Video game retail sales continued its downward slide in June 2012. According to market research firm NPD, U.S video game store sales slumped 29.0% year over year to $699.8 million in the month of June. Although dollar sales improved from the prior-month level of $516.6 million, the year-over-year decline deteriorated slightly from the prior-month level of 28%.

According to NPD, lower number of new game releases was a dampner for video game retail sales (which approximately accounts for 50% to 60% of total sales) in June. 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 $1.36 billion in the month of June as compared to $1.17 billion in May.

Both hardware and software sales continued to decline in June, primarily owing to the ongoing transition from the physical to the digital platform. Hardware fell 45% year over year to $201.3 million, while software sales plunged 29% year over year to $328.7 million. On a positive note, accessories sales increased 4.0% year over year to $169.8 million in the month, reflecting strong game-card sales.

According to NPD, Warner Bros. published Lego Batman 2: DC Heroes topped the game sales chart, brushing aside May topper Activision’s ( ATVI - Snapshot Report ) Diabolo III, which slipped to the #3 position. Ubisoft’s Tom Clancy’s Ghost Recon: Future Soldier grabbed the #2 spot. Activision’s most popular Call of Duty: Modern Warfare 3 was ranked #8, while its most recent release The Amazing Spiderman came in at #10. Another well known franchisee Battlefield 3 from Electronic Arts ( EA - Analyst Report ) lingered at #9 of the top 10 list for June.

Microsoft Corp’s ( MSFT - Analyst Report ) Xbox 360 was again the top-selling console for the 16th straight month with 257K units sold. Nintendo sold more than 155K units of its 3DS portable console, more than 150K of its older Nintendo DS portable and almost 95,000 of its Wii home console in June.

According to Bloomberg, Nintendo is expected to release its new 3DS XL with 90% larger screens and a new “Super Mario” game in August 2012. The company is also expected to offer its new Wii U later this year. We believe that the release of this new gaming hardware will drive video game retail sales going forward.

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.

Online gaming is also expected to witness growth at the expense of retail sales, given the growing popularity of digital distribution and free-to-play browser games. 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 the 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, lack of visibility around the monetization of the digital platform (particularly social & casual online games) compels us to remain on the sidelines. Since most of the digital and online games are offered as free-to-play, they remain significantly dependent on advertising revenues and online sales of the in-game virtual items. Moreover, the highly fragmented video game market continues to witness increased competitive pressures, which are hurting the overall profitability.

We remain Neutral on these stocks over the long term (6-12 months). Currently, EA, Activision and Zynga have Zacks #3 Ranks, which imply a Hold rating in the near term.