Gaming Consoles Surrender Ground

Not every sci-fi shoot-'em-up video game blasts into a smash hit. But when one does, gaming software companies cash in.That's the beauty of the business. The ugly side: creative mistakes will be punished by investors.

Game development and marketing costs have soared to the level of blockbuster Hollywood films. As gaming consoles gain processing power to crunch more complex computer graphics, software makers add high-salaried staff to create products with more realistic effects.

Activision Blizzard (ATVI) rolled out its futuristic shooter "Destiny" game in September. The combined development and marketing budget for the "Destiny" franchise reportedly tops $500 million. Activision aims to make "Destiny" a decade-long juggernaut, with multiple releases.

It's not alone. Rockstar Games spent big bucks on "Grand Theft Auto V," as did EA on "Star Wars: the Old Republic." Many gaming companies now typically spend in a range of $50 million to $100 million for high-end titles, analysts say.

Unlike video games, the risks are real. THQ, with licenses to Disney and WWE (World Wrestling Entertainment) games, filed for bankruptcy in 2012.

"It's a hit-driven business, but it's not always that profitable," said David Cole, analyst at DFC Intelligence. "We are going into somewhat of a boom time after about five years of being flat.

Sony (SNE) and Microsoft (MSFT) launched the PlayStation 4 and Xbox One respectively in late 2013, creating demand for riveting new games. Gaming companies received a boost from that, but are also getting a lift from digital distribution, including mobile screens and "free-to-play" business models that have created new revenue streams.

Money flowing into the stocks has kept IBD's computer-software gaming group in strong standing. On Friday, it ranked No. 45 out of 197 industry groups, despite companies reporting mixed Q4 earnings.

Big Games In Decline

Companies have become more selective in producing new titles, says Liam Callahan, games industry analyst at NPD Group.

"They're placing fewer bets but better bets, there's more discipline," said Callahan.

Market-testing products is key, he says, with companies offering focus groups an early taste of new games for feedback.

"Nurturing consumers well before a game launches is helping to drive higher sales," he added.

For many gaming companies, the challenge is hitting the jackpot more than once.

"For years much of Activision's profits were driven by 'World of Warcraft' and with 'Call of Duty' basically offsetting losses from other products," Cole said. "Both 'World of Warcraft' and 'Call of Duty' are declining, so they need something like 'Destiny' to replace it.

Other companies are in the same leaky boat.

King Digital Entertainment's (KING) future beyond the "Candy Crush" brand is uncertain, some analysts say. Then there's Zynga (ZNGA), which relied on Facebook's (FB) social network to garner users of "Farmville" and other games. It's still searching for new revenue-producing hits.

Creating software titles for gaming consoles that sell for $60 a pop at retail stores is still key for many video game publishers and developers. But the surge in smartphone users has reshaped priorities.

"The console space is past its peak as the cost of development continues to increase," Evan Wilson, a Pacific Crest Securities analyst, said in a report. "Publishers will need to diversify if they expect to grow long term.

Smartphone and tablet software will account for 36% of the gaming market in 2018, compared to 23% last year, forecasts research firm IDC. Console-related revenue will slip to 42% from 49% over the same period, says IDC.

Newzoo forecasts that worldwide mobile game revenue will jump to $40.9 billion in 2017, up from $25 billion last year.

In mobile, both EA and Activision must contend with mobile free-to-play game developers, such as King, that are pouring money into TV advertising aimed at attracting casual gamers.

The freemium model — where consumers play basic games for free but spend money on optional extras — first clicked in Asia's mobile market, then spread to the U.S. In-game sales of virtual items, called micropayments, provide smaller but recurring revenue.

Barriers To Entry On The Rise

Mobile gaming opened the door for products like "Flappy Bird," a one-off success from a Vietnam-based developer, to come out of the blue, and for small development teams to create low-budget hits. That's changing, says Patrick Walker, analyst at EEDAR (Electronic Entertainment Design and Research). He says with marketing costs rising, smaller developers will have a harder time cracking the all-important top 10 titles.

"It's getting harder to get visibility if you're not a major publisher who have the muscle to push their stuff to the top," he said. "There was this initial gold rush of small development teams, but now too many of them are fighting for a smaller piece of the pie.

The freemium model has expanded from mobile apps to PC gaming and works hand-in-hand with digital distribution of games. EA has launched several free-to-play PC titles. Activision scored with Hearthstone, analysts say, but Riot Games has led the way with "League of Nations." China's Tencent Holdings (TCEHY) owns a majority stake in Riot.

Privately held Valve, with its PC-based "Steam" software, runs the world's largest digitally distributed online game store.

"Digital is the industry's big move," said Walker. "Companies are still figuring it out, diversifying the portfolio.

Pacific Crest's Wilson estimates that digital downloads will make up 20% of sales for new titles in 2015 versus 15% last year.

Digital downloads are still a small percentage of the gaming console software market. Consumers have reason to stick with packaged software, because used copies can be traded in and resold at retailers.

Consoles Not Dead Yet

The PS4-, Xbox-One-driven console upgrade cycle could go on until 2020, analysts say. PS4 sales have outpaced Xbox One by an estimated 30% to 40%.

EA, which provided its "Titanfall" game exclusively on Xbox, has signaled that an upcoming sequel will be published on other consoles, including the PS4, increasing its market reach.

NPD says that while sales of packaged, new-generation (PS4, Xbox One) software jumped 238% in 2014, sales of previous generation software for PS3, Xbox 360 and Nintendo hardware fell 51%. Overall, packaged software sales slipped 13% to $5.3 billion in 2014.

Physical software sales, which have been slipping since 2009, will grow in 2015, other analysts say. Among the upcoming titles: a new Electronic Arts "Star Wars" video game, due out around the debut of the latest "Star Wars" movie.

Small, mega-hit makers are often gobbled up by industry incumbents. Microsoft last year bought Sweden's Mojang, the developer of "Minecraft" video games, for $2.5 billion. SoftBank earlier acquired a majority stake in Finnish mobile game maker Supercell ("Clash of Clans"), while EA bought PopCap Games.

King, aiming to grow beyond the "Candy Crush" brand, in February acquired Seattle-based Z2Live. Glu Mobile, meanwhile, bought Cie Games.

Doug Creutz, analyst at Cowen & Co., says 60% of the top digital games in January were from public companies, up from 40% a year earlier, due to acquisitions.

With gaming spreading to entertainment venues like YouTube, Internet giants are also on the prowl. E-commerce giant Amazon.com (AMZN) in 2014 bought Twitch Interactive, a live video platform for gamers.

Taming The Red Dragon

Despite its size, China remains a tough market for U.S. gaming companies to crack. Zynga's closure in February of its Beijing-based development studio is the latest example.

Most revenue in China comes from multiplayer, role-playing or shooter/sports games played on PCs. Activison and Tencent in January expanded the availability of a free-to-play version of "Call of Duty Online" for PC gamers. It's not clear how much of a boost Activision will get in 2015, analysts say.

Activision had some earlier success with "World of Warcraft" by partnering with NetEase (NTES). In other examples, Take Two's (TTWO) sales of "NBA 2K15" reached 24 million users last year and EA rolled out "FIFA Online 3" in December.

China's government banned console sales from 2000 to 2014, though hard-core players could buy machines in free-trade zones. Microsoft began selling the Xbox One in China in September, opening the door to higher packaged software sales. Sony's launch of the PS4 in China has been delayed as the government reviews distribution plans. Nintendo (NTDOY) hasn't announced plans for China.

Smartphone usage continues to surge. Many of China's PC game makers — such as Tencent, KongZhong (KZ), Perfect World (PWRD) and Changyou (CYOU) — are playing catch-up in the mobile market, analysts say.

King launched "Candy Crush Saga" in China on Tencent's mobile platforms in August.

Lewis Ward, analyst at IDC, says that for Western companies, China "is a big opportunity but a bit like the wild, wild west.

"Consoles are just getting started again; with PCs they really have to do joint ventures, where there's going to be a revenue split with a Chinese company; and with mobile there are huge piracy problems but it's growing very quickly," said Ward. "It's very challenging from a profitability perspective."