E3 Set to Kick Off

The annual video gaming extravaganza Electronic Entertainment Expo (E3) is set to kick off at the Los Angeles Convention Center (LACC) on June 5, 2012. Over the next 2 days (the event concludes on June 7) the world’s biggest gaming trade fair promises to be an extraordinary affair for game developers, critics and players.

The year’s most anticipated gaming event is expected to showcase a number of new games from the likes of Electronic Arts (EA - Analyst Report), Activision Blizzard (ATVI - Snapshot Report)), Microsoft (MSFT - Analyst Report) and Sony (SNE - Snapshot Report). However, hardware makers and their new offerings are expected to remain in primary focus, considering the ongoing softness in console sales.

Hardware Expectations

With the increasing usage of smartphones and tablets for playing games, the three console makers Nintendo, Sony and Microsoft are not only having a hard time luring new gamers but their existing customer base is also shrinking. This has resulted in a sharp drop in unit sales and revenue. According to market research firm The NPD Group, hardware revenues declined 11.0% year over year to $5.6 billion in calendar year 2011.

Hardware continued its slump in the first four months of calendar year 2012, with revenues declining 38.0%, 18.0%, 35.0% and 32.0% in January, February, March and April, respectively. We believe that the aging consoles of Microsoft (Xbox launched in 2005, 7^th year running) and Sony (PlayStation launched in 2006, 6^th year running) are failing to attract gamers, which resulted in this significant decline.

Although all the three console makers continue to suffer loses, Nintendo has faced much of the brunt lately, primarily due to the weaker-than-expected performance of its 3DS handheld device, which was launched in 2011. The Japanese company is expected to launch its latest version of Wii (Wii U in November) during the show. According to market research firm EEDAR, Nintendo will also focus on launching new versions of its popular titles such as Super Mario on the new console to attract gamers.

As new updates of both Xbox and PlayStation are expected in late 2013, we believe that the new console will provide Nintendo a competitive edge over Microsoft and Sony going forward. However, we believe that consoles will continue to face significant competition from handheld devices (PlayStation Portable, Vita, 3DS), mobiles (both smartphones and feature phones) and tablets going forward.

Software Expectations

On the software side, a lot of prequels and sequels from popular franchises such as Battlefield (EA - Analyst Report), Medal of Honor (EA - Analyst Report), Crysis (EA - Analyst Report), Call of Duty (Activision), Halo (Microsoft), God of War (Sony) are expected during the show. However, lack of new games/franchises can be a dampener in our view.

We believe that this year’s E3 will see a significant deviation in the industry’s business model, as free-to-play micro-transaction based social games are expected to hog the limelight. Recently, EA announced its intentions to launch free versions of some of its popular franchises such as FIFA and Battlefield, to attract more gamers. The company expects to earn significant revenue from additional features and through micro-transactions by selling in-game based items.

According to market research firm Gartner, consumer spending on global online gaming (subscriptions and micro-transactions) will grow at a compound annual growth rate of 27% through 2015. EA’s arch rival Activision has also been expanding its social presence for some time. According to a recent news feed from Bloomberg, Activision is building a new social site called Skylanders Spyro’s Universe where players can chat, play games alongside friends and customize their lands.

Our Take

We don’t expect any major update from either the software or the hardware side in this year’s expo that could significantly affect the video game industry’s growth trajectory in the near term. However, we believe that the ongoing transition from the physical to the digital platform will ultimately benefit the video game industry over the long term. This is particularly due to the low cost of development and the absence of packaging costs, which will help publishers keep a popular franchise running profitably over a longer period of time.

According to 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, with spending on the fast-growing online gaming segment outpacing software spending.

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. We believe that companies like EA, Zynga Inc. (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 its overall profitability. This compels us to remain Neutral on these stocks over the long term.

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