Investing in Video Games

Nov 9th, 2006 | By Craig Walters | Category: Investing Strategies

While the initial idea of owning an original Pac-Man machine for a reasonable price was somewhat intriguing, seeing a room full of these dirty, noisy machines had a sobering effect.

The room to which I’m referring was just about 15 miles north of Baltimore at the Timonium State Fairgrounds. The event was a coin-operated video game and amusement auction, temporarily located in a building that each year plays host to the livestock exhibition of the Maryland State Fair.

That day, though, it was more of a video game burial ground than anything else. At least one model of every video game ever produced was up for auction or for immediate sale at a fixed price. Their conditions ranged from a few pristine models to mostly those that had seen heavy use. Bidders were encouraged to bring their own extension cords to test that the games did indeed function. The panels to the coin slots on the machines were open so that savvy buyers could activate the games without actually dropping in quarters.

One of the facts that struck me in this room was that Midway Games had a stranglehold on this industry throughout the 1980s — when arcade games were big business. Today, I think arcades only exist at beaches and amusement parks.

But back in the ’80s, arcades were popular. The big names in this business, along with Midway, included Taito, Atari, and Williams, just to name a few.

Midway, however, had a significant number of top titles back then that have ultimately been modernized and transferred to Playstation and Xbox. You might remember Spy Hunter or one of their more contemporary titles like Mortal Kombat. These games have spawned sequels, spinoffs, and some have become franchises that are still alive 25 years later.

If Midway sounds like a dynasty in the electronic entertainment industry, its stock is clearly on the ropes…

Midway Games (MWY:NYSE) is a small-cap that’s been cut in the last 12 months. It’s down 54.7% and now has a market cap of $785 million:

Midway started to fall apart in mid-December 2005. During that month, the company’s largest shareholder, Sumner Redstone of Viacom, shifted a substantial amount of his direct holdings in the video game company to off-load personal responsibility of over $400 million in debt to a holding company. While Redstone wasn’t really dumping Midway stock on the open market at the time, it did turn a lot of negative attention on the game company. Analysts began to pile on with negative statements about its lofty valuation, Redstone’s ownership making it basically an illiquid stock, and the company’s inability to post positive earnings.

I’ll admit I was very hopeful of finding a compelling investment in Midway at these depressed levels. It’s still somewhat of a powerful name in a very big market, and we’re entering another cycle where lots of dollars are going to be thrown at new video game consoles from Sony and Nintendo. I at least had to see if Midway was going to be a smart buy for this new cycle…

There have been a lot of opportunities for Midway to capitalize on surges in video game sales, but the company has consistently failed to execute. The first Playstation was launched in 1994 and 1995 in Japan and the U.S., respectively. Playstation 2 was launched globally in 2000, and Playstation 3 will be launched in Japan and in the U.S. in about two weeks. Overlapping these releases were new entrants from Microsoft in the forms of Xbox and Xbox360, Nintendo’s 64, GameCube and the upcoming Wii. A few entrants fell by the wayside — notably Sega and their Saturn console.

Midway didn’t just hitch their wagon to one game company, either. They have produced software for virtually all of the systems, and yet profitability has been elusive:

As you can see from the income statement, Midway’s been losing money since 2000 up through 2005 — arguably the greatest “video game bull market” in this industry’s short history. A big drop in revenue from 1999 to 2000 occurred when Midway exited the coin-operated arcade business…and they never posted an annual profit since.

The Entertainment Software Association (ESA) reports that consumers spent $7 billion on video and computer games in 2005. That’s double what was sold in 1996. If we look at Midway’s home video game sales during the period between 1998 and 2005, it’s sales dropped 34.7% while the industry’s sales as a whole marched forward 45.8%. And for most of those years, this company was losing money.

While one could make the argument that Midway shares are hated assets and there is rarely a better time to buy an asset then when no one else wants it, this is one I would avoid.

In the last 12 months, Midway has taken on more debt than they have in the last 10 years combined, and the company is not cash flow positive on any level. Many of their key franchise software titles are getting very long in the tooth and may not remain marketable for much longer.

Management just reported a loss for 3Q06 that was an improvement over 3Q05. However, they did guide full-year earnings to be a loss of $73 million, which is a greater loss than they had previously told the Street.

Traditionally, the months leading up to a new generation video game console’s launch is tough on gamemakers who are still producing titles for the existing platforms — the ones that no one is going to want in a few months. That’s why Midway’s management is telling investors that recent losses are associated with their efforts to gear up for a strong 2007.

If I were convinced that Midway is going to make a massive turn to consistent profitability, now would be the precise time to take a position. But I’m not convinced.

Until next time,
Craig Walters
November 9, 2006

P.S.: When I’m not following the bigger trends affecting the small-cap market, I’m tracking the smart money. One of the best (and most misunderstood) ways of making money in the stock market is by following the insiders. As one famous fund manager said: “Insiders might sell their shares for any number of reasons, but they buy them for only one: They think the price will rise.”

Craig Walters

Craig Walters spent years entrenched in the investment industry doing what he loves best: performing financial research on scores of small-cap companies. Craig was formerly an equity analyst and Systems Director for Ferris, Baker Watts.

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