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Gamers' Ad Quandary

The new consoles could boost in-game commercials, but will this tactic alienate consumers?

Much as product placement has become a staple of movies and television, some analysts say advertising is a billion-dollar market opportunity for video game publishers, such as

Electronic Arts

(ERTS)

and

Activision

(ATVI) - Get Report

, and possibly console makers such as

Sony

(SNE) - Get Report

and

Microsoft

(MSFT) - Get Report

. That's a significant amount for an industry that pulled in around $10 billion in U.S. retail sales last year.

What's more, some bulls say, Wall Street isn't yet factoring in those advertising dollars into sales and earnings estimates, meaning these stocks could ultimately trade at a bargain compared with their prospective earnings.

"I think this is a great bullish opportunity," said Norm Conley, a portfolio manager for JAG Advisors and a contributor to

TheStreet.com's

sister site,

RealMoney.com

who is long EA, Activision and

THQ

(THQI)

. At current stock prices for game publishers, "You're basically getting any in-game advertising potential very close to free."

But skeptics say any potential is years off at best -- if it's ever met. And to have a chance of reaching it, game publishers, console makers and advertisers are going to have to overcome a slew of obstacles.

"It's premature to know whether this is going to turn into something significant or not," said one industry executive, who asked not to be named. The executive's company is only exploring incorporating ads in its games at this point. "Any company that says they're banking on in-game advertising is either lying or it's time to short their stock," the executive added.

The advertising debate comes as the industry enters one of its periodic transitions. Next month, the major hardware makers -- Sony, Microsoft and

Nintendo

-- are expected to unveil their next-generation game machines, at least one of which is likely to go on sale later this year.

In the past, this point in the product cycle has been a mixed blessing. Traditionally, publishers have seen revenue decline and costs surge during such periods. Indeed, investors will likely see some of the same when the big publishers report earnings next week.

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That dynamic could be even more pronounced this time around. Because of the sophistication of the upcoming consoles, development costs are expected to skyrocket for the related games.

Currently, the bulk of consoles are not connected, which means most of the advertising in video games comes in the form of static ads that must be incorporated in the game months in advance.

But analysts expect the booming sophistication means that network connectivity -- the ability to connect to the Internet and play other gamers online -- will be a key feature in the new machines. Such connections could offer publishers and hardware makers new revenue streams, allowing them to sell game updates, for instance. And they could be crucial to expanding advertising in games.

With game costs going up, so too are publishers' risks with each game. Advertising can help mitigate some of those risks by bringing in supplemental revenue.

"This is the only entertainment industry around that doesn't have any revenue beyond retail box sales," noted Nicholas Longano, chief marketing officer at Massive, a video game ad network firm.

Some companies are already positioning themselves to deliver interactive ads on the next-generation consoles. Last month, Massive launched an advertising network to deliver dynamic ads to games published by companies such as

Atari

(ATAR)

,

Take-Two Interactive

(TTWO) - Get Report

and

Ubisoft

. Right now, Massive is only serving the ads on PC-based games, but it plans to incorporate them into console games later this year.

The opportunity could be significant. The in-game advertising market was about $30 million to $50 million last year, estimates Michael Dowling, general manager of Nielsen Interactive Entertainment. But that could grow to a $1 billion market by 2010, he said.

"You can talk about 10% to 15% growth" from just game sales, "but to me

advertising is where all the money is," said Michael Pachter, an analyst with Wedbush Morgan Securities.

Advertisers have a natural incentive to bulk up their in-game marketing as video games spike in popularity. Males aged 8 to 34 are spending as much time playing video games as they are watching TV, according to Nielsen Interactive. And males in the all-important 18-year-old to 34-year-old demographic are spending more than three times as much time playing games.

"That's where the demographic is moving," said Dowling. "It's getting more difficult to reach them through traditional means."

But just because game advertising makes sense for both publishers and advertisers doesn't mean it is a sure thing. Even advertising supporters note that the industry has all kinds of challenges to overcome.

Most notably, perhaps, is the technology at the hands of consumers, who are already using technology to zip through commercials on television programs they receive for free. Some analysts wonder how much gamers are going to tolerate ads in games for which they pay $50 or more. Many play games to escape the real world and they may not be too happy to be thrust back into that world through advertisements.

"The people that really made the video game business ... are the same people that could destroy it: the gamers," said Dowling. "If gamers feel that their experience is being jeopardized or they feel they're being watched by Big Brother, they're going to make themselves known."

For EA, the end user is a big consideration, said Julie Shumaker, who heads up the company's in-game advertising efforts. EA expects revenue from such ads to double this fiscal year from the $10 million it recorded last year. But the company hasn't joined Massive's network and for now is focusing on the static ads it incorporates in its sports games, she said.

"EA is being very cautious about this business," she said. "We want to understand consumers' reaction."

Part of that caution is determining which advertisers fit with which games. Ads may not work in some titles, such as fantasy or medieval war games, at all, analysts say.

Additionally, publishers and advertisers are still trying to figure out how to incorporate ads within games in a way that doesn't upset gamers, but still gets the marketing message across. Adding to the problem is that there aren't yet any standards for ad sizes or rates or types of messages, analysts say.

"Right now, there's no standard metric to measure. There's no standard for what a video game integrated advertisement looks like, other than a billboard that you might see," said Dowling.

Add all that up and some analysts see long-term potential -- but nothing to bank on in the short term.

"It is very emergent at this point in time," said Jason Maxwell, a buy-side analyst at TCW, which is long EA, Take-Two and THQ. "It's way too early to develop expectations about it and pay extra for the stocks."