I have been out of the stock market since 2003. It is a long story that involves Cendant fraud scandals, tech market meltdowns and greedy CEO’s stealing from their shareholders that pushed me to invest in myself and my own businesses instead of the market. In spite of those bad experiences investing in stocks, the latest “sale” prices in the equity markets have me nibbling in again. I have been buying GOOG, AAPL, GE, etc. on their way down to the current bottom.

Stocks you won’t see on my list are Electronic Arts, Activision, Take Two, Ubisoft, or any other game company. Here’s why:

We have the biggest, most diverse world wide game market in history, but these companies are not making money. In addition, I think that these game companies are in trouble similar to industries such as music and newspapers. Add to this a General Motors kind of attitude for a couple of the companies, and I will not buy these stocks even though some of them are as cheap as they were in 1999. Let me explain.

As anybody reading this blog knows, gaming is exploding. Nintendo’s Wii is such a hit that even my 80 year old father in law plays Wii bowling. Games are available on any and every platform including downloads on computers, your phone, handhelds, Facebook or any other social network, the Internet, and, of course, game machines. Games have broken out of the box, and the world is ready for new games in different genres with different business models. The days of going into a retail store to pay $60 for a boxed, DRM’d disk full of standard 14-25 year old core gamer fantasies are numbered.

Big Problem Number 1: The boxed goods cash cow is running out of milk and will no longer support growth even though it will be around for a long time. We are not in a “transition year”, which is what industry and analysts call the years when consoles go from one generation to another, yet EA lost $315MM last quarter, Midway is nearing bankruptcy, Microsoft had to close down Ensemble, Take Two scales back, and on and on.

Game prices are going down, their delivery mechanisms are changing, and the type of content the mass market wants is different than what the publishers are giving them. What are the game companies responses? They adapt draconian DRM methods and complain that secondary sales are the root cause of evil in the industry. Or they use diversionary tactics like blaming the bad economy. “Hey, look over there! Don’t look at our root problems.”

Taken from a distance, doesn’t this scenario remind you of a blinded Detroit that wants to blame anything but their own misreading of what car buyers want for their current bail out predicament? How long do the game publishers need to see a changing market before they respond?

To be fair, Activision did respond by merging with Vivendi to get access to World of Warcraft’s >$1BB annuity/cash cow. That is a great property and a great move, but it will not continue to cover up their strategy of to pump out TEN versions of Guitar Hero in 2009, and that the vast majority of their additional titles will be sequels. All of these sequels will be delivered in the same boxed manner to the same crowd that they have always played to.

What are the other companies doing? Most have some form of MMO strategy, but, in reality, they are all making essentially the same game for the same audience with offerings such as Warhammer, Conan, Star Wars, etc. Instead of trying to expand the market and truly address the new audience that is buying these new games, they dip their toes into the water with small experiments such as Battlefield Heroes (which is very cool, but not enough), pump out more sequels to the same audience, and assume they can acquire their way to success as other companies such as Nexon address new audiences and sales methodologies. However, just as Google came out of nowhere to take the technical leadership from Microsoft, the company that figures this out will not be able to be bought.

Big Problem Number 2: Game companies are in a similar predicament to the music and newspaper industries. What they are good at is getting easier for anybody to do and the price consumers are willing to pay is dropping fast.

I have advocated for years that I think making a game is much more like making music than making movies. Movies cost up to $200MM and are mostly out of reach of the indie film maker. Publishers brag every time a new generation of consoles comes out that development prices will go up, there will be consolidation in the market, and making games will be more like making movies. This self serving rhetoric is meant to scare the smaller publishers and developers, but it becomes a self fulfilling prophecy with development prices for titles routinely approaching $30MM. All of the major publisher have built programming “factories” filled with thousands of developers in overhead laden offices with what appear to be tightly controlled schedules and development practices.

In more of a music like scenario, as opposed to the developer filled factories and movie-like budgets, a “band” of five great game makers supported by a world wide contractor market and readily available low cost technology can make an incredibly great game. They just need passion and creativity, and they can kick the ass of any of the big companies. Let’s say each of these developers were paid $100K per year, plus given an allowance for offices and an outside contractor budget of $800K, which would roll up to a total product cost of $3MM for a two year effort or ten bets for every one bet the big studios make.

Even more interesting is what happens when these same five guys eat beans and weenies, sleep at Mom and Dad’s, and make this great game with no funding. Once they have created their game, they are not going to take it to the closed off box channels, instead they will offer it through the Web. Without huge marketing budgets the first thing they do is drop the price, and this happens so often that the amount of free game entertainment on the Web is growing at a huge rate. It was crappy at first, but it is getting better by the day, and within a few years, I predict that most people will not be paying for games directly.

To wrap up, I believe the big game companies are so wedded to the box and retail channel that they will find it nearly impossible to make the transition to the new way of doing things. I don’t think they will go away, but I do think they will shrink. Already EA is predicted to go from $5BB or so this year to $4.6BB in 2009 according to analyst Colin Sebastian of Lazard Capital. I am glad I don’t have to run any of those companies because I don’t really have the answer. I just know I don’t have to buy their stock.

-Jeff Tunnell, Game Maker
Make It Big In Games