The video game industry is clearly in a slump. If the 8% drop in video game software sales in 2009 was not sufficient reason to convince most investors to stay away from the sector, the disappointing outlook from Electronic Arts (ERTS) today certainly will. Electronic Arts beat reduced earnings expectations of 31 cents by 2 cents when it reported results for last quarter. Despite the release of the highly anticipated game Mass Effect 2 in January, the company provided downright depressing guidance for the current quarter and the first quarter of its fiscal year 2011. Electronic Arts expects to make between just 2 to 6 cents in the current quarter (Q4 2010). Analysts were expecting the company to report earnings of 13 cents a share. The outlook for the first quarter of fiscal 2011 is a loss of 35 to 40 cents.

With the next game console cycle years away, investors in companies like our pick Activision Blizzard are left wondering if there is light at the end of this dark tunnel. Even though Activision has a strong pipeline of games for 2010, the general decline in the industry and the economy have been weighing the stock down ahead of earnings that come out on Wednesday. That light at the end of the tunnel could very well come in the form of a revolutionary technology called Project Natal, which has been discussed in great detail below by Jackie Judge, the newest addition to the team behind SINLetter.

An add-on peripheral for Microsoft's XBox 360 console, Project Natal has been deemed revolutionary. A strong choice in words for anyone in the tech world, as we well know, and often premature. Take the Apple iPad's recent launch - it, too, was touted as revolutionary, predicted to change the way we view tablets and computers, and yet Gizmodo and several other tech blogs regarded it simply as a larger, clunkier iPhone. Plenty of people, including myself, have more than a fleeting scorn over the choice in title. At least we can appreciate, right off the bat, the stunning name of XBox's Project Natal. It oozes with demure mystery while retaining a futuristic glow - it's a name that would feel right at home in the world of Avatar, even standing in, possibly, for the project of creating avatars. In a way, that's exactly what it is. But, will it be revolutionary? It certainly has the capacity, but history has a funny way of providing some perspective, before we decide a technology's future.

from youtube

When it comes to the battle between computer and console games, I always say I'm a computer gamer. Why? Maybe because I never made the full transition to console systems. It's an interesting stance, because I am a surefire product of my generation, a generation whose virginal experience with gaming was with a console system: the original Nintendo (the NES), and its blister-inducing red buttons that made their way into the halls of gaming notoriety. But, once games started appearing on the PCs, with their big, new aura of technological superiority, and with their superior graphics and gameplay, consoles began falling on the wayside for many, especially considering how in the late 1980s, the market was saturated with poor-quality games, simply to meet demand.

The NES revived the dying console system, but by this time, home computers were becoming affordable and commonplace. In the ensuing decade, we would see an evolution in computer gaming: from SCUMM games to the 3D graphics of Wolfenstein 3D and Doom; to the beginnings of bump-mapping as seen in Citizen Kabuto; to scripted events as seen in Half-Life; and now, the world of the physics engine as we've witnessed since 2005, when the nVidia PhysX PPU was released. Such precedented leaps in technology in the 1990s and 2000s, along with what I could fairly surmise as a healthy economy during the Clinton Administration, continued the rampant success of the computer game genre. And, this is only with first person shooters. To put this in perspective the video game industry (including computer games) was a $7.98 billion industry in 2000. Despite the slump in the industry, video game sales generated $19.66 in revenue in 2009.

So, where were console systems during all this? The console system really made it big in the mid to late 1990s. Televisions, after all, were far bigger than computer screens, and controller pads became much more ergonomic - saying goodbye to blisters and hello to more efficient performance. After acclimating to using a controller, the keyboard and mouse can seem archaic, clunky, less intuitive by far, than something you can hold in the palm of your hand. Plenty of people look toward a game's playability over its graphics, anyway, and with consoles being priced a good few hundred dollars cheaper than computers, consoles like the Sega Saturn, Sony Playstation and Nintendo 64 became incredibly popular in their heyday. However, it wasn't until the Dreamcast, the Playstation 2, the Nintendo GameCube, and the XBox, that console systems started taking a cue from computer software, and started amping up their graphical capabilities. Sixth-generation console systems - in particular, the XBox - started rivaling the PC in terms of video quality.

Maybe that's why at the brink of the millennium we saw a shift in the PC world toward simulation games (i.e. The Sims) and more strategy-based games (i.e. Starcraft, WoW) at the forefront of popularity. With consoles taking over with their highly playable, multiplayer games, it was almost as if the computer had to carve a name for itself someplace else, shift the paradigm, to remain appealing after reigning supreme on the graphics front for a long time. In the early 2000's Electronic Arts had huge success with The Sims series, a series that has only recently begun to taper off in popularity. Why? Because the market is saturated, once again, this time with anything simulation.

The brilliant thing about the XBox is that it is the best of both worlds, a fusion, by Microsoft, of the PC platform and the console system. It has been immensely successful since its inception, especially with the help of its most popular games Halo and Halo 2. However, it didn't break new ground like the Nintendo Wii did, which revolutionized console gaming by taking people off their couches and instead on their feet, in an interactive, gesture-based system. In a similar fashion, the Guitar Hero and Rock Band franchises were, and still are to a degree, monumental.

If the success of simulation games proves anything, it's that people are craving games that mimic reality - virtual reality. Right now, it seems the gaming public wants one of two things: a reversion to retro gaming, after being inundated with all the dynamic lighting and physics engines in games like Half Life 2 and FallOut, or something completely new. Retro games always come and go in popularity - a natural ebb and flow of gaming waters - but to breach new territory, and really impress gamers, would require an advancement of simulation and physics engine games. Something bigger and badder. Here is where Project Natal comes in.

You could say that the XBox's Project Natal is Microsoft's way of usurping Nintendo's throne. Sony, too, is trying to bank off the brilliance of the Nintendo Wii system. Rumors have been circulating of their arc controller, a controller that, most likely, will have gesture-reading capabilities like the Wii controller. Anyone could surmise that Microsoft would do the same, but if we know anything about this PC giant, it's that they like to put things in overdrive, take things a step further. So, what do they do? Get rid of the controller. Project Natal is Microsoft's foray into virtual reality, if I could use that term loosely, by creating a console system that relies on gestures, spoken commands, and presented objects or images sans the use of a controller. Thinking about this, I admit to feeling a static charge of excitement because, suddenly, anything seems possible. Ever since the birth of movies, and later, games, we've been trying to push the limits of pseudo reality - how can we make this experience more lifelike? How can we become a part of the game without these physical barriers of controller and screen, this distinct separation from projected reality and reality? Imagine the ability to interact with characters in a game by simply moving around, talking to them and even handing them objects. Despite companies like Mgestyk Technologies showcasing their futuristic gesture-based technologies, Microsoft's XBox will be introducing the first widespread tool of the future, for mass, consumer consumption, in the immediately accessible package of a game. With this move, Microsoft is re-establishing itself as cutting edge, at the forefront of technology, and it is doing it with a game.

The true brilliance in Project Natal, though, isn't just in its revolutionary gaming design or technologies we will be seeing, most likely, in more serious sectors in the next decade or two. The true brilliance lies in the timing with the reemergence of television as a technological frontier. TVs are making huge strides right now in being able to integrate as a computer system. Since people love their enormous flat screen TVs and computers, it makes sense to integrate them in one system, exactly like our iPhones. How does this tie in to Project Natal? Leaving behind the controller, we only have one more frontier to go before we reach, in a sense, a "full virtual reality" - add an immersive 3D environment. Soon, all our tv watching, movie downloading, movie renting, game playing, extracurricular activities, and work will be done via one system. Soon there will no longer be a disparity, a separation between consoles and computers - they'll synergize into one complete entity. Just like the virtual reality that Microsoft can almost taste with Project Natal.

Whether Natal can invigorate this slumping industry remains to be seen but it certainly appears to be a powerful beam of light at the end of the tunnel.

To fully appreciate the potential of Project Natal, check out some of the videos in the gallery section of the Project Natal website here.

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SINLetter is happy to host the Festival of Stocks #177, a weekly blog carnival featuring recent posts by contributing investment blog authors. The last time we hosted this festival was Festival of Stocks #15 way back in December 2006.

Here is the list of submissions for this festival.

Steve Alexander of MagicDiligence.com asks How Diversified Should You Be?

Mike Piper of The Oblivious Investor shows you How to Choose ETFs for Your Portfolio

I play devil's advocate with my investment in Activision Blizzard (ATVI)

Jeff Rose of GoodFinancialCents presents Lost and Found: Is the 2000’s the lost decade of investing?

Jim from Blueprint for Financial Prosperity presents The S&P500 Dividend Aristocrats

Dividend Growth Investor analyzes the dividend aristocrat Brown-Forman Corporation (BF-B)

Dividends Value presents AT&T Inc. (T) Dividend Stock Analysis

ETF Database provides us with the Ultimate Guide To Agricultural ETFs: Agriculture ETF Investing 101

Trading Stocks discusses the use of Currency Options.

Dan from ETF Base looks at the performance of new ETFs launched in 2009

The Sun's Financial Diary reviews 2009 Chinese IPO Stock Performance

The Smarter Wallet discusses Price Earnings Ratio: The Cyclically Adjusted P/E Ratio

PT Money goes over the 2010 Roth IRA Conversion Rules

Money Smart Life presents Capital Gains Tax Q&A

Manoj Bhagra reminds us about the Lessons In Investing From the Ancients!!!

And finally, Aussie from down under presents his thoughts about the Best Shares To Buy in 2010.

The next festival will be hosted by Compounding Life. Submit your entries here.

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There are two sides to every story and when it comes to investing in individual stocks, for every logical argument that one could provide for buying a stock, there may be an equally strong reason for avoiding it. My last article about gaming company Activision titled Ten Reasons I am Buying Activision Blizzard (ATVI), generated a healthy discussion on Seeking Alpha with 33 comments following the article and also resulted in a TV interview with a Canadian station called Business News Network.

While I briefly touched upon some of the risks of investing in Activision in my previous article, I did not get a chance to elaborate further and have for some time now wanted to write this post, playing devil's advocate to my long case for Activision.

The Industry:

The original thesis for investing in Activision Blizzard was not just the potential of Blizzard's pipeline of games and Activision's strong franchises but also the notion that the video game industry is traditionally resilient in recessions by providing one of the cheapest forms of entertainment ($0.60/hour when compared to $2/hour for DVD rentals). However the Great Recession we just experienced was not kind to the video game industry. The industry saw sales decline by 8% in 2009 to $19.66 billion from $21.4 billion in 2008, which was incidentally a record year. Software sales fared even worse with an 11% year-over-year decline to $10.5 billion.

The troubled video game giant Electronic Arts (ERTS) not only lowered its forecast for the quarter ended December 31, 2009 but lowered its non-GAAP earnings forecast for its full fiscal year, which ends in March, down to $0.40 to $0.55 from an earlier forecast of $0.70 to $1.00. EA executives expect industry sales to be flat to down 5% in 2010. The interesting thing about this forecast is that Electronic Arts has some highly anticipated games coming out in the current quarter including Mass Effect 2, which is the top selling game for XBOX 360 on Amazon even before its release date of January 26, 2010. It is nice to see Activision's Call of Duty: Modern Warfare 2 in second place on the best seller list after spending 268 days in the top 100.

Despite EA's gloomy outlook and the slump in the industry, we may still be on the money with Activision as the company reaffirmed its 2009 outlook when it reported results for the third quarter. This was before Call of Duty: Modern Warfare went on to register $1 billion in worldwide sales.

Current Games and Pipeline:

The worldwide success of Call of Duty: Modern Warfare 2 foreshadowed some of the recent misses in the Activision lineup. The critically acclaimed DJ Hero did not live up to its expectations when it was released last quarter and neither did Tony Hawk Ride, which was panned by both critics and gamers alike. The $120 price tag for the game (now $99.99) probably did not help much either. Guitar Hero Van Halen, which was released right before Christmas hardly struck a cord with customers. Unless Activision signs up bands like U2, the Guitar Hero series appears to be running out of steam. The only title from Activision that looks interesting for 2010 is time travel sci-fi game called Singularity that reminds me of a few episodes from Lost: Season 5.

The good news is that the Blizzard division might pick up the slack in 2010 thanks to the highly anticipated release of Starcraft II and an expansion pack for World of Warcraft called Cataclysm. Starcraft II will be split into three parts (one game for each of the three races Terran, Zerg and Protoss) and hopefully at least the first part will ship in the first half of 2010. There is also the possibility of Diablo III in 2011 (or beyond), expansion packs for each of the three Starcraft II games and another Massively Multiplayer Online Role-Playing Game (MMORPG) along the lines of World of Warcraft. Call of Duty or Diablo may translate well into a MMORPG.

Fourth Quarter Earnings:

Activision Blizzard is scheduled to report fourth quarter and full year 2009 on February 10th. Expectations for non-GAAP earnings in the fourth quarter are running very high with analysts expecting the company to report earnings of 41 cents per share on revenue of $2.23 billion. In contrast the company generated non-GAAP revenue of $2.34 billion in Q4 2008 but that was as a result of three big hits, Guitar Hero: World Tour, Call of Duty: World at War and World of Warcraft: Wrath of the Lich King, in a single quarter.

The recent success of Call of Duty: Modern Warfare 2 may not be sufficient to help Activision meet or beat the street consensus for earnings this quarter. However the reason Activision Blizzard is the largest position in both the SINLetter Model Portfolio and my personal portfolio has little to do with the company making its numbers this quarter and more to do with buying an industry leader with a strong pipeline at an attractive valuation.

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I received a question from a subscriber about Verizon asking if I would consider picking up Verizon's stock over AT&T. I started this analysis for the December 2009 investment newsletter but did not get a chance to finish it back then and hence am publishing it as a blog post instead. While his question was only about Verizon and AT&T, I included both Sprint and Comcast in the comparison tables listed in the valuation section below. With the baby bells increasingly moving into bundled offerings that include TV service and Comcast offering phone service, I figured it would be a good idea to see how Comcast stacks up against the baby bells.

Growth for Verizon and AT&T is being driven primarily by wireless and service bundles that include TV, phone, internet service and cell phone even as they are losing wireline business. The focus of this post is the valuation comparison tables at the bottom but I have briefly touched upon the two factors that are driving growth at these companies.

FiOS or U-verse?

Verizon had planned on investing $18 billion by 2010 to build out its fiber optic network and launch the FiOS service. I still recall the stock dropping back in 2006 when that news came out but the carrier had no choice to invest or be left behind. FiOS is generating $1.4 billion in quarterly revenue right now with Average Revenue Per User (ARPU) of $137/month when compared to standard consumer ARPU of $75/month. Using the quarterly revenue and monthly ARPU number provided, Verizon had approximately 3.41 million FiOS subscribers by the end of the third quarter of 2009. They expect to add a million new FiOS subscribers a year. Even if Verizon ends 2010 with 5 million FiOS subscribers, this would still be well below the 7 million subscribers estimated by the company back in 2006 when they started investing in FiOS. The investment in FiOS will be "substantially" complete by the end of 2010.

AT&T's equivalent service called U-verse is tracking well behind Verizon with 2 million subscribers as of December 9, 2009 but is growing at a much faster clip. Revenue from U-verse is expected to top $2 billion in 2010 and customers who purchase these services are less likely to leave AT&T, thereby reducing churn. Looking at the bundles offered by Verizon and AT&T, it looks like Verizon's $99.99 bundle offers more bang for the buck especially when you take into account the FiOS internet service (up to 15 Mbps downloads and 5 Mbps uploads) when compared to the $132 triple play bundle offered by AT&T with their Pro internet service (3 Mbps downloads) and U200 TV service.

iPhone or Droid?

Over the last decade, I have used mobile phone service from 5 different carriers starting with Voicestream Wireless (acquired by T-mobile) in 1999 to my current iPhone with AT&T. My worst experience was with Sprint and AT&T comes a close second in terms of connectivity issues. If I had the ability to transfer my iPhone from AT&T to another carrier like Verizon, I most likely would. When a journalist from AOL reached out to me a few weeks ago about AT&T's service in the San Francisco bay area, I told him that my calls often drop especially while driving along highway 101 on the stretch just north of the San Francisco airport. A friend of mine who lives in the City runs into two dead zones during a short 10 minute commute to work. The question is not if AT&T will lose its iPhone exclusivity but when.

Verizon on the other hand is often mentioned as the carrier with the best network but every time I looked at the phone offerings from Verizon I used to come away unimpressed. The much anticipated release of the Motorola Droid running Google's Android operating system sparked new interest in Verizon a few weeks ago. When having lunch with a friend earlier this week, he showed me his new Motorola Droid phone that he purchased after returning an iPhone. He told me that while there were certain things the Droid better than the iPhone, while the iPhone was like having a beautiful and charming person by your side, the Droid was the equivalent of a being in the company of a robot. I briefly tried the Droid and was not impressed. In contrast as you can see from this very detailed comparison of the iPhone vs. the Droid posted on our sister site AppStruck.com, a lot of iPhone users have found the Droid to be a worthy rival if not an iPhone killer.

Valuation:

AT&T activated 3.2 million iPhones just in the third quarter of 2009 and if you look at AT&T's wireless ARPU for post-paid customers, the phone has been very beneficial to AT&T bottom line despite the data usage issues that the top 3% of iPhone users are creating for AT&T. Churn rates for iPhone users are also lower.

If you were to only consider the numbers in the tables below, one could easily make the case of investing in AT&T over Verizon after considering its wireless ARPU, profit margins, leveraged free cash flow and dividend yield. However when you look at churn, the balance sheet, valuation (EV/Operating Cash Flow or EV/Revenue) and management effectiveness metrics such as ROA or ROE, Verizon appears to be the better alternative. Finally throwing in the risk of AT&T losing its iPhone exclusivity and the early ramp of FiOS, I would personally pick Verizon over AT&T. Interestingly legendary hedge fund manager George Soros decided to buy both AT&T and Verizon for his portfolio but picked up a larger stake in Verizon.

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It has been just over a year since the near demise of the company behind India's largest corporate fraud, Satyam Computer Service (SAY), a company that at the time provided services to more than a third of Fortune 500 companies. A subscriber asked me about Satyam last week and wanted to find out if I would consider buying the stock. Given that it has been a year since the scandal broke out and the company has started reporting results once again, I figured I would take a closer look at the company.

In case you did not follow Satyam's saga at the time, here is a timeline of the events that transpired:

• Dec 16, 2008: Satyam announces a plan to acquire Maytas Properties and Maytas Infrastructure, companies run by the sons of Satyam founder and chairman Ramalinga Raju that are completely unrelated to Satyam's core software business. Angry investors react by punishing the American Depository Receipts (ADRs) on the NYSE with a 55% loss. The company scraps its acquisition plans in the face of investor backlash and announces the board is instead going to consider a stock buyback program.
  
  
• Dec 23, 2008: The stock drops 13.55% on the Bombay Stock Exchange on rumors that its founder and chairman Ramalinga Raju has resigned from the board. On the same day the World Bank confirms that Satyam was barred from doing all business with the bank for an eight month period last February following allegations of data theft.
  
  
• Jan 7, 2009: Satyam's founder admits to falsifying accounts stating that the $1.04 billion in assets that the company listed on its balance sheet did not exist and that revenue was 20% lower than reported.
  
  
• Jan 10, 2009:Founder Ramalinga Raju is arrested and sent to prison awaiting trial.
  
  
• Jan 12, 2009: The stock plunges to $1.46 on the NYSE having closed the previous Friday at $9.35 per share. The stock is now down 95% from its 2008 high of $29.10 set less than 8 months ago on May 30, 2008.
  
  
• Apr 2009: Tech Mahindra eventually acquires a 43% stake in Satyam. Tech Mahindra is a subsidiary of Indian automobile company Mahindra & Mahindra, one of Tata Motors (TTM) key competitors and the company that battled Tata Motors to acquire Jaguar and Land Rover from Ford Motor (F).
  
  
• Jun 11, 2009: Satyam's new chairman Kiran Karnik announces that the near-term revenue outlook was not great and that the company was under severe stress. The stock rises 10% for a third day in a row after results show that the company was still profitable. The NYSE listed ADRs open at $5.20 and hit an intraday high of $5.49 before closing the day at $4.30. The stock slides the rest of the month to end June at $3.11.
  
  
• Nov 13, 2009: Indian infrastructure firm Larsen & Toubro that held a 6.9% stake in the new entity, sold a third of its position for Rs 112.5 ($2.42, based on an exchange rate of $1 = Rs 46.5)
  
  
• Dec 3, 2009: JP Morgan (India) upgrades the stock from neutral to overweight with a price target of Rs 140 ($3.02 based on an exchange rate of $1 = Rs 46.31). JP Morgan analysts expect revenue to decline 36% in Fiscal 2010 (ended March 31, 2010), increase 18% in 2011 and 19% in 2012.
  
  
• Dec 9, 2009: Satyam settles a more than $1 billion patent dispute lawsuit with U.K based Upaid Systems for $70 million. The settlement gives Satyam a royalty-free license of Upaid's patents. $265 million in lawsuits from 37 companies remain unresolved.
  
  

What is the stock actually worth?

Regarding JP Morgan's forecast, since the Satyam ADRs represent two shares each, the equivalent price target for the US listed ADRs is $6.04, representing a 9.6% upside from the current price of $5.51. The litigation risk that Satyam continues to face combined with a tarnished image and lack of visibility should ideally support a valuation that is at a steep discount of at least 50% to its peers. The last time Satyam reported revenue under US GAAP was back in October 2008 when they reported revenue of $652.2 million. If revenue was indeed inflated 20%, let us assume actual revenue was $543.5 that quarter. Revenue most likely declined after the scandal broke out and at the time Tech Mahindra acquired a stake in Satyam, full year revenue was expected to be $1.3 billion. If Satyam does post $1.3 billion in revenue for fiscal 2010 ending in March 2010, based on its current market cap of $1.86 billion, the stock is trading at 1.43 sales.

With competitors like Wipro (WIT) and Cognizant (CTSH) trading at 5.63 and 4.38 times sales respectively, Satyam is indeed trading at a steep discount to its peers when you look at revenue. However Satyam's operating margins were 3% when the scandal broke out while Wipro and Cognizant sport operating margins of 17.91% and 18.99% respectively. Unless Tech Mahindra can improve Satyam's operating margins, which it most likely will, the steep discount appears to be justified. Assuming Satyam does post revenue of $1.3 billion, manages to improve its operating margins to Cognizant's level, and we apply a 50% discount to Cognizant's 4.38 times sales valuation, I get a market cap of $2.85 billion for Satyam, representing 53% upside for the stock from current levels provided you are willing you live with the risks, don't mind the lack of visibility and are hopeful that these assumptions will bear out.

With the Indian economy expected to grow by 7 to 8% for the current fiscal year that ends in March 31, 2009 and a world bank real GDP growth forecast of 8% in 2010 and 8.5% in 2011, India is certainly a favored investment theme. Despite the fundamental reasons for buying into India and the cost cutting in developed countries that has fueled the rise of Indian software companies like Infosys, Wipro and Satyam, the industry does face a number of headwinds in the form of a weak dollar, rising salaries and increased competition from companies like IBM that have developed large operations in India. So along with company specific risk, you also have currency risk and industry risk to consider.

Overall it appears that Satyam might be worth considering as a highly speculative investment that may do well should conditions at the company improve in 2010 and beyond. If JP Morgan's revenue forecasts for 2011 and 2012 bear out, the stock is a bargain at current levels.

Model Portfolio Update: I am going to close our position in mattress fabric and furniture upholstery maker Culp Inc (CFI) and book gains of approximately 93% in the SINLetter model portfolio. The stock has performed well beyond my expectations since I wrote about it in the November 2009 investment newsletter and taking profits at this point would be prudent. The closing price tomorrow (Jan 13, 2010) will be used as the selling price.

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