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.

Electronic Arts Shareholder Meeting, July 31, 2008

Electronic Arts (ERTS) has a history of fun shareholder meetings. Its previous CEO, Larry Probst, seemed to enjoy being in the spotlight and demonstrating new games. In previous years, he had a member of the Board play a new skateboarding game in front of shareholders. ERTS also provides great sweets every year--no real food, but the non-Costco chocolate chip cookies, soda, mini-cheesecakes and Starbucks coffee are more than enough. The cafeteria is a few yards away from the auditorium where the meeting is usually held, and the panini I had was great. Wearing a buttoned shirt and slacks, I was obviously out of place among the jeans and t-shirt employee crowd. A group of employees was playing touch football on the lawn across from the cafeteria.

Mr. Probst was replaced by John Riccitiello in 2007. Mr. Riccitiello brings an East Coast bluntness to ERTS and is more intense than Mr. Probst. ERTS usually has a great video showing new and old games and its different franchises, such as Harry Potter, Spore, and other famous games. This year, the video seemed shorter. It was still a good video, but it's clear Mr. Riccitiello seemed to take the meeting as a more serious matter than a time to show off his company's numerous games. Some people in the audience privately complained no images of the new Batman game were shown. No live demonstration of any new games occurred.

The slides and presentation during the informal part of the meeting seemed to have two themes: cost-cutting through outsourcing, and the Pogo acquisition. ERTS has several top-selling titles, while competitors such as Take Two (TTWO) only have one (Grand Theft Auto). Riccitiello talked about cutting costs by using engineers overseas, and singled out Romania and India as desirable locations. ERTS also has workers in Shanghai and Montreal.

ERTS indicated the mobile segment was the new growth area and it was well-positioned to do well. (Yahoo made a similar point in its annual meeting.)

The Q&A session was brief. Only two people asked questions, including myself. One person asked about an online forum that criticized some ERTS games (I am not sure about the exact website, but the speaker basically asked about how the company responded to online criticism of its games). ERTS mentioned it had no control over the online forums but generally listens to consumer complaints.

I asked about diversity and whether ERTS was concerned about having a 100% Caucasian-looking management while its workers and employees were incredibly diverse. I received a stock answer about the company's commitment to increasing diversity. The officer pointed out there were now three women on the board, which was an improvement. Being in California and a tech company, it seems unusual to have no Asians or Indians on the Board or in upper management.

My second question was about the rumored Take Two (TTWO) acquisition. I asked how ERTS planned on incorporating a controversial game like Grand Theft Auto into its portfolio, which includes games geared to teenagers and children, like Harry Potter, Spore, pogo.com, Simpsons, and Madden football. Riccitiello first declined to answer my question because of ongoing discussions with Take Two. I then asked him to speculate and pretend as if the company might end up buying Take Two. Riccitiello said ERTS had several Mature-rated games (MA rated), and the Godfather games were similar to Grand Theft Auto. He smartly added that ERTS was looking to increase the diversity of its gaming portfolio, a jab back at my criticism of the company's homogeneous management look.

There are a couple of problems with his comments. One, Grand Theft Auto was actually rated "AO," or "Adults-Only," at one point, not Mature. Thailand just banned sales of the game after a Grand-Theft-Auto-related homicide. [Update on 7/6/08: apparently, the Thai government had nothing to do with the ban--a local distributor stopped selling the game.]

Two, no one mentioned risking the ire of conservative-minded consumers. Riccitiello did not seem to take seriously a potential backlash from marketing sex and violence to children. In 2006, the FTC reported, "In 2002 consumers purchased nearly 40 percent of M-rated video games for children younger than 17 years." Also, "69 percent of unaccompanied children aged 13 to 16 years participating in its mystery shopper survey successfully purchased M-rated video games." If ERTS is going to sell many games to children and teenagers, it needs to take its public image seriously. The juggling act of selling games to children and "AO" games to adults is even more difficult because Grand Theft Auto revels in its smashmouth, rebel-without-a-cause persona. If you're a one-trick pony like Take Two, having an in-your-face image is fine; however, when you're a larger company with ties to Hollywood and major media outlets, there are other considerations at stake.

After the meeting, I went to the ERTS company arcade and played some games. I always look forward to my annual John Madden playtime. A new game was there this year, a very realistic EA NASCAR racing game--I had a great time playing it. Some sports items were in the arcade also. I had not noticed these items before. Several autographed items were in clear locked boxes, including an autographed Karl Malone basketball shoe. My favorite was the picture of a young Michael Jordan in a Bulls jersey typing on a 286 desktop computer (with the old floppy drives and tiny green screens). That one was classic--if anyone at EA is reading this, one hit at next year's meeting would be having copies of that picture for shareholders.

As for my thoughts on shares, I bought Take Two shares after the meeting. If ERTS is successful in buying TTWO, then their stock price might take a small hit when the deal is announced. I continue to believe ERTS should have bought TTWO prior to both companies' earnings releases. Back then, TTWO's share price was in the mid-teens and represented a good value. TTWO has since released great earnings, while ERTS released not-so-great earnings. Any stock deal that occurs now will be more dilutive of EA's stock.

ERTS clearly has a strategy of acquisitions to feed its growth. To be fair, it's hard to create a lasting video game franchise, so acquisitions are a good way to grow in the video game business; however, timing is everything when it comes to buy-outs, and ERTS's timing is not ideal. ERTS might want to wait a year or two, when TTWO might miss their numbers, causing a correction in its stock price. When any company bets its future on one franchise, especially one like Grand Theft Auto, it takes a large risk. Meanwhile, ERTS is more diversified and can afford to wait.

I still don't blame EA for its impatience--if EA doesn't buy Take Two, it runs the risk that Microsoft might, especially after the failed Yahoo deal. EA cannot afford to have a competitor like Microsoft get immediate talent and a firmer foothold in the gaming industry because MSFT could potentially limit EA's future X-Box game sales. At the end of the day, EA's impatience may be TTWO's gain.

Update on August 19, 2008: WSJ today reported today that Grand Theft Auto sales were 78% of TTWO's total sales.