Tuesday, July 10, 2007

The Video Game Industry: Nintendo Returns To Dominance

The video game industry spans the globe and has emerged as a significant segment of the economic landscape. An analysis of its size and growth rate, along with an identification of the major companies in the industry, sheds important light on the existence of investment opportunities.

Size

The following list shows the most recent three years of video game revenue for 25 leading, publicly-traded companies in the video game industry. These better-known companies, whose common stocks are listed on various stock exchanges throughout the world, probably account for at least 90% of the worldwide sales in the video game in industry. With the exception of Sony, Microsoft, Disney, and Logitech, most of the other companies listed derive almost 100% of their income from the video game business.

Video Game Industry Sales: 2005-2007(in billions)
CompanyStockSymbol*200720062005Growth
SonySNE ADR$8.3$7.8$5.96.4
NintendoNTDOY8.1 4.3 4.288.4
MicrosoftMSFT5.04.33.116.3%
Sega SammySGAMY ADR4.54.74.44.3
ElectronicArtsERTS3.13.03.10.0
GamestopGME2.11.30.871.0
ActivisionATVI1.51.51.40.0%
KonamiKNMADR1.41.41.30.0%%
Square Enix3090 TSE1.41.00.640.0%
Namco Bandai1954 TSE1.11.11.00.0%
Take-Two InteractiveTTWO1.01.21.016.7%
THQTHQI1.00.80.825%%
VivendiVIVEF0.80.70.614.3
UbisoftUBIPSE0.70.50.540.0
Capcom9697TSE0.60.60.60.0
DisneyDIS0.50.40.325.0
NCSoft036570KRX0.40.30.333.3%
Game Group PLC GGOPF0.40.30.333.3
SCI EntertainmentSEG LSE0.30.20.150.0%
MidwayGamesMWY0.20.20.20.0
AtariATAR0.10.20.450.0%
GameloftGFT LSE0.10.10.10.0
LogitechLOGI0.10.10.10.0%
Mad Catz InteractiveMcz0.10.10.10.0%
MajescoCOOL0.10.10.10.0%
Total42.936.231.418.5%
*Note: ADR=American Depositary Receipt, TSE=Tokyo Stock Exchange, PSE=Paris Stock Exchange, KRX=Korean Stock Exchange, and LSE=London Stock Exchange.

The largest of the pure video game companies is Nintendo, which accounted for 18.9% of the most recent combined sales presented. Sony, however, edged Nintendo as the company with the largest sales revenue in the video game industry. Its sales of $8.3 billion represented 19.4% of the sales of all 25 companies.

The 25 listed companies had total video game hardware and software sales of $42.9 billion for the year ending March 31, 2007. Comparable sales in 2006 were $36.2 billion and in 2005 they were $31.4 billion.

Growth

The combined video game sales at these companies, therefore, grew at a rate of 18.5% during the year ending March 2007 after growing at a rate of 15.3% rate during the prior year. These growth rates are well above comparable growth rates in most other industries and suggest that investors have the opportunity to earn above average returns by purchasing stock of companies operating in the video game industry.

An examination of the most recent sales data for each company shows that Nintendo experienced the greatest growth rate. Its sales grew at a rate of 88.4% for the year ending March 31, 2007. The second and third largest growth rates in sales were produced by Gamestop (61.5%) and SCI Entertainment (50%).

Gamestop is a retailer of new and used video game hardware and software, while SCI Entertainment is a game developer based in London. The sales figures shown for Gamestop were adjusted to avoid double counting. In particular, only the gross profit (sales minus cost of goods sold) on sales of new video game hardware, software and other products was included along with the gross sales of used video game products. Similarly, only the gross profit was included for Game Group PLC, the largest retailer in Europe.

Major Hardware Manufacturers

Video game revenue at Microsoft and Sony represents only about 10% of their total revenue. Most of that revenue came from sale of their new video game hardware systems at prices below their production costs. Reportedly, Sony is selling the PS3 at a loss of $250 per console.

The expertise of these two industrial giants obviously did not extend to their video game business. Microsoft had an operating loss of $1.3 billion in 2006, which followed losses in each of the preceding four years. Microsoft’s combined losses in video games for its five fiscal years ending 2006 were $4.9 billion on sales of $15.3 billion.

Similarly, Sony reported an operating loss on its video game business of $1.97 billion for its 2007 fiscal year. Sony’s combined profit since it entered the video game industry is $3.3 billion on combined sales of about $72 billion.

Sony’s most profitable video game years were 1998 and 1999 when it reported profits of $950 million and $1.1 billion, respectively. On a relative basis, the video game segment of Sony’s business reached its zenith in 1999 when it accounted for 40.3% of Sony’s profit.

For the past last eight fiscal years ending in March 2007, however, the income earned by Sony on its video game business has been less than stellar. In fact, from 2000 through 2007 Sony’s video game business combined profit was only $920 million on combined sales of $57.3 billion, a gross margin of only 1.6%.

Shareholders of Sony and Microsoft might have been better served if they had stayed out of the video game business. At best, their video game segments have been a needless distraction and represent failed attempts by these companies to jump-start slowing growth in their main line of business.

Sony

Sony officially entered the video game industry in November 1994 when it introduced its PlayStation (PS) home console in Japan. In September of the following year it began selling the PS in the U.S. and the rest of the world.

The PS was quickly adopted as the platform of choice by video game developers who were particularly attracted by the fact that the PS used CD Roms, which cost pennies. By contrast, Nintendo required third-party video game developers to purchase proprietary cartridges from them in bulk at price of $20-$30 per cartridge. Because of the differences in cost between cartridges and CDs, PS games sold for $45-$50, while Nintendo 64 games sold for $60-$70.

The arrival of Sony, with its much cheaper CD game delivery system, marked the end of Nintendo’s dominance of the video game industry. In an effort to recapture its former glory it introduced the CD based GameCube home console system in 2001. That system, however, failed to gain traction because developers chose to focus their attention on games for the PS, PS2 and Microsoft’s Xbox.

Sony went on to sell more than 100 million PS systems. An up-dated version of the PS, which was aptly named the PS2, was launched in March 2000 and it enjoyed even more success. Through May 2007 Sony had sold 118 million PS2 home consoles.

Sony effectively dominated the hardware end of the video game home console market for a decade beginning in 1995. Sales of its industry leading PS2 finally began to run out of steam in late 2005. For its fiscal year ending March 2006 Sony reported PS2 sales of 16.22 million, which was slightly above its prior year total of 16.17. In its 2007 fiscal year sales of the PS2 system fell to 14.2 million units.

The decline in PS2 sales reflected the tendency of console sales to reach market saturation at a level slightly above the 100 million mark. The decline also coincided with the introduction of Sony’s next generation home console the PS3 in November 2006. The PS3 sold 5.5 million units during its first five months.

Sony entered the hand-held video game market with the launch of its PlayStation Portable (PSP) in December 2004 in Japan and in March 2005 in the U.S. Unit sales were 2.84 million through March 31, 2005, 14.06 million for the 12 months ending March 2006. Sales of PSPs then declined sharply and fell to 8.36 million in fiscal 2007. While the PSP drew rave reviews regarding its technological advances, it lacked a supply of compelling games.

Sales data show that while the introduction of the PS3 and PSP were initially greeted warmly, potential buyers quickly lost interest because of a lack of games. The fact is that games drive sales of video game hardware. Sales of the PS3 have also been hampered by its price tag of $800, which is significantly above prices for the Xbox 360 ($400-$600) and the Wii ($250).

The apparent failures of the PS3 and PSP certainly contributed to the departure of Ken Kutaragi, 56, an icon among gamers, who stepped down as Sony Computer Entertainment Inc.'s chairman and group chief executive in June 2007. In late 2006 Kutaragi had been relieved of day-to-day responsibilities as president but stayed on as chief executive and chairman. The departure of Kutaragi, marked the end of an era at Sony that saw the company long dominate the video game industry with its flagship PlayStation consoles. It also highlights troubles at Sony amid a series of blunders over the rollout of its PlayStation 3 and intense competition from Nintendo's popular Wii console and Microsoft's Xbox 360. Sony is not expecting to post a profit in its game business until the fiscal year ending March 2009.

Microsoft

Microsoft has been actively trying to establish itself within the video game industry since November 2001 when it launched its Xbox console. From then through December 2005, Microsoft sold 24 million Xbox consoles of which 16 million were sold in the U.S., 6 million in Europe, and 2 million in Japan.

On November 22, 2005, Microsoft launched the Xbox 360 as a successor console. From that launch date until June 2007 Microsoft sold 12 million Xbox 360 units. Accordingly, Microsoft has sold 36 million consoles since it entered the video game industry and, as previously mentioned, has managed to lose money every year. Microsoft’s supporters view these losses as a small price to pay to establish a beachhead in living rooms with the Xbox 360, which is designed to serve as the gateway for the convergence of the internet, television, and games.

Microsoft does have a valuable, proprietary video game franchise in its Halo series. Halo was developed by Bungie Studios, which was a long-time Macintosh game developer that was acquired by Microsoft in 2000. Halo:Combat Evolved (Halo 1), a multiplayer game for the Xbox, was introduced on November 15, 2001 and received the "Game of the Year" and "Console Game of the Year" awards for 2002 from the Academy of Interactive Arts & Sciences. On Nobember 9, 2004 Halo 2 was introduced and sales on the release date exceeded $125 million. On May 9, 2006 Microsoft announced that it would introduce Halo 3 for the Xbox 360 in August 2007. It has been reported that pre-orders for Halo 3 exceed 4 million units. Through the first half of 2007 Halo 1 and Halo 2 had combined sales of more than 14 million units.

Nintendo

The nascent video game industry collapsed in 1983-1984 taking with it Atari, which was the leading hardware and software company. That collapse provided Nintendo an opportunity to become the industry leader, because it coincided with the introduction of its Family Computer System home console in Japan in 1983 and immediately preceded the introduction of the Nintendo Entertainment System (NES) in the U.S. in 1985.

Nintendo’s rise to the pre-eminent position in the industry was sealed when its proprietary Mario Brothers video game became a smash hit worldwide in 1985. Nintendo further solidified its dominating presence in home consoles with the introduction of Legend of Zelda in 1987 and the launch of its up-dated Super NES system along with Super Mario World in 1991.

In 1989 Nintendo decided to extend its reach to the hand-held video game market. In that year it launched GameBoy, which was the first successful hand-held video game system with interchangeable game paks. By 1992 Nintendo had established itself as a fully integrated video game company. Furthermore, it had a stranglehold on the video game industry with the leading home console system, the leading hand-held system, and the leading video games.

By the end of 1992 Nintendo’s estimated market share was 90-95% of the video game market in Japan and 70% of the U.S. market. Its market dominance was reported in depth in a 1993 book, Game Over: How Nintendo Zapped an American Industry, Captured Your Dollars, and Enslaved Your Children by David Sheff.

Despite its market dominance Nintendo continued to introduce new versions of its hand-held and home console systems. In the hand-held arena it launched Super GameBoy in 1994 followed by GameBoy Advance in 2001. In its home console systems it introduced Nintendo 64 in 1996 followed by GameCube in 2001.
The combined sales of Nintendo 64, Super NES, and NES hardware through March 2007 exceeded 140 million units, while related software sales exceeded 770 million units. GameBoy and GameBoy Advance hardware sales exceeded 198 million units and accompanying software sales 867 million units. These systems, along with Sony’s PS and PS2 series, are the biggest selling video game systems of all time. Their sales totals serve as a barometer to gauge the size of the market for a video game platform. Sales of these systems suggest that a successful new video game system should be expected to sell about 120 million hardware units and 600 million software units within five years of such introduction.

Nintendo’s dominance began to fade with the entry of Sony into the video game business in 1995. Until the introduction of the PlayStation, video game developers were forced to deal with Nintendo. In general, developers believed that Nintendo was difficult to deal with, arrogant, and cheap.

Game developers moved swiftly to the PS. In that process, Sony was able to provide a wealth of new and exciting games that could be played only on its PS.

Nintendo’s decline accelerated with the entry of Microsoft and its Xbox in 2001. Sony and Microsoft recognized that games drove their sales, therefore, they either acquired game developers or they entered into exclusive contracts such that certain games would run only on their console. Game developers were able to command millions in up-front payments in return for granting Sony or Microsoft exclusive rights. Nintendo did not enter into a such deals with game developers; therefore, their games became stale.

During its fall from the mountain top, Nintendo also suffered because its new systems did not replicate the success of the previous generation. The Nintendo 64 and, especially the GameCube, failed to generate the desired sales. Nintendo sold only 21.59 million GameCube systems from 2001 to 2007 and 206 million units of GameCube software. It sold 33 million Nintendo 64 systems and 225 million units of software. It seems more than fair to say that these two systems were failures and contributed to Nintendo’s loss of dominance.

Nintendo originally listed its common stock on the Osaka and Kyoto Stock Exchanges in 1962. In 1983 it listed its shares on the Tokyo Stock Exchange. The performance of its shares closely paralleled its rise and fall within the video game industry. From 1983 to August 1990 the price of its shares rose 800%. They then fell 65% to January 1995, and then the share price rose 345% into March 2000. Following that rise, Nintendo’s share price fell 76% into March 2004, at which time it retested the low price it reached a decade earlier in 1995. As of July 5, 2007, Nintendo’s share price was 631% above its March 2004 level, but only 72% above the previous peak established in March 2000.

DS

The retirement of Nintendo’s legendary chairman and president Hiroshi Yamauchi in 2002 at age 75 after a distinguished 53 year career coincided with an internal review of the video game industry. The result was that Nintendo decided to focus its attention on expanding the video game user population by designing delivery platforms and games that were fun. This approach was in marked contrast to the direction of the video game industry, which was toward developing more complex, highly sophisticated hardware and games.

The DS hand-held was the first product introduced that reflected the new direction taken by Nintendo. The DS has been an unrivaled success. From its introduction in 2004 through March 2007, Nintendo sold 40.3 million DS hand-held units and 184 million units of DS software. Notably, sales of the DS rose from 5.3 million in 2005 to 11.5 million in 2006 and to 23.6 million in 2007. Sales of the DS are, therefore, running 2.8 times the sales of Sony’s PSP.

The sales of DS software are equally impressive. More than 183 million units of DS software have been sold though March 2007 and that amounts to about 4.5 software units per hardware unit sold.

Wii

In November 2006 Nintendo continued its bold move to expand the gaming population by launching the Wii. This new home console was enthusiastically greeted with long lines of anxious customers. Nintendo’s Wii production has remained far below demand. Nine months after the Wii was introduced people were still paying a premium via eBay to get their hands on this revolutionary home console or standing in long lines at retailers.

Through March 2007 Nintendo sold 5.84 million Wii consoles and 28.84 million units of related software. At its current sales pace, Wii sales will exceed the records established by Nintendo’s NES family of home game consoles and Sony’s PS and PS2.

Historically, two home console manufacturers have always dominated the video game industry. One company invariably captures the lion’s share, about 70% of the market, while the other dominant manufacturer captures about 20%. Remaining hardware manufacturers are left to fight for the remaining 10% as they struggle for survival before exiting that segment of the business. Atari and Sega are prime examples of companies that dropped out of the video console business after being #1.

Early reports strongly suggest that Nintendo’s Wii will be the dominant home video game console followed by the PS3 and the Xbox 360. In June 2007, the Wii was outselling the PS3 at a rate of six-to-one in Japan following having outsold it by 4:1 in April and 5:1 in May. At the same time, the Wii was outselling the Xbox 360 in Japan 15:1. Nintendo is dominating the home console war even though it has been unable to satisfy all its orders because of insufficient production.
Available data also suggest that the Nintendo DS will be the dominant hand-held video game platform. In June it outsold the PSP 5:1 in Japan.

Nintendo is in the early stages of recapturing the dominant position it held in 1992 in home consoles, hand-helds, and video games. The likelihood of it reaching it former 70-90% market share, however, seems remote.

Forecast Sales for DS and Wii

At its current pace, Nintendo will sell 100 million DS hand-helds by June 30, 2009 along with 500 million units of DS software units. The 100 million unit sales mark for the Wii should be reached by mid-2011 at which time Wii software sales should reach 500 million. Such sales will drive a growing stream of revenue as production ramps up to meet the burgeoning demand. While Nintendo management has stated that its profit margin on the Wii console is not as great as on the DS hand-held, the profit margin on its proprietary software is enormous and can be expected to provide dramatic growth in revenue and net income.

Nintendo’s stable of proprietary games gives it a franchise of incredible value. It should be expected that Nintendo will capture a growing percentage of the video game industry’s total revenue as its growth rate continues to exceed the industry average.

Nintendo has firmly established itself as a renowned manufacturer of video game hardware and software. Since 1983, Nintendo has sold nearly 2.4 billion video games and more than 409 million hardware units globally, and has created industry icons like Mario, Donkey Kong, Metroid, Zelda and Pok√©mon. Recently, it made a conscious decision to distance itself from the eternal quest of avid gamers for more realistic and complex game graphics. Nintendo’s strategic decision to expand the population of video gamers by introducing lower cost hardware along with software that appeals to the masses instead of only hardcore gamers is proving to be farsighted.

In an unusual move for Nintendo, perhaps in recognition of past problems it and Sony has had with game developers, it has reached out to encourage smaller independent developers to create video games for the Wii. In June 2007 it announced that, beginning in 2008, it will allow individuals and outside game studios to create and sell downloadable Wii games with a tool called WiiWare. Gamers will then be able to purchase the created games through the console's Wii Shop channel once Nintendo has quality-checked it.

Buy Nintendo Stock

Investors looking to participate the growth of the video game industry need to focus their attention on the clear market leader, Nintendo. It offers the purest play in that industry and its stock offers the greatest value with a PEG ratio (price earnings ratio divided by the growth rate in earnings per share) of 36%.

An examination of its share price trend shows that shareholders reaped dramatic rewards the last time Nintendo gobbled up market share in the video game industry. Returns similar to those earned during the 1983-1990 period are not totally outside the realm of possibility.

Amazingly, some security analysts insist on comparing the stock prices of Nintendo and Sony as if they are in the same industry. At best, such comparisons are specious, since about 100% of Nintendo’s revenue comes from the video game sector, while only about 12% of Sony’s total revenue comes from its video game segment. Similarly, comparisons between Nintendo and Microsoft would be equally absurd, since only about 10% of the latter’s total revenue comes from its video game segment.