Traditional Gaming Companies in Trouble

You want to know why Take Two Entertainment (TTWO) and Electronic Arts (ERTS) are going to have a harder time making money? Because smaller, more nimble companies like Zynga are moving on their turf. Here's an old TechCrunch post of Zynga--note that Bing Gordon, EA's former CEO, is involved in Zynga: Zynga Profile

Zynga is the creator of the new hit, YoVille, which is attracting fans not only worldwide, but also from more diverse groups, like college-age women. With its YoVille game attracting over 2.5 million active users on Facebook, Zynga is perfectly positioned to capture the growth in gaming, which is shifting away from major franchise hits to social networking and games that are able to get to the market faster, like Ultizen-style games: Interview with Ultizen CEO Lan Haiwen

Unfortunately, EA's and TTWO's problem lies within their business model. More specifically, their revenue projections rely on having hit franchises, like Madden NFL--meaning that revenue is dependent on very few sources--or on franchises that require large licensing fees. When you factor in the licensing fees a company like EA has to pay Hollywood studios (e.g. for EA's Harry Potter and Batman games), the NFL, and the NBA, you begin to see that EA is almost working to make money for other companies, while bearing most of the risk and the costs of failure.

I realize my assessment may be overly pessimistic; after all, most companies would kill to have exclusive rights to the only official Batman game, which will be a guaranteed hit. At the same time, relying on one-time hits has its own problems. For instance, EA/TTWO's business model must assume a major dropoff in sales after an initial release, because almost no game creates a major source of consistent revenue three years after its release. History has shown that a new franchise, like Spore, will do very well in an initial release, but sales will dramatically decrease afterwards, absent unusual circumstances. Thus, the larger gaming companies, despite creating blockbuster gaming hits once every few years, know they cannot rely on those hits for very long. Of course, certain games, like Grand Theft Auto, may be exceptions to this rule, but there is no guarantee of consistent success, and like most retailers, Take Two probably isn't looking forward to the 2008 X-Mas season.

Now, compare gaming software with Microsoft's Office software, which most analysts assume will attract new users and have old users upgrading for another ten years or more (despite arguably better products on the market, like Corel's Wordperfect Suite). A skeptic might look at the difficulty in creating gaming software that will attract users five to ten years from an initial release and say that even if a gaming company establishes a major hit, "So what?" The competition and costs in continuing to establish blockbuster hits will continue to be fierce and never-ending, while also being based in part on luck and consumer fickleness. It's now more apparent why the X-Box, even with Microsoft's money behind it and an in-house gaming development team, has had such difficulty making a net profit. Indeed, Microsoft recently lowered the price of its console to take market share from rivals--showing that it recognizes consumers have become more cost-conscious, exposing the gaming market's reliance on discretionary consumer income: X-Box Price Cut

If social networking games and mobile gaming are the future, then smaller, more nimble companies will be more competitive because of their smaller size, which leads to lower overhead, and their focus on bringing less complex games to market, which allows games to be introduced to the public faster and with less potentially devastating financial consequences. In contrast, if EA spends two years perfecting its new Batman game, and sales are flat, it will lose millions of dollars.

When I began analyzing the gaming market in light of the aforementioned issues, I came to the conclusion that the best way for EA and TTWO to continue growing would be to use their substantial cash reserves to acquire smaller companies; in other words, to choose the route Larry Ellison took Oracle (ORCL): Oracle's Acquisitions. Despite Oracle's proven software business model of smaller acquisitions and generating (not paying) licensing fees, most large gaming companies are trying to merge or buy out other major companies, which reveals a much different business strategy--one that may be completely out of touch with the future of gaming.