Outlook: The Battle of the Consoles Rages On

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With this note, we are publishing our video game hardware and software sales forecast for 2014 to 2016, and are making our industry growth model available to clients. Our model incorporates our views about the relative success of the next-generation consoles from Sony (NYSE:SNE), Microsoft (NASDAQ:MSFT) and Nintendo, and reflects our belief that the addressable market for handheld hardware and software will be smaller over the next three years than it has been historically.

We expect Sony’s and Microsoft’s new consoles to thrive over the next three years, with cumulative worldwide sales of 37.7 million PS4 and 29 million Xbox One consoles by year-end 2016. We do not expect Nintendo’s Wii U to fare as well, with cumulative sales of under 20 million by 2016.

We expect a modest reversion to more normal software attach rates or “tie ratios,” with software sales of approximately 3 units annually over the next three years for each Xbox One and PS4 sold, and with tie ratios of just over 2 units for the Wii U and just under 1 unit for the 3DS. We think that Nintendo consoles are more susceptible to competition from mobile and tablet games, as we believe that a disproportionately high percentage of Nintendo customers play more casual games, and are therefore more likely to view mobile and tablet games as close substitutes to software developed for Nintendo’s platforms.

Software sales for the next-generation consoles are expected to grow to $12.2 billion by 2016. In contrast to the last cycle, we expect software sales for PS4 ($5.9 billion) and Xbox One ($4.9 billion) to dominate, with Wii U software capturing market share of only 11 percent. We expect overall software sales growth (including PC) in the U.S. and Europe combined (the addressable market for the publishers we cover) of 10 percent in 2014, 7 percent in 2015, and 6 percent in 2016.

We expect combined Xbox 360/Xbox One/PS3/PS4 software sales to grow by over 50 percent over the next three years; because of this, we are favorably disposed to the OUTPERFORM-rated stocks under our video game coverage “Electronic Arts (NASDAQ:EA), Activision (NASDAQ:ATVI), Take-Two (NASDAQ:TTWO), Ubisoft (EPA:UBI) and GameStop (NYSE:GME),” each of which is focused on the hard-core gamer.

Our model projects software pricing for current-generation consoles to decline approximately 20 percent over the next three years, and projects current-generation console software dollar sales to decline by 57 percent. We expect Wii software sales to decline by over 90 percent, Xbox 360 software sales to decline by 64 percent, and PS3 software sales to decline by only 42 percent as we expect the PS3 to sell modestly well in emerging geographies. Our model projects software pricing for handheld consoles to decline only modestly over the next three years, but we forecast overall software sales for the handhelds to decline by 5 percent by 2016. We expect mobile and tablet games to continue to gain market share, and believe that the dedicated handheld consoles will see sales suffer as a result.

Our overall forecast is based upon several assumptions: first, we expect console prices to decline only modestly over the next three years, with PS4 pricing in the U.S. dropping from $399.99 at launch to $299.99 by 2016 and with Xbox One pricing in the U.S. dropping from $499.99 at launch to $349.99 by 2016. Second, we expect new release software pricing to remain at $59.99 in the U.S. for the next three years. Finally, we expect Nintendo to continue producing the Wii U. Should any of these assumptions prove to be incorrect, hardware and software sales will be affected, and it is highly likely that the ultimate results will differ significantly from our forecast.

We expect Sony’s PS4 to “win” the next console generation, assuming that it is able to maintain its price advantage over Microsoft’s Xbox One; however, we think “winning” is important to both companies, and it is possible that Microsoft will reduce Xbox One pricing far faster than we have forecasted. Should hardware prices come down faster than we have modeled, it is likely that hardware and software sales will grow faster.

Michael Pachter is an analyst at Wedbush Securities.

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