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R.I.P: The Xbox/ PS2 Video Game Cycle (1998-2004)


Thx Macke!


With this article Minyanville is proud to welcome Jeff Macke as its newest contributor. Jeff is a founder and president of Macke Asset Management and brings tremendous analytical skills to the mix in the retail space. We look forward to hearing more from Jeff and we are confident our readers will come to value his unique insights.

The platform cycle for the X-Box and PS2 consoles died last night after a long and somewhat inspiring fight against obsolescence. The cycle had been the most prosperous in history for the software makers. It made kings of Electronic Arts (ERTS:NASD), something akin to a Prince out of Take-Two (TTWO:NASD) and established entertainment software, once and forever, as a major industry. The latter was a considerable accomplishment as it put to rest the idea of games being a "fad", the conventional wisdom since the first game of Pong in the mid-70's.

You could see it coming

Take-Two announced the beginning of the end of the cycle when they teamed with ESPN to produce high-quality sports titles (football, basketball and hockey) and released them at an initial retail price under $20. The move was near-crazy in its aggression, particularly given that the production costs for these games has gone up over 2-fold in the last 4 years. Neither ESPN nor TTWO have any real intention of making money on these titles, what they are interested in is taking share going into the next cycle.

This could have been little more than a nuisance for ERTS had the ESPN titles been weak and/or concentrated on only a select few of the sports franchise titles that ERTS came to dominate over the last few years. But the titles are getting near-equivalent reviews to Electronic Arts offerings which are more than twice as expensive (or were, before ERTS started cutting their own prices).

As an example, consider ERTS' Madden NFL title, the Gold Standard of gaming franchises. Madden would seem the least vulnerable to Take-Two's gambit. That makes it more than worth noting that sales for the Madden'05 version for the PS2 fell 34% in September vs. last year and total cross-platform Madden unit sales came in 25% light of Wedbush Morgan's estimates. If you think ERTS is safe on their baseball, basketball and hockey titles... um.... I respectfully disagree.

ERTS has responded so far by offering "Buy 2 get 1 free" deals for their own sports titles. On the call last night they offered that they would continue to fight aggressively for share (read: cut prices) but weren't able to give much detail beyond that "until we see what ESPN is going to do".

This is a company with 10x the market cap of their nearest competitor. They concede that game production costs are rapidly rising while they are simultaneously having to cut their price-points simply to retain a majority share (as opposed to the near-monopoly they had as recently as last summer). If the 1,000lb gorilla is scrambling what is going to happen to the lesser beasts? (hint: Nothing good in my view)

Curiously, the Street doesn't seem to be fully grasping the fact of the cycle demise, let alone what it means for the companies involved. Having been burned by calling the end of the cycle for the last two years, analysts seem largely of the consensus that this is a mere hiccup and that margins and volumes will remain strong until the industry smoothly transitions into new hardware from Sony (SNE:NYSE) and Microsoft (MSFT:NASD), sometime in late '05 and/or '06.

My non-advice-giving opinion is that estimates for '05 are still far too high for most of the entertainment software companies. The battle for Kingship in the next platform generation is going to lead to over a year of margin-sapping battles for market share for at least the next year.

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