Can New Consoles Keep This Sector Alive?

Gamers have had five years to learn the ins and outs of the current generation of video game consoles. Like Ph.D. candidates, they've tested, broken, and rebuilt the platforms to learn their limits. But gamers are ready for the next big thing, and they're hoping it's not an adjunct position in Bancroft, Neb.

Sales of games and the consoles they're played on have been declining since 2008, when sales peaked. Microsoft (NAS: MSFT) , Nintendo (OTC: NTDOY), and Sony (NYS: SNE) all have plans to launch new consoles by 2013, but will these new toys be enough to entice players to spend again?

Hoarding gold for the next big thing
The three current-generation consoles on the market right now are Microsoft's Xbox 360, Sony's PlayStation 3, and Nintendo's Wii. Historically, the Wii has led the market with a 40% share while the Xbox and PS3 have both hung out near 30%. Each console owner owns, on average, nine titles per console.

Nintendo is the least diversified of the three companies, and thus the most reliant on video game sales to support its income. In the nine months leading up to the end of 2011, the company posted a $624 million loss, which was a huge drop from the previous year's $610 million gain. This loss was largely due to a decrease in Wii sales, with units sold falling 35% year over year.

Compare this drop with Sony's, which had hardware levels dip just below their 2010 position. Only Microsoft was able to increase sales, shipping 14% more consoles in the second half of 2011 as compared to 2010.

Sales are hurting because everyone can see the end of this generation and the beginning of the next. All of the visual pop and control magic that comes with new hardware has fallen away, as game designers have thoroughly explored the existing technical avenues. With lackluster sales and general consumer apathy, speculation about the future is now the main focus of the industry.

Prepare for the next wave
Rumors about the newest Xbox and PlayStation consoles have largely swirled around their ability to limit the play of used games. Currently, used games are sold through retail stores, just like used books or CDs. The market is driven by consumers, with retailers acting as middlemen.

However, hardware makers and game publishers only earn money on new game sales. Just like a car company, there is no immediate monetary benefit for the producer when you resell an already-purchased item. If the console makers and publishers could limit the resale of games, they would stand to make more money. There are a few ways to accomplish this limitation, but I doubt any of them will come to pass.

Publishers and hardware makers depend too heavily on resellers to sell their new products. For instance, GameStop (NYS: GME) earned 27% of its 2011 revenue from used-game sales, but the rest was made on new purchases. Jeopardizing the relationship with retailers by limiting used games puts the publishers' new game revenue at risk.

The next generation walk-through
All of this means that the next generation of consoles will have small changes in delivery but will not shut down the used-game market. As I've written before, there will likely be a shift toward more direct-to-consumer content, but that delivery will include retailers like GameStop.

Technologically, the next generation of consoles will advance toward PCs without matching the raw power of a desktop. Regular consumers will not see much change as most upgrades will focus on very technical advancements. The most notable consumer-facing upgrade will be an increase in HDTV-capable games. With so little changing for gamers, it's fair to wonder if console makers will profit.

It's shiny, new, and must be had
Sony and Microsoft will be fine. Microsoft makes video games but it also makes everything else. Seriously, I think they make cheese now. If the next generation of consoles is less-than-stellar, the company will weather the storm. Sony is in a similar boat; it sells hardware, movies, music, and financial services. It can ride the ups and downs of consumer sentiment.

Nintendo is certainly the most interesting play, if not the safest (full disclosure -- I have always loved Nintendo games because they're easy). Nintendo is the company that has the most to lose or gain on the next generation. In 2011 it made 99.8% of its income from game-related sales. Compare that with Microsoft's 20% revenue contribution from entertainment and Sony's 11%.

I think the Nintendo will succeed. It understands its relationship with distributors, it knows what consumers want, and the company has a history of innovation that brings more consumers to video games. While it is definitely the most volatile of the three producers, it also has the most potential to rake it in. With a P/E around 25 and good growth prospects starting later this year, I think the price is right.

If this is the first time you've looked into the video game market, you might want to keep an eye on these stocks before diving in. Try out the free Motley Fool Watchlist using the links below:

At the time this article was published Fool contributorAndrew Marderdoesn't own in any of the stocks mentioned in this article, but he has a Wii. He is horrible at it but enjoys it nonetheless. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft and Nintendo, as well as creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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