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Digital Growth Will Drive Video Game Stocks

Stocks in this article: ERTS THQI ATVI TTWO

NEW YORK ( TheStreet) -- Video game companies, including Electronic Arts (ERTS) and Activision Blizzard (ATVI), are continuing their shift towards digital distribution next quarter as sales of software sold in brick-and-mortar stores steadily decline, say analysts.

Consumers have started to turn from traditional shrink-wrapped games to cheaper alternatives found on Facebook and smartphones, and big game publishers have been forced to compensate by putting a sharper focus on digital content.

Electronic Arts is aggressively pursuing a digital strategy.

EA has been particularly aggressive with this strategy, acquiring social gaming start-ups Playfish and Chillingo, publisher of the popular games Angry Birds and Cut the Rope, last year.

The Redwood Shores, Calif.-based company is also prepping for a mid-2011 launch of its highly anticipated massively multiplayer online title, Star Wars: The Old Republic, which is being positioned as a competitor to Activision's wildly popular World of Warcraft franchise.

EA CEO John Riccitiello recently told IndustryGamer that by the end of 2011, sales of digitally-distributed games industry-wide should surpass that of packaged goods, a theme that has clearly excited EA investors. Although EA's net loss widened during its most recent quarter, shares have surged almost 20% since the beginning of the year as growth in the company's digital business strengthens.

EA estimates that digital revenue this year will top $750 million, or 20% of total sales, up from about $575 million, or 14%, in 2010.

A Narrower Market

While major publishers have pared down the number of console games they've released in recent quarters, they're not expected to abandon packaged goods altogether. Rather, say analysts, they'll likely invest more heavily in a handful of blockbuster franchises, like Activision's Call of Duty and Take Two's (TTWO) Grand Theft Auto.

"The console gaming business is defensible, but the market is going to become much narrower," said Atul Bagga, an analyst with ThinkEquity Partners. "If your game is not No. 2 or 3 in its category, you probably are toast."

Meanwhile, video game publishers are hoping to drive incremental revenue by selling downloadable content that accompanies packaged goods, such as expansion packs that give users access to new game areas and levels. Analysts note that these packs are typically very profitable for publishers and reduce used game sales, as they can't be sold on the secondary market like discs can.

THQ (THQI) recently lowered the price of its new MX vs. ATV title to $39.99 from $59.99, hoping that the decreased price might spur users into buying more related downloadable content.

This trend is expected to continue, as publishers fight to keep budget-conscious consumers from defecting to games on social networks and smartphones.

"The goal is to sell people fewer games but to upsell them," said Todd Mitchell, an analyst with Kaufman Bros. "When you're competing with games on certain platforms that have very low price points, you have to monetize the customer the whole way along."

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