The Downside of Direct Downloads

The business of selling videogames used to be pretty simple: A wholesaler sells a game to a store. The store sells the game to a consumer. The consumer plays the game.

Today, we’re in a new era. Hundreds of millions of gaming consoles and PCs with ever-growing amounts of storage space are now equipped with high-speed internet connections, allowing gamers to quickly and easily access new content directly from the source without venturing outside the living room.

PC gamers have long been downloading full, brand-new games from Steam and other sources, and console gamers are following suit. On August 11, Microsoft will launch its Games on Demand service, offering more than 30 full Xbox 360 titles for sale by download. Sony’s PlayStation Network, for its part, offers a handful of otherwise disc-based PS3 games for download, including Burnout Paradise, Warhawk and Gran Turismo 5 Prologue. It’s no stretch of the imagination to see that these are baby steps towards brand-new, full-featured games being delivered via direct download.

The videogame industry is also in the early stages of developing cloud-based business models where all the game content and computing power is remotely accessed from a far-off data center – just log in and play, no disk or massive download required.

Accessing content online has some benefits for gamers. It’s incredibly convenient. We can receive patches to update our games, download expansion packs and even purchase some games without leaving the couch. We can also download demos to try out new titles, something I wish I had 20 years ago before I bought garbage like Friday the 13th for the NES. But if you care about things like games staying affordable and having some choice as a consumer, you might want to start worrying right about now.

At its core, the movement from standard methods of content delivery to virtual ones is just a big, crazy chase for dollars. This shift will have a major impact on the whole supply chain from console-makers to software publishers and retailers.

Taking a look at GameStop’s SEC reports gives us a glimpse into some of the industry’s inner workings at the retail level. The company’s financial statements indicate that the markup on a new title is somewhere in the neighborhood of 20 percent, or about $10 for a game retailing at $60.

These markups represent dollars that software publishers would love to have for themselves. Wouldn’t it be great for Activision if it could keep the whole $59.99 for a brand-new Xbox 360 or PS3 title instead of sharing it with a retailer? Just a few dollars multiplied by millions of units adds up to a pretty nice chunk of change. If the middle man is making money you want, you take him out.

Software companies also wouldn’t have to worry about the logistics and expense of getting products into stores – just upload them to a server, and the money flows. There would be no shortages of the hottest titles on launch dates and no unwanted boxes piling up in stores. They’d have to compensate Sony, Microsoft and Nintendo for enabling the downloads, but it could still be a nicely profitable setup.

And as we move into the future, every dollar of potential revenue is becoming more and more important. Ubisoft CEO Yves Guillemot recently told business network CNBC that next-generation games will cost $60 million to produce as opposed to $20 to 30 million today.

To break even on a game, a publisher would have to move well over a million units, compared to about half that today. There isn’t much of a chance that the gaming market will double in size by the next console generation, which means revenue isn’t likely to increase as fast as production expenses.

Remember, a videogame company’s prime objective is to make money for shareholders, not necessarily to make great games. And it’s pretty much a given that companies with falling profit margins also have falling stock prices.

Of course, a direct-download system has potential drawbacks for the big software companies. Microsoft and Sony might end up charging publishers an arm and a leg to enable game downloads, especially as they gain more and more control over distribution.

Think about it: What if, 10 years from now, 50 percent of software sales for Microsoft’s latest console come through Xbox Live? Or, in an even scarier scenario for consumers, what if there is no physical media drive at all, and everything goes through Xbox Live? Sony’s marriage to the Blu-ray format ensures its continued support of game discs, but Microsoft has no such restrictions. They could cut console production costs and take control over the entire supply chain in one fell swoop.

There would be zero room for publishers to negotiate anything in such a de facto monopoly. The perfect comparison is Wal-Mart. As the world’s largest retailer, Wal-Mart is able to demand pretty much whatever it wants of suppliers because it grants access to such large numbers of consumers.

Brick and mortar game-sellers won’t like competing with direct downloads and could reduce shelf space for videogame hardware in retaliation. The average markup on a videogame console is roughly six percent, according to GameStop’s financial statements. The only reason to carry hardware is to sell higher-margin software and accessories along with it. If a retailer loses business on the software side, it won’t have an incentive to be in the videogame business at all.

In this scenario, that could force console companies to take on the responsibility of selling hardware directly to consumers – a complicated venture to say the least. Alternately, they could entice retailers by lowering wholesale prices or raising retail prices. Neither option seems very attractive for a console-maker: It’s either lose even more money on each console or limit your overall customer base.

Prohibitive console prices may be the least of consumers’ problems, however. The biggest one is the elimination of price competition in the software market. I like having a choice when I buy a game. Right now, I can walk into my local GameStop and pick up Fight Night Round 4 for $60, order it from Amazon for $55 or hit up Craigslist and find a used copy for $40.

In highly proprietary, closed systems like Xbox Live and the PlayStation Network, there will be no competing sources for game downloads – in other words, no shopping around for the best price. And no physical game disc means I have nothing to trade in or sell when I’m finished with a game to make a few bucks back.

To celebrate my Xbox 360 coming back from Microsoft for repairs, I decided to pick up UFC Undisputed 2009. Being a bit strapped for cash, I gathered up a few games that were collecting dust and toted them over to my local GameStop. I ended up paying about 74 cents for UFC after my trade-ins. And on the other side, some lucky fellow is playing my old copy of Frontlines: Fuel of War, which cost him about $10. For consumers, it’s a win-win situation.

But if I can’t shop around for my games or sell unwanted ones, I’m not getting as much value for my dollar – a real problem when the economy is so tough. That’s the fundamental problem with direct downloads: They typically cost the same to consumers, but they’re worth a lot less.

The current system isn’t perfect, but it works. Software companies still have fat profit margins and benefit from downloadable add-ons to existing games as well as full downloads of smaller titles. Retailers like GameStop and Best Buy still have plenty of incentives to continue selling both software and hardware, and console makers will see improving fortunes as their install bases grow and their sales mix shifts from low-margin hardware to more profitable software. And as gamers, we have an abundance of choices, including a thriving used-games market.

Change just might be overrated.

Michael Comeau runs the blogs VideoGameStocks.net and LongShortTrader.com. The Brooklyn-based freelance writer was a columnist for TheStreet.com, where he covered the video-game industry.