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A lack of major releases dragged video game retail sales in April down 32% year over year to $630.4 billion, according to market research firm NPD. Dollar sales declined significantly from $1.10 billion on a monthly basis.

Both hardware and software sales continued to decline in April, primarily owing to the ongoing transition from the physical to the digital platform. Hardware fell 32% year over year to $189.7 million, while software sales plunged 42% year over year to $292.1 million. Accessories sales were flat year over year at $148.6 million.

The steep year-over-year decline in software sales was primarily attributed to an early Easter and lesser number of title releases during the month. According to the NPD analyst, Easter fell much earlier this year compared to last year. Hence, the majority of Easter-related purchases were completed in March, which led to the unfavorable year-over-year comparison.

According to NPD, Activision’s (ATVI - Snapshot Report) Prototype 2 topped the game sales chart, brushing aside March topper Electronic Arts’ (EA - Analyst Report) Mass Effect 3, which fell to the #8 position. Lucas Arts Kinect Star Wars grabbed the #2 spot, while Activision’s all-time popular Call of Duty: Modern Warfare 3 jumped up 5 places from the prior month to grab the #3 position.

According to NPD, strong performance of Kinect Star Wars also drove higher sales for Microsoft's (MSFT - Analyst Report) Star Wars Kinect 360 bundle. During the month, Microsoft sold approximately 236,000 Xbox 360’s as compared to 371,000 units in the prior month.

According to NPD new physical retail sales generated 65.0% of total 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 $1.0 billion in the month of April.

Our Take

We believe that the ongoing transition from the physical to the digital platform will ultimately benefit the video game industry over the long term. As compared to the physical platform, digital games are more profitable since they require minimum packaging cost. This cost effectiveness has helped publishers to use the digital format to keep a popular franchise running profitably over a long period of time.

Traditional publishers such as Activision are banking on downloadable contents (DLCs) to expand the customer base of its popular games such as Prototype and Call of Duty. Launch of content packs has many a time provided much needed boost to sagging sales of the original game.

According to Electronic Entertainment Design and Research (EEDAR), DLCs are expected to generate $1.0 billion in sales in 2012 based on its increasing popularity among Xbox 360 and Play Station 3 console owners.

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.

We believe that consumers are increasingly spending more on smartphones and portable devices (such as the iPad) as compared to traditional devices for playing online games. This trend keeps us optimistic on the video game industry 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, NPD’s retail sales data partly reflects the gaming industry trends and hence it is gradually losing relevance. We believe that including digital gaming, the video gaming industry is poised for significant growth going forward. However, the highly fragmented video game retail market continues to witness increased competitive pressures, which is hurting overall profitability.

This compels us to remain Neutral on these stocks over the long term. Currently, EA, Activision and Zynga have Zacks #3 Ranks, which imply a Hold rating in the near term.

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