At retail, the big games are still selling (even if nothing else is)

Examining the state of the U.S. video game retail industry in September reveals doom and gloom as usual, though the biggest games are still doing fine. Is the "middle market" truly dead, or is everyone waiting for new consoles?
Measured in terms of software dollars, September has historically been the middle of the retail software year. In fact, last year 51 percent of all software revenue was generated prior to the first week in October. If the same is true this year, then the headlines we'll be reading in January 2013 can be written right now: Retail video game industry at lowest level in seven years. But, as long-time readers of this column and industry veterans well know, those kinds of headlines don't tell the full story. That one qualifier -- retail -- means that a significant segment of the video game industry's revenue, the revenue that comes from digital sales, is not being counted. Do those digital revenues make up for the losses at retail? No, they don't. But, those revenues are higher margin and could mean that the business is more profitable, but that's often a detail that gets missed. And, to add yet another wrinkle to the current situation, big games at retail are still big. I know it sounds like a tautology, but in this case I'm referring to a refinement of an idea I discussed earlier this year: the middle of the market has fallen out and that's left the market ripe for top-tier releases. It sounds like a lot of bad news, but I think it's more subtle than that. There is still a lot of money to be made, but you have to be the right kind of game in this late-generation market. Let's start back at the beginning, when I said that retail will be the smallest this year since 2005. Here's a simple diagram that shows just where we have been and where we are right now.
Since the beginning of this console generation, the January through September period has represented between 51 and 55 percent of the total retail software revenue in each year. If we apply that approximate rule of thumb to the current year, say by assuming that the first nine months will eventually be 52 percent of the full year's retail software revenue, then we end up with a total of around $6.2 billion for the year. That would represent a shocking 29 percent year-over-year decline from 2011. However, that does not take into account the moderation of the market of late. As I tried to argue a few weeks ago, the market is still contracting, but contracting at a slower rate. (In calculus terms, I would say the second derivative of revenue has turned positive while the first derivative remains negative.) If I'm right, then the last three months will still show negative growth, but the full year won't be down a full 29 percent. That means that the last three months of the year will probably represent even more than half the revenue in 2012, and the middle of the retail year will have shifted out of September (for the first time this generation) and into October. In short, the industry will be even more dependent on the holiday season than it has been in recent memory. Instead of spreading out revenue throughout the year, as has been suggested previously, the industry's revenues are going the opposite way. Among those who have made the transition to a digital world, the natural expectation is that even if retail revenues are down then digital revenues will help make up the slack. (I count myself among those who have made the shift personally. Our household purchased both LEGO Batman 2 and Borderlands 2 digitally.) Unfortunately, there still isn't enough data about the digital industry which I believe is as reliable as the NPD Group's retail tracking data. Whereas the NPD Group now gets reports from over 90 percent of the retail market for video games, their coverage of the digital market seems much more tenuous to me. Let's assume their estimates for digital revenues reflect some part of reality, even if it's not as precise as we might like. What do those estimates show?
Even with the inclusion of all content sales estimates – from full digital games, DLC, social games, used game resale, and game rentals – the entire content industry is down right around 10 percent for the year. That's a far cry from the 27 percent contraction of retail software, but it does make the point that while retail contracts the hole isn't being completely filled by the other sources. Moreover, until the NPD Group reports segmented data on these ex-retail sources more regularly, we can't assess how much of this data is just from digital sales. They have reported enough information this year that we can begin to separate physical rental and used game resales from the digital market revenues, but I don't have that kind of data for 2011. And, I should add, they have cautioned against relying too much on data in previous public statements, presumably because they are refining their modeling and estimates as they get more data. Regardless, I think the broad outlines are clear: digital isn't growing enough to stem all the losses at retail. All is not lost, and that's the silver lining I see in September's sales. Yes, the whole market is way down, but some games really are making very good money. Let me show you a graph that I think highlights this trend, and puts the September successes in context.
When Piper Jaffray's Michael Olson and his colleagues published their Teen Video Game Fall 2012 Survey results last week, they included a the graph above. The revenue is contracting very slowly for games in the top 20 during the holiday period each year, roughly from October to January according to a conversation with one of the authors. However, titles outside that top 20 are seeing their holiday revenue decline by a compound annual growth rate (CAGR) of approximately 11 percent. I think this picture fits nicely with the idea that the middle market is disappearing. Consider games like Sleeping Dogs and Darksiders II, each of which sold under 300,000 units in August and then disappeared from the top 10 by September. These middle-tier titles fall by the wayside when they don't get the first-class promotions of titles like New Super Mario Bros. 2, which is now over 500,000 units in its second month on a platform with fewer than 6 million owners. Or take the case of Borderlands 2, which got first-class treatment from its publisher and a tremendous amount of press attention based on the break-out success of the original game. It sold exceptionally well with a reported 1.48 million units in its first month, a 234 percent increase over the first month for the original Borderlands in October 2009. Games like Madden NFL 13 and NBA 2K13 which have annually renewed demand, strong reputations among consumers, and little competition are guaranteed to rise to the top. The figure below puts Madden NFL 13's strong showing last month in historical context.
This trend bodes well for games like Halo 4 and Call of Duty: Black Ops II, which can command attention from consumers. However, I think it likely that other titles, like say XCOM: Enemy Unknown, are on the edge and at risk of being overlooked by gamers who appear to have become more discerning with the money they're spending on games. As Andrew Connor of Piper Jaffray put it to me in a recent conversation: "It looks like in general gamers are spending more judiciously. Certainly this is always a dynamic of the video game retail market. People don't want to buy lousy games, but statistically it appears to be more pronounced at this final stage of the [current hardware] cycle." Wedbush Securities analyst Michael Pachter recently commented that publishers look to launch new properties alongside new hardware (like the Nintendo's Wii U and the expected hardware updates from Microsoft and Sony next year) and I followed up with him about the reasons behind that. I argued that late in the cycle, with a large installed base and mature development tools, the risk on new properties might actually be lower. He responded, "I agree with you that it isn't necessary [to launch with new hardware], but [publishers] are all reluctant to do it." I wonder, looking at this data, if we aren't seeing consumers giving publishers a very good reason to be conservative and only put their big money on sure bets late in the generation. If you're not a guaranteed win like LEGO Batman 2 or Borderlands 2, then they're extremely skittish about investing too much because consumers are choosing only the very top tier titles. In a market like this one, it isn't so much that no one is making money but rather that only the well-to-do can afford to place the winning bets. Or, to put it another way, would the original Borderlands have succeeded in the very market in which its sequel thrived?

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