Video Game Sales Down in July

Video game retail sales declined for the eighth consecutive month in July 2012. According to market research firm NPD, U.S video game store sales slumped 20.1% year over year to $548.8 million in the month of July. Although the year-over-year decline narrowed from the prior-month level of 29%, dollar sales deteriorated from $699.8 million reported in June.

Lower number of new game releases (which approximately accounts for 50% to 60% of total sales), as publishers continue to postpone titles for the upcoming holiday season, were a major cause behind this decline. Ongoing transition from physical to digital platform also hurt sales.

This is evident from the fact that both hardware and software sales continued to decline in July. Hardware fell 32% year over year to $150.7 million, while software sales plunged 23% year over year to $260.7 million.

NPD noted that consumer spending on used games, rentals, subscriptions, mobile games, social network games, digital full game downloads and add-on content jumped 17% year over year to $1.47 billion in the second quarter. However, this strong growth was not enough to offset the significant decline in physical sales, as overall consumer spending dropped 16% annually in the second quarter of 2012.

According to NPD, NCAA Football 13 from Electronic Arts ( EA - Analyst Report ) topped the game sales chart brushing aside June topper Warner Bros. published Lego Batman 2: DC Heroes. Activision’s ( ATVI - Snapshot Report ) The Amazing Spiderman came in at #3.

Microsoft Corp’s ( MSFT - Analyst Report ) Xbox 360 was again the top-selling console for the 17th straight month with 203k units sold. However, this was down from 277k sold in the year-ago quarter. As per NPD, only Nintendo’s DS and 3DS shipments increased on a month-over-month basis in July.

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 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 overall profitability.

We maintain our Outperform recommendation on Activision over the long term. We remain Neutral on EA and Zynga over the long term (6-12 months).

We believe that growing popularity of the Call of Duty franchise will drive Activision’s growth story in the near term. Currently, Activision has a Zacks #1 Rank, which implies a “Strong Buy” rating in the near term. EA and Zynga both have a Zacks #3 Rank, which implies a Hold rating in the near term.