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Electronic Arts Inc. (EA), Take-Two Interactive Software, Inc. (TTWO), Activision Blizzard, Inc. (ATVI): The Video Gaming Industry Has Awful Years Ahead

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The video game industry consistently under-performs the markets, as there are just too many things that can go wrong in the process of video game development.

Stock price performance

Electronic Arts Inc. (NASDAQ:EA)

Over the past five years, Electronic Arts Inc. (NASDAQ:EA) declined 47.6%, Take-Two Interactive Software, Inc. (NASDAQ:TTWO) declined 41.9%, and Activision Blizzard, Inc. (NASDAQ:ATVI) declined by 15.4%.

Three reasons for why game studios have under-performed:

–The cost of developing games has consistently gone up. All those extra polygons and physics effects require larger teams of developers to pull off. At some point, the cost of game developments gets so huge the total profit margins become compressed and the shareholders are left with much less in terms of earnings. This is why each major game studio only produces maybe 10 games in a year, but each game costs a lot to make.

–A gamer’s budget really isn’t that large. We’re talking about discretionary income here, and while I understand that the overall trend in discretionary income is on the rise, it doesn’t change the fact that the average video gamer is extremely price sensitive. This leads to subsidized used video game purchases. The purchase of used video games generally has a net-effect of reducing the profitability of video game studios, as it opens an alternate market that the video game developers don’t make a single dime of profit off of.

–Game studios become dependent on AAA titles like Call of Duty, Battlefield, BioShock, Grand Theft Auto, and Madden NFL. In the end, why bother taking risks when you can consistently release a series of sequels? Eventually, though, these franchises generate diminishing returns, which can have a nasty effect on earnings over the short-term.

Money spent on game development has declined

Over the past five years, Source: Ycharts, Activision Blizzard, Inc. (NASDAQ:ATVI), and Take-Two Interactive Software, Inc. (NASDAQ:TTWOhave spent less on game development or have not increased spending whatsoever. I used Take-Two Interactive Software, Inc. (NASDAQ:TTWO)’s cost of goods sold (because the company factors game development costs into its COGS, rather than in R&D). So going forward, there isn’t any upside catalyst in these businesses, as these companies haven’t slated themselves for long-term game development. Let me give you a quick example looking at Electronic Arts Inc. (NASDAQ:EA)’ release schedule.

Source: Electronic Arts

Electronic Arts has 14 games slated for launch in 2014, with about half of them being sports-genre games. And 13 out of the 14 games are sequels to pre-existing franchises, indicating that Electronic Arts Inc. (NASDAQ:EA) has turned this into a business of milking a cow rather than developing new games.

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