By Jennifer Lai
March 30, 2010

The video game stock has been a laggard – but fund managers and analysts say it will bounce back soon.

By Mina Kimes, writer

Once a blazing hot tech stock, Electronic Arts (ERTS), the maker of “Madden” and “Rock Band,” is badly in need of a restart. The video game company’s shares have sunk 63% over the last three years while the NASDAQ has been flat. Sales growth slowed after EA failed to anticipate the popularity of the Nintendo Wii. Management insists that a turnaround is underway — but a series of earnings misses have undermined their credibility, and investors shunned the stock during last year’s bull market.

Yet despite the company’s underwhelming performance, some fund managers think a recovery is around the corner. “We think it’s worth significantly more than it’s trading at,” says Christian Andreach, one of the managers of the $1.3 billion Manning & Napier Equity Fund, which has beaten 97% of its peers over the last decade. “Very few people are giving this company any credit.”

The stock’s 2011 price to earnings ratio of 31 doesn’t look cheap, but it was trading at 140 times earnings just three years ago. Harry Rady, CEO of Rady Asset Management, says that, given the company’s $1.1 billion cash hoard, it would become an acquisition target for big media companies or private equity firms if shares fell further. “The company could be LBO’d very easily,” he says.

Andreach’s fund has more than doubled its stake in EA over the last year, to 1.4 million shares. He’s not alone: The $43 billion Dodge & Cox Stock Fund added 11 million shares of Electronic Arts last quarter, and PRIMECAP Management has also been a big buyer.
One of the drivers behind the momentum is simple: The next few years are likely to be better for EA. The company — known for pouring massive sums of money into the research and development of high profile, ultra-realistic games — has been spending, not selling, in recent years. Hilliard Lyons analyst Jeffrey Thomison thinks its efforts deserve a two-year investment time frame. “We expect the company’s recent trend of earnings disappoints to end soon,” he wrote in a recent note.

“As you move into 2010, you’ll see a bigger release docket,” Andreach says, pointing to the success of new games like “Mass Effect 2” and “Battlefield Bad Company 2.” EA could also score wins with its upcoming installment of “FIFA World Cup” and an online Tiger Woods game. The company stuck by Woods through the scandal that hit the golfer last year, a move that looks like it will pay off now that he is returning for the Masters in concurrence with the release of the game.

One of the biggest dampers on the company’s bottom line has been an MMO (Massively Multiplayer Online) “Star Wars” game, its most expensive bet ever. Whether or not the release succeeds, says Andreach, it will provide much needed relief to the company’s cost base. “If 20 to 30% of their earnings is being spent on ‘Star Wars,’ you should see improvement in profitability,” he says.

New releases of “Final Fantasy” and “Halo” should also boost sales. EA doesn’t make those games — but it does make software for the PlayStation 3 and Xbox, the consoles they’re played on. Heath Terry, an FBR Capital Markets analyst, says the releases ought to help those consoles outpace the Wii, which in turns will improve sales of EA products. “It’s a situation where the market is moving in EA’s favor,” he says.

Video game industry sales dropped 8% last year, according to research firm NPD Group. Sales of used games, on the other hand, were up more than 20%, says Terry, a sign that demand didn’t drop off altogether. Secondhand sales are generally bad for game makers like EA, because when customers trade in games to stores like GameStop (GME), the next shopper is less likely to pay the full price.

But Terry says the rise in used games sales was partially driven by the dearth of new releases — and that EA’s latest products have been appearing less frequently on GameStop’s shelves. He credits the company with developing downloadable content like expansion packs to extend the lives of games so that customers don’t immediately return them. “If you look at EA’s docket for 2010, you’re not only seeing an increase in titles, but that every single game has a digital component,” he says.

Some analysts say that the company’s online efforts can’t compete with the advent of free social networking games like “Farmville.” Terry says that threat is blown out of proportion because the games appeal to different demographics: The average social networking gamer is a 43-year-old woman, he says, while the typical console game is a 27-year-old male. “There’s no guy out there that used to buy ‘Madden’ and is content playing ‘Farmville’ on Facebook,” he says.

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