Technology at a Crossroads…(IIIa) Video Games(1 of 2)

A big business

Yes, video game companies are classified by S&P as technology companies.

And, yes, video games are a big business.  For the past several years, video game sales in the US have exceeded domestic movie box office.

(And, yes, since I like video games, and am writing a lot about them.  So I have to break this up into two posts.)

Despite its large size and rapid growth, my impression is that most professional investors know almost nothing about the industry.  They consider the video game stocks as places to hide during stormy market weather, since, unlike “real” technology, their profits tend to be driven more by the pattern of new video game machine introductions than the ups and downs of the overall economy.  They also regard Electronic Arts as the dominant force among video game makers, which, while once true, is no longer the case, in my opinion.  I think that if anyone holds that position now, it’s Activision (I own ATVI stock).

A little history

Atari

The first commercially successful home video game machine, the 2600, was made by Atari (founded by Nolan Bushnell–of later Chuck E Cheese fame–and sold to Warner Entertainment in 1976).  The Atari 2600 was launched in 1977 with popular arcade machine games like Pong among its initial software titles.  Perhaps its most famous game was Space Invaders (1980).  Software was contained in ROM chips, which were held in plastic cartridges that plugged into the game console.

Although the game system was immensely popular, Warner made two fatal mistakes with Atari.

1.  It had no plan to control what software could be played on Atari machines, so the market was soon flooded with cheap, poorly-made games by clone manufacturers.  This cut into Atari’s sales and weakened the image of the game machine.  Rivals also rushed to launch competing video game machines and game-oriented home computers.

2.  In addition, Warner used the same inventory rules that prevailed in the phonograph record industry at that time–retailers had few limits on the quantities of game titles they could order, and were allowed unlimited returns.   This was, of course, a recipe for disaster–which is exactly what happened in 1983.

Nintendo vs. Sega

The Nintendo Famicom, or NES, spearheaded the next generation of game machines.  The NES was launched in Japan in 1983 and the rest of the world in 1985.

The Nintendo business model, which profited from Warner’s mistakes, became the industry standard.  For the US market, Nintendo placed a protective chip in its machines so that only Nintendo-manufactured cartridges would work in it.  The company relied very heavily on its in-house development staff, which produced titles like the Super Mario, Zelda and Donkey Kong families of games.  Nintendo did allow third-party games, but developers had to submit their output for Nintendo approval.  If that was given, Nintendo charged a per-unit royalty.  Nintendo also determined how many cartridges of a given game could be produced and arranged for their manufacture (although the cartridges were paid for and became the property of the third party).  Sometimes, Nintendo handled distribution as well.  Third parties were limited to a small number of games at any one time, and were asked not to release them for two years on any other system.

Nintendo’s main competition in the US was Sega, well-known for Sonic the Hedgehog, but a perennial also-ran in the US video game market, despite having some excellent products.  (After its unsuccessful Dreamcast machine, Sega became a third-party developer.  It was eventually bought by Sammy, a pachinko machine company and ceased making games.  Another Sega oddity:  for all its technology, its most profitable product was the “crane” arcade game, where you try to win a prize by maneuvering and dropping a miniature construction crane grabber onto it and lifting it to an exit chute.)

Independent game makers had two problems with the cartridge format:  it sometimes took several months for Nintendo to fill an order; and because the most advanced cartridges might cost $20 to make, unsold inventory could be a huge negative.

Playstation 1 vs. SuperNintendo

Sony started the next generation of machines in late 1994 with the Playstation, which used CDs.  Because CDs were available almost instantly and had a much lower cost of goods than cartridges, independents pulled out all the stops to help make Playstation successful.  Nintendo, which continued to rely on cartridges in its updated SuperNintendo, was left in the dust.

During this generation, Sony followed the Nintendo model, including having a strong stable of in-house game developers.  As time went on, however, Sony Computer Entertainment gradually lost a majority of its talent.  Industry rumors claimed this was because of friction with managers from Japan, who were not comfortable with game designers’ informal ways.

Playstation 2 vs. Gamecube and X-Box

The PS2 generation was a weird one.  The established rules for success in the video game industry had developed into:  be first to market; have strong first-party games; collect royalties from third parties; hope to reduce hardware costs enough to go from loss to profit over the several year life cycle of the machine.

In contrast, Sony, the hands-down winner in the generation, had lost most of its first-party software development staff during the PS1 generation and had pushed up its hardware costs by deciding to make many key components from scratch in-house.

Sony  did tout PS2, which could also play movie CDs, as a “stealth” home hub.  It would be sold to customers as a game machine but it would also act as the gateway for a wealth of future services that Sony could deliver to consumers in their residences.  Once PS2 was in the home, Sony theorized, it would have first access to consumers’ future home entertainment and computer purchases.  This vision, still largely unfulfilled, appears to have provoked a reaction from Microsoft, which belatedly produced a competitor to PS2, the X-Box. And I’m not sure many people bought a PS2 with the Sony vision in mind.

In a way, Sony won because its competitors were worse.

Nintendo insisted that the US market contained a childrens’ segment, that it wanted to focus on and dominate.  So it ignored the late teens and twenty-somethings who had grown up on video games, who were loyal fans of the Nintendo characters and who wanted to continue to play Nintendo games.  This had become the sweet spot of the market, as well.   But this segment rejected the Gamecube, despite the fact the machine had the highest technical specifications in this generation, because it looked like a toy and its software was aimed at much younger players.  (By the way, I don’t think a childrens’ segment exists, in the US at least.)

X-Box came to the market late, with a high-cost game machine, some spectacular software like Halo, and an inexperienced management that seemed to be trying to learn the business on the fly.

Nintendo had one huge success during this period, though, the Game Boy, introduced in 1989.  In an interview at the company headquarters in Osaka, Nintendo told me that Game Boy was originally designed for continental Europe and for developing economies where it believed people couldn’t afford game consoles and cartridges, or didn’t have enough TVs to use as monitors.  The company was surprised that it was a smash hit in wealthier areas like Japan and the US.

X-Box 360 vs. PS3 and Wii

The X-Box 360 generation has been similarly unconventional.  Microsoft appears to have really learned the business.  It came first to market, with good software and a strong online gaming community through X-Box Live.  Sony launched its PS3 much later than X-Box 360, at a very high price point (industry speculation was that Sony was still losing up to $200 per machine) and with little software support.  Very odd!  Nintendo, wisely, figured it shouldn’t compete directly against two much larger companies and launched the Wii, aimed at a casual gaming audience.

The economics of the business has changed

To see what the issue is, let’s start with the basic numbers for a third-party game developer putting one extra copy of a game on a retailer’s shelf.  The DVD, case, cardboard, plastic, and the cost of delivering it to the customer warehouse will cost, maybe, $7.  Add $8 for a royalty to the console maker and the total is $15 ($20 is probably the right number if characters are licensed).  If the unit is sold to the retailer for $45, the cash generated by that unit to the game maker is $30.

The industry can count on hardcore gamers to buy just about any reasonably good game.  To be generous, say there are 400,000 of them around the world.  That means an A-list game can figure it is fairly certain to generate $12 million in cash from the hardcore community alone.

When TVs weren’t HD and when expectations were lower, a good game might cost $1 million, or $3 million, or $5 million to produce–plus marketing costs.  For a good game, these costs were easily covered by highly dependable hardcore games sales.  So no one else mattered.

In today’s world. though, development costs are running as high as $25 million.  This means the game maker needs 833,000 copies sold just to recover production costs.  And that doesn’t take into account marketing expenses and possible returns.  So the shrink-wrap software business has gone from the equivalent of shooting fish in a barrel by catering to the hard core audience to making big budget games that have to attract a very wide audience to be profitable–sort of like the movie business.

This realization is part of what has made the current game console generation so different.

More about this in part 2 of this post, as well as on-line gaming, Nexon’s KartRider, Worlds of Warcraft, Facebook,  DeNA (a stock I own), a comparison of ERTS and ATVI and other stuff.

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