This article has been adapted from our sister site across the pond, Fool UK.
On Wednesday, Nintendo, the manufacturer of the wildly popular Wii and DS consoles, announced the price and release date of its latest gadget, the handheld Nintendo 3DS.
Due in Europe in late March, for the game industry the 3DS can't come soon enough. The device enables gamers to experience 3-D visuals without the need for 3-D glasses. It will cost $250 in the U.S., while U.K. game fans will be charged a relatively extortionate 250 pounds.
Nintendo of America President Reggie Fils-Aime justified the price, saying, "Nintendo 3DS is a category of one -- the experience simply doesn't exist anywhere else."
It's a revealing comment that gets to the heart of some of gaming's current woes.
Not so fun
Video-game designers obsess over what they call the difficulty curve. The ideal is a game that gets gradually more challenging, so that a player's skill steadily rises to match what the game throws at him.
If, in contrast, a player suddenly faces a 10-headed hydra when she's tackled only three-headed beasts so far, she can find it impossible to overcome. The result can be a lot of premature Game Overs.
Ironically, that's sort of what happened to the game industry in the past three years. The sector enjoyed huge growth from the mid-1990s, when the Sony (NYSE: SNE) PlayStation took games mass-market. The resultant wider audience and longer life of game consoles to some extent smoothed out the old boom-and-bust cycle that had plagued games since the 1980s.
However, game executives were slow to realize that with global acceptance came global vulnerabilities. When the world plunged into a steep recession following the financial crisis, game companies saw their projected profit curves droop as their hard-won mass-market audience curbed spending in a way gaming's previous narrower audience never would have.
Most games companies have suffered -- the share prices of U.S. giants Electronic Arts (Nasdaq: ERTS) and Take-Two (Nasdaq: TTWO) are down by more than 70% and 30%, respectively, from where they began 2008. Some weaker players, including a few notable U.K. game developers, went under.
Show me the margins
Against this backdrop, the 3DS is a breath of fresh hardware.
For all the increasing sophistication of games, the pastime has always thrived on novelty. Nintendo's touch and gesture control systems for the DS and Wii, for example, captured the wider public's imagination a few years ago and were soon aped by other manufacturers.
The 3DS is likely to inspire the same. Noted analyst Michael Pachter of Wedbrush Morgan Securities believes Nintendo will sell 20 million 3DS units worldwide in 2010, including 8 million in the U.S.
That would be great news for the big game publishers. While 3-D games may eventually evolve in gameplay, too, early output will follow the example of 3-D movies (similarly touted as the savior of film companies) and simply offer souped-up visuals.
As a result, game creators will be able to recycle their existing franchises and even entire games. Early Nintendo releases sure to sell millions include 3-D versions of Star Fox 64 3D and The Legend of Zelda: Ocarino of Time. Both titles first emerged more than a decade ago.
Big margins and little risk
The 3DS, then, is a bit like the arrival of CD for the music business in offering big margins for software publishers, at relatively little risk. That compares favorably with the other recent sexy hardware development -- Microsoft's (Nasdaq: MSFT) Kinect controller for its Xbox 360 console.
Kinect players use motion to control on-screen action, but unlike with Nintendo's Wii, you don't need to hold anything. Instead, Kinect's cameras track your body's movement.
Microsoft sold 8 million Kinects into the channel over Christmas -- much more than the 5 million it had planned to. Kinect represents a lot of revenue for both Microsoft and for the retailers selling it.
Game publishers will take longer to see the benefit. They've had to create Kinect games from the bottom up, and they will have started development as much as 18 months ago -- long before knowing what will work best on Kinect. It will be some time before Kinect is a software cash cow.
New rivals
At least Kinect games are relatively cheap to develop. Conventional top-end games for Xbox 360 and PlayStation 3 cost $18 million to $28 million to create, with the most expensive gobbling $40 million or more before recouping a penny.
Combine those sorts of budgets with the fact that games are a hit-driven business, and it's not hard to see why ever fewer game developers have been able to survive the impact of commercial flops. Even mega-publishers such as Electronic Arts have repeatedly slashed back development in the face of big losses.
Yet even while the conventional game industry has staggered under the financial load of its own ambition, newcomers have built entirely new multibillion-pound businesses by tapping into emerging markets such as Facebook and the iPhone.
On these mass-market platforms, development costs are comparatively tiny, and the business model is based primarily on advertising. Yet the returns can be huge -- start-ups such as Facebook-focused PlayFish and iPhone specialist ngmoco were acquired for $300 million to $400 million after just a few years in business. The biggest of the new breed, Zynga, is valued at $5 billion.
Unfortunately, these companies were never listed. The only way private investors have been able to tap in is by buying in the off-market exchanges.
Gaming's next level
Missing out on new developments such as Facebook has sapped the games industry's confidence, even on top of the woes caused by the economic downturn.
Other factors, such as the move to online distribution -- with its comparatively untested market characteristics -- and uncertainty over when (or even whether) Sony, Microsoft, and Nintendo plan to release new versions of their TV-based consoles (they would normally be expected by now), further darken gaming's "fog of war."
U.K.-listed Game Group put it well last week:
It is well recognized that the market is changing. Next year will see further innovation in existing formats as well as social and mobile gaming, and a growth in digital and online distribution. Given those developments, we recognize that we need to evolve our business and deploy our strengths in new areas.
It could have been speaking for the entire game industry.
The Nintendo 3DS offers sci-fi-style 3D graphics, which will set it apart from existing game consoles -- let alone upstarts such as the iPad -- and revive jaded appetites. But it's otherwise a conventional gaming platform.
Game publishers and investors should not be overly reassured. As much as the start of 3-D gaming, the 3DS may yet be remembered for marking the dying days of the old business model of video games.
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