The Global Mobile-Game Scramble

Investor's Business Daily

Perpetual change appears to be a constant factor in the computer software games market.

Console games produced by Electronic Arts (EA) and Activision Blizzard (ATVI) still account for the majority of the industry's billions in annual revenue. But games on mobile devices, and the so-called freemium games where players can play for free and pay for advanced features, are gaining share.

The fast-evolving market has forced many companies to tweak their business models to keep up with the changing demands of customers. This is particularly true as more consumers become increasingly reliant on mobile devices, says Lewis Ward, research director of gaming for market tracker IDC.

"The entire market is in a profound transition" from packaged retail models to online distribution, he said. "So there is a massive shift going on in terms of how games are distributed around the world, and at the same time the business model is shifting underneath that.

Industry transition could also extend to the hardware on which games are played. Sony (SNE) and others are testing virtual-reality machines that would further enhance the immersive experience for hard-core players. Meanwhile, game developers are still catching up, providing content for the November launches of Microsoft's (MSFT) Xbox One console and Sony's PlayStation 4.

Despite the changing landscape, one aspect of the market is unchanged, says Brian Blau, an analyst for Gartner, a research firm.

"Games are still a hit-driven industry, and that is never going to change — period, exclamation point," he said.

1. Business

The game-producing business is in a state of flux. Activision and Electronic Arts are best known for their console- and PC-based games, but both are also producing mobile games.

NetEase (NTES), Giant Interactive Group (GA) and Changyou.com (CYOU) are among the leaders in China's online games market.

Another player, Zynga (ZNGA), is the leading provider of social-network games.

But fundamentals remain spotty. Only 11 of 19 companies in the computer-software games trade posted positive year-over-year revenue growth in the last reported quarter. Fourteen showed a profit in their last reported quarter.

2. Market

Global revenue from the video-game software and hardware market is expected to reach $111 billion by 2015, up from $78.8 billion in 2012, says Gartner.

That forecast includes video-game consoles as well as mobile, PC and handheld video games. The living-room experience still commands the biggest share of the market, says Blau. "Consoles are favored by the demographic that likes to play very immersive, high-resolution games," he said.

Nobody knows that fact better than Take-Two Interactive Software (TTWO).

In its third quarter, ended Dec. 31, company revenue jumped 348% to $1.86 billion vs. the year-earlier period.

Take-Two's "Grand Theft Auto" console game was the primary driver. The fifth version of the game is one example of a game developer making the most of a hit game, Blau says.

"When a company has a hit like that they want to capitalize on it, and sometimes that means turning it into a franchise," he said.

But massively multiplayer online role-playing games played on PCs and mobile devices, including smartphones and tablets, are growing fast, says Michael Cai, an analyst for Interpret LLC, a research company.

"The beautiful thing about digital gaming is that it's quite diversified," he said. "These different models, each of them accounts for a fairly large chunk of revenue.

3. Climate

Transition is critical to survival but can be costly.

In January, EA's third-quarter revenue, minus one-time items, of $1.57 billion fell about $100 million short of its guidance. The company cited a slower-than-expected transition from Sony PlayStation 3 and Xbox 360 devices to the new consoles.

But a report by researcher NPD Group said that in the process, the company grabbed a 40% share of games on the new PlayStation 4 and 30% on Xbox One.

Revenue declines often occur during hardware updates, says Cai, as gamers delay purchases ahead of updated games.

China-based NetEase also appears to be in a transition scramble. On March 19 the company said that it plans to sell games in the U.S. but didn't provide any more details about the move.

In China, NetEase launched its first three mobile games last year. It plans more this year, including mobilized versions of some of its existing games.

The launches coincide with a sharp slowdown in year-over-year revenue growth to 3% in NetEase's Q4 vs. 21% in the prior quarter.

Competition from Tencent, China's largest web-services company, is likely one reason for the decline in revenue growth, says Cai.

"Tencent is the (Chinese gaming) company that is still experiencing very robust growth," he said. "Sometimes that is cannibalizing some of the other gaming companies.

Venture-fund investments in closely held game companies slid 40% to $170.4 million last year as interest shifted to other industries, say PricewaterhouseCoopers and the National Venture Capital Association.

But it could bounce back this year as part of overall growth in software investments, says Mark McCaffrey, PricewaterhouseCoopers' global software leader.

"We are going to see a consistent, healthy 2014 around investment compared to 2013 unless some macroeconomic event happens that shifts the market that we don't expect," he said.

4. Technology

Companies continually invest in developing new games. But investments vary. The production of one mobile game can cost between $250,000 and $750,000. Console games are far more expensive, says Ward.

"If you include the marketing budget, it can exceed $50 million, so they are not comparable at all," he said. "But neither is the money (they bring in).

More sophisticated technology could be right around the corner. Sony and Facebook's Oculus VR are separately developing virtual-reality equipment that could become a new industry revenue driver, Blau says.

"There has been a lot of interest in head-mounted displays for games, and it could be a very lucrative area for new hardware and game development over the next five to 10 years," he said.

Facebook announced March 25 it would pay $2.3 billion for Oculus, a move that mystified many. The deal is "another step toward building the three key pillars" of Facebook's Internet strategy, wrote JP Morgan analyst Doug Anmuth in a March 25 report. Its three pillars: connect everyone, understand the world and build the knowledge economy.

5. Outlook

Gamers are here to stay. But the one-size-fits-all model no longer works. Game developers have to serve multiple markets to thrive and to satisfy customers.

Upside: Mobile might be the biggest factor — particularly in China, where sales of mobile devices dwarf PCs, Cai says.

"It's not unheard of to have a mobile game that during the month of its launching is generating more than $10 million in a single month," he said.

The number of smartphone game players in the U.S. will reach 187.2 million in 2018, up from 84.1 million in 2012, says eMarketer, a research company.

Risks: Increases in smartphone shipments and users don't bode well for handheld-game manufacturers such as Nintendo (NTDOY), says Blau.

"When people pull a device out of their pocket, they want to be able to do many things with it, and that is what they are accustomed to with smartphones and tablets today. And that is one major reason why handheld game consoles are on the decline," he said.

Console games continue to make the most money. But they also cost the most, especially if the game isn't a hit, Cai says.

"You hear about these billions of dollars of revenue, but it also takes hundreds of millions of dollars to develop that market, so the profit margin isn't as good as smartphone, tablet and free-to-play games that are cheaper to develop," he said.

The growing number of games on mobile devices can also become a threat to larger and better-known game providers such as Zynga, which rose to prominence on Facebook, says IDC's Ward.

"A lot of the more casual gamers who did Facebook three years on Zynga games — they are being reasonably satisfied by smartphone and tablet experiences," he said.

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