MIDWAY GAMES SLASHES EARNINGS FORECAST

In conference call with analysts, Midway CEO Neil Nicastro said worse-than-expected results were “primarily due to lower- than-expected demand” for games Defender, Dr. Muto and Haven: Call of the King that were “only partially offset by higher-than- expected demand for Mortal Kombat: Deadly Alliance,” latest entry in company’s most popular game franchise. Midway said Dr. Muto and Haven were character-based adventure games -- category that has performed substantially below expectations for it and videogame industry overall this holiday season. As result of decreased revenue expectations, additional reserves and other charges expected as result of what company called its “poor performance,” Midway said it now expected to post loss instead of profit for quarter. It said it planned to announce its final results for 4th quarter and fiscal year “in the latter half of February.” Also in conference call, Nicastro declined comment on L.A. Times report Sat. (CED Dec 24 p8) that said struggling Midway had talked with 2 other companies to ascertain whether they were interested in acquiring it or merging with it.

Looking ahead to fiscal 2003, Nicastro told analysts that his company now expected to report revenue of $250-$275 million and pretax earnings of $20-$30 million. He said company was exploring opportunities to streamline operations” that, if adopted, could result in nonrecurring charges reducing expected pretax earnings. But one analyst asked how Midway could have been so far off in estimating 4th-quarter results and how it could predict accurately how it would fare next fiscal year when its estimate for just one quarter was off by so much. Nicastro said Midway’s forecast was off by so much for 2 basic reasons: (1) It had no way of knowing, as THQ complained earlier that day, that retailers were going to change their 4th-quarter ordering strategy across board, resulting in cautious initial orders followed by lower-than-expected reorders on most titles. Nicastro said Midway’s new Mortal Kombat title did better than expected and was success on all 4 platforms on which it was released but inventory that retailers took was “extraordinarily low compared to the sales rate” of game. He told analysts that “inventory out there is bone dry” for title at this point. (2) “The other products [Midway shipped in quarter] have sold poorly” in 4th quarter. He said Midway had made honest guess on how majority of its games would fare that just didn’t pan out.

Nicastro told analysts that one of company’s major observations in recent months was that biggest hit games now were being bought by older players than at similar point in past game cycles -- and older gamers were buying more adult-oriented titles. “The marketplace has acted a bit differently this holiday season” from past, he said, and many gamers now were tending to focus their buying on fewer 2nd- and 3rd-tier games. As result, Midway said it had shifted its 2003 slate of games to include more adult-oriented titles than planned. When asked by analyst how company could be sure that as console installed bases increased, mainstream gamers wouldn’t start coming from younger audience that wouldn’t want same kind of titles as older gamers were craving now, Nicastro said marketplace will be “changed forevermore” by what is happening now. With younger people tending to follow what their older siblings are buying, he offered analogy in which he said younger people whose older siblings smoked pot were more likely than other kids to smoke pot. Younger gamers, he said, now want to buy more mature games than people their age had purchased in past because that’s what their older siblings were playing.

Continued strong sales of Mortal Kombat: Deadly Alliance in 2003 domestically, coupled with introduction of title in Europe “alone [should] provide substantial momentum [for Midway] going into next year,” Nicastro told analysts. Midway said it was upbeat about its overall portfolio of products for 2003, saying lineup was “diverse and focused on today’s most popular game genres.” Company plans to ship 40-50 SKUs next year, Nicastro said. In first quarter 2003, Midway said, it expects to release MLB SlugFest 20-04, sequel to its popular PlayStation 2 (PS2) baseball game of 2002 and to ship European version of Mortal Kombat: Deadly Alliance to all PAL territories. Later in 2003, Midway plans to continue its success in what it labeled “over- the-top” sports genre with what it called “fresh approach to the company’s football and hockey brands as well as the introduction of a new basketball title.” It said its next installments in NFL Blitz and NHL Hitz franchises would “include dramatic new gameplay featuring the same over-the-top excitement that made MLB SlugFest an instant hit.” New in its sports lineup in 2003 is to be NBA Ballers, basketball title being developed by same internal development team that was responsible for creating previous basketball franchises NBA Jam, NBA Hangtime and NBA Showtime: NBA on NBC, which together have sold more than 4 million domestic home videogame units, company said. Midway said it also expected to release several titles next year “targeted at today’s most successful and popular game genres,” including 3rd-person shooter with military/espionage theme, survival horror game set in maximum security prison, adult-oriented open-world action game with crime-fighting theme, immersive-world combat driving game, several driving/racing titles including sequel to Midway’s “one- million-plus unit seller, SpyHunter.”

After Midway conference call, Wedbush Morgan Securities analyst Michael Pachter reduced his earnings-per-share (EPS) estimate for Midway’s 4th quarter to -1? from 28? and fiscal 2003 estimate for company to $230 million revenue from $313 million and EPS to 20? from 43?. In research note to investors, he said: “We are hesitant to continue our positive investment recommendation on shares of Midway. Mortal Kombat is a best- seller over its first month of release, and we expect significant revenue contribution from the European launch next quarter and from continuing catalog sales in the U.S. Notwithstanding the impressive performance of this title, the company’s other releases in Q4 flopped, indicating that catalog sales in 2003 are at risk. The company announced during the conference call that it intends to refocus its strategy on more mature-themed games, as it has observed consumer demand for these titles has increased over the past year. This refocus appears to us to be similar to the strategy embarked upon by Activision last week [CED Dec 19 p6], and we note that we lowered our investment rating on Activision at that time. We think that the strategy is sound, but question whether Midway can compete effectively for consumer dollars in the face of increasing competition. We are concerned that a new shooter game by Midway may experience the same flat consumer response as did its games released in Q4, and we have limited confidence in the company’s ability to forecast its revenues and earnings.”

“Notwithstanding these concerns,” Pachter said, “we are modeling FY:03 [fiscal year 2003] at a modest 21% top line growth rate. Although 21% growth may sound like a large step up, we believe that anything Midway produces is likely to sell better than its Q4 releases last quarter (11 SKUs released during the quarter sold through a combined 52,000 units!). We are hopeful that Midway will cancel projects that have such limited consumer appeal, and will manage its 40--50 SKU count so that each of its releases achieves cash flow breakeven or better… In spite of our [downgraded] outlook, we continue to believe that Midway is on track to return to profitability. The company has abandoned several planned projects (there was no mention of Freaky Fliers or of Haven for GameCube and Xbox), and seems to be quite focused on its mature-game strategy. Given the enormous success of Mortal Kombat, we no longer doubt the company’s ability to make good games that sell. Our only remaining question is whether it can create a good game that can sell without the advantage of brand recognition. We are somewhat troubled that management revealed plans for a 3rd-person shooter game, a survival/horror game, a crime-fighting action/adventure game and a combat driving game, but could not provide names or developers for any of the projects. Although we agree that the potential for these games is great, we are not as confident as Midway management in its ability to attract consumer attention to its new titles… The company is only one hit away from being substantially profitable.”

Similarly, Gerard Klauer Mattison analyst reduced his EPS and revenue estimates for Midway’s 4th quarter to -14? and $68 million from 23? and $105 million, fiscal 2002 estimates to -53? and $179 million from -13? and $216 million, fiscal 2003 estimates to 22? and $248 million from 30? and $301 million. He said: “We remain neutral on the shares of Midway until we gain confidence in the quality of the company’s software and management’s ability to execute in an increasingly competitive interactive entertainment environment. Although the company introduced a strong title during the quarter, the balance of its product portfolio has performed below expectations. Midway indicated that it is taking steps to remedy this issue, by introducing products that appeal to the older demographic. However the success of new brands in the current videogame retail environment has been less than encouraging, giving us pause… Given that the company does control a meaningful amount of intellectual property, as well as development studios and the associated resources, we believe Midway can still be the target of a buyout or takeover.” SWS Securities analyst Arvind Bhatia also maintained “neutral” rating on Midway stock Tues. At our Tues. deadline, shares in Midway were trading down 22? (5.13%) at $4.07.