Why China Allowing Gaming Consoles Won't Help Game Makers

Reports this week that China was considering lifting its 13-year ban on video game consoles sent shares of companies like Sonyand Nintendo soaring.

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But as the euphoria wears off and the waiting period for the country's government to take action (if, indeed, it plans to) sets in, analysts say the potential impact on major U.S. video game publishers will likely be minimal.

"You'll see a lot of consoles sold, but not a lot of games," said Wedbush analyst Michael Pachter. "The audience is ready to buy consoles, but it's not ready to pay full price for games."

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China is certainly an untapped market for game publishers. However, there are several hurdles with the country that could make substantial revenue increases difficult, if not impossible.

Among those is the country's historical pattern of not aggressively chasing software pirates. Game companies have long complained about the overwhelming prevalence of bootleg software that's sold in the country, but have received no relief.

In 2005, id Software CEO Todd Hollenshead told the story of a trip to the country, where he saw a copy of the then still unreleased "Doom 3" already for sale in some shops.

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"There's no indication from the Chinese government that they'll help keep pirates form ripping off IP," says Pachter.

With those pirated games unlikely to go away anytime soon, game publishers would have to adjust their pricing models—and keep expectations low. But that doesn't mean there's not a potential upside, note analysts.

"As long as that piracy doesn't negatively affect sales outside of China, it doesn't matter," said Edward Williams of BMO Capital Markets. "Let's say—hypothetically they lift the ban and console are available and the business model is the same as it is here… And let's say 80 percent of the market in China is pirated. A U.S. publisher may look at that and say 'I'm not going to enter that market'—or they'll look at it and say 'It's going to be contained to China. And even though I can only get 20 percent of the sales, that's more than I was getting before.'"

Piracy isn't the only obstacle, though. The most lucrative model in the Chinese video game market is free to play games. And convincing customers to migrate from that to a pay to play model will be challenging.

"The Chinese consumer is not geared to the habit of 'I go to the store, spend X dollars to acquire this game, then go home and play it all night long.' That creates some challenges for [publishers]," said Williams.

Many U.S. game companies— including Activision-blizzard and Take-Two Interactive Software—are already taking this into account.

Last July, Activision partnered with Chinese game developer Tencent to launch the free-to-play "Call of Duty Online" in the country. The game is being financed through microtransactions—small in-game purchases from players—rather than a monthly subscription fee.

The companies say they expect to attract tens of millions of players. In announcing the game, Activision CEO Bobby Kotick called China "one of the most exciting places in the world for us to grow our business and to develop innovative new games."

Take-Two, meanwhile, is partnering with Tencent for "NBA 2K Online"— creating a game that moves beyond a simple simulation of the sport to include role-playing elements, such as character personalization, quests and achievements. (The company has not announced any numbers around the project as yet.)

U.S. game publishers who have committed to the free to play model, though, have seen great success.

Since transitioning to free-to-play for its game "EverQuest 2," Sony Online Entertainment has seen a 300 percent increase in new players, a 125 percent increase in item sales and a 350 percent bump in overall registrations. "Planetside 2," its most recent free to play release, has more than 1.6 million registered users — with 750,000 logging in to play every week.

"Sometimes you make a decision and you're like 'Oh God, let's buckle in and hope everything goes well.' That's how it was with free-to-play," says company president John Smedley. "Now we look back and wonder 'How did we ever survive before this?' Living in a world where retailers control your software was horrible."

To date, though, free-to-play is not something console companies have embraced. That's due, in part, to the razors and razor blade model of the industry. Systems are sold at a loss or a minimal profit, with Nintendo, Sony and Microsoft making it up on their cut of software sales. Free-to-play complicates that.

"Realistically, to successfully bring consoles into mainland China, you would need to embrace that free-to-play business model, so it would be a different iteration," says Williams. "The products you have would be a hybrid of what people are playing in China today and what publishers bring to the table."

Should China choose to allow console imports, don't expect Microsoft, Sony and Nintendo to release their most recent systems there. Each would likely opt to test the market with a legacy system, where they don't have as much to lose. (Nintendo, in 2003, collaborated with a Chinese company to create a gaming system that was made in China, which offered titles from the then 7-year old Nintendo 64 console.)

That, analysts said, would make a relatively minor impact on the bottom line of these companies — especially in the short term — which makes this week's stock spike all the more curious.

"I'm kind of a skeptic on whether they'll ever be able to compete just because of the way China operates," says David Cole of DFC Intelligence. "As for the spike, investors are looking for an positive news and are jumping on any sign of optimism."