The video-game sector is entering its biggest quarter as the competition begins for holiday sales, but many investors and analysts are already focusing on what follows: the debut of the next-generation game consoles.
to begin unveiling those devices next year. The transition has many investors nervous because of past experience: When the current generation of consoles debuted, many video-game software publishers saw their stocks stagnate or drop amid rising costs and falling earnings.
Software publishers vow to do better this time, and many investors and analysts take them at their word. But there's no guarantee they will.
"The companies are healthier
than they were during the last transition, they have established franchises, and their portfolios are now more robust," said one industry executive, who asked to remain anonymous. "But something always goes wrong."
"The issue from an investor perspective is whether that negative sentiment or perception will overwhelm" what should be strong financial results, said Stephen Monticelli, president of Mosaid Investments. (Monticelli's firm is long shares of
, which is his only position in the sector.)
Gamers could catch their first glimpse of the next-generation devices next spring at the Electronic Entertainment Expo, the industry's annual confab. Analysts widely expect Microsoft to launch its Xbox successor later in 2005, while Sony is expected to follow with its PlayStation 3 as soon as the spring of 2006.
While those launch dates are still a year or more away, the video-game publishers are already bumping up development efforts. In its most recent quarter, for instance, industry leader
spent $157 million on research and development, up 38% from a year earlier. On a conference call with investors and analysts, EA officials said they expect the growth in development costs will start to slow next year, but will continue to increase.
Indeed, analysts expect that the cost of developing a version of each title a software company offers will be as high as $10 million on the new platforms, compared with about $4 million on the current generation.
"The costs are going up dramatically enough that it's going to make everyone pay attention," said Michael Pachter, who covers the video-game industry for Wedbush Morgan. (Wedbush Morgan does not have any investment banking clients in the video game sector and Pacther does not own any of the video game stocks.)
But besides growing costs, another concern for investors is a possible decline in revenue. The current consoles are starting to get long in the tooth, and all three major device makers have already slashed retail prices on the devices.
Despite this, software publishers have largely been able to post solid revenue growth this year and maintain the premium prices on games. The big question is how long that can continue. And on that front, trouble already seems to be brewing.
taken a piece of EA's market share in the sports-game market by offering games at less than half of what EA charges. EA has since
responded by offering a "buy two get one free" promotion on its sports games. Some investors fear that EA may have to make further concessions to maintain its share and they worry that the pricing battle could spread beyond the sports-game segment.
In the last go-round, EA's revenue declined by 7% in the fiscal year in which the PlayStation 2 was released as it cut back on development of previous-generation games and sales of next-generation games didn't materialize as fast as it had hoped.
Despite those looming issues and past history, many analysts believe the companies will do better this time around.
First of all, said Pachter, the publishers know the market better. Last time around, none of the software companies knew how big a player Microsoft would become in the market. Worried that Microsoft would displace Sony at the top of the console heap, many companies threw development resources at the Xbox. Because the Xbox found limited support, that won't happen this time, Pachter said.
"I don't think anybody is going to be
on the new Xbox in a big way initially," he said. "They're just not going to take the risk."
While the companies will likely show greater support for the new PlayStation, many plan to be cautious there as well, Pachter and others expect. Many software publishers plan to support the older consoles for several years after the next-generation devices appear on store shelves.
"The transition will be gradual. It will smooth out sales growth," he said. "It will be better for everybody."
One potential aid for the software makers: Sony and Nintendo plan to launch new, high-powered handheld game machines beginning this holiday season. Should sales of those new devices take off, video-game makers will have an incremental source of revenue even as sales of games for the older consoles start to decline.
Still, not everyone's convinced these developments will lead to smooth sailing.
During the last console transition, all the major players had vowed to do better than the previous go-round, which took place in the mid-1990s, noted the unnamed industry executive. But things didn't turn out as planned, due in part to external factors beyond publishers' control, the industry executive said. Sony, for instance, shipped far fewer PlayStation 2 consoles than expected, depressing sales of software.
While the video game companies can keep their own houses in order, they have little control over the broader industry dynamics, the industry executive said.
"That's a lesson learned from 2000," the executive said. "If Microsoft, Sony or Nintendo decide to throw a monkey wrench in there, who knows how the
video-game companies are going to do over next 12 to 18 months?"
One possible twist is if sales of the next-generation devices take off much quicker than they expect, particularly on the new Xbox, said Norm Conley, a portfolio manager for JAG Advisors and a contributor to
. That could hurt companies that don't have a sizeable presence on the new devices and force them to rapidly ramp up their development spending.
(Conley's firm is long
"I know what
the companies want to do: not to have a repeat of 2000, 2001," Conley said.