Video game firms enjoy moment despite cloudy future. (Media & Technology).

Video games are shaping up to be one of the few bright spots in an otherwise lackluster holiday season. After that, however, the situation gets a little murky.

Shares in Santa Monica-based Activision Inc. and Calabasas Hills-based THQ Inc. took major hits last week after UBS Warburg analyst Michael Wallace downgraded his recommendations on the two stocks from "strong buy" to "hold."

While Wallace said the industry was on track for a record-breaking year, he expressed concerns about soft sales in 2003, when video game consoles now on the market will be in their second and third years.

"The 'buy the group' phase is over," he said in a research note to clients. "We think the publishers stocks are going to look past the 2002 holiday season and begin trading on 2003 numbers." Even before the UBS report, both Activision and THQ shares had been down sharply for the year.

Last week's downgrades represent a rare dose of bad news for an industry that has continued doing well amid an otherwise weak technology and media sector.

A report by Wedbush Morgan Securities estimates that shoppers may spend $2.8 billion on games in November and December, a third more than last year. Hundreds of new titles are being released for Sony Corp.'s PlayStation 2, Microsoft Corp.'s Xbox and Nintendo Co.'s GameCube. The companies are cashing in as teens and young adults shift from traditional toys to interactive games.

Online retailer Buy.com reported that sales for the Thanksgiving Day weekend rose 30 percent this year from 2002 results.

"Video games are at the top of his list," said Latham Williams, referring to her 12-year-old son Powen at a Sony game store. "He'd rather do this than just about anything else."

At the Sony store in downtown San Francisco, Mike Croke, 38, spent $100 on Electronic Arts Inc.'s "Lord of the Rings" and Eidos Plc's "Hitman 2: Silent Assassin." He didn't blink at the cost, saying that the entertainment provided by the games was cheaper than a night on the town back home in Los Angeles. "I could spend $100 in a bar in a couple of hours," Croke said. "This is a bargain."

Video-game makers tend to prosper when the economy weakens because people spend more time at home.

"In poor economic times, the video game industry has done exceptionally well," said Robert Kotick, chief executive of Santa Monica-based Activision, which produces "Spiderman" and the "Tony Hawk Pro Skater" series.

Video-game leaders

Activision raised its sales forecast by $14 million to $934 million for the 12 months ending next March. Electronic Arts, maker of three best sellers last quarter, expects sales to rise more than 40 percent to as much as $1.18 billion this quarter.

"Their product lineup is spectacular," said Tom Holman, manager of the $125 million Evergreen Select Small Cap Growth Fund, which owns 200,000 Electronic Arts shares. Lower prices and better planning among console makers may boost demand. Last year, Microsoft's Xbox and Nintendo's GameCube weren't released in the U.S. until a month before Christmas.

"We are definitely expecting a sales growth in the U.S.," compared with the previous year's shopping season, said Yoichi Wada, president of Tokyo-based Square Co. The maker of the "Final Fantasy" role-playing game series this month raised its sales forecast for the year ending March by a third.

Many retailers aren't bemoaning the lack of blockbuster toys and the increased emphasis on video games. The companies are paying more attention to inventories because of the sluggish economy and just as important is to avoid a glut of merchandise that must be discounted once a hit fades.

"We are planning conservatively," said John Eyler, chief executive of Toys "R" Us, the nation's second largest toy retailer. Inventories were 2 percent below last year's stocks when the fourth quarter began, Eyler said. Sales are expected to rise 2 percent to 3 percent this quarter in stores open at least 12 months, he said.

Concern among video game publishers and retailers centers is based not so much on the current holiday season but what happens in 2003. Only two video game publishers have seen their shares rise this year: Electronic Arts, largely thanks to its successful "Madden NFL 2003" interactive football software series, and Take-Two Interactive Software Inc., with its "Grand Theft Auto" series of criminal adventures.

But publishers are especially reliant on blockbuster product. Last week, Gerard Klauer Mattison analyst Edward Williams cut his second quarter earnings estimate for Acclaim Entertainment Inc. to a loss of 1 cent per share and a loss of 5 cents for the year. He had earlier expected break-even results for the quarter and a loss of three cents for the year. "In our view, (Acclaim) continues to suffer from a lack of compelling content," Williams said.

There also has been some concern about the violent nature of the games. FAO Inc., owner of FAO Schwarz toy stores, said it would stop selling video games at its 170 Zany Brainy locations because most are too violent for younger children. "Video-game makers make the products that sell," said FAO Chief Executive Jerry Welch. "What sells are products that are more graphic and violent."

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