfers haven't signed up for paid subscription-based interactive games fast enough to offset rising costs. Williams says EA.com has just 250,000 paying subscribers, although the company does bring in some money in advertising sold through that venue. EA says its online unit will turn profitable in fiscal 2003, a promise that's contingent on the delivery of The Sims Online, a much-anticipated release slated for late 2002. "If that game works, then dot-com has a chance of working. If it doesn't, then you have some issues," says Williams.

Should EA.com not turn the corner, it won't cripple the company. But it might persuade investors that EA shares are overvalued. Right now they carry a steep forward price-earnings ratio that falls in the high 50s when calculated against analysts' mean earnings estimates for 2002 according to Market Guide. That's high in comparison with Activision, which sports a forward p-e of 32.

CRITICAL MASS. That differential used to be much greater, but Activision has blossomed from a one-hit wonder into a bona fide hit-maker. Over the first nine months of 2001, 2 of the 10 best-selling game titles belonged to Activision, while EA claimed only one. Activision has expanded its efforts in the popular extreme-sports genre with a strategy built around creating true-to-life representations of the actual moves of real-world snowboarding, surfing, and BMX bicycle champions.

Once regarded as loosely managed, Activision has improved its operating margins considerably in the past two years. In fiscal 2001, which ended March, 2001, it posted a 6.42% operating margin, vs. the 3.25% it has averaged over the past five years, according to Market Guide. CEO Robert Kotick says "we have a target of 12% operating margins. I think we can hit that." He believes his company has finally attained the critical mass needed to boost those margins, explaining that Activisioncan can now put out a larger number of titles without adding to staff, and that it has a broad support infrastructure to better serve clients. That, says Kotick, will allow Activision to add $100 million in revenues in 2002 with minimally higher costs.

If it can pull off this and other minor miracles, Activision could eventually give EA a run for its money. Activision's revenues jumped 327%, from $189.2 million in 1997 to $620.2 million in fiscal 2001. That's more than three times the revenue growth rate that EA enjoyed over the same period. Moreover, says Kotick: "We're growing faster in categories that are easy to protect. We have more operating margin improvements ahead. And we don't have the distraction of a separate dot-com business."

HOT HOLIDAY. That's not to say Activision faces no challenges. Analysts remain worried that competitors' products in the extreme-sports pipeline will slow Activision's momentum. "I think the one real risk you have in this business is [not] following a monster hit with another monster hit. EA has traditionally been less susceptible to that," says Mike Wallace, an analyst with UBS Warburg.

Not to mention that EA is still the biggest player around. By all accounts, it's having a hot holiday shopping season. And that's just a taste of what's to come, as the company is readying a raft of new titles for the just-released GameCube and Xbox consoles in the coming year.

If EA's online gamble pays off, moreover, the company could develop the type of predictable subscription model that Wall Street loves -- and dominate a virtually untapped market. "From a valuation perspective, Activision is cheaper, and EA is much bigger and steadier," says Wallace, who has ratings of strong buy on Activision and buy on Electronic Arts.

Neither of these companies comes cheap right now compared to other software stocks, so the market is betting that the new consoles spark push mammoth sales. If investors want to put money on the challenger, they may have more upside but also more risk. If they go with the reigning champ, the risks are tempered -- but the rewards may be, too. By Alex Salkever, Technology editor for BusinessWeek Online


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