Are Video Games A Good Play?

By Chad Langager | June 08, 2006 AAA

If you are a parent of a teenager or a video game enthusiast, I am sure you are well aware of the fact that we are currently at the beginning of a new video game console cycle.

So far, only one of the three next generation consoles is on the market; the Xbox 360 by Microsoft (MSFT) was released last November. Microsoft has so far shipped 1.75 million units worldwide. The other two console offerings, Sony's (SNE) Playstation 3 and Nintendo's (NTDOY) Wii, are both being released this November, just in time for the holiday season.

So these new releases should be a boon for the video game industry, right? Actually, the beginning of a new console cycle is the worst for the industry – both on the hardware and software side. There are a few reasons for this that affects the different participants in the industry.

On the hardware side, at the beginning of each console life cycle, production and component costs are at the highest. This has, in almost all cases, meant that initially each console is sold at a heavy loss. For example, Microsoft estimated it was losing $126 per Xbox 360 system it sold during its release. Over time these costs are reduced as scalability in the manufacturing process comes into play, but even then consoles are generally loss leaders for software and accessories, never actually making the company money on the units themselves.

The software side of the industry is impacted in a couple of ways during the beginning of a video game console cycle. Video game makers are impacted by decreased sales of existing video games, as consumer hold off purchasing games for the outgoing systems in anticipation of the newer system games.

But these weaker sales should soon be offset by game sales used on the new systems, right? This is not the case, as there is limited adoption of new game systems during the beginning of the cycle. This is due to both the limited amount of systems available in the market, and the generally high costs of systems at initial release. The limited adoption, compared to what is found at cycle peaks, diminishes the number of potential video game purchasers, at least at the beginning. These effects have even been witnessed by the largest game maker, Electronic Arts (ERTS), which saw Q4 sales decline by 11% in 2005.

This is not a slant against the industry or an investment in any of the players. With U.S. sales of $10.5 billion in 2005, this is not just child's play, and the prospects for this new console cycle are actually the best of any cycle. It is widely expected that this cycle will see the highest level of adoption as video gaming continues to gain wide acceptance as a form of entertainment.

So as we move deeper into the later stages of the console cycle, both console makers and video game producers should reap the benefits. This is why now may be the time to invest in the industry. In terms of an investment in the console makers, this is more difficult as Nintendo is the only real pure play as both Sony and Microsoft have a broad product line, with gaming only being a fraction of overall sales.

The video game side of the industry is where I see more of an attractive investment, especially companies that have been harder hit during the early stages of the cycle. Electronic Arts is clearly a candidate as its shares have been battered over the last year, trading down nearly 25%. The company is the largest video game producer and has an unrivaled portfolio of games and licenses, including the highly coveted NFL license.

If the expectations for this being the best console cycle to date materialize, all of the game makers should see a boost in sales. So it may be worthwhile to take a look at companies such as THQ Inc. (THQI), Activision (ATVI), Take-Two Interactive (TTWO), and Midway Games (MWY), and a longer term play may prove to be profitable.

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