Smartphone & Freemium Games Killing Console Competitors? (ATVI, ERTS, TTWO, NTDOY, SNE, MSFT, AAPL, GOOG)

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Sales of video games fell by 10% in June according to market research firm NPD Group, from $1.15 billion in June 2010 to $1.03 billion. This past May was even worse, with a sales drop-off of -15%, a four-year low. The decline is worst among publishers of traditional console games like Activision Blizzard, Inc. (NASDAQ: ATVI), Take-Two Interactive Software Inc. (NASDAQ: TTWO), Electronic Arts Inc. (NASDAQ: ERTS), Nintendo Co. Ltd. (OTC: NTDOY), and Sony Corp. (NYSE: SNE). Downloadable games from Apple Inc. (NASDAQ: AAPL) and Microsoft Corp. (NASDAQ: MSFT) are not included in the NPD Group’s data.

Game makers have finally gotten the message that packaged software sales are not likely to recover in the face of competition from digital sales. Activision reported second-quarter earnings yesterday, and adjusted EPS rose to $0.10, double the expected $0.05. Revenue also came in higher that the expected $602 million, at $699 million. Digital sales accounted for 60% of Activision’s revenue in the quarter.

Activision also raised its revenue guidance for 2011 from $4.05 billion to $4.18 billion and forecast an EPS boost from $0.61 to $0.68.

None of the traditional video game-makers is about to give up on packaged retail sales. The industry currently garners about 75% of its revenue from packaged sales, although some industry leaders expect that to drop to just 50% within the next five years.

For some game-makers that will mean a change in revenue mix, but a change in total revenues because digitally-distributed games generally don’t cost as much though margins are usually better. Revenue growth could be a problem unless game companies can figure out ways to get buyers to spend more on tokens and add-ons for the games they play.

Another thing that may have to change is the $40 price for a packaged game. That is considered by many gamers to be too high. If the game-makers are forced to drop their prices for packaged games and are, at the same time, seeing total revenues fall, they could find it difficult to convince investors of their value.

The other major shift is away from hand-held devices like Nintendo’s DS and 3DS and toward smartphones from Apple or companies using the Android operating system from Google Inc. (NASDAQ: GOOG). Even the pre-teen market, the largest for hand-helds, is perfectly happy to play games on an iPhone or other smartphone.

Nintendo and Sony have not fared nearly as well as Microsoft in the console/game market, primarily because Microsoft beat them to the punch with digital downloads and online gaming from the Xbox and Xbox Live. Nintendo expects to expand its digital offerings over the next three years. The company has already dropped the price of its 3DS in an effort to boost sales. It’s trying to avoid the same mistake that Sony made with its introduction of the PlayStation 3, when the $600 console kept buyers away in droves.

Avoiding past mistakes and adjusting to new distribution and revenue models is not going to be easy for game-makers. One thing that may make it easy to adapt is consolidation in the industry. That may be on the horizon sooner rather than later.

Paul Ausick