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Video Game Industry Moves to the Cloud

- By John Kinsellagh

When people think of the entertainment industry, the most common images that come to mind are Hollywood movies, famous actors and actresses, cable TV programs, popular network television series, music and sports.

But of all the forms of entertainment, one unheralded area dwarfs them all. What type of entertainment could possibly exceed the scope of Hollywood?

The surprise answer? The video game industry.

The size of the video game market is mind-boggling.

Consider these statistics. According to Dutch research group NewZoo, games played on personal consoles such as Xbox will generate an estimated $67.5 billion this year. This represents $25 billion more than the box office receipts of films worldwide.

For the past 20 years, the gaming experience has followed a predictable path. With each passing year, gamers' voracious appetites for more realistic graphics and elimination of lag times has required an increase in hardware to play the games at their full potential. The reality was that at some point, new video games with higher graphics resolutions, quicker movements, a more immersive experience and lower lag times exceeded consumers' existing hardware components.

There is also the problem of heat generated from taxing hardware to its limitations. Currently, those gamers who are serious enough in the sport to enter competitions employ water-cooled systems to deal with the tremendous heat generated by utilization of graphic chips and powerful processors running at their maximum cloud speeds.

With the exception of hard-core gamers, very few are willing or can afford to upgrade their computers just to play new games that enter the market. Due to expensive hardware requirements, there is always going to be an inherent limitation to new games sales for publishers.

Enter the cloud.

The cloud is going to change gaming in ways that were unimaginable five years ago. Expensive hardware requirements are no longer going to be an integral and necessary component for a high-end gaming experience. For example, graphics-intensive, sci-fi first-person shooter games can be played on a FireTV stick, which is slightly larger than the size of a memory stick. Most of these games can be played on two-year-old smart phones as well. Gamers are now unshackled from the expense of high-end computers and peripherals.

And, more importantly, the performance is no different than if it was played on a high-end and prohibitively expensive computing system. For longtime gamers, this change is revolutionary and provides profit opportunities for gaming companies that were previously unimagined. Electronic Arts (EA) Chief Technology Officer Ken Moss said, "There's going to be more change in videogames in the next five years than there has been in the past generation."

Until recently, cloud gaming was not a viable platform for most users. The landscape has changed, however. Brick-and-mortar video game stores have gone the way of Blockbuster. Large cloud services companies such as Amazon (AMZN) have pushed computing costs dramatically lower. Bandwidth has increased geometrically and monthly subscription fees, as the phenomenal success of Netflix (NFLX) demonstrates, are well within reach of most consumers.

An additional advantage for users is they would have a plethora of gaming titles available that they could never have purchased en masse before.

An essential question for investors, however, is, will gamers go with a subscription service or continue to make a one-time purchase of game titles?

Despite long-held habits of purchasing titles, many of these users, over time, will shift to cloud gaming as they realize the benefits from making the shift. There is good news for gaming companies on this front as well. An analysis by Electronic Arts of its existing subscription services demonstrates that, over time, monthly subscribers spend more money than gamers who follow the traditional experience by purchasing individual titles outright.

The potential for future growth for existing companies in the gaming market is enormous. In terms of internal storage capabilities, consoles plugged into broadband will soon rival personal computers' capacity for internal storage. This would help digital sales for prominent gaming companies like Electronic Arts and Activision Blizzard (ATVI) expand, including downloads and in-game purchases, which could account for more than half of their overall revenues.

Such a shift would profoundly impact operating margins. Consider the following. Five years ago, Electronic Arts converted less than 10 cents of each gaming sales dollar into operating profit. Currently, that figure has grown to well over 30 cents.

The switch to online subscription services that can be played on consumers' existing devices will dramatically change the business operations and revenue outlook for prominent excising game companies. For example, analysts anticipate earnings per share for Electronic Arts will double over the next four years, with fellow gaming companies Activision and Take-Two (TTWO) showing similar results. The stock of all three companies trade at multiples of 25 to 28 times near-term earnings projections.

The implications for investors are immense. How many households have TV consoles, smart phones, tablets or Xboxes? Here are the estimates: 300 to 400 million. This is a recipe for gamemakers to enjoy the type of stable monthly revenue enjoyed by digital streaming pioneer Netflix.

For enterprising investors, the momentous shift in the industry presents an opportunity to be present at the dawning of a new and profitable era.

Disclosure: I have no positions in any of the securities referenced in this article.

This article first appeared on GuruFocus.