Entertainment Software
SECTOR REVIEW
2008 Videogame Strategy Guide
We believe the entertainment software industry is entering the sweet spot
of the videogame cycle. With significant install base growth, industry-driving
software releases, new business models like online and wireless, and
reasonable investor expectation we believe the stocks are likely to outperform
despite the likelihood of a weaker consumer. Historically this industry has
traded best the year before and during a videogame software revenue peak,
which we currently forecast to be calendar 2009.
Activision remains our favorite large-cap name in the space; Take Two is
our top small-cap pick. We believe Activision will outperform based on their
solid product pipeline combined from the Vivendi merger, despite the strength of
the prior year. While the most significant catalyst for TTWO is the launch of
Grand Theft Auto 4 on April 29th, we believe the halo effect it creates will
benefit their other titles and enable management to further streamline the
company’s financials.
We expect overall software revenue will grow 16% globally in 2008
following the 28% in 2007. This increase will be driven by a growing install base
of new consoles and handhelds, demographic trends, the rise of casual gaming,
new markets, and emerging business models such as online and wireless
gaming. We expect this cycle to be no different from before and believe the
space will outperform in 2008, despite investor concerns over the macro
environment. During the two previous videogame cycles, stocks have risen on
average 35 - 60% per annum in the third and fourth years of the cycle.
In this report, we take a close look at the global outlook on the industry
and detail our hardware and software expectations. We discuss changing
industry demographics and the rise of casual gaming and their contributions to
growth during this cycle. We also examine historical trading patterns and
peak/trough valuations to determine how the industry enters, matures, and exits
through previous cycle transactions. We believe the evolving industry business
model will drive significant multiple expansion as the videogame industry draws
near its peak year of earnings during the next generation cycle

Executive Summary
We believe that we are poised to see an explosion in the growth of videogame software
sales with the next generation videogame cycle as we enter the third year post-console
launch, approaching the sweet spot of the cycle. We expect overall software revenue will
grow by +15% in North America during CY 2008, following a 37% increase in CY 2007.
The strength has been driven by the increasing install base of seventh generation
consoles with the Microsoft Xbox 360, Sony PS3, and Nintendo Wii reaching critical mass
at the end of 2007 (at 17.6 million, 12.4 million, and 18.3 million, respectively). In addition,
robust sales for legacy systems such as the Sony PS2 and a strong handheld market
highlighted by the Sony PSP and Nintendo DS, have contributed to significant growth.
Along with the expanding install base, changing consumer demographics and the rise in
popularity of casual gaming have broadened the videogame industry. In this report, we
will examine the most important factors that will help sustain this upturn in the cycle and
will highlight the main reasons why we believe this cycle could be longer than prior cycles.
Activision remains our favorite large-cap name in the space. We continue to believe
Activision is extremely well positioned to outperform, fueled by a solid product pipeline,
continued strength from its core franchises (i.e., Guitar Hero and Call of Duty), the
attractive implied multiple of the combined company and the protection offered by the
tender. We believe these drivers far outweigh any concerns over the tough comps many
point to in FY’08. Take Two is our top small-cap pick. The most significant catalyst for
Take Two is the much anticipated launch of Grand Theft Auto 4 on April 29th. We believe
GTA4 will provide a compelling halo effect for the company’s strong second half pipeline of
product including Midnight Club: Los Angeles and Civilization Revolution.
We believe investors should use this period to build positions in these stocks. Historically,
this industry has traded best the year before and the year of a videogame software
revenue peak, which we currently forecast to arrive in CY 2009. We expect this cycle to
be no different from before and believe the space will outperform in 2008, despite investor
concerns over the macro environment. Video games offer a compelling value proposition
in terms of dollars spent relative to the hours of entertainment value provided to the
consumer. During the two previous videogame cycles, stocks have risen on average 35–
60% per annum in the third and fourth years of the cycle.
In the first section of the report, we focus on the macro environment and our take on the
impact of the uncertainties over the global economic outlook on the videogame industry.
Here we also discuss the global videogame market by region and detail our expectations
for hardware and software (units and pricing) over the next several years.
The second section of the report, discusses the expanding role of demographics in the
growth of the videogame industry. While the videogame industry has primarily addressed
children and males ages 18–34 historically, it has shifted its focus to concentrate on a
changing customer base, including an increase in the age band of gamers as well as an
increase in female gamers. The industry’s growth has kept apace with its growing
customer base and the rise in popularity of casual gaming. It’s no coincidence that for the
last two decades, household penetration for videogame systems has mirrored the
percentage of the population born since 1972, when the first home game console was
introduced.
The third section details specific industry-related characteristics that software publishers
and retailers share. Generally, entertainment software publishers conform to similar
business models within the industry. The development process is largely driven by the
agreements with hardware manufacturers. Many of these agreements also dictate when a
product is released on the market. With respect to the actual publishing of the software,
more flexibility is available to the individual publishers. Among those differences are how
publishing is accomplished, whether within the company’s corporate umbrella or without,

how development is characterized in financial statements and how involved a company is
in the distribution business of publishing software.
Due to the cyclical nature of the entertainment software industry, we have provided an indepth
look at how individual companies have traded during each cycle by month in the
fourth section. Exhibit 18 outlines the overall price action history by month from 2005
through 2007. The second column lists the average of each month over the past two
years. These averages demonstrate that the industry tends to trade up in July and August
after the industry’s premier event, E3, takes place in July. The industry also performs well
during the holiday season when sales substantially increase in December. We then
examine each company’s peak, average, and trough forward year P/E valuations as well
as their historical stock performance, highlighting the stock’s strong performance during
peak years of prior cycles. During the fifth generation cycle 1998 and 1999 were the third
and fourth years, or sweet spot, of the cycle. During the sixth generation cycle 2003 and
2004 marked the peak years.
The fifth section discusses new growth opportunities in the industry, starting with the
evolution of casual games. The proliferation and popularity of casual games, a category of
video games targeted at a mass audience available on a broad array of gaming platforms,
has resulted in tremendous growth and change in the entertainment software industry. In
addition to casual games, emerging market segments (online, wireless, in-game
advertising, international expansion) have created ancillary revenue streams for the
industry. The recent progression of casual gaming has been driven by the advent of new
consoles appealing to a wider consumer demographic, the explosive growth in online
media consumption, the ubiquity of mobile devices, increasing spend on in-game
advertising, and international expansion opportunities.
Finally, we outline the past six years of overall market share across next generation
console and handheld platforms in Exhibit 38, as well as software market share by console
and by major genre. At the end of the report, we have provided additional details on each
of the major players in the industry, including Activision, Electronic Arts, Midway, THQ,
Take Two, Ubisoft, Microsoft, Sony, Nintendo, Gamestop, Sega Sammy Holdings, Namco
Bandai Holdings, Square Enix, Koei, Konami, and Capcom.
We believe the evolving industry business model (growth in online, in-game advertising,
and increasing economies of scale, lower inventory risk, and a broadening addressable
market, including new international opportunities) will drive multiple expansion as the nextgeneration
videogame cycle reaches its sweet spot and we draw near peak earnings,
which we currently forecast to arrive in 2009.