Like the embattled hero of one of its own video games, Electronic Arts (TR Large Cap 100) is facing a spate of challenges – including a difficult and costly console transition phase and increasingly tough publisher-rivals – that may force the world’s largest video-game publisher to expand into new arenas.

These challenges came into sharp focus in early May when EA announced that its profits had plunged more than 90 percent in its last fiscal quarter (ending March 31), from $90 million a year earlier to just $8 million. To make matters worse, EA executives announced that they anticipate the company will take a hit in the current quarter as well – with net revenue expected to come in around $300-340 million for the fiscal quarter ending June 30, compared with $432 million a year earlier. A release from the Redwood City, CA company cited “lower net revenues at a lower gross margin and higher operating costs” as the reason for the sharp slide in net income. 

In other words, EA isn’t making as much profit on its games. And it’s been forced to spend a lot more lately to develop games for all the new consoles coming out over the next year – at a time when the competition for game quality and price is fierce.

But EA may be positioning itself to be less dependent on the cycle of new console releases and to be less easily shaken by price competition. Known for its sports and movie game franchises, the video-game publisher has recently gotten into music publishing, and may more actively leverage its technology and intellectual property into other sectors as well. 

Industry experts think it’s unlikely that EA will try to remake itself into a movie production company, though – a la Sony, Warner Bros., or DreamWorks. But the idea of EA more closely partnering on media or technology deals to diversify itself is a good bet. Michael Pachter, a research analyst with Wedbush Morgan Securities, says the company will likely expand its success in console games into the emerging handheld and online gaming markets, as well as into new markets outside the United States. Also, he suggested, EA will further leverage deals with ESPN and the NFL and their hugely successful sports franchise by offering more services tied to fantasy sports leagues.

While its market may expand in the long term, right now EA is focused intently on console gaming. And with three of the biggest video hardware manufacturers –Microsoft, Sony and Nintendo – set to ship new consoles within the next year, the video game business appears to be on the verge of a new boom.

When Nintendo launched its GameCube and Game Boy Advance and Microsoft first offered its Xbox in 2001, U.S. retail sales for video games soared 43 percent over the previous year, to $9.4 billion. But until Microsoft’s Xbox 360, Sony’s PlayStation 3, and Nintendo’s Revolution actually hit stores, EA and other game publishers are in a Catch-22: They need to lay out money to publish games for all these platforms – while game buyers wait for the new systems and games to come out.

At the same time, to further expand its market and get in early on new devices, EA is also investing heavily in developing games for new platforms, such as Sony’s PlayStation Portable (PSP) and Nintendo’s DS (dual screen).

“The console transition has something to do with [the financials],” admits Jeff Brown, EA’s vice president for corporate communications. “We have four completely new pieces of technology [including the recent Sony PSP], which have limited bases for now, with almost no revenue coming off those developments.”

But Brown also thinks the fruits of these efforts will “kick in” when the new platforms come to market. And he believes there’s still a committed base of video game aficionados “who are not going to just quit buying video games” until new consoles are released.

What’s more, even financially, the news isn’t all bad for EA. Its net revenue for fiscal 2005, which also ended in March, was up 6 percent from the previous year, to $3.1 billion. And the company has expanded its game titles that sell more than a million units in a year from 27 to 31. In fact, the company has a half-dozen consistently solid franchises – including The Sims, Need for Speed, and Madden NFL Football – that sell more than five million units a year.

David Cole, president of San Diego-based research firm DFC Intelligence, which follows the gaming industry, says he “wasn’t really surprised” at EA’s disappointing financials, given the runup on its highly valued stock in January and expectations that the company was going to do poorly in the previous quarter.

In spite of its standing as the premier maker of sports video games, with its hugely popular Madden football and Federation Internationale de Football Association (FIFA) soccer franchises, EA got blind-sided by rival Take2 Interactive, which began offering its own line of much cheaper ESPN-branded sports games last year. 

This value-priced alternative forced EA to slash prices on its own Madden game, and, according to Cole, forced EA to take a defensive position, spending an estimated $200 million in December to seal an exclusive five-year deal with the National Football League and another $790 million on a 15-year exclusive arrangement with ESPN, effectively locking out the Take2 Interactive competition.

Outside its lucrative sports franchises, EA sorely underestimated smaller game developers that rolled out a number of highly competitive offerings, notably, Halo 2, Grand Theft Auto: San Andreas, and Half-Life 2. Even Brown admits that over the big holiday season at the end of last year “we faced a murderers’ row of great products…in 22 years, EA has never seen competition from so many quality games.”

But EA has been flexing its competitive muscles as well. Judging by the company’s string of successes developing video games based on blockbuster movies – such as its chart-topping Harry Potter and Lord of the Rings franchises, as well as a forthcoming release based on Batman Begins – and its expanding interests in music production, EA is broadening its reach beyond just video games by leveraging its game technology and its tremendous consumer reach to bolster revenues.

Since hiring a new executive of music and audio, Steve Schnur, EA has been progressively broadening its interest in music, most recently by teaming up last November with Cherry Lane Music Publishing to create Next Level Music LLC, a publishing company that will sign, publish, and license EA’s existing music assets to commercials, films, film trailers, ring tones, and other commercial media, which EA in turn will promote through its games.

But Brown contends that, in spite of the company’s expanded interests in music, “we’re not moving aggressively in anything but the games space.” Even the Cherry Lane partnership, he says, is driven by a desire to improve the music in the video games, not necessarily to sell music.

Given the gaming giant’s better-than-average track record of scoring hit games to be released alongside blockbuster movies, moving further into that business might seem to be a good fit. Many film production companies, like Lucasfilm Ltd. through its LucasArts unit and Disney through its Buena Vista Games unit, have moved more of their video game production in-house. And EA has insisted it doesn’t plan on moving into the movie production business.

“They might try to license a property like ‘The Sims’ to the movies,” says Pachter at Wedbush Morgan Securities. “But I don’t see them starting up a film company.” 

Angela Emery, a spokeswoman for Buena Vista Games, says her company and EA are indeed “competitors on the game side,” but she doesn’t see the company as a rival in the movie space – and doesn’t see the competition as limiting their potential to work together on video games in the future. Buena Vista does about 60 percent of its own games, but works with other publishers, such as THQ and SquareEnix, on the other 40 percent. 

Indeed, while lines between film production and game production may be blurring, Pachter believes the trend of film companies trying to produce music and games is “a fluke” and won’t threaten EA. Deals like Time Warner’s arrangement to license distribution of “The Matrix Online” to Sony, announced last Friday, will do little to make a dent in EA’s core gaming business. “ ‘The Matrix Online’ sucks,” analyst Pachter says, “It’s like if Warner Bros. bought the rights to ‘Gigli 2’. Who cares?”

While EA might not be gunning for Disney or Warner Bros. anytime soon, DFC Intelligence’s Cole believes that the company may well be looking to move into “new entertainment opportunities” if it expects to maintain its growth and become less dependent on the ebb and flow of the new gaming platform releases. If EA wants to justify its $15-20 billion market valuation, Cole says “they need to break away from their profitability being tied so closely to the console cycle.”

Just how will EA manage that? Cultivating a base among a growing number of portable, handheld and cell-phone gamers, EA’s Brown believes, will help insulate the company against the downturns that come with a major console transition. Protecting its core franchises in sports and movie games, which tend to appeal to a broader base of mainstream players, will continue to bolster EA, says Brown.

In addition, the company is seeking to expand its range of new games – which Brown admits are a bit more risky than proven standards like Madden NFL or a movie tie-in, but give the company a more diverse mix of products. For instance, Spore, developed for EA by the maker of their popular Sims franchise, took top honors from game critics at last month’s E3 trade show.

Ultimately, though, analyst Cole is confident that, although EA has hit some rough spots, it remains in the lead. As an independent third-party publisher, “they’re in a league of their own,” Cole says. “Their biggest challenge is really keeping up with their own success.”

Karen Epper Hoffman writes about business and technology issues from her home in Poulsbo, WA.