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Major releases in the month of March 2012 failed to curb the slide in video games sales as it declined 25% year over year to $1.10 billion, according to market research firm NPD. Although dollar sales improved from $1.06 billion on a monthly basis, the year-over-year decline was worse than the prior-month level of 20%.

As expected, both hardware and software sales plunged in March, primarily due to the ongoing transition from physical to digital platform. Hardware fell 35% year over year to $323.5 million, while software sales declined 26% year over year to $553.1 million. We note that hardware sales ($381.4 million in February) also declined on a month-over-month basis in March. However, software sales ($464.4 million in February) improved significantly from the prior month. Accessories sales also declined 8% year over year to $222.5 million in the month of March.  

Microsoft’s (MSFT - Analyst Report) Xbox 360 was the top selling hardware gaming console for the 15th consecutive month, according to NPD. Microsoft sold 371,000 Xbox 360, down from 433,000 reported in the year-ago month.

However, the steep year-over-year decline in software sales was surprising; despite a number of highly anticipated game releases in the month. Electronic Arts’ (EA - Analyst Report) much-hyped Mass Effect 3 (released early March), topped the game sales chart, brushing aside February topper Activision’s (ATVI - Snapshot Report) Call of Duty: Modern Warfare 3, which fell to the #8 position. Capcom’s Resident Evil: Operation Raccoon City grabbed the #2 spot, while Sony’s baseball game MLB 12 was placed at #3.

Emergence of Digital Gaming: New Data trends

We believe that NPD’s retail sales data partly reflects the gaming industry trends. As the industry continues to shift from physical to digital gaming; driven by increased usage of portable devices, smartphones and tablets, NPD’s retail sales data is gradually losing relevance.

However, NPD has provided some broad numbers for digital sales. NPD noted that consumer spending on used games, rentals, subscriptions, mobile games, social network games, digital full game downloads and add-on content accounted for approximately $2.5 billion to $2.7 billion across the U.S., U.K., France and Germany in the first quarter of 2012.

This is particularly significant considering the staggering growth projections for online gaming, which includes social and mobile gaming. According to one of the studies conducted by Strategy Analytics, the global online games market is currently worth $4.0 billion and is expected to triple in the next five years.

Most importantly, according to market research firm Gartner, video game-related spending is expected to reach $112.0 billion by 2015, with 50.4% of spending on software ($56.5 billion). Over the next five years, the share of gaming hardware as a percentage of total spending on gaming will remain constant, while spending on the fast-growing online gaming outpaces software spending.

Gartner estimates that consumer spending on global online gaming (subscriptions and microtransactions) will grow at a compound annual growth rate of 27% through 2015. Online gaming is expected to grow from 15.6% in 2010 to 25.2% by 2015, representing the highest growth among all other gaming platforms.

Online gaming is also expected to witness growth at the expense of retail sales, owing to the growing popularity of digital distribution and free-to-play browser games. Gartner believes that the subscription-based business model will gradually be replaced by the freemium model, where a game is provided for free to gamers but is monetized through advertising.

Our Take

With rising consumer spending on digital gaming (social, mobile, casual), we remain optimistic on the video game industry’s growth trends over the long term. We believe that publishing companies with a focus on the digital segment will stand out even amid sluggish market conditions. For instance, some companies like EA, Zynga (ZNGA - Snapshot Report) and Activision are well positioned to benefit from this trend going forward.

However, the highly fragmented video game market continues to witness increased competitive pressures, which are hurting the overall profitability. This compels us to remain Neutral on these stocks over the long term.

Currently, EA, Activision and Zynga have a Zacks #3 Rank, which implies a Hold rating in the near term.

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