Min Kim, vice president of Nexon Corp.'s U.S. division, in its Los… (Lawrence K. Ho / Los Angeles…)
The future of the video game business is playing out very differently on two sides of Los Angeles.
In Westwood, nearly 200 people recently lost their jobs when Pandemic Studios, the maker of Saboteur and other gritty video games, shut its doors.
But 12 miles east, at Nexon Corp.'s U.S. division, bustling staffers are upbeat as they prepare to double the size of their workforce. The South Korean publisher best known for its lighthearted game MapleStory saw sales climb 12% in 2009.
The difference? Pandemic makes games on discs that come shrink-wrapped in plastic boxes and sell for $60 at stores such as Best Buy and Target. Sales for that kind of video game fell 11% last year.
Nexon, however, distributes its video games online free of charge and generates revenue by selling virtual items such as weapons and costumes that players use in the game.
Whether it's $15-a-month subscriptions to World of Warcraft, $10 downloads on a PlayStation 3, 99-cent iPhone games or ad-supported games on Facebook, digital transactions are growing fast and could be the future of the video game business.
Even as traditional media companies struggle to find profitable business models on the Web -- as evidenced by recent moves by Hulu.com and the New York Times to start charging for content -- the games industry is experimenting with a variety of methods to generate revenue online.
"What a lot of folks miss is that when you add online services, micro-transactions and subscriptions, the whole industry is headed for strong growth in 2010," Electronic Arts Inc. Chief Executive John Riccitiello said.
Discs aren't going away soon. Retail video game sales are still a $45-billion-a-year global market, compared with an estimated $5 billion for online digital games. And game executives expect sales to remain strong for blockbuster titles such as Call of Duty: Modern Warfare 2, which has raked in more than $1 billion since its launch in November.
But the long-term trend is clear: Retail sales are declining, and online digital sales of games face rapid growth.
Valve Corp.'s Steam service, the largest seller of downloadable games for personal computers, reported a 165% jump in revenue in 2009. Direct2Drive, owned by News Corp., grew 40%. Sony Corp. reported that sales of downloadable games and game-related content on its PlayStation 3 increased 139%, and Microsoft Corp. saw 50% growth for the same items on its Xbox 360. EA's digital revenue grew more than 25%.
There are still risks in depending too much on online revenue for games, however. Unlike the shelves at Wal-Mart, there's no limit to the number of games that can be stocked in a digital store, making it difficult for individual titles to stand out. Apple Inc. alone sells more than 130,000 games and applications for the iPhone.
In addition, although people are spending more time playing games online, they tend to pay less for the experience, leading to lower revenue generation.
"Unfortunately, as with other media as they migrate from traditional distribution to online, you increase the amount of hours spent, but you decrease the amount of money you get," said Bing Gordon, partner at Silicon Valley venture capital firm Kleiner Perkins Caufield & Byers and former chief creative officer at EA.
The transition to online gaming is particularly evident at EA. In December, on the same day that it announced it would lay off 1,500 workers, EA agreed to buy Playfish, a maker of games for social networks such as Facebook, for $275 million.
The costs of distributing goods digitally are much lower than manufacturing and shipping discs. Production expenses are lower as well, because players online are often interested in shorter, less lavish experiences that cost less to make.
But lower cost is only one reason that game publishers see dollar signs in broadband and wireless connections. When players get engaged in an online game such as World of Warcraft, they become a subscriber, ensuring a continuing revenue stream for the company.
"We're going away from a packaged-goods mentality to a service mentality, which means instead of extracting as much money as we can at once, we're generating ongoing revenue," said Gabe Newell, managing director of Valve.
Even games sold at stores are having their business models transformed by the Internet. As the cost of producing a top-quality title has escalated to $20 million or more and sales have stagnated, publishers have become increasingly dependent on players who have already bought the disc to fork over an additional $10 to download more digital accessories.
"It's crucial for the economics of our business today," said Peter Dille, senior vice president of marketing for Sony Computer Entertainment of America.
Companies such as Playfish, Nexon and Zynga Game Network Inc., meanwhile, offer free versions of their games and generate revenue by "upselling" players on additional content.
Nexon has a catalog of more than 10,000 virtual accessory items for sale that run from $1 for colored contact lenses for characters to a $32.90 sniper rifle. Most players never touch any of it, but the minority who do buy the features are enough to make it a viable business, company executives note.
"We operate by the 80/20 rule," said Min Kim, Nexon America Inc.'s vice president of marketing. "Twenty percent of our audience make up 80% of our revenue."
Playfish co-founder Sebastien de Halleux notes that by dividing the company's online games into small chunks that can be rolled out and sold separately, Playfish captures revenue from a broad range of people, unlike retailers that charge a single price for a uniform experience. Some Playfish fans spend only a few dollars, but others invest $100 or more.
The result, De Halleux said: "Over time, many of our players end up spending a lot more than they would for a retail disc game."