Sun TzuAs the games business transitions from console and PC titles to social and mobile games, China is set to take away the United States’ leadership in the business.

That’s the bold prediction from Tim Merel, who has made a splash analyzing the video game market in the past couple of years as the managing director at investment bank Digi-Capital. Merel believes that in 2010, video game investment and acquisition activity changed fundamentally and accelerated in a way that it never had in the industry’s decades-long history.

In a 68-page report released this week, Merel (pictured) predicts that revenue from online and mobile games will grow from one-third of industry revenues now to half of industry revenue, or $44 billion, by 2014. China will make up nearly half of sales, increasing its share from 12 percent of the worldwide market today to 25 percent. Meanwhile, the U.S. share of the game market is expected to fall from 26 percent to 22 percent.

As the video game industry gathers for the Game Developers Conference next week in San Francisco, it’s a sobering thought. What if the U.S. video game companies aren’t moving fast enough into the new social and mobile markets and will lose their grip on financing and innovation?

Right now, it’s easy to disagree with Merel. Activision Blizzard and Electronic Arts are giants in the traditional game business. But that business is expected to be flat or down. Zynga is leading in social games, with a commanding leadership on Facebook with 266 million monthly active users. The company reportedly had revenue of $850 million in 2010 and a profit of $400 million and it is reportedly raising a round of funding at a $10 billion valuation. DeNA, the Japanese firm that acquired iPhone game maker Ngmoco for $403 million last year, is also a force to be reckoned with in mobile. That seems to suggest that, for 2011, the game industry is still pretty strong in the West and in Japan. What’s more, video games are just about at their finest hour, with total hardware and software revenue of $77 billion coming near global film revenue at $85 billion. And the games that are delivering the best cinematic experience are console titles such as Uncharted 2: Among Thieves and Call of Duty Black Ops.

Still, Merel says that Tencent’s $315 million acquisition of Riot Games a couple of weeks ago is a portent of more to come. Tencent’s valuation is more than $49 billion, and that gives it the market power to acquire just about every major video game company in the U.S. The company gets 20 million simultaneous players for its online games and it enjoys 50 percent gross profit margins on its games. By comparison, U.S. game publishers have to dish out $20 million to invest in a top game and sell a million units to break even.

Venture capital investment has moved to the online and mobile markets. Fundings for game companies were up 52 percent in 2010 from the year before, with funding amounts returning to the peak level in 2007. Mergers and acquisitions were up 60 percent in value in 2010. The Chinese stock market — inflated as it might be — has given billion-dollar valuations to Shanda, ChangYou.com, Giant and NetEase. By 2014, Merel estimates that Asia and Europe will account for 90 percent of the revenues in online and mobile games.

“The time to act is now, whether raising funds to accelerate growth prior to consolidation, create joint ventures and strategic partnerships to enter major foreign markets,” Merel said, or just exit and take the money and run. “Major console publishers must evolve to survive.”

Merel believes that major conglomerates in the media and entertainment space have the best chance to adapt. They can assemble all of the assets across the different sectors, while pure play console publishers have less money available to invest in the new markets. In other words, Disney is better off than Ubisoft.

Just as Tencent moved beyond the Chinese market with the Riot Games deal, Merel predicts the Asian companies will lead the wave of consolidation as they push into the U.S. and European markets. That will lead to Chinese domination of the video game market. Perhaps that shouldn’t be surprising, as China could very well dominate every technology market. But the path for the Chinese game companies is pretty clear and it’s not such a stretch to predict this outcome anymore.

The good news is that video games should grow to $87 billion in 2014, with mobile and online games growing at an 18 percent compound annual growth rate from 2009 to 2014. The major market sectors include console games, social online, casual online, smartphones and tablets, browser-based massively multiplayer online games, retail MMO games, online skill-based gaming, and online gambling. (The latter is usually considered outside of gaming). Each one of these sectors has successful game companies that are substantially growing the market and making lots of profits. Each sector also has clear investment, acquisition and joint venture opportunities, Merel said.

In 2009, Merel said the $19 billion in revenue related to online games and mobile was about 32 percent of total video game revenue worldwide. By 2014, that should grow to $44 billion, or 50 percent of video game global revenue.

What do you think? Please take our poll below. Merel’s report is at the bottom.

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