Analyst sees growth, but not from next-gen consoles

In Wedbush Morgan Securities' exhaustive annual report on the state of the gaming industry released last week, analysts Michael Pachter and Edward Woo poked holes in some commonly held beliefs about the industry's short-term future...and forecasted a period of steady, controlled annual sales growth of 10 to 12 percent in the coming years.

The idea of such stable growth seems to run counterintuitive to a gaming industry on the verge of a new generation of consoles, but Pachter and Woo believe the current generation of systems still has life left in it.

"Unlike most industry observers, we do not believe that the industry has reached the end of a 'console cycle' that is winding down with slow or even negative growth. Rather, we believe that the current consoles (at least the PS2 and the GameCube) will continue to be the systems of choice for several more years, and expect a transition to the next-generation consoles to occur gradually. As a result, we expect sales of interactive entertainment software to continue to grow at approximately 10 percent per year through 2010."

The flip side of the longer life span for existing consoles is that the next-generation systems might not get off to a particularly impressive start, partly because of the prohibitively expensive and time-consuming development required by next-generation games.

"We expect the average next generation console game to take at least two full years to complete (with some efforts likely taking three to four years), compared with the average 20-month completion time for current generation games," the report states. "We think that limited time made available to third parties to develop launch titles for both the Xbox 360 and the PS3 will limit the degree of game play improvement in early next generation games."

Developers and publishers, therefore, might not have the inclination to make great next-gen games early in the cycle, the report suggests. Why step up the development costs to make games for an unproven system when you can keep producing content for proven winners?

"There is an installed base of over 84 million current generation consoles in the U.S. and Europe," the report reads. "To forsake the installed base and chase sales to an estimated installed base of 2.5 million Xbox 360s at year end would be insane."

Pachter and Woo also remained unconvinced that online gaming will amount to anything more than a niche market until late 2008, citing concerns with the business model and the relatively few genres that have successfully made the transition online. They even seemed to question the very idea of online gaming.

"We believe that most people play video games for a form of mindless escape," the report states. "The most popular video games are almost all single-player games, player vs. console, and allow the player to remove himself from a social environment. In these games, the player can act out fantasies of power (in shooter games), often playing the 'bad' guy and playing to win. MMORPGs are just the opposite, a highly social interactive experience. ... The level of social interaction involved in MMORPGs is inconsistent with the goal of mindless escape sought by most of the U.S. audience."

The report also raised questions about the future of supplemental income for publishers (in-game advertising and using microtransactions to purchase bonus content) and warned of an impending shelf-space squeeze at some major retailers. With three new consoles, three current consoles, and three handheld systems to support, Pachter and Woo think it more likely that retailers will devote their increasingly precious shelf space to proven sellers and squeeze out niche games rather than expand the space they devote overall to gaming.

The outlook isn't entirely bleak, as something needs to cause that 10 to 12 percent annual growth the report is projecting. Beyond the simple tenacity of the current generation of systems to keep moving units for a few years, the report suggests that sales of "edgy" games will outpace all other genres by at least a 2-to-1 margin.

"Our bias is obvious: we expect today's late-teen boys (tomorrow's twenty-somethings) to drive interactive software sales growth for the next several years," the report reads. "As these boys grow into young men, they will become bored with kiddie and family-oriented content and will look for more edgy content."

Extreme sports games are also expected to grow in popularity "as younger children age and emulate their older brothers."

The report also contained Wedbush Morgan's industry picks for industry-related stocks. The company is very high on Atari right now, projecting at least a 20 percent return over the next year, while publishers Activision, Electronic Arts, Majesco, Take-Two Interactive, and THQ were tagged as good buys, with an expected 15 percent return on investment over the next year. The only rated publisher left out of the lineup of likely winners was Midway, which received a "hold" rating in light of expected net losses for the fiscal year and uncertainty over the effect of Viacom chairman Summer Redstone's recent buying spree of Midway stock. The report says Redstone now owns approximately 80 percent of the company and is looking at the possibility of "going private" with the company.

On the retail end of the spectrum, Blockbuster was a hot pick, projected to return at least 20 percent in the next year, with Movie Gallery expected to top 15 percent over the same time. Due to uncertainty over the efficiency of their impending merger, retailers GameStop and Electronics Boutique were given a "hold" rating in the report.