Dysfunction Junction – The Recession and Videogames

The games industry is recession proof!

Tell that to the thousands of games industry workers who have been laid off from some of the most high-profile houses in the last year. The headlines tell a story of fear and woe that seems to run completely counter to prevailing theories about entertainment in an economic downturn. EA cuts 11% of its workforce. Microsoft lays off 5,000. Midway files for Chapter 11. THQ shuts down San Diego office.

This is a growth industry?

I asked a couple of videogame industry analysts about the hard-to-reconcile disconnect between record growth of revenues and devalued companies. Why were game sales recession-proof while game companies were not? The answer was very simple: stocks trade on the future, not on the present.

The question about the apparent gulf between the insatiable desire of gamers to buy and play games and the apparent inability of game makers to capitalize on that desire is a complex one. Casual explanations reference the industry’s greatest hits like piracy, mismanagement and malfeasance. The more sophisticated answers are ripe with numbers, decimal points and percentages. But, perhaps the truth about the industry has less to do with the global recession and more to do with sustainability.

Start with an analysis of the present. What are the most successful game companies in the world – the ones that are truly elevated above this recession everyone seems to be losing their job over? If you want to talk about success and profitability in the global industry, you need only look at the strong growth in the PC gaming market.

Let me say that again: the strong growth in the PC gaming market.

And, who is leading the way? Companies like Netease, Giant Interactive and Shanda to name a few; publishers that mean virtually nothing to a Western audience but that are generating phenomenal profits in the East with margins five to ten times that of in their Western cousins. Netease, for example, is the operator of Fantasy Westward Journey (pictured), a Chinese MMO with more than 25 million subscribers – that’s over twice the subscriber base of World of WarCraft. According to industry analysts, it also has a market value equivalent to THQ, Take Two and Ubisoft combined.

Never heard of them? I guarantee you that Activision big-cheese Bobby Kotick has. It’s his company, Activision, that seems to be learning the most from the successful model built in China and along the Pacific Rim and that seems best equipped to weather the storm. When the dust has settled, loathe as some may be to admit it, Activision’s partnership with Blizzard will be the master stroke that will have propelled them to unquestioned dominance of the American and European market.

As one analyst I spoke with pointed out, “Blizzard did $1.3B of revenue in 2008 which is only 26% of Activision’s total sales but it contributed $700M of operating profit or 59% of the total. Blizzard had an operating profit margin of 52% while the rest of Activision (i.e. console biz) had a profit margin of 14%.” The lesson: in today’s market every company that wants to live high on the console bubble needs its own World of WarCraft to pay the bills.

This is all about profitability and the ability to create a plan for long-term growth. It is the explanation behind why companies like Electronic Arts are selling millions of copies of a console game such as Dead Space or Madden and still slipping into the valuation black hole.

The console industry as it is currently structured is dysfunctional. It is built upon the need for its own growth. In 2009, the industry still expects to see its revenues growing, but that growth is likely to drop from roughly 20% down to perhaps only 5%. Sure, revenue will increase, but that drop in growth is a nuclear strike to already razor thin profit margins, and the steep drops in share prices and mass layoffs are a clear indication that the publishers sense that the once firm ground under their feet has become one of the infamous bubbles.

If you’re a console exec, you’re probably looking at the collapse of the housing and banking industries worldwide and seeing a stark vision of your own future.

So, then, what does a more sustainable future look like? As much as we have been entirely focused on the console market as the definition of gaming dominance, the model for the industry may be more in flux that most people suspect. There’s a reason that four years into the current generation no one wants to talk about the next PlayStation or Xbox.

John Riccitiello, CEO of Electronic Arts hinted last year at these changes for the future, pointing out that right now console and dedicated handhelds currently account for two-thirds of the industry. By 2011, he expects that market share to contract to around 50%.

This year EA will be talking big words about The Sims 3, Harry Potter and of course Madden, but the core of the business is in trouble. Their biggest successes last year came not through in-house efforts but via EA Partners with titles like Left 4 Dead and Rock Band, which is revenue rich but profit poor. What EA really needs is what Activision already has, which is why the most important upcoming game on their books is probably the Knights of the Old Republic MMO (pictured).

Between Activision and EA, the model going forward is a question of who can sustain their existing franchises best while restructuring a console industry that seems completely unsustainable. They will talk about breaking into markets in China, finding new models of distribution and development, trimming their investments and finding sustainable methods of generating revenue, and more importantly profit.

Outside of the big two, the analysts I spoke with seemed positively dire. THQ, Ubisoft, Take 2; none of them seemed positioned to do anything but tread water and struggle against the rising tide.

So, in the end, the recession does play its part here, but not as the driving force in a contracting market. The answer to the original question about the disconnect between a healthy consumer base and a sickly industry is that the economic turmoil isn’t preventing gamers from buying games.

It’s preventing companies from making them.

The cyclical nature of the console market naturally describes a historic plateau that publishers have seen, or at least should have seen, coming. The problem is that the easy investment of capital and loans that allowed a largely broken console industry to glut itself on free money has dried up, and now the industry has to try and sustain itself. The companies that can do that, certainly Activision, most definitely Eastern companies like Netease and possibly EA, will come through the storm dinged up but perhaps better positioned to enjoy the recovery. Those who aren’t sustainable, and that’s almost everybody else, will see more layoffs, more closures, more cancellations and perhaps the darkest days since the 1980s.

Sean Sands is the co-founder of gamerswithjobs.com and a freelance games writer. He shares in common with the videogame industry the apparent total inability to make any really impressive amount of money.