The Game of Our Lives

Want to play a game?

This week's Electronic Entertainment Expo shed a little more light into the two next-generation systems that will compete with last fall's rollout of Microsoft's (Nasdaq: MSFT) Xbox 360. Weeks before the crucial 2006 holiday shopping season begins, Sony's (NYSE: SNE) PlayStation 3 and Nintendo's (OTC BB: NTDOY) peculiarly named Wii will hit store shelves, gunning for a spot on gamers' wish lists.

The implications are huge. Between video game publishers looking to bounce back from a horrendous 2005, and conventional toymakers that will have to adjust to the big-ticket shift in holiday shopping priorities, a lot is riding on the new gaming consoles.

As an investor, you don't have to wait that long to play. Right now would be a great time to crack your knuckles, sneak a peek into the future, and profit from your visionary glimpse by investing in the industry accordingly.

2006 is only the beginning
Understanding why 2005 was such a dud for the industry may help you understand why salvation can't be counted on until 2007 at the earliest. The Xbox 360, despite being offered up in pricey bundles with several high-margin titles, wasn't enough to rescue the sector. Nintendo and Sony moving a few million boxes will stir up some ripples, but it won't be enough to turn the tide over the course of a few weeks.

When gamers know that a new system is on the way, they are reluctant to spend money on current titles that may be collecting cobwebs in a few months. They're also saving their pennies, since the new consoles, particularly the PS3, aren't going to come cheap.

Video game sales tend to peak in the third and fourth year of a console's life, when the systems have a large enough installed base to produce mainstream success for hit titles. Here in the nascent stages, early adopters are willing to pay a premium for a freshly-minted system and gobble up a better than average sum of titles, but the numbers aren't enough to rescue the software industry. That will come later.

So if you're wondering why Take-Two Interactive (Nasdaq: TTWO) won't hit the market with the next console game in its flagship Grand Theft Auto franchise until the fall of 2007, it's because it wants to give the Xbox 360 and the PS3 another year to build up their core audiences.

On the retail front, chains like GameStop (NYSE: GME) are positioned to score huge top-line gains in the holiday quarter, but it remains to be seen how much of that will trickle down to the bottom line. Hardware is costly, but it's a lower-margin business than the juicy software side. Retailers have been successful in forcing buyers to order software bundles to get their consoles during the initial shipment, but it's not a slam dunk. Bundles work if supply is scarce. Scarce supply translates into fewer systems being sold.

This holiday season should get interesting. The feature-packed PS3, including Blu-ray DVD playback, will be priced at $499 and $599. Nintendo hasn't yet announced the pricing of the Wii, but with the company falling back into third place on the console battlefront, it's going to have to be aggressively priced at less than half the cost of the PS3 if it doesn't want this to be its swan song. Stand-alone Xbox 360 systems should also be in ample supply. That will keep Sony and Nintendo honest, as tight shipments or delivery delays may divert frustrated gamers to Microsoft's gaming workhorse.

Microsoft won't kill Sony
It's easy to draw a parallel of 2005 and 2006 to 2000 and 2001. That's when Sony beat its two rivals to the punch by launching its PlayStation 2 system a year before the Xbox and Nintendo GameCube.

There are two problems with this comparison. The first is that, back then, Sony was already the market leader by a wide margin. Microsoft is being cast in that role as a distant second-place player. And since PlayStation has made the brilliant call of making its consoles backward-compatible, the PS3 can play games from older incarnations, ensuring that a huge built-in audience is clamoring for the chance to upgrade.

There is also the potential of the 360 feeling obsolete among its newer competitors. In a dramatic -- if not drastic -- attempt to stand out, Nintendo redesigned its controller. The remote-control-shaped controller that can sense players' motion and position relative to the screen should encourage active gameplay. By getting gamers to physically reel out a fishing line or take a backhand swing on a virtual tennis court, Nintendo should score points with groups concerned about the sedentary state of most couch potato gamers. In a surprising E3 announcement, the PS3 controller will also offer some motion-sensing characteristics.

Anyone who has seen arcade junkies breaking into a sweat while moving to the beat of Dance Dance Revolution knows that gamers don't mind getting active. Some games may even rival the best cardiac workouts. If these new on-the-move controllers catch on, the Xbox 360 may suddenly seem stale.

The pot of gold at the end of the rendered rainbow
Microsoft should be aided by software. Activision (Nasdaq: ATVI) will be back with Call of Duty 3 later this year, and Bungie's Halo 3 will be setting the tone in 2007. Ironically enough, it may also be helped by the existence of competing next-generation systems.

As a 360 owner, I've scoffed at paying $20 more for a title with only marginal enhancements over the same game available on older systems. With software publishers inflating prices across the board over the holidays, the value disparity will lessen.

In the end, 2006 will be better than 2005 -- a year that found video game sales dipping by 5% -- but 2007 will be when companies really start raking in the bucks. The perfect proxy to prove this would be Electronic Arts (Nasdaq: ERTS). Thanks to the annual installments of its popular pro sports games, one can gauge the health of the industry by simply making a timeline of how its latest Madden football game is selling in any given year.

At least, that's the way it used to be. Let's explore the software-publishing benefit of Nintendo breaking from the pack with its eclectic controller. Even if a gamer owns several consoles, there's never really been much of a reason to snap up more than one version of Madden's legendary football game. But now that the gameplay on a stationary 360 version may vary considerably from the Wii version -- with gamers possibly carrying out the passing, kicking, and receiving motions -- EA may wind up selling a pair of copies into homes where it was only good for one annual score.

The differentiation may also help the hardware makers. A one-console home may now find itself tempted to have a PS3 in the living room to take advantage of the Blu-ray optical disks, a Wii in the family room to give younger family members room to move around, and a 360 in the bedroom to dig into popular combat titles away from impressionable younger players.

The industry should thrive in the future, especially with the inevitable arrival of digitally delivered titles and more home-entertainment functionality. The new dynamics of the video game sector emerging in 2006 will likely make for great long-term rewards for investors willing to bank on the video game space while it's down.

If you want to win this game, that's how you play.

GameStop, Electronic Arts, and Activision have been recommended to Motley Fool Stock Advisor newsletter subscribers, among other favorite stocks from Tom and David Gardner. Microsoft was singled out last year by the Motley Fool Inside Value service as a top-notch stock trading at a bargain-bin price. If you like to play games, you can also join Rick at the growth-stock-centric Rule Breakers service, where active participants also engage in stock-picking and essay-writing contests.

Longtime Fool contributor Rick Munarriz loves playing video games, but he doesn't own shares in any of the companies mentioned in this story. T he Fool has a disclosure policy.