Interactive Industry Report 2009

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Entertainment Software Publishing and Retail

INDUSTRY REPORT

July 2009

Money for Nothing How Ancillary Revenues Can Extend The Console Cycle

We expect favorable industry dynamics over the next several years to provide the foundation for entertainment software publishers to grow revenues by nearly 10% per year, with the top publishers realizing a much higher rate of earnings growth during this period. In this report, we analyze the fundamentals of the interactive entertainment industry and detail our criteria and methodology for identifying its champions.

Michael Pachter Edward Woo, CFA (213) 688-4474 (213) 688-4382 [email protected] [email protected]

Wedbush Morgan does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see page 206 of this report for analyst certification and important disclosure information.

mailto:[email protected]

ACKNOWLEDGEMENT We thank our good friend, Junkwaffle, for the fabulous cover art and for demonstrating that there is tremendous value to entertainment that is digitally delivered, even though it is intangible and nearly impossible to trade in at GameStop. We also thank the folks at GameTrailers.com and especially at GameTrailers TV for giving us many of the ideas discussed in this report. It is important to acknowledge the contribution from media sites IndustryGamers.com, Edge-Online, Kotaku.com, bitmob.com, VentureBeat.com, gamesindustry.biz, eurogamer.net and gamasutra.com for keeping us on our toes and always asking us to think about the industry in real-time. Finally, we feel we must call out NeoGAF.com and its members, for challenging virtually everything we say as being wrong, and for making us re-think many positions over the years.

i Interactive Entertainment Industry Report Michael Pachter (213) 688-4474 Edward Woo, CFA (213) 688-4382

TABLE OF FIGURES......................................................................................................................................5

EXECUTIVE SUMMARY.................................................................................................................................7

DEFINING THE INDUSTRY ..........................................................................................................................17

INDUSTRY SIZE: THE ADDRESSABLE MARKET OPPORTUNITY...........................................................21

GEOGRAPHIC MARKETS................................................................................................................21

HARDWARE AND SOFTWARE SALES SPLIT ................................................................................23

SOFTWARE VS. OTHER ENTERTAINMENT SECTORS ................................................................23

DEMOGRAPHIC TRENDS............................................................................................................................26

WIDENING AGE DEMOGRAPHIC ...................................................................................................26

RAPID TEEN GROWTH....................................................................................................................28

FEMALE MARKET ............................................................................................................................28

INCREASING YOUTH INCOME .......................................................................................................28

HARDWARE PLATFORMS ..........................................................................................................................30

HOME CONSOLES...........................................................................................................................31

WHY THIS IS LIKELY THE LAST CONSOLE CYCLE......................................................................49

HANDHELD, PORTABLE AND MOBILE CONSOLES......................................................................52

MONEY FOR NOTHING ...............................................................................................................................59

ONLIVE COULD CHANGE THE LANDSCAPE.................................................................................61

THERE MAY NOT BE ANOTHER CONSOLE CYCLE (BUT LOTS AND LOTS OF CONSOLE SKUS) ...............................................................................................................................................62

DIGITAL DOWNLOADS ARE HERE AND NOW ..............................................................................64

THE WII PLUS (HD) IS COMING (EVENTUALLY) ...........................................................................65

THE XBOX 360 COULD END UP A WINNER, EVEN IN THIRD PLACE..........................................67

THE NEW, DIGITAL PSP IS NOT QUITE DEAD, YET, (OR IS IT?).................................................69

THE NEW DSI WILL ADVANCE THE BRAND..................................................................................69

BLIZZARD IS THE PRESENT AND FUTURE OF ONLINE GAMING...............................................70

IN-GAME ADVERTISING IS NOT A BIG DEAL................................................................................73

DIGITAL DOWNLOADS WILL LIMIT GAMESTOP’S GROWTH.......................................................75

FREE-TO-PLAY GAMES HAVE POTENTIAL...................................................................................79

MOBILE PHONE GAMES ARE A FAD .............................................................................................80

POST SCRIPT—LESSONS NOT LEARNED FROM THE LAST CONSOLE CYCLE.......................81

CONCLUSION ..................................................................................................................................82

INDUSTRY CONSOLIDATION .....................................................................................................................83

M&A DOESN’T MAKE SENSE..........................................................................................................83

COMPETITION FROM MEDIA COMPANIES DOESN’T MAKE SENSE ..........................................84

Michael Pachter (213) 688-4474 Interactive Entertainment Industry Report 1 Edward Woo, CFA (213) 688-4382

VIDEO GAME HARDWARE FORECAST .....................................................................................................89

PERSONAL COMPUTER VIDEO GAMES........................................................................................95

SOFTWARE ECONOMICS ...........................................................................................................................97

RETAIL PRICING TRENDS...............................................................................................................97

PRODUCTION COSTS ...................................................................................................................101

SOFTWARE GENRES ................................................................................................................................106

CONTENT OVERVIEW ...............................................................................................................................115

BRAND ............................................................................................................................................115

GAME PLAY....................................................................................................................................117

GENRE............................................................................................................................................117

TARGET DEMOGRAPHIC ..............................................................................................................120

“BUZZ”.............................................................................................................................................123

CONCLUSION.................................................................................................................................123

SOFTWARE GROWTH FORECAST ..........................................................................................................124

INVESTING IN SOFTWARE PUBLISHERS................................................................................................131

INDUSTRY PRICE PERFORMANCE..........................................................................................................132

HISTORICAL INDUSTRY RETURNS..............................................................................................132

REVENUE SIZE AND GROWTH.................................................................................................................134

COMPANY STRATEGIES...........................................................................................................................136

PLATFORM FOCUS........................................................................................................................136

DEVELOPMENT ASSETS...............................................................................................................139

DEVELOPMENT SYNERGIES........................................................................................................140

THIRD-PARTY DISTRIBUTION ......................................................................................................141

GEOGRAPHIC DISPERSION OF REVENUES...............................................................................141

ONLINE STRATEGIES....................................................................................................................142

INTELLECTUAL PROPERTY STRATEGIES ..................................................................................143

CONTENT COMPARISON..........................................................................................................................148

BRAND BUILDING ..........................................................................................................................148

TOP BRANDS OF 2008 ..................................................................................................................148

TOP BRANDS BY COMPANY.........................................................................................................149

ACCOUNTING ISSUES...............................................................................................................................152

CAPITALIZED SOFTWARE DEVELOPMENT AND PREPAID ROYALTIES ..................................152

RESERVES .....................................................................................................................................154

UPSTARTS AND STARTUPS.....................................................................................................................156

2 Interactive Entertainment Industry Report Michael Pachter (213) 688-4474 Edward Woo, CFA (213) 688-4382

COVERED PUBLICLY TRADED INTERACTIVE ENTERTAINMENT COMPANIES .................................158ACTIVISION BLIZZARD (ATVI) ......................................................................................................159

ELECTRONIC ARTS (ERTS)..........................................................................................................162

MAJESCO ENTERTAINMENT (COOL) ..........................................................................................165

MIDWAY GAMES (MWYGQ) ..........................................................................................................168

NINTENDO (7974.JP / NTDOY.US)................................................................................................171

TAKE-TWO INTERACTIVE SOFTWARE (TTWO)..........................................................................174

THQ (THQI).....................................................................................................................................177

UBISOFT ENTERTAINMENT (UBI.FP)...........................................................................................180

BEST BUY (BBY) ............................................................................................................................183

BLOCKBUSTER (BBI).....................................................................................................................186

GAMESTOP (GME) ........................................................................................................................189

OTHER RELATED INTERACTIVE ENTERTAINMENT COMPANIES .......................................................192

CAPCOM (9697.JP) ........................................................................................................................193

GAMELOFT (GFT.FP).....................................................................................................................193

GIANT INTERACTIVE GROUP (GA) ..............................................................................................194

GLU MOBILE (GLUU) .....................................................................................................................194

GRAVITY (GRVY) ...........................................................................................................................195

KONAMI (KNM) ...............................................................................................................................195

MAD CATZ INTERACTIVE (MCZ) ..................................................................................................196

MICROSOFT (MSFT)......................................................................................................................196

NAMCO BANDAI HOLDINGS (7832.JP).........................................................................................197

NCSOFT (036570.KS) ....................................................................................................................197

NETEASE.COM (NTES) .................................................................................................................198

PERFECT WORLD (PWRD) ...........................................................................................................198

PLAYLOGIC ENTERTAINMENT (PLGC)........................................................................................199

SEGA SAMMY (SGAMY) ................................................................................................................199

SHANDA INTERACTIVE ENTERTAINMENT (SNDA) ....................................................................200

SONY (SNE) ...................................................................................................................................200

SOUTHPEAK INTERACTIVE (SOPK) ............................................................................................201

SQUARE ENIX (9684.JP) ...............................................................................................................201

TECMO KOEI HOLDINGS (3635.JP)..............................................................................................202

THE9 LIMITED (NCTY) ...................................................................................................................202

TIME WARNER (TWX)....................................................................................................................203

VIVENDI (VIV.FP) ...........................................................................................................................203


WALT DISNEY (DIS) .......................................................................................................................204

WEBZEN (WZEN) ...........................................................................................................................204


TABLE OF FIGURES

Figure 1—Top 20 Entertainment Software Publishers - U.S. Retail Sales 2007 – 2008 ($ millions) .....18 Figure 2—U.S. Retailer Console and PC Software Market Share 2007 – 2008 .......................................20 Figure 3—Worldwide Interactive Entertainment Sales 2004 – 2011E ($ millions)..................................22 Figure 4—Addressable Market for U.S. Software Publishers 2004 – 2011E ($ millions) .......................23 Figure 5—U.S. Entertainment Sectors 2003 – 2008 ($ billions) ...............................................................24 Figure 6—Primary Video Gamer by Age and Gender ...............................................................................29 Figure 7—2008 Video Game Software Sales Market Share by Platform Type........................................30 Figure 8—U.S. Console Cycles and Hardware Launches ........................................................................33 Figure 9—U.S. Cumulative Hardware Unit Sales ......................................................................................34 Figure 10—U.S. Annual Hardware Unit Sales ...........................................................................................36 Figure 11—U.S. Software Sales by Platform .............................................................................................38 Figure 12—Console Installed Base (U.S. and Europe) .............................................................................39 Figure 13—Console Installed Base (Worldwide) ......................................................................................40 Figure 14—Sony PlayStation 2 Unit Sales (2000 – 2011E) .......................................................................41 Figure 15—Nintendo GameCube Unit Sales (2001 – 2008) ......................................................................43 Figure 16—Microsoft Xbox Unit Sales (2001 – 2007)................................................................................44 Figure 17—Microsoft Xbox 360 Unit Sales (2005 – 2011E) ......................................................................45 Figure 18—Sony PS3 Unit Sales (2006 – 2011E).......................................................................................47 Figure 19—Nintendo Wii Unit Sales (2006 – 2011E) .................................................................................48 Figure 20—Nintendo Game Boy Advance Unit Sales (2001 – 2008)........................................................53 Figure 21—Nintendo DS Unit Sales (2004 – 2011E)..................................................................................54 Figure 22—Sony PSP Unit Sales (2004 – 2011E) ......................................................................................56 Figure 23—U.S. Console Price History ......................................................................................................58 Figure 24—Average U.S. Console Ownership by Household..................................................................89 Figure 25—Console Unit Sales U.S. and Europe (2004 – 2011E) ............................................................91 Figure 26—Console Unit Sales Japan and Worldwide (2004 – 2011E) ...................................................92 Figure 27—Console Dollar Sales U.S. and Europe (2004 – 2011E) .........................................................93 Figure 28—Console Dollar Sales Japan and Worldwide (2004 – 2011E) ................................................94 Figure 29—PC Entertainment Software Sales (2004 – 2011E) .................................................................95 Figure 30—Average U.S. Retail Software Price by Platform....................................................................97 Figure 31—Sample Gross Margin Calculation ........................................................................................105 Figure 32—U.S. Video Game Software Market by Genre .......................................................................106 Figure 33—U.S. Top Video Game Software - Strategy/Role Playing Games ........................................107 Figure 34—U.S. Top Video Game Software - Sports/Extreme Sports ...................................................109 Figure 35—U.S. Top Video Game Software - Action/Shooter ................................................................111 Figure 36—U.S. Top Video Game Software - Racing..............................................................................112 Figure 37—U.S. Top Video Game Software - Fighting/Simulations ......................................................113 Figure 38—U.S. Top Video Game Software – Family/Children/Other....................................................114 Figure 39—Percentage of U.S. Publishing Sales by Genre (2008) ........................................................118 Figure 40—Percentage of U.S. Console Software Genre Sales by ESRB Rating (2008) .....................121 Figure 41—Percentage of U.S. Console Software Publisher Sales by Ratings (2008) ........................121 Figure 42—Percentage of Total U.S. Console Software Sales by Rating .............................................122 Figure 43—Worldwide Interactive Entertainment Software Sales (2004 – 2011E) ...............................124 Figure 44—Software Unit Sales U.S. and Europe (2004 – 2011E) .........................................................126 Figure 45—Software Unit Sales Japan and Worldwide (2004 – 2011E) ................................................127 Figure 46—Software Dollar Sales U.S. and Europe (2004 – 2011E) ......................................................128 Figure 47—Software Dollar Sales Japan and Worldwide (2004 – 2011E) .............................................129 Figure 48—Key U.S. Publicly-Traded Interactive Entertainment Software Publishers........................131


Figure 49—Industry Stock Performance (1996 – 2009) ..........................................................................133 Figure 50—Publishing Revenues 2005 – 2008 ($ millions).....................................................................134 Figure 51—Total Revenues 2005 – 2008 ($ millions) ..............................................................................134 Figure 52—Covered Companies Publisher Sales Mix by Platform........................................................138 Figure 53—Domestic vs. International Revenues ...................................................................................142 Figure 54—Top Interactive Entertainment Software Brands (U.S. $ Sales 2006 – 2008) .....................149 Figure 55—Publisher Top Brands (U.S. $ Sales 2008)............................................................................150


EXECUTIVE SUMMARY

Since the launch of the Xbox 360 in late 2005, interactive entertainment software sales have grown by over 60%. Sales of legacy generation console software declined by 71%, more than offset by growth of “next generation” software. Even though there will be many new games created for the PS2, we expect legacy generation software sales to decline to less than $1 billion in 2009, compared with almost $25 billion in overall software sales this year. The current generation is fully underway, with overall growth in 2009 of 4% expected in the U.S. and Europe. We define “next generation” as software for the Nintendo DS and Wii, for the Sony PSP and PS3, and for the Microsoft Xbox 360, and will refer to this as “current generation” throughout this report. Because console prices remain relatively high, we expect the transition to continue for several more years, with the market for interactive entertainment growing at double-digit rates through 2011. Beyond 2011, we expect revenues from non-traditional sources (online games, casual games, mobile phone games, downloadable content, and in-game advertising) to contribute meaningfully, offsetting slowing growth of packaged goods software sales.

The current generation began without fanfare in 2004. That year, Nintendo reinvented its handheld Game Boy Advance as a dual-screen device, with a touch screen allowing the consumer to interact with video game content in a different way. Few observers appreciated that the Nintendo DS signaled a change in game play that previewed the company’s plans for its console (the Wii) introduced in 2006. In early 2005 (December 2004 in Japan), Sony launched the PlayStation Portable (PSP), intending to capture share in the handheld market from Nintendo. Later that same year, Microsoft launched the Xbox 360, offering true high definition gaming. In late 2006, Sony and Nintendo launched the PS3 and the Wii, respectively, and the current generation was in full gear. Although the last of these launches completed the beginning of the current generation cycle, they by no means marked the end of the current cycle. All major software publishers made a distinct effort to extend the value of the “legacy” system in 2007 and 2008 by continuing to develop games for the PS2. Perhaps the most successful of these new games were the music-themed rhythm games, Guitar Hero and Rock Band.

The last video game software cycle began with a dip. Annual industry software sales, reflecting combined sales of console, handheld and PC games in the U.S. and Europe, declined by 9% in 2000, followed by growth of 4%, 15%, 12%, and 11% in 2001 – 2004, respectively. The current console cycle began with a similar dip, as sales declined by 3% overall, with a rebound to 6% growth in 2006. After a relatively modest beginning, the current cycle became a force, with 25% sales growth in 2007 and 20% growth in 2008. The 2008 figures were dramatically impacted by foreign currency translation (all of our sales figures are stated in U.S. dollar terms). Two factors contributed to the robust results in 2007 – 2008: first, while consumers were slow to adopt current generation technology due to supply constraints, they chose to continue purchasing legacy generation software while waiting to replace their old consoles. While last generation software sales declined by 71% between 2005 and 2008, the category still contributed almost $2.5 billion in overall sales (11% of the total) in 2008, compared to only $550 million (4.2% of sales) for legacy software at a similar point in the last cycle. The second reason for robust sales growth is the rate of adoption of the Wii, with non-traditional households buying Wiis and Wii software


at historically high rates. At the same time, sales of the relatively high-priced PS3 have been unimpressive, with the more moderately priced Xbox 360 performing about as expected.

In the last console cycle, the installed base of legacy generation hardware (PS2, GameCube and Xbox) peaked at around 115 million units in the U.S. and Europe. Total console and handheld software sales grew from $6.6 billion in the U.S. and Europe in 2000 to $11.2 billion in 2005, representing a compound annual growth rate of 11%. This growth rate accelerated between 2005 and 2008 to over 22%, and we expect growth to average in the low double-digits over the next three years (partially offset by continuing declines in PC software sales), reflecting unprecedented levels of software sales growth.

Phenomenal sales growth and underperformance of video game publisher stocks has triggered heightened investor interest in the dynamics of the video game “console cycle”. In this report, we explore industry fundamentals, forecast industry sales growth by segment and geographic area, and compare several publicly traded publishers to uncover the industry’s likely top performers over the next several years. As packaged goods sales growth inevitably slows, we expect significant contribution from five non-traditional sources of revenue: online subscription games (MMOs), casual games, mobile phone games, digital downloads, and in-game advertising. Later in this report, we forecast the overall market size for each of these non-traditional sources, and attempt to quantify their impact on publisher earnings over the next decade.

Ultimately, we expect console hardware sales to be closely correlated to the quality and quantity of the underlying available content. There are two key differences in the current console cycle: first, the emergence of the Wii as the industry leader; and second, console prices are significantly higher for the PS3 and Xbox 360 than they were for the PS2 and Xbox, allowing Nintendo to exploit the mass market audience early on with its low-priced (and innovative) Wii. It is clear that Sony made a conscious decision in allowing Microsoft to gain a first mover advantage with the 2005 introduction of the Xbox 360, as it chose to forego potential PS3 sales in order to dominate the high definition DVD market. However, by focusing on winning the Blu-ray/ HD-DVD battle, Sony was forced to price its PS3 too high, and the company inadvertently allowed Nintendo to gain an all-but-insurmountable advantage. This decision may preclude Sony from winning the “console war”, and most certainly has increased Microsoft’s options to sustain its first mover advantage over Sony. PS3 sales have been quite weak due to its relatively high price, and although sales have increased steadily over the last two years, we expect Sony to remain in third place until the PS3 price is competitive with the other two consoles.

In contrast, Nintendo began the cycle (in late 2006) with a modestly priced console. The Wii was offered at an initial price of $249 in the U.S., and came bundled with Wii Sports. Nintendo continued to offer high quality content, innovating with Wii Fit in late 2007 in Japan and in early 2008 in the U.S. and Europe. With its low relative price (the PS3 launched at $499/599 and remains at $399 as of this writing), the Wii outsold its competitors by a large margin in 2007 and in 2008. Nintendo made a strategic decision in the planning stage, choosing to forego competition based solely on microprocessor speed and graphics capability, instead emphasizing game play and an innovative control mechanism. Because its console was less expensive to produce, Nintendo was able to pass along the cost savings to consumers.


The Xbox 360 and PS3 are differentiated from the Wii insofar as they have the ability to display game content in high definition (1080p). In contrast to past cycles, providing “cutting edge” high definition features may have resulted in slower adoption by the masses, especially given the depth of the global recession, and the relatively slow sell through of the two high definition consoles may persist until penetration of HD monitors accelerates. In prior console cycles, new consoles were compatible with standard format televisions, so the only hardware required in order to play the new games was the console itself. While the current generation consoles will operate satisfactorily on normal 4:3 format 480p televisions, most games for the PS3 and Xbox 360 are designed for 16:9 formats in 1080p high definition. We believe that ultimately, most console purchasers will desire the full benefits of the current generation experience, but expect most consumers to defer purchasing a PS3 or an Xbox 360 until they have purchased an HD monitor. Nintendo positioned itself to exploit the slower adoption of current generation technology, as its Wii console does not require an HD monitor. In that respect, the global recession served to benefit Nintendo at its competitors’ expense. To date, overall console adoption is running at the same rate as in the past cycle, with slower sales of the PS3 and Xbox 360 (compared to their predecessors) exactly offset by more robust sales of the Wii compared to the GameCube. There were roughly 78 million current generation consoles sold worldwide as of year-end 2008, with 16 million PS3s, 23 million Xbox 360s and 39 million Wiis. This compares to 78 million legacy consoles sold worldwide at year-end 2003, with 54 million PS2s, 12 million Xboxes and 12 million GameCubes. It is clear that Nintendo is winning the current console war, and equally clear that Sony sales are sorely behind the level of its last console.

There have only been two “real” console cycles before the current one—the PlayStation cycle that began in 1995, and the PS2 cycle that began in 2000. In each of these cycles, advances in the quality of content drove robust sales growth, as advances in processing power allowed content to be richer and more complex. In the current cycle, quality for current generation games was noticeably better from the outset, leading to solid attach rates notwithstanding light hardware sales for the PS3 and the Xbox 360. The surprise has been the software attach rate for the Wii, which is running at or above Xbox 360 attach rates notwithstanding the lack of high definition graphics. As quality for current generation games continues to improve, we expect to see hardware sales remain stable or even increase, resulting in an unprecedented tail for software sales growth. For the first three years of the current cycle, high prices for current generation consoles and more prudent planning from the publishers kept demand for last generation PS2 games from falling off a cliff. PS2 software sales declining only 11% in 2006, 27% in 2007, and 31% in 2008, compared to a 37% decline in PS1 software sales in 2001 (the year after the launch of the PS2). This slow rate of decline for legacy software resulted in an overall sales gain of 6% in 2006, 25% for 2007, and 20% for 2008, notwithstanding slow PS3 sales and limited supply for the Wii through year-end 2008. High development costs and long lead times caused conservative publishers to limit the quantity of software developed for the Xbox 360 and PS3, and market penetration for these new platforms has lagged penetration by their predecessors. At the same time, the modestly priced and innovative Wii has captured consumers’ imaginations, and the console was consistently sold out from its late 2006 launch until the beginning of this year. We believe that as a greater number of games are developed for each console, current generation software sales will accelerate. We expect PS2 software sales to decline sufficiently (around 64%) to be almost irrelevant to overall software


sales growth, with PS2 software comprising less than 4% of overall software sales in 2009.

We believe that the Xbox 360 and the PS3 are far more similar than their predecessors were, and think that the economics of game development will limit the amount of third party exclusive content for either console. In a perverse way, the similarity between the two platforms will likely serve to lower the costs of porting software from one platform to the other, and we anticipate that virtually every third-party title produced for one will be produced for the other. The lack of differentiation between the PS3 and the Xbox 360 has in part allowed the Wii to gain a competitive advantage—due to its differential control mechanism and relatively simple components, publishers must make a separate SKU for the Wii, further differentiating the console. Because of its superior library of first party titles and relatively low price, we think that the Wii will again capture the greatest share of the hardware market in 2009.

Although we believe that digital content offers the potential for tremendous growth, we do not expect a significant revenue contribution from sales of digital content for another few years. Digital content takes five forms: online gaming, casual games, mobile games, downloadable content, and in-game advertising. The first three of these will grow at a relatively stable rate over the next several years, while the latter two will grow exponentially for traditional publishers once penetration of the current generation consoles exceeds 50% of the ultimate installed base (likely in 2009). Of course, Activision Blizzard is the exception to the bolded rule above, with approximately ¼ of its revenues and ½ of its profits derived from its World of Warcraft online game. We discuss the growth of digital revenues at length in the section beginning on page 59.

Industry Forecast

• We estimate that the interactive entertainment industry generated worldwide sales of $40 billion in 2007 and $44 billion in 2008. We estimate that the addressable market opportunity for U.S. software publishers is $23 billion in 2008 (packaged software only) and we expect sales to grow at a nearly double-digit pace for the next three years. We note that the Japanese market remains virtually closed to U.S. and European publishers, with only minor inroads made by Electronic Arts and Take-Two, and do not anticipate significant contribution for the U.S. and European publishers in the near future.

• We forecast the combined U.S. and European software markets to grow at a 9% CAGR over the 2009 – 2011 period. Our forecast assumes console software sales (i.e., Xbox 360, PS3 and Wii) of $17 billion in 2009, growing to $20 billion in 2010 and to $22 billion in 2011. We expect handheld software sales (i.e., DS, DSi and PSP) of $4.2 billion in 2009, $4.6 billion in 2010 and $4.8 billion in 2011. We believe that the top-performing software publishers will capture a disproportionate share of top-line growth, will deliver operating leverage, and will grow EPS at a higher rate during this period.

• We expect growth to be driven by higher console penetration rates (particularly of handheld platforms), with lower “tie ratios” (a tie ratio is the number of software units sold per hardware console) offset by higher overall game pricing.

• In 2009, we forecast that U.S. interactive entertainment software sales (at $12.2 billion) will still be only around 40% the level of movie box office, rentals and


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sales (approximately $32 billion in the U.S. in 2008), indicating that there is significant potential for further growth.

• Several demographic trends and market drivers will fuel rapid growth of interactive entertainment software sales. The most compelling of these trends is the expanding age demographic of the interactive game consumer (as evidenced by the typical Wii purchaser), accompanied by an increasing level of disposable income and the propensity to spend that income on entertainment.

Hardware Forecast

• Total last generation (PS2, Xbox and GameCube) hardware shipments through the end of 2008 reached 125 million units in the U.S. and Europe (the addressable market for U.S. and European publishers). By comparison, 32-/64-bit (PSOne, N64 and Saturn) shipments in the U.S. and Europe totaled only 93 million units during the analogous 1995 – 2003 period.

• We expect current generation hardware shipments through the end of 2009 to reach 100 million units in the U.S. and Europe. By comparison, shipments of the last generation consoles in the same regions totaled only 88.5 million units during the analogous 2000 – 2004 period. This clearly indicates that the current cycle is far more robust than the last cycle, especially given the relatively high price points for the three major consoles.

• Even more dramatic is expected penetration of handheld hardware. We project cumulative DS, DSi and PSP sales in the U.S. and Europe to total 101 million units by year-end 2009, compared to GBA and GBA SP sell through of only 43 million units in the analogous 2000 – 2004 period.

• By the end of the current cycle, we expect increased console and handheld penetration rates in every major geographic segment, due to strong demographics, additional functionality, increased market segmentation, and much higher marketing spending. Now that Sony has won the high definition DVD format war, we expect PS3 adoption steadily to increase in correlation with HDTV household penetration. We believe that Microsoft can maintain its first mover advantage by continuing to lower prices and by continuing to enhance its offering on Xbox Live.

• The current generation consoles have increased multimedia functionality, with high-definition DVD playback on the PS3 and Xbox 360, high definition display for both, online gaming capability for all three consoles, and access to Internet content downloads for all three. Ultimately, we expect the current generation of game machines to appeal to a much wider audience, driving the percentage of households that own at least one console from 52% during the 128-bit cycle to 60% during the next cycle. Innovations with peripherals such as Rock Band, Guitar Hero and Wii Fit have converted new households into video game households, and we expect the trend to continue.

• Our growth forecast assumes that the number of consoles owned by each household will hold relatively steady, decreasing slightly from 1.40 to 1.38 during the next cycle. In contrast with the last cycle, we think that the second console of choice in most households ultimately will be the Nintendo Wii, driven by innovative game play and a deep library of proprietary content. Because of its low price, we expect a large number of dual console households to buy the Wii first. We do not expect as many households to purchase both a PS3 and Xbox


360 as purchased the PS2/Xbox combination last cycle, given the similarities between the consoles.

• We expect the dominant console at the end of the this cycle to be the Wii, as we think that the console’s low price point, innovative control mechanism, and compatibility with standard definition televisions will provide it with a competitive advantage over the next two years. We expect Nintendo to sustain this competitive advantage by introducing a high definition version of the Wii, perhaps as early as the end of 2010, in order to convert its large installed base into true “next generation” households. We think that the PS3 will capture significant market share, primarily due to Sony’s victory in the high definition DVD format war, and will end up in second place by 2015. Although Microsoft’s Xbox 360 enjoyed a first mover advantage, we think that its market position will fade to third place due to lack of penetration in Japan. We expect the Wii to capture 49% share of the U.S. and European market by the end of 2009, followed by the Xbox 360 at 29% and the PS3 at 22%. By the end of 2011 (the extent of our current forecast), we see Nintendo “winning” the console war by maintaining its share, with 48% of this market. We expect Sony to pull even with Microsoft, each with 26% market share. Notwithstanding the projected finish, we truly believe that all three manufacturers should be considered “winners”, with Microsoft selling twice as many Xbox 360s as Xboxes and building a robust Xbox Live business, and with the other two companies generating significant profits from their respective shares. These estimates do not include console sales in Japan, which we expect to be dominated by Nintendo with over 65% market share through 2011.

Software Forecast

• One of the primary drivers of Sony’s success during the last two cycles was its ability to provide a greater quantity of high-quality titles than its competitors. In addition to a large first party library (Gran Turismo, SOCOM Navy Seals, The Getaway, God of War, Ratchet and Clank and Jak), the company was successful in securing enormous third-party software development support for the PS2. The three most successful single platform titles of all time, Take-Two’s Grand Theft Auto III, Grand Theft Auto: Vice City, and Grand Theft Auto: San Andreas debuted exclusively on PS2 and have so far sold over 42 million units on the PS2 alone, each selling approximately twice as many units as the best selling Xbox and GameCube games. The Xbox was effectively discontinued in 2006 with the launch of the Xbox 360, while demand for PS2 hardware and software remained strong in both 2006 and 2007. Because Sony sold over 18 million PS2s in 2006 and 2007, it was able to maintain the price of the PS2 at $129 through March of this year. We do not expect meaningful contribution from PS2 software sales after 2009, but note that catalog sales of PS2 games may comprise 2 – 3% of overall software sales in the future.

• We do not expect Sony to secure significant third party exclusivity for PS3 titles over the next few years, and expect the company to continue to focus its internal development efforts on blockbuster games. At the same time, we think that the company will maintain solid overall software market share by virtue of the growing installed base for the PS3 and PSP, offset by continued PS2 software sales declines. For 2009, we expect software sales for Sony consoles to account for 31% of all game software sold worldwide.


• We expect the PS2 tie ratio to end up at around 12.5 units of software for each hardware unit sold, exceeding the 10.8:1 tie ratio of the highest-selling console of the last cycle, the PlayStation (PSX or PSOne). We expect the Xbox and GameCube tie ratios to end up close to the PSOne’s, and expect both to be significantly higher than the number two console of the last cycle, the N64. It appears that the tie ratios for the PS3 and the Xbox 360 will approach or exceed that of the PS2, likely ending at least at 10.3:1 and 11.9:1, respectively by 2011.

• We believe that a wildcard for current generation console sales will be the hardware manufacturers’ ability either to develop content internally or to secure third-party commitments for software designed exclusively for a single platform. Nintendo has a large advantage over its competition with a deep library of internally developed games/brands (e.g., Mario Brothers, Zelda, and Pokemon), all of which will be offered exclusively for the Wii. Microsoft developed Halo 3 as an exclusive on the Xbox 360, with third party titles like Gears of War, BioShock and Mass Effect selling well early in the cycle. The company’s other exclusives have received good reviews, but have not (so far) driven sales of hardware to the same extent as the Halo. Sony enjoyed a large first-mover advantage in the last cycle, with a handful of contractual exclusives (including the Grand Theft Auto games). In the current cycle, we expect the playing field between Sony and Microsoft to be more level, and think that Nintendo will have the largest library of exclusives.

• Notwithstanding the efforts of the three console manufacturers to deliver compelling exclusive content, we expect the ultimate outcome of the console wars may have been decided by Nintendo. The company’s revolutionary decision to forego high definition graphics capability in favor of innovative controls captured the imagination of consumers early in the cycle, and its introduction of innovative peripherals has so far allowed it to sustain its competitive advantage.

• Developing video games has become an increasingly complex endeavor. Most video games created for the legacy consoles (the PlayStation and N64) could be built in less than one year (we estimate that the average development time was six to nine months) and cost less than $1 million to produce. In the last generation, the average console game required 18 to 36 months to finish, and cost an average of $4 million. Thus far in the cycle, current generation console games require between 24 and 36 months to develop, and average development costs have risen to between $8 – 10 million, with some economies obtained if games are developed for both the Xbox 360 and the PS3 simultaneously. We believe that the first efforts for most current generation games cost more than $10 million (with some games costing as much as $20 million), but most publishers have quickly advanced along the learning curve, with average costs declining in over the last two years.

• PC software sales in 2006 had U.S. and European sales declining by only 3% (due to strong sales of online games), though in 2007, declined 11%, and (largely due to foreign currency translation) in 2008, declined 14%. We think that the market for PC games may have approached a bottom, and expect PC software sales to decline by only 2 – 3% per year over the next three years.


Geoffroyde Nanteuil

Texte surligné

Investing in Software Publishers

• With the economic downturn, the historical gains in share prices for the major publishers were all but wiped out. The average forward multiple for a video game publisher has historically been 25 – 50% higher than the overall market multiple, reflecting the superior growth prospects for the industry and the tremendous earnings leverage generated by massive early investments in R&D. However, as of this writing, most of the public video game publishers trade at or below the market multiple, reflecting investor concern about the health of the industry.

• We believe that the interactive entertainment industry offers secular dynamics that will provide extended and sustainable growth. Several publishers stand poised to capitalize on this growth, providing investors with an opportunity to participate. In this section, we analyze historical returns for the industry, and compare and contrast the publishers in order to provide insight into how their different strategies and assets produce different risk and return profiles.

• The universe of publicly traded entertainment software publishers includes companies with market capitalizations ranging from under $50 million to over $30 billion. The industry offers two large-cap companies (Nintendo and Activision Blizzard), one mid-cap company (Electronic Arts), three small-cap companies (Take-Two, THQ and Ubisoft), and one micro-cap company (Majesco) to consider as investment opportunities. Over the last three years, six micro cap companies (Acclaim, Atari, Bam!, Interplay, Midway and 3DO) declared bankruptcy or ceased operations.

• The publishers with the greatest success in creating and nurturing high-quality branded entertainment software are Nintendo, Activision and Electronic Arts. Nintendo is unquestionably the most successful creator of entertainment software over the past 20 years and captured the number one position in U.S. sales among software publishers each year until 2001. Many of the brands that Nintendo introduced in the 1980s and early 1990s for the NES and SNES consoles are still dominant brands today such as Mario, Zelda, and Donkey Kong. Similarly, Electronic Arts has built a portfolio of recurring revenue streams by growing its library of established brands. Electronic Arts now dominates the sports genre and its hit football, soccer, basketball, and golf games (among many others) are best sellers year after year. Electronic Arts also has expanded beyond the sports game genre and built successful brands in many other genres, including the real-time-strategy genre (Command & Conquer and Battlefield), strategy/RPG genre (The Sims), extreme sports (Skate), kiddie (Harry Potter) and the driving genre (Burnout and Need For Speed). Activision’s results are far more concentrated, with its top two brands (Guitar Hero and Call of Duty) responsible for over 70% of its domestic sales. According to NPD, in 2008, Electronic Arts captured the highest market share for entertainment software sales in the U.S., with its 20.3% market share slightly ahead of second place Activision’s 16.7% share, with Nintendo in third place with 16.6% market share.

• We believe that brand depth is one the most important indicators of a publisher’s future prospects. Strong software brands provide a publisher with sequel titles for several years and a deep library of brands provides a steady base of recurring revenues. We note that all but one of the top 30 brands of 2008


is an established brand with a history of producing successful titles prior to 2008. These mega-hit brands are the result of growing and developing successful brands over several years. Possessing a deep library of solid brands is the first step to producing one of these mega-hit brands in the future.

• Nintendo, Electronic Arts and Activision were the only publishers with more than one brand that generated over $100 million in U.S. retail sales during 2008. We chose a $100 million threshold because we believe that this figure reflects potential lifetime sales of more than three million units, indicating a bona fide “home run”. All of Electronic Arts’ top-10 brands generated more than $57 million in 2008, demonstrating the company’s exceptional brand library. Nintendo had ten brands generate more than $20 million apiece, with Activision (nine), and Ubisoft (nine) right behind. Take-Two and THQ each had six brands over the $20 million threshold, with Midway (two) and Majesco (one) rounding out the rest. The $20 million level of U.S. retail sales, in our view, is a good proxy for a worldwide million unit seller, reflecting a bona fide “hit” franchise that contributes significantly to each company’s bottom line results.

• We have a positive outlook for sales growth over the next several years, and expect the publicly traded publishers to maintain or gain market share throughout the current cycle. We believe that the larger companies (Activision Blizzard, Electronic Arts Nintendo, Take-Two, THQ and Ubisoft) are poised to deliver operating leverage, particularly as the installed base of consoles grows sufficiently to drive unit volumes higher for new software. We expect the smaller companies to struggle to gain market share, with their future profitability determined by their ability to grow revenues.

• We expect shares of the interactive entertainment publishers to trade higher later in 2009, as investors gain greater comfort about the effects of the recession. Our industry growth model projects combined U.S. and European compound annual sales growth of 8.8% over the next three years, with a 4% increase in 2009. We believe that earnings of the publicly traded publishers can grow at a much higher rate, as the larger publishers have made a significant investment in current generation technology, and are poised to deliver operating leverage as their revenues grow.

• We note that publicly traded publisher stocks are trading at or below the market multiple for the first time this decade. Historically, these stocks trade at a premium to the market, as the rate of top line growth has consistently exceeded overall GDP growth, and the companies have typically been able to deliver operating leverage. As a result of the recession and confusion over the timing of the next console cycle, investors appear to be concerned that top line growth and operating leverage will lag the overall market, creating an investment opportunity for those who see the industry growing as we forecast.

• We recommend that investors accumulate shares in publishers Activision Blizzard, Electronic Arts, Majesco, Nintendo, Take-Two, THQ, and Ubisoft at current levels.


SECTION 1: INDUSTRY OVERVIEW AND FORECAST


DEFINING THE INDUSTRY

The interactive entertainment industry consists of several constituencies: the manufacturers of dedicated video game consoles and portable devices; the publishers of packaged software products that can be played on consoles, handhelds and PCs; the developers of packaged software; and the producers of games that can be accessed digitally, whether through a mobile, Internet or direct download. This report will primarily focus on packaged product sales, subscription game services, and Internet downloads. Total hardware and packaged product sales in the U.S., Europe (comprising Europe, Middle East and Africa) and Japan totaled an estimated $44 billion in 2008, with hardware sales comprising $17.7 billion and software sales $26.4 billion of the total. U.S. sales represented about 44% of the total, Europe about 43%, Japan about 13%. Sales in Japan have trended down the last couple of years because of relatively slow console adoption rates and declining tie ratios. Our report speaks in general terms about only those sales generated from the three primary markets for video games, the U.S., Europe, and Japan. On its face, our analysis disregards sales from the rest of the world; however, we believe that the totals reflected in our estimates represent a good proxy for worldwide sales. Historically, rest of world sales have accounted for only a very small portion of total worldwide sales, and the rest of world market has not necessarily been particularly lucrative for the U.S. and European publishers. The markets with the greatest demand for video game products (outside of the U.S., Europe and Japan) are Australia and Canada, with combined demand comprising approximately 4% of the global total. We estimate that rest of world sales (including Australia and Canada) totaled $4 billion in 2008, or about 9% of the total sales generated in the U.S., Europe and Japan, split roughly 60% software and 40% hardware. Further, we believe that around 35% of the estimated $2.4 billion in software sales consists of catalog sales with relatively high distribution costs, and correspondingly low profits. We expect the rest of world percentage to climb by 100 basis points per year for the next several years, with increasing penetration in non-traditional markets such as South America, Eastern Europe, and Scandinavia. As these sales grow, they will likely generate higher profits for the U.S. and European publishers. Accordingly, we will incorporate rest of world into our estimates in future industry forecasts.

Video game hardware includes dedicated game consoles for both home and handheld use, as well as various accessories (e.g., controllers, peripherals and memory cards) for these consoles. Game consoles are the machines or platforms that play dedicated video game software. We include sales of game software for personal computers (PCs) within our definition of video game software, but do not include sales of PC hardware within our industry definition. Several “games” include a peripheral as part of a bundle (notably Wii Fit and Guitar Hero). These games are considered software, and are included in the software data published by the NPD Group. In addition, although the origin of video game consoles is rooted in location-based entertainment (e.g., arcade games and pinball machines), we consider this a separate industry and do not consider these devices in our analysis. One area that is rapidly expanding is mobile games played on cell phones. We do not include these sales in our forecasts, as they do not generate significant revenues for any of the U.S. and European publishers (except for Electronic Arts). Later in this report, we discuss opportunities for cell phone game sales.


Our report and research coverage focuses on interactive entertainment software publishers and retailers that derive a significant portion of sales from interactive entertainment. The following is a more thorough description of the key players in the hardware and software sectors and the various roles they play within the industry.

Figure 1—Top 20 Entertainment Software Publishers - U.S. Retail Sales 2007 – 2008 ($ millions)

Source: The NPD Group/Retail Track and Wedbush Morgan Securities estimates.

Rank Publisher U.S. Sales Market Share Rank Publisher U.S. Sales Market Share1 Electronic Arts 1,710$ 18% 1 Electronic Arts 2,356$ 20%2 Activision (Corp) 1,583$ 17% 2 Activision Blizzard (Corp) 1,954$ 17%3 Nintendo of America 1,382$ 15% 3 Nintendo of America 1,943$ 17%4 Microsoft (Corp) 653$ 7% 4 Take 2 Interactive (Corp) 737$ 6%5 Ubisoft 578$ 6% 5 Ubisoft 631$ 5%6 THQ (Corp) 473$ 5% 6 THQ (Corp) 443$ 4%7 Take 2 Interactive (Corp) 468$ 5% 7 Microsoft (Corp) 417$ 4%8 Sony (Corp) 417$ 4% 8 Sony (Corp) 394$ 3%9 Vivendi (Corp) 260$ 3% 9 Lucasarts 355$ 3%10 Sega of America 221$ 2% 10 Sega of America 340$ 3%11 Disney Interactive Studios 193$ 2% 11 Konami Digital Ent. 265$ 2%12 Lucasarts 167$ 2% 12 Disney Interactive Studios 218$ 2%13 Namco Bandai Games of America ( 154$ 2% 13 Namco Bandai Games of America ( 207$ 2%14 Konami Digital Ent. 150$ 2% 14 Midway 157$ 1%15 Capcom USA 124$ 1% 15 Square Enix Inc (Corp) 132$ 1%16 Midway 102$ 1% 16 Bethesda Softworks 123$ 1%17 Eidos Interactive (Corp) 92$ 1% 17 Capcom USA 103$ 1%18 Atari 91$ 1% 18 Warner Interactive 94$ 1%19 Square Enix Inc (Corp) 81$ 1% 19 Atari 85$ 1%20 Majesco 65$ 1% 20 Majesco 83$ 1%

All Others 523$ 6% All Others 638$ 5%9,488$ 100% 11,675$ 100%

20082007

Distributors Distribution refers to the warehousing, handling, and transporting of games from a publisher to a retailer’s shelves. Each major publisher distributes its own games to the largest retailers, and many distribute their own games to all retailers. Some publishers also use their own distribution assets to distribute games for other smaller publishers–referred to as “third-party” distribution. The major hardware companies also distribute the bulk of their software directly to retailers. National distributors, such as Ingram Micro and Handelman, provide third-party distribution services to the smaller publishers and also provide the larger publishers with access to small “mom & pop” retail outlets. The industry trend this decade has moved away from third-party distribution as publishers seek to capture a greater portion of the software value chain. We estimate that third-party distribution declined from approximately 50% of the retail market to less than 15% of the retail market over the last 10 years. We estimate that distribution accounts for approximately 5 – 10% of the retail price of a video game, whether captured internally by a publisher or paid to a third-party distributor.

It is important to distinguish “distribution” from “co-publishing”. In the former case, the distributor arranges for the placement of a publisher’s product in a particular territory; in the latter, the “co-publisher” places its name on the packaging as if the game were created by it, and is responsible not only for distributing the game but for all associated marketing expenses. Co-publishers typically receive close to 30% of


revenues from a game, and operating margins are typically 10 – 15% after factoring in marketing expense. Examples of co-published games are Electronic Arts’ Rock Band, Activision’s Doom and Take-Two’s Elder Scrolls Oblivion.

Retailers Video games are sold primarily through mass-market retailers such as Wal-Mart, Best Buy and Target (over 50% of total U.S. sales) and through specialty retailer GameStop, which has around 25% U.S. market share. The balance of game sales take place at other toy and electronics retailers, as well as at other retail outlets and online (Amazon has around 3% of the market). Figure 2 illustrates our estimates for retailer market share of U.S. sales in 2007 and 2008, reflecting sales of console, handheld and PC games. Console and handheld games comprised approximately 94.8% of the U.S. software market in 2008 (up from 86.5% in 2005), while PC games totaled approximately 5.2%. We expect console and handheld games to capture 95.5% of the software market in 2009.

The retail environment for entertainment software has trended toward mass-market retailers over the last several years. It is now common to see a sizeable video game department within every destination retailer. We estimate that retail margins for new games are 20% (not including vendor allowances), with higher margins on lower priced “budget” or “value” titles. In the past, retail margins were as high as 30% on all games, but since the introduction of the PS2 in 2000, software margins have compressed. Overall retail margins for the video game category (reflecting the mix of hardware, software, and accessories) can range from 15 – 25%, trending toward the low end of the margin range early in the console cycle (shortly after the introduction of new hardware), with margins expanding as the installed base grows. This is attributable to a shift of product mix from a high percentage of hardware at high prices and low margins (around 6 – 10%, including warranty revenue) early in the cycle to a lower percentage as hardware prices decline and console sales flatten. In addition, over the life of the console cycle, the amount of older “value” titles and used software available allows retailers to capture incremental margins as high as 50%, driving up average selling margins.

Specialty retailers have developed a competitive advantage over the mass merchants due to their ability to offer a large number of used games to consumers. We estimate that the market for used video games is approximately $2 billion in the U.S. and around $500 million in Europe, with retailer GameStop capturing over 90% market share in the U.S. Margins on used games have averaged between 45 – 50%, with some moderation toward the midpoint as GameStop has attempted to turn its inventory faster. We believe that the total global market opportunity will approach $3.5 billion annually in the combined U.S. and European markets by 2010, and expect GameStop to capture at least 70% share, with some competition from Amazon, Best Buy, Blockbuster and Movie Gallery, as well as from several European retailers. We don’t consider any of GameStop’s competitors to be a real threat to the company’s established market share leadership, but think that the existence of competition, particularly from Amazon, could cause some downward pressure on margins.

Retail margins in Europe tend to be somewhat higher than in the U.S., with UK margins historically close to 30% earlier this decade, and continental European margins in the low 20% range. There has been some margin pressure in the UK as mass merchants have endeavored to gain market share through promotional activity,


and UK margins on new software have trended closer to 20% over the last two years.

Figure 2—U.S. Retailer Console and PC Software Market Share 2007 – 2008

2007 2008

Rank Video Game Retailer Share Rank Video Game Retailer Share1 GameStop 25% 1 GameStop 25%2 Wal-Mart 24% 2 Wal-Mart 25%3 Best Buy 14% 3 Target Stores 13%4 Target Stores 14% 4 Best Buy 13%5 Toys R Us 4% 5 Toys R Us 4%6 Circuit City 3% 6 Circuit City 2%7 Amazon.com 1% 7 Movie Gallery 2%8 K Mart/Sears 1% 8 Blockbuster 2%9 Movie Gallery 1% 9 Amazon.com 1%10 Blockbuster 1% 10 K Mart/Sears 1%

All Other 12% All Other 12%

Total 100% Total 100%

Source: Wedbush Morgan Securities estimates.


INDUSTRY SIZE: THE ADDRESSABLE MARKET OPPORTUNITY

We estimate that interactive entertainment sales totaled $44 billion worldwide in 2008, consisting of $26.4 billion in software sales and $17.7 billion in hardware sales. The nearly $4 billion Japanese software market remains challenging for non-Japanese publishers, primarily due to cultural differences, and we expect the U.S. and European publishers to continue focusing primarily on the U.S. and European markets for the foreseeable future. We estimate that the addressable market opportunity for U.S. and European packaged software publishers in 2009 is $23.5 billion, growing to over $29 billion by 2011. In addition, we estimate that the addressable market for subscription online games and game-related downloads is well over $3 billion, with U.S. and European publishers competing for as much as 70% share. We expect the subscription market to grow more rapidly than the packaged goods market, as “new” models (such as Xbox Live subscriptions, PlayStation Network, OnLive and WildTangent) are established in non-traditional gaming channels, with the market opportunity likely exceeding $5 billion by the end of the decade. Console, handheld and PC video games comprise a significant portion of overall entertainment industry sales, comparing favorably with other mainstream entertainment products such as movies, books, and music. With comparable size and growth at a faster rate than these competing forms of entertainment, we expect the interactive entertainment software sector to continue to present a compelling investment opportunity over the next five to 10 years.

GEOGRAPHIC MARKETS The interactive entertainment industry encompasses three primary geographic markets: North America, Europe/Middle East/Africa, and Japan. We expect the North American and European markets to be close to the same size in 2009 ($19.1 billion and $17.8 billion in combined hardware and software sales, respectively), followed by the smaller Japanese market ($5.7 billion). Several other large potential geographic markets exist, notably Australia, the Middle East, and South America; however, we estimate that total sales for all these markets combined amounts to less than 10% of overall interactive industry sales. The software publishers that we cover generally sell less than five percent of their products directly into these markets, and retail presence for U.S. and European based companies is minor. Figure 3 illustrates historic and forecasted interactive entertainment dollar sales by region for the three primary markets.


Figure 3—Worldwide Interactive Entertainment Sales 2004 – 2011E ($ millions)


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On average, the U.S. software publishers generate approximately 60% of their sales from the North American market and 40% from the European market, with European publisher Ubisoft generating approximately 45% of sales from the U.S. market and 55% from Europe. Japanese publisher Nintendo (the only Japanese company we cover) derives approximately 40% of its software sales from the U.S. and 40% from Europe, with the balance from Japan. European sales comprise approximately 13% PC games, 87% console and handheld games, down from a 25-75 split just three years ago; we expect further degradation of the PC game component of European sales over the next three years, with PC sales ultimately comprising less than 10% of overall packaged software sales. It is rare for a U.S. or European publisher to realize more than 5% of revenues from Japan; that market is generally closed to gai-jin content. In 2006, we estimate that industry leader Electronic Arts derived approximately 5% of total sales from Japan, with strong sales of FIFA World Cup Soccer, and we think that performance was a high water mark for the company. We think that overall Japanese sales for U.S. and European publishers declined to less than 3% of overall sales in 2007 and to around 2% in 2008. Japan has been critical to the overall growth and success of the interactive entertainment industry because it is the source of the majority of console hardware and some of the industry’s best development talent. Notwithstanding Japan’s overall importance to the market, we do not expect U.S. or European software publishers to achieve significant market penetration in Japan over the next several years, at least not until a foreign publisher acquires a going concern in Japan. We believe structural and cultural barriers in the Japanese market will preclude any U.S. or European publisher from generating significant sales in that market in the near term. We believe that the addressable market for U.S. and European publishers for the next several years will be limited to the U.S. and European markets.


Figure 4—Addressable Market for U.S. Software Publishers 2004 – 2011E ($ millions)


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Europe PC SoftwareEurope Console SoftwareN.A. PC SoftwareN.A. Console Software

HARDWARE AND SOFTWARE SALES SPLIT Of the $44 billion in interactive entertainment sales in the three primary geographic markets last year, we estimate that 40% of this amount, or $17.7 billion, was attributable to sales of dedicated game console hardware. The remaining 60% consisted of sales of console, handheld and PC entertainment software. Software for dedicated consoles comprised 41% of overall worldwide industry sales, 13% for handhelds, and 6% for PCs. Of the over $26 billion in worldwide entertainment software sales in 2008, we believe that the $23 billion from the North American and European markets defined the immediate addressable market opportunity for U.S. and European software publishers. Figure 4 illustrates our forecast of the addressable market opportunity for U.S. software publishers through 2011.

SOFTWARE VS. OTHER ENTERTAINMENT SECTORS We estimate that U.S. retail sales of interactive entertainment hardware and software totaled $19.5 billion in 2008, with software sales comprising 60% of the total. The 8.5% compound annual sales growth for software over the past 10 years has resulted in the interactive entertainment segment being among the largest sectors within the entertainment industry. In 2008, the U.S. market for interactive entertainment was larger than both the U.S. movie industry (box-office receipts) and the U.S. music recording industry. We note that total film industry revenues are much larger when VHS and DVD rentals and sales are included (we estimate that these revenues added over $22.4 billion to the total in 2008); the market for video game rentals is much smaller in comparison, at approximately $1.0 billion in 2008. The U.S. interactive entertainment industry is significantly smaller than the total book publishing industry ($24 billion); however, book publishing includes sales of reference materials and textbooks that do not compete directly for entertainment dollars. We estimate that the total sales of books intended for leisure or


entertainment amounted to over $9 billion in 2008. Figure 5 compares the size of these competing sectors of the U.S. entertainment industry in 2008, illustrating how interactive entertainment competes with the largest sectors of the entertainment industry.

Figure 5—U.S. Entertainment Sectors 2003 – 2008 ($ billions)

$-$2$4$6$8

$10$12$14$16$18$20

VideoGames

Movies (boxoffice)

Movies(rentals)

Movies(purchases)

Books* Music

2003 2004 2005

2006 2007 2008

* Includes trade, book club, paperback, and other sales.

Sources: The NPD Group/Retail Track, MPAA, AAP, RIAA, DEG, and Wedbush Morgan Securities estimates.

We expect interactive entertainment to be the fastest growing U.S. entertainment sector over the next five to 10 years. We forecast U.S. interactive entertainment software sales to grow by approximately 9% per year over the next three years, and expect hardware sales to decline by almost 25% annually, as hardware prices are expected to decline. We project that all other entertainment products sales (other than video game software, mobile game software, MMOs and digital downloads) will grow in the 0 – 2% range over the same time period. Using our projected growth rates, we forecast that the U.S. interactive entertainment industry in 2009 will continue to be larger than books, box office and music, becoming the second largest major entertainment sector in the U.S.

We note that the U.S. retail market for movie rentals and sales for home use was approximately $22.4 billion in 2008 according to Digital Entertainment Group. We estimate that $15 billion of this amount represented sales of movie and television DVDs to an installed base of approximately 95 million DVD console owners. This translated to approximately $157 in DVD software purchases for each DVD console owner, below our estimate of around $200 in game sales per U.S. current generation console, but almost three times higher than our forecast for sales of video game software for each console and handheld owner in 2008 (when last generation consoles are included). Of course, our forecast does not account for “retired” game consoles, so the figure is more likely closer to twice as high. Nonetheless, the size of the home DVD market suggests that the video game market could continue to grow at a double-digit rate for several more years. We believe that the entertainment value of interactive entertainment software makes the purchase of video games a


compelling value proposition for consumers, and expect sales growth to increase dramatically as household console penetration increases.

We also think it is important to consider video game software purchases in the context of all entertainment spending. When books, music, movies and video games are added together, total U.S. spending on entertainment content totaled over $75 billion in 2008. The portion spent on video game software, at around 15% of the total, has the potential to grow at a faster rate than any of the other entertainment categories for many years to come.


DEMOGRAPHIC TRENDS

In addition to fundamental market drivers, we expect a broadening demographic is the most important factor that will determine the size of the interactive entertainment software market. This broadening demographic includes the aging of the pre-existing video game customer, rapid growth of the teen and twenty-something population, growth of the female gamer market, penetration of the Wii among people over 40, and the increasing disposable incomes of teens and pre-teens. We believe that these demographic trends will continue to drive sales growth in both the hardware and software sectors of the industry.

WIDENING AGE DEMOGRAPHIC The primary demographic driver behind the industry’s growth is the dramatic expansion in age profile of the interactive game consumer. Video game consumers typically enter the market as children as young as six years old. In the 1970s through the early 1980s, most consumers were introduced to interactive entertainment in arcades. In the early 1980s, home consoles began to proliferate, and a group of “Atari kids” grew up playing video games at home. In the late 1980s and early 1990s, Nintendo emerged as the console manufacturer of choice, and a new generation of gamers was born. Since 1995, PCs have become prevalent in U.S. households, and an increasing number of consumers were first exposed to graphically complex video games through the PC. Internet connectivity has created yet another group of gamers who are aficionados of online games. Widespread Internet use led to broader distribution of “casual” games, with very small files available for download (often for free), and increasing penetration of flash-based casual video games. The availability of wireless downloads has created yet another market for casual games played on cell phones. Finally, the introduction of the Wii, with its innovative control mechanism, appears to have expanded the market to older consumers who have never played video games before. Once they have entered the market, video game customers typically remain market participants long after their adolescence ends, and the increasing slate of product offerings (casual games, cell phone games, Wii games, etc.) should expand the age demographic further.

The first mass-market generation of interactive consumers (and now the oldest) started playing video games with the release of the Atari home console during the late 1970s. We estimate that the age range of video game consumers in the late 1970s was approximately 8 – 20, with a mean age of 11 (or an average year of birth of 1967). Since the 1970s, succeeding generations of video game consumers have embraced more advanced game systems and complex technology. Some older consumers dropped out of the market each year, replaced by a larger number of children receiving their first DS or PlayStation consoles. The mean member of the original generation of “Atari kids” is now over 40 (with an emerging group of “Nintendads” approaching their mid-30s), and many still play games on PCs or on home consoles. We believe that the age demographic of 90% of gamers now ranges from 6 – 40, dramatically broader than the demographic of the late 1970s.

It is difficult to assess the “average” video game customer’s age. We have seen forecasts placing the average age of video gamers as high as 29, although we believe that these figures include casual gamers who play games like solitaire and backgammon on their PCs. Our best guess is that the average age of console


gamers is between 23 – 25 years old, but we think that the bell curve for game play is flattening, and that 80% of active gamers are between 8 – 35. We believe that this average age is likely to increase modestly (to around 27) once the current generation consoles have fully penetrated the market, some time in 2010 or 2011. The impact of the Wii is a wild card, as it is clear that the console’s ease of use and intuitive game play has attracted large numbers at the high and low ends of the age spectrum. We also think that greater penetration of casual and arcade-style games on the consoles (such as Xbox Live Arcade) will attract a greater number of older and younger gamers.

As the high end of the gamer age range increases, the number of overall video game consumers continues to increase. More important, in a “normal” economy, people over 22 tend to be employed, and those who are employed generally have a significant amount of disposable income. People in their 20s are also generally quite self-indulgent, and we believe that they are willing to spend a large portion of their disposable income on entertainment. As the average age of video gamers expands beyond 22, we expect to see acceleration in spending per user. This phenomenon differentiates the present console cycle from past cycles.

We see continuing expansion of the age demographic for at least another 20 years, as the oldest gamers stay interested in games well into their 60s and children continue to embrace games. Over the next ten years, we envision a generation of “Nintendads” who grew up in the 1980s playing on the Nintendo Entertainment System and who will have kids of their own playing games in the next decade. We think that these fathers (average age 35 by 2010) will enjoy playing video games with their own children, and expect this phenomenon to further expand the average age of video game consumers when it occurs. We believe that this phenomenon has already manifested itself in the widespread early appeal of the Nintendo Wii.

One of the drivers for the “stickiness” of video gaming has been the convergence of multimedia in games, with surround sound, music soundtracks, and movie footage interspersed throughout the game. We envision incremental demographic expansion as the PS3 and Xbox 360 consoles have embraced high definition as the graphics standard. Of particular importance is the cost of high definition monitors: for early adopters, the expense of the monitor has tended to accelerate the adoption of any technology that provides HD content. As prices for HD monitors decline over time, we expect household penetration to increase and HD content, including video games, to proliferate. We believe that HD, music, movie footage, and similar features appeal equally to gamers young and old, and anticipate that the market will continue to expand until the upper end of the age range is no longer able to manipulate the game controller (if there is one!). We think that Nintendo will join the HD revolution in the next two years, and will announce or launch a high definition version of the Wii (see discussion beginning on page 65).

Over the past few years, online console gaming has proliferated, further enhancing the social experience of game play. Player-vs.-player gaming through services like Xbox Live and PlayStation Network have made games far stickier than in the past, with over 35 million unique accounts opened on the two networks combined. The introduction of casual, arcade, and mobile phone games has made video gaming ubiquitous, with gamers in airports, offices, bus stops, and everywhere else. This expansion of the potential market should result in sustainable growth for software sales significantly above the GDP growth rate for at least another decade.


RAPID TEEN GROWTH The core video game consumer is an early teen to mid-20s aged male. Historically, this demographic (known as “hard core” gamers) has purchased a disproportionate number of games and formed the target audience for many of the industry’s best-selling titles, driving a proliferation of testosterone-charged games. We expect this group to continue to grow at least through the middle of the next decade. According to the National Center for Health Statistics, more than four million children were born in the U.S. every year from 1989 to 1993. This is the highest number of births over a five-year period since the baby boomer years of the 1960’s. The oldest members of this group are 20 this year, and the youngest are 16, and we expect them to drive sales of the current generation consoles in 2009 and beyond.

FEMALE MARKET Notwithstanding the historical strength of the male demographic in the interactive entertainment industry, the largest area of future growth is likely to be the female market. Over the next five years, the “casual” phase of the current video game cycle should hit its stride, with a proliferation of games that target female audiences. Some of the most popular games of the past few years have been the music-themed games Guitar Hero and Rock Band, and we note that there were several sleeper hits developed for the Wii, such as Carnival Games, Jillian Michaels’ Fitness Ultimatum and Game Party. Because of the widespread popularity of the Wii and the performance of such non-violent games, we expect to see the continuation of an overall industry trend toward games with a non-violent focus. Mass-market games are clearly the focus of most publishers, as evidenced by the success of popular titles such as: Pokemon, The Sims, and Mario Brothers. In addition, many publishers are focusing on licensed content from mass-market sources, such as Harry Potter, SpongeBob SquarePants, Simpsons, Shrek, Spider-Man, etc. As more games target the mass-market, we expect the trend toward more female gamers to continue. We estimate that over 30% of all primary gamers in households are female, up from the low teens just a few years ago. The Entertainment Software Association (ESA) estimates that female users (either primary or secondary) make up only 35% of the console market and 43% of the PC market. An increase of 5% penetration in these platform compositions by female gamers could translate into as much as $1 billion of incremental annual revenues to the industry each year.

Contributing to growth of the female gamer market is the emergence of casual online games and cell phone games. We think that these games are more socially acceptable choices for women, and their ubiquity provides demographic expansion opportunities. At the same time, advances in technology (such as the Nintendo DSi and iPhone) have allowed developers to create games that are less competitive in nature, such as Nintendogs, Super Monkey Ball and Brain Age that may have greater appeal to the female market.

INCREASING YOUTH INCOME Another positive demographic trend for the industry is increasing disposable income for children ages 8 to 14, frequently referred to as “tweens”. Tweens make up one of the largest segments of the interactive entertainment market. An indication of how pervasive interactive gaming is in the tween consciousness can be gleaned from their reading habits – the top three periodicals read by males in this age group are all gaming magazines (GamePro, Nintendo Power, and Game Informer). According to


magazine publisher information, Game Informer is the 16th highest circulation magazine in the U.S., with over 3.5 million monthly subscribers (just behind People’s 3.7 million and ahead of Time magazine). Increasing incomes of this group and their rising influence on household spending means more money spent on interactive entertainment. We believe that spending for this age group has increased 300% in the last decade (a 12% CAGR) and estimate that the 27 million tweens in the U.S directly influence more than $120 billion of family spending.

Figure 6—Primary Video Gamer by Age and Gender

Source: Entertainment Software Association

Age Range %

under 18 25%18-49 49%

50 and older 26%

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age Age 35Aver


HARDWARE PLATFORMS

Video games are played primarily on three major hardware platforms: home consoles, handheld gaming devices, and PCs, with hybrid devices such as cell phones and iPod Touch units beginning to generate significant interest and drive additional revenues. Home consoles capture the greatest share of the global interactive entertainment market. In 2008, we estimate that approximately 56% of all packaged video games on a unit basis were console games. We estimate that video games sold for the handheld and PC platforms accounted for roughly 30% and 13% of the market, respectively. Over the last five years, the console market has declined only slightly from a 61% share, and the handheld market has grown from a 15% share, while PC games have declined in market share from 24%. Over the next five years, we expect console games to capture roughly 70% of all software sales, with handhelds capturing around 20% and PCs capturing 10%.

Figure 7—2008 Video Game Software Sales Market Share by Platform Type


Home Console Handheld Console PC Software Total

North America 76% 18% 6% 100%

Europe 68% 19% 13% 100%

Japan 47% 46% 7% 100%

Worldwide 69% 22% 9% 100%

As Figure 7 illustrates, dollar sales by platform vary widely across the three primary geographic markets. Although the home console is the largest platform within all three primary markets, the degree of dominance of home consoles varies widely. In Europe, while home console software sales are strong, the market for PC software remains relatively robust, and handheld software has just begun to capture market share. We believe that this is due to slow console adoption in Eastern Europe and Scandinavia, with Western European adoption rates similar to those in the U.S. Meanwhile in Japan, home console software has lost market share, while sales of handheld software have grown dramatically. PC software barely registers in Japan, at 7% of total sales, and the U.S. has followed Japan’s lead with a precipitous decline in PC game software sales over the last several years as a percentage of overall sales. We think that Japan is the trendsetter for adoption of handheld software, and while we expect that category to grow in North America and Europe, we think that European adoption rates for console software and pricing on console software will allow that category to dominate throughout this cycle.


Market share trends in Europe should mirror U.S. sales by 2012, with each region generating approximately around 70% market share from console software sales. We expect to see PC software sales decline more slowly in 2009, due to the introduction of more online content and casual games. We note that the quality of games created for both home consoles and handhelds is now competitive with PC game quality.

The prevalence of online games should extend the life of PC gaming. The phenomenal success of World of Warcraft, with over 11 million subscribers, has led to the impending introduction of several new online games. The success of these new titles and the stickiness of WoW should affect whether the PC software market is stable over the next five years or whether it declines. We discuss the MMO market beginning on page 70.

The adoption of handheld consoles in Japan is a trend worth noting. The devices have always performed well in the region, but the increase in market share for handheld games was dramatic in 2004 through 2008, doubling from 21% to almost 46% in just a few years. The U.S. market appears to be several years behind the Japanese market in this category, with the European market catching up only slightly faster. We think that U.S. market share for handheld games may have peaked at the current 18% level, with European market share for the category peaking at the current 19%. While we don’t expect dramatic increases in the market share for handheld games, we see the category contributing significantly to overall software growth.

The following are our views and analyses of these competing platforms. We include forecasts for each platform within the specific platform descriptions and present a summary hardware forecast for the home and handheld consoles at the end of this section.

HOME CONSOLES Over the last 30 years, we estimate that more than 100 dedicated gaming consoles were introduced to the video game market. Of these various console platforms, only a handful proved economically successful. The business model of choice is a “razor-and-blade” economic model. Under this model, consoles (the razors) are sold at very low or negative gross margins with the expectation that the console manufacturers will recoup their investment by charging royalties to publishers on software produced or from online services and downloads (the blades). Because the stakes of console introduction are quite high, this model dictates that only a few consoles capture enough market share to succeed, with those that do dominating the market. The winners have historically been those manufacturers that penetrate the market most deeply while keeping manufacturing costs low. Over the last 30 years, the clear leader was Sony, with more than 130 million PS2s sold. We estimate that PS2 production costs averaged well below $100 per unit, compared to the current PS3’s $450 per unit. In the last cycle, Sony had a cost advantage over Microsoft (estimated to be more than $50 per hardware unit) that allowed Sony the luxury of competing on price.

The tables have turned in the current cycle. In late 2005, Microsoft introduced the Xbox 360 at a $299/399 price point. Sony and Nintendo launched current generation consoles in late 2006, with the PS3 priced at $499/599 and the Wii priced at $249. Microsoft wasted little time in exploiting its cost advantage, cutting the price of its Xbox 360 Pro in 2007 to $349 and again in 2008 to $299, and introducing an “Arcade” version (sans hard drive) at a $199 price point. We estimate that


Microsoft’s cost of production for the Xbox 360 Pro version (with a 60 Gb hard drive) is close to its $299 cost, and estimate that the company loses no more than $25 on its Arcade model, and makes a slight profit on its $399 Elite model (with a much larger 120 Gb hard drive).

In contrast, Sony has had difficulty keeping up in the present console cycle. The PS3 likely cost far more than its $499/599 launch price to produce, and although the price of the core model (with a relatively large 80 Gb hard drive, built-in Wi-Fi and a Blu-ray drive) is currently $399, we estimate that Sony continues to lose money on each unit sold. Although it is reasonable to conclude that the inclusion of Wi-Fi and Blu-ray (as well as a slightly larger hard drive) should justify the $100 higher price point when compared against the Xbox 360 Pro, consumers have as yet to embrace the more expensive PS3.

Meanwhile, Nintendo has dominated the present cycle, with its $249 Wii (which includes its Wii Sports game) allowing it to undercut pricing for the core models offered by its competitors. We estimate that the Wii costs under $150 to produce, and that Nintendo makes a solid profit on each unit sold.

Console Cycles Since 1985, console manufacturers have introduced new hardware technology approximately every five years. We think that practice will end in the current cycle. In the past, new hardware was referenced by the prevailing CPU technology of that era (i.e., 8-bit, 16-bit, 32-/64-bit or 128-bit console cycles). This convention is no longer used to describe the current consoles, as the architecture of the three new consoles differs markedly from prior consoles. The five-year time period that has defined each of the prior three console cycles is not coincidental: the lag in time was both a function of the time necessary to create new hardware (typically based upon manufacturers waiting for the commoditization of components) and the time necessary for hardware manufacturers to recoup their investment via software sales. Although it is likely that the leaders in each cycle (Nintendo in 1990 – 95, Sony in 1995 – 2000 and 2000 – 05) would have preferred a longer tail on the cycles, competition from upstarts (Sony in 1995, Microsoft in 2001 and 2005) triggered a rush to introduce a new console sooner than consumer demand may have justified. It is apparent that consumers didn’t crave new consoles in late 2005, given the relatively slow ramp of the Xbox 360 and continued strong demand for the PS2. In fact, the PS2 outsold the Xbox 360 or held relatively even in the U.S. until early 2008, when the Xbox 360 moved ahead for good. We think that pricing had a lot to do with the relatively slow start of the Xbox 360, given that no successful console had been priced above $300 in the past. We believe that in the past, the pace of technological advancement drove innovation in the functionality of consoles, leading manufacturers to build “better mousetraps” as soon as they were able. While consumer appetite for something new has provided support for new hardware introductions every five years, it is less apparent that consumers will be ready to support another launch in 2010, as many are just showing a desire to adopt “next generation” consoles now, a full 3 ½ years into the current cycle.


Figure 8—U.S. Console Cycles and Hardware Launches

U.S. Launch Date CPU Manufacturer Console

U.S. Life Cycle Units Sold

(mil) % Growth

Oct-85 8-bit Nintendo NES 36.3 ActualTotal 36.3

Jan-89 16-bit Sega Genesis 18.5 ActualAug-91 16-bit Nintendo SNES 20.0 Actual

Total 38.4 +6%

May-95 32-bit Sega Saturn 1.4 ActualSep-95 32-bit Sony PlayStation 30.2 ActualOct-96 64-bit Nintendo N64 18.0 Actual

Total 49.5 +29%

Sep-99 128-bit Sega Dreamcast 4.1 ActualOct-00 128-bit Sony PlayStation 2 46.0 ProjectedNov-01 128-bit Microsoft Xbox 14.3 ActualNov-01 128-bit Nintendo GameCube 11.7 Actual

Total 76.1 +54%

Nov-05 Next-gen Microsoft Xbox 360 30.0 ProjectedNov-06 Next-gen Nintendo Wii 45.0 ProjectedNov-06 Next-gen Sony PS3 28.0 Projected

Total 103.0 +35%


Figure 8 illustrates the most recent console cycles and the dominant consoles within those cycles (note that the “Units Sold” includes U.S. sales over each console’s life cycle, not just the initial five-year period).

Each prior console cycle in the U.S. resulted in increasing sales and a larger installed base. As discussed later in this report, we think that the term “console cycle” is a misnomer, insofar as it implies that this is a cyclical business. We estimate that console software sales (excluding handheld software) in the U.S. and Europe combined will rise from approximately $1.3 billion in 1990 to over $22 billion in 2011, resulting in a compound annual growth rate of almost 15%.

In the 1995 and 2000 console cycles, demand and price points for both hardware and software were relatively high, with hardware prices dropping in the second full year of each cycle. In the latest cycle (which began in 2005), price points started at unprecedented levels, with the Xbox 360 priced 33% higher than the Xbox and the PS3 priced at 200% of the PS2’s introductory price. In contrast to earlier cycles, hardware pricing held for quite a while, with the Xbox 360 remaining at $399 until mid 2007, then cut by only $50, or 12% (in contrast to a 33% price cut six months after the Xbox launched). Microsoft cut price another $50 in mid-2008. The PS3 price was cut to $399 in mid-2007 as well, but has remained there as of this writing (see figure 23 for a console price history). In contrast to other cycles, Sony and Microsoft


have offered several different SKUs for each console (five apiece for the PS3 and Xbox 360); our reference to price cuts is for the most popular models. At today’s prices of $399 and $299, the PS3 and Xbox 360 are more than double the price of their predecessor console ancestors at a similar point in the past cycle (the middle of the fourth full year of the cycle).

Price elasticity of demand dictates that lower price points will spur sales growth, as the target audience shifts toward a lower socioeconomic demographic (typically defined as “mass-market” or more casual gamers). In past cycles, console hardware sales typically peaked three years after each console’s introduction, and software sales tended to peak in the fourth year. The end of the fifth year historically marked the introduction of new console hardware, with a dramatic decline in both hardware and software sales for the older systems, as consumers tended to defer purchase decisions until they were able to acquire the current generation technology.

This cycle is different. Because it is eminently clear that no new console is planned for launch in 2010 (the fifth year of the current cycle), we do not expect hardware or software sales to peak any time soon. Rather, we expect that hardware and software sales will peak, as they have in the past, in the year prior to the introduction of a new console; this cycle, we think that will happen several years from now, if at all. Hence, we believe that the “peak” of the cycle will be in year n-1, with “n” representing the launch of a next generation console. As we believe that will not occur until 2013 or later, we calculate year n-1 as 2012 or later.

The console manufacturers have signaled this to be the case by maintaining console pricing well above historical levels three and one-half years into the current cycle. We expect hardware prices to continue to decline in future years, with consoles selling for $149 for at least a year prior to the introduction of a true next generation console.

Figure 9—U.S. Cumulative Hardware Unit Sales


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cycles and illustrates the timing of past console transitions, with a flat “tail” to the end of each cycle followed by a rapid ramp in sales for the succeeding console. We think that it is noteworthy that the ramp up of both the 32/64-bit cycle and the 128-bit cycle was steeper and more sustained than either of the prior two cycles. This suggests to us that the technological improvement of each console compared to its predecessors was more dramatic than in past cycles, drawing an ever-increasing number of consumers to the console. We do not expect the five-year trend to continue going forward, as we believe that the “law of diminishing returns” will ultimately result in smaller incremental gains in game play and graphics resolution in future generations. As the software development time and effort required to fully exploit faster microprocessors and faster graphics cards drives up the cost of game development, we expect game developers and publishers to become more selective about games produced, with a decreasing number of titles available for this generation’s consoles.

As shown from the significantly higher slope of the curve for the current cycle, we expect this cycle to last somewhat longer than past cycles. We believe that significant advances in microprocessor speeds and the amount of data that processed per cycle have advanced the art of video game publishing and substantially increased the entertainment value of the medium. In our view, the steep increase in demand for 128-bit machines was a function of better games, pure and simple. We discussed this phenomenon in our industry report entitled “Content is King,” published seven years ago, and elaborated upon it in our industry report entitled “The Great Console Cycle Myth,” published six years ago. In our 2004 report, “The Definition of Insanity”, we questioned the wisdom of a premature truncation of the 128-bit cycle in order to gain first mover advantage, and elaborated on this question in our report four years ago entitled “Field of Dreams”. Notwithstanding our concerns, Microsoft chose to introduce its current generation console, the Xbox 360, in late 2005, and sales of Xbox software declined precipitously in 2006 as a result.

Our views from the last seven years have been borne out over the first few years of the current cycle. Hardware prices held up significantly longer for the 128-bit consoles than for any predecessor console. The first price cuts for the PS2 came almost 19 months after the console was introduced (from $299.99 to $199.99), and the second price cut came 12 months later (to $179.99). The price point dropped to $149.99 a staggering 43 months after the console’s debut, and was maintained for an additional 23 months. Sony cut the price of the PS2 to $129.99 in April 2006, six months prior to the launch of the PS3, in order to maintain demand for the legacy console, and cut price to $99.99 in April 2009, a full 30 months after the PS3 launched. In contrast, the original PlayStation (a 32-bit machine) price was cut to $149.99 barely 24 months after introduction, and was further discounted at retail 48 months after launch. We calculate the average selling price for PS2s sold to be approximately $180/unit in the U.S. over the first eight plus years since launch, compared to an average price of $134 for the original PlayStation over a similar period. Even at these higher prices, we expect that by year-end, Sony will have sold 31% more PS2s worldwide than PlayStations at a similar point in the latter console’s life cycle.

We believe that Sony chose to keep the price point of the PS2 higher longer because it was generating substantial profits from hardware sales, especially after redesigning the device in late 2004. If our estimates are close, Sony generated over $500 million in gross profit from PS2 hardware sales in 2006. PS2 sales continue to be strong for the next two years, even without a price cut. Now that Sony has cut price to $99, the


PS2 is well-positioned for penetration into new geographic markets. The company is well on its way to fulfilling its stated goal of a ten-year console cycle with the PS2, and it has repeated this mantra when referring to the PS3’s potential life.

In contrast, production of the Xbox was discontinued early in 2006, fulfilling the “five-year cycle” vision for Microsoft. Unlike Sony, which has a production cost that is far lower than the wholesale price of its current generation console, Microsoft likely lost money on every Xbox produced. We think that the company focused on building and sustaining its first mover advantage in the next cycle, and chose to truncate additional losses from the current cycle.

Figure 10—U.S. Annual Hardware Unit Sales


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Historically, console transitions have been difficult for software publishers because consumers have tended to slow their purchases of existing hardware and software while waiting for the new consoles to launch. This was particularly evident and painful for software publishers in the transition from 16-bit systems to 32-/64-bit systems in 1995. That year, console and handheld software sales in the U.S. and Europe declined 35% to $2.3 billion from $3.6 billion the prior year. We believe that a key contributing factor to this decline in software sales was the level of support given to the PlayStation launch, with most U.S. and European publishers developing an inordinate number of titles for the new platform. The U.S. and European publishers learned very little from their experience in 1995, and again rushed to support the 128-bit hardware launch in 2000. Again, software sales in the U.S. and Europe declined significantly from the prior year. Sales of console and handheld software dropped from $7.2 billion in 1999 to just under $6.6 billion in 2000, a decline of 9%. Importantly, the year 2000 marked the slowing of a phenomenon experienced in 1995, where current generation (i.e., 16-bit) software sales declined by almost 50% (from over $2.5 billion to under $1.3 billion). In 2000, current generation (i.e., 32/64-bit) software sales decreased 21%, from $6.0 billion to $4.8 billion. It appears that this trend began to reverse in 2005, with current generation software sales down only 3%, and the modest decline continued in 2006 with only a 13% decline. The


modest declines are attributable to rapidly growing contribution from the handhelds, which are somewhere in between “current” and “next” generation. Increasing sales of current generation software offset declines in software sales for legacy systems in 2006, leading to overall software sales growth that year. In 2007, current generation console sales declined by only 38%, with over 45% growth in handheld and current generation software sales. This rapid shift from legacy to current generation software drove overall sales growth of 25% for the year.

Figure 10 illustrates the annual sales of hardware systems in the U.S. for the past three console cycles and our estimate for the coming cycle. Note the severe drop off in sales during the last two console transitions (1995 – 1996 and 2000 – 2001). The drop off in the most recent transition (2005 – 2006) was not as steep, as Sony continued to promote the PS2 and publishers continued to create software for the legacy platform.

The continued strength in software sales for last generation consoles was most likely due to the order of launch for the current generation consoles. Microsoft launched first, releasing the Xbox 360 in November 2005. At the time of launch, we estimate that last generation’s Xbox had only 21.8% market share in the U.S. and Europe, compared to the PS2’s 63% share. This contrasts with the launch of the PS2, where Sony had 65% market share and was first to launch. There was significant developer support for the PS2 in 2005, and it appears that only the Xbox faithful dramatically slowed their purchase habits. The 2005 decline in Xbox software sales was consistent with our forecast (we forecast a decline of 11%, and Xbox software sales declined 13%), with a relatively modest 9% decline in 2005 PS2 software sales. The early decline in PS2 software sales implied more dramatic declines in 2006, which did not materialize, likely due to significant publisher support for the PS2 platform in 2006.

The U.S. and European publishers did not repeat their past mistakes a third time. Though we expected only modest software support from U.S. and European publishers when the first of the current generation consoles was launched in 2005, the consumer appeared not to care about the limited offering on the Xbox 360, and many consumers deferred purchases of current generation software, triggering a decline in overall industry sales in 2005. Most publishers attempted to harvest investments in current generation technology throughout 2006 and 2007, allowing the publishers the opportunity to harvest profits from an extension of the past cycle. As a result, the transition between the past and current cycles was less dramatic than it was in the past.

Prior Console Transition Prior to the Xbox 360 cycle, the industry last completed a console transition between 2000 and 2002, when the generation of 32-/64-bit hardware was phased out and replaced with 128-bit technology. Figure 11 illustrates U.S. software market by platform technology over the last several years (and our forecast of the next three years), highlighting the shift in the U.S. console market from 32-/64-bit systems to the 128-bit machines.

In 2005, 128-bit software comprised 96% of total U.S. console software sales, up from 57% in 2001. 128-bit software sales dropped to 71% of total U.S. console software sales in 2006 and declined to 31% in 2007 and 14% in 2008, as publishers chased market share on current generation consoles. This contrasts with 32-/64-bit software market share of 84% in 2000 (the year of the PS2 launch), 43% in 2001, 14% in 2002 and 5.6% in 2003. The staying power of the last generation software


and corresponding slower ramp in sales of current generation console software supported higher average software selling prices for both sets of software, slightly lengthening the transition between console cycles.

Figure 11—U.S. Software Sales by Platform


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128-BIT CONSOLES As in prior console cycles, the 128-bit cycle did not generate sufficient software sales to support three successful consoles, with Sony’s PS2, Nintendo’s GameCube, and Microsoft’s Xbox all clamoring for market share. While most industry observers have generally declared Sony’s and Microsoft’s efforts successful, declaring Nintendo’s a failure, we disagree. In our view, success should be measured by profitability, and based upon that metric, only Sony was wildly successful. It is important to note that Microsoft lost billions of dollars garnering its 18% hardware market share (and 20% software market share) during the 128-bit cycle, while Nintendo was generally profitable throughout with only 17% market share. The dominant console of the 128-bit cycle was the PS2, garnering approximately 65% of worldwide 128-bit hardware unit sales through 2006 and over 67% software market share. Xbox and GameCube production ceased in 2006, giving Sony an opportunity to gain share in a declining market for current generation software sales.

Although PS2 sales in the U.S. started slowly in 2000, the sheer volume of titles available for the PS2 (which was backward compatible and allowed the playing of a large number of PlayStation One games) gave the console a huge first-mover advantage and made it the most popular choice among 128-bit machines. We believe that Nintendo’s software offering allowed it to capture a dominant market share among young gamers, keeping the company close to Microsoft in the worldwide hardware rankings. Although much was written about Nintendo’s third place position in the last console cycle, pundits frequently overlook the company’s


dominance in the handheld arena, with over 73 million Game Boy Advance hardware units sold worldwide and 27 million Nintendo DS hardware units sold at the end of 2006 (when the GameCube was discontinued). The strength from its handheld offering allowed Nintendo to remain profitable throughout the last console cycle. Nintendo-produced first party software captured the dominant share of software sales for these devices, driving its profitability. We believe Microsoft’s challenge to gain share in the 128-bit console cycle was due in large part to lack of support from Japanese software developers, compounded by the company’s late entry and its relatively light line-up of first-party software. Microsoft has clearly established itself as a long-term player in this market, and learned much from its mistakes in the last cycle. The company was better prepared for its launch of the Xbox 360 (discussed below), and has gained significant share in the current generation.

Figure 12—Console Installed Base (U.S. and Europe)


(million units) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E 2011EStation 52 57 61 62 64 64 64 64 64 64 64 64

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GameCube - 1 5 9 13 16 17 17 17 17 17 17 urrent Gen Subtotal 2 15 37 61 82 101 112 120 125 128 130 130

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Figure 13—Console Installed Base (Worldwide)

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(million units) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E 2010E 2011EStation 72 78 82 83 85 85 86 86 86 86 86 86

e/SP - 12 25 42 58 67 73 76 76 76 76 76 Si - - - - 2 10 27 52 77 96 114 130

PSP - - - - 2 9 17 27 38 51 60 69 Handheld Subtotal - 12 25 42 61 86 117 155 191 223 250 275

Station2 6 20 38 55 68 82 93 101 107 110 112 112 x - 1 6 12 19 23 23 23 23 23 23 23 eCube - 2 7 12 17 21 22 22 22 22 22 22

urrent Gen Subtotal 6 23 51 79 104 126 138 147 153 155 157 157

- - - - - - 1 8 16 26 37 49 box 360 - - - - - 1 8 15 23 30 37 44 i - - - - - - 3 18 39 59 77 93

Next-Gen Subtotal - - - - - 1 12 40 78 115 151 186

Play

GB AdvancDS/D

PlayXboGamC

PS3XWi


Sony PlayStation 2 Sony’s PlayStation 2 (PS2) hit store shelves in Japan in March 2000. Retailing for approximately $370, Sony sold nearly one million units at the Japanese launch. Sony followed with a U.S. launch of 500,000 units, retailing for $299 each, in October 2000. The company had originally anticipated shipping one million units for the U.S. launch, but due to microprocessor production problems, it scaled back initial shipments into the U.S. The company launched the PS2 in Europe in November 2000, also with a reduced initial shipment. Sony’s lowered shipments angered customers, publishers, and retailers in the U.S. and Europe, who were counting on much higher volumes for the holiday season. In particular, the U.S. and European publishers were hard hit by the low initial shipment, as many devoted an extraordinarily large portion of their development budgets to launch titles. The PS2 represented a significant technological advance over its predecessor, the PSOne, as it was capable of several multimedia functions, including DVD playback, CD audio,


as well as the potential for Internet connectivity. The company also chose to make the PS2 fully backward compatible, allowing new PS2 owners to enjoy game play from their cumulative library of PSOne games. Notwithstanding the relatively light launch, the company ramped its manufacturing capacity dramatically, selling over 14 million PS2s worldwide in 2001.

Sony enjoyed a large first-mover advantage, and the PS2 was the dominant console of the 128-bit cycle by a large measure. Sony received tremendous third-party software development support for the PS2, and we believe that this was the deciding factor in the console war this cycle. Many titles released only (or initially) for the PS2 performed quite well, such as Sony’s Gran Turismo 3: A-Spec, Gran Turismo 4, SOCOM Navy Seals I and II, and God of War 1 and 2; Square Enix’s Final Fantasy and Kingdom Hearts I and II; and Take-Two’s Grand Theft Auto 3, Grand Theft Auto: Vice City, and Grand Theft Auto: San Andreas. Figure 14 illustrates unit sales of PS2 hardware by geographic area.

Figure 14—Sony PlayStation 2 Unit Sales (2000 – 2011E)


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Until late in 2004, Sony’s strategy for competing in the console business was to generate profits from software royalties (approximately $8 per unit on average for the PS2, higher now for the PS3). Consoles were sold at a small profit, allowing Sony to gain market share and receive more software royalties once the installed base of console owners continued to purchase software. In late 2004, the company was able to redesign the PS2 and cut its manufacturing costs dramatically, while maintaining the price of the device at $149. We estimate that for the first time, Sony was able to generate substantial profits from hardware sales, with $600 – 700 million in gross profits in 2005. When the company cut the price of the console to $129 in 2006, its gross profits from hardware likely declined to around $500 million. This compares to our estimate of $1.5 – 1.6 billion in gross profit from software royalties.

We think that Sony learned a difficult lesson from its experience with the Betamax video recorder in the early 1980s—Sony’s product was technologically superior to


rival Panasonic’s VHS format, but VHS won market share by sacrificing margin and forsaking software royalties in order to drive unit sales. With the PS2, Sony embarked upon a strategy of securing wide support for its format, despite claims of technological superiority by its competitors, Nintendo and Microsoft. The company tried to do the same with the PS3 (discussed below).

Nintendo GameCube Nintendo launched the GameCube in November 2001. At the time of launch, Nintendo chose a small form factor (a cube) and chose to compete on price, with its console debuting at $199 compared to its competitors’ launch pricing of $299. In support of the GameCube, Nintendo capitalized on its internal development strength and targeted its loyal fan base, composed of players in their twenties who grew up playing Nintendo games and younger players who favored more family friendly games. Notwithstanding its oft-stated desire to appeal to hardcore gamers, Nintendo’s product offering tilted toward E-rated games. The GameCube’s appeal as a kiddie device was made more apparent given the fact that the device did not include DVD playback functionality, a more adult feature included in its competitors’ 128-bit consoles. We believe that Nintendo made several strategic errors at launch. First, it launched its console prior to the release of its most popular content, striving to “keep up” with competitor Microsoft. Second, it failed to include DVD functionality, leading to a lower price point than its competitors, and created the perception that the GameCube was an inferior device. Third, it depended too heavily on internally developed content that was high quality but skewed too far toward a younger audience. Fourth, it made its device too “cute”, giving it the appearance of a toy and appealing to younger consumers as a result. Fifth (and finally), it chose to change the format of its medium from cartridge-based to disc based, eliminating the potential for backward compatibility. Accordingly, we believe that the GameCube’s failure to capture share close to Sony’s, and failure to surpass Xbox sales is explainable. Nintendo adroitly managed to avoid these mistakes with the launch of the Wii (see our discussion below). With a strong lineup of games featuring the ever-popular Pokemon, Zelda, Metroid, Donkey Kong and Super Mario Bros. franchises, GameCube sales were solid, if not spectacular, but insufficient to allow it to rise above the number three console position worldwide, well behind the PS2 and only slightly behind the Xbox.


Figure 15—Nintendo GameCube Unit Sales (2001 – 2008)


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In essence, Nintendo “invented” the razor-and-blade business model, having competed in the video game arena since 1985 with its NES, SNES, and N64 systems and with the various iterations of Game Boy prior to entering the 128-bit console wars. In addition, the company has significant development strength, enabling it to provide exclusive content for its consoles. Also, Nintendo was able to secure modest support from Japanese third-party developers for the GameCube, notably with the Resident Evil series of games from Capcom. Figure 15 illustrates unit sales of GameCube hardware by geographic area.

Microsoft Xbox Microsoft launched the Xbox in November 2001 for a retail price of $299. With a $500 million marketing budget and agreements with more than 150 video game developers, Microsoft immediately became a major player at the outset of the last console cycle. Though the Xbox was technically superior to the PS2 and GameCube, with a significantly faster microprocessor, Microsoft had trouble capturing market share from Sony and struggled in its efforts to overcome Nintendo for second place in the console wars. Although its year late start hampered its prospects for success, we believe that a bigger problem for Microsoft was the lack of Japanese developer support for the Xbox, with very few major Japanese developers developing titles exclusively for the Xbox. We note that one of the big keys to Sony’s success during its first console cycle was the company’s ability to convince influential game companies Square and Enix (since merged) to publish their blockbuster games on the PlayStation and not on the Nintendo 64. Despite significant obstacles, Microsoft was able to capture 20% of the 128-bit console market through 2006 (a level that we consider a success for a first effort). From a standing start, Xbox hardware sales peaked at approximately 7 million units in 2004. The company matched Sony’s pricing, and cut the price of the hardware to $199 in 2002 and to $149 in 2003. Sony cut the PS2 price to $129 in April 2006, and Microsoft chose instead to discontinue the Xbox in favor of the Xbox 360.

Microsoft pioneered a strategy that differed from its predecessors—rather than being focused on the razor-and-blade business model, the company focused on driving the


home Internet connection from behind the PC in the home office to behind the television in the living room or den. This strategy was apparent from Microsoft’s laser focus on Xbox Live, its subscription service for online gaming. The company’s consistent mantra was that gaming is a social experience, and that an ever-increasing number of consumers will choose to play online against one another rather than play alone. We were skeptical at the outset, but consistent inroads made with Xbox Live Arcade and Xbox Live Marketplace suggest that the online business is much larger than we originally thought, so we changed our view.

Once the Xbox was discontinued in 2006, the number of Xbox SKUs dropped by around 75% in 2007, and new Xbox games disappeared altogether in 2008. Worldwide Xbox software sales were only $226 million in 2007 (down 77% year-over-year), and only $36 million in 2008. Figure 16 illustrates historical worldwide Xbox hardware sales by region.

Figure 16—Microsoft Xbox Unit Sales (2001 – 2007)


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Xbox 360 Microsoft released its entry this generation, the Xbox 360, in November 2005, with a simultaneous worldwide launch. The console’s technical specifications were a huge advance in graphics capability: it has three symmetrical core CPUs running at 3.2 GHz each (each over 4x faster than the Xbox CPU); a custom ATI graphics processor that allows 500 million polygons per second (faster than the then state-of-the-art PC graphics process that allowed 380 million polygons, and 4x greater than the original Xbox); 512 Mb of RAM (8x the current Xbox); and some backward compatibility. The device utilizes a DVD-ROM drive, with the now defunct HD-DVD drive as a separate accessory. The Xbox 360 was released with a deep slate of “launch” titles (available at or near the launch date), with a handful of exclusive titles developed by Microsoft Game Studios and a few third party publishers.

The Xbox 360 sold out from the day of launch through early April 2006. In part, the sell out was attributable to incredible demand for the console, and in part


attributable to lack of supply. According to company reports, Microsoft shipped 1.5 million Xbox 360 units in 2005, although according to the NPD, only 610,000 found their way into U.S. living rooms. The company stated that it sold 10 million consoles as of the end of 2007, although again, NPD figures showing U.S. sales of 4.5 million units suggest that the overall sell-through figure was likely closer to 9 million. In its most recent quarterly report, cumulative worldwide shipments have reached 30 million units, although again, the installed base in the U.S. suggests a somewhat lower figure. The initial price of the “Pro” model of the console (fully equipped with a 20 Gb hard drive) was $399.99, with an “Arcade” version (no hard drive) available for $299.99. In 2007, Microsoft introduced an “Elite” version of the console, with HDMI output, a high definition video cable, and a 120 Gb hard drive for $479.99. The company cut prices for all three versions in 2008, with the Pro version cut to $299.99, the Arcade model at $199.99, and the Elite model at $399.99. Microsoft’s monthly U.S. sales are still dominated by sales of the Pro model, with slightly more Arcade units sold compared to the Elite version.

Microsoft appears on track to selling approximately 8 – 10 million Xbox 360 units annually for the next few years. At that rate, the installed base should end up around 45 million by 2010, or more than twice the installed base of the original Xbox. As of the end of 2005 (a comparable point in the last cycle), the combined U.S. and European installed base for that generation’s hardware was only 101 million units, so Microsoft’s performance this cycle represents a significant improvement over the prior cycle. Figure 17—Microsoft Xbox 360 Unit Sales (2005 – 2011E)


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PS3 Sony released its current generation console, the PlayStation 3 (PS3), in November 2006, with a simultaneous worldwide launch. The company surprised many with a launch price of $599.99 for the 60 Gb SKU, with a 20 Gb model (since discontinued) offered for $499.99. Like the Xbox 360, the technical specifications of the PS3 were mind-numbing. The device has a 3.2 GHz “cell” microprocessor


running simultaneously over seven cores, with 512 Mb of RAM and a 550 MHz graphics processor. The improvement over the PS2 is staggering, given that the former device ran at only 295 MHz, with 32 Mb of RAM and a 150 MHz graphics processor. Sony’s console features a Blu-ray High-Definition DVD-ROM drive, allowing it to play CDs, DVDs, or high definition DVDs (not to be confused with Toshiba’s now defunct HD-DVD format).

There has been some debate about whether the PS3 is more powerful than the Xbox 360. Sony has claimed technological superiority, but Microsoft has countered that since the PS3’s memory must be allocated across seven cores compared to the Xbox 360’s three cores, the Xbox 360 will actually outperform its counterpart. Our lay view of the two devices is that both provide significantly more power than is required to run the games designed for them to date, and that the two are comparable to one another.

The more important differentiating factor, in our view, was the inclusion of the Blu-ray drive. Sony made a bet that Blu-ray would be the technology of choice for movie studios when films complete the migration from standard DVD format to HD format. Blu-ray is a partnership between Sony and Matsushita (and several others), and competed directly with the HD standard sponsored by Japanese rival Toshiba. The Blu-ray format became the de facto standard early in 2008, when Toshiba announced that it intended to discontinue its HD-DVD format. The Blu-ray format (54 Gb discs) is more than sufficient to host the most complex video game (typical files are between 1 – 4 Gb, and most file sizes are under 9 Gb—we note that the DVD format supported by the Xbox 360 will hold up to 9 Gb files). However, most films recorded in DVD format require approximately 1Gb of storage per hour of content, while most HD recordings require 6 – 7 Gb of storage per hour. Thus, once film migrates to the Blu-ray format, the disc drive included in the Xbox 360 will be unable to play HD movies. Sony’s plan was that when it prevailed in its bid to establish Blu-ray as the uniform standard for HD movies, the inclusion of a Blu-ray drive in its PS3 would potentially drive sales of the console to consumers interested in both games and HD movies. The ability to play DVDs was a factor in the early advantage enjoyed by the PS2 over the GameCube (which could not play DVDs), and helped Sony with its first mover advantage over Microsoft in the current generation.

Unfortunately for Sony, its victory in the Blu-ray/HD-DVD format wars did little to help it establish the PS3 as the dominant console early this cycle. The inclusion of a Blu-ray drive drove Sony’s cost of production at least $100 higher than Microsoft’s, and the inclusion of a Cell processor drove costs even higher. As of this writing, the least expensive PS3 is still priced at $399.99, or $100 above the Pro Xbox 360 model and $200 above the Arcade version. At the same time, Blu-ray players have come down in price to around $200, and are widely expected to come down in price further this holiday. Households without an HDTV (approximately 65% of households) do not perceive a need to switch to the Blu-ray format yet, and the spike in sales Sony (and we) expected when Blu-ray prevailed did not materialize.


Figure 18—Sony PS3 Unit Sales (2006 – 2011E)


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Wii Nintendo launched its current generation console, the Wii, in November 2006, Although observers were initially skeptical, consumers embraced the device in record numbers, and enthusiasm has continued to build. The Wii uses a DVD-ROM drive, is backward compatible with all content originally released for the N64, the Super NES, and the original Nintendo Entertainment system (through software downloads), plays all GameCube games, and is significantly more powerful than the GameCube, but not as powerful or feature-packed as the PS3 or Xbox 360. The Wii launched at a lower price than its competitors, at $249.99 (including a game), and pricing has held for the 30 months since launch.

Nintendo chose to compete with the others through innovations in game play, devising a motion-sensitive controller (the “Wii-mote”) that allows the player to interact directly with characters and items on the screen (much like a mouse). The company has a competitive advantage based upon its considerable library of high quality content, and the early success of the Wii encouraged third party development. In our opinion, the Wii has been successful due to two factors: first, it is priced significantly lower than its competitors’ products; and second, the company’s redesign of the console’s controller, a cordless remote-control-like device designed to be used with only one hand, allows for a unique style of game play that is not available from the competition. A small sensor placed near the monitor, along with an accelerometer chip and infrared pointer inside the controller, allow tracking of its position and orientation. This allows the player to manipulate the action on screen by physically moving the controller itself. For example, in Red Steel (a launch title from Ubisoft), players are able to wield an in-game sword by actually swinging the controller from side to side. Wii golf games allow players to swing an imaginary club, race cars are steered with a turn of the wrist, and guns are aimed in shooter games by pointing the controller at the target.

Coincident with the publication of this report, Nintendo is launching Wii Motion Plus, an accessory for the Wii-mote that adds a second accelerometer to the motion-sensitive control scheme. With the Wii-mote and Wii Motion Plus, golfers who tend


to slice in real life will slice in a golf game using the Wii Motion Plus; tennis players will be able to put top spin on a shot.

Nintendo’s strategy has proved brilliant. The company capitalized upon its software development strength, acknowledged an unwillingness to compete in the console wars “at any price”, and to date, has exceeded sales of the PS2 over a comparable period. Nintendo is well on its way to establishing the Wii as the best selling console of all time (the record holder is the PS2 with over 136 million cumulative consoles sold since its October 2000 launch). As we noted in our report five years ago (The Definition of Insanity), Microsoft paid a significant financial price to compete with Sony in the last cycle, and spent even more to compete this cycle (although with much better financial results). At the same time, Sony has seen its market dominance erode, generating losses from its computer entertainment division for the first time in over 12 years. Nintendo, on the other hand, leveraged its dependable revenue stream from its first party software sales and from its market dominance in the handheld arena, and endeavored to be a major player in the console wars, without feeling compelled to finish in first place. As a practical matter, the Wii’s low price point and novel game play drove Nintendo into first place in 2008, and it appears that strong sales of the device will be sustainable for years to come.

Figure 19—Nintendo Wii Unit Sales (2006 – 2011E)


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We believe that Nintendo has begun to capitalize on a demographic that is likely to emerge over the next several years: a growing number of “Nintendads”, who grew up playing Nintendo games 20 years ago, and who are just beginning to have children of their own. We think that Nintendo’s decision to make the Wii compatible with older Nintendo titles will encourage these Nintendads to play older Nintendo games and updated versions of Nintendo classics with their own children.

It now appears to us that over the long run, Nintendo will devote the resources necessary to finish in first place in the current generation. We think that even if the PS3 and Xbox 360 end up priced lower than the Wii, the company will maintain its first place position due to another factor, dual ownership of consoles. In the last cycle, many consumers purchased both a PS2 and an Xbox, largely due to the high


quality exclusive content offered on the PS2 and the better graphics and online functionality of the Xbox. In the current cycle, there have been only a few exclusive titles, and we believe that the graphics of the PS3 and Xbox 360 are sufficiently similar as to largely eliminate the need to own both. Xbox Live is still a differentiator, but Sony’s PlayStation Network had an impressive re-launch in 2008, and is gaining ground fast. Ultimately, we think that most traditional video game households will decide to own either a PS3 or an Xbox 360, and believe that most consumers who opt to purchase a second console will choose the Wii. The lower price point and innovative control scheme for the Wii flipped the order of the “second console” choice, with most households that will ultimately own two consoles choosing the Wii first.

A wild card in the current cycle is the potential for a mid-cycle product launch from Nintendo. We expect Nintendo to consider introducing a “Wii-HD” sometime in 2010, providing a console that has graphics that compare favorably to the PS3 and the Xbox 360. In our view, component costs are likely to decline sufficiently to justify such a launch, and Nintendo could offer a console that is priced competitively with its competitors’ consoles, while offering access to the extensive library of Nintendo first party content. We believe that the publishers would welcome such an introduction, as it would allow for relatively easy ports of games already produced for one of the other major consoles. We don’t expect any announcement of a mid-cycle new product until sales of the Wii begin to decline. That most likely won’t be apparent until early in 2010, and we expect a “Wii-HD” announcement as early as the E3 Expo in 2010.

WHY THIS IS LIKELY THE LAST CONSOLE CYCLE There is a commonly held misperception that consoles can only support software sales growth for a five-year period, and that current generation console software sales will drop dramatically in 2010. As is fully explained in our industry report six years ago (The Great Console Cycle Myth) we disagree with this belief. We think that the basis for this misperception is historical, as each prior generation console was replaced after five years. However, it is important to note that this pattern has occurred only four times (in 1990, 1995, 2000 and 2005). While four data points is certainly a meaningful sample, we do not think that it is statistically significant. Rather, it is clear to us that Sony learned from its past experience, and chose to defer the launch of its current generation console until 2006, notwithstanding that it ceded the first-mover advantage to Microsoft. Sony’s patience allowed it to sustain a high level of PS2 game sales, with PS2 software sales down only 30% in 2007. This compares to a 50% decline in PSOne software sales at the outset of the last cycle. Notwithstanding Sony’s strategy to use PS2 software profits to fund a slow transition to the PS3, the company stumbled with the PS3 launch, and lags in a distant third place as of this writing.

The past four transitions occurred for different reasons. The first transition occurred in 1990, when Nintendo chose to replace its 8-bit Nintendo Entertainment System (NES) with its own 16-bit Super NES. At the time, Nintendo’s first-party software dominated the available software for both platforms, and the company was in a good position to truncate the NES cycle, as consumers had few alternatives. The next transition occurred in 1995, when Sony decided to compete with Nintendo head-to-head through the introduction of its 32-bit console, the PlayStation One. Nintendo had previously announced its intention to skip development of a 32-bit console in favor of developing a 64-bit console (the N64). Sony, in an attempt to preempt


Nintendo’s technological advantage, chose to introduce its 32-bit console two years before the launch of the N64 in order to gain a first-mover advantage. In order to gain this advantage, Sony acquired first-party development capability and enlisted the support of third-party publishers (notably, Electronic Arts). These steps allowed the PlayStation to launch with a significant number of titles available, and the console attracted a large number of purchasers (over 27 million) in the two years before launch of the N64. Concern over competition led to the third console transition, in 2000, when Sony launched the 128-bit PS2, again in order to gain a first-mover advantage over Nintendo and Microsoft. Both Nintendo and Microsoft launched consoles in 2001, and although both were technologically superior to the PS2, neither console was backward compatible. Also, Sony’s pre-emptive launch ensured that it would have a leadership position in terms of the number of software titles available for the PS2 when the Xbox and GameCube were launched a year later (an advantage of over 3 to 1). We believe that Sony’s decision to include backward compatibility as a PS2 feature was one of the key reasons for the console’s dominance in the last cycle. The fourth console cycle began in 2005, with Microsoft launching its Xbox 360 late in the year in order to obtain a first-mover advantage over Sony. Microsoft’s console is a technological wonder, and its games are visually stunning, but the company’s zeal to launch a year ahead of the competition led to undersupply at retail, with an installed base of approximately 2 million four months after the worldwide launch. At the same time, Microsoft discontinued production of the current generation Xbox, limiting its potential for profitability from software royalties and ceding the mass-market opportunity to Sony.

It is important to briefly review Sony’s business model for participating in the video game product cycle. Sony has adopted a razor-and-razor blade model, whereby it sells consoles at close to its cost (the “razors”), and makes a profit on each unit of software sold for those consoles (the “razor blades”) by controlling the manufacture of the software. At the outset of the current cycle, Sony was indifferent as to whether it sold Trac-2 razor blades (PS2 software) or Mach 3 razor blades (PS3 software), so long as it maximized the total number of razor blades it sold. By extending the life of the last cycle, Sony expected to be in a position to generate maximum annual royalties. Neither Microsoft nor Nintendo exploited their respective installed bases in the same way as Sony, placing each at a competitive disadvantage. Sony continued to sell a large number of PS2s, allowing it to generate significant profits from the sale of hardware, and giving it an opportunity to slow the rate of sales decline for its legacy software while the current generation cycle is well under way. Of course, the ramp in sales of the PS3 sorely lagged the ramp of the PS2 six years earlier, eroding the competitive advantage Sony sought to gain by extending the PS2 cycle for another few years.

When the Sony PlayStation was introduced in 1995, it represented a paradigm shift in console technology. The PSOne offered an amazing 48-fold increase in information processing capability over its 16-bit predecessors, and advances in game play and graphics triggered a significant increase in the number of units sold. Worldwide, the PSOne sold over 100 million units, dwarfing the penetration of its predecessors, the Nintendo Entertainment System (NES) at 60 million units, the Super NES at 46 million units, the N64 at 30 million units, or the Sega Genesis at 26 million units.

The PS2 had even more impressive results, penetrating over 130 million households to date (according to Sony). We expect that the number of households that intend to purchase a console in the current cycle will increase by approximately 25% over the


10-year period following the last cycle’s midpoint due to a combination of increasing household affluence, aging of the target demographic, and demographic expansion by the Wii. We also expect the number of consoles per household to increase slightly over the next four years, due to the price point and differential game play offered by Nintendo’s Wii. Accordingly, by the end of 2013, we expect that more than 175 million worldwide households will own at least one current generation console.

Most consumers do not readily “abandon” their last generation consoles until a new console is purchased. Rather, these devices typically remain connected to the living room TV until replaced, albeit with decreasing annual software sales per household. We believe that the appropriate analogy is to the PC market, where individual consumers aren’t buying 3.2GHz machines for $499 at the same rate as they replaced PCs in the past because they don’t need them. Until an application exists that will compel consumers to replace their existing PCs, they won’t. We believe this analogy holds for the current generation video game consoles; until an application (game software) exists that will compel consumers to replace their existing consoles, they won’t, especially if they don’t have an HD monitor. As we believe that the “killer app” is high definition, we think that abandonment of current technology will be highly correlated to household adoption rates of HDTV, currently at around 35% in the U.S. and at around 15% in Europe. This factor appears to have benefited Nintendo so far in the current console cycle, as its Wii console does not require an HD monitor.

In the preceding paragraphs, we pointed out that the U.S. and European publishers chose to abandon the PSOne audience prematurely, instead devoting resources to the development of compelling content for the PS2. Because of a relatively thin lineup of games in 2000 and beyond for the PSOne, U.S. software sales for that platform declined from $2 billion in 1999 to $1.7 billion in 2000, $1.06 billion in 2001, and under $600 million in 2002. The drop-off in European sales was more dramatic, declining from almost $2.3 billion the prior year to $1.5 billion in 2000, $600 million in 2001, and $440 million in 2002. The U.S. and European publishers collectively captured over 65% of the PSOne software market at the time, meaning that the decision to abandon the PSOne and support the PS2 caused a decline in collective annual revenues of over $2.2 billion between 1999 and 2002. Full support of the PS2 in 2006 mitigated the decline in software sales, with combined U.S. and European sales for the platform declining only 11%, from $5.4 billion to $4.8 billion. We expect a similar long tail for the current cycle, with solid sales for several years, and only a modest decline once the “next” generation consoles are announced.

The important question is when this phenomenon will occur. As we discuss in our 2007 “Curb Your Enthusiasm” industry report, the relatively low adoption rates for current generation consoles indicates that support for the consoles will extend well beyond 2010. The economics of game development and the tremendous capital required to produce the consoles virtually compels all constituents to milk the current cycle for all that it’s worth. Sony appears to believe that the cycle will last far beyond 2010, hence its “late” introduction of the PS3 and insistence on maintaining relatively high console price points well into 2009. We think that PS3 and Xbox 360 sales will peak only when HD monitor sales peak, likely early next decade (again, Wii sales are likely to be robust and steady over the next several years). At that time, we think that the tail on the current cycle will be quite long, and much like PCs, consumers will have little reason to upgrade to yet another console until software development capability is able to harness the power of the existing hardware.


HANDHELD, PORTABLE AND MOBILE CONSOLES There is some confusion about the size of the market for handheld games. Many industry observers refer to “handheld”, “portable” and “mobile” games interchangeably, intending to describe games played on a device that can be carried. We believe that the “handheld” market consists of three distinct subsets: handheld, describing devices that offer a gaming experience designed for dedicated devices; portable, describing devices that offer a gaming experience similar to home console gaming; and mobile, describing hybrid devices that function as cell phones in addition to allowing downloads of ever more complex games.

Over the past 10 years, Nintendo’s Game Boy, Game Boy Advance and DS consoles have dominated the market for handheld or portable games (around 70% of hardware units and over 70% of software sales in 2008), generating over $4.1 billion in retail software sales last year. We expect worldwide sales of DS software over $4.1 billion in 2009. Since the introduction of the Game Boy in 1988, several companies have attempted to launch and support handheld consoles with little or no success. The most recent failure is the Nokia N-Gage hybrid cell phone and handheld gaming console, which generated total U.S. retail software sales of under $5 million since its October 2003 launch, or the equivalent of two days of sales for Nintendo handheld software. Although sales of Sony’s PSP have slowed somewhat after a very strong start, the device continues to sell well. Sony positioned the PSP as a portable device, with many games appearing on both consoles and the PSP. PSP software sales worldwide were just under $1.7 billion in 2008, and are expected to approach $1.9 billion in 2009.

Cell phone game downloads present a solid opportunity, with sales of approximately $2 billion worldwide. We do not expect overall mobile phone sales to approach the level of portable and handheld game sales over the near term, as memory and battery constraints limit mobile phone technology to simpler games. We note that with the increase in adoption of “smart” phones, games are becoming more complex and are approaching the game play found on the DS.

Game Boy Advance Nintendo launched the first widely successful handheld, the Game Boy, in 1989. After selling over 50 million of the devices and over $200 million per year in software, the company introduced the Game Boy Color in 1998. The latter device sold almost 50 million units in only three years, and software sales increased to over $1.6 billion in 2000 alone. Nintendo further improved upon its Game Boy technology with the introduction of the Game Boy Advance (GBA) in Japan in March 2001 and in the U.S. and Europe a few months later. The GBA was a giant technological step up from the older Game Boy/Game Boy Color technology, with a 32-bit processor compared to the 8-bit unit found in the Game Boy Color (GBC). The processor speed and memory in the GBA were comparable to the system specs for the Sony PlayStation. The GBA sold over 25 million units in its first two years, and generated worldwide software sales of over $1.7 billion in 2002.

In late March 2003, the company launched an improved version of the GBA, named the GBA SP (for “special”). With the GBA SP, Nintendo further improved the device design by placing a hinge in the middle of the console (a “clamshell” design allowing proper positioning of the screen and a protective cover for the screen when the device is not being used). Perhaps the most significant improvement in the GBA SP was a front-lit screen (the poorly lit GBA screen was among its biggest drawbacks). Another benefit was its rechargeable batteries, which eliminated the need to


constantly replace its predecessor’s two AA batteries. The GBA SP was compatible with all GBA and GBC software, and launched at an MSRP of $99.99, with a price cut to $79.99 in 2004. The GBA SP sold over 40 million units, and software sales peaked at just under $2.4 billion in 2004.

Nintendo constantly tinkers with its product design, and introduced a new, smaller GBA SP called the GBA Micro in 2005, with a 2¼” screen compared to the 3” screen on the GBA SP. The Micro was priced higher than the GBA SP at $99.99, and the device was intended to be “pocket” sized. The device did not have a significant impact in the marketplace.

We classify the GBA line of products as handheld devices, as opposed to portable devices. Few, if any of the games created for the GBA or for the DS (discussed below) are created in the same form for consoles, with the same level of game play. As we believe that Sony’s PSP (discussed below) has targeted a different market niche, we never expected any serious competition for the GBA/GBA SP/DS. The primary market for handheld consoles is the 8-to-12-year-old gamer and Nintendo’s software dominates this market segment. As is more fully discussed in the next section, Nintendo expanded this demographic with the DS. The company produced approximately 1/3 of all GBA software units sold, and received tremendous third-party support for the handheld platform, most significantly from THQ, which captured approximately 30% of U.S. GBA software sales. Figure 20 illustrates historical Game Boy Advance hardware sales by region.

Figure 20—Nintendo Game Boy Advance Unit Sales (2001 – 2008)


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DS Nintendo released the Nintendo DS (for dual-screen), in November 2004, and the device sold through extremely well. The DS was a departure from the GBA SP, offering two 3” front-lit screens in a clamshell design, with the lower screen activated by touch. The DS permitted developers to expand the game play experience for


handheld devices, as consumers are able to control characters with a combination of buttons, fingers, and motions of a stylus. The DS debuted at a price of $149.99, and the price dropped to $129.99 in 2005. In mid-2006, Nintendo tinkered with the DS design and introduced a “Lite” version of the product, with a brighter screen and a streamlined form factor. The DS Lite was a phenomenal success from the start, with sell through volumes double the level of its predecessor in the first ten months following launch. DS games are typically priced between $30 – 40, compared to pricing on GBA games of between $20 – 30. The DS offered full backward compatibility, allowing consumers to play over 1,200 GBA and GBC software titles. We believe that backward compatibility served to drive an inordinate number of “replacement” sales, with consumers who previously owned the GBA or GBA SP trading up to the DS. Accordingly, “tie ratios” for the device (the number of software units sold for each hardware unit) trended slightly lower for the DS than for the GBA SP in the early months following introduction. Tie ratios rebounded last year, and through March 2009, annualized U.S. tie ratios for the DS averaged around 2.1 units of software for each unit of hardware, comparable to the 2.0 tie ratio for the GBA/SP.

Figure 21—Nintendo DS Unit Sales (2004 – 2011E)


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Sony PSP

Sony launched its first portable gaming device, the PlayStation Portable (PSP) in late 2004 in Japan, followed by a March 2005 launch in the U.S., and a European launch in September 2005. The PSP is a 170 x 69mm device (approximately 6.7” x 2.7”) with a 4.3” diagonal LCD screen. The medium for game play is a UMD (universal media disc). The name UMD reflected Sony’s intentions to create a device that would play more than just video games. We also think it is important to note that the UMD is a 1.8 gigabyte capacity, 60mm disc, remarkably similar in size to the Sony MiniDisc, the company’s failed attempt to capture share of the music market. To date, there are over 450 video game titles available and hundreds of movies


available on UMD format. In addition, there are thousands of movies available for download to the PSP, stored on a Sony memory stick. Early consumer response to movie content on UMD was underwhelming, and we expect the number of movies offered in that format to decline in 2009 and beyond. However, we envision that the offering of movies available (each film is around 400 Mb) will continue to expand through downloads.

The PSP debuted for $249.99, including a bundled copy of the Spider-Man 2 movie, and this price point held for its first year. In March 2006, Sony lowered the price to $199.99, and this price point held for another year. The device is now priced at $169.99, and we do not expect another price cut until well after the PSP Go is introduced. Software for the PSP typically retails for $40, or $10 on average higher than Nintendo DS software and $15 on average higher than GBA software. We believe that royalty rates for PSP games are competitive with other formats (around $7, including manufacturing, for a full-priced game, compared to an estimated $5 for GBA games and $6 for DS games), and that development costs are low (approximately $1 million per title). This means that a modest seller can generate large margins for publishers, making a proliferation of content more likely going forward. The PSP is not backward compatible with any other Sony game device.

At E3 last month, Sony formally announced the PSP Go (after several months of rampant news leaks). The PSP Go (with a U.S. launch in October) is a slightly smaller version of the current PSP with the biggest difference being the elimination of a physical media player (no UMD), and the inclusion of 16Gb of flash memory. While the device looks promising, we believe the $249.99/€249.99 price point may limit adoption though this is another step towards digital distribution of games as all future PSP games will be available for downloading at release.

Sony’s original strategy for the PSP was its third try (following its failed attempts with both the Betamax and with the Sony MiniDisc player) to induce music publishers and movie studios to pay royalties for the privilege of placing content in a format playable only on Sony devices. The Betamax failed due to competition from the technologically inferior Panasonic VHS format, which allowed movie studios to publish royalty-free. The MiniDisc player failed for similar reasons, as music publishers did not feel particularly compelled to pay Sony for the production of discs when the CD format was universally accessible at extremely low fabrication costs. This time around, Sony failed to capture strong third party video game software support, and although it has sold a relatively large number of PSPs to the video gaming community, the device has not captured a large tie ratio for software, averaging only around 1.2 units per PSP in 2008. Should the company have greater success with its redesign (without the UMD format) Sony will likely once again approach movie studios and music publishers, this time, perhaps, with greater success.

Of course, Sony has an uphill struggle given the incredible popularity of Apple’s iPod Touch and iPhone, each of which offers downloads of both music and filmed content. We believe that in order to be competitive with the iPod or iPhone, the PSP must be enhanced by including a larger storage medium in order to allow content downloads. We expect Sony to offer this feature in future versions of the device.


Figure 22—Sony PSP Unit Sales (2004 – 2011E)


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Mobile Gaming

Nokia introduced its hybrid cell phone/video game device in late 2003, and the device failed miserably. Tiger Telematics launched its hybrid GPS/video game device, the Gizmondo, late in 2005 with similar results. These devices offered hybrid functions, and attempted to compete with cell phones, which had superior download capability and a deep slate of content available through cell service providers and dedicated mobile gaming portals.

For the last several years, we have been skeptical about the potential for mobile downloads. Initially (back in 2002), mobile devices were bandwidth, storage and battery constrained. As bandwidth has improved with 3G networks and flash memory has come down in price, there is significantly greater potential for mobile downloads today than there was even three years ago. We estimate that the U.S. market for mobile downloads was under $1 billion in the U.S. in 2006, including downloads of ring tones, wallpaper, greeting cards and games, but not including music. With the advent of smart phones (mobile devices with wireless access, built-in Internet browsers and relatively large storage capacity of 1 Gb or more), the potential for mobile downloads has increased exponentially. We estimate that the market for downloads has tripled to $3 billion in 2008, and will continue to grow this year. However, we remain skeptical about the long-term growth potential for this market.

Game downloads represent no more than two-thirds of the mobile download market. We note that industry leader EA Mobile generated estimated revenues of $180 million in 2008, largely due to strong sales of mobile games offered on the iPhone. At an estimated ASP of $4 per game, EA Mobile’s revenues equate to approximately 45 million game downloads, or over half the level of unit sales for all other portable/handheld game devices in the U.S. in 2008 (the total was 79.5 million units sold). If our estimate of $2 billion for the total mobile game download market is close, consumers are currently downloading over 500 million games annually, and EA Mobile has a 9% market share. We think that EA Mobile may grow its market share


somewhat over the next few years, with international market expansion opportunities. We also expect mobile games to continue to outsell portable/handheld software sales, given the ubiquity of Internet enabled wireless devices and the low price points for software. However, it is difficult to conceive of a world where smart phone owners download billions of games, so we question whether the mobile game download market will continue to grow much beyond another 50% or so. Considering that our forecast for U.S. portable/handheld software unit sales is still below 115 million units in 2011 at an average price point of over $20 per unit, it should be easy to understand our skepticism that the mobile games download sales will substantially surpass handheld/portable games in the foreseeable future.

We are skeptical about sustainable growth of this segment for several reasons. First, cell phones are carried primarily as communications devices, and battery life is important to most users. We think it unlikely that many consumers would risk being “out of reach” by draining the battery on their cell phones in order to complete another level of Bejeweled. Next, cell phones are somewhat memory constrained (although memory is getting cheaper all the time), limiting the complexity of games that can be downloaded. Third, bandwidth is a constraint, with more complex games taking longer to access and creating risk of glitches in the transfer. Fourth, the user interface can be a constraint, with the touch screens offered by the iPhone and BlackBerry Storm offering perhaps the most user-friendly interface, but with the control schemes of other smart phones quite game unfriendly. Fifth, and finally, we (and Apple) think that the ubiquity of devices such as the iPod could ultimately create an alternative to mobile phone games, with a shift in the business model for publishers. Apple has had early success in branding its iPod Touch as an entertainment device, and it is clear that games form one component of its plans.

Further adding to our skepticism is the business model used by most mobile content publishers. While EA Mobile and Gameloft are pure play games publishers with some notable exclusive content (such as Tetris) and access to a deep catalog of Electronic Arts and Ubisoft titles, respectively, most others are full-service mobile download publishers offering a variety of entertainment, SMS messaging, greeting cards, ring tones, ring backs, etc. The publishing side of the business has grown more competitive over the past year, with the introduction of the iPhone App Store. Apple has encouraged commoditization of the content offered, and as a result, there are thousands of titles available for download, with no easy way for consumers to find a particular title. We think that publishers will have little choice other than to sacrifice margin for market share, paying up for a spot on the App Store deck, or cutting price to as low as $0.99 in order to drive volume.

We expect the cell service providers (other than AT&T, which has a different model for the iPhone) to willingly accept higher margins in choosing among content providers, and ultimately believe that the economic rent available to the mobile content publishers will be bid away, so that only the strongest survive.

Ultimately, we do not see mobile gaming as direct competition for portable/handheld games. Rather, we see the emergence of mobile gaming as an opportunity to convert more casual gamers (primarily women) into more active gamers, much in the way that EA.com has capitalized on its Club Pogo web audience to convert users to other EA product offerings.


Figure 23—U.S. Console Price History

S o n y P S 2

O c t- 0 0 L a u n c h e d a t $ 2 9 9M a y - 0 2 C u t to $ 1 9 9M a y - 0 3 C u t to $ 1 7 9M a y - 0 4 C u t to $ 1 4 9N o v - 0 4 P S 2 S lim in t r o d u c e dA p r - 0 6 C u t to $ 1 2 9A p r - 0 9 C u t to $ 9 9

N in t e n d o G B A - N o L o n g e r In P r o d u c t io nJ u n - 0 1 L a u n c h e d a t $ 9 9M a r - 0 3 C u t to $ 7 9 , G B A S P in t r o d u c e d a t $ 9 9S e p - 0 4 G B A C u t to $ 5 9 , G B A S P C u t to $ 7 9

M ic r o s o f t X b o x - N o L o n g e r In P r o d u c t io nN o v - 0 1 L a u n c h e d a t $ 2 9 9M a y - 0 2 C u t to $ 1 9 9M a y - 0 3 C u t to $ 1 7 9M a r - 0 4 C u t to $ 1 4 9

N in t e n d o G a m e C u b e - N o L o n g e r In P r o d u c t io nN o v - 0 1 L a u n c h e d a t $ 1 9 9M a y - 0 2 C u t to $ 1 4 9S e p - 0 3 C u t to $ 9 9

N in t e n d o D SN o v - 0 4 L a u n c h e d a t $ 1 4 9A u g - 0 5 C u t to $ 1 2 9J u n - 0 6 D S L ite in t r o d u c e dA p r - 0 9 D S i in t r o d u c e d $ 1 6 9

S o n y P S PM a r - 0 5 L a u n c h e d a t $ 2 4 9M a r - 0 6 C u t to $ 1 9 9A p r - 0 7 C u t to $ 1 6 9

S e p - 0 7 P S P S lim in t r o d u c e d

M ic r o s o f t X b o x 3 6 0N o v - 0 5 L a u n c h e d a t $ 2 9 9 ( C o r e ) /3 9 9 ( P r o 2 0 G b )M a y - 0 7 N e w X b o x 3 6 0 E li te ( 1 2 0 G b ) a t $ 4 7 9A u g - 0 7 C u t to $ 2 7 9 C o r e , $ 3 4 9 P r e m iu m , $ 4 4 9 E lite O c t- 0 7 L a u n c h e d A r c a d e a t $ 2 7 9J u l- 0 8 C u t to $ 2 9 9 P r o , to la u n c h n e w P r o w / 6 0 G b a t $ 3 4 9

S e p - 0 8 C u t to $ 2 9 9 P r o w / 6 0 G b f r o m $ 3 4 9 , A r c a d e to $ 1 9 9 f r o m $ 2 7 9 ,

S o n y P S 3N o v - 0 6 L a u n c h e d a t $ 4 9 9 ( 2 0 G b ) /5 9 9 ( 6 0 G b )

J u l- 0 7 C u t to $ 4 9 9 fo r 6 0 G b , in t r o d u c e 8 0 G b a t $ 5 9 9O c t- 0 7 C u t to $ 4 9 9 fo r 8 0 G b , in t r o d u c e 4 0 G b a t $ 3 9 9

A u g - 0 8 C u t to $ 3 9 9 fo r 8 0 G b , in t r o d u c e 1 6 0 G b a t $ 4 9 9

N in t e n d o W i iN o v - 0 6 L a u n c h e d a t $ 2 4 9



MONEY FOR NOTHING Introduction Two years ago, we based our industry report, Curb Your Enthusiasm, on our thesis that several things could go wrong with the current generation console launches. This year, the launches are well behind us, and our theme has shifted focus. During 2007 and 2008, there was some measure of euphoria among investors, who apparently believed that all of the risk is behind the video game publishers. It became apparent in late 2008 and early 2009 that while a great deal of risk had been eliminated, the “good news” many expected (rapid industry growth, industry consolidation, the advent of digital downloads) are taking somewhat longer to materialize than most anticipated. In our view, investors were overly optimistic about the ramp of current generation consoles, tie ratios, alternative revenue streams from sources such as online games, the advent of in-game advertising, and the ease of delivering downloadable content.

We waited two years to issue this report, as we carefully considered how likely these expectations are to materialize. By taking twice as long as we normally do between reports, we were able to observe one large successful merger (Activision and Vivendi Games), one large failed merger (Electronic Arts and Take-Two), two companies absorbed by others (Atari and Eidos), and one company declare bankruptcy (Midway). It appears to us that after a mid-cycle transition year in 2009, video game software sales will rebound in 2010, about the same time as we see traction for ancillary revenue streams.

Video game publishers are positioned to capitalize on the increasing acceptance of digital distribution. More consumers than ever before are connected to the Internet, whether through traditional PCs, or through smart phones, handhelds, or even consoles. Both the PS3 and Wii come with built-in Wi-Fi, although both consoles have lagged far behind the Xbox 360 in convincing consumers to connect and download. However, after only a year of effort, Sony has come close to matching Microsoft in online-enabled console accounts, even though the PS3 has a much smaller installed base than the Xbox 360.

Over the next five years, we envision exponential growth of digital delivery. We have consistently believed that digital downloads would be driven by the adoption of Internet-ready devices, and now, almost four years into the current console cycle, that adoption has reached critical mass. Once the console manufacturers and publishers increase the amount of content available for download, we believe that it is only a matter of time before digital downloads become the norm.

There are several obstacles to digital delivery. First, the current generation consoles are storage constrained. The typical Xbox 360 owner has an original console (the Pro version) with a 20 Gb hard drive and an average game size of 7 Gb. The typical PS3 owner has between 60 – 80 Gb of storage, and an average game size of 7 – 15 Gb. And the average Wii owner has no hard drive, with only a flash memory accessory. Because of the storage constraint, we do not see the current installed base downloading large game files in large numbers any time soon.

Second, bandwidth is a constraint for large file sizes. Only 26% of U.S. households and under 20% of European households currently have broadband Internet, meaning long download times for large game files. We expect broadband penetration to


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accelerate over the next five years, with well over 50% of households having access to broadband by the middle of the next decade.

Third, digital files have no resale value. Because many consumers value the option to trade in games (we estimate that as many as 50% of console games in the U.S. are ultimately traded in), digital delivery will be limited to an “opt-in” service, where the purchaser will likely have the choice of a physical disc or digital delivery. This will limit the penetration of digital delivery for several years, with a likely maximum of 50% of all purchases digitally delivered in the latter half of the next decade.

Finally, there is no clear cut aggregator for digital downloads. Music downloads have services such as iTunes to provide a wide variety of content. In order to download games, it is likely that consumers will visit the Wii Shop Channel, PlayStation Network or Xbox Live Marketplace to find games. These services have expanded significantly over the last year, and it is likely that most games available for download will be available on each console manufacturer’s respective website. For PC games, services like privately-held Valve’s Steam service serve as aggregator.

We no longer think that the “winner” of the current console cycle has any relevance. Microsoft’s penetration this cycle, while already well beyond its penetration last cycle, lags leader Nintendo. As of the end of the first calendar quarter this year, Microsoft had a worldwide installed base of 25 million consoles, while Nintendo’s penetration was already at 50 million in a shorter period of time. Sony sorely lagged the others with only 19 million consoles shipped, and an estimated 17.5 million sold through at the end of March.

Instead we think that the “winners” of the current generation cycle will be those manufacturers who achieve overall profitability. It is clear, at least thus far in the cycle, that Sony’s Blu-ray DVD strategy was a drain on its early profits. The company miscalculated in building in many features that are nice to have, but which apparently were not sufficiently valued by consumers. As a result of offering a feature-rich console, Sony’s cost of production was higher than its competitors by a large measure, and it was forced to pass along the bulk of its higher costs in the form of a higher selling price. Due to its high price point, traction for PS3 sales has thus far failed to materialize.

On the other hand, the Wii, with its relatively low price point, was a smashing success out of the gate. We estimate that production costs for the Wii are well below its wholesale price point, meaning that Nintendo is able to generate a profit for every box sold. The Xbox 360, priced in-between the Wii and the PS3, has the benefit of being farther along a declining cost curve by virtue of its one-year head start, and we estimate that Microsoft is close to breakeven on each console sold. Microsoft’s Xbox Live service is likely profitable, and its games division is most certainly profitable.

Thus far in the cycle, Nintendo is making the most money, with Microsoft a distant second, and with Sony still losing money. Sony’s CEO, Sir Howard Stringer, is committed to profitability, but this commitment has so far kept PS3 prices high, with the console costing slightly more to make than its average selling price. As long as the cost of production exceeds wholesale pricing, any price cuts will serve to increase the losses generated by Sony’s game division. Every $1 in lower wholesale pricing will trigger an incremental $1 loss at Sony, at least until production costs are well below average wholesale pricing.

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suggests to us that a price cut is planned for later in the year. We note that a cut of $50 in average price will trigger a loss of $650 million annually, assuming that 13 million consoles sold is a steady state goal. Thus, until Sony is able to get its production costs substantially lower, it will have difficulty achieving profitability.

On the other side, Microsoft has made a big bet with its Xbox Live service, and views the service as a potential differentiator for the Xbox 360. Microsoft has managed to achieve a material penetration with its Xbox Live service, with over 17 million members and an estimated 11 million “Gold” members paying $50 per year to play online. We think that the $550 million in Gold fees substantially exceeds the cost of the service, and estimate that Microsoft generates at least 50% operating profits on this figure. Should the company be able to maintain or grow its installed base, it could see profits rise dramatically through game and other content downloads.

Can the Wii maintain its #1 position? Nintendo remains an enigma. Some have branded the Wii a fad, while others think it is a placeholder for consumers who ultimately intend to purchase one of the other two “next generation” consoles. We expect the Wii to outsell its competitors by a large margin for at least two years, but have difficulty predicting whether Wii demand will remain strong or will fade thereafter. We expect Nintendo to tinker with its hardware some time in the foreseeable future, likely offering high definition graphics in a future version of the console. Should it fail to do so, we think that the other two consoles will become far more competitive as prices come down.

Will the PS3 lose? Without question, Sony’s console is off to a slow start, and it may have fallen sufficiently far behind that it will not be able to recover. The price point for the PS3 remains high ($399 for the preferred model as of this writing), far above the prices for the Wii ($249) and Xbox 360 ($299), and well above comparable console prices in any prior cycle (an average of $199). Consumers have been trained to wait for console price drops, and so far this cycle, Sony has been uncooperative, with no meaningful price cuts since October 2007. Until the price of the PS3 is below $300, we do not expect sales of the console to exceed monthly sales of the Xbox 360.

We believe that it is a mistake to expect this console cycle to develop in the same way as past cycles. We expect digital distribution of content to affect the outcome of the current generation console cycle, and in the pages that follow, offer our observations. Our predictions are intended to provoke discussion, and are our best guesses as to what will happen. We have structured our discussion in terms of events that we believe may occur far in the future, and in some cases much later than commonly held perceptions. The ultimate outcome of the console wars will be impacted by a variety of factors. In addition to the emergence of digital distribution models, these include pricing, timing, competition, and most importantly, third-party support. This cycle, third parties include the movie studios and advertisers.

ONLIVE COULD CHANGE THE LANDSCAPE In mid-March, 2009, we were given a private demo of OnLive. We were blown away. The OnLive service consists of a server-based gaming platform and a simple device that compresses and decompresses the game file to allow a low latency transmission of the game from server to user’s television or PC. Game files reside on central servers, and users access the game by logging into their OnLive accounts


and playing either single-player or multi-player games. We demoed both, and the results were utterly impressive.

The secret to OnLive is its compression technology. Provided that the user has high speed Internet access, signals between OnLive servers and the user interface make the round trip journey in 80 milliseconds or less (less than 1/10 of a second). The games we demoed ran at around 25 milliseconds, according to the company. At this transmission rate, most games feel as if there is no lag whatsoever, and the game we played (Crysis) felt as if we were playing on a fully-optimized gaming PC.

It is not clear to us that OnLive will dominate any time soon, but we are confident that this breakthrough technology will ultimately be widely adopted. In our view, the “killer app” for the technology is videoconferencing, which will likely attract widespread demand and which can be bundled with Internet or telephone service at a meaningful up charge. With close to zero latency, we envision tremendous demand for OnLive as a videoconferencing service, and think that broadband Internet providers like Verizon or AT&T would find the service appealing as a way to increase penetration and revenues.

Regardless of the ultimate killer app, it is clear to us that there is a future for server-based gaming. OnLive should appeal to those households that have not yet purchased a current generation console, and if the company is able to get pricing right for its business model, it is likely that it will penetrate some portion of the tens of millions of households that have not yet adopted current technology. The trade-off between buying a new console and subscribing to the OnLive service is the perceived present value of a console (around $300, using the current price of the Xbox 360 as a proxy). If the OnLive service is priced below $5 per month (our best guess as to the trade-off between buying a new console and subscribing to a service), it is likely to succeed. If it is priced much higher, it will likely face consumer resistance.

While we think OnLive is promising as a standalone service, we think that it will likely end up part of an expanded service offering from a much larger company. Microsoft could buy OnLive (the company bought WebTV from the creators of OnLive) and integrate the service into its Internet hub strategy. Apple could buy the company as part of its AppleTV rollout. Verizon or another broadband provider could buy the company for its videoconferencing capability, and could offer games as an add-on to the videoconferencing service. The possibilities are endless, but the technology is quite appealing, and we are confident that OnLive will end up as part of the video game culture some time next decade.

THERE MAY NOT BE ANOTHER CONSOLE CYCLE (BUT LOTS AND LOTS OF CONSOLE SKUS) Conventional wisdom dictated that after a brief transition period, consumers would wildly embrace current generation console technology, and rapidly accelerating software sales growth would follow. There was a certain Field of Dreams mentality among the console manufacturers—if we build it, they (the consumers) will come. Conventional wisdom turned out to be wrong—consumers embraced “old” technology, with demand for the Wii outstripping supply for a full two years past launch, but demand for the “new” technology offered by the Xbox 360 and PS3 has sorely lagged expectations. Through May 2009, U.S. sell through of Xbox 360 and PS3 combined totaled only 23 million units, 9 million units (or 30%) behind the pace of Xbox and PS2 sales over a comparable period last cycle. Clearly, some


of the early anticipated demand for current generation technology was satisfied by the Wii, but the Wii’s output and game play is strikingly similar to the legacy consoles, with only the control scheme and price point a differentiator. Due to the phenomenal success of the Wii, cumulative sales of the three current generation consoles are running 10% above the level of combined sales in the last cycle over a similar period, but it is clear that consumers have not “wildly embraced” the current generation consoles.

To us, the cumulative sell through pattern suggests that the life cycle of current generation consoles still has years to play out. While we admire and respect Nintendo’s accomplishment in taking an insurmountable lead in the console race, it appears to us that Nintendo has done so by attracting non-traditional households to gaming. We estimate that over half of Wii households are non-traditional, meaning that they would not have bought a console but for the novelty and innovation offered by the Wii. While this is a good thing, insofar as it expands the ultimate market for video games, the early success of the Wii has created a misperception that Sony and Microsoft will never see a spike in sales, and that the Wii will dominate forever. When placed in the context of a longer console cycle than in the past, it is not clear that Sony and Microsoft should be written off.

There are several differences between this cycle and past cycles that may be sufficient to trigger an outcome that differs from conventional expectations. Perhaps the most significant difference is console pricing in the current cycle. The average console (as of this writing) is priced at $283, with the Wii maintaining its launch price of $249.99, the core Xbox 360 priced at $299.99, and the core PS3 priced at $399.99. We expect each manufacturer to cut price by $50 before year-end, so the average console price should end 2009 at $233, a full $100 higher than the average console price at a similar point in the last cycle. More importantly, the average price point at year end will remain over $200, which is widely considered the “mass market” price point for consoles.

In past console cycles, approximately 90% of ALL consoles purchased were sold at price points below $200. Consumers have been trained to wait until console prices come down, and with the Wii remaining at launch pricing for 2 ½ years and the last PS3 price cut approaching its two-year anniversary, it is clear that those consumers who have waited for a reduction are still waiting. We think that once the “next” generation consoles (the PS3 and the Xbox 360) are priced below $200, we will see a dramatic increase in unit demand.

Another factor affecting the adoption of the Xbox 360 and PS3 is the penetration rate of HDTV. Approximately 40% of U.S. households and 20% of European households have purchased HDTVs, limiting the size of the addressable market that can appreciate the stunning graphics capability of the Xbox 360 and PS3. The global recession has limited HDTV adoption, but we expect a rapid increase in the rate of adoption between now and the end of 2010. If this increase in adoption rates coincides with intelligent price reductions for the Xbox 360 and PS3, we expect to see a similarly rapid increase in console sell through. Our industry growth model forecasts a modest increase in combined Xbox 360/PS3 console sales in the U.S. and Europe, from 14.7 million in 2008 to 15.9 million in 2009 and to 16.6 million in 2010. Should price cuts be deeper than we expect, these adoption rates could increase faster than we have forecast.

In summary, fewer people will buy consoles at high prices than will buy them at low prices. At the outset of the current cycle, we think that many industry


observers believed that “hardcore” gamers had deep pockets, and would line up to pay any price for a current generation machine. The launch of the PS3 in Europe demonstrates the limits on this thesis, with over 600,000 units sold in just three days, followed by a drop off to 100,000 units over the succeeding week. It is clear that people considered $599 for a PS3 expensive.

Of course, nobody should expect console pricing to remain high forever. Another fallacy in conventional wisdom was the belief that a slow start means a slow finish. To paraphrase Sir Isaac Newton, what starts out high priced, must come down. While we do not expect rapid price cuts for the current generation consoles, we do not expect them to remain at twice the price points of the last generation consoles forever. Instead, we expect regular price cuts for the PS3, and believe that the console will ultimately be priced at the “magic” price point of $99. However, a cut in price to this level requires that Sony achieve dramatic manufacturing economies, and may take five years or more to materialize. Because we believe price cuts for all three consoles are inevitable, we think that consumer demand for all three will grow over time.

The solution to console pricing is in the manufacturing, with console redesigns driving cost savings for the manufacturer. In prior cycles, we saw two PSOne SKUs and two PS2 SKUs, with only one Xbox SKU. Thus far in this cycle, we have seen five PS3 SKUs and five Xbox 360 SKUs, and we expect another PS3 SKU later this year (the rumored PS3 Slim). Manufacturers have a huge incentive to redesign their consoles to use less expensive components. At the same time, the potential for downloading digital content has grown in inverse proportion to the cost of storage, so we should expect to see ever-increasing hard drives in the new console SKUs. Many expect Microsoft to offer a completely new Xbox 360 in late 2010 (with the launch of Project Natal); we would not be surprised to see a terabyte of storage offered as standard fare by the end of next year.

The endgame for the console manufacturers is the re-positioning of their devices as Internet and Entertainment hubs in the living room. Microsoft is farthest along, creating access points for Netflix, Facebook, Last.fm and Twitter via its Xbox Live dashboard. Sony and Nintendo each have a built-in web browser, with access through a keyboard peripheral, but these browsers are not widely used, and are certainly not accessible to the technologically unsophisticated. With the advent of new console SKUs, we envision the migration of the boxes into multi-media devices, with games, Internet access, IPTV, DVRs, and VOD for movies and TV built in.

DIGITAL DOWNLOADS ARE HERE AND NOW We think it will take several years until digital downloads of complete console games becomes a reality. However, Nintendo has already begun downloads of its retro classics, while Microsoft has built a sizeable business with downloads of arcade games through its Xbox Live Arcade. The core PS3 SKU has a 80 Gb hard drive, while the core Xbox 360 has a 60 Gb hard drive. Game files are typically between 7 – 10Gb in size, so the average current generation console owner would have capacity for only a handful of games through download. As hard drives get larger with each new console SKU, it is likely that we will see an acceleration of digital downloads of full games, pressuring the retail packaged goods model.

Games that are downloaded do not have a physical disc that can be traded in at the local GameStop. The number of games traded annually is striking; we estimate the overall used game market to be $2 billion in the U.S., with an average ticket of


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around $20 per used game. This means that an estimated 100 million units of used games are traded in each year, representing around 1/3 of all games sold annually. Thus, the option value of trading a game is quite high, and we can only surmise that 1/3 of game consumers place some measurable value on the ability to resell a game. This option is eliminated with downloads. We think that the resale option will ultimately serve to lower demand for digital downloads, and expect that packaged goods will continue to be offered over the next ten years, with migration to digital content absorbing much of the overall growth of video game sales.

Another factor limiting the likely adoption of digital downloads is the lack of portability. With a physical disc, consumers can take games to different locations (to play with others, or to loan the game to a friend). Digital downloads eliminate portability. Again, we believe that consumers will perceive some value to portability, meaning that some portion of consumers will prefer packaged products to downloads.

Until storage capacity in the installed base grows sufficiently to allow full game downloads, we expect to see a meaningful increase in sales of creeping downloads (selling a game in installments). We think that the poster child for this scenario is Grand Theft Auto IV on the Xbox 360, a game first sold in physical form, with additional levels sold periodically thereafter through downloads. Notably, after a tepid embrace of its first downloadable “episode”, Take-Two decided to offer the first and second “episodes” in a combined physical package, with the two episodes allowing full game play without the purchase of the original GTA IV game disc. This model reinforces our belief that packaged goods will capture the majority of game purchases for the next ten years.

In ten years, we envision a world where the typical console has a terabyte or more of storage, and where full game downloads are the norm. As stated above, there will always be a sizeable number of consumers who value the trade-in option and portability, and we expect those consumers to favor physical goods over digital downloads. Thus, we expect that digital downloads will represent less than 50% of total game sales ten years hence. If we’re right about game sales growing at above GDP rates for the next ten years, it is likely that by 2019, packaged goods sales will grow modestly (around 3% per year, to $30 billion in the U.S. and Europe) and that digital goods sales will grow exponentially (greater than 50% per year, to over $20 billion). These combined rates of growth suggest overall game sales growth of 8 – 9% per year for the next ten years, creating an opportunity for the publicly traded publishers to grow revenues and to dramatically grow earnings.

THE WII PLUS (HD) IS COMING (EVENTUALLY) Nintendo is smart. Very smart. The company decided to avoid cutting-edge technology, and chose not to offer a console that competes graphically or technologically with either the Xbox 360 or the PS3. Rather, Nintendo offered a completely different game play experience. Nintendo chose to build a console in the current cycle that used relatively inexpensive, commodity components, and to compete against its better capitalized rivals by changing the control scheme. Its Wii console has sold an amazing 50 million units in its first 30 months, ahead of the all-time leader, the PS2, at a similar point in the console cycle.

The company’s big gamble was on its controller innovation, allowing one-handed game play and encouraging the development of content unique to the Wii. Whether Wii owners are playing Ubisoft’s Red Steel, a shooter/adventure game where the player wields the controller as if it were a sword or a firearm, or EA’s Tiger


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Woods PGA Golf with Wii Motion Plus, the game play experience is different from the other consoles. Games such as this are not offered on the other consoles, and the unique nature of the game play afforded by the controller has driven sales of the console. Both Microsoft and Sony have announced plans to develop similar controller schemes, but it is unlikely that either will erode Nintendo’s competitive advantage.

In our view, Nintendo’s success with the Wii will last for another two years. Perhaps its biggest advantage is its deep library of first party content, including Mario, Zelda, Metroid, Pokemon and several others. Its other big advantage is its demographic focus on younger gamers. While this demographic is not likely to grow dramatically (see our discussion on demographics on 26), it is a robust group that has largely be ignored by Sony and Microsoft in their quest to capture older and more affluent gamers. We also believe that a generation of “Nintendads” has emerged that has helped Nintendo secure a sizeable niche following. Further, the innovative controller and peripherals such as Wii Fit and Wii Motion Plus have led to the development of several third-party exclusive titles, as the prohibitive cost of Xbox 360 and PS3 development limited the porting of these titles to the other consoles.

If Nintendo hopes to build on its momentum thus far in the cycle, it will likely take steps to capture further market share from Sony and Microsoft when the PS3 and Xbox 360 begin to address the mass market. We expect that the PS3 will be priced below $300 some time in 2010, and that the core Xbox 360 SKU will crack the $200 barrier. We think that Nintendo is likely to release a “next” generation console of its own that is competitive with the current generation consoles offered by Sony and Microsoft at that time, in order to attract both new console owners (who have been waiting for the appropriate price to purchase a “next” generation console), and to retain those Wii owners who may consider a trade up.

Our vision is that Nintendo will wait until the cost of a console with technical specifications similar to the Xbox 360 (1080p output at 60 frames per second) is sufficiently low that it can launch close to the $199.99 price point. We would expect such a console to be fully backward compatible with the current Wii, but would expect the new console to have additional features and functionality. It is possible that Nintendo will redesign the existing Wii controller (the “Wiimote”) to include built-in Wii Motion Plus, and also possible that the Wii Plus (our best guess for the name of the Wii HD) will include a hard drive.

In our view, if Nintendo can offer such a device by year-end 2010, it will be in a position to seriously damage Sony’s chances of a comeback this cycle. We would expect publishers to support such a move, given that the cost of porting an Xbox 360 game to the new Wii Plus HD format would likely be lower than the cost of building a ground up Wii game (we estimate under $5 million). Should Nintendo be able to convince publishers like EA and Take-Two that the Wii Plus should be supported by the entire EA Sports catalog and by the next installment of Grand Theft Auto, it should be in a position to successfully convince consumers that the Wii Plus is the last console they will ever need to purchase.

Of course, the timing of such a launch will depend upon several factors, including the cost of production, the price points of its competitors’ consoles, and the willingness of publishers to support a launch. We believe that each of these factors will shift in Nintendo’s favor eventually, and are targeting fall 2010 for a Wii Plus announcement.


One factor that is likely to work in Nintendo’s favor is the rate of adoption of HD technology. Households have been slow to purchase HD monitors, and many non-HD households selected a Wii as their console of choice over the last two years.

Once Wii households switch to HDTV, consumers may consider the Wii as “old” technology (due to its standard definition output), particularly if Microsoft and Sony are successful in convincing developers to make similar games for their consoles once they add a comparable controller as a peripheral. It is hard to know whether this scenario is likely until we have more information about pricing and launch dates for Microsoft’s Project Natal and Sony’s eye-toy-like controller, so until we are able to assess the competition and the content available, we won’t know for sure.

The open question in our mind is whether the Wii’s early success will be sustainable. It is likely that due to its relative price advantage and unique game play, the Wii attracted many consumers who ultimately intend to purchase a PS3 or Xbox 360, but who either cannot afford to do so now, or who intend to wait until pricing and software support justify a purchase of one of the other two consoles. We believe it is highly likely that a large percentage of early Wii purchasers intend to ultimately own two consoles. In the last console cycle, these “two-console” households tended to purchase either the Xbox or the PS2 as their primary console, and made a later purchase of another console as the secondary console. In this cycle, we believe that two-console purchasers are buying their “secondary” console (the Wii) first, and will likely purchase their “primary” console (the Xbox 360, PS3, or the Wii Plus) later. If Nintendo hopes to capture a significant share of this substantial market opportunity, it must offer a console that is comparable to those offered by its competitors.

Nintendo has seen a more rapid sell-through profile for the Wii than for any console in history. In sharp contrast to the delayed sell-through we project for the PS3, we think it is likely that the Wii has experienced an accelerated sell-through, with as many as 50% of lifetime units sold in the first two full years following launch. It will be nearly impossible to know whether this thesis is correct until well after the fact, but the decline in Wii sales we are seeing in mid-2009 could be a signal that consumers are considering an upgrade to a competitor. If so, Nintendo is likely to offer a competitive product sooner, rather than later.

THE XBOX 360 COULD END UP A WINNER, EVEN IN THIRD PLACE Microsoft has positioned itself to thrive, securing a more dominant position this cycle through its decision to launch the Xbox 360 a full year ahead of the PS3 launch. Demand for the Xbox 360 has remained stable since launch, and we believe that Microsoft’s first mover advantage will allow it to sustain its lead over Sony in the U.S. and Europe for at least another three years. Pricing continues to be a problem for Sony, and Microsoft has managed pricing brilliantly, lowering price when it can and consistently pricing below the PS3.

In order to drive demand, the company focused upon building its Xbox Live service. The service attracted 2 million users in the last generation, or around 10% of all console owners. Microsoft recently announced that 20 million users (over 65% of 360 owners) had signed up for the Xbox Live service, consistent with the company’s vision for a completely connected gaming experience. This percentage has been consistent throughout the current cycle, and we think that it is a sustainable figure. Two-thirds of Xbox Live members pay for the privilege, paying up $50 per year to have access to online game play as Gold members. With Gold membership


comes additional perks, such as access to Netflix streaming (for Netflix members) and, later this year, access to Last.fm.

One driver behind consumer acceptance of the Xbox Live service was the expansion of the Xbox Live Marketplace. This feature allows Xbox Live subscribers to download game upgrades (microtransactions), download demos of games and movies, personalize their home pages and add pictures, and play retro classic games through Xbox Live Arcade.

Xbox Live has been a success to date, and Microsoft continues to differentiate from the free PlayStation Network offered by Sony. Under the latter service, Sony offers an open platform to encourage game development, downloadable services and content, community tools (such as live chat), and a marketplace, all free of charge. The key difference between the online services offered by Microsoft and Sony is their breadth of offering. Microsoft has diligently built Xbox Live for almost eight years, while Sony’s service is in its infancy. Microsoft’s user base is generally hardcore, and accustomed to online access of game content. Over the past year, Microsoft partnered with Netflix to allow streaming of older movies to Netflix customers who were also Xbox Live Gold members. With over 10 million members (only 1 million of whom are Xbox Live Gold members), the Netflix installed base has an incentive to purchase an Xbox 360 and to join Xbox Live. Later this year, Microsoft will add Facebook, Twitter and Last.fm applications to its dashboard. While the PS3 has an Internet browser (making it technologically capable of offering each of these services), the user interface is somewhat more difficult than the one presented by the new Xbox experience.

We expect Microsoft to gain market share, primarily at Sony’s expense, during the current cycle. Microsoft has sold 30 million consoles from its November 2005 launch through the end of March, and appears on track to sell approximately 9 million per year going forward. Sony has sold 22 million consoles since its November 2006 launch, and expects to sell 13 million consoles (a 30% increase over last year’s level) in 2009. In order to accomplish this goal, Sony must take some action to drive sales. We expect a price cut later this year, accompanied by a bundle of first party software. Going forward, we think that Microsoft and Sony will sell a similar number of consoles in the U.S. and Europe, with Sony maintaining its advantage in Japan.

The key measure of success, in our view, is profitability. Microsoft has managed to lower its production cost for the Xbox 360 to the point where it is breaking even or generating a small profit. Its Xbox Live service, while robust and costly to maintain, generates a significant profit, with an estimated 13 million Gold members worldwide paying over $600 million per year. We expect the pace of game and movie downloads to increase exponentially over the next few years, and estimate that Microsoft generates over $100 million in profit annually from downloads. We expect consumers to purchase over 90 million units of Xbox 360 software this year, generating further profitable revenues of over $1 billion.

Most importantly, we think that Microsoft has positioned the Xbox 360 to be an Internet and Entertainment hub in the living room. With the rollout of Project Natal (the new and innovative control mechanism that allows players to use their bodies as game controllers) expected in late 2010, we think that Microsoft will position itself as a centerpiece of the living room. We expect Natal to appeal to non-gamers, not as a game control mechanism, but as an Xbox Live dashboard controller. Project Natal essentially allows users to interact with the television screen by pointing, and will allow users to manage the dashboard with a swipe of their


finger. We envision the addition of Internet television, video on demand, and open Internet access over the coming years, once Microsoft has decided how best to monetize its product offering. With an installed base of 30 million and counting, Microsoft has a huge first mover advantage over competitor AppleTV for dominance in the living room. Should the company succeed in convincing consumers to use their Xbox 360s for access to other entertainment, Microsoft will be in a good position to grow its revenues far beyond those generated from gaming.

THE NEW, DIGITAL PSP IS NOT QUITE DEAD, YET, (OR IS IT?) For its first few years of existence, the media was fixated on the “battle” for portable dominance between the Sony PSP and the Nintendo DS. Now, it’s fixated on the “battle” between the iPod Touch and the PSP. The phenomenal performance of the DS made the PSP’s performance appear poor, although the PSP actually performed quite well. By the end of its fourth full year, the PSP’s installed base reached approximately 40 million units, hardly a disappointment. With the introduction of the iPhone and the iPod Touch and the availability of games through Apples App Store, the media has shifted its focus in the handheld wars to Apple, and has pronounced the PSP dead, once again.

Sony’s response is the introduction of the PSP Go, a download only device with 16Gb of internal flash memory, with a slot for a Sony Memory Stick to allow for additional storage. The PSP Go is a full-featured multi-media device, with the ability to download music, movies, television shows, and, of course, games. It is not significantly different in function from its predecessor, the PSP 3000, but differs in that it does not have a disc drive and will not play UMD-based games or movies.

Sony’s PSP software sales have been lagging, and the PSP Go appears to us to address that problem by encouraging the download of other forms of entertainment. PSP software sales were over $1.3 billion in 2006, but sales growth has stalled, with only $1.7 billion in 2008 sales. Year to date, U.S. PSP software sales (through May) are down 37%, suggesting that consumers are not carrying the device as a primary gaming platform. We believe that Sony introduced the PSP Go to reinvigorate sales, and we think that Sony is hopeful that the multi-function PSP Go will replace iPods for many consumers.

It is true that Sony’s vision of the PSP as a multimedia device has yet to come true. Sales of UMD movies were quite disappointing, with many studios withdrawing support for films in the UMD format. Similarly, the evolution of Sony’s music download service has been quite slow, and consumers have as yet to embrace the memory stick as a storage medium.

The PSP’s performance has been disappointing in the context of comparison to the DS. We expect PSP Go sales to be somewhat constrained at its $249.99 price point (compared to the PSP 3000’s price of $169.99), but expect sales to grow in inverse proportion to the price point. Once the PSP Go is priced below $150, we think that Sony may see a rebound in overall portable hardware and software sales.

THE NEW DSI WILL ADVANCE THE BRAND The new Nintendo DSi was launched earlier this year, with a slot for physical media, and with flash memory that allows users to download games and store photographs. Although the DSi is positioned as a download device, we continue to believe that Sony and Nintendo have targeted different markets with their handheld hardware. Sony appears to us to have positioned the PSP Go to appeal to an older


demographic looking for a portable entertainment experience, and Nintendo appears to have positioned the DSi to appeal to a younger demographic looking for a handheld gaming experience with some additional features (such as playful photography) that may appeal to pre-teens. In our view, there is room for both to succeed with their respective strategies. So far, Nintendo’s success with the DS has far exceeded our most optimistic expectations, and we think that the DSi is positioned to expand upon the DS demographic by appealing to somewhat older gamers.

DS sold through approximately 100 million worldwide units since 2004, becoming the best-selling handheld game device of all time. Over the last three years, Nintendo has seen annual sales of 30 million units per year, ahead of the Wii and PS2 in overall sales. The DS is one of the primary reasons we expect the current generation console cycle to be the biggest ever. For the five year period ending in 2003, global handheld software sales averaged $1.75 billion annually. Over the next five years, global handheld software sales averaged over $4.5 billion per year, with DS software sales contributing 50% of all sales. DS software is expected to generate over $4 billion in global sales this year, or 15% of all video game software sold worldwide.

The DSi is priced somewhat higher than its predecessor, debuting at $169.99. We think that the relatively high price point of the PSP Go may help Nintendo to sell DSi units, but ultimately, we believe that the hardware must come down in price if Nintendo intends to achieve its global sales forecast of 30 million units.

It is not clear whether Nintendo added download capability to the DSi in response to rampant piracy of DS software (which has been particularly onerous in Europe), or because the company intends to advance into the digital age. Perhaps the answer is some combination of both, but we see the introduction of the DSi and the PSP Go opening the door to digital downloads of full games, and believe that as soon as storage is no longer a constraint for the consoles, we will see increased downloads of full games to all gaming devices.

BLIZZARD IS THE PRESENT AND FUTURE OF ONLINE GAMING Six years ago, we said that we thought that online gaming is a joke. Five years ago, we acknowledged that online gaming is not so funny, but were still relatively unimpressed. Four years ago, we remained unimpressed, noting our belief that Microsoft’s focus on online gaming was a strategic error, while acknowledging that there is potential for online gaming to grow into a meaningful niche. Notwithstanding the remarkable success of MMOGs such as World of Warcraft, we remained convinced that the vast majority of game play will be done offline. Three years ago, we began to think that we could have been wrong (perish the thought), and acknowledged that online gaming may, indeed, have some potential. Two years ago, we acknowledged that online gaming is something to be taken seriously.

Today, we acknowledge that online gaming is real, and is here to stay. Lines between MMOGs, games played through server farms (like GameSpy), games played on Xbox Live, and games played solo while the player’s console or PC is connected to the Internet are becoming blurred. Digital content downloads are becoming prevalent, even in single-player households. “Always on” console Internet connections enable gamers to sample game demos, and even to download beta versions of new games. In addition, growth of casual Internet games has been explosive, and the quality of these games has improved dramatically. We think that as console manufacturers, publishers and consumers are offered an incentive to be


online all the time, the nature of game play and the business models for the manufacturers and publishers will undergo a dramatic shift.

For the last several years, we have questioned the potential for online gaming as a source of revenues. We now believe that the opportunity is real, but it appears to be developing differently than most expected. Many observers define “online” games as MMOGs, and expect these to grow in popularity, rivaling and even surpassing console games. In the western world, we do not see this happening. We continue to believe that MMOGs will appeal only to a relatively small niche of gamers in the Western world, perhaps approaching 20%. While there are notable U.S. and European successes online, such as World of Warcraft with about 5.5 million subscribers in the U.S. and Europe, these successes are few. Notably, WoW’s greatest potential lies in the East, with over 6 million subscribers. The rest of the MMO community consists of around 10 million active subscribers to dozens of other games. Despite the well-intentioned efforts of games like Lord of the Rings Online, Age of Conan and Warhammer: Age of Reckoning, few western games have attracted even 1 million subscribers, and the MMO opportunity appears to be destined to be dominated by Blizzard.

We expect Blizzard to capitalize on its first mover advantage, and to exploit a similar strategy with Starcraft. The company created World of Warcraft as an RPG only after enjoying phenomenal success with its Warcraft series of RTS games. It is slated to offer the second installment of the immensely popular Starcraft RTS, and we think that it is likely that history will repeat itself in late 2010 or early 2011 with the launch of a World of Starcraft MMO. Should it choose to, Blizzard can capitalize on its installed base of subscribers, servers and call centers, and can roll out a multi-million player MMO overnight. We think that a World of Starcraft MMO would certainly cannibalize World of Warcraft subscribers, but in the aggregate, we would expect the two games to attract a greater number of subscribers than WoW does today.

The area with the most explosive growth is MMOG play in Asia. While China and Korea have been relatively small markets for console games, both countries have seen dramatic growth of online gaming, with an estimated 10 million monthly subscribers to one or more MMOGs. Although subscription rates are generally lower in Asia, these subscriptions add up to a $500 – 700 million recurring revenue streams, typically by the minute. The potential for revenues through microtransactions can double the annual revenue opportunity. As the emerging middle class in China grows to a size comparable to the middle class in Europe (likely some time in the middle of the next decade), China alone may support video game sales approaching $7 billion annually. The potential of this market is too large to ignore, although most U.S. and European publishers have done a credible job of ignoring it so far.

Although we think that the publishers will largely succeed in growing overseas revenues through international expansion, we are concerned about their ability to compete with MMOGs. In our view, the global market for video games is likely to grow far beyond the $23.5 billion we have forecast for U.S. and European software sales in 2009. Should the Chinese middle class embrace video games, we think that their first experiences will be playing MMOGs, and there are few U.S. and European publishers actively participating in this genre (World of Warcraft being the large exception).


The console and handheld markets in the U.S. and Europe will provide ample growth opportunities for U.S. and European publishers over the next several years, with software sales expected to increase from over $22.5 billion in 2008 to over $50 billion by 2020. Over that same period, we conservatively expect MMOG sales in Asian markets to grow at a 25% compound annual growth rate, from an estimated $500 million to as much as $7 billion. We think that a 25% CAGR is sustainable in Asia, given the rapid emergence of the Chinese middle class, driven by GDP growth in the high single digits. We think that this potential is too big to ignore.

The market is definitely not being ignored by several Asian companies. Netease, Tencent, Perfect World, Giant Interactive, The9 Ltd., Webzen and NCSoft are all chasing this market, and given cultural differences between Western and Eastern consumers, we think that their head start may give them an insurmountable advantage if the U.S. and European publishers continue to wait for the market to develop.

Our concern about the U.S. and European publishers is long-term. Although we expect dramatic console software sales growth over the next several years, we believe that the current generation cycle may be the last. If that is true, we expect software sales growth to revert to the high single digits, reflecting combined GDP and demographic growth in the U.S. and Europe. Should the U.S. and European publishers desire to grow revenues at a higher rate, we believe that they must pursue the Asian markets. In order to access these markets, we think that they will have to offer MMOGs.

Demonstrating its commitment to maintaining its first mover advantage in Asia, Blizzard appears poised to monetize its Battle.net service. In the past, Blizzard allowed gamers to play multiplayer games like Warcraft and Starcraft against one another through a free, hosted site called Battle.net. Going forward, it appears that there is potential for Blizzard to charge for multiplayer gaming, whether through tournament entry fees or some other mechanism. The Battle.net experience is similar to multiplayer gaming on Xbox Live, and it is clear from the success of that service that gamers are willing to pay for the privilege of playing against one another. Should Blizzard attempt a subscription offering similar to Xbox Live, we could see a large bump in revenues from online gaming.

On the console front, Microsoft is the clear leader. Microsoft has over 20 million Xbox Live members around the world, and an estimated 13 – 14 million of them pay $50 annually for the privilege. This yields subscription revenues of $650 million annually from Xbox Live, with an ever-increasing revenue stream from content downloads.

We expect content downloads over the Xbox Live service to grow to an annual level of somewhere $300 – 500 million, and expect subscription revenues to grow by $50 – 100 million per year. Thus, on a single console, we envision “online” revenues, unrelated to MMOGs, of over $1 billion. Sony has rolled out its free PlayStation Network, and offers a similar experience. The PSP Go will be a download only device, and will allow users to access many forms of digital entertainment. Nintendo has as yet to develop an online offering, and may sorely lag its rivals for several years. However, the company recently launched the DSi, a new handheld that allows content downloads. The Wii Channel allows downloads of older Nintendo titles, albeit with limited storage on the console itself. With the increase in subscription revenues and content downloads, we could see total online gaming revenues on the consoles approach $2 billion in a matter of years.


Sony’s free PSN may have some potential. We think that if the online experience is free, the potential audience for online games would be several hundred million people. Once a fee is charged, we think that the potential audience drops to something closer to 15 million, and if the fee is substantial (say, $40 per month), the potential audience drops to 1 million or fewer.

Thus, we think that the area of online gaming with the greatest potential is the area of casual games. These games typically require little instruction, take several seconds to several minutes to complete, and tend to be addictive in nature. It is our view that all gamers are casual gamers, and a subset of the casual games audience likes to play hardcore games. Every gamer starts out playing simple games, and the most hardcore gamer typically advances to more complicated games over a period of years. Playing games is like anything else; proficiency requires practice.

In our view, the “hook” necessary to make online gaming ubiquitous is the development of compelling casual games. Electronic Arts has focused on this with its Pogo.com subscription service, and it has spent hundreds of millions of dollars in an effort to traverse the gap between mobile gaming and casual online gaming. Once consumers become accustomed to logging on to a website in order to play games, the lines between online and console are likely to become blurred.

In order for this to occur, the consoles must become Internet access devices. All three current generation consoles make connecting to the Internet simple.

IN-GAME ADVERTISING IS NOT A BIG DEAL For the last several years, much was expected from in-game advertising. The in-game advertising model allows advertisers to target and reach a desired demographic with dynamic ads placed within games. The publishers and console manufacturers can benefit greatly if these sources are fully exploited over the next several years, but the division of the profit pie will remain up in the air until one party or the other takes steps to exploit the opportunity.

The delivery of in-game advertising requires a persistent online connection in order for ads to be truly dynamic. Although all three current generation consoles are equipped with online capability, an online connection is not required in order to access game content. As a result, advertisers are only able to target and measure page views for those gamers who have connected their consoles to the Internet, and then only while these consumers are logged on. Microsoft has done an admirable job, with two-thirds of all consoles connected to its Xbox Live service. The company bought an in-game advertising company, Massive, in 2006, in order to facilitate the delivery of in-game ads to its Xbox Live members. Of its 20 million Xbox Live members, we estimate that 14 million are Xbox Live Gold members, most of whom are online whenever the Xbox 360 is in use. Thus, we believe that Microsoft may be able to monetize the in-game advertising opportunity more quickly than other console manufacturers or publishers.

Sony, on the other hand, has over 20 million PlayStation Network accounts, but it is not clear whether the company has the ability to deliver dynamic ads to its members in the same way that Microsoft can.

Microsoft is experimenting with the delivery of ads through some of its innovative offerings, such as 1 vs. 100. In that “game” (which is interactive, and plays like the television show), Microsoft proposes to offer full one-minute commercial breaks (similar to the television show). Because 1 vs. 100 is still in its beta phase, it is not


clear to us whether the delivery of differing ads will be targeted to specific groups of consumers, but it is clear that Microsoft has the technical expertise to do so if it chooses. Assuming that its experiment is successful, we think it is only a matter of time before Microsoft offers similar targeted advertising to publishers.

In the absence of a persistent connection, the publishers will have to rely on an alternate measurement mechanism. We believe that advertisers will be reluctant to agree to pay television-like advertising rates in the absence of proof that a gamer has actually viewed the ad delivered. For example, a gamer playing the latest Tony Hawk Ride game may tire of the experience after level 7 is completed. Advertisers who chose to place content on a billboard on level 8 would not reach this particular consumer, and would likely be unwilling to pay for the privilege of placing an advertisement within the game. As such, we think that a rate card for such a game could only be established if the publishers were able to demonstrate to advertisers that a measurable percentage of players actually viewed their ads.

We note that a company like TiVo is able to track user preferences by compelling its users to connect to the service via a once-per-day upload of program guide data. The company tracks user activity, and extrapolates from this activity to recommend other programs. If this same intelligence capability were applied in the video game context, we believe that educated guesses about consumer behavior would be close to the mark, and that in-game advertising could be both delivered and measured in such a way as to command premium advertising rates. This would be true of all games, whether single player, multiplayer, or MMOGs.

Another way to do this is to establish a Nielsen-like ratings system, whereby several thousand households opt-in to participate in having their gaming habits measured. We believe that this type of a system will be implemented before the majority of gamers are online all of the time, as we think the publishers will be motivated to make this happen.

According to dated information from Massive, in-game advertising can generate as much as $2 per unit in royalties for game publishers. This number is somewhat of a mystery, as Massive never publicly disclosed how much advertisers pay for delivering ads into game networks. Using $2 per software unit as a proxy for the value that could flow to publishers, we envision a potential market for in-game ads of approximately $500 million in the U.S. and Europe by 2011, based upon our forecast of 621 million units of software sold, with perhaps 40% of games susceptible to the insertion of ads within the game. In the event that ads are more finely targeted in the future, we could see this number increasing exponentially, as ad rates would be more closely correlated to page views and hours played than to unit sales. If measurement of user behavior improves dramatically, we could see in-game advertising throw off revenues of somewhere between $2 – 10 billion annually.

Viewed from the publisher’s perspective, in-game advertising has the potential to add significantly to margins. The large U.S. and European publishers are expected to generate operating margins of between 10% and 30% in 2009. If the average game sold has an average wholesale price of $30.10 (our model predicts a weighted average retail price of $37.62, discounted to reflect retail margin), publishers will generate operating profits of $6.02 per unit at the midpoint of the expected operating margin range. If 40% of these games are in-game ad enabled, the expected royalty across all games will be $0.80 per unit, contributing 2.7% to average operating margins.


We have not modeled a dramatic increase from in-game advertising revenues for the publishers we cover over the next three years, as we see growth from this source stalling. Ultimately, although we think that in-game advertising could total as much as $1 billion annually in the U.S. alone. However, we see little traction from the category, and note that most of the publishers we cover have stopped talking about the potential of in-game advertising revenues altogether. We think that one of the reasons for stalled growth is the inability of the publishers and console manufacturers to determine a fair split of in-game ad revenues, with advertisers remaining on the sidelines until a champion is able to develop an acceptable rate card. Until one dominant player emerges to create a business model acceptable to all (we suspect that this will be Microsoft), we think that in-game advertising will be a slow growth business.

DIGITAL DOWNLOADS WILL LIMIT GAMESTOP’S GROWTH There is a commonly held perception that used game sales limit new game sales growth, and that digital downloads will replace packaged products sales, killing off GameStop in the process. As a general rule, used game sales don’t negatively impact new games sales. The commonly held perception is that GameStop (the industry leader in used game sales, with an estimated 90% market share in the U.S.) “pushes” used games on unsuspecting customers lined up to purchase new games. This perception (perpetuated by publisher executives) has led many to conclude that GameStop’s used game business largely replaces sales of new games. We do not believe this to be true.

On the contrary, we think that used game sales benefit new game sales by providing currency to gamers with less disposable income, thereby enabling the purchase of additional games. The vast majority of used games are not traded in until the original new game purchaser has finished playing, typically well beyond the window for a full-retail priced new game sale. Thus, while there may be some limited substitution of used game purchases when GameStop employees “push” used merchandise upon consumers lined up to buy new games, the vast majority of used game purchases occur more than two months after a new game is released. Other than the potential impact at holiday (when new game lives are extended beyond the typical two month sell-through pattern), used game sales just don’t impact new game purchases very much.

To the extent that there is a substitution effect, we estimate that fewer than 5% of new game sales are impacted. By our reckoning, more than one-third of all games purchased in the U.S. end up as used games. If we’re right, then one-third of game consumers derive some currency from the trade-in of games, and if these trade-ins occur at GameStop, they should position the trade-in customer to buy more new games than he/she would otherwise normally purchase. Because the average used game value is around 20% of the new game price, we think that used game trade-ins fuel incremental sales of over 6% of total new game sales, suggesting that the cannibalization from the used game “push” is more than offset by the benefit from used game currency.

Notwithstanding our views, publishers seem determined to end the practice of used game sales, with the rush toward downloadable content a precursor to full-game downloads in the next several years. Over the last several years, we have seen an increase in the number of map packs, downloadable levels and other downloadable content available for retail sales. This “DLC” (for downloadable content) has, without question, cut into the addressable market for packaged


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products. Conventional wisdom holds that the rush to DLC is a precursor to full-game downloads, with the inevitable conclusion that once full-game downloads are offered, they will spell the end for GameStop. Publishers are interested in eliminating the potential for used game sales, and have concluded that digital files are difficult, if not impossible, to resell as used games. The publishers’ reasoning concludes that if games are downloaded, they cannot be resold, and games that are downloaded will not be purchased as packaged goods at GameStop. As more games become available for download, their availability will inevitably lead to a shift in purchase patterns away from packaged goods and in favor of download. Necessarily, any growth in game downloads will reduce the addressable market for GameStop. Many industry observers have concluded that like the music industry, the video game industry will rapidly adopt full downloads, resulting in the end of consumer retail sales of packaged goods.

Nothing could be further from the truth—Full game downloads are not imminent, and will not widely substitute for packaged goods sales until a significant portion of the installed base purchases consoles with much larger hard drives. As we discuss elsewhere in this report, average console game files are quite large, with Xbox 360 game files typically 5Gb or larger, and with PS3 games often exceeding 10Gb in size. The average Xbox 360 has a hard drive of only 20 Gb, with only a small percentage of consumers owning the “Elite” version of the console with its 120 Gb hard drive. Similarly, the average PS3 has a hard drive of 80 Gb or smaller (the preferred launch SKU was 60 Gb), meaning that very few full-game downloads could be stored by the average consumer.

We expect the console manufacturers to address limited storage capacity with the next wave of console SKUs. We expect Microsoft to launch a new version of the Xbox 360 with the introduction of Project Natal (its camera-based motion control mechanism), some time in late 2010 or early 2011. This new version is likely to have a significantly larger hard drive; we can only guess as to the size, but we expect a hard drive of 500Gb or larger to come standard with the new Project Natal Xbox 360 SKU. At the same time as hard drives get larger, we expect to see an expanded offering of full-game downloads, available at the same price as the competing packaged product, but offered through Xbox Live or the PlayStation Network. Publishers will benefit in two ways: first, full-game downloads will generate higher margins, with the console manufacturer taking an estimated 30% of the retail price instead of 20% to the manufacturer and 20% to the retailer for a packaged product sale; and second, insofar as digital downloads will not enter the market again as used games.

The increased incidence of digital downloads does not necessarily mean an end for GameStop. In our view, one of the drivers of new game sales is the perception on the part of many consumers that the game will have value when the purchaser is finished playing it. The consumer may choose to trade in the game for nominal credit at his local GameStop, or may choose to give the used game to a friend. While it is true that most gamers do not trade in games, we note that the used game business is a substantial one.

We estimate that GameStop sells around $2 billion in used games each year in the U.S. At an average retail price of $20 (to make the math simple), this represents 100 million used games that are traded in each year. Given that GameStop’s business is primarily conducted in the U.S., we think it is relevant to compare this figure to 2008 overall U.S. video game unit sales of around 270 million units. Given that used


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games can be sold more than once, the used figure we calculated represents around one-third of all new game sales on an annual basis.

We believe that the large percentage of games traded in reflects the size of the consumer market for trading in games. In other words, if one-third of all games are traded in, it is likely that one-third of all consumers value the proposition of a used game market, and are attracted to used games as a currency for new game purchases. We do not believe that this market will evaporate; rather, we think that demand for packaged products will continue, even after a substantial percentage of the installed base has upgraded to new consoles with very large hard drives.

In our view, the video game market is likely to grow at or above a 7.2% rate for the next ten years, at least doubling over that time. We envision digital downloads to account for all of the growth. The “rule of 72s” says that if demand for video game software averages 7.2% for ten years, the industry will exactly double. We think that this is highly likely, and think that digital downloads will grow exponentially during that period, limited only by the storage capacity of current consoles. We envision a world in ten years with twice as much demand for used games, but with only a constant level of packaged product sales, due to growth of digital downloads.

If we are right, GameStop is positioned to thrive for many years to come. Assuming that the company manages slowing growth effectively, GameStop should see its packaged products sales flatten over the next few years. At the same time, it should see demand for used games grow with the overall market, while the available supply of used games (which must be packaged products) stalls. Simple economics dictate that if demand for a product doubles over time, while the available supply of that product remains static, pricing must go up.

Thus, we see the potential for GameStop to generate flat new game sales, but see the company selling a similar number of used game units at ever-increasing prices over the next ten years. Should the company manage its SG&A costs effectively, it should generate profits from higher used game pricing that are sufficient to offset its escalating costs, resulting in relatively stable earnings over a ten-year period.

Therefore, notwithstanding the conventional wisdom that GameStop will be doomed by digital downloads, we think that the company may see its earnings grow for a few more years, then flatten out and remain relatively constant. Company management has downplayed the potential for digital downloads, impairing their credibility with investors, and GameStop’s multiple has suffered as a result. Once the company acknowledges that digital downloads are coming, we think that investor confidence will return to the extent that management sets out a plan to continue to grow earnings. Although not technically within the definition of our “Money for Nothing” section, we thought it appropriate to discuss the threat from used game competition in this section. Recently, several large companies have begun testing used game concepts that have been interpreted by many investors as a threat to GameStop’s market share. Amazon has begun a trade-in program (managed by a third-party fulfillment partner) where consumers are offered free postage round trip, and are offered credit for anything on the Amazon website. Wal-Mart has partnered with a third party to install kiosks at some stores that validate the disc traded in, and provide consumers a voucher that can be redeemed for cash or merchandise in the store. Best Buy is testing a concept on a limited basis similar to


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Wal-Mart’s, with kiosks in a test market and vouchers for merchandise within the store.

We do not expect any of these programs to capture significant market share for quite some time. In our view, GameStop has a real and sustainable competitive advantage due to the makeup of its “core” customer. GameStop welcomes boys under 18 to hang around in their stores and to test games, and provides a generally pleasurable experience within the store for teenagers. In contrast, Best Buy is not particularly friendly to young teens, and Wal-Mart is not a desirable place for young teens to hang out. Both Best Buy and Wal-Mart are relatively inconvenient to get to for kids without cars, while GameStop’s strip mall penetration makes them a short bike or skateboard ride away for most kids.

The key to GameStop’s competitive advantage lies in the fact that its core customer is more likely to trade in games than most other demographics. Boys under 18 are more likely to be unemployed than the core demographic at Best Buy or Wal-Mart, and are generally more self-indulgent. An unemployed 14 year-old seeking immediate gratification has few options when a “must have” game is released, other than to trade in a handful of older games. We estimate (in an unscientific manner) that around 70% of all used games traded in at GameStop are traded in by boys under 18. The other 30% is traded in by every other demographic. In our view, Best Buy and Wal-Mart will have difficulty attracting these trade-in customers (and likely do not desire them), and we therefore estimate that the addressable market for their kiosk offering is limited to “everyone else”.

Amazon is a different story. Although Amazon does not offer immediate gratification, the barriers to its ability to reach boys under 18 are lower. Anyone with an email account and a credit card (perhaps 1/3 of the GameStop trade-in clientele in the under 18 group) can be reached by Amazon. In the Amazon model, the consumer enters the games intended for trade-in, and prints out a postage-paid mailing label. Credit is posted to the consumer’s account when the discs are received in good condition. Because Amazon makes it so convenient for consumers, we think that it has some potential to capture market share.

The bigger issue for GameStop is the threat that one or more of these competitors will compete on price. Few products sold by Best Buy, Wal-Mart or Amazon generate margins as high as the 50% captured by GameStop on used games. Because each competitor’s program is in the test phase, we cannot yet determine whether any intend to compete on price. However, each has the ability to discount used games (or pay higher trade-in prices) to the point that they generate only a 30 – 40% margin. It is likely that each company’s third party partner will seek 10% or so margin, but we think that any of the companies would be happy to price at a 30 – 40% gross margin, and to generate a 20 – 30% net margin after paying its partner. We estimate that round-trip postage will cost Amazon an incremental 10%, so the company may not be willing to discount as steeply as the others. Notwithstanding, we think that should any of these companies be serious about gaining market share, discounting is likely

If one of GameStop’s competitors competes based on price, GameStop has two choices: either match pricing, or lose market share. We expect Best Buy, Wal-Mart and Amazon to capture between 5 – 10% market share over the next several years (assuming all three decide to roll the test program out). At that level, it is inevitable that some GameStop customers will notice if one or more of the competitors offers higher trade-in prices or lower used game prices. We would


expect some portion of GameStop sales to be price protected in such a case. For example, if the average GameStop transaction involves a trade-in for $10 and a subsequent sale for $20 (50% margin), we think it is likely that one or more of its competitors will offer $11 for the trade-in and charge $19 for the used game (around a 40% margin) in order to attract more merchandise and to capture market share.

The math here is a bit fuzzy, as we are dealing with a hypothetical. However, we think that a 10% margin discount is likely, and believe that such a discount will cause at least 10% of GameStop’s used game customers to seek a price match. Such a result would cause GameStop to lose 1% margin on its used business (10% discount offered to 10% of its customers). GameStop’s used business in North America is an estimated $2 billion this year, so a 1% margin hit would represent $20 million in lost pre-tax profits, or an EPS cost of around $0.08 per share. If one or more of its competitors discount by 20%, it is likely that even more customers will notice. In that case, we envision price protection of 20% offered to as many as 20% of GameStop customers, resulting in a 4% margin hit, or around $0.32 per share.

We don’t expect this to materialize overnight. In our view, the test marketing by GameStop’s competitors will last through 2009, and a widespread rollout will not occur until 2010. Our best guess is that the EPS hit will be $0.04 or so in 2010, and an incremental $0.04 – 0.08 for the next year or two, before the market stabilizes. GameStop can combat this margin hit by being more aggressive with used game promotions, sacrificing margin in favor of greater velocity of used game sales at higher overall prices. If it chooses this strategy, it can actually grow its used game gross profits, albeit at lower margins. We don’t expect a conclusion to the onslaught from competitors for several more years, and will update the used game market in next year’s report.

FREE-TO-PLAY GAMES HAVE POTENTIAL A business model has emerged in Asia that provides online game play for free to consumers, with microtransactions generating hundreds of millions of dollars for the sponsors. Perhaps the biggest cash generator of the free-to-play genre is Kart Rider, published by Nexon of Korea. The game purportedly has over 100 million players in Asia, and most of the users don’t pay anything to play. A small percentage (perhaps 5%) purchase items (such as tires and wheels) for their carts, and we have seen reports that the game has grossed over $200 million from these microtransactions in just a few years. Another popular game is Combat Arms, where players can purchase over 100 real world guns, grenades, rockets, camouflage, etc. This game is available in the West.

Companies like Electronic Arts are pursuing the Free-to-Play genre with a vengeance. EA has introduced NBA Street, FIFA Online and Battlefield Heroes in the last several months, and has several more games under development for rollout in the next few years. The company appears committed to participating in the explosive growth of this genre, particularly in Asia.

Of course, the question is “how big is this market, and when will it develop”. There is little publicly available information about the free-to-play sector, other than the occasional press release from one of the Korean or Chinese gaming companies. It is our view that the market is over $1 billion annually at present, and is growing at a rate of greater than 25%, suggesting that this will be a $3 billion or larger market by 2014. It appears to us that Electronic Arts is intent upon capturing a meaningful


share, with 5% of the market justifying the considerable development expense that the company has incurred to date.

We intend to monitor the Free-to-Play genre closely, and expand our coverage in next year’s report. Companies like Acclaim are focused on this sector, and we expect to see considerable market expansion beyond Asia in the coming year. Our “guess” about the market potential is just that, and we will monitor to see if the market is growing faster or slower than we have estimated.

MOBILE PHONE GAMES ARE A FAD For several years, industry pundits have estimated that the mobile phone game market would grow to over $10 billion, cutting into the market for handheld games. We disagree. The market for mobile phone games is likely closer to $2 billion at present, with rapid unit growth offset by ever-lower pricing for games. While it is true that Apple’s estimated 31 million iPhones and iPod Touch units have downloaded over 1 billion “apps”, it is not evident that more than 20% of these downloads are games. According to Mobclix.com, the average price for games sold through the iPhone app store is under $2, suggesting that this enormously successful platform has generated under $400 million in game downloads in its first year.

We expect mobile phone game sales to grow at 25% per year for a few years, then expect sales to cool off. As competing handsets emerge, such as the Palm Pre, we think that new “app” store models will emerge, and we expect the mobile phone game market to grow to perhaps $4 – 6 billion over the next three to five years. While this appears to be a considerable opportunity, we think that the nature of the app store, which is an Internet based open forum, may limit the ability of the major game publishers to participate. A few small private companies (notably ngmoco and Digital Chocolate) have consistently released games in the top 50 on Apple’s best seller lists. However, at last count, there were over 1000 games available for the iPhone, with several new games added each day. In order to capture market share, a publisher would have to capture the attention of consumers, either through advertising, word of mouth, or paid listing (it is not clear whether Apple accepts payment for slotting on its game dashboard).

We do not expect any publisher to dominate the mobile phone game market. In our view, Electronic Arts’ emphasis on mobile games is misplaced. The company acquired JAMDAT in 2005 for over $600 million, and while it has been able to double revenues from its EA Mobile division over the last three years to almost $200 million annually, we estimate that the division is barely profitable. Competing firms Gameloft and GLU Mobile have struggled to grow (or even to generate) profits, as competition on the iPhone is fierce. Moreover, the iPhone has a unique business model, wherein the handset maker (Apple) runs the game download service for an estimated 30% fee, leaving 70% to the game’s publisher. Most other game downloads are administered by carriers with Verizon or Sprint capturing a greater share of the retail sale. Until there is a better business model for mobile phone game downloads, we do not expect any publishers to become wildly popular.

The perception that mobile game downloads spell the beginning of the end for handheld gaming platforms is a myth, in our view. The Nintendo DS has a wealth of proprietary software, and its CPU is sufficiently sophisticated that games developed for it are more complex than the average iPhone game. While it is likely that mobile phones will include ever more powerful CPUs in the future, we don’t expect parents to purchase such phones for their young children any time in the next


five years. The average iPhone requires a data plan of over $100 per month, far above the amount that most parents are willing to pay for a child under 16 (the sweet spot for the Nintendo DS). Similarly, we think that the PSP Go, positioned as a multimedia player with a far more powerful CPU than the iPhone, will maintain its niche, without significant cannibalization of sales from mobile games.

POST SCRIPT—LESSONS NOT LEARNED FROM THE LAST CONSOLE CYCLE Chasing the new consoles—As we stated in each of our last six industry reports, Electronic Arts, Activision, and THQ managements have repeatedly stated their intention to “harvest” the last cycle through 2010. Each management team has repeatedly publicly lamented its participation in the console transition from PSOne to PS2, commenting on mistakes made in “abandoning” the PSOne in favor of the PS2. Each pledged not to make the same mistake again, and each devoted significant resources to PS2 game development well into the current cycle. At the same time, the three publishers were quite conservative with the launches of the Xbox 360, PS3 and Wii, with only a handful of titles produced at launch for each. The only publisher that “chased” a new console was Ubisoft, with an impressive 10 Wii titles released over the first several months following launch.

In hindsight, the publishers appear to have made a mistake. The Wii has been a runaway success, with the PS3 sorely lagging sales expectations. As the current cycle entered its third year (in 2008), decisions made two years prior to fully support the PS3 turned out to be in error. Companies that chose to support the Wii benefited mightily, with Ubisoft’s casual division growing from virtually nothing in 2005 to over €300 million in revenue in 2008, largely due to strong sales of Wii games. Other companies that had solid Wii sellers were Take-Two, with its Carnival Games brand, and Midway, with Game Party. Of the three publishers that supported the PS3, only Activision had any meaningful success on the Wii, largely because its Guitar Hero game was such a runaway hit on the platform.

Licensed properties and sequels are sure-fire sellers—Over the course of this decade, we have seen a decline in original intellectual property in video games, with increasing emphasis on licensed content and sequels. In 2003, there were only three new original brands that finished in the top 30, and in 2004 there were only two. In 2005, the only new brand to finish in the top 30 was a licensed property. In 2006, there were three new brands (Guitar Hero, Gears of War and Cars), with one a licensed property. In 2007, two new brands cracked the top 30, both for the Wii (Wii Play and Petz), and in 2008, two more new brands made the cut, also for the Wii (Wii Fit and Imagine). This pattern suggests to us that video game publishers are reluctant to take risks with new content as each console cycle matures. They appear to believe it a safer route to develop content based upon well-known brands such as Harry Potter, Lord of the Rings, Spider-Man, SpongeBob, Scooby Doo, Yu-Gi-Oh, and Dragon-Ball Z, or to focus on sequels to proven brands such as Need for Speed and Tony Hawk. To some extent, this decision appears wise, as the “mass market phase” of a console cycle (which we expect to begin in late 2010) typically brings more casual gamers into the market. It is true that each of these brands accounted for at least a million units sold in past years, and each produced a million-unit seller in its most recent iteration. However, we are not convinced that merely licensing a successful brand from another genre will necessarily guarantee successful video game sales, and we are equally unconvinced that sequels to popular games will sell well in all cases.


The problem faced by the publishers is the pace of discounting. For the first three years of the current cycle, game pricing has held up remarkably well, with many games holding launch pricing for six months or more. Beginning in 2009, we began to see pricing crack, with heavy discounting of several holiday titles, and in particular, discounting of the Guitar Hero World Tour and Rock Band bundles. It appears to us that retailers are quick to request discounts, and in many cases, consumers have been trained to wait for discounts. It is understandable when disappointing performers at holiday are deeply discounted, but we believe that the true test of game pricing will occur this holiday, when we will see whether the recession impacts demand.

We believe that the publicly traded publishers have begun to demonstrate pricing discipline, instead of training consumers to wait for price cuts. New game pricing is holding up, with highly successful games like Call of Duty 4: Modern Warfare and Call of Duty: World at War holding launch pricing for more than a year and for six months, respectively. We think that rapid price cuts and discounts on premium titles in the past led to consumers waiting for discounts. Over the last two years, we have seen more discipline in pricing, with a greater number of “collector’s edition” games selling for a $10 premium, and little consumer resistance to very expensive bundles such as Guitar Hero World Tour for $189.99. In our view, the publishers simply cannot afford to allow game discounting, given prohibitively high development costs. Most observers expect front-line pricing to remain at $59.99, but it is not clear how rapidly prices will fall once these games are on the shelf. We have seen relatively modest discounting of Xbox 360 games in the 43 months since launch, and equally modest discounting of Wii and PS3 games. Very few games are priced at $19.99 (primarily “party” games), and most have been sticky at the $39.99 price point.

Shorter games entail lower risk—As development costs continue to escalate, publishers have an incentive to cut expense wherever possible. The biggest component of development expense is manpower, so it follows that shorter games are less expensive to develop than longer games. It follows logically that if shorter games are less expensive to develop, they require fewer units sold in order to break even, thus entailing lower risk. Shorter games have two disadvantages: first, they are more susceptible to rental; and second, they are more susceptible to poor reviews. Because the average rental outlet offers a week of game play for only $6, consumers can play a short game through to completion in two to three weeks for far less than the retail cost of the game. Interestingly, one of the best selling games of all time, Call of Duty 4: Modern Warfare, was one of the shortest, with an estimated 10 hours of game play. Consumers appeared not to mind, as the multiplayer component of the game allowed countless hours of enjoyment. It will be interesting to see if this year’s sequel, Modern Warfare 2, is equally short.

CONCLUSION The big takeaway is that digital content is growing in popularity, and that the publishers are well positioned to charge money for nothing as they collect on digital distribution. We think that Microsoft is well ahead of the others in the delivery of downloadable content, and expect Sony to make steady progress over the next two years. Nintendo appears genuinely unconcerned with downloads to the Wii this cycle, but its recent launch of the DSi suggests that there is an overarching download strategy being developed in Kyoto. Over the next 10 years, we think that downloadable content will comprise a full 50% of all console and handheld games played, accounting for virtually all of the industry’s growth over that period.


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INDUSTRY CONSOLIDATION

M&A DOESN’T MAKE SENSE For the past six years, there have been persistent rumors about imminent consolidation of the video game publishers, with the most common rumor involving several of the major media companies. To date, only one U.S. publisher has been acquired, while several have gone out of business. During the last console cycle, 3DO and Acclaim declared bankruptcy, BAM! and Interplay faded away, startup Gizmondo (Tiger Telematics) ceased operations, and Atari, Infogrames and Majesco were financially weakened to the point of irrelevance. In the current cycle, Atari and Infogrames merged, Midway declared bankruptcy and Brash Entertainment ceased operations. Over the last eight years, Sega merged with Sammy, Square merged with Enix and subsequently acquired Eidos (who had earlier been acquired by SCi), TDK was acquired by Take-Two, Electronic Arts acquired Digital Illusions, and Vivendi-Universal Games was carved out of the GE-VU joint enterprise. The only major acquisition on the media front was Vivendi’s merger of its games unit into Activision (to form majority controlled Activision Blizzard. Other acquisitions have been far more minor and strategic, including the News Corp acquisition of online video game site IGN, Viacom’s purchase of social networking site Xfire, MTV’s purchase of Gametrailers.com and Harmonix, Warner Bros. acquisition of TT Games, Disney’s acquisition of Junction Point Studios, Microsoft’s acquisition of Massive and Google’s purchase of Adscape.

The economics of game development have made publishing an increasingly costly endeavor, and the hit driven nature of the business has made it difficult to predict winners and losers among the publishers. Smaller publishers, such as Atari and Midway, have struggled to compete with the larger publishers for consumer dollars and retail shelf space during the current cycle, even though each had a relatively strong lineup of proven intellectual property, and both declared bankruptcy over the last two years. Exacerbating the problem is the cost of obtaining intellectual property rights from “sure-fire” sources, with royalties for new licenses rising in cost substantially.

In the past, we consistently believed that the most likely acquirers would be either Electronic Arts or Microsoft, due to the former’s desire to expand into digitally delivered gaming and the latter’s desire to control more first party content. Electronic Arts’ acquisition of JAMDAT and its minority investments in Neowiz and The9 Ltd. reflected that company’s plans, and we continue to expect EA to focus on Asian acquisitions. Should Microsoft choose to expand through acquisition, we believe it will do so as a way to expand its Xbox Live presence (such as its acquisition of Massive). We do not believe that Electronic Arts plans to pursue an acquisition of Ubisoft, notwithstanding its almost 20% stake in the European publisher.

Notwithstanding that the current generation began almost four years ago, we continue to believe that it is premature for an acquisition of a U.S. publisher by a media company. In our view, the uncertainty involved in choosing winners and losers in the current cycle is too great, and media companies have become increasingly risk-averse. We therefore believe that discussions of consolidation at this time are premature. The significant challenges posed by the current cycle, with the PS3 sorely lagging its rivals and with Wii sales far outpacing even the most optimistic expectations at the start of the cycle, has left most publishers


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overleveraged in R&D. We believe that a prudent company such as Viacom or Disney is likely to defer an acquisition decision until it has more visibility regarding the costs of such an acquisition. The high costs of current generation console development has kept profits in check for most companies for the last three years, and though we believe that companies such as Electronic Arts are in a very strong position to grow revenues and earnings over the next several years, this conclusion is likely not as apparent to a potential acquirer. Because Electronic Arts expenses its development costs, it is in a position to grow earnings dramatically in 2010. However, we believe that a prudent Viacom or Disney Board of Directors would prefer to wait until the earnings leverage from R&D investment has been demonstrated before making an acquisition, as it will have significantly more information about the future costs of doing business.

One overarching concern for a media company should be the status of current license arrangements, and what happens to those licenses upon a change of control. We discuss our views about likely acquisition targets more fully in the Industry Consolidation section immediately following.

COMPETITION FROM MEDIA COMPANIES DOESN’T MAKE SENSE Another area of discussion is looming competition from media companies. Some of the major media companies appear to covet the profits that are generated by video game publishers, and these companies appear to believe that the value added in publishing is more attributable to the underlying intellectual property than to execution. We disagree.

Companies like Disney and Warner Bros. have begun to bring video game development in house, with each showing solid early results. Disney has developed DS and Wii games in house, and has published Disney-owned properties with relatively solid results for the last two years. For example, games based on Disney properties High School Musical and Hannah Montana sold around 1 million units in the U.S., both quite respectable figures, with very low development costs.

We think that Disney will continue to experiment with games by taking baby steps, making incremental investments in studios and bringing more development in house over the next few years. We do not expect the company to make a large-scale acquisition in order to compete. The test of the company’s resolve will come when it releases the animated film Toy Story 3 in 2010, with an internally developed game accompanying the film. Recent Pixar-produced predecessors Ratatouille and WALL-E performed well at the box office, but games produced by THQ were underperformers, with around 4 million units sold of each. While we think that Disney is far behind THQ in learning how to succeed in the video game publishing business, it will be interesting to see if its internally produced Toy Story 3 game sells more than 4 million units. Of course, Disney will make more money from an internally produced game, given that it will not share any profits with THQ, so it is possible that the company will consider a 3 million unit seller an overwhelming success.

We feel the same about other media companies, and note that Warner Bros. has recently produced LEGO games based upon the Batman, Star Wars and Indiana Jones franchises, and will release a LEGO version of Rock Band later this year. We think that the company has taken a prudent approach, exploiting a particular expertise of its TT Games subsidiary, and developing content that is consistent with its expertise. Warner will face its test in future years, when it develops games based


upon the Lord of the Rings franchise, which it recently took in-house from Electronic Arts.

Perhaps the greatest media company success has been achieved by Viacom unit MTV/Harmonix Games release Rock Band. In under two years, the franchise has generated $1 billion in game sales, and we expect this fall’s Beatles Rock Band to be one of the best-selling games of the year. We think that the media companies will “stick to their knitting” and produce content based upon owned intellectual property, and expect those who have ramped up to continue to exploit competitive advantages when those advantages exist.

We do not see imminent consolidation of the video game industry. We discussed this in a preceding section, and in this section, we explore the consolidation prospects for each of the major publishers.

Electronic Arts Until the merger of Activision and Blizzard, Electronic Arts was the largest third party video game publisher, with over 20% market share in the U.S. and Europe, Electronic Arts is probably too large a target other video game companies. The company’s share price declined precipitously in the past year, dropping from above $50 to below $20 before settling in the low $20s. EA generates revenues in excess of $4 billion, and has a current market capitalization of over $6 billion, with around $2.5 billion in cash (around $8/share). Electronic Arts has a strong management team, a stable lineup of game franchises, recurring revenue streams from its sports franchises, a solid online presence, is the leading mobile gaming publisher, and has a growing presence in the Asian market. Notwithstanding its recent restructuring and downsizing, it is clear that the company intends to grow revenues and earnings for the next several years. EA is exploring opportunities in online gaming, in-game advertising, and other areas.

Electronic Arts currently spends approximately $850 million per year on game development and around $400 million annually on other growth opportunities, giving the company a technological head start over much of its competition, but severely depressing its earnings potential until its investment is recovered via higher revenues. This amount translates to roughly $2.75/share in after-tax expense, given that the company currently expenses all of its development costs. Console games for the PS3 and Xbox 360 cost an average of $10 – 12 million apiece to develop, while Wii, DS and PSP games will cost less than half that amount. At 125 – 150 console, handheld and PC SKUs per year, Electronic Arts’ fully phased in R&D costs are likely to remain at around $1 billion per year, or $2.30 per share, with the investment in other opportunities representing a huge swing factor. A risk averse acquirer will likely wait until it has greater visibility into the cost curve for software development and into the revenue opportunities from “all other” before paying a premium to enter the video game business.

Electronic Arts has a deep library of licensed content, including Harry Potter, plus a myriad of sports licenses. It is not clear whether the licensors have the ability to terminate relationships with Electronic Arts upon a change of control, although we believe that this is standard fare in most licensing agreements. More problematic is EA’s license arrangement with ESPN, calling for $850 million in advertising guarantees over a 15-year period. We believe that media companies other than Disney (parent of ESPN) would find the ESPN relationship problematic.


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In our opinion, Electronic Arts has no interest in being acquired. Revenues and operating margins consistently grew through FY:04 (ended March 31), but over the last five years, the company has experienced stalled sales growth and declining margins. We expect EA to grow revenues at least in line with industry growth this year and next. Operating margins have contracted over the last five years, from an industry leading 27% at its peak to only an estimated 10% in FY:10, with a rebound to around 12% expected in FY:11 (after adjustments). The management team has made a conscious decision to invest heavily in R&D, and the company should be in a good position to deliver substantial operating leverage in FY:11 and beyond. As such, we think that the company would command at least a 30% premium to the current share price (around $22), and believe that any takeover would likely be hostile. We think that company management shares our view that it is in a great position to grow the business, and would likely perceive a takeover offer as a distraction. We think that should a major media company make a serious offer to acquire Electronic Arts, the latter would take steps to accelerate growth or to drive up its share price, including an acquisition or stock buy-back. Accordingly, we view an acquisition of Electronic Arts by a major media company as unlikely.

Activision Blizzard Activision is equally unlikely to be an acquisition target. The company has a market capitalization of over $16 billion, with around $3 billion in cash (around $2/share). Its revenues exceeded $5 billion last year, and it has industry leading operating margins. Company management appears focused upon growing revenues and earnings over the next several years, and Activision is the world leader in online subscription games.

Because Vivendi has over 50% control of Activision, the company is highly unlikely to be acquired by another media company.

THQ THQ is the least expensive of the “major” video game publishers, and may make an appealing acquisition target for a media company, but because its other licenses (with Pixar and World Wrestling) could possibly terminate upon a change of control, it may be somewhat less attractive. The company currently holds the master license for games based upon Nickelodeon properties. THQ has had tremendous success with Viacom properties such as SpongeBob SquarePants, Jimmy Neutron, Rugrats, Fairly OddParents and Avatar. Its WWE and Disney/Pixar licenses have paid consistent dividends, with more than three million units of WWE sold each year and solid but declining revenues from Finding Nemo, The Incredibles, Cars, Ratatouille, WALL-E and this year’s Up. After a one-year hiatus in 2010, THQ has the rights to produce a game based upon the next Disney/Pixar property in 2011, after which time we expect its license agreement with Pixar to expire. In addition, it has several other licenses, the most successful of which include UFC, Scooby-Doo and Bratz.

THQ has a market capitalization of approximately $400 million, with around $200 million in cash (around $3/share). An acquisition would be “bite sized” for most media companies, with the net purchase price likely in the $300 - 500 million range. For the reasons enumerated above, we continue to believe that an acquisition at this time is premature.

Take-Two Interactive We believe that Take-Two is a solid acquisition candidate for a company looking for a strategic partner, and on a fundamental basis, we think that an acquisition may


make some sense to media companies. The stock is relatively inexpensive on an earnings multiple basis, given its recent strong performance, but the company is highly dependent upon one brand for the bulk of its earnings power. Take-Two might attract potential suitors, as it has some of the best development talent in the business, a stable of decent brands (including the best-known brand of all time in Grand Theft Auto), and the always-desirable geographic proximity to major media companies. In addition, Take-Two has almost no meaningful long-term licenses other than its sports licenses, meaning that a media company could acquire Take-Two with little risk of license termination.

Take-Two has a market capitalization of approximately $600 million, with around $100 million in cash (about $1/share). The stock trades at a discount to its peer group, likely due to its uneven earnings performance and its “one-hit wonder” status.

We continue to believe that an acquisition in the video game space is premature, and think that an acquisition of Take-Two prior to the launch of the next Grand Theft Auto installment (expected in late 2010) is unlikely. The stock trades at only 6x our EPS estimate for next year (excluding cash, and adjusted for normalized taxes), and should be considered “bite-sized” by a potential acquirer. At a 50% premium, an acquisition would cost less than $1 billion. However, current management rejected a bid of over 2x this figure less than a year ago, and notwithstanding the decline in equities over the last several months, we think that a $1 billion offer (around $14/share) would be rejected.

We think that the most likely acquirer for Take-Two is News Corp., which has a similar reputation for producing edgy content. In addition, the company’s Fox Network appears intent upon gaining share in sports from Disney’s ESPN brand. We think that the ESPN license agreement with Electronic Arts is a powerful one, and think that Take-Two’s unprofitable position in the sports video game market may be an impediment to completion of a deal any time soon. However, Take-Two has steadily grown its sports business and the quality of its games, with the business likely to be profitable in 2012.

Majesco

Majesco is a relatively young company, and has not been consistently profitable. It is primarily a distribution company, taking little development risk while co-publishing titles developed by third parties. We think that it would be difficult for a media company to evaluate its worth in an acquisition. Further complicating matters, insiders hold almost 1/3 of the company’s shares, rendering an acquisition over the next year unlikely.

Ubisoft Ubisoft is a fine acquisition candidate, and reminds us of Activision three or four years ago. The company has a large slate of owned (or fully controlled) intellectual property, including ownership of the Tom Clancy stable of titles (including Ghost Recon, Rainbow Six, Splinter Cell and the recently released EndWar). In addition, Ubisoft owns brands such as Rayman, Red Steel, Assassin’s Creed, Haze, Driver and the Petz line of games. The company has several strong relationships with licensors, and has the second largest development studio in the world, behind Electronic Arts. Ubisoft’s market cap is around $1.8 billion, with a small amount of net cash. We think that an acquirer would be required to pay at least a 50% premium, and believe that minority stakeholder Electronic Arts (with around 18% of the stock) could be an impediment to an acquisition.


Ubisoft is unlikely to be acquired by a media company, as it is headquartered in France, making consolidation difficult. We believe its most likely suitor is Electronic Arts, but think that a completion of the creeping acquisition begun in 2004 is unlikely, as the share price has risen since EA acquired its minority stake, while EA shares have fallen by over 50%. More likely, we expect to see Ubisoft become more aggressive as an acquirer, and think that a combination of Ubisoft and THQ makes some sense, given the former’s European distribution strength and owned I/P, and the latter’s U.S. distribution strength and powerful licensed content. Alas, we do not expect the two companies to view the combination as attractively as we do, so we assign a low probability of such a merger coming to fruition.


VIDEO GAME HARDWARE FORECAST 128-bit hardware shipments were 118 million units in the U.S. and Europe (the addressable market for U.S. and European publishers) at the end of 2006. By comparison, 32/64-bit shipments in the U.S. and Europe totaled only 86 million units between 1995 and 2001. This increase translates into a compound annual growth rate 6.5% higher than the 32/64-bit cycle, notwithstanding that the average price for 128-bit hardware was $193 compared to only $153 for the earlier cycle. This hardware sales growth is much higher than our estimate of 2% per annum growth in the GDP during the same period in these markets. We think that the overall potential for the current cycle is far greater than the 128-bit cycle, with penetration through year-end 2008 of 69 million, with sales of 33 million forecast for this year. As we expect the current cycle to last well beyond 2012, we envision overall penetration of more than 150 million consoles. Figure 24 illustrates the ratios of console sales to households in the U.S. for the last three console cycles and our estimate for the current cycle.

Figure 24—Average U.S. Console Ownership by Household

Cycle Period Console Cycle

Peak Installed

Base (mil)U.S. Households

(mil)Consoles/ Household

Households that Own Consoles

Average Consoles Owned

(console owners)

1985-90 8-Bit 36 89 0.41 31% 1.321989-95 16-Bit 38 93 0.41 33% 1.241994-00 32/64 Bit 50 98 0.51 38% 1.351999-06 128 Bit 76 110 0.69 50% 1.382005-11 Next-Gen 103 125 0.82 55% 1.50


We expect continued household penetration for current generation consoles, increasing from 50% in the last cycle to 55% in the current cycle, primarily due to our expectation that the Wii has expanded the gamer demographic. We expect the number of consoles owned per household that owns a console to increase to 1.5 units, higher than each of the last three cycles, as we believe that the majority of households owning a Wii will ultimately purchase a second console.

It is possible that the percentage of households owning at least one console will increase even more dramatically. This could occur as positive demographic drivers and improved technological functionality drive increasing console penetration. We estimate that during the 8-bit console cycle, 31% of U.S. households owned at least one console. This percentage increased to an estimated 38% during the 32/64-bit console cycle, and increased further to 50% in the last cycle. Last-generation consoles offered increased multimedia functionality, including DVD playback and Internet access, as well as a much broader range of high-quality content than earlier generation machines. The current generation consoles include enhanced multimedia functionality, wireless controllers, built-in online capability, high definition display, and an HD disc drive (in the Xbox 360 and PS3). The combination of these features,


rapid adoption of high-definition television monitors, increased marketing, an aging and more affluent addressable market, and the emergence of the mass-merchandise retailers as a significant distribution channel, could drive penetration for the current generation consoles to 60% or more. We estimate that the Wii will ultimately penetrate close to 40% of U.S. households.

There is an ever increasing number of consumers who consider themselves “hardcore”, leading us to conclude that the number of households owning more than one console will possibly increase over the last cycle. We expect the number of consoles owned by each household owning a console to grow, from 1.35 in the 32/64-bit cycle and 1.38 during the 128-bit cycle to around 1.5 in the current generation. One key driver for multiple console ownership is the increasing segmentation and specialization within the console market. Specifically, we believe that many families owning a Wii will also purchase either a PS3 or Xbox 360 to satisfy different gamers within the household—Wii for young (and old) gamers and PS3 or Xbox 360 for those gamers in between. We also believe the percentage of PS3 owners who will purchase an Xbox 360, and vice versa, will ultimately depend upon the number of exclusive games for each platform. As we believe that the economics of game development will make it more difficult for publishers to offer exclusives to either Microsoft or Sony, we do not anticipate many third party exclusive titles over the next few years. At the same time, first party (Sony and Microsoft) development capability has diminished over the past few years, and we do not anticipate many “killer app” exclusives for either console, other than games like Gears of War 3 from Microsoft and God of War 3 and Gran Turismo 5 from Sony.

We speculate that competition for market share will drive console prices lower over the next few years. At launch, Microsoft priced the fully equipped Xbox 360 at $399.99, and Sony priced its console at $599.99. Sony has been slow to price the PS3 competitively, with the core console SKU priced at $399.99 as of this writing. We expect the price point to come down to $299.99 as soon as manufacturing efficiencies permit, but think that a cut to this likely will not occur until 2010. It is unclear whether Microsoft intends to cut the price of the Xbox 360 before this holiday (we don’t expect a cut). As we expect the PS3 to remain priced at least $50 higher than the Xbox 360, Sony must convince consumers that the premium is justified. By 2011, we expect the price points of all three consoles to fall below the $200 level, making them truly mass-market consumer products.

Nintendo positioned the Wii as a cheaper alternative to the Xbox 360 and PS3, competing with a strong lineup of proprietary content and a compelling control scheme. The Wii remains at its launch price of $249.99, including the Wii Sports game. The relatively low launch price immediately allowed Nintendo to achieve mass appeal, and the Wii captured early market share over its more expensive rivals. Because the specs for the Wii are based upon commodity components, the Wii has consistently generated profits for Nintendo. We expect a price cut for the Wii to $199.99 later this year, and expect Nintendo to keep the console priced $50 – 100 below its rivals at least until the introduction of a high-definition version is launched.


Figure 25—Console Unit Sales U.S. and Europe (2004 – 2011E)

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S. Hardw are Units (m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EayStation 0.7 0.0 0.0 - - - - - 4 - - - - - - - -

ayStation2 4.6 5.5 4.7 4.0 2.5 1.3 0.7 - 3 - - 0.7 2.6 3.5 4.3 4.8 5.5

am eCube 2.3 1.7 0.8 0.2 0.0 - - - i - - 1.1 6.3 10.2 9.5 8.0 7.0

Xbox 4.0 2.2 0.4 - - - - - Xbox 360 - 0.6 3.9 4.6 4.7 4.6 4.3 4.0

l O ther 0.5 - - - - - - - otal Hom e Console 12.1 10.1 11.6 17.6 21.0 19.7 17.8 16.5

Growth (% ) -18% -17% 15% 52% 19% -6% -10% -7%

Advance/SP 7.1 4.3 3.2 1.1 0.0 - - - /DSi 1.2 2.6 5.3 8.5 10.0 8.0 7.5 7.0 P - 3.6 3.0 3.8 3.8 4.5 3.3 3.2

l O ther 0.1 0.1 0.1 - - - - - otal Portable 8.4 10.6 11.7 13.4 13.8 12.5 10.8 10.2

Growth (% ) 8% 26% 10% 15% 3% -9% -14% -6%

otal Hardw are 20.5 20.7 23.2 31.1 34.8 32.2 28.6 26.7 Growth (% ) -9% 1% 12% 34% 12% -7% -11% -7%

rope Hardw are Units (m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EayStation 0.7 0.4 0.2 0.1 0.1 - - - 4 - - - - - - - -

ayStation2 5.8 6.7 4.4 3.8 2.8 1.4 1.0 0.5 3 - - - 2.8 3.5 4.5 5.0 5.5

am eCube 1.6 1.1 0.4 0.1 - - - - i - - 1.0 4.8 8.3 8.0 8.0 7.0

Xbox 2.7 1.6 0.2 - - - - - Xbox 360 - 0.3 3.1 1.9 3.0 2.5 2.5 2.5

l O ther - - - - - - - - otal Hom e Console 10.8 10.1 9.3 13.5 17.7 16.4 16.5 15.5

Growth (% ) -9% -6% -8% 45% 31% -7% 1% -6%

Advance/SP 5.6 3.5 2.5 1.7 0.1 - - - /DSi - 2.0 4.2 8.7 11.2 8.0 7.0 6.5 P - 2.0 2.7 3.1 3.8 4.5 3.0 3.0

l O ther 0.3 0.4 0.2 - - - - - otal Portable 5.9 7.9 9.6 13.5 15.1 12.5 10.0 9.5

Growth (% ) 7% 34% 22% 41% 12% -17% -20% -5%

otal Hardw are 16.7 18.0 18.9 27.0 32.8 28.9 26.5 25.0 Growth (% ) -4% 8% 5% 43% 21% -12% -8% -6%

S. and Europe Sales 37.2 38.7 42.1 58.1 67.6 61.1 55.1 51.7 Growth (% ) -7% 4% 9% 38% 16% -10% -10% -6%



Figure 26—Console Unit Sales Japan and Worldwide (2004 – 2011E)

Japan Hardware Units (mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation - - - - - - - - N64 - - - - - - - - PlayStation2 3.0 2.1 1.4 0.8 0.5 - - - PS3 - - 0.4 1.2 1.0 1.4 1.2 1.0 GameCube 1.0 0.6 0.1 0.0 - - - - Wii - - 0.8 3.7 2.9 2.6 2.0 1.5 Xbox 0.2 0.1 - - - - - - Xbox 360 - 0.1 0.2 0.3 0.3 0.2 0.2 0.2 All Other - - - - - - - - Total Home Console 4.2 2.9 2.9 6.0 4.7 4.2 3.4 2.7 Growth (%) 0% -31% -1% 108% -22% -10% -19% -21%

GB Advance/SP 2.8 1.4 0.4 0.1 - - - - DS/DSi 0.8 3.2 8.2 7.3 3.8 3.5 3.0 2.5 PSP 1.5 2.2 1.8 3.1 3.7 3.4 3.0 2.5 All Other - - - - - - - - Total Portable 5.1 6.8 10.4 10.5 7.5 6.9 6.0 5.0 Growth (%) 17% 35% 52% 1% -29% -8% -13% -17%

Total Hardware 9.3 9.7 13.2 16.5 12.1 11.1 9.4 7.7 Growth (%) 9% 5% 36% 24% -26% -9% -15% -18%

Worldwide Hardware Units (mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 1.4 0.4 0.2 0.1 0.1 - - - N64 - - - - - - - - PlayStation2 13.4 14.3 10.5 8.6 5.8 2.7 1.7 0.5 PS3 - - 1.1 6.6 8.0 10.2 11.0 12.0 GameCube 4.9 3.4 1.2 0.3 0.0 - - - Wii - - 2.9 14.8 21.4 20.1 18.0 15.5 Xbox 6.9 3.9 0.6 - - - - - Xbox 360 - 1.0 7.2 6.8 8.1 7.3 7.0 6.7 All Other 0.5 - - - - - - -

Total Home Console 27.1 23.1 23.7 37.1 43.4 40.3 37.7 34.7 Growth (%) -12% -15% 3% 56% 17% -7% -6% -8%

GB Advance/SP 15.5 9.2 6.1 2.9 0.1 - - - DS/DSi 2.0 7.8 17.7 24.5 24.9 19.5 17.5 16.0 PSP 1.5 7.9 7.5 10.0 11.3 12.4 9.3 8.7 All Other 0.4 0.5 0.3 - - - - - Total Portable 19.4 25.3 31.6 37.4 36.4 31.9 26.8 24.7 Growth (%) 10% 31% 25% 18% -3% -12% -16% -8%

Total Hardware 46.5 48.4 55.4 74.5 79.7 72.2 64.5 59.4 Growth (%) -4% 4% 14% 35% 7% -9% -11% -8%



Figure 27—Console Dollar Sales U.S. and Europe (2004 – 2011E)

U.S. Hardware Sales ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 36 2 1 - - - - - N64 - - - - - - - - PlayStation2 726 823 628 519 327 129 55 - PS3 - - 396 1,286 1,482 1,501 1,195 1,095 GameCube 228 163 73 18 1 - - - Wii - - 269 1,558 2,550 2,176 1,432 903 Xbox 612 344 68 - - - - - Xbox 360 - 231 1,512 1,737 1,421 1,145 856 596 All Other 20 - - - - - - - Total Home Console $1,622 $1,565 $2,947 $5,118 $5,781 $4,950 $3,538 $2,594 Growth (%) -27% -4% 88% 74% 13% -14% -29% -27%

GB Advance/SP 599 329 251 88 1 - - - DS/DSi 182 356 684 1,113 1,306 1,192 893 693 PSP - 911 685 722 717 671 426 317 All Other 13 13 13 - - - - - Total Portable $794 $1,609 $1,631 $1,923 $2,024 $1,863 $1,318 $1,010 Growth (%) 10% 103% 1% 18% 5% -8% -29% -23%

Total Hardware $2,416 $3,174 $4,578 $7,041 $7,806 $6,813 $4,856 $3,603 Growth (%) -18% 31% 44% 54% 11% -13% -29% -26%

Europe Hardware Sales ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 34 20 10 5 5 - - - N64 - - - - - - - - PlayStation2 1,154 1,199 656 490 361 139 49 25 PS3 - - - 1,960 1,922 1,796 1,495 1,095 GameCube 158 109 32 7 - - - - Wii - - 340 1,344 2,482 1,992 1,592 1,043 Xbox 456 238 30 - - - - - Xbox 360 - 120 1,237 720 987 623 498 373 All Other - - - - - - - - Total Home Console $1,803 $1,686 $2,304 $4,526 $5,756 $4,549 $3,634 $2,535 Growth (%) -27% -6% 37% 96% 27% -21% -20% -30%

GB Advance/SP 476 263 175 85 4 - - - DS/DSi - 270 542 1,122 1,445 1,192 833 644 PSP - 558 564 617 718 671 357 297 All Other 48 48 20 - - - - - Total Portable $524 $1,138 $1,301 $1,824 $2,167 $1,863 $1,190 $941 Growth (%) -16% 117% 14% 40% 19% -14% -36% -21%


U.S. and Europe Sales $4,743 $5,999 $8,183 $13,391 $15,729 $13,224 $9,680 $7,078 Growth (%) -21% 26% 36% 64% 17% -16% -27% -27%



Figure 28—Console Dollar Sales Japan and Worldwide (2004 – 2011E)

Japan Hardware Sales ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation - - - - - - - - N64 - - - - - - - - PlayStation2 585 317 140 40 23 - - - PS3 - - 243 706 491 559 359 199 GameCube 119 59 6 1 - - - - Wii - - 247 990 662 517 298 149 Xbox 36 15 - - - - - - Xbox 360 - 31 68 94 105 55 45 35 All Other - - - - - - - - Total Home Console $740 $423 $703 $1,830 $1,280 $1,131 $702 $383 Growth (%) -14% -43% 66% 160% -30% -12% -38% -45%

GB Advance/SP 277 125 25 3 - - - - DS/DSi 112 413 1,058 797 337 242 177 123 PSP 449 531 372 587 550 439 297 198 All Other - - - - - - - - Total Portable $837 $1,068 $1,456 $1,387 $887 $680 $474 $320 Growth (%) 128% 28% 36% -5% -36% -23% -30% -32%

Total Hardware $1,577 $1,491 $2,159 $3,218 $2,167 $1,811 $1,176 $703 Growth (%) 29% -5% 45% 49% -33% -16% -35% -40%

Worldwide Hardware Sales ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 70 22 10 5 5 - - - N64 - - - - - - - - PlayStation2 2,465 2,340 1,424 1,049 711 267 104 25 PS3 - - 639 3,951 3,894 3,855 3,049 2,388 GameCube 505 332 110 25 1 - - - Wii - - 856 3,892 5,694 4,685 3,322 2,095 Xbox 1,104 598 98 - - - - - Xbox 360 - 383 2,817 2,552 2,513 1,823 1,398 1,004 All Other 20 - - - - - - - Total Home Console $4,165 $3,674 $5,953 $11,475 $12,818 $10,630 $7,874 $5,511 Growth (%) -25% -12% 62% 93% 12% -17% -26% -30%

GB Advance/SP 1,353 717 451 175 5 - - - DS/DSi 294 1,039 2,284 3,033 3,088 2,626 1,903 1,459 PSP 449 2,000 1,621 1,926 1,986 1,780 1,080 811 All Other 60 60 32 - - - - - Total Portable $2,155 $3,815 $4,388 $5,134 $5,078 $4,405 $2,982 $2,270 Growth (%) 26% 77% 15% 17% -1% -13% -32% -24%




PERSONAL COMPUTER VIDEO GAMES We do not include sales of PC hardware or peripherals in our industry hardware definition, as most PC owners own the machines for other purposes. However, we do include PC software sales in our software industry numbers, as these represent a significant slice of the software market. Software produced for the PC will run on compatible computer equipped with the minimum system requirements. Currently, the overwhelming majority of PC games are made for Windows-based PCs, while relatively few are sold for the Mac or Linux-based PC systems. According to the NPD group, in 2008, over 93% of all PC software sold was for Windows-based computer systems.

We estimate that PC game sales totaled $700 million in North America in 2008, down 14% from the prior year. Worldwide, we estimate that PC game sales totaled $2.43 billion in 2008, down around 13% over 2007. PC software sales have trended downward for 13 years, roughly coinciding with the increasing popularity of home consoles. Figure 29 illustrates actual and estimated PC game sales by major geographic market for the 2004 – 20011 period.

Figure 29—PC Entertainment Software Sales (2004 – 2011E)

330 310 305 285 270 305 285 270

818 701 678 658 638

1,6961,458 1,500 1,438 1,350

3,4093,247 3,144

2,799

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Demand for PC software is driven by three trends: (1) gains from rising home PC penetration; (2) gains from an increasing percentage of PC owners who play games; and (3) losses from the shift in PC gamers toward console games as console penetration increases. IDC reports that home PC penetration rates increased from 39% in 1996 to almost 51% in 2000 and we believe that this number exceeded 80% in 2008. Home PC penetration is undoubtedly growing due to, among other things, the continued reduction of PC prices and, more important for the game industry, the lowering of costs associated with graphics cards, high-end monitors, and sound systems. We estimate that the average price of a fully loaded desktop computer has fallen 70%, to below $500, over the past seven years. As better technology at lower cost is available to a greater number of PC owners, an increasing number of high-quality games has lured more PC owners into the gaming community. A 1998 survey


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by IDC indicated that 76% of all PC households have someone who uses the computer to play games.

Recent declines in PC game demand resulted from a slowing of the rate of growth in PC penetration, accompanied by the significant increase in the penetration rate of 128-bit and current generation consoles. As more households add consoles to their mix of consumer electronic products, we expect a continued migration of gamers from the home office to the living room, where the furniture is typically more comfortable and the television monitor is typically larger. Last generation consoles were powered by a 733 MHz microprocessor, slower than the typical home PC, while two of the current generation consoles have 3.2 GHz microprocessors. PC software publishers have always designed games to work with the “commodity standard” microprocessor. Prior to 2003, PC games were designed to run with 733 MHz microprocessors, which meant that the PC gaming experience was quite similar to the console gaming experience. Beginning in 2004, PC games were designed to run with 1.5 GHz or faster PCs, making them unfit for consumers with slower PCs. We believe that the introduction of consoles faster than the commodity standard PC placed further pressure on PC software sales.

One other factor impacting PC software sales is the recent growth of online gaming. There are several MMOGs that have attracted players to the subscription model (subscription rates are not currently captured in our models), so it is possible that the overall spending by PC gamers was higher in 2008 than it was in 2005.


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SOFTWARE ECONOMICS This section of our report analyzes the two main components that determine gross margin for publishers, video game pricing and video game production costs.

RETAIL PRICING TRENDS Video game software is sold in the U.S. market at prices between $5 and $70 per game, with higher price points for specialty bundles that include controllers (such as Guitar Hero and Rock Band). Most new games made for current generation consoles are priced in the $40 – 60 range, with 2009 releases pricing around $49.99 – 59.99, with higher price points for “collectors’ editions”. PC games on the CD-ROM format are inexpensive to manufacture, and tend to have the lowest price points. Games sold on DVD (PS2 and Xbox 360) or proprietary formats similar to DVD (Wii and PS3) are slightly more expensive to create and purchase. Nintendo sells games using flash memory for the DS, with a slightly higher manufacturing cost. Sony’s PSP uses a proprietary UMD format, with manufacturing costs similar to DVD costs. Figure 30 illustrates the average retail U.S. prices between 2000 – 2011 for software sold on various hardware platforms.

Figure 30—Average U.S. Retail Software Price by Platform

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PlayStationGB Advance/SPDSPSPPlayStation2/PS2XboxGameCubePS3Xbox 360WiiWeighted ASP


In the past, average selling prices (ASPs) for console games trended down over the first four years following console launch. Through 2005, launch prices for new titles held steady at the $49.99 price point for AAA titles, $39.99 for most casual titles, and $29.99 for most budget titles, with the number of new titles introduced each year holding steady at around 850 SKUs. In 2008, most front-line titles for the current generation were priced at $59.99. The driver of ASP increases in the current cycle has been the proliferation of newer games priced at $60 or above, with slower discounting in the months following a game’s launch and a dramatic increase in music-themed game bundles and Nintendo peripheral bundles. Because of the rapid ramp in Wii sales during the current cycle, publishers who backed the PS3 or Xbox 360 have been slow to recoup their development costs within the first several months following a game’s launch, keeping game pricing high for longer than in the past in


order to maximize revenues. The average life of a game has been lengthened to over a year, with price cuts occurring infrequently unless the game is selling poorly. As an example, in the last cycle, a game like Madden NFL Football might debut in August at $49.99, drop in price after the holidays to $39.99, drop to $29.99 following the Super Bowl, and drop again to $19.99 the following June. In the current cycle, pricing for a game like Call of Duty 4 remained at $59.99 for more than a year after the game’s fall 2007 launch. As of this writing (more than 18 months after launch), the game remains priced at $39.99.

Average selling prices are important, as all games serve as close substitutes for other games. Thus, if a consumer purchases a console, the publishers should care if the consumer buys two or three old titles for a relatively low price or two or three new titles for full price. The ASP of the prior generation console (32-/64-bit) game declined from $47 in 1997 to $33 in 2000. The ASP for PS2 software in 2000 was $49.14 per game, consistent with the PlayStation One’s average price during its launch phase, and pricing increased following the launches of the GameCube and Xbox a year later. The ASP for last generation console games dropped from $49.14 in 2000 to $30.02 in 2006 as a proliferation of older “greatest hits” titles attracted consumer attention at $20 price points.

As expected, we have seen dramatic price increases for current generation software since launch, with most games launching at a $59.99 price point ($49.99 for Wii games), and handheld and portable games launching at $29.99 – 39.99. ASPs for PS3 games were $56.73 in 2008, while Xbox 360 and Wii games were $56.68 and $47.82, respectively. The ASP for all console and handheld games in 2008 was $40.87, up a full $9 over the ASP in 2000.

It is important to note that in the last cycle, the typical “half-life” of a title was only three months, so 75% of all units were typically sold within the title’s first six months. In the current cycle, it is difficult to project the sales profile of new releases, with many “steady sellers” on all three consoles well past the six-month mark.

We expect premium games for the current console cycle to maintain pricing for a majority of units, keeping the ASP high. We continue to expect a decline in the number of games produced each year, due to the economics of game development. We think that discounting will be slower than in the past, and ASPs could remain at 2008 levels. We note that ASPs in 2007 and 2008 were up 14% and 10%, respectively, largely due to contribution from high-priced music-themed bundles like Guitar Hero and Rock Band. As growth for the music category inevitably slows, we expect ASPs to moderate around the $38 – 40 level for a few years.

The average price of PC games has declined slightly over the last twelve years, from an average of $28 in 1995 to an average of around $24 in 2008. Average prices bottomed in 2000, at $21.72, and prices began an upward trend over the next five years before flattening out. We believe the overall erosion in PC prices was due to competition from superior software products available for the consoles at the high end, and competition from downloadable games and handheld games at the low end. We believe that the rebound in average prices is attributable to a lower number of budget title games now available for PCs. We note that these figures do not include casual game downloads from the Internet, or Internet based casual game subscriptions, both of which have likely hurt sales of lower priced budget titles. We believe that as console hardware prices continue to decline, a larger number of budget titles will be offered on consoles, and the console gamer demographic will increasingly reflect a demographic with less disposable income and a greater


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appetite for budget games. As we expect to few high-quality premium PC games in 2009, we expect to see PC game average selling prices stabilize at $24/unit.

We believe that ASPs will decrease only slightly over time, in contrast to dramatic declines in the past. We think that the line on Figure 30 that best illustrates this point is “weighted ASP all”. This line reflects the average selling price for all games, whether produced for the PC, legacy consoles, handhelds, portables, legacy generation consoles or current generation consoles. Between 2000 and 2006, the weighted ASP all has fluctuated between $31.11 and $28.55, averaging $29.89. We saw a dramatic increase in 2008, to $39.22, as game sales were dominated by high priced bundles for the music themed games. Going forward, we expect to see a modest decline in the mix of music themed games, driving the weighted modestly lower. Factors that could affect this price are the mix of premium titles, especially on the PC side, and a more rapid rate of decline for older title pricing.

We strongly believe that weighted average selling prices of all games is the most accurate barometer of retail pricing trends, and note the trend has been toward price increases, rather than toward price declines. In our view, all video games (regardless of platform) are close substitutes for all other video games. Further, as was discussed more fully in our industry report six years ago (see Myth #6—Average Selling Prices Always Decline Over Time), we believe that as the current consoles required significant increases in development spending, a portion of the higher costs must be passed through to consumers in the form of higher ASPs.

There are only three drivers for a reduction in retail pricing, in our view: a decline in the economics of software production (the “supply” side); increasing competition; or erosion in consumer demand at current price points (the “demand” side). We do not believe that any of the three drivers are present or will arise over the next few years, for the following reasons.

On the supply side, we see no signs that software economics are improving dramatically for the publishers. In the PSOne cycle, Sony’s first-party titles were among the best sellers, and it was the dominant software publisher. The company was also in a position to discount its manufacturer’s software royalty at will in order to induce third-party publishers to write software for its PSOne. As Sony chose to cut pricing on software during the PSOne cycle, other publishers felt compelled to follow suit. In the current cycle, Sony is one of many publishers, with a market share smaller than three of the four largest U.S. and European publishers. Sony has adopted the “razor and razor blades” business model, historically selling PSOnes and PS2s at a very low margin in order to profit immensely from software royalties paid by third parties. We see no indication that Sony is willing to discount the royalty, except in cases where a game has achieved “greatest hits” status (more than 400,000 units sold), or where an exclusive on a Sony platform is offered (such as was the case for Grand Theft Auto: San Andreas).

We also see no sign that research and development costs are coming down. Current generation video games cost dramatically more than last generation titles to produce, given more intense graphics and much more demanding specs for the consoles. Over the first few years of the current cycle, we saw publishers spending more and more in development, with each trying to build the “perfect” game. Of course, during the last cycle, retail prices came down by $10 per unit a mere 10 months into the cycle. We note that the average PSOne game cost somewhere around $750,000 to produce. Spread over 250,000 units, the R&D cost was only


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$3/unit. In the last cycle, the average game cost was around $2.8 million (increasing to $4 – 5 million in 2004 and 2005). Spread over the same 250,000 units, the R&D cost is $11/unit. In the current generation, games cost an average of $10 million to produce, meaning that the cost for a 250,000-unit seller will be a staggering $40 per unit. At this level of development cost, it is highly likely that publishers will opt to pass on games with marginal prospects. In order to insulate publishers against the risks of poor sales, the obvious solution was to raise the retail price of current generation games.

Also on the supply side, we see ever-increasing license fees for the rights to a familiar figure or brand. We understand that the first Tony Hawk game cost publisher Activision a mere 50¢ in license fees per unit. We expect that the Activision’s cost of the Spider-Man 3 license was several times that figure (an estimated $3/unit), and believe that the average motion picture license in the current generation could approach 15 – 20% of sales. This means that a $60 retail game that wholesales for $48 will command a royalty of between $7.20 and $9.60 per unit.

On the competitive front, we also see no indication of pricing pressure. Most games do not compete head-to-head. For example, while PS3 titles Modern Warfare 2 and WWE Smackdown vs. Raw 2010 are expected on retail shelves the same week, there was no reason to believe that a consumer with $120 wouldn’t purchase both games. If one or the other were discounted, we believe it unlikely that the consumer would expect that both should be discounted. It is true that some games, notably sports and racing titles, do compete head-to-head. Because of this, we saw early discounting of both NBA Live 2009 and its direct competitor NBA 2K9.

We expect the average publisher cost of a video game for current generation games to be approximately $19 – 33 per unit, consisting of $12 manufacturing and royalty, $5 – 12 R&D, and $2 – 9 in license fees (the latter two figures will vary based upon the number of units produced). A $59.99 retail title will generally wholesale for $48, resulting in a $15 – 29 (expected value of $22) per unit gross margin to the publisher. If the publisher were to discount the game to $49.99, the wholesale price would drop to $40, and the gross margin would drop to $10 – 23 per unit (expected value of $16.50). We think it highly unlikely that unit sales of such a lower priced game would increase by the 33% necessary to compensate for the reduced margin.

On the demand side, we also see no evidence of pricing pressure. We estimate that the average PSOne game had a rated playing time of 10 hours. This means that if a player was perfect, and never made an error, the game could be completed in 10 hours. Mere mortals typically take as much as four times as long to complete games, so the maximum time a PSOne game could be enjoyed was 40 hours. We estimate that the average PS2 game has a rated playing time of 40 hours, or 160 hours of maximum enjoyment. We note that Grand Theft Auto III, the third best-selling video game of all time, has a rated playing time of 75 hours, and its successor (and #2 best-selling game of all time), Grand Theft Auto: Vice City has a rated playing time of 100 hours. GTA San Andreas (the #1 all-time best seller) is even longer than Vice City, and we have as yet to hear of anyone who felt cheated for plunking down $50 for one of these games. The most recent installment in the series, Grand Theft Auto IV, was apparently so long that few people were able to finish the game, limiting demand for Xbox Live downloadable content.

Another factor that should support retail pricing near current levels is the wide availability of trade-in credits. GameStop, and to a lesser extent, Hollywood Video (GameCrazy) and Blockbuster, all allow customers to trade in used games for store


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credit toward the purchase of a new game. The trade-in supports retail pricing in two ways: first, it increases demand by making new games more affordable (e.g., three trade-ins plus $20 instead of $60 cash); and second, it makes the risk of a bad purchase more affordable (the newly purchased game can be exchanged shortly after it is purchased, usually for more than 50% of the price paid).

In addition, the interactive entertainment experience is greater than ever before. The graphics and sound quality of current generation games are an order of magnitude better than in the prior cycle. Finally, we note that the $40 PSOne game of 1997 would cost approximately $50 in 2008 dollars, according to the federal Bureau of Labor Statistics. In 2005, with the introduction of the Xbox 360 and its HD graphics, we saw consumers embrace the $59.99 price point without complaint.

A fourth factor is pressure at retail—we don’t think that publishers will be as susceptible to retail pressure to discount in the future. We expect fewer SKUs as game development costs rise, and note that retail shelf space has been increasing due to dramatic declines in other packaged entertainment sales (especially for music CDs). Of course, retailers have ordered fewer units than in the past, and publishers have become more reliant upon reorders of popular games to drive revenues.

For 2009, we have modeled an overall average retail price decline in the U.S. of $0.96 per unit for video game software. In Europe, we have modeled a $2.54 per unit decline for video game software, primarily due to a stronger dollar.

PRODUCTION COSTS There are many participants in the video game value chain – hardware manufacturers, licensed content providers, developers, publishers, and retailers – each contributing some added value to the creation and sale of a video game. The amount of compensation that each of these participants receives varies greatly from game to game and impacts the cost of goods sold for these games. The gross margin earned on a particular game by a publisher is a direct function of which players are involved and their level of involvement. For instance, producing Transformers for the PC, PS2, PS3, Xbox 360, Wii, PSP and DS requires widely differing payouts for the various players involved in the creation of each of these games, and the payouts are likely quite a bit higher than payouts on a game such as Need for Speed. The result is that the publisher of the former, Activision, has a very different gross margin on each game, and in most cases, the margin will be lower than the margin earned by Electronic Arts on Need for Speed. Although many variables affect which participant gets what share of a game’s revenues, we believe that three most leveraging variables are (1) game platform, (2) content source, and (3) level of developer involvement. Following is a more detailed explanation of how these major variables affect the economics of a game as well as a brief description of some of the other drivers that factor into determining the production costs for a game.

Game Platform A game’s platform is the single biggest variable in determining the ultimate margin a publisher receives for a game. Games developed for dedicated consoles (e.g., PS2, PS3, PSP, Wii, DS and Xbox 360) require the approval of the console manufacturer before they are produced and sold. The hardware manufacturer is thus able to control the number of titles produced for the platform, ensure minimum quality standards, and most important, collect the manufacturer’s royalty on the production


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of the game. The three console manufacturers (Sony, Nintendo, and Microsoft) actually oversee manufacture of the game software to ensure control over the process. Publishers compensate the console companies through a per-game royalty and manufacturing payment. Production costs vary slightly among console manufacturers, with direct costs of around $1 per DVD, and a $8 – 9 per game net royalty charged for a premium-priced DVD title (the average royalty plus manufacturing charge is typically around 25% of the wholesale price of the game, with some price breaks for volume sales). All platform manufacturers offer tiered rates based on a title’s intended retail price, thus allowing budget titles priced at $9.99 to be profitable. We estimate that the console manufacturers charge approximately $12 per unit to produce a current generation console game (production costs plus manufacturer’s royalty) and approximately $6 – 8.50 per unit for DS and PSP games. We expect the 25% all-in cost to hold throughout the current cycle. There are no manufacturer royalty payments for PC software, and the per title cost of creating a CD-ROM is approximately $2 including the box art. Distribution costs and reserves for price protection impact the cost of sales by between 0 – 10% of sales, depending upon the game. The cost of sales as a percentage of revenues for the typical console game runs at around 30 – 35% ($13 average cost, including reserve, divided by an expected $42 average wholesale price for a current generation game). The average for the typical handheld game is between 35 – 45% ($10 average cost, including reserve, divided by $29 average wholesale price for DS and PSP games). Because manufacturing royalties are paid at the time of manufacture and reserves are taken after a game is sold to the retailer, the provision for reserves impacts gross margin without a corresponding benefit on the royalty side.

Content Source The next most leveraging driver in determining the margin on video game software is the source of the game’s content. If a game is based on content licensed from an external party, (e.g., sports leagues, movies, television franchises, book, comic book or toy characters), then the game’s publisher will typically pay a royalty of approximately 5 – 20% of gross sales (usually between $3 – 10 per unit) to the content owner. Often, these license arrangements carry a minimum guarantee to the licensor, whereby the licensee promises to pay a fixed dollar amount regardless of the ultimate number of units sold. These guarantees can be quite high, with an estimated $15 – 20 million guarantee for each Pixar title and an estimated $40 – 50 million annual guarantee for the NFL and Major League Baseball licenses.

Games that are original concepts owned by the publisher generate higher margins because they require no royalty payments. For example, one of Electronic Arts’ most profitable franchises is its wholly owned Sims series, which requires no third-party royalties. Over the past five years, licensed content has become increasingly common as publishers turned to established franchises and brands to lower the risk in their product portfolios. This began toward the end of the last cycle, as the industry was well within the “mass market” phase of the console cycle. However, the emphasis on licensed content did not translate to blockbuster sales. Only 10 of the 30 best selling brands in 2008 were based on some form of licensed content (down from 20 in 2004), while 18 of the remaining 20 were sequels to proven brands introduced in prior years. Among last year’s top sellers derived from another medium: Pokemon, Star Wars, WWE, Tom Clancy and LEGO. This year, we expect top sellers to include games based upon Avatar, Harry Potter, and Transformers. Included in the top 30 were several popular games based upon licensed sports


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content, including Madden NFL Football, NCAA Football, FIFA and Tiger Woods Golf. Games based on established television, movie, or print content are becoming increasingly common in the U.S. markets as well as overseas.

It is important to note that 19 of the top 30 brands (and all of the top 6) were original brands owned by the major publishers, including Guitar Hero, Wii Fit, Grand Theft Auto, Tom Clancy, Mario, Need for Speed, Call of Duty and The Sims. It is clear that publishers understand the operating leverage potential from owned intellectual property, and the centerpiece of most corporate strategies is the creation of new owned I/P.

Development Costs The third key variable adding to the cost of a video game is the cost of development, paid either through internal staff compensation expense or through royalties to third-party developers. Development costs for a video game can vary widely based on the platform and scope of the project. Games built for the DS only cost around $500,000 to create, while a game built for the Xbox 360 or PS3 may cost as much as $20 million to create. We expect the average for current generation games to settle at around $10 million apiece over time, compared to an average development cost for legacy console games of $2.5 – 4 million. Sequels built on a pre-existing “engine” (the artificial intelligence that determines how the game’s characters will interact) generally cost less to develop than newly created games, and we expect development costs for current generation games to decline as engines are utilized well into the cycle. As a rule of thumb, we estimate most game development costs are budgeted at 10 – 20% of a video game’s expected revenues, but the actual percentage depends upon the ultimate success of the underlying game. Whether a game is developed internally or externally will frequently affect how the game’s costs are classified on a publisher’s income statement and how the revenues are shared.

Because a game’s development occurs prior to revenue recognition, a publisher can entirely expense the cost of building a game before any revenues are received (this method of accounting is practiced by Electronic Arts). Publishers can also track specific game development costs, capitalize these costs on the balance sheet, and later amortize the costs as the games are sold (this method is practiced by all other major U.S. and European publishers). Games built internally are much more likely to be expensed rather than capitalized because external developer payments are much easier to track to a particular game. As a general rule, publishers capitalize software development if the development expenditure is incurred in one period and revenues from the developed game are expected to be realized in a different period. As the time for development has expanded with the added complexity of the current generation consoles, more game development costs have been capitalized than ever before. Once capitalized, development costs are amortized under the “units-of-production” method, in which the publisher estimates total unit sales for a particular title, and amortizes a portion of the capitalized development as each unit is sold. For example, a game with $5 million of capitalized development costs that is expected to sell one million units would bear amortization of $5 per unit as the units are sold. Many publishers include amortization of software development in the cost of goods sold line, while others separately state amortization as an expense below the gross profit line.

Even more confusing is the treatment of royalties paid to external developers. Often, external developers are paid upfront fees for the development of the game, and a


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per-unit royalty for units in excess of a threshold amount. Thus, it is possible for publishers to minimize development costs by allowing the external developers to share in the risks and rewards inherent in any title. If the game is a success, the developer receives a windfall; if not, the developer receives only the fixed payment. These arrangements have an impact on gross margins, as almost all of these expenditures are included in the cost of goods sold.

Despite its impact on the gross margin, classifying external development costs as either “cost of goods sold” or as “research and development” has no impact on the ultimate profitability of a game. In contrast, the revenue-sharing arrangement with an external developer for a particular game may have a significant impact on the game’s profitability. Games built by external developers frequently provide incentives that include additional royalty payments if a game’s sales meet a certain threshold level. Extremely successful games built by external developers are generally not as profitable as similarly successful games built by internal studios. The benefit to a publisher of using external developers is typically lower overhead costs and frequently lower overall costs. In addition, external developers are typically less constrained by corporate culture, and are therefore less constrained creatively. Similar to the leverage opportunity with licensed vs. owned intellectual property, the publishers have recognized the opportunity to improve operating margins by migrating toward internal development, and the use of external developers has declined over the past several years.

Other Costs There are other less leveraging costs that factor into the economics of producing video games. Two other costs that frequently lower a publisher’s gross margin are the use of third-party distributors and allowance for returns and price discounts. Most publishers handle the bulk of distribution themselves, but in some territories (primarily international) and with some smaller customers, publishers turn to third-party distributors to warehouse and place their titles on retailer shelves. Third-party distribution typically costs between 7 – 15% of a game’s wholesale price (around $3 – 4 per unit) but usually affects only a small percentage of major publishers’ games. One highly variable factor influencing costs is the allowance for price protection that publishers must provide to retailers. In the video game industry, publishers take the bulk of price risk on the games that they create. Retailers often expect that a game will sell for a predetermined price, and are invoiced at this price. If the game does not sell for the predetermined price, the publisher must provide a credit to the retailer for the difference between the sale price and the predetermined price for all units remaining in the retailer’s inventory. Industry-wide, we estimate that publishers maintain a reserve of 20% of receivables, or approximately 14% of shipped quarterly revenues (wholesale price) as price protection for their games. It is important to note that price protection doesn’t always involve games that aren’t selling well; rather, planned price reductions also carry price protection, for the simple reason that publishers are interested in keeping the channel well-stocked, and must protect retailers when retail prices are cut on older games. Additions to and charges against the price protection reserve are closely guarded secrets among publishers, and we estimate that actual charges for price protection and returns range from 7 – 10% of annual revenues. These numbers can vary widely depending on the specific titles shipped and the publisher’s success in maintaining premium pricing.

Figure 31 illustrates the impact of these cost variables on a publisher’s gross margin for a hypothetical game produced on the major hardware platforms (excluding third-party distribution and price protection costs).


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PC-CD ROM games typically produce the highest gross margin while DS games produce the lowest margins. PC games are also less likely to carry any licensed content fees, as more PC games are based on original content than console games. Despite these advantages, PC games rarely achieve the margins indicated in our side-by-side comparison. PC software tends to be distributed through a larger number of small specialty retailers (versus mass-market super stores), resulting in lower inventory turnover and higher product returns. The market for PC games also tends to be more hit-driven than the market for console games, resulting in a few mega-hits and many busts. As a result, PC games are either extremely profitable because of their favorable margins or are marked down to just above development costs. On the other hand, average console games are far more likely to turn a profit than the average PC game. The highly volatile nature of the PC game market has driven almost all publishers to focus on the console market as their primary revenue platform.

Figure 31—Sample Gross Margin Calculation

Current Gen Next Gen DS PSP DownloadablePC CD-ROM Console DVD Console DVD Game Card UMD Content (Xbox Live)

Retail Price $49.99 $39.99 $59.99 $34.99 $39.99 $9.99

Retailer Take $10.00 $8.00 $12.00 $7.00 $8.00 $3.00

Wholesale Price to Publisher $39.99 $31.99 $47.99 $27.99 $31.99 $6.99

Cost of Goods SoldManufacturing/Packaging $2.00 $2.00 $2.00 $3.00 $2.00 $0.00

Hardware Royalty Fee $0.00 $6.00 $10.00 $4.00 $5.00 $0.00

Licensed Content Royalties $0 - 8.00 $0 - 6.00 $0 - 9.50 $0 - 6.00 $0 - 6.00 $0 - 1.50

Development Costs $1 - 7.00 $1 - 5.00 $1 - 10.00 $1 - 3.00 $1 - 4.00 $1 - 3.50

Total COGSLow $3.00 $9.00 $13.00 $8.00 $8.00 $1.00High $17.00 $19.00 $31.50 $16.00 $17.00 $5.00Average $10.00 $14.00 $22.25 $12.00 $12.50 $3.00

Publisher Gross Proft Margin*High 92% 72% 73% 71% 75% 86%Low 57% 41% 34% 43% 47% 28%Average 75% 56% 54% 57% 61% 57%

*Does not include possible external distributor costs ($3/title) or price protection for returns (7%-10%).

Third-Party Distributor $0 - $4.00 $0 - $4.00 $0 - $4.00 $0 - $4.00 $0 - $4.00 $0



SOFTWARE GENRES Video games fit into broad categories or ‘genres’, classified by their general subject matter and style of game play. The NPD Group, a firm that tracks retail sales of video games, defines 12 genres: strategy, role-playing, sports, extreme sports, action, adventure, racing, shooter, fighting, simulation, family and children’s (which includes the music genre). These genres are generally recognized throughout the industry as primary game genres, although many sub-categories within these definitions also exist. In addition, many games simply cannot be described by one genre and it is becoming more common to build games that combine elements of many different genres, (e.g., fighting/role-playing-games, driving/shooting games, and strategy-simulation games). For purposes of our analysis, we have collapsed the 12 categories into eight, combining the strategy and role-playing genres, the children’s and family entertainment genres, and the action and adventure genres.

Figure 32—U.S. Video Game Software Market by Genre

2001 2002 2003 2004 2005 2006 2007 2008STRATEGY/RPG 24% 18% 17% 17% 16% 20% 10% 13%SPORTS 14% 13% 14% 15% 15% 16% 12% 15%EXTREME SPORTS 7% 4% 3% 2% 2% 1% 1% 1%ACTION 19% 26% 27% 30% 31% 25% 20% 21%RACING 10% 13% 9% 7% 10% 9% 6% 7%SHOOTER 10% 9% 11% 13% 11% 12% 14% 12%FIGHTING 5% 5% 6% 5% 4% 4% 4% 5%SIMULATIONS 2% 2% 2% 1% 1% 1% 1% 0%FAMILY/ CHILDREN 9% 8% 9% 9% 8% 9% 22% 25%ALL OTHER 1% 2% 3% 2% 2% 2% 1% 1%

TOTAL 100% 100% 100% 100% 100% 100% 100% 100%

Source: The NPD Group/Retail Track, Wedbush Morgan Securities estimates.

Despite the subjective nature of classifying games by content and game play, we believe that an analysis of historical trends in gaming genres will lead to useful and interesting conclusions. Demand for games in any particular genre tends to be relatively stable from year to year, but over a multi-year period, definite trends will emerge. Although the overall size of the market for entertainment software has grown substantially and best-selling titles vary tremendously from year to year, demand for certain game genres has remained stable over time, with others showing higher demand and yet others showing lower demand. For example, the strategy/role-playing-game (RPG) genre was the fastest growing genre from 1997 – 2000, and showed the greatest decline from 2000 – 2005. We believe that the increased popularity of strategy/RPG games was largely due to the rapid increase in the quality of these games during the 32/64-bit console cycle, and other games caught up in quality during the 128-bit cycle. As we forecasted seven years ago, growth rates for several genres reverted to the mean during the last console cycle. Games with a shooter component (the action and shooter genres) experienced a large market share increase, from 26% in 2000 to 33% of total sales in 2008. This trend was magnified in 2004, when such high profile action/shooter games such as


Halo 2, Doom 3, and Grand Theft Auto: San Andreas were released, with the genre capturing 43% market share. The family/children’s genre grew the fastest over the last decade, due to the introduction of the impossibly popular Guitar Hero and Rock Band games, and we look for a slight decline in market share for this genre in 2009 and beyond.

The following is a more detailed description of these game genres and our evaluation of future trends. Each genre’s share of the U.S. interactive software market in 2008 is included in brackets after the genre name.

Strategy/RPG (13%) Strategy/Role Playing Games are those in which players’ characters are placed in realistic situations and typically follow a pre-determined storyline. As the storyline progresses, the chosen character is typically required to manage resources (e.g., money, weapons, armies) to be utilized at some point during the game. The emphasis of a Strategy/RPG game is to manage the character’s actions and build necessary skills in an effort to complete all given tasks. Because of their size and sheer volume of game play (deep story line and intricate artwork), RPGs are often the most expensive games to develop. RPGs can also take a very long time to develop – typically as long as four years to finish and as much as $30 – 50 million. RPGs are tremendously important to the success of a hardware system, particularly in the Japanese market. We believe that a key success factor in Sony’s PlayStation triumph over Nintendo was the decision by since-merged Square (Final Fantasy series) and Enix (Dragon Quest series) to support Sony rather than Nintendo. Some of the biggest games of all time are RPGs. Square-Enix is now selling the twelfth sequel to its Final Fantasy franchise and has sold more than 45 million copies of the franchise worldwide since its debut in Japan in 1987. The thirteenth and fourteenth editions of Final Fantasy are coming out this year and next, and the latter is exclusive to the PS3. Other examples of Strategy/RPG games that are popular in the U.S. include Elder Scrolls, Fallout, Fable, Civilization, World of Warcraft, Diablo, Xenosaga and Baldur’s Gate.

Figure 33—U.S. Top Video Game Software - Strategy/Role Playing Games

2008

Rank Title Publisher Platform Sales ($ mil)1 FABLE II Microsoft 360 64$ 2 FALLOUT 3 Bethesda Softworks 360 55$ 3 WORLD OF WARCRAFT: WRATH OF Activision PC 54$ 4 SPORE Electronic Arts PC 32$ 5 ANIMAL CROSSING: CITY FOLK Nintendo WII 30$ 6 CRISIS CORE: FINAL FANTASY VII Square Enix PSP 26$ 7 POKEMON DIAMOND VERSION Nintendo NDS 22$ 8 FALLOUT 3 Bethesda Softworks PS3 22$ 9 LEGEND OF ZELDA: TWILIGHT PRIN Nintendo WII 21$

10 IMAGINE: BABYZ Ubisoft NDS 20$

Genre Total 1,530$

STRATEGY/RPG



The Strategy/RPG game genre has experienced a modest decline in popularity over the last five years, with large sales increases in the late 1990s followed smaller declines in this decade. In the first years following the PS2 launch, RPGs benefited from better graphics and more data storage capability, as faster processors in consoles and PCs allowed for more visually stunning games. The DVD format has allowed for more data in the games, resulting in better graphics, movies, and story telling, attracting hardcore gamers. Additionally, with increasingly improved fighting and shooting aspects, the RPG genre captured market share from the “fighting” and “shooting” genres late last decade, only to give back market share to these genres over the past four years. We expect the Strategy/RPG genre to maintain a high-teen market share over the next five years, as game graphics are dramatically better on current generation consoles.

Sports (15%) The Sports category is consistently one of the most popular genres in gaming. Sports games have existed since the earliest days of consoles, and include games that are primarily adaptations or simulations of real-world sporting activities. Successful sports games are valuable franchises for a publisher because the games have excellent potential for recurring revenues. Each year, a publisher can produce a new sequel to a popular sports game, (e.g., Madden NFL), because professional rosters and teams change significantly from year to year. A sequel does not require a complete overhaul of the game every year; rather, the publisher can just add new players, stadiums, and rule changes, thus minimizing development costs. Over the past two years, sports games have suffered some market share losses as consumer spending migrated to the music genre. In 2009, we expect sports games to gain some share, as the music genre loses a bit of share, and as Electronic Arts focuses its efforts on the Wii audience.


Figure 34—U.S. Top Video Game Software - Sports/Extreme Sports

2008

Rank Title Publisher Platform Sales ($ mil)1 FIT W / BALANCE BOARD Nintendo W II $ 2 MADDEN NFL 09 Electronic Arts 360 $ 3 MADDEN NFL 09 Electronic Arts PS3 $ 4 MARIO AND SONIC: OLYMPIC GAM

407 102

63 ESega W II $

5 MADDEN NFL 09 Electronic Arts PS2 $ 6 MARIO AND SONIC: OLYMPIC GAM

48 43

ESega NDS $ 7 NCAA FOOTBALL 09 Electronic Arts 360 $ 8 MARIO SUPER SLUGGERS Nintendo W II $ 9 MADDEN NFL 09 Electronic Arts W II $

10 NBA 2K9 Take-Two Interactive 360 $

Genre Total $

SPORTS

41 38 30 29 25

1,764

2008

Rank Title Publisher Platform Sales ($ mil)1 SHAUN W HITE SNOW BOARDING: R Ubisoft W II $ 2 SHAUN W HITE SNOW BOARDING Ubisoft 360 $ 3 SKATE Electronic Arts 360 $ 4 SHAUN W HITE SNOW BOARDING Ubisoft PS3 $ 5 SKATE IT Electronic Arts W II $ 6 SKATE Electronic Arts PS3 $ 7 TONY HAW K'S PROVING GROUND Activision PS2 $ 8 SHAUN W HITE SNOW BOARDING Ubisoft PSP $ 9 SHAUN W HITE SNOW BOARDING Ubisoft PS2 $

10 TONY HAW K'S PROVING GROUND Activision 360 $

Genre Total $

EXTREME SPORTS

22 14

9 7 6 4 3 3 3 2

92


Because of predictable demand for the genre, a deep and high-quality library of sports titles will generally launch with a new console. We believe that one of the main reasons Sega’s Dreamcast platform failed was due to Electronic Arts’ decision not to produce any of its extremely popular sports games for that platform. Microsoft recognized the importance of the sports genre to the success of the Xbox, securing Electronic Arts as a third-party publisher that supported its Xbox Live service. Some of the best-selling video games are sports franchises, including Madden NFL, NBA Live/NBA 2K, and FIFA Soccer. We expect the sports category to grow in line with the overall industry. The importance of sports to EA was reinforced in 2004, when the company signed a highly publicized exclusive arrangement with the NFL, adding this license to its other exclusives (NASCAR and FIFA Soccer). Competitor Take-Two responded by signing its own semi-exclusive arrangement with Major League Baseball.


Extreme Sports (1%) We have broken out the extreme sports category from the overall sports genre, as we believe that extreme sports appeal to a slightly different (and smaller) audience than conventional sports games in the current console cycle. Only a small fraction of the size of the sports genre in 2008, we expect extreme sports sales to gain some share of overall software sales over the next several years, particularly as games like Shaun White Snowboarding and Tony Hawk Ride gain in popularity. An extreme sports game typically involves a single player trying to perform tricks or race through a course while sustaining minimal damage. There has been some crossover between the sports and extreme sports lines, with games such as NBA Street, FIFA Street and NFL Street including features of both genres.

Action/Adventure (21%) Action/adventure games are those in which players select a character to control throughout a mission consisting of various shooting, fighting, and sometimes puzzle solving aspects. The difference between an action/adventure game and a strategy/role-playing-game is the former’s emphasis on game play versus the latter’s emphasis on character development. Fast and fun game play is the focus of the action/adventure genre while the strategy/RPG genre stresses decision-making and the game’s storyline. Included within the NPD definition of action/adventure games is the platform/scrolling character genre (such as Super Mario Bros.), as well as classic action games (such as Spider-Man) and classic adventure games (such as Resident Evil). Action/adventure games are designed to have short learning curves so that players can pick up a game controller and play immediately. This category declined slightly in 2007 – 2008, with 21% of total sales, but has remained the largest single genre over the last decade, with music themed games selling fewer units at far higher average prices. We expect the Action/Adventure genre to maintain market share in the 20 – 25% range over the next five years.

Shooter (12%) Another highly descriptive genre title, shooters are simply games in which a character travels through various settings, shooting other characters or objects. Shooters typically come in three varieties, shooters shown looking down the barrel of a gun (first-person shooters), character controlled shooters (third-person shooters), and vehicle shooters. First-person shooters allow the player to “see” his surroundings through the eyes of his character while third-person shooters provide the player with a view of his character in the character’s surroundings. Vehicle shooters usually provide a third-person perspective of the vehicle so that the player can see his vehicle reacting to the controls.

The shooter genre has maintained its popularity over the past few years, notwithstanding the increased hybridization of Strategy/RPG games that now include a shooter element and that threatened to capture market share from the shooter genre. In addition, conventional wisdom dictates that as the mass-market audience grows in size relative to the hardcore audience, the significance of this genre shrinks – mass-market gamers have historically not played these games to the same extent as hardcore gamers. We reject conventional wisdom, and note that although the genre has historically been popular among a narrow audience – males aged 15 – 30 – we expect the demographic to expand further during the current console cycle. Popular shooter games include Call of Duty, Gears of War and Halo. In 2009, we


expect this genre to gain share, as several shooters are expected during the holiday season.

Figure 35—U.S. Top Video Game Software - Action/Shooter

2008

Rank Title Publisher Platform Sales ($ mil)1 GRAND THEFT AUTO IV Take-Two Interactive 360 185$ 2 GRAND THEFT AUTO IV Take-Two Interactive PS3 105$ 3 METAL GEAR SOLID 4: GUN OF THE Konami PS3 66$ 4 NEW SUPER MARIO BROS Nintendo NDS 57$ 5 SUPER MARIO GALAXY Nintendo W II 56$ 6 STAR W ARS: THE FORCE UNLEASH LucasArts 360 47$ 7 LITTLE BIG PLANET Sony PS3 36$ 8 LINK'S CROSSBOW TRAINING W / Z Nintendo W II 32$ 9 STAR W ARS: THE FORCE UNLEASH LucasArts W II 28$

10 NINJA GAIDEN II Microsoft 360 28$

Genre Total 2,421$

ACTION

2008

Rank Title Publisher Platform ($ mils.)


Racing (7%) Racing games place the player in the driver’s seat of some sort of vehicle (e.g., car, motorcycle, jet ski, or boat), racing against the clock and/or competitors in an enclosed or defined setting. The racing genre has been around since the earliest video games, and is usually one of the easiest games to produce. Game play is extremely important in this genre; how the vehicles ‘handle’ in the virtual world determines the level of enjoyment, and players tend to continue to play enjoyable games. Even with enhanced game play, the nature of the racing genre tends to cause gamers to lose interest in racing games more quickly than other genres. Some of the most popular racing games include Gran Turismo, Need for Speed, Burnout, NASCAR, Forza and Midnight Club. We expect the racing genre to maintain its current market share over the next several years. In late 2004 and early 2005, there were an unprecedented number of “big” racing games released, including Gran

1 CALL OF DUTY: W ORLD AT W AR Activision 360 145$ 2 GEARS OF W AR 2 Microsoft 360 113$ 3 CALL OF DUTY: W ORLD AT W AR Activision PS3 65$ 4 LEFT 4 DEAD Electronic Arts 360 61$ 5 TOM CLANCY'S RAINBOW SIX: VEGA Ubisoft 360 57$ 6 CALL OF DUTY 4: MODERN W ARFAR Activision 360 55$ 7 ARMY OF TW O Electronic Arts 360 46$ 8 HALO 3 Microsoft 360 43$ 9 CALL OF DUTY 4: MODERN W ARFAR Activision 360 40$

10 CALL OF DUTY 4: MODERN W ARFAR Activision PS3 33$

Genre Total 1,446$

SHOOTER


Turismo 4, Burnout 3, Need for Speed Underground 2, Street Racing Syndicate, Midnight Club III: DUB Edition and Juiced, with several sequels later in 2005, driving the category (pun intended) to a record market share. This year, there is renewed competition, with new intellectual property Blur competing with a redesigned Need for Speed Shift, as well as console exclusives Forza 3 and Gran Turismo 5. We therefore expect the category to capture market share closer to 9% this year.

Figure 36—U.S. Top Video Game Software - Racing

2008

Rank Title Publisher Platform Sales ($ mil)1 MARIO KART W / W HEEL Nintendo W II 248$ 2 MARIO KART DS Nintendo NDS 57$ 3 BURNOUT PARADISE Electronic Arts 360 19$ 4 GRAN TURISMO 5: PROLOGUE Sony PS3 19$ 5 NEED FOR SPEED: UNDERCOVER Electronic Arts 360 18$ 6 MIDNIGHT CLUB: LOS ANGELES Take-Two Interactive 360 17$ 7 BURNOUT PARADISE Electronic Arts PS3 14$ 8 NEED FOR SPEED: UNDERCOVER Electronic Arts PS3 13$ 9 MIDNIGHT CLUB: LOS ANGELES Take-Two Interactive PS3 13$

10 GRID Codem asters 360 8$

Genre Total 785$

RACING


Fighting (5%) Fighting games involve characters that fight hand-to-hand, usually in a one-on-one situation. NPD includes professional wrestling games under this genre, which has given the sagging popularity of this genre a boost. Fighting games tend to be most popular with young males ages 10 to 14. Popular Fighting games include the WWE, Tekken, Mortal Kombat, Dead or Alive and the new UFC game. With the continued popularity of professional wrestling and the advent of UFC and the competing MMA from Electronic Arts, we expect the Fighting genre to maintain market share in the 5 – 7% range.

Simulation (less than 1%) Simulation games attempt to re-create a realistic situation in a virtual world (note that this category does not include one of the most popular sim games – The Sims – as it is classified as Strategy/RPG). Situations usually involve control of various vehicles such as planes, helicopters, and submarines. The most popular simulation games are designed for the PC. These games are not very time-intensive and usually attract an older audience. We expect this genre to continue to remain relatively small over the next several years.


Figure 37—U.S. Top Video Game Software - Fighting/Simulations

2008

Rank Title Publisher Platform Sales ($ mil)1 SUPER SMASH BROS: BRAW L Nintendo W II2 MORTAL KOMBAT VS DC UNIVERS

193$ EMidway Games 360

3 SOUL CALIBUR IV Namco Bandai Game30$

s 3604 MORTAL KOMBAT VS DC UNIVERS

27$ EMidway Games PS3

5 SOUL CALIBUR IV Namco Bandai Game25$

s PS36 W W E SMACKDOW N VS. RAW 2009 THQ PS27 NARUTO: ULTIMATE NINJA 3 Namco Bandai Game

18$ 18$

s PS28 W W E SMACKDOW N VS. RAW 2008 THQ PS29 W W E SMACKDOW N VS. RAW 2009 THQ 360

10 W W E SMACKDOW N VS. RAW 2009 THQ PS3

Genre Total

FIGHTING

16$ 14$ 13$

9$

552$

2008

Rank Title Publisher Platform Sales ($ mil)1 ACE COMBAT 6: FIRES OF LIBERATI Namco Bandai Games 2 BLAZING ANGELS: SQUADRONS OF Ubisoft3 MS FLIGHT SIMULATOR X DELUXE Microsoft4 ACE COMBAT 5: UNSUNG Namco Bandai Games P5 W W II ACES Destineer Studios6 ACE COMBAT 6: FIRES OF LIBERATI Namco Bandai Games 7 BLAZING ANGELS 2: SECRET MISSI

360 9$ W II 4$ PC 4$ S2 3$

W II 2$ 360 2$

O Ubisoft8 BLAZING ANGELS 2: SECRET MISSI

360 2$ O Ubisoft

9 MS FLIGHT SIMULATOR X Microsoft10 REBEL RAIDERS: OPERATION NIGH

PS3 2$ PC 1$

TXS Games

Genre Total

SIMULATIONS

PS2 1$

45$


Family Entertainment/Children (25%) The Family Entertainment genre includes interactive versions of puzzle, board, dancing, music and trivia based games suitable for people of all ages, as well as games based upon popular children’s characters. Throughout this decade, many publishers have licensed cartoon or book content aimed at children and have developed the content into popular games such as Harry Potter, SpongeBob, The Incredibles (note that NPD characterizes Harry Potter and Little Big Planet as Action/Adventure games while SpongeBob falls under the Family/Children’s game). Casino and puzzle games such as Hoyle Casino and Tetris, round out this genre. The growth in this genre came primarily from music themed games Rock Band and Guitar Hero, requiring players to follow a rock music soundtrack while playing an interactive guitar, drums or microphone. The Children’s category has probably maintained around a 9% share over the last two years, with the music category driving all of the growth in making the category dominant. We expect music themed games to lose some market share over the next few years, as unit sales grow modestly, but at lower price points with the mix shift from bundles to software.


Other (1%) Some of the more popular games that we include in the “Other” category include arcade games, such as the Pac-Man series, learning games, and some exer-games. This category also includes a small number of games that are not classified in any genre, usually because the publisher does not include a description of the game and the game play is not obvious to the data-gathering company. With the success of Jillian Michaels Fitness Ultimatum and EA Sports Active, and new games like Daisy Fuentes Pilates on the horizon, we expect this category to grow somewhat over the next few years.

Figure 38—U.S. Top Video Game Software – Family/Children/Other

2 0 0 8

R a n k T itle P u b lis h e r P la tfo rm S a le s ($ m il)1 P L A Y W / R E M O T E N in te n d o W II 2 6 1$ 2 R O C K B A N D S P E C IA L E D B U N D L E E le c tro n ic A rts W II 1 4 0$ 3 R O C K B A N D S P E C IA L E D B U N D L E E le c tro n ic A rts 3 6 0 1 3 2$ 4 R O C K B A N D S P E C IA L E D B U N D L E E le c tro n ic A rts P S 2 1 2 9$ 5 G U IT A R H E R O III L E G E N D S O F R O C A c tiv is io n W II 1 2 6$ 6 G U IT A R H E R O W O R L D T O U R W /B A N A c tiv is io n W II 1 2 5$ 7 G U IT A R H E R O W O R L D T O U R W /B A N A c tiv is io n 3 6 0 7 1$ 8 G U IT A R H E R O III L E G E N D S O F R O C A c tiv is io n 3 6 0 7 1$ 9 G U IT A R H E R O III L E G E N D S O F R O C A c tiv is io n P S 2 6 8$

1 0 R O C K B A N D 2 S P E C IA L E D B U N D L E E le c tro n ic A rts 3 6 0 6 3$

G e n re T o ta l 2 ,9 3 9$

F A M IL Y / C H IL D R E N

2 0 0 8

R a n k T it le P u b lis h e r P la tfo rm S a le s ($ m il)1 P E R S O N A L T R A IN E R : C O O K IN G N in te n d o N D S 9$ 2 A C T IO N /A D V E N T U R E /F A M IL Y B U N D L O th e r N D S 5$ 3 A C T IO N /A D V E N T U R E B U N D L E O th e r P S 2 5$ 4 N A M C O M U S E U M 5 0 T H A N N IV N a m c o B a n d a i G a m e s P S 2 4$ 5 N A M C O M U S E U M N a m c o B a n d a i G a m e s N D S 4$ 6 V A L U E G A M E B U N D L E 1 9 .9 9 O th e r W II 4$ 7 M Y S P A N IS H C O A C H U b is o ft N D S 4$ 8 N A M C O M U S E U M B A T T L E C O L L E C T N a m c o B a n d a i G a m e s P S P 3$ 9 V A L U E G A M E B U N D L E 1 4 .9 9 O th e r N D S 3$

1 0 M Y W O R D C O A C H U b is o ft N D S 3$

G e n re T o ta l 1 2 4$

O T H E R



CONTENT OVERVIEW Notwithstanding the specific game genre definitions used by the NPD group, we think that it is important to focus on content in a manner useful to investors. Several factors determine overall interactive entertainment software sales. We believe that the primary drivers of software unit volume are (1) the number of consoles sold each year, (2) the installed base of consoles sold in prior periods, and (3) the “tie” ratios of software sales to hardware purchases. Overall software sales are a function of price multiplied by volume, so increases in price per unit will drive sales growth. As discussed in a prior section, front line pricing has increased in the current generation, primarily due to higher starting price points and the introduction of peripheral bundles. We expect software pricing to hold relatively steady over the next few years, with front line games remaining at $59.99 and peripherals and premium editions increasing in number, offsetting the inevitable sales decline for high priced music bundles.

Approximately 33 million current generation home consoles were sold in the U.S. and Europe in 2008, up 44% from the prior year due to the increased Wii production and a price cut for the Xbox 360; we estimate the installed base in those two regions as of this writing to be approximately 77 million consoles. As the current generation installed base grows, we expect continued growth in software sales. We note that “tie” ratios slightly exceeded the historic 3.5 – 4 units annually for each current generation console in the first two years following launch (averaging 3.84 units in 2008) and we expect tie ratios to decline to below 3.3 units in 2009. We think that the dominance of the Wii in the current cycle may skew tie ratios more seasonally than in past cycles, as a greater number of Wii owners are more casual players than has historically been the case this early in the cycle.

As is the case with motion pictures, it is always difficult to determine which titles will be sure-fire “hits,” which will be moderately successful, and which will be “bombs”. This problem is exacerbated by the constant shift in consumer hardware purchase patterns among handhelds, portables, old consoles at discount prices, and new consoles at relatively high prices. There are as many theories as there are forecasts for the successful video game formula, and in this report, we offer yet another thesis.

In our view, content is the primary determinant in the consumer decision to purchase a video game, as well as a driver in the selection of consoles. By “content”, we mean a combination of the game’s brand, game play, genre, target demographic, and “buzz” (e.g., online and magazine reviews, word-of-mouth, etc.). We offer a brief summary of these factors below.

BRAND A large number of titles produced by U.S. and European publishers have brand identity. By “brand”, we do not mean the publisher’s name (e.g., Activision or Electronic Arts), although we acknowledge that the success of similar games sold by a particular publisher can create name recognition for other games sold by the same publisher (as has been the case with Rockstar titles). Rather, we use the term “brand” to refer to the main character or main title of a particular game. For example, we would classify Electronic Arts’ Madden Football as a brand (also known as a franchise).


There are several ways for publishers to brand their content. The most sure-fire way to create a new brand is through licensing. Thus, brands such as Harry Potter, Lord of the Rings, Transformers, WWE, Cars, Shrek, Spider-Man, and The Simpsons can be licensed from the creators of the intellectual property, and will provide the licensee immediate recognition with consumers. Through licensing, the publisher can be confident that consumers will feel comfortable in making a game purchase, and therefore more willing to incur the risk of developing the particular title.

Another way to create a brand is by using a celebrity endorser. For example, the Tony Hawk, Madden, Tom Clancy, and Tiger Woods brands all have name recognition that is sufficient to give their respective publishers the confidence to take development risk. This approach has been very successful in the development of sports and extreme sports games, and we expect the trend to continue.

Still another way to create a brand is through the successful sequels of original content. Mario, Zelda, Halo, Tomb Raider, Grand Theft Auto, Need for Speed, Mortal Kombat, and Call of Duty are all examples of brands developed by publishers that are successful sequels launched in the current console cycle.

In the past, the most successful branding strategy was practiced by Electronic Arts. In the last cycle, the company focused on delivering approximately 40 brands to market each year that either were sequels or had the potential to become sequels. Over the past decade, Electronic Arts licensed the rights to Harry Potter and Lord of the Rings, established the Tiger Woods Golf brand, created the SSX snowboarding, Def Jam, Need for Speed and Medal of Honor brands, and purchased the Sims, Battlefield and Burnout brands. The company has recently developed a set of Hasbro-licensed brands, and has spent game development dollars on franchise brands that it believes will provide it with revenue streams for years to come, including Dead Space and Dante’s Inferno.

Emulating this strategy, the U.S. industry’s other big player, Activision, licensed rights to or created new titles that have sequel potential. During the last cycle, Activision used the significant cash flow generated from its Tony Hawk brand to launch the extremely successful Spider-Man brand. It then reinvested in creating new wholly owned brands True Crime, Call of Duty and Gun. Two of these brands were disappointments, highlighting the risk inherent in creating a brand from the ground up. However, Call of Duty (and its Modern Warfare spin-off) provided the capital necessary to purchase the Guitar Hero brand, and the success of these brands led indirectly to a combination with Vivendi Games, owner of the World of Warcraft, Starcraft and Diablo brands.

Other publishers have tried to create brands with sequel potential, with mixed results. THQ had the most difficult time, with modest success from Saint’s Row, a wholly owned intellectual property, and offset by poor performance from sequels to the Juiced and Stuntman brands (purchased from less fortunate competitors). Take-Two, on the other hand, has produced mixed, but generally positive results with its branding strategy, producing a string of unsuccessful games based upon licensed strategy, but producing generally successful brands from internally developed intellectual property. The company has been able to leverage the huge success of its flagship Grand Theft Auto brand into smaller successes with brands like Civilization, BioShock and Midnight Club, and its new management (installed in 2007) appears to be succeeding in changing the company’s strategy.

Perhaps the most successful upstart among the publishers is Ubisoft, which has established an entire line of casual brands, with surprising success. The


company’s Petz, My Coach and Imagine brands generated €325 million in sales in 2008 from virtually zero just three years prior, accounting for approximately 30% of Ubisoft revenues. While Ubisoft’s casual business is susceptible to challenge from better capitalized competitors (notably, Electronic Arts), management has reinvested its profits from these brands in wholly owned intellectual property such as Assassin’s Creed and Rayman.

GAME PLAY All publishers strive to make high quality games that are fun to play. A bad game with good brand recognition is still a bad game, and poor reviews and word-of-mouth can kill a game’s sales potential (the exception to this rule was Vivendi Games’ 50 Cent, a million unit seller with lower ratings than its title). A large portion of the amount spent to develop a game is dedicated to getting the right look and feel, although games produced for the handheld platforms can look comparable to console games with lower overall software development costs due to the small screen size. With the proliferation of big-screen televisions and surround-sound home entertainment systems, a console game with poor graphics or poor sound quality is likely to be a poor seller.

As we noted in our industry report published seven years ago (Content is King), there is a high correlation between a game’s average rating by third-party reviewers and its unit sales. Most games are rated on a 100-point scale, with the average rating hovering around 65. Games rated 80 or higher tend to dominate the best-seller lists, and games rated below 60 are seldom on the best-seller list for more than a few weeks. Each time a publisher releases a sequel to a successful brand, industry pundits quickly note the third-party ratings. A rating of less than 85 for an established franchise brand such as Madden, WWE, Need for Speed or Tony Hawk generally starts the rumor mill spinning about the pending demise of the brand, and in some cases (notably with Tony Hawk), declining ratings can lead to a redesign of the game from the ground up.

There is some variability among ratings from different sources, leading to speculation as to whether ratings can be “bought”. While we do not believe this to be the case, we have noted that many reviewers are biased in favor of or against certain games, with review scores easy to predict in advance. For example, most RPG games receive very high scores because most reviewers have an affinity for the genre, while most movie-based games have difficulty receiving scores above 80 because most reviewers find the games predictable. We have also seen reviewers exhibit a tendency to rate sequels more harshly than originals, although there are exceptions for games such as Halo 2 and Halo 3 (“the best game ever”) and Grand Theft Auto: San Andreas and GTA IV (“the best game ever”, notwithstanding the same term having been applied just a few months before to Halo 3). Similarly, most children’s games are rarely taken seriously by reviewers, even though there may be a large market for them. There are exceptions, but on balance, we think that review scores can provide a useful statistic to consider in determining the likely success of a game.

GENRE Publishers have historically developed competencies and competitive advantages within specific software genres and gamers tend to stick to familiar genres when purchasing software. Several companies have earned well-established reputations for their competency in producing and marketing games targeted at specific genres such as Electronic Arts (sports games), THQ (children’s games), Activision (music and superhero games), and Take-Two (mature-themed games).


Figure 39—Percentage of U.S. Publishing Sales by Genre (2008)

ATVI ERTS COOL MWY NTDOY TTWO THQI UBISTRATEGY/RPG 7% 12% 60% 1% 11% 8% 11% 20%SPORTS 3% 32% 16% 6% 23% 22% 2% 2%EXTREME SPORTS 1% 1% 0% 0% 0% 0% 0% 8%ACTION 11% 4% 4% 2% 13% 53% 38% 19%RACING 2% 7% 1% 1% 16% 7% 15% 1%SHOOTER 24% 13% 2% 15% 0% 2% 4% 27%FIGHTING 0% 0% 0% 51% 10% 0% 23% 1%SIMULATIONS 0% 0% 0% 0% 0% 0% 0% 2%FAMILY/CHILDREN 52% 31% 16% 23% 26% 8% 6% 18%ALL OTHER 0% 0% 1% 1% 0% 0% 0% 3%TOTAL 100% 100% 100% 100% 100% 100% 100% 100%


We believe that the NPD genres, although generally descriptive of each particular game’s focus, are not suitably descriptive of the potential audience for the game. For example, NPD classifies THQ’s WWE brand as a fighting game, comparing the brand to other fighting games such as Midway’s Mortal Kombat and Sega’s Virtua Fighter. In our view, the typical customer for the WWE brand is a fan of the real-life World Wrestling Entertainment, and has a lot more in common with fans of NASCAR than with fans of fighting. WWE video game customers purchase the game for the same reasons that NFL fans purchase Madden Football; they like to control a simulated game in which their heroes compete on the small screen. Customers of the Mortal Kombat and Virtua Fighter series are looking for an altogether different gaming experience.

We believe that investors are better served by having the various genres simplified into fewer and more general categories as follows:

KIDDIE CONTENT: This category includes games targeted at children under the age of 12. The category would include Pokemon, Hannah Montana, Mario Brothers, Shrek, Scooby-Doo, Harry Potter, Pixar titles, SpongeBob and other internally developed and licensed brands targeted at children. Though it is true that many brands such as Mario are enjoyed by a much wider demographic, in our view these brands generate the bulk of their sales by providing family-friendly content that is always safe for play by children. The typical game in this category is built upon the platform/scrolling character model, in which the character traverses a landscape and overcomes various obstacles placed in its way. The object of most kiddie games is to move to ever-higher levels, and the games are typically designed to allow a 10-year old to progress to the end. Because of the relatively simple content, these games are easily developed for the handheld platforms, which are disproportionately owned by small children. Some popular kiddie content has been developed for the current generation consoles, including Crash Bandicoot. To date, blockbuster titles such as Harry Potter, Mario Galaxy, LEGO and The Legend of Zelda have all been bona fide hits on the current generation consoles. Games included in this category are almost always “E” rated. We believe that the relevant question to ask in determining whether a particular game is a kiddie game is “would grandma buy it for junior as a birthday present?”


SPORTS: This category is better defined by what is NOT included. It does not include extreme sports, nor does it include “edgy” over-the-top sports titles such as Midway’s Blitz: The League or Ready to Rumble Boxing. The category can generally be defined as including family-friendly team and individual sports, including most of the EA Sports and 2K Sports titles. The target audience is truly “everyone”, hence the “E” rating on the label. It is important to draw a distinction between “E”-rated sports games and other “E”-rated content—unlike the “Kiddie” games described above, which are targeted at small children, the “E”-rated sports games are truly aimed at the whole family, and we believe that the typical consumer includes parents as well as children. The object of sports category games is to win the race, score more points than your opponent, or win the boxing match.

EXTREME SPORTS: Activision can lay claim to inventing this category with its Tony Hawk brand, and is hopeful of taking the brand to the next level with its peripheral-based game, Tony Hawk Ride, planned for release later this year. Extreme Sports games are targeted at early teens, although a large percentage of sales is attributable to consumers outside the target audience. These games are “edgy”, and provide an out-of-control gaming experience in which the player is always on the verge of crashing. Content is very important, and almost all U.S. publishers offer a game in this category (e.g., Midway with Blitz: The League, Activision with Tony Hawk, Electronic Arts with SSX and its Street games, THQ with MX vs. ATV and Take-Two with Amped). We also include THQ’s WWE franchise in this category, as we believe that the outrageous nature of the wrestling experience is analogous to other extreme sports entries. The winners in this category provide excellent content, maximum control over game play, and sound branding. These games differ somewhat from the typical sports games, insofar as the object of extreme sports games is to avoid injury to the central character while scoring the most points, winning the race, and so on. The extreme sports category also differs from the typical “T”-rated shooter or fighting games in that the object of those games is to injure the other character, while the object of extreme sports games is to avoid injury to the player’s character. Depending upon the content, extreme sports games can be labeled “E” or “T”, but the focus is clearly on mid-teens. Acclaim had a disastrous experience in trying to raise the bar with its “M”-rated BMX XXX game released in late 2002. The game was a poor seller, with fewer than 200,000 units sold across three platforms. We believe that the inclusion of sexual innuendo and adult humor alienated the core late teen male audience and limited opportunities for purchases by parents as a gift, perhaps contributing to Acclaim’s ultimate bankruptcy.

EDGY CONTENT: This category includes almost all shooter and fighting games, as well as several crossover-category role-playing, action, and racing games. The games that best describe the category are Take-Two’s Grand Theft Auto games, in which the central character is a criminal sent on various missions. In order to complete the increasingly difficult missions, the character is required to steal cars and money, kill other characters, and avoid the police. Each game is part racing, part shooter, and part role-playing. We also include most shooter games, such as Halo, Doom, Gears of War, Resistance, Resident Evil, and Wolfenstein in this category and note that one thing these games have in common is that all were blockbusters. On the fighting front, we believe the edgy category includes games in which the object is to kill the opponent in a gory manner, and we therefore include Midway’s Mortal Kombat in the category. There are other titles, like Saint’s Row, and Left 4 Dead that very comfortably fit the “edgy” definition.


ALL OTHER: It’s easy to lump all of the remaining genres together and leave it at that. This category includes non-edgy action games, such as Activision’s recent Bond game, role-playing games such as EA’s Mass Effect series, strategy games such as The Sims and Final Fantasy, and puzzle games such as THQ’s Tetris Worlds. These games are aimed at a broader demographic than are kiddie games.

TARGET DEMOGRAPHIC In order to support the more than the expected 100 million consoles in the worldwide installed base at the end of 2009, everyone should be considered a potential customer. We believe that in the past, many publishers overlooked certain groups in their quest to grow market share. With the success of the Wii, the publishers’ focus has shifted dramatically in favor of more casual games.

Electronic Arts has consistently focused on the entire family in almost all of its product offerings. In developing games, the company looks for brands that are susceptible to sequels. This strategy has served the company well, as most of its games appeal to at least 50% of potential game buyers. In targeting the broadest audience possible, Electronic Arts has tended to focus on the middle demographic (the early teen boy customer) and work its way outward in order to broaden the appeal of its games from there. As a result, only a few of Electronic Arts’ offerings fit within the Kiddie category (most notably the Harry Potter brand), and only a few fit within the Edgy category (Dead Space and the Dante’s Inferno).

Activision, THQ, and to an extent Take-Two have emulated Electronic Arts’ strategy of developing brands susceptible to sequels. Each company has taken a different path, with Activision exploiting its strengths in music and superhero games, THQ focused on the Kiddie category, and Take-Two squarely focused on the Edgy category. Although Electronic Arts, Activision and THQ all are intent upon developing brands that allow sequels, each was late in the Edgy category, following the success of Take-Two with its Grand Theft Auto brand. Electronic Arts launched Def Jam Vendetta, Black and The Godfather a couple of years ago, and has introduced one or two new M-rated titles annually since. THQ introduced its “M”-rated Saint’s Row in 2006, and followed with a sequel in 2008 and this year’s Red Faction: Guerrilla, evidence that both companies recognize the opportunity in this category that they have all but overlooked in the past. Activision has had the most success of the three, with its Call of Duty and Modern Warfare brands among the best selling M-rated games ever. Ubisoft, no stranger to M-rated games with its Tom Clancy series, launched Assassin’s Creed as a new brand in 2007, and this year’s sequel is expected to be one of the top performers.


Figure 40—Percentage of U.S. Console Software Genre Sales by ESRB Rating (2008)

EC E E10+ T M(EARLY CHILD) (EVERYONE) (EVERYONE 10+) (TEEN) (MATURE) TOTAL

STRATEGY/RPG 0% 36% 13% 33% 18% 100%SPORTS 0% 93% 3% 4% 0% 100%EXTREME SPORTS 0% 11% 51% 37% 0% 100%ACTION 0% 24% 20% 24% 32% 100%RACING 0% 72% 14% 15% 0% 100%SHOOTER 0% 0% 3% 19% 77% 100%FIGHTING 0% 0% 1% 96% 3% 100%SIMULATIONS 0% 18% 14% 68% 0% 100%FAMILY/CHILDREN 0% 36% 8% 56% 0% 100%ALL OTHER 0% 77% 16% 5% 2% 100%


In our opinion, target demographic is significant for two reasons: first, the largest (and growing) group of consumers, consisting of males ages 16 and older, is interested in edgy content. Over 70% of primary current generation console users fit this demographic and we expect this market share to expand as the PS3 and Xbox 360 further penetrate the console installed base. Because of the expense of the PS3 and Xbox 360, early adopters were squarely within the sights of the edgy content producers. As such, there were not a large number of “E”-rated games for the PS3 or Xbox 360 for the first few years, with most “E”-rated content released on the lower priced (and more mass market friendly) Wii. We think that many consumers have a tendency to shop for games by ESRB rating, and much as the “G”-rated motion picture is an anathema to teens, we believe that the “E”-rated video game can cause a similar aversion to early adopters of the PS3 and Xbox 360. Second, the success of the Wii has caused a mismatch in content created by the publishers, with the early focus of most publishers on the Xbox 360 and PS3, causing all (but Ubisoft) to overlook the more family friendly Wii audience.

Figure 41—Percentage of U.S. Console Software Publisher Sales by Ratings (2008)

EC E E10+ T M(EARLY CHILD) (EVERYONE) (EVERYONE 10+) (TEEN) (MATURE) TOTAL

ACTIVISION 0% 5% 12% 61% 22% 100%ELECTRONIC ARTS 0% 39% 8% 44% 9% 100%MAJESCO ENTERTAINMENT 0% 93% 3% 1% 2% 100%MIDWAY GAMES 0% 28% 1% 47% 24% 100%NINTENDO 0% 86% 1% 13% 0% 100%TAKE 2 INTERACTIVE 0% 29% 8% 8% 54% 100%THQ 0% 53% 3% 32% 12% 100%UBISOFT 0% 35% 14% 19% 32% 100%



The proof of this concept is the music category, which has been phenomenally successful on all platforms, with games intended for everyone (notwithstanding their T ratings, for lyrics). We think it is notable that in focusing on the hard core, Electronic Arts and THQ lost their way in the face of the Wii’s early success. Those companies misjudged the market, and are just now beginning to recover from their early mistakes. In contrast, Take-Two chose to release a relatively low cost title, Carnival Games, that has so far sold almost 3 million units on the Wii. Ubisoft made a calculated decision to exploit the Wii audience with its casual lineup, with generally successful results.

We see a trend in growth rates of interactive entertainment software sales when segmented by ESRB rating. Over the last seven years, the “E” category has declined in popularity, with the “T” and “M” ratings capturing market share. When combined, “T” and “M” have grown consistently each of the last eight years, peaking at 51% of overall game sales in 2008 while “E” has struggled to maintain market share. We expect the edgy category to maintain its market share this year, with a number of expected “M”-rated titles scheduled for release on current generation consoles.

With sports titles (almost all “E” rated) taken out, the contrast in growth rates is even more striking. The “T” and “M” categories grew from a combined 29% of console dollar sales in 1999 to a combined 51% of sales in 2008, while non-sports “E” games have declined from the stable 50% range to last year’s 33% (combined wit E10+). Figure 42 supports our thesis that demand for “edgy” content is on the rise.

Figure 42—Percentage of Total U.S. Console Software Sales by Rating

CONSOLE RATINGSTOTAL

2001 2002 2003 2004 2005 2006 2007 2008NOT SPECIFIED 0% 0% 0% 0% 0% 0% 0% 0%EC (EARLY CHILDHOOD) 0% 0% 0% 0% 0% 0% 0% 0%E (EVERYONE) 66% 53% 53% 51% 46% 41% 40% 39%E10+ (EVERYONE 10+) 0% 0% 0% 0% 5% 13% 11% 10%T (TEEN) 23% 29% 33% 28% 32% 29% 30% 32%M (MATURE) 10% 18% 14% 21% 17% 17% 19% 19%TOTAL 100% 100% 100% 100% 100% 100% 100% 100%

CONSOLE RATINGSSPORTS SEPARATED

2001 2002 2003 2004 2005 2006 2007 2008NOT SPECIFIED 0% 0% 0% 0% 0% 0% 0% 0%EC (EARLY CHILDHOOD) 0% 0% 0% 0% 0% 0% 0% 0%E (EVERYONE) 50% 36% 39% 35% 34% 25% 28% 24%E10+ (EVERYONE 10+) 0% 0% 0% 0% 1% 12% 10% 9%T (TEEN) 23% 25% 30% 25% 30% 26% 29% 32%M (MATURE) 10% 18% 14% 21% 16% 16% 19% 19%S (SPORTS) 16% 21% 17% 19% 19% 20% 15% 16%TOTAL 100% 100% 100% 100% 100% 100% 100% 100%



“BUZZ” We think that a game’s rating and word-of-mouth are almost as important as brand and game play in the consumer’s purchase decision. This “buzz” can carry a game beyond the ordinary hype surrounding its release, and will position the publisher to create a successful sequel the following year. Consumers can determine a game’s rating from a variety of sources, including websites and magazines, and most consumers will ask others’ opinions before plunking down $60 for a game.

Publishers, who tend to promote their games aggressively, create much of the “buzz.” The larger publishers advertise on television, and all publishers advertise in print and online. In addition, publishers send copies of games to research analysts (full disclosure—we seldom purchase games from the companies that we cover, and Activision, EA, THQ, Sony, Nintendo, and Microsoft have been especially generous with product), the press, and anyone else who can influence purchase decisions.

We believe that the most influential “buzz”-creating group consists of employees at specialty retailer GameStop. GameStop hires hardcore gamers, and customers are quite comfortable asking their employees about a particular game’s rating and game play. A second source of influence is dedicated gaming magazines, with a combined circulation of over 3 million subscribers. Ratings in these magazines can determine the success or failure of a game. Perhaps even more influential are online ratings, led by IGN/GameSpy, with over 25 million monthly visitors, and GameSpot, with over 15 million visitors. There are two popular websites that aggregate game ratings, metacritic.com and gamerankings.com.

It is important to note that a large percentage of games receiving positive “buzz” fall within the Edgy category. It is common to find four or five of the most popular games on www.GameSpot.com at any given time to be “M”-rated edgy games.

CONCLUSION We expect sales of interactive entertainment software to increase at an annual growth rate of 8.8% over the next three years. Statistically, it is unlikely that each genre will grow at exactly that rate. We expect the kiddie, and other categories to grow as slowly as under 5% annually, the sports genre to grow in line, and the edgy and extreme sports categories to grow as much as 15% annually, with much riding on the success of Tony Hawk (pun intended).

We think that each of the five categories we have listed above currently account for between 5% and 25% of overall video game sales. We expect the following growth rates:

Kiddie 5%

Sports 10%

Extreme Sports 15%

Edgy 15%

Other 5%

Our bias is obvious: we expect today’s 18 – 30 year olds to drive interactive software sales growth for the next several years. As the boys behind this group grow into young men, they will become bored with kiddie and family-oriented content and will look for more edgy content. We expect strong growth of the edgy category as younger children age and emulate their older brothers.


SOFTWARE GROWTH FORECAST Our outlook for sales of interactive entertainment software is very positive over the next three years, with industry growth of 29%. The installed base of current generation consoles is expected to reach 100 million units in the U.S. and Europe by year-end, and we expect annual console sales of over 30 million annually for the next several years. Last generation software sales have ceased to make an impact on overall sales growth, with contribution of less than 4% in 2009, and with sales of current generation and handheld/portable software more than making up for the decline. Figure 43 illustrates historical and forecasted sales of interactive entertainment software worldwide.

Figure 43—Worldwide Interactive Entertainment Software Sales (2004 – 2011E)

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5,000

10,000

15,000

20,000

25,000

30,000

35,000

($ m

illio

ns)

2004 2005 2006 2007 2008 2009E 20010E 20011E


We forecast the worldwide interactive entertainment software market to grow at a 7.8% CAGR from 2008 to 2011, with slower growth in Japan offset by higher growth in the rest of the world.

We expect U.S. and European software sales – the addressable markets for U.S. and European publishers – to grow at an 8.8% CAGR over 2008 – 2011. We expect the U.S. publishers to focus on the console, handheld and European markets over the next three years, as we believe that these will provide the most upside, with some investment in Asian online gaming.

In order to accomplish these growth rates, we believe that the industry must achieve higher console hardware penetration rates than in the past and must manage the inevitable decline in overall software “tie ratios”. Our forecast assumes strong contribution from sales of software for the current generation consoles (e.g., Xbox 360, PS3 and Wii), representing approximately 65% of total worldwide game software sales in 2009. We assume that the tie ratios for the current generation consoles will be slightly above 3.25 units per console in 2009, and that future declines will be relatively minor. At the same time, we expect handheld and portable software to maintain market share of 20 – 22% of the overall market. We


think that these assumptions are conservative, and think that there is potential for upside, but our estimates presume that many households will have both a current generation console and at least one handheld/portable device, and may make purchases for each during this time. Going forward, we expect many households to purchase more than one console, pressuring tie ratios, but expanding the market for software even further.

As discussed in the Hardware Platform section, we expect the combined U.S. and European current generation console installed base to end up in 2009 at a combined 100 million home console units. By year-end 2009, we expect the installed base of over 100 million PS3, Xbox 360 and Wii console owners and 105 million DS and PSP owners to continue buying software. We believe that strong demographic fundamentals, additional functionality, increased market segmentation, and much higher marketing spending will increase console penetration rates in this cycle in every major geographic segment. We believe these same drivers will also allow overall software “tie ratios” throughout the industry to remain at around 3.0 annually.

A “tie ratio” is defined as the number of software units sold per hardware unit. All tie ratios are measured over a specific time period, e.g., the first three months of a system launch, the first year, or the life of a hardware platform. Over the “life-of-platform” for the current generation consoles, we expect tie ratios to hit record levels, as we expect these consoles to have a longer life than in past cycles. The “life-of-platform” tie ratio refers to all software units sold for a platform divided by all hardware units sold for the platform during the platform’s entire lifecycle (usually six to seven years for most consoles, but likely closer to 10 years for the current cycle). Historical tie ratios for the 32-/64-bit console cycle and 128-bit console cycles averaged approximately 11 units of software for each console. We expect a significant increase in tie ratios during the current cycle, given the large number of peripheral-based games currently under development, and the expected longer overall life of the average console.

As a result of higher penetration rates and stable tie ratios, software sales are expected to exceed those of the last console cycle. The charts in Figures 44 – 47 illustrate our worldwide forecast for software sales, as well as sales by geographic and platform segments.


Figure 44—Software Unit Sales U.S. and Europe (2004 – 2011E)

U.S. Softw are Units (m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 7.9 2 .1 0.4 0.1 0.1 - - - N64 0.0 0 .0 - - - - - - Dream cast 0.1 0 .0 0.0 - - - - - PlayStation2 84.1 76.2 73.5 56.1 40.0 18.0 4 .7 - PS3 - - 1.3 12.6 27.2 40.3 53.5 67.6 G am eCube 26.2 21.7 17.2 6.1 0.6 - - - W ii - - 3.0 32.0 70.3 85.9 105.4 120.9 Xbox 42.4 37.3 22.2 7.3 2.1 - - - Xbox 360 - 2 .6 20.8 40.7 48.3 57.8 68.1 76.8 All O ther - - - 0.1 0.4 - - - Total Hom e Console 160.7 139.9 138.4 154.9 189.0 201.9 231.8 265.3 G row th (% ) 8% -13% -1% 12% 22% 7% 15% 14%

G am eBoy/Color 0.6 0 .1 0.0 - - - - - G B Advance/SP 40.3 32.5 25.1 13.5 2.8 0.7 - - DS 1.4 8 .2 23.4 46.1 59.0 70.2 80.7 88.9 PSP - 9 .8 14.3 18.0 17.7 18.8 22.1 24.9 All O ther 0.1 0 .1 - - 0.1 - - - Total Portable 42.3 50.6 62.9 77.6 79.5 89.7 102.8 113.8 G row th (% ) 13% 19% 24% 23% 3% 13% 15% 11%

Total Console 203.0 190.5 201.3 232.5 268.5 291.6 334.6 379.1 G row th (% ) 9% -6% 6% 16% 16% 9% 15% 13%

PC Unit Sales 47.0 38.0 39.8 35.0 29.1 28.3 27.4 26.6 G row th (% ) -11% -19% 5% -12% -17% -3% -3% -3% Total Softw are 250.0 228.5 241.1 267.5 297.7 319.9 362.0 405.7 G row th (% ) 4% -9% 5% 11% 11% 7% 13% 12%

Europe Softw are Units (m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 6.0 3 .0 2.0 1.0 0.5 - - - N64 0.4 0 .3 0.2 - - - - - Dream cast - - - - - - - - PlayStation2 78.1 77.8 77.8 54.0 38.8 17.5 4 .7 - PS3 - - - 10.9 25.2 39.4 53.3 67.3 G am eCube 12.0 10.9 8.9 2.9 0.3 - - - W ii - - 2.5 24.0 56.7 70.3 91.1 107.0 Xbox 22.8 21.0 12.2 4.1 1.2 0.3 - - Xbox 360 - 1 .5 17.6 23.5 28.7 33.7 39.8 45.4 All O ther - - - - - - - - Total Hom e Console 119.2 114.6 121.2 120.2 151.5 161.2 188.9 219.7 G row th (% ) 17% -4% 6% -1% 26% 6% 17% 16%

G am eBoy/Color 0.5 0 .3 0.2 - - - - - G B Advance/SP 26.2 22.5 18.5 9.6 2.0 0.5 - - DS - 4 .5 14.5 38.1 55.5 67.2 77.0 84.5 PSP - 5 .0 10.1 13.3 13.9 16.1 19.1 21.7 All O ther - - - - - - - - Total Portable 26.7 32.3 43.3 61.0 71.5 83.8 96.1 106.3 G row th (% ) 24% 21% 34% 41% 17% 17% 15% 11%

Total Console 145.9 146.9 164.5 181.2 223.0 245.0 285.0 326.0 G row th (% ) 18% 1% 12% 10% 23% 10% 16% 14%

PC Unit Sales 63.5 62.0 60.0 57.5 54.0 60.0 57.5 54.0 G row th (% ) -5% -2% -3% -4% -6% 11% -4% -6% Total Softw are 209.4 208.9 224.5 238.7 277.0 305.0 342.5 380.0 G row th (% ) 10% 0% 7% 6% 16% 10% 12% 11%

U.S. and Europe Sales 459.4 437.4 465.6 506.3 574.7 624.9 704.6 785.7 G row th (% ) 7% -5% 6% 9% 14% 9% 13% 12%



Figure 45—Software Unit Sales Japan and Worldwide (2004 – 2011E)

Japan Software (mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 5.0 3.0 1.5 0.5 - - - - N64 0.7 0.5 0.3 0.3 - - - - Dreamcast - - - - - - - - PlayStation2 53.0 45.5 39.0 24.0 12.0 6.0 3.0 1.0 PS3 - - 1.4 6.2 10.0 13.0 17.0 20.0 GameCube 8.5 3.0 0.4 7.0 2.0 - - - Wii - - 3.5 14.9 15.5 18.0 20.0 22.0 Xbox 1.2 0.9 0.5 0.2 0.1 - - - Xbox 360 - 0.3 1.2 1.8 3.2 4.0 4.0 4.0 All Other - - - - - - - - Total Home Console 68.4 53.2 47.8 54.9 42.8 41.0 44.0 47.0 Growth (%) 5% -22% -10% 15% -22% -4% 7% 7%

GameBoy/Color - - - - - - - - GB Advance/SP 17.1 7.3 2.6 0.4 0.3 - - - DS 1.1 21.5 49.8 39.9 31.9 30.0 28.0 26.0 PSP 3.0 7.5 11.0 17.0 24.0 30.0 35.0 38.0 All Other - - - - - - - - Total Portable 21.2 36.3 63.3 57.2 56.2 60.0 63.0 64.0 Growth (%) 25% 71% 74% -10% -2% 7% 5% 2%

Total Console 89.6 89.5 111.2 112.2 99.0 101.0 107.0 111.0 Growth (%) 10% 0% 24% 1% -12% 2% 6% 4%

PC Unit Sales 7.8 7.6 7.4 7.3 7.2 7.4 7.3 7.2 Growth (%) -3% -3% -3% -1% -1% 3% -1% -1% Total Software 97.4 97.1 118.6 119.5 106.2 108.4 114.3 118.2 Growth (%) 8% 0% 22% 1% -11% 2% 5% 3%

Worldwide Software (mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 18.9 8.1 3.9 1.6 0.6 - - - N64 1.1 0.8 0.5 0.3 - - - - Dreamcast 0.1 0.0 0.0 - - - - - PlayStation2 215.2 199.5 190.3 134.1 90.8 41.5 12.4 1.0 PS3 - - 2.7 29.6 62.4 92.7 123.8 155.0 GameCube 46.7 35.5 26.5 15.9 2.9 - - - Wii - - 9.0 70.9 142.6 174.2 216.5 249.9 Xbox 66.4 59.3 34.9 11.5 3.4 0.3 - - Xbox 360 - 4.4 39.6 66.0 80.3 95.4 111.9 126.2 All Other - - - 0.1 0.4 - - - Total Home Console 348.3 307.7 307.5 330.1 383.3 404.1 464.7 532.0 Growth (%) 10% -12% 0% 7% 16% 5% 15% 14%

GameBoy/Color 1.1 0.4 0.2 - - - - - GB Advance/SP 83.6 62.3 46.2 23.4 5.0 1.2 - - DS 2.5 34.2 87.7 124.1 146.4 167.4 185.8 199.5 PSP 3.0 22.3 35.4 48.3 55.6 64.9 76.2 84.6 All Other 0.1 0.1 - - 0.1 - - - Total Portable 90.3 119.2 169.5 195.8 207.2 233.5 262.0 284.1 Growth (%) 19% 32% 42% 16% 6% 13% 12% 8%

Total Console 438.6 426.9 476.9 525.9 590.5 637.6 726.6 816.1 Growth (%) 12% -3% 12% 10% 12% 8% 14% 12%

PC Unit Sales 118.3 107.6 107.2 99.8 90.3 95.7 92.2 87.8 Growth (%) -7% -9% 0% -7% -10% 6% -4% -5% Total Software 556.8 534.5 584.1 625.7 680.8 733.3 818.9 903.9 Growth (%) 7% -4% 9% 7% 9% 8% 12% 10%



Figure 46—Software Dollar Sales U.S. and Europe (2004 – 2011E)

U.S. Software ($m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 100 20 5 2 1 - - - N64 0 0 - - - - - - Dream cast 0 0 0 - - - - - PlayStation2 2,817 2,530 2,304 1,767 1,218 414 94 - PS3 - - 75 750 1,543 2,135 2,782 3,448 Gam eCube 839 664 482 140 10 - - - W ii - - 145 1,502 3,363 3,864 4,533 4,956 Xbox 1,485 1,282 604 137 24 - - - Xbox 360 - 146 1,148 2,368 2,739 3,005 3,441 3,764 All Other - - - 1 2 - - - Total Hom e Console $5,243 $4,642 $4,762 $6,667 $8,899 $9,418 $10,851 $12,168 Growth (% ) 7% -11% 3% 40% 33% 6% 15% 12%

Gam eBoy/Color 7 1 0 - - - - - GB Advance/SP 949 744 519 249 38 7 - - DS 47 258 671 1,248 1,571 1,684 1,816 1,867 PSP - 420 501 507 462 452 486 498 All Other 2 1 - - 1 - - - Total Portable $1,004 $1,424 $1,692 $2,004 $2,072 $2,142 $2,303 $2,366 Growth (% ) 11% 42% 19% 18% 3% 3% 7% 3%

Total Console $6,246 $6,066 $6,454 $8,670 $10,971 $11,560 $13,153 $14,534 Growth (% ) 8% -3% 6% 34% 27% 5% 14% 10%

PC $ Sales $1,111 $953 $979 $818 $701 $678 $658 $638 Growth (% ) -9% -14% 3% -16% -14% -3% -3% -3%

Total Softw are $7,357 $7,019 $7,433 $9,488 $11,672 $12,239 $13,811 $15,172 Growth (% ) 5% -5% 6% 28% 23% 5% 13% 10%

Europe Softw are ($m il) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 90 30 16 15 9 - - - N64 4 1 0 - - - - - Dream cast - - - - - - - - PlayStation2 3,122 2,879 2,490 1,754 1,203 447 104 - PS3 - - - 738 1,464 2,129 2,772 3,367 Gam eCube 456 370 267 72 6 - - - W ii - - 130 1,392 2,950 3,304 4,099 4,602 Xbox 911 801 366 89 12 - - - Xbox 360 - 105 1,188 1,599 1,753 1,817 2,067 2,268 All Other - - - - - - - - Total Hom e Console $4,583 $4,187 $4,457 $5,658 $7,396 $7,697 $9,043 $10,237 Growth (% ) 25% -9% 6% 27% 31% 4% 17% 13%

Gam eBoy/Color 9 3 2 - - - - - GB Advance/SP 701 573 423 230 28 8 - - DS - 157 471 1,333 1,666 1,680 1,849 1,944 PSP - 245 404 466 390 386 430 456 All Other - - - - - - - - Total Portable $710 $978 $1,300 $2,029 $2,084 $2,074 $2,279 $2,401 Growth (% ) 22% 38% 33% 56% 3% 0% 10% 5%


PC $ Sales $1,969 $1,984 $1,860 $1,696 $1,458 $1,500 $1,438 $1,350 Growth (% ) 6% 1% -6% -9% -14% 3% -4% -6%

Total Softw are $7,262 $7,149 $7,617 $9,384 $10,938 $11,271 $12,759 $13,988 Growth (% ) 19% -2% 7% 23% 17% 3% 13% 10%

U.S. and Europe Sales $14,619 $14,168 $15,051 $18,872 $22,611 $23,510 $26,570 $29,160 Growth (% ) 11% -3% 6% 25% 20% 4% 13% 10%



Figure 47—Software Dollar Sales Japan and Worldwide (2004 – 2011E)

Japan Software ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 78 39 20 7 - - - - N64 15 6 3 3 - - - - Dreamcast - - - - - - - - PlayStation2 2,067 1,593 1,287 744 348 150 57 17 PS3 - - 84 360 540 650 782 860 GameCube 383 113 15 140 32 - - - W ii - - 175 717 713 792 840 880 Xbox 47 32 14 4 1 - - - Xbox 360 - 18 66 90 144 172 164 156 All Other - - - - - - - - Total Home Console $2,589 $1,800 $1,663 $2,064 $1,778 $1,764 $1,843 $1,913 Growth (% ) -1% -30% -8% 24% -14% -1% 4% 4%

GameBoy/Color - - - - - - - - GB Advance/SP 479 183 54 6 4 - - - DS 42 710 1,543 1,157 861 750 672 572 PSP 135 315 440 646 864 1,020 1,120 1,140 All Other - - - - - - - - Total Portable $656 $1,208 $2,036 $1,809 $1,729 $1,770 $1,792 $1,712 Growth (% ) 29% 84% 69% -11% -4% 2% 1% -4%

Total Console $3,245 $3,008 $3,699 $3,873 $3,507 $3,534 $3,635 $3,625 Growth (% ) 4% -7% 23% 5% -9% 1% 3% 0%

PC $ Sales $330 $310 $305 $285 $270 $305 $285 $270 Growth (% ) -4% -6% -2% -7% -5% 13% -7% -5%

Total Software $3,575 $3,318 $4,004 $4,158 $3,777 $3,839 $3,920 $3,895 Growth (% ) 3% -7% 21% 4% -9% 2% 2% -1%

W orldwide Software ($mil) 2004 2005 2006 2007 2008 2009E 20010E 20011EPlayStation 268 89 40 23 10 - - - N64 20 7 3 3 - - - - Dreamcast 0 0 0 - - - - - PlayStation2 8,006 7,002 6,080 4,265 2,769 1,011 255 17 PS3 - - 159 1,848 3,546 4,914 6,336 7,675 GameCube 1,677 1,148 763 352 48 - - - W ii - - 450 3,611 7,026 7,961 9,472 10,438 Xbox 2,443 2,114 984 230 37 - - - Xbox 360 - 269 2,402 4,057 4,636 4,994 5,673 6,188 All Other - - - 1 2 - - - Total Home Console $12,415 $10,629 $10,882 $14,388 $18,073 $18,879 $21,736 $24,318 Growth (% ) 11% -14% 2% 32% 26% 4% 15% 12%

Game Boy/Color 16 4 2 - - - - - GB Advance/SP 2,129 1,500 996 485 70 15 - - DS 89 1,125 2,685 3,738 4,098 4,114 4,337 4,384 PSP 135 980 1,345 1,618 1,716 1,858 2,036 2,094 All Other 2 1 - - 1 - - - Total Portable $2,370 $3,610 $5,029 $5,842 $5,885 $5,986 $6,374 $6,478 Growth (% ) 19% 52% 39% 16% 1% 2% 6% 2%


1.56 1.39 1.29 PC $ Sales $3,409 $3,247 $3,144 $2,799 $2,429 $2,483 $2,380 $2,258 Growth (% ) -1% -5% -3% -11% -13% 2% -4% -5%

Total Software $18,194 $17,486 $19,055 $23,030 $26,388 $27,349 $30,490 $33,055 Growth (% ) 10% -4% 9% 21% 15% 4% 11% 8%



SECTION 2: INVESTING IN SOFTWARE PUBLISHERS


INVESTING IN SOFTWARE PUBLISHERS With the economic downturn, the historical gains in share prices for the major publishers were all but wiped out. The average forward multiple for a video game publisher has historically been 25 – 50% higher than the overall market multiple, reflecting the superior growth prospects for the industry and the tremendous earnings leverage generated by massive early investments in R&D. However, as of this writing, most of the public video game publishers trade at or below the market multiple, reflecting investor concern about the health of the industry. We believe that the interactive entertainment industry offers secular dynamics that will provide extended and sustainable growth. Several publishers stand poised to capitalize on this growth, providing investors with an opportunity to participate. In this section, we analyze historical returns for the industry, and compare and contrast the publishers in order to provide insight into how their different strategies and assets produce different risk and return profiles.

In prior console cycles, U.S. investors in this industry were offered few domestic investment alternatives. Given rapid growth and industry consolidation during the last console cycle, we believe that the industry now offers investors fewer viable choices, while at the same time limiting risk. Figure 48 lists the key publicly traded entertainment software publishers.

Figure 48—Key U.S. Publicly-Traded Interactive Entertainment Software Publishers

Share Market CY 2008 2008 U.S.Price Capitalization Revenues Market

Ticker 5/20/2009 ($ mils) ($ mils) Share

Activision Blizzard ATVI 11.41$ 15,874$ 4,370$ 17%Electronic Arts ERTS 22.08$ 7,110$ 4,396$ 20%Majesco Entertainment COOL 1.33$ 37$ 64$ 1%Midway Games MWYGQ 0.07$ 6$ 220$ 1%Nintendo 7974.JP ¥25,720.0 ¥3,292,000 ¥1,892,000 17%Take-Two Interactive Software TTWO 9.35$ 720$ 1,538$ 6%THQ THQI 5.96$ 407$ 845$ 4%Ubisoft UBI.FP € 15.08 € 1,493 € 1,070 5%

Year for COOL & TTWO = Nov-Oct

Source: Company reports, Bloomberg, and Wedbush Morgan Securities estimates.

The universe of publicly traded entertainment software publishers includes companies with market capitalizations ranging from under $50 million to over $30 billion. The industry offers two large-cap companies (Nintendo and Activision Blizzard), one mid-cap company (Electronic Arts), three small-cap companies (Take-Two, THQ and Ubisoft), and two micro-cap companies (Atari and Majesco) to consider as investment opportunities. Over the last three years, five micro cap companies (Acclaim, Bam!, Interplay, Midway and 3DO) declared bankruptcy or ceased operations.


INDUSTRY PRICE PERFORMANCE Investing in a portfolio of entertainment software publishers over the last ten years has not been a profitable venture, primarily due to the bankruptcies of five companies and the precipitous decline in value of Atari. An index of U.S. and European entertainment software publishers (Activision, Acclaim, Atari, BAM!, Electronic Arts, Interplay, Midway, Take-Two, 3DO, THQ and Ubisoft) over the past ten years produced a negative 3.2% compound annual return, compared to positive returns for the broader market indices. There have been clear winners, with Activision investors realizing returns of 29% over the last ten years, with more modest returns for Ubisoft, EA and Take-Two investors in the mid-to-high single digits. There were also clear losers, with THQ investors losing approximately 4% per year over the last ten years and Majesco losing over 90% of its value in its first two years as a public company. Publishers Acclaim, BAM!, Interplay, Midway and 3DO all went out of business over the last six years. Investors who sought quality substantially outperformed the market indices. The index of the six largest publishers (Activision, Electronic Arts, Nintendo, Take-Two, THQ and Ubisoft) generated a CAGR of 8.5% over the last ten years, crushing negative returns for the broader market. In our view, the rewards of investing in video game publisher stocks far outweigh the risks. Investing in a portfolio of high quality entertainment software publishers over the years has proven a profitable venture.

HISTORICAL INDUSTRY RETURNS Share prices of U.S. entertainment publishers increased roughly in tandem with the top-line growth of these companies during the past two console cycles. Revenues within the entertainment software industry grew at a 20% CAGR during the 1991-2002 period. Similarly, the share-price returns of U.S. and European publishers during this period grew at a 20% CAGR. We note that share prices grew quite rapidly during the 16-bit cycle, and somewhat more slowly during the 32-/64-bit cycle. This result was largely driven by the success of Electronic Arts during the 16-bit cycle and the underperformance of several small firms during the 32/64-bit cycle. In contrast, the average share price declined by a 28% CAGR during the first two full years of the 128-bit cycle, but rebounded significantly over the next four years. The industry was not immune to the broader market downturn, with share prices declining faster than the overall market. We believe that this presents an opportunity, as we expect a reversion to the mean sometime in the next few years. Figure 49 illustrates the share price appreciation for the U.S. and European publishers over the last two console cycles. We include the universe of U.S. and European publishers (plus Nintendo) in this index (Acclaim, Activision, Atari, BAM!, Electronic Arts, Interplay, Majesco, Midway, Nintendo Take-Two, THQ, 3DO and Ubisoft).


Figure 49—Industry Stock Performance (1999 – 2009)

Company 1/4/1999 5/20/2009 CAGR %Acclaim Entertainment 11.44$ -$ -100%Activision Blizzard 0.91$ 11.41$ 29%Atari 237.50$ 1.68$ -39%BAM! 8.00$ 11/14/2001 -$ -100%Electronic Arts 12.63$ 22.08$ 6%Interplay 1.75$ 0.06$ -28%Nintendo ¥10,710 ¥25,720 11%Majesco Entertainement 12.50$ 1/26/2005 1.33$ -41%Midway Games 10.94 0.07$ -40%Take-Two Interactive Software 5.75 9.35$ 5%3DO 35.00$ -$ -100%THQ 8.69$ 5.96$ -4%Ubisoft Entertainment € 7.18 € 15.08 8%

Stock Priceas of close

Other Date

Source: Bloomberg, Baseline, Wedbush Morgan Securities estimates. Includes dividends for Nintendo.


REVENUE SIZE AND GROWTH The publicly traded publishers vary tremendously in terms of size. The largest public firm in the industry, Nintendo, generated revenues of over $18 billion in 2008, while the smallest, Majesco, recorded sales of only $64 million. Total revenue for each U.S. publisher includes both publishing and distribution revenues. Only three publishers – Electronic Arts, Activision, and Take-Two – currently derive any significant portion of their total revenues from distribution. Because publishing revenues generally grow faster and deliver higher margins than distribution revenues, we believe that investors value publishing revenues more. Figures 50 and 51 illustrate publishing and total revenues for the eight companies in our coverage universe.

Figure 50—Publishing Revenues 2005 – 2008 ($ millions)

2005 2006 2007 2008Activision Blizzard 1,159 1,035 2,201 3,230 Electronic Arts 2,613 2,937 2,663 3,363 Majesco Entertainment 60 67 51 64 Midway Games 150 166 157 220 Nintendo ¥217,000 ¥338,600 ¥547,800 ¥700,100Take-Two Interactive Software 856 753 691 1,230 THQ 830 1,003 1,016 845 Ubisoft Entertainment € 598 € 597 € 873 € 996


Source: Company reports and Wedbush Morgan Securities estimates.

Figure 51—Total Revenues 2005 – 2008 ($ millions)

2005 2006 2007 2008Activision Blizzard 1,484 1,387 2,608 4,370 Electronic Arts 2,863 3,119 3,151 4,479 Majesco Entertainment 60 67 51 64 Midway Games 150 166 157 220 Nintendo ¥508,300 ¥809,500 ¥1,570,000 ¥1,892,000Take-Two Interactive Software 1,203 1,038 982 1,538 THQ 830 1,003 1,016 845 Ubisoft Entertainment € 622 € 627 € 909 € 1,070




We forecast publishing revenues for the five largest companies to grow slightly faster than our forecasted industry CAGR (8.8%) over the next three years, as we expect each to expand its international market share over this period (in Ubisoft’s case, we expect growth in the U.S.). We expect distribution revenues for the top three publishers to be flat to down over this period. Although it is highly likely that market share for some publishers will change dramatically during the next console cycle, we have little specific product visibility after 2009. However, we believe that the industry will continue to experience contraction or consolidation, and our long-term forecasts for some of these publishers assume that some of them will slightly outperform the industry average. Accordingly, our revenue models assume that some will gain market share in 2010 and beyond.


COMPANY STRATEGIES Software publishers employ a variety of strategies to differentiate themselves from one another and to gain competitive advantages. In this section, we analyze the publishers along seven key strategic lines:

(1) Platform focus

(2) Internal versus external development

(3) Third-party distribution

(4) Geographic sales dispersion

(5) Online (including microtransactions and in-game advertising)

(6) Intellectual property ownership

(7) Game genre focus

PLATFORM FOCUS Deciding how best to allocate development resources is an important decision for publishers. In some cases, publishing games on every platform is a good idea (such as when a mass-market title like Madden NFL Football or Transformers is published). Other times, it makes more sense to limit development to those platforms that have the right target demographic for a particular game. For example, some games that are clearly aimed at the kiddie audience (such as Sonic the Hedgehog games) may be profitable if published only on the DS and Wii. Different game platforms require varying development costs, time to market, and marketing budgets, and generate different gross margins.

The first decision a publisher faces is whether to produce console, handheld or PC software. Although generally ignored by sell-side analysts, the PC software market is still quite large, and expected to generate sales of over $2 billion annually for the next several years. While software sales for the DS, Xbox 360, PS3 and Wii each exceeded PC software sales in 2008, the significant size of the PC software market (a combined $2.2 billion in U.S. and European 2008 sales) makes this option an immediately attractive one. Unfortunately, the PC software market is also the most highly competitive and highly saturated, and we expect the overall market to shrink slightly over the next three years. Games sold for the PC platform produce below average unit and dollar sales, and generally carry ASPs well below most console games, with few PC titles achieving bona fide “hit” status.

PC gamers also tend to be more demanding customers than console gamers, most likely due to a much older and affluent demographic profile. Because of this, successful PC games often require development budgets and development periods similar to current generation console games. We estimate that the average new property takes over two years to develop for the PC, similar to the current generation consoles. High development costs and a hit-driven market combine to produce a difficult competitive environment, and few publishers can generate sustainable profits with a PC focus. In our view, publishers (like Blizzard) that approach the PC platform cautiously and stick to developing games within proven PC genres and with a history of success (like Starcraft) will be the most successful. Over the long term, we expect PC software sales to decline, especially as the specs for the current generation consoles are similar to those of the most powerful PCs, and we believe that


publishers will devote development dollars primarily to the faster-growing console market.

Most publishers take a diversified approach to platform development, concerned that committing a disproportionate amount of development budgets to a particular platform is risky. The economics of game development in the last cycle often dictated that games were developed for the PS2 first, as that platform had the largest installed base. This changed in the current console cycle, as publishers initially developed for the PS3 and Xbox 360, discounting the potential of the Wii. When it became clear that the Wii was the clear winner, it became obvious that ignoring this platform was a big mistake. Development for the Wii added a layer of complexity due to its different architecture. While Wii development carries generally lower development cost, making a bet on the platform less risky, games for the console had to be built from scratch, as they could not easily be ported from the other two consoles. Console games for the PS3 and Xbox 360 take from 24 – 36 months to develop and bring to market and cost an average of $10 million each, with many costing twice that amount. Therefore, at launch, publishers were forced to forecast the future market climate at least two years in advance before they decided which games to publish on which platforms. Committing funds and resources to a slow-growth platform can be costly; similarly, publishing a game for a hot platform can turn a mediocre title into a winner (as evidenced by Take-Two’s Carnival Games for the Wii). The Dreamcast platform provides a good example. Publishers such as Acclaim and Midway suffered in 2000 when the Dreamcast platform failed to sell enough hardware to make software releases for this platform profitable. Publishers must also attempt to gauge likely future competition on a particular platform, favoring a diversified strategy. In general, most publishers match their platform development to their expected platform market share, i.e., the largest number of games is produced for the largest expected platform. Although profitable publishing opportunities can exist on relatively small platforms if the competitive landscape is favorable, we expect publishers to employ this strategy cautiously.

Choices about platform focus in the current cycle are a moving target. Many games produced for the Xbox 360 have been ported to the PS3, but it is not clear whether this was the most efficient method. Because the PS3 has a seven-core processor and the Xbox 360 has a three-core processor, development for the PS3 is somewhat more complicated than for the Xbox 360. This has worked to Microsoft’s advantage, as early in the cycle, publishers chose to develop all games for the 360 because of the relative ease of development; conversely, in the future, it could work against Microsoft, should publishers choose to develop first for the more complex device, anticipating an easier time porting to the competitor’s device.


Figure 52—Covered Companies Publisher Sales Mix by Platform

CY 2005 ATVI ERTS COOL MWY NINT THQI TTWO UBIPersonal Computer 16% 16% 5% 3% 0% 9% 17% 19%GBA 7% 3% 48% 2% 38% 23% 1% 12%DS 3% 3% 1% 0% 24% 3% 0% 2%PSP 5% 9% 5% 1% 0% 2% 17% 5%PlayStation 2 37% 46% 19% 55% 0% 42% 37% 33%Xbox 19% 16% 22% 35% 0% 14% 24% 23%GameCube 7% 5% 0% 4% 38% 7% 1% 4%Xbox 360 6% 3% 0% 0% 0% 0% 3% 2%

Total 100% 100% 100% 100% 100% 100% 100% 100%

CY 2006 ATVI ERTS COOL MWY NINT THQI TTWO UBIPersonal Computer 9% 18% 0% 6% 0% 12% 18% 18%GBA 5% 2% 33% 6% 18% 14% 2% 6%DS 5% 3% 26% 6% 54% 11% 0% 6%PSP 4% 10% 3% 9% 0% 7% 16% 8%PlayStation 2 42% 36% 20% 47% 0% 31% 32% 16%Xbox 6% 8% 18% 10% 0% 3% 6% 3%GameCube 3% 3% 0% 7% 21% 5% 0% 1%Xbox 360 20% 17% 0% 2% 0% 15% 25% 31%PS3 3% 2% 0% 0% 0% 0% 1% 0%Wii 3% 1% 0% 7% 7% 2% 0% 11%

Total 100% 100% 100% 100% 100% 100% 100% 100%


Total 100% 100% 100% 100% 100% 100% 100% 100%


Total 100% 100% 100% 100% 100% 100% 100% 100%

Year for COOL & TTWO = Nov-Oct; ex. CY2005 and CY2006 Year for TTWO = Feb-Jan



DEVELOPMENT ASSETS Publishers create games using either full-time employee developers or by hiring an external developer. The number of internal development personnel can greatly impact a publisher’s cost structure. Maintaining a large internal development team raises the publisher’s fixed overhead costs, but gives the publisher the opportunity to increase operating margin should sales exceed forecasts. Utilizing external developers typically shifts some of the commercial product risk to the developer as developers frequently trade some near-term compensation for royalty payments on highly successful titles.

There is no rule for the appropriate mix of internal and external development. Most publishers approach development opportunistically, hiring those developers who are truly exceptional (“own the best and hire the rest”). Highly talented developers are rare and can mean the difference between good games and great games; publishers have tended to move quickly to hire truly talented developers. However, we believe that development has become more of a commodity than ever before, and we do not endorse internal development capability if the reason for an acquisition is to give the publisher greater control. Several publishers have shown that external developers can be used effectively to produce excellent games on schedule without adding these costs to their income statement and increasing operating leverage. Good examples of top-notch development talent, wisely acquired by publishers include Electronic Arts’ purchase of Maxis (SimCity and The Sims), Activision’s purchase of Neversoft Entertainment (Tony Hawk’s Pro Skater) and Infinity Ward (Call of Duty and Modern Warfare), Take-Two’s purchase of Angel Studios (Midnight Club), Visual Concepts (2K Sports games), Irrational (Bioshock) and Firaxis (Civilization), and THQ’s purchase of Volition (Saint’s Row and Red Faction).

Several publishers have fallen on hard times over the last few years, largely due to their cost structure growing faster than their revenue base. At Electronic Arts and THQ, one of the biggest factors depressing earnings was the decision to bring development in-house, and both companies completed restructurings earlier this year involving the closure of studios and layoffs of development personnel.

One trade-off that should be considered when determining the benefit of a shift in favor of internal development is the likelihood of “groupthink”. We believe that internal studios are often more creatively constrained than are external studios, due to a combination of corporate hierarchy, comparisons to past internally developed products, and constant scrutiny by management. Additionally, over dependence upon internal personnel can serve to limit the flow of “new” ideas, solely by virtue of limiting the potential number of creative people consulted. We believe that over the past year, declining game quality at several U.S. and European publishers is attributable to over dependence upon internal creative talent.

Six years ago, we noted that the companies with the highest percentage of internal development personnel and highest operating leverage were 3DO and Midway Games. 3DO declared bankruptcy in 2003, and Midway declared bankruptcy earlier this year. Another highly leveraged publisher, Acclaim (with over 60% internal development talent), declared bankruptcy in 2004. Still another, Eidos, was acquired for a fire sale price earlier this year. As noted above, THQ and Electronic Arts fell on hard times, largely due to overhead that was growing faster than revenues. We estimate that Take-Two and Activision each have approximately 75% of development performed in house. Both companies have acquired external studios in the past two


years, and appear to be moving even more development in house over the next few years.

DEVELOPMENT SYNERGIES One of the foreseen consequences of current generation console launches was the dramatic increase in the cost of game development. Each of the last three console transitions involved significant advances in hardware technology, with correspondingly significant advances in the quality of software produced for the new consoles. We think that the success of past console cycle transitions was determined more by advances in software development than by advances in hardware technology. The terms 8-bit, 16-bit, etc., refer to the amount of information processed by the console during each microprocessor cycle. The total amount of information processed is therefore a function of both the “bits” and the “cycles”. When microprocessors routinely doubled in power every 18 months during the 1980s and 1990s, the amount of information that could be processed in a finite period of time also routinely doubled. When Sony replaced its PSOne (which processed 32 bits of information per cycle at 33 megahertz cycle speed) with the PS2 (which processed 128 bits of information per cycle at 295 MHz), it increased the amount of information seen each second by almost 40 fold. This allowed for significant improvements in graphic design, with more fluid motion capture and a greater number of characters on screen performing more detailed maneuvers. To the extent that software developers were able to take advantage of this processing speed, games were longer, more complex, more visually stunning, and generally more interesting.

Unfortunately, providing greater information carries a greater cost, both in terms of time and money. The average PSOne game took a team of 10 – 12 developers approximately nine months to complete. If we assume fixed costs of $100,000 per game plus variable costs of $100,000 per year per developer (including office expense, systems support, taxes, benefits, etc.), the typical PSOne game cost publishers approximately $900,000 to produce. The average PS2 game took a team of 15 – 24 developers approximately 20 months to complete. If we assume no changes to fixed or variable costs, it’s easy to understand the estimated average cost of $3 – 4 million per PS2 game.

The Xbox 360 and the PS3 CPUs are 4 – 10x faster than those in their predecessors, with RAM that is 8 – 16x greater than legacy console memory. This means that current generation software has the potential to carry around 60 times the amount of information contained in legacy software. Middleware and development tools can significantly reduce the cost of creating games containing this exponential increase in information, but we estimate that at least a two- to four-fold increase in manpower or time is required to complete a current generation game. Current generation games frequently require the efforts of 50 – 70 person development teams, and cost between $10 – 15 million to produce. Increasingly, substantial investments in common development tools and processes allow for “learning curve” benefits, with subsequent games using the same game engine as a predecessor costing as much as 20% less to produce. The average current generation console game takes at least two full years to complete (with some efforts taking three to four years), compared with the average 20-month completion time for legacy generation games.

As we pointed out in our industry report five years ago (The Definition of Insanity), most of the large publishers lamented overspending on PS2, Xbox, and GameCube software development and abandoning the large PSOne installed base too early


when the last cycle launched. In the first three quarters of calendar 2000, Electronic Arts had a net loss of $73 million, while Activision and THQ eked out profits of $7 million and $5 million, respectively. The latter two companies capitalize software development, while EA expenses its development; on an apples-to-apples basis, all three companies lost a significant amount in the months leading up to the last console launch. Profits suffered in 2006 – 2008, as the publishers who made bets on the Xbox 360 and PS3 (EA, THQ, and to some extent, Take-Two) had rocky results, while the publishers with an emphasis on the Wii (Activision with its Guitar Hero brand and Ubisoft with its Imagine and Petz brands) thrived.

The greatest potential synergy is likely to come from porting games from one console to another. At present, games can be ported from the Xbox 360 to the PS3 at a relatively low cost, perhaps $3 million. Should Nintendo launch the Wii Plus (HD) over the next few years, we will expect to see games ported from the Xbox 360 to the other two consoles, driving average development costs lower. Should porting synergies materialize, we expect SKU counts to increase, and selection to broaden, driving current generation hardware adoption rates higher.

THIRD-PARTY DISTRIBUTION Every major publisher owns distribution assets sufficient to place the majority of its products on U.S. store shelves. We estimate that Nintendo and the U.S. and European publishers distribute between 90% and 95% of their published software using their own internal resources. Many of these publishers also own international distribution assets, particularly in Europe, that are used to place their own software products with retailers. Some publishers also pursue a strategy of using these internally owned distribution assets to distribute product for other publishers. Some publishers such as Activision and Electronic Arts acquired their international distribution assets primarily to distribute their own products, but now also distribute some third-party software. In the case of Activision and Take-Two, some publishers also distribute hardware.

Third-party distribution is a low-margin, low-risk line of business that we expect to decline during the current console cycle. The amount of software distributed by publishers using internal resources grew significantly over the past two console cycles as publishers expanded their operations to capture this link in the software value chain. We expect this trend to continue and to limit the growth rate for third-party distribution businesses in the future. However, as a greater number of games appear on retail shelves, particularly with the large boxes for the music themed games and several new peripheral bundles, we believe that distribution assets could provide some margin expansion as underrepresented independent publishers seek distribution for their products.

We believe that publishers should only pursue third-party distribution revenues when they maintain some form of competitive advantage or unique market position. Distribution is highly competitive, and with low margins and low growth rates, we believe that publishers should place a priority on growing publishing assets. We believe that most U.S. and European publishers have shed their marginal distribution assets and now only own value-added or strategic distribution assets, though we continue to believe that Take-Two’s U.S. distribution business is non-strategic.

GEOGRAPHIC DISPERSION OF REVENUES As we noted earlier in our discussion of geographic markets, we believe that the addressable market for U.S. and European publishers includes the North American


and European markets. The Japanese and other Asian markets are very difficult for U.S. companies to penetrate because of differences in consumer preferences and challenging distribution and retail networks. Going forward, we expect some further penetration of Asian online markets by U.S. and European publishers, though (with the exception of Activision Blizzard), we do not expect significant penetration over the next two years. EA intends to penetrate Asian markets with its free-to-play games, but we think that the company will likely generate only modest revenues over the near term.

We believe that approximately 70 – 85% of all U.S. software has the same appeal to European consumers as to U.S. consumers. Some products, such as U.S.-based sports games (e.g., football and baseball) and games based on U.S.-specific pop culture or media trends (e.g., children’s cartoons and some music themed games), simply do not carry the same appeal with European consumers. Other products, such as soccer games or racing games, generally perform better in Europe than in the U.S. We estimate that U.S. publishers with established distribution channels in Europe should expect to earn 45 – 50% of total revenues from this region by 2011. While some U.S. publishers have already achieved this level of international reach, we note that several U.S. publishers still have ample room to grow in this area. Figure 53 illustrates domestic versus international revenues for U.S. and European publishers in our coverage universe.

Figure 53—Domestic vs. International Revenues

North America International

North America International

Activision Blizzard 58% 42% 54% 46%Electronic Arts 51% 49% 58% 42%Majesco Entertainment 86% 14% 91% 9%Midway Games 62% 38% 65% 35%Nintendo 31% 69% 39% 61%Take-Two Interactive Software 75% 25% 65% 35%THQ 50% 50% 52% 48%Ubisoft Entertainment 41% 59% 39% 61%

2007 2008



ONLINE STRATEGIES When it merged with VU Games, Activision jumped past the rest of the publicly traded publishers to become the most successful online game publisher. There are many Chinese companies involved with online gaming, and many are enjoying great success, but among the packaged goods video game publishers, only Activision Blizzard has managed to generate significant profits from its online endeavors. Electronic Arts is perhaps the next farthest along among U.S. and European publishers in adopting an online gaming strategy with its several online efforts (Warhammer Online, pogo.com, a Star Wars MMO, and several free-to-play games


in development), but the company has experienced significant growing pains. EA has had mixed results in the past, developing several online games aimed at a massively multiplayer audience with its Ultima Online and Sims Online games, but neither ever achieved the level of success most expected. To date, Electronic Arts has not been profitable in online gaming, as the size of its audience has been smaller than generally expected. As we discussed in our industry report six years ago (see Myth #8—Online Gaming is the Next Great Thing), we believed that this market would take several years to develop and mature. So far, the other major U.S. and European publishers have been modest in their approaches to online gaming, with most incorporating multiplayer features into PC and console games. Among Western publishers, only Activision Blizzard has managed to generate immense success with its World of Warcraft.

All of the large U.S. and European publishers are looking for ways to add revenue streams through in-game advertising and microtransactions. For several years, Activision led the charge in developing a rate card for in-game ads, but since its merger with VU Games, we have not heard much about the in-game advertising opportunity. Electronic Arts has been working hard to deliver microtransactions to customers with its free-to-play games, but we remain skeptical that its choice of Western content (FIFA Online, NBA Street and Battlefield Heroes) will resonate with Asian audiences. The other Western publishers appear to have adopted a “wait and see” approach, and we expect that many will selectively exploit whatever opportunities arise in the future.

INTELLECTUAL PROPERTY STRATEGIES Content source is a key driver in determining the margin on video game software sales. A game’s content can be based upon an original concept (or sequel to an original concept), or may be based upon a concept owned by a third party. In most cases, third party intellectual property (“IP”) will have value only if the IP has been developed and used in another medium, such as film, television, comic books, toys or literary works. Games also may be based on “real-life” content, such as sports leagues or prominent celebrities.

A typical video game is burdened by both fixed and variable costs. On the fixed side, costs usually consist solely of development costs for the game (typically $10 million or more for a PC game, $10 – 20 million for current generation console games, and $300,000 to $1 million for a handheld game). Variable costs include the manufacturer’s royalty (typically 20 – 25% of gross sales for console and handheld games, zero for PC games), manufacturing costs ($1 – 2 per unit), distribution costs (zero to 15% for large publishers), royalties for licensed content (5 – 20% of gross sales, depending upon the license), royalties paid to third-party developers (typically 20 – 30% offset by any advance for R&D), and vendor allowances and other marketing support (zero to 10% of gross sales). The highest margin game in a perfect world is a PC sequel based upon original content that is internally developed, requires no license fee, and requires little marketing support. In such a case, the gross margin could approach 90%. We believe that Electronic Arts’ The Sims games generate gross margins that approach 90%. The lowest margin game will be externally developed, based upon licensed content, and published on a console, with margins below 30%. We believe that most EA Partners games (including Rock Band) provide examples of low-margin games, primarily due to the revenue sharing arrangement with the third party developer.


It follows then, that when content is original, margins can be quite high, because the games produced require no royalty payments. However, the risk associated with original content is quite high, as publishers are burdened with the expense of brand building. Although the margins generated from original properties can cushion some of the brand-building burden, publishers have tended to take the more conservative route over the past few years, and have increased reliance upon proven brands, especially as the “mass market” phase of the console cycle emerges. Of the 30 top-selling games in 2008, eight were licensed and 21 were sequels (only Wii Fit was a new intellectual property), and we expect similar figures in 2009. Notably, high profile new intellectual properties such as Dead Space, Mirror’s Edge, Shaun White, Left 4 Dead, Spore and Wii Music failed to break through, with some likely to be abandoned. The following paragraphs detail the intellectual property strategies of the eight publishers we cover.

Activision Blizzard

Activision Blizzard’s major licensed properties include Marvel properties (Spider-Man, X-Men, Marvel Ultimate Alliance), DreamWorks properties (Madagascar, Shrek, Shark Tale, Over the Hedge, Bee Movie, Kung Fu Panda and Monsters vs. Aliens), and several one-off licenses, including Tony Hawk, Doom, Wolfenstein, World Series of Poker, Lemony Snickets, and Cabela’s. Over the last decade, the company’s publishing sales mix has fluctuated between 50% and 80% derived from licensed content, but in 2002, the company began to focus on increasing the percentage generated from owned IP, and it developed three new brands: True Crime, Call of Duty and Gun. Only one of these brands was a huge success, but the company re-focused in late 2005, when Call of Duty sold quite well, and True Crime and Gun were disappointments. Activision cut its losses with the two disappointing brands, and cemented its future in 2006 by purchasing the Guitar Hero brand. Its merger with VU Games cemented Activision’s diversification into owned IP, when it gained control of the Blizzard stable of franchises, including Warcraft, Starcraft, Diablo and World of Warcraft. The company derives over two thirds of its revenues from owned IP, and we expect this percentage to grow in the future.

Activision’s licenses are relatively long term, with its license for Spider-Man locked up through 2017, and its license for Shrek subject to a renewal option. It has Tony Hawk under long-term license to lend his name to video games for another five years. While Activision does not disclose the terms of its licensing arrangements, we believe that its Spider-Man license carries a royalty rate of 12 – 15%, its Shrek license a rate of 15%, and most of its other licenses below a 10% rate. Its Doom license is rumored to carry a higher rate, but given that Doom IP owner id Software is also the developer of the content, we believe that Activision is able to earn at least a 40% gross margin on the PC game, and earn above a 30% margin on the console version. Because of the balance between licensed and owned IP, Activision is able to generate overall publishing gross margins in excess of 60%. We do not believe that any of Activision’s licenses represent more than 5% of total revenues.

Electronic Arts Electronic Arts is heavily dependent upon licensed content (with approximately 60% of revenues derived from third party IP), but much of its licensed content is differentiated through superior game development and marketing. Its sports franchises are all included as licensed content, and the company generally can be counted on to capture 60% or more in market share within each genre. Its licenses with the NFL, NBA and other sports leagues are likely to be renewable indefinitely,


and we see little risk to the company’s sports licenses overall. Because of its size and superior execution, Electronic Arts typically is granted a “first look” from IP owners, and in the past, it successfully exploited both the Harry Potter and Lord of the Rings licenses. While the company does not disclose the terms of its licensing arrangements, we believe that it pays royalties at an average rate of approximately 12%, with a range of between 5 – 20%. The higher end properties likely command royalties at the full 20% rate, while sports licenses on average probably command lower overall royalties. We note that in 2004, the company signed exclusive licenses with the NFL and its players, rumored to be significantly higher than its licenses in the past (we estimate an annual guarantee of $35 million). However, due to the exclusive terms of its license, we believe that the company will be able to generate profits over time.

Because of its ability to scale R&D expense due to the large number of units sold per game, we believe that Electronic Arts is able to generate margins in excess of 55% on most of its licensed content. EA has relinquished licenses for the James Bond (to Activision) and Lord of the Rings franchises over the last two years, but we do not believe that Electronic Arts is at risk to lose any meaningful licenses over the next few years. Given the shift by its competitors to owned intellectual property, we believe that EA is well positioned to win any licenses it chooses. We do not believe that any of Electronic Arts’ licenses represent more than 10% of total revenues.

The company also has several high profile brands that are wholly owned. Among these are The Sims, Burnout, Dead Space, Need for Speed, Medal of Honor, Army of Two, Spore, Mass Effect, Dragon Age, Mercenaries and The Saboteur. Each of these brands is likely to provide significant sequel potential over the next five years.

Majesco Entertainment Majesco has a relatively brief history as a publisher, with only a handful of games published to date, generally with disappointing results. Its first few games were based upon original content (BloodRayne, Psychonauts, and Advent Rising) and it released several more based upon third party IP (Jaws, Aeon Flux, and Taxi Driver). Because of disappointing sales of its first few releases, it cancelled its other new games, and decided to focus the company’s efforts on more modest budget and value titles. Its Game Boy Advance Video products (since discontinued) were all licensed, and its gadget business (also discontinued) was substantially dependent upon third party licenses, and both delivered results substantially below expectations. We believe that the company does not intend to grow its internal development capability, and we do not expect it to develop original IP over the next several years. Instead, Majesco is focused on gaining rights to DS and Wii titles that have been overlooked by its larger competitors. It has had tremendous success with this strategy, and has established two brands, Cooking Mama and Jillian Michaels Fitness Ultimatum in just over two years, with more likely on the horizon.

Midway Games Midway recently declared bankruptcy, we think it is an interesting case study on what can go wrong in terms of focus. Over the past decade, the company had been intent upon exploiting its deep stable of arcade IP, with its big sellers during the last cycle consisting of Mortal Kombat, Spy Hunter, and Gauntlet. We estimate that less than 30% of Midway revenues come from third party IP, but note that it licensed the publishing rights to Unreal Tournament in 2006. It enjoyed success with licensed property NBA Ballers, a “street” version of NBA basketball with the unique twist of gambling with the NBA star to win his prized possessions. It also released the highly


successful Blitz: The League, a story-driven football game with no professional sports license. Due to its reliance on owned IP, Midway positioned itself to generate healthy gross margins of 60% or more on most of its games, but the company could not generate sufficient sales to cover its sizeable overhead, and it generated losses year after year.

Nintendo Nintendo is laser focused on developing owned intellectual property, and 100% of its first party publishing revenues are derived from owned IP. The company is different from the other publishers we cover insofar as it is also a hardware manufacturer, and its software strategy is intended to provide differentiated content that will support its proprietary hardware. Thus, Nintendo first party games are available only on its DS and Wii consoles, providing an incentive to consumers to purchase those platforms instead of competitive platforms offered by Sony and Microsoft.

Take-Two Interactive Take-Two’s content, until 2006, consisted almost exclusively of owned IP. In 2005, the company purchased a development studio from Sega, allowing it to produce and publish branded sports games. The company has a fledgling sports business, with its NBA game performing very well, its hockey game likely breaking even, and its baseball games likely losing money. The baseball losses are the result of an onerous contract with Major League Baseball (through 2012) that all but ensures that Take-Two cannot generate a profit from these games. We expect licensed products to make around 30% of publishing revenues in FY:09. Take-Two owns the rights to the Civilization franchise, and owns Firaxis, its developer. The company also acquired Irrational Software, and obtained the rights to the highly successful BioShock. Because of the incredible margins earned on its flagship Grand Theft Auto franchise, we expect Take-Two to generate publishing gross margins of around 55 – 60% over the next three fiscal years, but think that the company’s relatively high fixed cost structure and its baseball license guarantee could limit its profitability. We do not expect any of Take-Two’s licensed properties to represent more than 15% of total revenues over the next few years.

THQ THQ has historically been somewhat more dependent upon licensed content than its competitors. Part of this dependence was intentional; the company has grown the video game market for products based upon the WWE license and has successfully exploited the Nickelodeon license (SpongeBob, Jimmy Neutron, Rugrats, Rocket Power, Fairly OddParents, Danny Phantom, everGirl, The Wild Thornberrys and Avatar) over the last five years. THQ has also executed well in building a market for Nickelodeon property Tak and the Power of JuJu under an innovative “game first” arrangement wherein the company produced the Tak game five years prior to the debut of the Nickelodeon cartoon show. The company has had even greater success with its Disney/Pixar license, producing multi-million unit sellers including Finding Nemo, The Incredibles, Cars, Ratatouille, WALL-E and Up. Other licenses include Polar Express, Monster House, Barnyard, Bratz, Scooby Doo, and The Punisher. We estimate that THQ incurs royalties on its licensed content ranging from 5 – 20%, with its Nickelodeon and Disney/Pixar licenses likely at the high end of the range. Because of the large number of units sold under these licenses, we estimate that THQ generated gross margins in excess of 60% on most of its licensed properties. The Nickelodeon master license (essentially all properties other than Tak) runs through 2010, and the company’s license with Pixar covers one additional property,


expected in 2011. Its WWE license was also renewed in 2004 for several more years, although the license is the subject of litigation (we expect the litigation to be resolved amicably, with a likely increase in the royalty rate, but a renewal of the overall license). We estimate that the combined Nickelodeon licenses represent approximately 15% of total revenues. We estimate that the Disney/Pixar license will account for approximately 18% of revenues this year. We estimate that the WWE license represented approximately 20% of revenues last year, and expect it to represent approximately 20% of revenues going forward. The company’s newest license, based on the Ultimate Fighting Championship league, is off to a spectacular start, and could represent as much as 15% of revenues this year. We do not expect any of THQ’s other licensed properties to represent more than 10% of total revenues over the next few years.

The company has had generally poor results from its efforts to develop owned IP, with properties Juiced, Full Spectrum Warrior and Destroy All Humans each having disappointing sequels. It also had fair to poor results with The Outfit, Company of Heroes, Stuntman, Frontlines Fuel of War and S.T.A.L.K.E.R., with at least two of these brands likely to be abandoned. Its Saint’s Row brand has fared better than the others, with solid sales of the original and a sequel, and the company revived its Red Faction brand this year, with generally positive reviews. In order to succeed going forward, we expect the company to focus on one or two new brands each year, and its recent restructuring supports this level of activity.

Ubisoft Ubisoft has an impressive lineup of owned IP, having purchased the licenses for the Tom Clancy series of games. The company produces five Tom Clancy games (Splinter Cell, Rainbow 6, Ghost Recon, EndWar and H.A.W.X) and likely plans further brand extensions. In addition, Ubisoft owns the Rayman, Driver, Far Cry, Petz and Imagine properties, and has rights to Prince of Persia, Brothers in Arms, Teenage Mutant Ninja Turtles, Open Season, Surf’s Up and Star Trek games. This generation, Ubisoft had phenomenal success with wholly-owned Assassin’s Creed, and it is preparing a sequel to its Wii brand, Red Steel. Every few years, Ubisoft releases a large scale game based upon a licensed property, with King Kong in 2005 and Avatar expected later this year.

Ubisoft’s strategy is to develop and control an ever increasing mix of owned IP, with a smattering of licensed content to enable it to broaden its exposure to the Wii and DS platforms. It’s overall blended license rate is probably less than 5% of sales, giving the company the greatest operating leverage in the industry, should it be able to successfully grow revenues over the next three years.


CONTENT COMPARISON The most successful publishers in the past have been those who built diverse libraries of branded games, producing sequels and recurring revenue streams. With steady, sequel-driven revenues, publishers have better visibility into their future performance, leading to better planning and investment. Less volatile revenue and earnings models have tended to engender more confidence from Wall Street and higher public valuations. In this section, we identify the most lucrative entertainment software brands and the publishers profiting from them.

For purposes of the following discussion, we examine U.S. retail sell-through figures provided by the NPD Group. We compare the reported sell-through figures for each brand to reported overall U.S. retail sell-through for each publisher, in order to extrapolate the contribution of each brand to the publisher’s overall success. Although NPD reports sell through (i.e., sales to consumers) rather than sell in (i.e., wholesale sales) and reports on a retail dollar basis rather than actual amounts realized by the publishers, we believe that this “apples to apples” comparison is useful in determining publisher dependence on individual brands.

BRAND BUILDING The publishers with the greatest success in creating and nurturing high-quality branded entertainment software are Nintendo, Activision and Electronic Arts. Nintendo is unquestionably the most successful creator of entertainment software over the past 20 years and captured the number one position in U.S. sales among software publishers each year until 2001. Many of the brands that Nintendo introduced in the 1980s and early 1990s for the NES and SNES consoles are still dominant brands today such as Mario, Zelda, and Donkey Kong. Similarly, Electronic Arts has built a portfolio of recurring revenue streams by growing its library of established brands. Electronic Arts now dominates the sports genre and its hit football, soccer, basketball, and golf games (among many others) are best sellers year after year. Electronic Arts also has expanded beyond the sports game genre and built successful brands in many other genres, including the real-time-strategy genre (Command & Conquer and Battlefield), strategy/RPG genre (The Sims), extreme sports (Skate), kiddie (Harry Potter) and the driving genre (Burnout and Need For Speed). Activision’s results are far more concentrated, with its top two brands (Guitar Hero and Call of Duty) responsible for over 70% of its domestic sales. According to NPD, in 2008, Electronic Arts captured the highest market share for entertainment software sales in the U.S., with its 20.3% market share slightly ahead of second place Activision’s 16.7% share, with Nintendo in third place with 16.6% market share.

TOP BRANDS OF 2008 A look at the top-selling brands of 2008 (Figure 54) provides a proxy for which publishers currently own mega-hit content. We note that Electronic Arts published eight of the top 30 brands, with four from Nintendo, three each from Activision and Ubisoft, two each from LucasArts, Microsoft and Konami, and one apiece from six other publishers. Most strikingly, Sony had no top 30 brands for the third year in a row.


Figure 54—Top Interactive Entertainment Software Brands (U.S. $ Sales 2006 – 2008)

2008 2007 2006 Brand Primary Publisher 2008 2007 2006

1 1 8 Guitar Hero Activision Blizzard 992$ 821$ 154$ 2 2 2 Mario Brothers Nintendo 761$ 472$ 257$ 3 8 - Rock Band Electronic Arts 662$ 181$ -$ 4 5 5 Call Of Duty Activision Blizzard 446$ 316$ 169$ 5 - - Wii Fit Nintendo 407$ - -6 - 14 Grand Theft Auto Take-Two Interactive 361$ 54$ 94$ 7 4 1 Madden Football Electronic Arts 312$ 321$ 339$ 8 7 - Wii Play Nintendo 261$ 204$ -9 - - LEGO LucasArts 224$ - -10 11 3 Star Wars LucasArts 180$ 142$ 227$ 11 27 25 Sonic Sega 163$ 63$ 64$ 12 - 16 Gears Of War Microsoft 146$ 50$ 92$ 13 9 7 The Sims Electronic Arts 143$ 178$ 158$ 14 13 6 Tom Clancy Ubisoft 130$ 132$ 165$ 15 6 9 Pokemon Nintendo 119$ 237$ 114$ 16 12 4 Need For Speed Electronic Arts 106$ 132$ 173$ 17 14 - Warcraft Activision Blizzard 104$ 120$ 32$ 18 15 13 WWE THQ 103$ 114$ 94$ 19 - - Fallout Bethesda Softworks 100$ - -20 19 11 NCAA Football Electronic Arts 94$ 90$ 110$ 21 18 22 Tiger Woods Electronic Arts 89$ 91$ 67$ 22 20 12 FIFA Electronic Arts 79$ 76$ 102$ 23 - - Imagine Ubisoft 78$ 19$ -24 - 10 Final Fantasy Square Enix 78$ 56$ 113$ 25 21 23 Dance Dance Revolution Konami 78$ 75$ 66$ 26 - - Metal Gear Solid Konami 77$ 7$ 18$ 27 - - Fable Microsoft 77$ 4$ 12$ 28 26 20 NBA Live Electronic Arts 71$ 65$ 83$ 29 - - Mortal Kombat Midway Games 70$ 21$ 36$ 30 28 - Petz Ubisoft 70$ 60$ 33$

Top 30 Brands as a % of Total U.S. Retail Sales 56% 43% 46%

Rank Sales ($ mil)


TOP BRANDS BY COMPANY The table in Figure 55 lists the top 10 brands for each publisher (U.S. sales) and the percentage of total company sales that these ten brands generated for their publishers and illustrates the depth of each publisher’s portfolio of “hit brands” and dependence on these brands. We believe that brand depth is one the most important indicators of a publisher’s future prospects. Strong software brands provide a publisher with sequel titles for several years and a deep library of brands provides a steady base of recurring revenues. We note that all but two of the top 30 brands is an established brand with a history of producing successful titles prior to 2008. These mega-hit brands are the result of growing and developing successful brands over


several years. Possessing a deep library of solid brands is the first step to producing one of these mega-hit brands in the future.

Figure 55—Publisher Top Brands (U.S. $ Sales 2008)

CY 2008 ACTIVISION CY 2008 ELECTRONIC ARTS Amount Amount

Rank Brand ($ mil) Rank Brand ($ mil)1 Guitar Hero 992$ 1 Rock Band 662$ 2 Call Of Duty 446$ 2 Madden Football 312$ 3 Warcraft 104$ 3 The Sims 143$ 4 Spider-Man 42$ 4 Need For Speed 106$ 5 Cabela's 32$ 5 NCAA Football 94$ 6 Kung Fu Panda 32$ 6 Tiger Woods 89$ 7 James Bond 25$ 7 FIFA 79$ 8 Transformers 23$ 8 NBA Live 71$ 9 Crash Bandicoot 20$ 9 Left 4 Dead 67$ 10 Tony Hawk 17$ 10 Battlefield 57$

Total Top 10 Brands 1,734$ Total Top 10 Brands 1,680$

%* 89% %* 71%CY 2008 MAJESCO CY 2008 MIDWAY CY 2008 NINTENDO

Amount Amount AmountRank Brand ($ mil) Rank Brand ($ mil) Rank Brand ($ mil)

1 Cooking Mama 45$ 1 Mortal Kombat 70$ 1 Mario Brothers 761$ 2 Jillian Michaels 13$ 2 Game Party 30$ 2 Wii Fit 407$ 3 Cake Mania 3$ 3 Unreal 17$ 3 Wii Play 261$ 4 Left Brain Right Brain 3$ 4 TNA IMPACT! 9$ 4 Pokemon 119$ 5 Wonder World Amusement Park 2$ 5 Touchmaster 6$ 5 Zelda 67$ 6 Wild Earth 2$ 6 Blitz: The League 5$ 6 Animal Crossing 54$ 7 Furu Furu Park 2$ 7 NBA Ballers 4$ 7 Nintendogs 44$ 8 Nancy Drew 1$ 8 Blacksite: Area 51 3$ 8 Wii Music 42$ 9 Jaws 1$ 9 Stranglehold 2$ 9 Brain Age 39$ 10 Pet Pals 1$ 10 Cruis'n 1$ 10 Kirby 26$

Total Top 10 Brands 72$ Total Top 10 Brands 147$ Total Top 10 Brands 1,820$

%* 88% %* 94% %* 94%CY 2008 TAKE-TWO CY 2008 THQ CY 2008 UBISOFT

Amount Amount AmountRank Brand ($ mil) Rank Brand ($ mil) Rank Brand ($ mil)

1 Grand Theft Auto 361$ 1 WWE 103$ 1 Tom Clancy 130$ 2 NBA 2K 60$ 2 Saints Row 40$ 2 Imagine 78$ 3 Carnival Games 54$ 3 MX Vs ATV 33$ 3 Petz 70$ 4 MLB 2K 49$ 4 Wall-E 25$ 4 Shaun White Snowboarding 49$ 5 Midnight Club 49$ 5 SpongeBob SquarePants 25$ 5 Assassin's Creed 41$ 6 Civilization 37$ 6 Cars 20$ 6 Rayman 40$ 7 Bully 17$ 7 Frontlines: Fuel of War 17$ 7 Prince Of Persia 33$ 8 Elder Scrolls 14$ 8 Drawn To Life 17$ 8 Far Cry 25$ 9 NHL 2K 12$ 9 Paws & Claws Pet 14$ 9 Brothers In Arms 21$ 10 Top Spin 9$ 10 de Blob 11$ 10 My Coach 18$

Total Top 10 Brands 662$ Total Top 10 Brands 305$ Total Top 10 Brands 505$

%* 90% %* 69% %* 80%*% of total company U.S. sell-through attributable to top ten brands

*% of total company U.S. sell-through attributable to top ten brands


As Figure 55 illustrates, Nintendo, Electronic Arts and Activision were the only publishers with more than one brand that generated over $100 million in U.S. retail sales during 2008. We chose a $100 million threshold because we believe that this figure reflects potential lifetime sales of more than three million units, indicating a bona fide “home run”. All of Electronic Arts’ top-10 brands generated


more than $57 million in 2008, demonstrating the company’s exceptional brand library. Nintendo had ten brands generate more than $20 million apiece, with Activision (nine), and Ubisoft (nine) right behind. Take-Two and THQ each had six brands over the $20 million threshold, with Midway (two) and Majesco (one) rounding out the rest. The $20 million level of U.S. retail sales, in our view, is a good proxy for a worldwide million unit seller, reflecting a bona fide “hit” franchise that contributes significantly to each company’s bottom line results.

Figure 55 also provides insight into the U.S. revenue concentration of the publishers. We note that the two most diversified large publishers, EA and THQ, derived 71% and 69% of 2008 U.S. sales, respectively, from their top 10 brands and only 28% and 23% from their top single brand, respectively. As much as this sounds balanced, we note that both EA and THQ had miserable financial performance in 2008, with each generating significant operating losses. The least diversified companies last year were Activision and Nintendo, who not so coincidentally had the best financial performance. Thus, diversification may not always be a good sign, particularly if the average game in a company’s portfolio is unprofitable.

Over the past five years, we have seen a concerted effort from the U.S. and European publishers to emulate Electronic Arts, recognizing that increased brand diversification mitigates risk as we enter the console transition. Take-Two has added a full line of sports titles to its portfolio, and has created or acquired several solid intellectual properties in an effort to diversify away from its dependence upon the Grand Theft Auto brand. We expect THQ to continue its diversification selectively, and believe that Activision continue its strategy of annually introducing one new wholly owned intellectual property (this year’s Blur) in order to grow margins late in the current console cycle.


ACCOUNTING ISSUES CAPITALIZED SOFTWARE DEVELOPMENT AND PREPAID ROYALTIES Under GAAP, companies are required to capitalize amounts paid for intellectual property that relate to future periods. “Payments” consist of advances paid to third parties for licenses, progress payments to third party developers, and amounts paid as salaries and occupancy for internal developers prior to the release of the game that is being developed. Because some licensing and development arrangements represent efforts that may extend over several years, video game publishers are required to capitalize amounts paid in one period when the underlying game is expected to be delivered in a later period. There is little flexibility under the accounting rules regarding the amounts to be capitalized, once a decision is made that the game being developed is “feasible”. However, great flexibility is offered to companies in determining the rate at which capitalized license and royalty fees are amortized. In general, these amounts are amortized on a units-of-production basis, whereby each company makes its best estimate of the number of units of a game that will likely be produced. Should the estimate be lower than the actual units sold, the game’s capitalized license fees will be amortized relatively rapidly; should the estimate be greater, the license fees will be amortized relatively slowly.

As a general rule, many people are confused by the treatment of capitalized software development and prepaid royalties. It appears to us that investors are frequently confused/concerned about how various publishers treat software development costs, and many investors believe that the companies are deferring recognition of expense (and managing earnings) by making additions to the capitalized software or prepaid license account. In particular, investors are confused about the "current asset" account treatment of capitalized software and prepaid licenses, as amortization of the current asset account should be expected to impact earnings over the next 12 months.

Under GAAP and SFAS No. 86, companies are required to make every effort to match expense and revenue within the same period (meaning, for example, that if an expense is incurred in the first quarter of the year that results in revenue in the third quarter, the recognition of the expense should be deferred until the third quarter). Most of the companies in the interactive entertainment software publishing business follow SFAS No. 86, and have been capitalizing software development for several years. Electronic Arts has chosen to expense software development when incurred, creating the appearance of negative operating leverage when the expenses are incurred, and positive operating leverage when the underlying games are released. Electronic Arts has managed to convince its auditors that it cannot determine whether a game is “viable” (requiring capitalization) until the game is released, and therefore, the company has chosen to expense all software development (continuing to capitalize prepaid royalties). We think that the recent decline in EA’s share price is in large part attributable to the fact that the company continues to invest in development without any underlying revenues, causing investors to believe that growth has stalled.

The problem many investors perceive is a gradual and substantial increase in the amounts capitalized. Midway, THQ and Take-Two have all built sizeable capitalized software and prepaid royalty balances over the last few years. These balances are a


function of two factors: first, the number of games under development expected to be released during the year; and second, the escalating development cost of the typical game. In the current console cycle, it is clear that each publisher is interested in capturing as much market share as possible. In addition, the launches of three major console platforms, as well as the launches of the Nintendo DS and the Sony PSP required the development of as many as eight versions of each new title, contributing to the proliferation of games under development. The cost of development has risen from an average of $100,000 (handheld) and $500,000 (console) in the PSOne cycle to an average of $350,000 (handheld) and $3 million (console) in the PS2 cycle (our estimates), and current generation console games typically cost as much as $10 million each to produce. Taken together, these factors have contributed to a large increase in development costs for every publisher.

Activision has become more like EA throughout the current cycle. The company’s capitalized software balance is at a record low as a percentage of its sales, as it has adopted the conservative policy of deeming new games infeasible until launch. As a result, development spending on games like Blur (a new racing game) have been largely expensed rather than capitalized. We expect Activision to deliver far more leverage than is typical from a company that capitalizes software development, due to its conservative approach.

The timing of game development and release is yet another important factor. In the PSOne cycle, game development seldom took more than a year, and often took as little as three months. Thus, there were fewer occasions that created a mismatch in timing between development spending and revenue recognition. In the PS2 cycle, the major console games typically took 18 months or longer to develop. The bulk of development spending therefore seldom occurred within the same year as games were released, creating a need to capitalize to the current asset account. In the current cycle, game development often takes as long as three years, resulting in even larger growth of long-term capital accounts. In addition, the typical console game has enjoyed an extension of its “shelf” life, due to tiered pricing for new releases and catalog titles. Thus, games that used to sell 90% of total units within six months of release now sustain reasonable sales levels for as long as a year.

We believe that growth in the capitalized software account balance is necessary for companies choosing to participate in the current console cycle, notwithstanding that many industry observers see it as a deferral of expense. Increases in prepaid royalties are a function of company strategy, with companies that are more heavily dependent upon licensed content (such as THQ) spending more to acquire key licenses. In our view, spending on new products reflects management commitment to growth, and we think that additions to the capitalized software and prepaid royalty account balances reflect such commitment. We expect to see continued additions to the capitalized software account balances at each publisher that capitalizes over the next two years, as the publishers ramp up their capability to create current generation games.

As we approach the middle of this console cycle, we believe that higher and higher development spending will be the norm. First, developing games for multiple platforms is likely to increase overall development spending. Second, most publishers are concerned about conceding a competitive advantage to the others, and each has incurred investment in development tools for the current generation consoles. So long as the current console cycle creates growth in demand, we expect to see net additions to capitalized software development costs. The pace of the additions for current generation consoles will slow as the rate of growth of the


installed console base slows, but will be more than offset by significant development spending for online games, microtransaction-based free-to-play games, and MMOs.

RESERVES Another area of concern for investors is an account called “reserves for returns and allowances”. This account is created by companies to protect against the financial risk arising from either returns of games that under perform in the marketplace or from planned price cuts for games that were released in prior periods. Because of the negotiating leverage of video game retailers (such as Wal-Mart, Best Buy, Target, and GameStop), the publishers must also protect against “requested” price concessions for any game not selling well.

Each of the interactive entertainment software publishers maintains a reserve against the potential for product returns and price protection. Historically, these reserves have been managed by adding a sufficient amount to the reserve balance to create a cushion, and drawing down against the reserve whenever price protection is granted. We estimate that actual charges against reserves for most companies in the industry average approximately 6 – 9% of sales, and we expect additions to reserves to be sufficient to maintain a cushion. In other words, we believe that overall reserve balances should grow in line with revenue growth, and that quarterly additions should generally offset actual charges during the preceding quarter.

Unfortunately, the practice in the industry has been to compare the absolute dollar amount of the reserve against the absolute dollar amount of gross accounts receivable, creating a misleading “reserve ratio” that is analogous to the more typical bad debt reserves maintained by manufacturers of other products. Investors are often confused by this ratio, and any downward movement in the ratio typically causes downward pressure on the publisher’s stock price. We believe that reserves for allowances and returns are much more closely correlated to sales than they are to receivables balances, for two reasons:

First, receivables balances in this sector are more volatile than in other sectors due to the nature of interactive entertainment software publishing. Most publishers offer relatively few products each quarter (an average of 10 – 15), and each shipment of product will cause receivables to swell temporarily. This is in contrast to classic manufacturing, where 1,000 widgets flow off the assembly line each day, and sales are relatively constant from week to week. Thus, reserve ratios will fluctuate wildly as the denominator (accounts receivable) fluctuates, even if the numerator (reserves) remains constant.

Second, the reserve balance reflects the risk that a portion of sold product will be returned or will be discounted through vendor concessions. Although highly subjective, the underlying analysis of reserves should consider the quality of the products sold, and whether they are being sold at expected levels and at full price. Again, this relationship is more closely correlated to sales than it is to receivables. In addition, reserves would be maintained even if all purchases were paid for in cash (i.e., no accounts receivable balance), so it is clear that the reserve balance should reflect the risk that a portion of the company's sales, and not receivables, will be returned or offered price protection. Because sales occur throughout the quarter and receivables are merely a snapshot in time, trying to gauge a relationship between reserves and receivables will always be a moving target; measuring them against sales more closely reflects the risk inherent in the sales.


Each company we cover appears to have sufficient reserves, with most maintaining reserves of approximately 20% of peak quarter sales. In our view, reserves in excess of 10% of peak quarter publishing revenues are excessive. We believe that five of the companies we cover may have reserves in excess of what will be required to provide price protection to customers, but believe that each of these companies has maintained a conservative reserve balance in order to minimize the likelihood of earnings shortfalls in subsequent periods attributable to games that under perform.

In summary, we believe that reserves should reflect the likelihood that a portion of full-price sales will be returned or discounted. We think that although subjective, the adequacy of a particular company’s reserve should be a function of the quality of its products. This measure will apply regardless of the level of receivables, and we caution investors against accepting a reserve “ratio” as proof of reserve adequacy.


UPSTARTS AND STARTUPS The video game industry is likely to change considerably over the next five years, with constantly evolving business models. In this section, we briefly explore the strategies of several new companies we expect to change the landscape. Among these are game delivery network OnLive, console manufacturer Zeebo, casual gaming startup WebWars, and free-to-play startup Quick Hit.

OnLive

OnLive is the creation of Rearden Labs, founded by Internet pioneer Steve Perlman. The company has created technology that compresses video games in such a way as to limit latency when games are played online. The company intends to host games that are purchased or rented by consumers on central servers, and to enable its customers to play games on any television or PC, provided that there is a high speed Internet connection nearby. While the business model is still under development, we find the concept incredibly exciting, given that the OnLive offering will not involve any physical purchase of a game disc or download. Thus, game publishers will be protected against piracy, and consumers will not be in a position to re-sell games for later sale in the used market.

Zeebo Zeebo is a videogame console that launched in Brazil earlier this year. The console allows consumers to purchase games through a 3G wireless connection, and is expected to retail for around $249, or one-third the cost of a current generation console. While games for the device are primarily last generation quality, Zeebo is marketing to an audience that is just beginning to adopt last generation consoles, and newer games from EA and id are offered on the system. It appears that this concept will allow Zeebo to expand games to markets where taxes and political considerations have blocked access in the past.

WebWars WebWars offers browser-based online games for younger gamers, making the web browser a fundamental component of the game. The WebWars approach offers games in modular form, with each module serving as a building block for any other game. The concept is simple and the execution appears brilliant, with the company’s ad-supported model likely to generate significant revenues. Although its initial launch will be in the West, it’s clear that there will be opportunities in Asia in the future.

Quick Hit Quick Hit is a free-to-play football game supported by microtransaction revenue. Unlike many of its competitors, the company’s approach is to sell real-world items (energy drinks, footwear, jerseys) that are essential to real-world football players to play at a professional level. There is opportunity for the game to attract sponsored microtransactions, lowering the cost of play to the consumer. Like WebWars, Quick Hit is browser-based, placing the player in the role of coach and allowing him to make strategic choices. Players improve and advance with persistent game play. The game is expected to launch in September.

We think that these four upstarts will make headlines in 2009, and have the potential to make their investors a lot of money in the future.


SECTION 3: COMPANY PROFILES


COVERED PUBLICLY TRADED INTERACTIVE ENTERTAINMENT COMPANIES

Companies Under Coverage Activision Blizzard (ATVI)

Electronic Arts (ERTS)

Majesco Entertainment (COOL)

Midway Games (MWY)

Nintendo (7974.JP / NTDOY.US)

Take-Two Interactive Software (TTWO)

THQ (THQI)

Ubisoft Entertainment (UBI.FP)

Retail Companies Under Coverage

Best Buy (BBY)

Blockbuster (BBI)

GameStop (GME)


Activision Blizzard (ATVI)

52-Week Range $8.14–19.28 ST / LT Debt $0 / 0 Shares Outstanding 1.3 billion Debt/Capital 0% Insider/Institutional 52% / 48% ROE NMF Public Float 572 million Cash & Inv/Share $2.29 Market Capitalization $16 billion Book Value /Share $8.42

FYE 2009A** CY 2009E** CY2010E** EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 $0.08 $0.08A $0.09E Q2 0.12 0.07E 0.12E Q3 0.07 0.11E 0.12E Q4 0.31 0.41E 0.47E Year** $0.58 $0.67E $0.80E P/E Ratio N/A 18x 15x Change N/A N/A 19%

FYE 2009A** CY 2009E** CY2010E** Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 $603 $724A $783E Q2 654 785E 916E Q3 770 870E 898E Q4 2,343 2,490E 2,653E Year** $3,767 $4,869E $5,250E Change N/A N/A 8%

**Pro forma ** Numbers may not add up due to rounding. **Activision changed FY to CY in 2008, amounts shown are in calendar quarter format.

Activision’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)

Price (as of close 6/22/09)

$12.33

Rating STRONG BUY

12- Month Price Target $16

Source: Nasdaq.com Company Description Activision Blizzard, headquartered in Santa Monica, California, develops, publishes, and distributes interactive entertainment software for PCs, home consoles, handheld devices, and the Internet.

C Y 2 0 0 8 A C T IV IS IO N A m o u n t

R a n k B ra n d ($ m il)1 G u ita r H e ro 9 9 2$ 2 C a ll O f D u ty 4 4 6$ 3 W a rc ra f t 1 0 4$ 4 S p id e r -M a n 4 2$ 5 C a b e la 's 3 2$ 6 K u n g F u P a n d a 3 2$ 7 J a m e s B o n d 2 5$ 8 T ra n s fo rm e rs 2 3$ 9 C ra s h B a n d ic o o t 2 0$

1 0 T o n y H a w k 1 7$

T o ta l T o p 1 0 B ra n d s 1 ,7 3 4$

Source: The NPD Group/Retail Track and Wedbush Morgan Securities.


COMPANY OVERVIEW Activision Blizzard, based in Santa Monica, California and founded in 1979, was the first independent developer and distributor of entertainment software. Today it is a leading video game software publisher for Nintendo, Sony, and Microsoft video game consoles as well as for the PC. In addition to publishing, it maintains distribution operations in Europe for third-party publishers of interactive entertainment software, its own publishing operations, and manufacturers of interactive entertainment hardware. Key games include its Marvel licensed Spider-Man and X-Men games, and its Call of Duty, Tony Hawk, and Guitar Hero games. In July 2008, it merged with Vivendi’s game unit bringing the highly successful World of Warcraft online game to the company. Vivendi owns approximately 52% of the Activision’s shares. VALUATION Activision’s core business remains strong, and the continued growth of Blizzard’s business give us great confidence in our estimates. Blizzard has recently shifted service providers in China, driving a likely $0.03 increase in EPS this year and another $0.03 in EPS growth next year as a result. Blizzard is expected to launch Starcraft 2 later this year, with two Starcraft 2 expansion packs launching next year. We expect to see the Activision’s product mix shift, with owned intellectual property and lower cost licensed property comprising a greater portion of publishing revenues next year. We note that most of Activision’s major FY:10 games (Modern Warfare 2, Tony Hawk Ride and Blur) showed very well at the E3 Expo. We believe Modern Warfare 2 will be the best selling game in 2009. Maintaining our STRONG BUY rating, and our $16 price target, which reflects a forward multiple of 18x our calendar 2010 adjusted EPS estimate of $0.76 plus $2.50/share in cash. Our price target reflects a discount to the current forward multiple for the S&P 500 to reflects concerns about Activision’s revenue concentration from its three flagship properties. Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software, the effects of competition, options investigation impact, and lower than expected consumer demand for video game hardware.



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Electronic Arts (ERTS)

52-Week Range $14.24–$50.17 ST / LT Debt $0 / 0 Shares Outstanding 325 million Debt/Capital 0% Insider/Institutional 5% / 92% ROE N/A Public Float 314 million Cash & Inv/Share $7.83 Market Capitalization $6 billion Book Value/Share $9.73

FYE MAR 2009A 2010E 2011E EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun $(0.42) $(0.12)E $(0.05)E Q2 Sep (0.06) 0.28E 0.29E Q3 Dec 0.56 1.03E 1.05E Q4 Mar (0.37) (0.20)E 0.06E Year** $(0.30) $1.00E $1.35E P/E Ratio N/A 20x 15x Change N/A N/A 35%

FYE MAR 2009A 2010E 2011E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun $609 $779E $892E Q2 Sep 1,126 1,244E 1,277E Q3 Dec 1,742 1,670E 1,736E Q4 Mar 609 657E 795E Year** $4,086 $4,350E $4,700E Change 2% 6% 8%

*Pro forma.

** Numbers may not add up due to rounding.

Electronic Arts’ Top 10 Selling Brands for 2008 (U.S. Retail Sales $)


$19.97

Rating BUY


Source: Nasdaq.com Company Description Electronic Arts, headquartered in Redwood City, California, develops, publishes, and distributes interactive entertainment software for personal computers, home consoles, handheld devices, and the Internet.

C Y 2 0 0 8 E L E C T R O N I C A R T S A m o u n t

R a n k B r a n d ( $ m i l )1 R o c k B a n d 6 6 2$ 2 M a d d e n F o o t b a l l 3 1 2$ 3 T h e S im s 1 4 3$ 4 N e e d F o r S p e e d 1 0 6$ 5 N C A A F o o t b a l l 9 4$ 6 T ig e r W o o d s 8 9$ 7 F I F A 7$ 8 N B A L iv e 7 1$ 9 L e f t 4 D e a d 6 7$

1 0 B a t t le f ie ld 5 7$

T o t a l T o p 1 0 B r a n d s 1 , 6 8 0$

9

Source: The NPD Group/Retail Track and Wedbush Morgan Securities


COMPANY OVERVIEW Electronic Arts, based in Redwood City, California, is one of the largest independent developer and publisher of interactive entertainment software in the world. EA games are segmented into three major brands, EA Games, EA Sports, and EA Play. Top titles under the EA Games label include Battlefield, Need For Speed, Medal of Honor, and Harry Potter. The EA Sports division is the industry leader with top-selling sports games including Madden NFL, NCAA Football, NBA Live, FIFA Soccer, and Tiger Woods PGA Tour. EA Play brands include The Sims and its Hasbro and other casual games. Electronic Arts also develops online subscription games such as Warhammer and Pogo as well as games for mobile devices/phones. VALUATION Despite recent weak performance, we continue to like the EA story. We have been wrong about this stock for close to five years, overestimating management’s ability to manage the company’s cost structure. This time, we are again placing our faith in management’s ability to cut costs (the definition of insanity), but this time, we genuinely expect a different outcome. In contrast to prior false starts, EA management has actually cut costs and reduced both headcount and projects. We think that the Q4 results reflect management’s commitment to cost cutting, and believe that the company is sincere in its expressed desire to grow profits substantially over the next few years. EA’s first half lineup is loaded, with Harry Potter, Tiger Woods, EA Sports Active and Fight Night up against easy Q1 comps, and with FIFA and Need for Speed up against easy Q2 comps. We think that the company’s lineup will allow it to handily beat consensus expectations the first half of the year, and expect EA shares to continue to appreciate over the near term. We are particularly impressed with the potential for EA Sports Active and for Tiger Woods, and think that both could be blockbusters on the Wii. Maintaining BUY, and our $27 price target, reflecting a multiple of 15x our adjusted FY:11 EPS estimate of $1.29/share, plus $8/share in cash. Our target is below the low end of the company’s historical range, reflecting market contraction and recent poor execution. Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software, the effects of competition (both from other video game publishers and from other forms of entertainment), and slower than expected consumer demand for video game hardware.


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Majesco Entertainment (COOL)

52-Week Range $0.36–2.18 ST / LT Debt $0 / 0 Shares Outstanding 29 million Debt/Capital 0% Insider/Institutional 43% / 19% ROE 13% Public Float 22 million Cash & Inv/Share $0.35 Market Capitalization $54 million Book Value/Share $0.40

FYE OCT 2008A 2009E 2010E EPS($) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jan $0.07 $0.13A $0.12E Q2 Apr (0.01) 0.01A 0.00E Q3 Jul 0.01 (0.01)E 0.04E Q4 Oct (0.04) 0.03E 0.05E Year** $0.02 $0.15E $0.21E P/E Ratio 94x 12x 9x Change N/A 650% 40%

FYE OCT 2008A 2009E 2010E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jan $19 $33A $29E Q2 Apr 13 21A 16E Q3 Jul 14 14E 17E Q4 Oct 18 19E 29E Year** $64 $86E $90E Change 25% 35% 5%

** Numbers may not add up due to rounding. **Pro forma.

Majesco’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)


$1.87

Rating BUY

12- Month Price Target $2.50

Source: Nasdaq.com Company Description Majesco Entertainment, based in Edison, New Jersey, is a global developer, publisher and marketer of interactive entertainment software and accessories.

C Y 2 0 0 8 M A J E S C OA m o u n t

R a n k B ra n d ($ m il)1 C o o k in g M a m a 4 5$ 2 J il l ia n M ic h a e ls 1 3$ 3 C a k e M a n ia 3$ 4 L e f t B ra in R ig h t B ra in 3$ 5 W o n d e r W o r ld A m u s e m e n t P a rk 2$ 6 W ild E a r th 2$ 7 F u ru F u ru P a rk 2$ 8 N a n c y D re w 1$ 9 J a w s $

1 0 P e t P a ls 1$

T o ta l T o p 1 0 B ra n d s 7 2$

1



COMPANY OVERVIEW Majesco Entertainment, based in Edison, New Jersey, is a global developer, publisher and marketer of interactive entertainment software and accessories. In addition to its own proprietary brands such as BloodRayne, Majesco is a supplier of value-priced Nintendo GBA, DS, and Wii software, and accessories. Majesco Sales Inc. was incorporated in 1986 in New Jersey. On December 5, 2003, Majesco Sales Inc. completed a reverse merger with ConnectivCorp, then a publicly traded company with no active operations. As a result of the merger, Majesco Sales Inc. became a wholly-owned subsidiary and the sole operating business of the public company. On April 13, 2004, the public company changed its name from "ConnectivCorp" to "Majesco Holdings Inc." On December 31, 2004, Majesco completed a 1-for-7 reverse stock split. On January 26, 2005, Majesco completed a secondary offering of 6 million shares at $12.50/share for $75 million, with about $46 million in company proceeds and the rest to selling shareholders. On April 11, 2005, Majesco changed its name from Majesco Holdings Inc. to Majesco Entertainment Company. VALUATION Majesco’s recent performance is solid. We continue to believe that Majesco can deliver sustainable profits, as we have better revenue visibility with an ever stronger game lineup. Majesco has stabilized margins, aggressively managed expenses, and delivered $0.16 in EPS over the last six quarters. The company’s focused portfolio of casual titles continues to expand, and we expect it to add one hit title per year to its current lineup of Cooking Mama and Jillian Michaels. We think there is some potential to expand the Mama brand. It is difficult to measure the impact of any potential capital raise. We believe that the company has sufficient liquidity for its operations, and envision a sale of securities only in the event of an acquisition. We believe investors should remain focused on Majesco’s continuing profitability. The company has delivered consistent profits for six quarters, and appears positioned to do so for the foreseeable future. Maintaining our BUY rating, and $2.50 price target, which reflects a forward P/E multiple of 12x our FY:10 EPS estimate of $0.21. The company appears to be in a position of sustainable profitability, and its liquidity is much improved. Risks to attainment of our share price target include negative changes in performance of the company’s products, access to capital, balance sheet and cash liquidity risks, changes to game release timing, the effects of competition, changing macroeconomic factors, and changes in consumer demand for video game hardware.



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Midway Games (MWYGQ)

52-Week Range $0.03–$4.20 ST / LT Debt (mil) $225 / 0 Shares Outstanding 93 million Debt/Capital 97% Insider/Institutional 86% / 6% ROE N/A Public Float 13 million Cash & Inv/Share $0.26 Market Capitalization $6 million Book Value/Share $(1.70)

FYE DEC 2007A 2008A 2009E EPS($)* ACTUAL ACTUAL PREVIOUS CURRENT PREVIOUS Q1 Mar $(0.22) $(0.37)A $(0.32)E Q2 Jun (0.16) (0.38)A (0.21)E Q3 Sep (0.37) (0.83)A (0.13)E Q4 Dec (0.35) (0.50)A 0.17E Year** $(1.09) $(2.08)A $(0.50)E P/E Ratio NA NA NA Change NA NA NA

FYE DEC 2007A 2008A 2009E Revenue ($ mil.) ACTUAL ACTUAL PREVIOUS CURRENT PREVIOUS Q1 Mar $11 $30A $27E Q2 Jun 32 23A 28E Q3 Sep 37 51A 48E Q4 Dec 78 115A 97E Year** $157 $220A $200E Change -5% 40% -9%

*Excludes preferred stock accretion.


Midway’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)


$0.06

Rating HOLD

12- Month Price Target N/A

Source: Nasdaq.com Company Description Midway, headquartered in Chicago, Illinois, publishes interactive entertainment software primarily for video game consoles.

C Y 2 0 0 8 M ID W A Y A m o u n t

R a n k B r a n d ( $ m il)1 M o r ta l K o m b a t 7 0$ 2 G a m e P a r ty 3 0$ 3 U n r e a l 1 7$ 4 T N A IM P A C T ! 9$ 5 T o u c h m a s te r 6$ 6 B litz : T h e L e a g u e 5$ 7 N B A B a lle r s 4$ 8 B la c k s ite : A r e a 5 1 3$ 9 S t r a n g le h o ld 2$

1 0 C r u is 'n 1$

T o ta l T o p 1 0 B r a n d s 1 4 7$



COMPANY OVERVIEW Midway Games, based in Chicago, Illinois, has been a pure-play, interactive entertainment company since 1998 when it was spun-off from WMS Industries. In June 2001 Midway exited the coin-operated arcade games business to focus entirely on developing and publishing titles for Nintendo, Sony, and Microsoft video game consoles. Midway key games include Mortal Kombat, SpyHunter, Slugfest, Blitz, NHL Hitz, Gauntlet, and Defender. Sumner Redstone had owned approximately 88% of Midway until late 2008 when he sold his entire position. Because of this, $150 million of Midway notes were now callable by its holders. On February 12, 2009, Midway filed for Chapter 11 bankruptcy protection due to an acceleration of payment due on its $150 million convertible notes. In June, Warner Bros. Entertainment made an offer for most of Midway’s assets for $33 million, with completion subject to court approval. VALUATION Midway’s value remains uncertain. It has had success with key games (notably Mortal Kombat), though it has not been able to consistently produce profitable games. We were hopeful that the company will perform better in 2009 than in 2008, but the departure of Sumner Redstone’s and National Amusements’ support for the company in December was too much of a challenge for its already fragile balance sheet. Midway cash position will limit its ability to continue its investment in game development, and presents significant challenges to its operations. With continued restructurings and uncertainties due to its bankruptcy filing, Midway’s path to profitability remains steep; and without better visibility into a return to profitability, we are maintaining our HOLD rating. We expect the company to liquidate as it completes its bankruptcy. Risks to the company include changes to investment position of Midway’s shares by the company’s control shareholder, game release timing, greater than expected deterioration of the average selling price (ASP) for game software, debt level, changing macroeconomic factors, the effects of competition, and bankruptcy resolution.


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Nintendo (7974.JP / NTDOY.US)

52-Week Range ¥22,000-36,800 ST / LT Debt $0 / 0 Shares Outstanding 128 million Debt/Capital 0% Insider/Institutional 40% / 25% ROE 23% Public Float 85 million Cash & Inv/Share ¥10,236 Market Capitalization ¥3,295 billion Book Value/Share ¥9,805

FYE MAR 2009A 2010E 2011E EPS(¥)** ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun ¥839 ¥427E ¥698E Q2 Sep 294 454E 810E Q3 Dec 529 1,375E 1,387E Q4 Mar 521 437E 420E Year** ¥2,182 ¥2,693E ¥3,315E P/E Ratio 12x 10x 8x Change 8% 23% 23%

FYE MAR 2009A 2010E 2011E REV (¥ bil) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun ¥423 ¥350E ¥364E Q2 Sep 414 368E 381E Q3 Dec 700 770E 662E Q4 Mar 302 312E 234E Year** ¥1,839 ¥1,800E ¥1,639E Change 10% -2% -9%



¥25,740

Rating BUY

12- Month Price Target ¥43,000

0

1

2

3

4

5

6

7

J J A S O N D J F M A M J¥18,300

¥23,300

¥28,300

¥33,300

¥38,300

¥43,300

¥48,300

¥53,300

¥58,300

Source: Thomson Company Description Nintendo, based in Kyoto, Japan, is a leading manufacturer of video game consoles and publisher of video game software.

Nintendo’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)

C Y 2 0 0 8 N IN T E N D OA m o u n t

R a n k B r a n d ( $ m il)1 M a r io B r o th e r s 7 6 1$ 2 W ii F i t 4 0 7$ 3 W ii P la y 2 6 1$ 4 P o k e m o n 1 1 9$ 5 Z e ld a 6 7$ 6 A n im a l C r o s s in g 5 4$ 7 N in te n d o g s 4 4$ 8 W ii M u s ic 4 2$ 9 B r a in A g e 3$

1 0 K ir b y 2 6$

T o ta l T o p 1 0 B r a n d s 1 ,8 2 0$

9



COMPANY OVERVIEW Nintendo, based in Kyoto, Japan, is a leading manufacturer of video game consoles and publisher of video game software. The company’s hardware include the Wii (sold over 50 million units to date) and the DS (sold over 102 million units to date) and its software include blockbuster franchises such as Super Mario Bros., Pokemon, and Legend of Zelda. VALUATION Notwithstanding variances in earnings due to volatile F/X, Nintendo’s recent operating performance has been solid, and we expect its outstanding performance to continue in FY:10. The lone weak spot for the company remains Japan. We expect 5% software sales growth in the U.S. and European markets in 2009, but expect the Japanese market to grow only 2%. The company should be able to dramatically grow earnings in FY:10 as its mix of sales shifts in favor of high margin software. We have modeled slightly down revenues, with hardware contributing less and software contributing more than in FY:09, triggering a material increase in gross margin, relatively flat operating profit, and significant earnings growth (due to expected lack of foreign exchange losses). Maintaining BUY, and our ¥43,000 price target, which reflects a forward P/E multiple of 13x our FY:10 adjusted EPS estimate of ¥2,600, plus an estimated ¥9,000/share in cash. We value Nintendo at a multiple at the low end of its historical range in light of market multiple contraction. Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software and hardware, the effects of competition, changing macroeconomic factors, unexpected changes in foreign exchange rates, and slower than expected consumer demand for video game hardware and software.



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Take-Two Interactive Software (TTWO)

52-Week Range $5.56–$26.88 ST / LT Debt (mil) $0 / 70 Shares Outstanding 77 million Debt/Capital 10% Insider/Institutional 6% / 91% ROE 21% Public Float 77 million Cash & Inv/Share $2.33 Market Capitalization $672 million Book Value/Share $7.20

FYE OCT 2008A 2009E 2010E EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jan $(0.41) $(0.52)A $(0.16)E Q2 Apr 1.52 (0.04)A (0.06)E Q3 Jul 0.93 (0.55)E 0.45E Q4 Oct 0.02 1.18E 1.85E Year** $2.08 $0.10E $2.10E P/E Ratio 4x 87x 4x Change N/A -95% 2000%

FYE OCT 2008A 2009E 2010E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jan $240 $257A $282E Q2 Apr 540 230A 259E Q3 Jul 434 155E 339E Q4 Oct 323 484E 670E Year** $1,538 $1,125E $1,550E Change 57% -27% 38%



$8.73

Rating BUY


Source: Nasdaq.com Company Description Take-Two, headquartered in New York City, develops, publishes, and distributes interactive entertainment software for PCs, home consoles, and handheld devices.

Take-Two’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)

C Y 2 0 0 8 T A K E -T W OA m o u n t

R a n k B ra n d ($ m il)1 G ra n d T h e f t A u to 3 6 1$ 2 N B A 2 K 6 0$ 3 C a rn iv a l G a m e s 5 4$ 4 M L B 2 K 4 9$ 5 M id n ig h t C lu b 4 9$ 6 C iv il iz a t io n 3 7$ 7 B u lly 1 7$ 8 E ld e r S c ro lls 1 4$ 9 N H L 2 K 1 2$

1 0 T o p S p in 9$

T o ta l T o p 1 0 B ra n d s 6 6 2$



COMPANY OVERVIEW Take-Two Interactive Software, based in New York City, is a leading developer and publisher of games for Nintendo, Sony, and Microsoft video game consoles as well as for the PC. Take-Two publishes its products under its Rockstar Games and 2K (Games, Sports, and Play) labels. Take-Two games include the top three selling games for the PS2, Grand Theft Auto 3, Grand Theft Auto: Vice City, and Grand Theft Auto: San Andreas. Other key games include Max Payne, Midnight Club, and BioShock. Take-Two also owns a third-party distribution business, Jack of All Games, which distributes its software as well as third-party software, hardware and accessories to retail outlets in the United States. VALUATION As we look forward to FY:10, we see an impressive lineup, with the two shifted games, reorders of this fall’s BioShock 2, the release of Max Payne 3, and a likely installment of Grand Theft Auto. We are increasingly confident in our FY:10 estimate, and expect to see consensus estimates for the out year steadily increase over the next several months. We note that the last Grand Theft Auto came out 13 months ago, and if the company chooses to use the same game engine from the prior version, it could allow 30 months of game development and still release the next installment within its 2010 fiscal year. Should we be right, we think that consensus estimates will rise to above the $2.00 level, and we expect Take-Two shares to appreciate dramatically. Maintaining our BUY and our $11 price target, which is based on a forward multiple of 12x estimated sustainable EPS of $0.80 (fully-taxed) plus $1.50/share in net cash. This multiple is at the low end of Take-Two’s historical range, and reflects the company earnings volatility and market contraction. Risks to attainment of our share price target include performance of the company’s games, levels of competition, changing macroeconomic factors, changes in consumer demand for video game hardware, and the ability of the company to attract merger partners.


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THQ (THQI)

52-Week Range $2.23 – 21.98 ST / LT Debt $24 / 0 million Shares Outstanding 68 million Debt/Capital 5% Insider/Institutional 1% / 99% ROE N/A Public Float 66 million Cash & Inv/Share $2.58 Market Capitalization $466 million Book Value/Share $4.49

FYE MAR 2009A 2010E** 2011E** EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun $(0.38) $(0.08)E $(0.04)E Q2 Sep (0.46) (0.27)E (0.18)E Q3 Dec (0.14) 0.76E 0.77E Q4 Mar (0.54) (0.12)E (0.06)E Year** $(1.52) $0.30E $0.50E P/E Ratio N/A 23x 14x Change N/A N/A N/A

FYE MAR 2009A 2010E** 2011E** Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun $121 $175E $176E Q2 Sep 152 111E 139E Q3 Dec 386 387E 423E Q4 Mar 154 147E 162E Year** $813 $820E $900E Change -23% 1% 10%

** Numbers may not add up due to rounding. **Pro forma.


$6.85

Rating BUY


Source: Nasdaq.com Company Description THQ, headquartered in Agoura Hills, California, develops, publishes, and distributes interactive entertainment software for home consoles, handheld devices, PCs, and the Internet.

THQ’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)

C Y 2 0 0 8 T H QA m o u n t

R a n k B r a n d ( $ m il)1 W W E 1 0 3$ 2 S a in ts R o w 4 0$ 3 M X V s A T V 3 3$ 4 W a ll- E 2 5$ 5 S p o n g e B o b S q u a r e P a n ts 2 5$ 6 C a r s 2$ 7 F r o n t l in e s : F u e l o f W a r 1 7$ 8 D r a w n T o L if e 1 7$ 9 P a w s & C la w s P e t 1 4$

1 0 d e B lo b 1 1$

T o ta l T o p 1 0 B r a n d s 3 0 5$

0



COMPANY OVERVIEW THQ, based in Agoura Hills, California, is a leading developer and publisher of games for Nintendo, Sony, and Microsoft video game consoles as well as for the PC. Most of THQ’s games are geared toward mass-market audiences and include recognizable product lines including World Wrestling Entertainment (WWE), Nickelodeon (SpongeBob SquarePants), and Disney/Pixar (Cars and The Incredibles) games. VALUATION THQ has largely completed its restructuring, with considerable reductions in headcount, consolidation of facilities, reductions in the planned number of titles, and overall lower spending. Its strategic plan is focusing on fewer titles, with emphasis on fighting games, children’s games, family games and online games. The restructuring involved the cancellation of several titles and a reduction in annual product development and corporate spending by approximately $220 million. Recent releases have performed very strongly, with UFC 2009 Undisputed selling over 2 million units, exceeding our estimates, and Red Faction Guerilla received review scores averaging 87%. We are maintaining our BUY rating, and $9 price target, which reflects an enterprise value multiple of 10x our FY:10 free cash flow estimate of $0.70 per share, plus an estimated $2/share in cash. We are using a free cash flow multiple for THQ because we think that consensus EPS estimates do not adequately reflect the company’s performance. Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software, the effects of competition (both from other publishers as well as from other forms of entertainment), slower than expected consumer demand for video game hardware, and lower demand for its games.


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Ubisoft Entertainment (UBI.FP)

52-Week Range €9.66 – 35.50 ST / LT Debt €62 / €23 million Shares Outstanding 97 million


€16.49

Rating BUY

12- Month Price Target €21

0

2

4

6

8

10

J J A S O N D J F M A M$8

$13

$18

$23

$28

$33

Source: Thomson Company Description Ubisoft Entertainment, based in Montreuil-sous-Bois, France, is a leading worldwide developer, publisher, and distributor of interactive entertainment products.

Debt/Capital 4% Insider/Institutional 29% / 11% ROE 11% Public Float 44 million Cash & Inv/Share €2.47 Market Capitalization €2 billion Book Value/Share €7.83

FYE MAR 2009A 2010E 2011E EPS(€)** ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS 1H – Sep €0.24 €(0.19)E €(0.10)E 2H – Mar 0.47 1.09E 1.14E Year* €0.71 €0.91E €1.05E P/E Ratio 24x 18x 16x Change -38% 28% 15%

FYE MAR 2009A 2010E 2011E Revenue (€ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Jun €169 €98E €128E Q2 Sep 175 140E 160E Q3 Dec 508 647E 670E Q4 Mar 20 315E 343E Year* €1,058 €1,200E €1,300E Change 14% 13% 8%


Ubisoft’s Top 10 Selling Brands for 2008 (U.S. Retail Sales $)

C Y 2 0 0 8 U B IS O F TA m o u n t

R a n k B r a n d ( $ m i l )1 T o m C la n c y 1 3 0$ 2 Im a g in e 7 8$ 3 P e tz 7$ 4 S h a u n W h ite S n o w b o a r d in g 4 9$ 5 A s s a s s in 's C r e e d 4 1$ 6 R a y m a n 4$ 7 P r in c e O f P e r s ia 3 3$ 8 F a r C r y 2$ 9 B r o th e r s I n A r m s 2 1$

1 0 M y C o a c h 1 8$

T o ta l T o p 1 0 B r a n d s 5 0 5$

0

0

5



COMPANY OVERVIEW Ubisoft Entertainment, based in Montreuil-sous-Bois, France, is a leading developer, publisher, and distributor of interactive entertainment products. Through a combination of organic growth and acquisitions, the company has grown significantly over the past several years to its current position as a top tier global video game publisher. Ubisoft has a deep and varied portfolio of strong selling video game franchises and brands. These include Rayman, Tom Clancy’s Rainbow Six/Splinter Cell/Ghost Recon, Prince of Persia, The Settlers, Assassin’s Creed, and Far Cry. VALUATION Our thesis on Ubisoft has been that the company is well-positioned to deliver meaningful upside to revenue and earnings in FY:10. In our view, the FY:10 lineup, consisting of Assassin’s Creed 2, Ghost Recon 4, Splinter Cell Conviction, Avatar, Red Steel 2, I Am Alive, R.U.S.E. and several recurring franchises, has the potential to generate €250 – 400 million in revenue growth when compared to the FY:08 lineup. That year, the company had Assassin’s Creed, Ghost Recon, and several family and licensed titles, and managed to deliver €928 million in revenue and a 14.3% operating profit (before stock options expense). In our view, Ubisoft’s FY:10 lineup has the potential to generate between €1.2 – 1.33 billion in revenue. We note that most of its major FY:10 games (Assassin’s Creed 2, Splinter Cell Conviction, and Avatar) showed very well at the E3 Expo, and have the potential to exceed our estimates though we believe the back end loaded revenue profile may limit upside to guidance. We are maintaining our BUY rating, and our €21 price target, which reflects a forward P/E multiple of 18.5x our FY:11 adjusted EPS estimate of €1.02 plus €2/share in cash. Ubisoft shares have historically traded at a forward multiple of 24 – 30x, and our target reflects a premium of 20% to the S&P 500 multiple, well below its historical 25 – 50% premium to reflect recent industry weakness. Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software, the effects of competition, foreign exchange changes, and lower than expected consumer demand for video game hardware.


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Best Buy (BBY)

52-Week Range $16.42 – 48.99 ST / LT Debt $1.0 B / $1.1 B Shares Outstanding 426 million Debt/Capital 13% Insider/Institutional 18% / 75% ROE 24% Public Float 152 million Cash & Inv/Share $1.26 Market Capitalization $14 billion Book Value/Share $12.92

FYE FEB 2009A


$33.44

Rating HOLD


Source: Nasdaq.com Company Description Best Buy is a specialty retailer of consumer electronics, home office products, entertainment software, appliances, and related services primarily in the United States, Canada, and China.

2010E 2011E EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 May 0.43 $0.42A $0.50E Q2 Aug 0.48 0.46E 0.55E Q3 Nov 0.35 0.43E 0.49E Q4 Feb 1.61 1.69E 1.87E Year** $2.87 $3.00E $3.40E P/E Ratio 12x 11x 10x Change -8.0% 4.5% 13.6%

FYE FEB 2009A 2010E 2011E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 May 8,990 $10,095A $10,611E Q2 Aug 9,801 10,990E 11,697E Q3 Nov 11,500 11,649E 12,682E Q4 Feb 14,724 15,422E 16,965E Year** $45,015 48,155E 51,955E Change 12.5% 7.0% 7.9%

*Excludes non-recurring charges.



COMPANY OVERVIEW Best Buy is a specialty retailer of consumer electronics, home office products, entertainment software, appliances and related services under multiple brand names throughout the world. These include: -923 U.S. Best Buy stores in 49 states, the District of Columbia and Puerto Rico that averaged approximately 39,700 retail square feet. -19 Pacific Sales stores in California that averaged approximately 34,000 retail square feet. -12 Magnolia Audio Video stores in California, Oregon and Washington that averaged approximately 11,600 retail square feet.. -Nine Best Buy Mobile stand-alone stores in New York and North Carolina that averaged approximately 1,400 retail square feet. -Seven Geek Squad stand-alone stores in California, Colorado, Georgia, Minnesota and Texas that averaged approximately 2,000 retail square feet. -121 Future Shop stores throughout all of Canada's provinces and 51 Canada Best Buy stores in seven provinces: Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec and Saskatchewan. -160 Five Star stores in seven of China's 34 provinces and one China Best Buy store in Shanghai VALUATION We continue to believe that Best Buy’s earnings leverage is under-appreciated by the Street. The company not only continues to gain market share, but is controlling costs extremely well. SG&A spend is expected to be roughly flat with last year, despite a major integration of Best Buy Europe and continued store expansion. Even on a disappointing comp number, gross margins in the company’s core domestic business expanded 70 bps vs. last year and pro forma EPS was roughly flat with a year ago. In other words, while facing formidable internal and external challenges, the company has managed to earn roughly the same amount of money as it did during better times. Maintaining our HOLD rating and $40 price target. Our price target reflects a P/E multiple of just under 12.0x our FY 2011 (calendar 2010) EPS estimate of $3.40, slightly lower than the company’s historical 13 – 15x multiple to account for market contraction. Risks to attainment of our share price target include changes to the macroeconomic outlook, variability in new product release timing, the effects of competition from other consumer electronic and big-box retailers and changes in consumer demand for consumer electronics.



Best BuyIncome Statement ($ millions) 2008 May-08 Aug-08 Nov-08 Feb-09 2009 May-09 Aug-09 Nov-09 Feb-10 2010 2011Fiscal Year End: February 28 FY-A Q1A Q2A Q3A Q4A FY-A Q1A Q2E Q3E Q4E FY-E FY-E

BBY Domestic revenue 33,328 7,453 8,133 8,196 11,288 35,070 7,525 8,231 8,373 11,812 35,941 38,566BBY International revenue 6,695 1,537 1,668 3,304 3,436 9,945 2,570 2,759 3,276 3,610 12,214 13,388

Total revenue 40,023 8,990 9,801 11,500 14,724 45,015 10,095 10,990 11,649 15,422 48,155 51,955

BBY Domestic COGS 25,170 5,633 6,107 6,197 8,513 26,450 5,637 6,156 6,331 8,932 27,055 29,010

BBY International COGS 5,308 1,224 1,313 2,442 2,588 7,566 1,901 2,047 2,424 2,693 9,065 9,927

Total cost of revenue 30,478 6,857 7,420 8,639 11,101 34,016 7,538 8,203 8,755 11,624 36,120 38,937

Gross profit 9,545 2,133 2,381 2,861 3,623 10,999 2,557 2,787 2,894 3,797 12,035 13,018

Consolidated gross margin 23.8% 23.7% 24.3% 24.9% 24.6% 24.4% 25.3% 25.4% 24.8% 24.6% 25.0% 25.1%

Domestic SG&A 6,163 1,544 1,711 1,714 1,750 6,719 1,560 1,740 1,743 1,801 6,844 7,275

International SG&A 1,224 312 331 873 749 2,265 649 709 832 812 3,002 3,282

Total selling, general & admin 7,387 1,856 2,042 2,587 2,499 8,984 2,209 2,449 2,575 2,613 9,846 10,557Consolidated SG&A margin 18.5% 20.6% 20.8% 22.5% 17.0% 20.0% 21.9% 22.3% 22.1% 16.9% 20.4% 20.3%

BBY Domestic op income, adj 1,995 277 315 283 1,025 1,901 328 335 300 1,079 2,042 2,281

BBY International op income, adj 163 0 24 (9) 99 114 20 3 20 105 147 179Total operating income 2,158 277 339 274 1,124 2,015 348 338 319 1,184 2,189 2,460

Consoldiated operating margin 5.4% 3.1% 3.5% 2.4% 7.6% 4.5% 3.4% 3.1% 2.7% 7.7% 4.5% 4.7%

Investment impairment, restructuring (111) (144) (255) (52) (25) (77)

Net interest expense (income) (67) (8) 12 38 17 59 14 16 25 8 63 56

Earnings bef tax and min. interests 2,225 285 327 125 963 1,701 282 297 294 1,176 2,049 2,404

Provision for income taxes 815 106 122 68 378 674 126 113 112 437 788 923

Minority interests (3) (11) (17) (31) 0 (3) (3) (17) (23) (31)Equity in earnings (loss) of affil iates 6 2 8 (3) (3) 3 3 0 12Net Income - pro forma 1,411 179 202 52 570 1,004 153 178 182 724 1,238 1,462

Basic Shares 440.0 411.4 412.1 412.9 413.6 412.5 415.2 416.2 416.7 417.2 416.3 418.2

Diluted Shares 452.5 423.4 423.3 422.6 423.2 423.1 425.7 426.7 427.5 428.0 427.0 429.5

Basic EPS (GAAP) 3.21 0.44 0.49 0.13 1.38 2.43 0.37 0.43 0.44 1.74 2.97 3.50Diluted EPS (GAAP) 3.12 0.42 0.48 0.13 1.35 2.38 0.36 0.42 0.43 1.69 2.90 3.40

Diluted EPS (pro forma) 3.12 0.43 0.48 0.35 1.61 2.87 0.42 0.46 0.43 1.69 3.00 3.40

Comps FY 2008 May-08 Aug-08 Nov-08 Feb-09 FY 2009 May-09 Aug-09 Nov-09 Feb-10 FY 2010 FY 2011Domestic comps 1.9% 3.5% 5.3% -6.3% -4.8% -1.3% -4.9% -5.0% -1.0% 1.5% -1.9% 2.7%International comps 9.0% 4.7% -1.0% 0.3% -5.3% -0.9% -13.9% -7.0% -3.0% 2.5% -3.1% 2.9%

Total comp-store sales 2.9% 3.7% 4.2% -5.3% -4.9% -1.0% -6.2% -5.3% -1.6% 1.7% -2.1% 2.7%

Income Statement Ratios FY 2008 May-08 Aug-08 Nov-08 Feb-09 FY 2009 May-09 Aug-09 Nov-09 Feb-10 FY 2010 FY 2011

BBY DomesticGross margin 24.5% 24.4% 24.9% 24.4% 24.6% 24.6% 25.1% 25.2% 24.4% 24.4% 24.7% 24.8%

SG&A margin 18.5% 20.7% 21.0% 20.9% 15.5% 19.2% 20.7% 21.1% 20.8% 15.3% 19.0% 18.9%

Operating margin 6.0% 3.7% 3.9% 3.5% 9.1% 5.4% 4.4% 4.1% 3.6% 9.1% 5.7% 5.9%

BBY InternationalGross margin 20.7% 20.4% 21.3% 26.1% 24.7% 23.9% 26.0% 25.8% 26.0% 25.4% 25.8% 25.9%SG&A margin 18.3% 20.3% 19.8% 26.4% 21.8% 22.8% 25.3% 25.7% 25.4% 22.5% 24.6% 24.5%

Operating margin 2.4% 0.0% 1.5% -0.3% 2.9% 1.1% 0.8% 0.1% 0.6% 2.9% 1.2% 1.3%

CONSOLIDATEDGross margin 23.8% 23.7% 24.3% 24.9% 24.6% 24.4% 25.3% 25.4% 24.8% 24.6% 25.0% 25.1%

SG&A margin 18.5% 20.6% 20.8% 22.5% 17.0% 20.0% 21.9% 22.3% 22.1% 16.9% 20.4% 20.3%Operating margin 5.4% 3.1% 3.5% 2.4% 7.6% 4.5% 3.4% 3.1% 2.7% 7.7% 4.5% 4.7%

Net margin 3.5% 2.0% 2.1% 0.5% 3.9% 2.2% 1.5% 1.6% 1.6% 4.7% 2.6% 2.8%Tax Rate 36.6% 37.2% 37.3% 54.4% 39.2% 39.6% 44.7% 38.0% 38.0% 37.2% 38.5% 38.4%

Blockbuster (BBI)

52-Week Range $0.13 – 3.19 ST / LT Debt (mil) $881 / 0 Shares Outstanding 223 million Debt/Capital 15% Insider/Institutional 8% / 92% ROE N/A Public Float 177 million Cash & Inv/Share $0.48 Market Capitalization $167 million Book Value/Share $1.12

FYE DEC 2008A


$0.71

Rating STRONG BUY

12- Month Price Target $2.50

Source: Nasdaq.com Company Description Blockbuster, based in Dallas, Texas, is the largest specialty retailer of rentable home videocassettes (VHS), DVDs and video games in the world.

2009E 2010E EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Mar $0.20 $0.12A $0.07E Q2 Jun (0.20) (0.07)E 0.02E Q3 Sep (0.08) (0.02)E 0.00E Q4 Dec 0.40 0.24E 0.27E Year** $0.35 $0.28E $0.35E P/E Ratio 2x 3x 2x Change N/A -20% 25%

FYE DEC 2008A 2009E 2010E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Mar $1,394 $1,122A $1,167E Q2 Jun 1,305 1,131E 1,096E Q3 Sep 1,205 1,123E 1,076E Q4 Dec 1,385 1,372E 1,288E Year** $5,288 $4,748E $4,627E Change -5% -10% -3%

*Excludes non-recurring charges.



COMPANY OVERVIEW Blockbuster, headquartered in Dallas, Texas, is the largest specialty retailer of rentable DVDs and video games in the world. The company has approximately 7,000 company operated and franchised stores in 28 countries. Blockbuster’s customer transaction database contains more than 51 million U.S. and Canadian household member accounts. International revenue accounts for about 20% of total revenues. Its Total Access online rental and Game Rush store within a store video game specialty retailer concept have proven to be growth drivers for the company. VALUATION Investment in Blockbuster requires two acts of faith: first, investors must believe that this management team has sufficient control over the company’s cost structure to deliver on its promises to generate over $300 million of EBITDA annually and to repay debt aggressively; and second, investors must believe that the rental industry is not in a death spiral that will cause Blockbuster’s revenues to decline at a rate that cannot be saved by aggressive cost cutting. We are confident that the first act of faith is well-placed; we are less confident about the second, given the precipitous decline in same store sales during the first quarter, but we agree that the theatrical release schedule was sufficiently strong to drive improving comps in the middle part of the year. We believe Blockbuster’s valuation is compelling. At an enterprise value of 3x EBITDA, the company is trading at less than half its historical valuation. We understand that investors may remain skeptical so long as comps are negative. Maintaining STRONG BUY, and our 12-month price target of $2.50, which reflects an EV/EBITDA multiple of 4x our 2009 EBITDA estimate of $320 million. This multiple is less than half of Blockbuster’s historical multiple, reflecting recent market contraction, credit concerns and execution risks. Risks to attainment of our share price target include changes to movie release timing, the effects of competition (both from other video rental companies and other forms of entertainment), greater than expected weakness in consumer demand for video rentals, online subscriber attrition, and debt repayment risk.


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Gro

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Net

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GameStop (GME)

52-Week Range $16.91 – 48.53 ST / LT Debt (mil) $0 / 496 Shares Outstanding 168 million Debt/Capital 9% Insider/Institutional 7% / 90% ROE 22% Public Float 154 million Cash & Inv/Share $1.37 Market Capitalization $4 billion Book Value/Share $14.42

FYE JAN 2008A 2009E 2010E EPS($)* ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Apr $0.38 $0.43A $0.50E Q2 Jul 0.34 0.34E 0.49E Q3 Oct 0.34 0.48E 0.54E Q4 Jan 1.34 1.68E 1.77E Year** $2.40 $2.93E $3.30E P/E Ratio 9x 8x 7x Change 33% 22% 13%

FYE JAN 2008A 2009E 2010E Revenue ($ mil.) ACTUAL CURRENT PREVIOUS CURRENT PREVIOUS Q1 Apr $1,814 $1,981A $2,070E Q2 Jul 1,804 1,816E 1,920E Q3 Oct 1,696 1,899E 1,961E Q4 Jan 3,492 3,705E 3,835E Year** $8,806 $9,400E $9,786E Change 24% 7% 4%


$21.96

Rating BUY


Source: Nasdaq.com Company Description GameStop, based in Grapevine, TX, is the largest video game and PC entertainment software specialty retailer in the world, with more than 6,200 stores.

*Excludes non-cash charges for amortization of goodwill and intangibles, restructuring, and non-recurring charges.



COMPANY OVERVIEW GameStop, based in Grapevine, Texas, is the largest video game and PC entertainment software specialty retailer in the United States with over 6,000 stores. GameStop also operates an e-commerce web site under the name www.gamestop.com/www.ebgames.com and publishes Game Informer, one of the industry’s most popular video game magazines in the U.S. with a subscriber base of over three million. In October 2005, GameStop completed its acquisition of Electronics Boutique for $1.7 billion in cash and stock. Prior to the merger, Electronics Boutique was the second largest specialty retailers of video game and PC entertainment software, with over 2,200 stores worldwide. VALUATION We find GameStop a compelling investment at these levels. We do not think that the end is near, and think that the company is in a good position to grow its used business by compressing the time between new game releases and when it is willing to offer trade-in credits for used games. By so doing, GameStop can drive used game pricing higher, and will drive its gross profits correspondingly higher. In our view, GameStop can grow earnings through used game growth. With higher pricing comes disproportionate growth, higher gross profits, and higher EPS. We think that the used business can grow at a 20% rate for several more years. Maintaining BUY, and our $29 price target, which reflects a multiple of 8.7x our FY:10 EPS estimate of $3.30. This multiple is a 30% discount to the S&P 500 forward multiple, reflecting slowing comp growth, recent market multiple contraction, and a higher likelihood of digital distribution. Risks to attainment of our share price target include changes to game release timing, the effects of competition, limited supply of video game products, and slower than expected consumer demand for video game hardware and software.


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0.5%

0.5%

0.3%

0.4%

0.4%

0.4%

0.5%

0.3%

0.4%

Ope

ratin

g m

argi

n6.

1%5.

5%5.

0%10

.9%

7.7%

6.5%

5.6%

7.2%

12.2

%8.

7%6.

6%7.

0%7.

5%12

.4%

9.1%

Net

mar

gin

3.4%

3.2%

2.8%

6.7%

4.5%

3.6%

3.2%

4.2%

7.6%

5.2%

4.0%

4.3%

4.7%

7.8%

5.7%

Tax

Rat

e37

.3%

37.1

%39

.0%

36.8

%37

.2%

38.2

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.0%

36.0

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36.3

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36.0

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36.0

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Year

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r-Ye

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hang

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omps

27.1

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5%-1

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tore

uni

t gro

wth

13.2

%12

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12.2

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17.9

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14.4

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4.7%

4.7%

5.3%

5.2%

5.5%

5.4%

5.4%

Net

Sal

es41

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34.8

%5.

2%21

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24.1

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6.1%

6.7%

4.5%

5.8%

3.2%

3.5%

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Cos

t of g

oods

sol

d44

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35.2

%2.

6%21

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23.8

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11.7

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7%5.

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9%G

ross

Pro

fit35

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34.0

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22.7

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14.5

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13.6

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4.4%

7.2%

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SG

&A

26.7

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15.8

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22.0

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Dep

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atio

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mor

tizat

ion

12.2

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8.6%

7.4%

9.0%

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0.0%

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Ope

ratin

g In

com

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et In

com

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147.

4%5.

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40.8

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22.4

%15

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41.7

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12.9

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ilute

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114.

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4.1%

17.9

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11.7

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25.1

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15.3

%41

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13.3

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7%12

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Dilu

ted

Sha

res

Out

stan

ding

3.8%

2.0%

1.0%

0.2%

1.7%

0.4%

0.0%

0.2%

0.7%

0.3%

0.4%

0.4%

0.4%

0.4%

0.4%

Sou

rce:

Com

pany

repo

rts a

nd W

edbu

sh M

orga

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ecur

ities

est

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Gam

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mill

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pr-0

8Ju

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l-10

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scal

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r End

: Jan

uary

31

Q1A

Q2A

Q3A

Q4A

FY-A

Q1A

Q2E

Q3E

Q4E

FY-E

Q1E

Q2E

Q3E

Q4E

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Tota

l rev

enue

1,81

3.6

1,80

4.4

1,69

5.7

3,49

2.1

8,80

5.9

1,98

0.8

1,81

5.6

1,89

9.4

3,70

4.5

9,40

0.3

2,06

9.9

1,92

0.2

1,96

1.0

3,83

4.5

9,78

5.6

Cos

t of s

ales

1,34

0.2

1,32

0.3

1,22

2.3

2,65

2.9

6,53

5.8

1,43

8.6

1,30

6.2

1,36

5.4

2,75

1.2

6,86

1.5

1,50

3.9

1,37

4.2

1,40

5.8

2,84

3.6

7,12

7.5

Gro

ss p

rofit

473.

448

4.1

473.

483

9.2

2,27

0.1

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150

9.4

534.

095

3.3

2,53

8.8

566.

054

6.0

555.

299

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2,65

8.1

Sel

ling,

Gen

eral

& A

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exp

ense

s31

6.9

339.

432

6.9

426.

31,

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7.8

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334

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2.9

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4D

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mor

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34.8

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11.8

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8.8

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9.8

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Res

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10.8

9.2

8.8

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41.2

14.5

10.5

10.4

10.5

45.9

5.0

5.9

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Q1A

Q2A

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Q2E

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Tota

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1,81

3.6

1,80

4.4

1,69

5.7

3,49

2.1

8,80

5.9

1,98

0.8

1,81

5.6

1,89

9.4

3,70

4.5

9,40

0.3

2,06

9.9

1,92

0.2

1,96

1.0

3,83

4.5

9,78

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Cos

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ales

1,34

0.2

1,32

0.3

1,22

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2,65

2.9

6,53

5.8

1,43

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1,30

6.2

1,36

5.4

2,75

1.2

6,86

1.5

1,50

3.9

1,37

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1,40

5.8

2,84

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8.8

7.0

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4.6

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5.0

164.

716

5.1

165.

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5.4

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5.3

Dilu

ted

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167.

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8.1

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616

8.7

168.

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8

Bas

ic E

PS

(GA

AP)

0.38

0.35

0.29

1.42

2.44

0.43

0.35

0.49

1.71

2.98

0.51

0.50

0.55

1.81

3.37

Dilu

ted

EP

S (G

AA

P)

0.37

0.34

0.28

1.39

2.38

0.42

0.34

0.48

1.68

2.92

0.50

0.49

0.54

1.77

3.30

Bas

ic E

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(pro

form

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400.

350.

351.

372.

470.

440.

350.

491.

712.

990.

510.

500.

551.

813.

37D

ilute

d EP

S (p

ro fo

rma)

0.38

0.34

0.34

1.34

2.40

0.43

0.34

0.48

1.68

2.93

0.50

0.49

0.54

1.77

3.30

Inco

me

Stat

emen

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Gro

ss m

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90.9

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367.

563

4.0

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Net

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62.1

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232.

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Net

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8

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1.8

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3.7

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3.2

164.

516

4.6

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5.0

164.

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5.1

165.

216

5.4

165.

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5.3

Dilu

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8.1

168.

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168.

616

8.7

168.

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9.1

168.

8

Bas

ic E

PS

(GA

AP)

0.38

0.35

0.29

1.42

2.44

0.43

0.35

0.49

1.71

2.98

0.51

0.50

0.55

1.81

3.37

Dilu

ted

EP

S (G

AA

P)

0.37

0.34

0.28

1.39

2.38

0.42

0.34

0.48

1.68

2.92

0.50

0.49

0.54

1.77

3.30

Bas

ic E

PS

(pro

form

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400.

350.

351.

372.

470.

440.

350.

491.

712.

990.

510.

500.

551.

813.

37D

ilute

d EP

S (p

ro fo

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0.38

0.34

0.34

1.34

2.40

0.43

0.34

0.48

1.68

2.93

0.50

0.49

0.54

1.77

3.30

Inco

me

Stat

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t Rat

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Gro

ss m

argi

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26.8

%27

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27.4

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28.1

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27.0

%27

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28.4

%28

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25.8

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SG

&A

17.5

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19.3

%12

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16.0

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19.9

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12.2

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18.5

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atio

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9%2.

0%2.

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tock

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Ope

ratin

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1%5.

5%5.

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5.6%

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7%6.

6%7.

0%7.

5%12

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9.1%

Net

mar

gin

3.4%

3.2%

2.8%

6.7%

4.5%

3.6%

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7.6%

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4.7%

7.8%

5.7%

Tax

Rat

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37.1

%39

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36.8

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38.2

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36.0

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36.3

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36.0

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36.0

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Year

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27.1

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%9.

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2.8%

2.5%

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5%1.

5%-1

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0%S

tore

uni

t gro

wth

13.2

%12

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12.2

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17.9

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14.4

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4.7%

4.7%

5.3%

5.2%

5.5%

5.4%

5.4%

Net

Sal

es41

.8%

34.8

%5.

2%21

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24.1

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6%12

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6.1%

6.7%

4.5%

5.8%

3.2%

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Cos

t of g

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sol

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35.2

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OTHER RELATED INTERACTIVE ENTERTAINMENT COMPANIES

Publicly Traded Related Companies

Capcom (9697.JP)

Gameloft (GFT.FP)

Giant Interactive Group (GA)

Glu Mobile (GLUU)

GRAVITY (GRVY) Konami (KNM)

Mad Catz Interactive (MCZ)

Microsoft (MSFT)

NAMCO BANDAI Holdings (7832.JP)

NCsoft (036570.KS)

Netease.com (NTES)

Perfect World (PWRD)

Playlogic Entertainment (PLGC)

Sega Sammy (SGAMY)

Shanda Interactive Entertainment (SNDA)

SONY (SNE)

SouthPeak Interactive (SOPK)

SQUARE ENIX (9684.JP)

Tecmo Koei Holdings (3635.JP)

The9 Limited (NCTY)

Time Warner (TWX)

Vivendi (VIV.FP)

Walt Disney (DIS)

Webzen (WZEN)


Capcom (9697.JP)

52-Week Range ¥1,491–2,090 Revenues FY:09 (Mar) ¥92 billion

Shares Outstanding 67 million

Market Capitalization ¥117 billion

Company Description

Capcom Co., Ltd., based in Osaka, Japan, is a leading global publisher, developer, and manufacturer of home and arcade video games. Its top games include Street Fighter, Onimusha, Devil May Cry, and Resident Evil. Capcom shares trade primarily on the Tokyo Stock Exchange.


¥1,753

Rating Not Rated


Source: QUICK Corp. Two-Year Price Chart

Gameloft (GFT.FP)

52-Week Range €1.26–3.80 Revenues FY:08 (Dec) €110 million


Market Capitalization €197 million


€2.77

Rating Not Rated


Company Description

Gameloft, founded in 1999, is a leading international publisher and developer of video games for mobile phones. Ubisoft Entertainment owns approximately 10% of Gameloft. Gameloft shares trade primarily on the Euronext Stock exchange.

Source: Yahoo!


Giant Interactive Group (GA)

52-Week Range $5.00–$13.97


$8.00

Rating Not Rated


Revenues FY:08 (Dec) $233 million


Market Capitalization $2 billion

Company Description

Giant, based in Shanghai, China, is one of China's leading online game developers and operators, focusing on MMORPG games for personal computers. Its online games include ZT Online, a online role-playing game; ZT Online PTP, a pay-to-play game based on the ZT Online free-to-play game; and Giant Online, a military-themed MMO game. Giant shares trade primarily on the NYSE.

Source: Nasdaq.com One-Year Price Chart

Glu Mobile (GLUU)

52-Week Range $0.22–$5.16 Price (as of close 6/22/09)

$1.13

Rating Not Rated




Market Capitalization $33 million

Company Description

Glu, based in San Mateo, California, is a leading global publisher of mobile games. Founded in 2001, its games includes original titles Super K.O. Boxing!, Stranded and the Ancient Empires franchise, and titles based on major brands from Atari, Harrah's, Hasbro, Microsoft, PlayFirst, PopCap Games, SEGA and Sony.



GRAVITY (GRVY)

52-Week Range $0.36–$1.99


$1.10

Rating Not Rated





Company Description

GRAVITY Co. Ltd., based in Seoul, Korea, develops and distributes online games in Korea and other Asian countries. Its key product is the MMORG Ragnarok Online. The company also offers various mobile games; participates in the production of a televised animation series; and licenses characters-related products. GRAVITY shares trade primarily in the U.S. with American Depositary Shares (each representing 0.25 ordinary share).

Konami (KNM)

52-Week Range $12.77–$35.60



$18.77

Rating Not Rated


Revenues FY:09 (Mar) $3 billion



Company Description

Konami, based in Tokyo, Japan, produces video game software for home consoles, game machines for amusement arcades and other entertainment venues and other amusement-related products, and operation of health and fitness club facilities. Key video game franchises include Metal Gear Solid, Castlevania, Silent Hill, Frogger, Yu-Gi-Oh!, and Dance Dance Revolution. Konami shares trade primarily on the Tokyo Stock Exchange with ADS (each representing one ordinary share) in the U.S.



Mad Catz Interactive (MCZ)

52-Week Range $0.15–$0.80 Revenues FY:08 (Mar) $88 million




$0.31

Rating Not Rated



Company Description

Mad Catz Interactive, based in San Diego, CA, engages in the design, manufacture, marketing, and distribution of accessories for video game platforms, personal computers, and audio devices. Its products include control pads, steering wheels, joysticks, memory cards, video cables, light guns, flight sticks, dance pads, microphones, car adapters, carry cases, mice, keyboards, and headsets.

Microsoft (MSFT)

52-Week Range $14.87–$28.92 Revenues FY:08 (Jun) $60 billion

Shares Outstanding 9 billion



$23.28

Rating Not Rated

12- Month Price Target N/A Company Description

Microsoft, based in Redmond, WA, develops, manufactures, licenses, and support its software products (operating systems, server applications, business applications, software development tools). The company also produces the Xbox and Xbox 360 video game console and software. It’s leading game software franchises include Halo and Age of Empires. Microsoft’s Home and Entertainment division which includes the Xbox business accounts for approximately 10% of total revenues.



NAMCO BANDAI Holdings (7832.JP)

52-Week Range ¥817 - 1,080 Price (as of close 6/22/09)

¥1,020

Rating Not Rated

12- Month Price Target

Revenues FY:08 (Mar) ¥426 billion



N/A

Company Description

NAMCO BANDAI Holdings, based in Tokyo, Japan, was formed in September 2005 from the merger of two major Japanese toy and video game companies. Key brands include Tekken, Soul Calibur, Pac-Man, Mobile Suit Gundam, Digimon, Dragon Ball Z, and .hack series. NAMCO BANDAI shares trade primarily on the Tokyo Stock Exchange.


NCsoft (036570.KS)

52-Week Range 22,900–201,500KRW Revenues FY:08 (Dec) 347 billion

Shares Outstanding 21 million KRW

Market Capitalization $3,654 billion KRW


174,000KRW

Rating Not Rated


NCsoft, based in Seoul, Korea, is the leading Korean online game company with branches in North America, Japan, China, and Taiwan. The company's key title Lineage, a massively multiplayer online role-playing game (MMORPG), has over three million subscribers in Asia. Other titles include City of Heroes, Lineage II, and Guild Wars. NCsoft shares trade primarily on the Korea Exchange.

Source: KOREA EXCHANG EOne-Month Price Chart


Netease.com (NTES)

52-Week Range $15.00–$38.74 Revenues FY:08 (Dec) $452 million




$33.80

Rating Not Rated


Company Description Netease.com, based in Beijing, China, operates an interactive online and wireless community in China. It provides Chinese language content and services, including content, community and communication, and commerce, through its online games, wireless services, and Internet portal. In June 2009, Netease.com became the operator of World of Warcraft in China. Netease.com shares trade primarily in the U.S. with American Depositary Shares (each representing 100 ordinary share).


Perfect World (PWRD)

52-Week Range $8.78-$30.00 Revenues FY:08 (Dec) $211 million


Market Capitalization $1.4 billion


$28.93

Rating Not Rated


Company Description

Perfect World Co., Ltd. is a leading online game developer and operator based in China. Perfect World primarily develops online games includes Perfect World, Legend of Martial Arts, Zhu Xian, Chi Bi, Pocketpet Journey West and Battle of the Immortals. Perfect World shares trade primarily in the U.S. with American Depositary Shares (each representing 5 ordinary share).



Playlogic Entertainment (PLGC)

52-Week Range $0.10–$1.16 Revenues FY:09 (Mar) $9 million




$0.95

Rating Not Rated



Company Description

Playlogic Entertainment, based in New York and Amsterdam, is an independent publisher of entertainment software for consoles, PCs, handhelds, mobile devices, and other digital media. Playlogic publishes various genres of games developed throughout the world and also has an in-house production facility.

Sega Sammy (SGAMY)

52-Week Range $2.00–$3.15 Price (as of close 6/22/09)

Revenues FY:07 (Mar) $6 billion

Shares Outstanding 1.1 billion


$3.05

Rating Not Rated


Company Description

Sega Sammy Holdings, based in Tokyo, Japan, is the holding company for SEGA and Sammy. SEGA is a leading maker of video games, with key brands including Sonic the Hedgehog, Phantasy Star, and Virtua Fighter, while Sammy is Japan's top pachinko game machines maker. Sega Sammy shares trade primarily on the Tokyo Stock Exchange with American Depositary Shares (each representing 0.25 ordinary share) in the U.S.



Shanda Interactive Entertainment (SNDA)





$51.83

Rating Not Rated



Company Description

Shanda Interactive Entertainment Limited, based in Shanghai, China, develops and operates online games and related businesses in China. These games include The Legend of Mir II and The World of Legend. Shanda shares trade primarily in the U.S. with American Depositary Shares (each representing two ordinary share).

SONY (SNE)

52-Week Range $15.64–$46.93 Revenues FY:08 (Mar) $79 billion




$25.32

Rating Not Rated


Company Description

Sony, based in Tokyo, Japan, develops, manufactures, and sell electronic equipment, instruments, and devices. Its Game segment (approximately 10% of total revenues) provides entertainment hardware, including PlayStation 2 and 3, and PSP, along with related software. Its key software franchises include SOCOM, Jak, Ranchet and Clank, and Gran Turismo. Sony shares trade primarily on the Tokyo Stock Exchange with American Depositary Shares (each representing one commom share) in the U.S.



SouthPeak Interactive (SOPK)

52-Week Range $0.55–$2.65 Revenues FY:08 (Jun) $40 million




$0.81

Rating Not Rated



Company Description

SouthPeak Interactive, based in Midlothian, Virginia, develops and publishes interactive entertainment software for all current hardware platforms. In October 2008, the company acquired video game developer Gamecock Media Group.

SQUARE ENIX (9684.JP)

52-Week Range ¥1,497–2,925 Revenues FY:09 (Mar) ¥135 billion




¥2,420

Rating Not Rated


SQUARE ENIX Co., Ltd. based in Tokyo, Japan, is a leading global game company best known for its console role-playing game franchises, Final Fantasy, Dragon Quest, and Kingdom Hearts series. In April 2009, SQUARE acquired video game publisher Eidos plc. for approximately $150 million. SQUARE shares trade primarily on the Tokyo Stock Exchange.



Tecmo Koei Holdings (3635.JP)

52-Week Range ¥634–797 Price (as of close 6/22/09)

¥709

Revenues FY:10 (Mar) ¥43 billion

Shares Outstanding 90 million Estimated


Rating Not Rated


Tecmo Koei Holdings is a Japanese company formed in 2009 when Koei merged with Tecmo. Tecmo, Ltd. is a leading Japanese video game company best known for the Ninja Gaiden, Dead or Alive, and Monster Rancher video game series. Koei is known for its Romance of the Three Kingdoms and Dynasty Warriors games. Tecmo shares trade primarily on the Tokyo Stock Exchange.


The9 Limited (NCTY)





$10.54

Rating Not Rated


The9 Limited, based in Shanghai, China, is a leading online game operator in China. The9 operates licensed MMORPGs, consisting of MU, and Mystina Online. The9 was the Chinese operator of World of Warcraft until June 2009. The9 Limited shares trade primarily in the U.S. with American Depositary Shares (each representing one ordinary share).



Time Warner (TWX)

52-Week Range $17.81–$50.70 Revenues FY:08 (Dec) $47 billion



Company Description

Time Warner, based in New York, is a leading media and entertainment company, whose businesses include interactive services, filmed entertainment, television networks and publishing. Time Warner companies include AOL, Time Inc., HBO, Turner Broadcasting System and Warner Bros. Entertainment. Warner Bros. Interactive Entertainment is the video game group, and we esimate that this represents well less than 5% of Time Warner’s total revenues.

Vivendi (VIV.FP)

52-Week Range €16.32–27.39 Revenues FY:08 (Dec) €25 billion


Market Capitalization €21 billion

Company Description

Vivendi SA, based in Paris, France is a French media conglomerate with activities in music, television and film, publishing, telecommunications, and video games. In July 2008, Vivendi merged its video game business with Activision to create Activision Blizzard (whom it holds a 52% interest). Vivendi’s video game business accounts for about 8% of its total revenues. Vivendi’s shares trade primarily on the Euronext Stock exchange.


€17.36

Rating Not Rated


Source: Yahoo! One-Year Price Chart


€17.36

Rating Not Rated


Source: Yahoo! One-Year Price Chart


Walt Disney (DIS)

52-Week Range $15.14–$34.85


$22.66 Revenues FY:08 (Sep) $38 billion


Market Capitalization $43 billion Rating

Not Rated


N/A

Company Description

The Walt Disney Company, based in Burbank, CA, is a diversified global entertainment company. The company’s video game group Disney Interative Studios has historically leveraged its parent company’s vast portfolio of intellectual properties but is now broadening into self developed games. We esimate that Disney Interative Studios represents well less than 5% of Disney’s total revenues.


Webzen (WZEN)

52-Week Range $0.42–$4.68


$3.37 Revenues FY:08 (Dec) $22 million


Market Capitalization $145 million Rating Not Rated


N/A

Company Description

Webzen, based in Seoul, Korea, develops and distributes online games, and other related services principally in the Republic of Korea and other Asian countries. The company’s principal game product, MU, is an online role playing game (MMORPG) and HUXLEY. Webzen shares trade primarily on the Korea Exchange with American Depositary Shares (each representing 0.3 commom share) in the U.S.

Source:Nasdaq.com One-Year Price Chart



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Public Companies Mentioned in this Report (priced as of close 6/26/09)

COMPANY TICKER RATING PRICE PRICE TARGET ACTIVISION BLIZZARD ATVI STRONG BUY $12.66 $16 BEST BUY BBY HOLD $33.58 $40 BLOCKBUSTER BBI STRONG BUY $0.62 $2.50 DREAMWORKS ANIMATION DWA HOLD $27.24 $27 ELECTRONIC ARTS ERTS BUY $20.90 $27 GAMESTOP GME BUY $22.17 $29 HASBRO HAS HOLD $24.47 $25 JAKKS PACIFIC JAKK BUY $13.40 $14 MAJESCO ENTERTAINMENT COOL BUY $2.00 $2.50 MARVEL ENTERTAINMENT MVL HOLD $34.67 $35 MIDWAY GAMES MWYGQ HOLD $0.05 N/A NETFLIX NFLX BUY $40.37 $48 NINTENDO 7974.JP BUY ¥25,850 ¥43,000 TAKE TWO INTERACTIVE TTWO BUY $9.50 $11 THQ THQI BUY $7.41 $9 UBISOFT ENTERTAINMENT UBI.FP BUY €16.58 €21 WORLD WRESTLING ENTERTAINMENT WWE BUY $12.88 $13

ANALYST CERTIFICATION

I, Michael Pachter, certify that the views expressed in this report accurately reflect my personal opinion and that I have not and will not, directly or indirectly, receive compensation or other payments in connection with my specific recommendations or views contained in this report.

IMPORTANT DISCLOSURES INVESTMENT RATINGS STRONG BUY – The stock is expected to return at least 20% over the next 6-12 months. BUY – The stock is expected to return at least 15% over the next 6-12 months. HOLD – The stock is expected to return between -15% and +15% over the next 6-12 months. SELL – The stock is expected to decline by at least 15% over the next 6-12 months. DISTRIBUTION OF RATINGS (as of March 31, 2009) BUY – 43% (2% of this rating category were investment banking clients within the last 12 months). HOLD – 56% (3% of this rating category were investment banking clients within the last 12 months). SELL – 1% (0% of this rating category were investment banking clients within the last 12 months).

The analysts responsible for preparing research reports do not receive compensation based on specific investment banking activity. The analysts receive compensation that is based upon various factors including WMS’ total revenues, a portion of which are generated by WMS’ investment banking activities. WMS makes a market in the securities mentioned herein. WMS changed its rating system from (BUY/ HOLD/SELL) to (STRONG BUY/BUY/HOLD/SELL) on January 5, 2006. Additional information is available upon request by contacting Ellen Kang in the Research Department at (213) 688-4529, or by email to [email protected], or the Business Conduct Department at (213) 688-8090.

OTHER DISCLOSURES


mailto:[email protected]

RESEARCH DEPT. * (213) 688-4505 * www.wedbush.com INSTITUTIONAL TRADING Los Angeles (213) 688-4470 / (800) 421-0178 * INSTITUTIONAL SALES Los Angeles (800) 444-8076

CORPORATE HEADQUARTERS (213) 688-8000 The information herein is based on sources that we consider reliable, but its accuracy is not guaranteed. The information contained herein is not a representation by this corporation, nor is any recommendation made herein based on any privileged information. This information is not intended to be nor should it be relied upon as a complete record or analysis; neither is it an offer nor a solicitation of an offer to sell or buy any security mentioned herein. This firm, Wedbush Morgan Securities, its officers, employees, and members of their families, or any one or more of them, and its discretionary and advisory accounts, may have a position in any security discussed herein or in related securities and may make, from time to time, purchases or sales thereof in the open market or otherwise. The information and expressions of opinion contained herein are subject to change without further notice. The herein mentioned securities may be sold to or bought from customers on a principal basis by this firm. Additional information with respect to the information contained herein may be obtained upon request.


EQUITY RESEARCH DEPARTMENT

(213) 688-4529

DIRECTOR OF RESEARCH Mark D. Benson (213) 688-4435

INDUSTRIAL MATERIALS AND SERVICES Industrial Materials & Services Al Kaschalk....……..….……………………. (213) 688-4539 Christine Hersey....……..…...…………….. (213) 688-4311 CONSUMER PRODUCTS AND SERVICES Consumer Products Rommel T. Dionisio ………………..……… (213) 688-4418 Kurt M. Frederick, CPA …………………… (213) 688-4459 Education Ariel Sokol …………………..…………...... (212) 668-9874 Entertainment Retail Michael Pachter …………………..……..... (213) 688-4474 Edward Woo, CFA …………………….….. (213) 688-4382 Chris White…………..….…………………. (213) 688-4423 Footwear & Apparel Jeff Mintz, CFA…………….…………….… (213) 688-4518 David Epstein …………………...….……... (213) 688-6624

Specialty Retail: Hardlines Joan L. Storms, CFA ……………………… (213) 688-4537 John Garrett…………………………...…… (213) 688-4523

Specialty Retail: Softlines Betty Chen …………………..…………...... (415) 273-7328 Connie Wong…….…………..…………..... (415) 273-7315

Specialty Retail: Sporting Goods Jeff Mintz, CFA …..……………….…..….… (213) 688-4518 David Epstein …….……….…………..…… (213) 688-6624 ENTERTAINMENT AND MEDIA Advertising & Broadcasting James Dix, CFA………………….…..….… (213) 688-4315 Entertainment: Software Michael Pachter …………………...…….… (213) 688-4474 Edward Woo, CFA ………….…………….. (213) 688-4382 Chris White…………..….…………………. (213) 688-4423 Entertainment: Toys Chris White…………..………….…………. (213) 688-4423 Edward Woo, CFA …………………….….. (213) 688-4382 Movies & Entertainment Chris White…………..…...………..…….... (213) 688-4423 Michael Pachter….….………….…………. (213) 688-4474 Internet Advertising/Media Edward Woo, CFA…….…………….…..… (213) 688-4382

TECHNOLOGY Communications Equipment Rohit Chopra …………………...…………. (212) 668-9871 Sanjit Singh …………………...…………... (212) 938-9922 Communications Technology Matthew Robison………..……...…………. (415) 263-6659 Leo Choi ………………………………….… (415) 263-6669 Datacenter Technologies Kaushik Roy…...………………...…………. (415) 274-6873 Software: Enterprise Applications / SaaS Michael B. Nemeroff.……………..………. (212) 668-9876 David Giesecke…...…..…………………... (212) 938-9925 Software: Data Warehouse / Analytics & Online Business Optimization J. Derrick Wood, CFA…………..…………. (415) 274-6822 David Kaczorowski….……………………….(415) 274-6883 Internet: Infrastructure Kerry Rice, CPA …………………………… (213) 688-4538 Next Generation Tech Al Kaschalk....……..………....……………. (213) 688-4539 Christine Hersey....……..…………………. (213) 688-4311 Semiconductors Patrick Wang…………………………...…. (212) 938-9938 Michael Lucarelli..………………...…….…. (212) 938-9927 Telecommunications Software Scott P. Sutherland, CFA ……………..…. (213) 688-4522 Suhail Chandy …………………...……..…. (213) 688-4380 Transaction Processors Gil B. Luria....….…..………....……………. (213) 688-4501 Nick Setyan……....……..…………………. (213) 688-4519 Wireless Equipment Scott P. Sutherland, CFA ………….…….. (213) 688-4522 Suhail Chandy ……………...……….…….. (213) 688-4380 LIFE SCIENCES Biotechnology / Biopharmaceuticals Gregory R. Wade, Ph.D.………...……….. (415) 274-6863 Jeremiah Shepard, Ph.D.………...……….. (415) 274-6862 Richard Lau ..…………….………..………. (415) 274-6851 Kimberly Lee, D.O….……………..………. (415) 274-6842 Cardiovascular, Devices & Regenerative Duane Nash, MD JD MBA…...…..………. (415) 263-6650 Emerging Pharmaceuticals Liana Moussatos, Ph.D.….........…………. (415) 263-6626 Life Sciences Tools & Diagnostics Un K. Kwon-Casado, M.SC...…....………. (415) 263-6634 Specialty Pharmaceuticals Patricia Bank …………………...…………. (415) 263-6646

EQUITY SALES EQUITY TRADING Los Angeles (213) 688-4470 / (800) 444-8076 Los Angeles (213) 688-4470 / (800) 421-0178 San Francisco (415) 274-6800 San Francisco (415) 274-6811 New York (212) 668-9868 New York (212) 344-2382 / (800) 421-0178 Boston (617) 832-3700 Boston (617) 832-3700 / (800) 421-0178

CORPORATE HEADQUARTERS 1000 Wilshire Blvd., Los Angeles, CA 90017-2465

Tel: (213) 688-8000 www.wedbush.com

Documents

Interactive Industry Report 2009