Although not a surprise, I’m sure many people were struck by the chart below showing the decline in the US physical video game industry.
It really brings home the decline in the size of the overall physical market that has many investors talking about the traditional video game market and video game consoles as “legacy systems”. I have heard many people say they believe that the future of gaming growth will come from alternative platforms such as facebook and tablet devices and that the traditional console industry is on its way out.
This has led to the traditional video game publishers being rated as legacy companies, on low p/e’s to reflect the lack of potential for earnings growth.
However, I would like to offer an alternative, and somewhat contrarian, view on both the future of the industry and on the potential for earnings growth amongst the traditional video game publishers.
In terms of industry growth then it is very dangerous to draw any conclusions from the state of the industry without looking a little deeper into the rise and fall of the Wii and the lengthening of the console cycle. The following chart shows a very interesting comparison of how the different consoles over different generations have sold through their lifecycle. It is only for the US but certain aspects hold true across the western markets.
The first thing to notice is the purple mountain that is the Wii. Wii sales were a phenomenon which drove the figures for the industry through 2008 and 2009. However, the fall in Wii sales has been almost as steep as the rise and the impact on the top level numbers is dramatic. The Wii is still selling well but nothing like the dizzy heights which it achieved in 2008/9 and the trend is downwards.
The other things to note about the chart are the PS3 and 360 sales. Not the relative sales of each consoles (because in Europe the positions would be reversed) but the fact that although sales started off slower than in previous generations, the console sales have continued to grow, much later in the cycle than with previous generations. The impact of this on the top level figures is being masked by the Wii decline but the traditional consoles (360 and PS3) are actually growing sales year on year, even 5 or 6 years into their cycle.
And the reason why this is so significant is because I have long held the view that the only company that makes money out of the Nintendo platforms...is Nintendo. Apart from the odd aberration, 3rd party publishers (i.e. not Nintendo) just don’t make money out of Nintendo platforms.
To illustrate my point, here is the top ten list of best selling games on the Wii as of March 2011.
- Wii Sports (76.76 million)
- Mario Kart Wii (28.23 million)
- Wii Sports Resort (27.68 million)
- Wii Play (27.38 million)
- Wii Fit (22.61 million)
- New Super Mario Bros. Wii (21.94 million)
- Wii Fit Plus (18.49 million)
- Super Smash Bros. Brawl (9.48 million)
- Super Mario Galaxy (8.84 million)
- Mario Party 8 (7.6 million)
Notice anything about that list? Every game on there is published by Nintendo. What about the next ten:
11. Mario & Sonic at the Olympic Games (7.09 million)
12. Super Mario Galaxy 2 (6.36 million)
13. Wii Party (5.77 million)
14. Just Dance 2 (5 million)
15. Donkey Kong Country Returns (4.98 million)
16. Link's Crossbow Training (4.80 million)
17. The Legend of Zelda: Twilight Princess (4.52 million)
18. Just Dance (4.3 million)
19. Animal Crossing: City Folk (3.38 million)
20. Wii Music (2.65 million)
All published by Nintendo apart from Just Dance 1 and 2 which are published by Ubisoft.
Although I have focused on the Wii here, the same will be true of the DS platforms in terms of its sales decline and also the significance (or lack of it) for the video game publishers. In terms of the top 20 best selling DS games for 2010, none of the top 20 was a game from one of the traditional western video game publishers.
So, although nobody would say this publicly, it is clear that in reality, the size of the video game market for the traditional publishers is actually dependent on the non-Nintendo consoles.
On a related point, although giving further evidence to the previous one, it is worth noting that the revenues and profits of the traditional publishers over the past three years have not been falling as would be expected given the original graph. The fortunes of these companies are governed by many things and the macro environment, although not totally irrelevant, is quite a long way down the list of considerations.
To illustrate that point, let’s look at the revenue and profits for the big three US publishers. First up, Activision:
Totally at odds with the “size of the market” graph we have rising revenues and rising earnings. This is easily and simply explained by the success of both Call of Duty and World of Warcraft. Clearly there are other things going on with Activision, failures such as Blur and Tony Hawk and successes such as Starcraft 2 but the big profit drivers are the two big franchises and everything else is detail.
Next up, let’s look at Electronic Arts
A more complicated story for EA with rising earnings (i.e. lower losses) and falling revenues. To summarise (and not get the whole story), EA has not had the greatest success with a lot of new ip and has also been attempting to restructure itself to stop selling titles which flatter the top line (revenue) but not the bottom line (earnings).
Next let’s have a look at Take Two
Again, I think it is easy to summarise and explain this chart. In 2008 there was GTA4, in 2010 there was Red Dead Redemption, in 2009 there wasn’t any hit of note. Again, that misses a lot of detail but in terms of the big profit drivers and the reasons for the under-performance in 2009 and the bounce back in 2010 the reasons are simple.
If you add in THQ, normalise everything to 2008 and put everything together on to one chart then you get the following.
It’s a bit of a mess I know but I think even through the mess it is clear that the fortunes of the different publishers show now correlation whatsoever to the state of the physical video game industry as represented by the original graph above.
And that is the conclusion that I am suggesting. Yes, it would be more comfortable for any investor to see double digit growth in the overall industry but if you look under the top level numbers then you see an industry which, from a publisher’s perspective, is not contracting and an industry where the earnings potential of the individual publishers is governed not by overall industry numbers but by the success or failures of their own games.
With the investment market rating these companies down because of a mis-conception about the future size of the industry then there may be big opportunities for the canny investor to spot a publisher whose future earnings will surprise the market. In what, at first glance, appears to be a declining industry, the potential for surprising earnings growth is still very much alive.