Games industry revenues were down again in 2011. Here’s my analysis – and why I believe things won’t improve any time soon.

NPD’s recent report on the revenue generated last year by the games industry confirmed what most people involved in the business already knew: the market continued to decline in 2011, dropping 8% year on year to $17 billion. There’s no mystery about this continued slump: the sun is setting on the current generation of consoles, and, as always, there is a slowdown in gamer interest.

It’s a cycle that’s becoming a very familiar one. A new generation of machines comes out, and early adopters are fully engaged with their latest and greatest gaming systems. Every subsequent year, games get better and better as developers learn how to get more out of the new systems, ever increasing numbers of players are seduced by this new technology and its killer apps, and the money rolls in. However, as the years go by, it becomes increasingly difficult for developers to squeeze more out of the hardware, and we see diminishing returns in terms of the effort put into making a game, and the consumer’s perceived improvement over last year’s version.

2011 was a case in point. Despite a glut of incredibly good games, most of them felt like an evolutionary step forward, rather than a giant leap like in previous years. Sure, there were some stunning releases that certainly pushed gaming to new heights – Skyrim being a good example – but most took what felt like an incremental step forward. Modern Warfare 3, for example, looked terrific, and certainly dialed up its multiplayer aspects to new heights. But while hardcore players appreciated it, there’s plenty of evidence that mass-market gamers – judging by user reviews on retail sites, blogs and in forums – felt it was a bit of a disappointment. That it was just perhaps just a little too similar to the previous year.

The games market has a huge broad spectrum of players, and the reality is, most of them are casual players – right now more so than any previous generation. And while those more casual players buy plenty of games, gaming is not their life. These people are the 80% who never post on forums. They read games sites, but not necessarily every day. They like games, but don’t necessarily live and breathe them like hardcore players, and they don’t have the eye for detail that many hardcore players do. They see gaming a little more at face value, and when they see a game that looks a little too much like last year’s version, they’re not particularly motivated to buy it, because to them they already have one like it.

It’s these players who are at the heart of the industry’s cyclical nature. While hardcore gamers continually buy games because gaming is their primary activity, the casuals are more fickle, finding other things to do while they wait for the next big thing in gaming to come along that looks like it’s worth dropping money on. And that’s the industry’s major issue right now: it doesn’t have that next big thing. The previous two generations of gaming machines ran on six-year cycles. This one will likely run to seven – and that’s assuming Wii U actually gets released at the end of this year and starts the clock running on the next generation.

This longer generational cycle stems from manufacturer belief that Xbox 360 and PS3’s highly sophisticated software would give them a longer life than any preceding generation of hardware. However, the reality is that games development has followed an almost identical evolutionary curve as previous generations, resulting in a similar timeline of mass-market engagement and then slowdown in interest. But unlike previous generations when we’d expect to see new machines coming out right about now, neither Sony nor Microsoft have new hardware ready, and the next generation won’t seriously get going until sometime next year, Which is bad news for the industry.

That said, I don’t think 2012 will be bad news for everyone.

It most certainly is for big companies. The behemoths with high run-rates that require massive-selling hits to feed themselves are most at risk. This year there’s the same amount of companies releasing a similar amount of games into a market that could be anything between 10-20% smaller. Do the math, and something will have to give. Don’t get me wrong – I’m not wringing my hands and saying it’s the end of the world, but I do think we’ll see a shake out. Cost-cutting to save money, less development dollars flowing into the market. Perhaps a mid-sized company putting too much money on what it thinks will be a hit that doesn’t sell well as they hoped, resulting in them running into trouble.

Retail will also suffer – because less games and hardware sales will obviously mean less revenue for them. Again, it won’t be earth shattering, but retailers that rely heavily on games sales will have to cut themselves to the bone to show any kind of growth to their investors: the smart ones will roll with the punches and manage expectations accordingly.

Where there’s potential good news is for smaller companies. While mass-market gamers will most likely be spending fewer dollars on big titles, I believe – as is evidenced by the healthy growth in the digital download market last year – that they will continue to buy cheaper games. Because at the end of the day, while it’s difficult for them to justify spending $60 on a game that really doesn’t look that much better than something they bought last year, spending $10 impulsively on a fun download to while away the hours is a no-brainer. I think small companies with low overhead, bright ideas and good games available through digital downloads will continue to do very well because of this, and I think that’s great news.

The big question is, though, how much will the industry decline next year?

There are definitely a few high profile games that will help bring in big money – Diablo III, GTA V and the new World of Warcraft expansion will generate impressive bucks, and there will doubtlessly be a few of the big-franchise games having their generational swan-song at the back end of this year.

Digital downloads are predicted to grow next year, and when combined with the continued expansion of the mobile market, will definitely help prop up the industry as a whole. But even then, I really can’t see it offsetting a fairly dramatic decline in physical premium game sales driven by mass-market apathy.

Aggressive hardware price cuts could stop losses a little bit by generating an influx of super-late adopters, but even then I doubt it. Late-late adopters don’t buy many games – we’ve seen impressive hardware sales spikes at the back end of previous generational cycles fueled by cut-price hardware, but ultimately the kind of people interested in cheap machines are also more interested in sifting through the bargain bins and getting serious bang for their buck with several quality older games than dropping all their money on just one latest and greatest release.

The biggest hopes can be pinned on Wii U. If Nintendo releases the machine this year, and assuming that consumers are excited about this new direction in gaming and feel its price is reasonable, the system could potentially sell 3 million units given a full Q4 at retail with a solid supply. That’s not going to be particularly good news for anyone other than Nintendo and the few publishers who manage to rush games to market and capitalize on early software sales demand, but it will begin to drive the next generation and provide an interesting new platform to stimulate industry growth.

All that taken into consideration, I think we’ll see the industry witness a median decline to around $13-14 billion in 2012. I think that figure that might also be true of the following year – assuming additional next generation machines are launched in time for the 2013 holiday period to help to offset what I feel will be a quite precipitous drop in software sales as mass-market consumer become increasingly more apathetic about their ageing machines.

But the good news is – if it can be construed as such – when 2014 rolls around, we’ll have potentially huge market demand for the next generation of machines, and that could fuel enormous growth, assuming the hardware manufacturers can keep up with the demand, of course.