AUG. 31, 2009 • The news in 2009 has not been entirely positive for the video game industry. Sales are down in what was once considered a growing, recession proof industry. Of course, the mentality is to look at short-term sales as an indication of a major change in consumer behavior. This begs the question: has consumer behavior suddenly undergone a radical change in 2009? As a short answer, DFC Intelligence sees nothing so far in 2009 that indicates a major shift in consumer or industry trends.

There are some major concerns for the future of the industry, but they would exist even if first half 2009 sales had shattered records. It is first important to note that comparing monthly sales on an annual (or even month to month) basis is simply not a strong indicator of market trends. This is especially true when looking at the first nine months of the year. In any given month sales can swing dramatically with the release of a single major title, or the absence of a major title.

These swings are not as noticeable in the last three months of the year because there is a much higher concentration of sales from October to December. However, the rest of the year can fluctuate dramatically. Furthermore, sales in the first half of the year are not a good indication of second half sales. Sales can be weak in the first half and set records in the holiday season, or vice versa.

Paying attention to short-term sales trends tells us very little about what will happen in the next few years. However, this is not to say there are no fundamental concerns with consumer spending on games and how it will impact industry growth. On the contrary, from a macro perspective, DFC has two major concerns for the video game industry:

1) Consumers have a rapidly increasing abundance of choice among low cost games and other entertainment products and; 2) The five-year console model that has driven industry growth in the past is currently not working for Sony and Microsoft.

When DFC published its first game industry report in 1994 the market was dominated by expensive to produce cartridge-based games. Game prices routinely ranged from $50 to $70-plus. DFC argued that this price level was not sustainable. Some games provide two hours or so of entertainment while others could provide 40 to even 100 or more hours of play value. Clearly as the market matured it would head towards a wide price range indicative of the relative entertainment value of each individual product. DFC’s prediction was that, as technology lowered the cost of manufacturing and distribution, game prices would run across a vast spectrum of prices from $5 to as much as $100.

While our thinking was not necessarily flawed, DFC was sure wrong about how long publishers were able to maintain a premium price on non-AAA content. Yes, with the introduction of the CD/DVD medium and the PlayStation brand, prices did start to head towards the $40 range. However, with the launch of the latest systems, manufacturers remarkably were able to drive prices beyond $50 towards $60 and more. Sales in 2007 and 2008 smashed all records.

Of course, we still argue that what we said in the mid-1990s still holds true. The game industry needs a broader range of price points that are more indicative of the relative entertainment value a product provides. A game that gives 100 hours of entertainment may not be worth 50 times a game that can be finished in two hours. However, clearly charging $60 for the former and $10 for the later seems more natural than charging $60 for both.

In today’s marketplace there is currently the flexibility to do a wide range of pricing. Digital distribution, brought about by increased broadband penetration and increased client side storage, has made it possible to cost effectively distribute products at the sub-$20 price range. The new consoles allow for distribution of games in the $5 to $20 range. In many cases these products provide just as much entertainment value as the full $50+ retail games.

The competition from competing products is really starting to have an effect on the overall game business. This includes not just sub-$20 digitally distributed games, but also rental and used games. Furthermore, free online games, social networks and services like YouTube all compete for consumer time, even if they don’t put a major dent in the wallet. If you can easily play something for free why pay for it?

Of course, the game industry has always faced competition from other entertainment products and historically the industry has done a great job at creating exciting new products that spur sales to new heights while convincing consumers to pay a substantial premium for products. However, the reality is that much of this excitement has historically revolved around major new hardware that gets consumers in a spending lather. Just about the time a system is building up a nice catalog of value-priced software along comes a new hardware system that everyone must have. To a large extent this excitement is what opens consumer’s wallets

The dirty secret of the game industry is that the console hardware manufacturers have helped subsidize much of the industry by spending billions to develop and market hardware platforms that drive such a large portion of consumer excitement and spending. The most profitable platforms for third-party publishers have been those from Sony and Microsoft. Nintendo has offered a third option, but the Nintendo business model has not been as successful for third-party publishers.

The problem the industry faces is that the current console model is broken for Sony and Microsoft, the two companies that drive the model today. The old model of introducing a new generation of consoles with vastly improved graphics every four to five years is simply not sustainable. The costs to do so are simply too expensive. Sony and Microsoft need a new model or one more along the lines of Nintendo. In the next few years, this stark reality is likely to have a major impact on third-party publishers that have a strong dependence on Sony and Microsoft platforms. At the very least, it is becoming clear that Sony and Microsoft cannot afford to launch a brand new console every five years or so.

The bottom line numbers for Sony and Microsoft’s game business are not pretty. From fiscal 2007 to fiscal 2009, Sony’s game division showed an operating loss of well over $3 billion. Meanwhile, during the period from 2004 to 2009, Microsoft’s Entertainment & Devices Division has lost over $4 billion. Much of this loss can be attributed to the cost associated with launching a new console system that is sold at a loss. The reality is Sony and Microsoft really need their hardware systems to have a true 10-year lifecycle so that initial costs can be amortized.

Both Microsoft and Sony have a long-term vision that their game boxes will eventually provide a whole host of entertainment services. The problem with that vision is both companies are still caught up in the arms race of the video game console business. It is extremely expensive to launch a new game system every few years and build an installed base from scratch. But game consumers have been trained to constantly demand a new game system and that is what drives much of the market.

For Sony and Microsoft, it simply makes little business sense to launch a new game system. They need their current systems to last as long as possible so that they can actually make some money. What makes business sense for Sony and Microsoft is to focus on getting costs down, offering new (and profitable) services to their existing systems and looking to build renewed consumer excitement via new form factors and incremental additions like Project Natal for the Xbox 360.

So what does it mean for the game industry if Sony and Microsoft are no longer spending billions to drive consumer spending on a major new hardware product? On the good news side, when consumers don’t have to plunk down $300-plus on new console hardware it means, at least in theory, they have that much more money to spend on software. However, this pure economic view ignores consumer psychology. Consumers love things that are exciting and new and that is huge driver of consumer spending. In the absence of a major new product, consumer spending will most likely settle to fairly predictable levels, or that extra cash could migrate to other platforms such as the iPhone, or other entertainment media entirely.

The game industry cycle has been driven in large part by new console launches. New game systems have consistently spurred consumer spending to new record heights, right at a time when the established systems are starting to decline. DFC has run best and worst case scenarios for the current generation game systems and in all scenarios, they show a decline in sales over the next several years. Furthermore, with these systems, a growing portion of consumer spending will continue to shift to catalog product, used games and rentals.

In short, without a major new console system available to pump up consumer enthusiasm the game industry faces an inevitable decline. Other game platforms like the PC and mobile systems are expected to keep growing, but not nearly enough to offset the decline from the existing console systems.

Of course, there will always be room for major blockbuster products. Even in the absence of new hardware grab the attention of consumers we can expect a handful of new must-have titles every year that far outpace the rest of the market. However, the gap between the haves and have-nots will continue to widen. Those companies that have been dependent on getting consumers to buy non-AAA titles are the ones that we expect will suffer the most.