UBS Investment Research analysts Michael P. Wallace and Stephen A. Tam today released their game industry update, and they suggest that investors gather their nuts, because winter's coming.

　　While software sales have been up nine percent so far this year, Wallace and Tam expect some fourth-quarter backsliding. They point out that half the industry's sales occur between now and the end of the year, and without last year's bounty of must-haves like Grand Theft Auto: San Andreas or Halo 2, they expect software sales to finish the year down one percent overall.

　　Other factors playing into that figure include higher gas prices, slower consumer spending, generation transition issues starting with the Xbox 360, and scaled-back retail orders for games as buyers brace for a slower holiday season. Even Electronic Arts' NFL-exclusive license for Madden 06 was mentioned in the report as having a negative impact on game sales. This year's Madden lineup is pulling in more money than last year's, but the overall take of the football market is down without 2K Sports' rival gridiron games to boost the numbers.

　　However, there are some positive catalysts to look for this holiday season. The Xbox 360 launch will get people into stores, and PSP and DS sales are expected to help out as well. But the PlayStation 2 still represents the bulk of the market, Wallace and Tam said, and it will come down to the PS2's game sales to determine how strongly the industry ends the year. While the analysts refer to it only as a remote possibility, a PS2 price cut to $129.99 or $99.99 could spur sales for the system while stealing some of Microsoft's Xbox 360 thunder.

　　Looking into next year, the report expects flat sales, suggesting that 2006 is going to be the true transition year between console generations, where current-generation systems lose steam faster than adoption rates of the next generation can make up for the difference in sales. During the transition year, Wallace and Tam expect game publishers to have a harder time making their quarterly projections, and the report states that right after a missed quarter is often the best time to pick up a game stock on the cheap.

　　Of course, not all gaming stocks are created equal. Take Midway for example. The stock closed today at $15.56, but Wallace and Tam attribute its current worth largely to the recent sprees of a single investor.

　　"If Sumner Redstone were not buying this stock, we think it would be below $5," the report states. "As it stands now, Redstone keeps buying (his ownership is over 85 percent) and the stock keeps going up, despite the fact that Midway will lose money again for the sixth year in a row. Midway has a market capitalization of about $1.5 billion, about the same as THQ and Take-Two Interactive, which is absurd to us. We are unsure why Mr. Redstone pays these kind of prices for Midway shares, but if he ever stops we think the stock could see a material drop."

　　Atari is another stock expected to have a rough few quarters ahead of it. "We think the company needs: 1) a new CEO, 2) financing (probably about $100 million to fund the business), and 3) to rework its agreements with Infogrames for products and distribution." However, the pair said the stock could rise significantly if these conditions are met, and that it might be an attractive acquisition for media companies looking to get into gaming.

　　Game stocks with a more optimistic appraisal in the report included Activision, which could finish the year strong thanks to anticipated titles like Gun and True Crime: New York City, and Electronic Arts, which has a history of picking up sales quicker than most in transition periods, and should have little trouble improving over recent quarters where it missed targets due to game delays.