How retail figures may point to a coming disruption

When the NPD Group announces their retail video game sales estimates for the U.S. tomorrow, it's almost guaranteed that December and the full year figures will show – again – a contraction. We already know the UK video game industry results, based on GfK/Chart-Track results reported through retail trade publication MCV UK: total revenue from 2012 physical software sales were down 26.4 percent over the 2011 total. I'll break down the U.S. figures in detail next week, but I want to point to a few things in the UK sales figures that I think give a good indication of just what's going on underneath the surface. This is important, I think, because the headline titles in the traditional video game industry are hiding just how sick that market really is. Before I go too far, I want you to look at these two figures for the UK market. I know they're painful, but just look quickly and then I'll show you what's hidden inside them. First up, the total retail software revenue figures from 2008 to 2012. Now, here's the corresponding figure for total video game unit sales at retail over the same period. They tell a brutal tale: a market that got cut in half from 2008 to 2012. Actually, that's a bit too crude of a description. While revenue decreased by almost exactly 50 percent, the total units were down a bit more, around 54 percent. To get a handle on what's going on behind the scenes, we can look at the average selling price for software in each of these years. That is, divide each revenue figure in the first graph by its corresponding units figures in the second graph. That gives you a picture like this one. And there it is: all the time that software revenues have been decreasing and the total unit sales have been decreasing there has been a rise in average prices each year since 2008. The total rise over the period here is right at 10 percent. To put this in U.S. terms, the average price of video game software (excluding the PC) in the U.S. was about $40-$41 in 2008. If the same thing that's happening in the UK had been happening in the U.S., we'd be seeing average software prices of around $44-$45. Instead the average price this year will likely be under $39. So just what is going on in the UK to drive up prices at the same time that the market is shrinking in value? It's similar to the death of the middle-market that I talked about last year, but worse. I'd refine that thesis now and say that the middle-market and down is falling out, leaving what are largely the big games at the top propping up the entire system. That is, you have companies like Electronic Arts, Activision, and Ubisoft sinking immense resources into games like Battlefield 3, Mass Effect 3, Call of Duty: Black Ops II, Skylanders, and Assassin's Creed III and chasing the high-margin consumers. These are the consumers willing to buy two or three new releases in a relatively short period, not the ones who, I suspect, were previously buying Just Dance or Brain Training. Just looking at Wii and Nintendo DS software since 2008 in the UK, both platforms have seen their unit sales cut more than in half, mirroring what you see in those two graphs I showed above. The UK PC software market has also been cut more than in half, in terms of units at retail, but I think that's largely explained by migration to online markets like Steam. And when those consumers are gone, the ones willing to pay for cheap software, what's left is just that fat top of the market. That's precisely how one could get average prices to rise while the whole market itself appears to be tumbling into oblivion. Let me add one more data point to this, not from the UK market but from the U.S. In a recent note to investors, Michael J. Olson and his colleagues at Piper Jaffray and Co. compared console software sales data from October and November of 2011 to the same months for 2012. Their results showed that revenue from the top five titles across that two month period grew approximately 1 percent from 2011 to 2012. The top 10 titles had a revenue total that was down a mere 1 percent while the top 15 showed revenue down only 3 percent. Now compare that to the overall console software market during that two month period: down 16 percent, year over year. Moreover, these top 15 titles now represent 71 percent of the entire software market's revenue, up from 63 percent a year earlier. And, although I suspect you've guessed already, it's also true that the average price across these titles also increased. Olson and his colleagues wrote about this that “these data points suggest well-capitalized publishers with a focus on proven, cross-platform franchise titles are able to outperform the rest of the video game industry despite an aging console cycle.” What they've said is true, but in terms of the larger market I think there is something more fundamental going on. Prices on the best-selling products are rising, as the publishers require more margin to pay for their ever larger bets to grab more of the shrinking market. As they abandon the low end consumers, they cede the market to insurgent players who play by different rules in terms of margin and distribution and consumer expectations. That is, I think that collectively these data points describe a traditional video game market that is well past what one would call ripe for disruption, in the sense that I've seen Clayton Christensen use the term. Instead, it appears to me that disruption is well underway, and the consequences for the incumbents may be unavoidable. If this process continues, the weaker players will succumb (THQ) and the remaining players will move upmarket to higher-margin sales. Those higher margins are currently taking the form of DLC and online passes, and that process can continue for a while yet. Perhaps another year, perhaps more. But we know that the big players are trapped by their existing cost structures, all built to address a market that has built-in overhead to pay the way from development of the software to its eventual delivery as a physical product in a retail store. It's not their fault, but rather just how they were shaped by the market they were born into. Their real competition now are the developers and publishers who address completely virtual markets with far less overhead. They were born into markets that companies like Electronic Arts and Activision simply weren't bred to address. These new developers and publishers can make a living, even thrive, selling games at $1 or $2 per unit on platforms like iOS and Android. They are inheriting those consumers who no longer buy traditional game systems and physical game software, reeling them in with inexpensive or even free-to-play software with in-app purchases. These games simply cannot deliver the experience that Call of Duty can on a console, but they don't have to. They just have to be good enough and priced low enough for consumers to buy them. That's the paradox of the current market: it is precisely the low prices of the insurgents that are driving up the average prices in the traditional market. And where will it leave the incumbents? If the process continues as it has in other industries, the old guard will move up-market to an ever smaller pool of higher-margin consumers and continue to cede the lower market to the insurgents. Sure, they may have great margins, but ultimately they may run out of higher-end market to target. And this result isn't doom for the industry. Not at all. Instead we will have a video game industry far different from the one we have today, one that provides its games to consumers in different and hopefully better ways than it does today. [Parts of this column grew out of long, productive discussions with my colleague, Marshall Vale.]