The video game industry will be in (a happier) transition at the E3 trade show

Consider these little tidbits about E3, the mad house video game trade show that starts on Monday. About 45,000 video game professionals will attend, including a few thousand press. The cavernous Los Angeles Convention Center will house more than 200 exhibitors from around the world. There will be 35,000 displays on site, 10 miles of extension cords, and 5 miles of duct tape.

And of course there will be “booth babes” and “booth beefcake”, or attractive women and men at the booths, trying to get your attention. E3 is an extravaganza where the video game industry “sends messages worldwide to the consuming public and retailers about what is coming next,” said Mike Gallagher (pictured right), president of the Entertainment Software Association, the industry’s trade group that puts on the show.

“E3 defines what is coming next,” Gallagher said. “And this year, you could say the industry is firing on all cylinders.”

Game publishers are probably going to be in a good mood. They survived the recession and a period of layoffs and declining sales. Revenues are going back up for the core console game industry, even though there is a lot of competition from games on smartphones, tablets, and other portable platforms.

And while Apple will do its best to steal the thunder of E3 by having its own Worldwide Developer Conference in the same week, it no longer seems like the iPhone and the iPad are pummeling the traditional game industry. Apple won’t kill the consoles, or so it seems. In fact, it almost seems that, after years of struggle for control of the industry, the various factions of the game industry are becoming more and more satisfied with the concept of variety. Consumers are embracing games in any kind of form. About 67 percent of American households play games, and the average gamer is 34 years old. Forty percent of gamers are women.

Perhaps because of the competitive threats, innovation is starting to happen faster. Microsoft’s Kinect motion-sensing system sold millions of units and has been certified as the fastest-selling consumer electronics device in history. Sony also successfully launched its motion-sensing PlayStation Move controller, and Nintendo has introduced glasses-free stereoscopic 3D with the 3DS. Next year, Nintendo is launching its Wii 2 game console and Sony is introducing its NGP game portable either late this year or next year. As long as those devices continue to delight consumers, the traditional game industry might be able to weather the rise of digital competition, which includes smartphones, iPads, social games on Facebook, and online titles.

The promise and threat of digital distribution are looming large. Publishers are fretting about how they lose sales to piracy, used games, and free apps. But Gallagher says the industry is handling the transition to digital distribution quite well.

Consider that the music industry is half the size of what it used to be before Napster. And movie makers are trying all sorts of new digital distribution schemes in order to deal with declining DVD sales and piracy. By comparison, the console video game industry is growing and has found a way to make money through digital distribution: free-to-play games with micro-transactions. With free-to-play, game companies can offer their games for free and make money by getting users to pay real money for virtual goods such as better weapons via small transactions. Gallagher says this business model will enable game makers to have a smooth transition to free content in a way that the movie and music companies didn’t.

“Our industry is leading the way among all forms of media on how to successfully make the transition,” Gallagher said. “Are the free games a threat? Is YouTube a threat to movies like Lord of the Rings?”

That may be true. Electronic Arts generated $800 million in digital revenues in the fiscal year ended March 31. That was 20 percent of its total revenue of $3.8 billion on a non-GAAP basis. A lot of that money comes from digital downloads of add-on material for the consoles. Still, it is a sign that EA will be able to adapt to the disruption facing it. EA chief executive John Riccitiello says he can’t claim victory yet, but he credits EA for getting a few wins in the digital business.

But some of the companies that are pure plays in digital distribution, such as Zynga, are still luring lots of users to their social games on Facebook. Zynga’s value is reportedly around $10 billion and it may go public soon. That is having a disruptive effect on the core business. Electronic Arts has a value of $5.8 billion and Activision Blizzard has a value of $10.1 billion. If things keep going this way, it may be possible for Zynga to buy a major console game maker at some point. That would cause some serious disruption.

In some ways, Zynga is creating new recruits for the hardcore game companies. With so many people playing games, the definition of a hit is changing. It used to be that getting a million users was a big deal. Now, Zynga can launch games that reach tens of millions of users. While Zynga dominates casual games on Facebook, there are still some openings for rivals. Venture capitalists are pouring money into the pure play rivals such as Kabam, which raised $85 million in venture money last week to make hardcore games on Facebook.

Still, hardcore console game makers such as Ubisoft are adapting.

“We have the basics of the traditional business covered, and we are launching games first on the new platforms,” said Laurent Detoc, North American president of France’s Ubisoft. “We know that online is coming at us from all directions and we are building our infrastructure for a big digital business in a few years. We can see that it is time to put your best efforts online.”

Ubisoft is launching Ghost Recon Online as a free-to-play game this year, after more than two years of development. More titles for Facebook and online platforms are in the works. Yet Ubisoft continues to make major investments in its consoles games. With cross-platform brands, Ubisoft believes that consumers will want to play their favorite games on every platform.

By contrast, smaller companies have to make tough choices. Brian Fargo (pictured right), founder of inXile Entertainment and a longtime maker of console and PC games, is leading his company away from the hardcore titles. His company just finished Hunted: The Demon’s Forge, a fantasy role-playing game that the company worked on for years. The title got mixed reviews, with an average of 64 out of 100 on the review aggregator Metacritic. That title took a lot of hard work and a team of about 60 to make.

With 40 employees, Fargo is marching off to become a full-time digital game publisher. The company will focus on social games that can be operated as a service, where the game launches and is operated in perpetuity online. Because of all of the funding going into mobile and social games, Fargo said, “I see opportunities that might not be here in two years.” One of the company’s new games is a revival of a 1980s classic, Choplifter HD, which will debut this fall as a downloadable title on Xbox Live Arcade, PlayStation Network, and the PC. The company will try to do a top-notch job, but for a lot less money than it would spend on a $60 packaged good game.

“People are afraid to spend too much money in core games,” Fargo said in an interview. “But if you don’t spend, you don’t get the bigger pay off. We are going to get away from the AAA titles and migrate fully to the digital world.”

Some hardcore game stalwarts are sticking to their guns. Ken Levine (pictured right), the designer of BioShock and the upcoming BioShock Infinite, said that focusing on quality and doing what it takes to build a massive fantasy world for gamers is the only creative approach worth taking when there are lots and lots of poor-quality titles on the market.

“Speaking from my own creative view, the only constant of our industry is change,” he said. “If I look at what has happened to our industry in the last five years, I can only conclude that what we make has to be that much better if we’re going to ask someone to give us $60 for a game. You have to set your sights high and you have to deliver on that. That’s our responsibility, to deliver something they can’t get anywhere else in the universe.”

That means that the company (Levine’s studio Irrational Games is part of Take-Two Interactive) has to invest more resources and take more time to build games to make them stand out. But the studio may also have to think about which parts of the major game can be steered to a smaller social or mobile platform.

“The good thing about the game industry is that there can be a lot more creative control than there is in the movie industry,” Levine said.

In fact, like Levine, some of the hardcore game companies are responding by doubling down on their investments. Ubisoft has shifted hundreds of developers into multiple teams for its Assassin’s Creed franchise so that it can launch a blockbuster game every November. Activision Blizzard cut back on unsuccessful titles such as Tony Hawk and Guitar Hero. And now it has multiple studios making Call of Duty games so that it can turn out a Call of Duty game every November as well.

That may seem like risk-averse behavior, and Detoc says it’s his company’s responsibility to make sure consumers don’t get tired of the games. He notes that preorders for the latest game, Assassin’s Creed Revelations, are up 75 percent from before. And Activision Blizzard took an interesting path with its newest game, developing a Call of Duty social network, in a stab at integrating the innovations of social games with the quality of traditional games.

Even as the sequels pay off better, companies have to invest heavily in original content too. Sensing Activision Blizzard’s retreat from guitar games, Ubisoft has commissioned Rocksmith, a guitar video game that has the interesting twist of using a real guitar to play the game.

“I love the variety of the game industry,” Levine said. “I don’t have a vision for where I want it to go, because it goes off into many more interesting places that I can imagine. I’m along for the ride and I’m reacting to what is happening. It would be a dull world if the game industry were just the way I wanted it to be.”