Technology at a crossroads…(III) Video Games(2 of 2)

A brief recap..

Over the past several years, the sharp rise in video game software development costs has engendered radical changes in the traditional shrink-wrapped software business.  Fifteen years ago, sale of 50,000 units would cover development expenses; today that breakeven level is about 850,000 units, or 17X as many.  These figures compare with “guaranteed” sales to hard core gamers of about 350,000 units.  So risk has increased as well.

In my prior post, I mentioned the video game company boast that the video game industry is bigger than movie box office.  That’s true, and very impressive, but fails to note that until the present recession, half a movie’s revenues would come from DVD sales.

One more preliminary:  from the Atari days onward, there has been a split between games for consoles like X-Box and PS, and those played on personal computers.  The industry has, fairly or not, characterized players of the former as groups of friends having fun together, and players of the latter as solitary individuals unable to get a date for Saturday night.

The extraordinary rise in the processing power of game consoles and the rise of online gaming communities for PC games have blurred the distinction between the users of the two.  It seems to me that market power has shifted decisively toward the consoles.   Of course, if the next Starcraft ever comes out, I may have to revisit my thinking.  The issue is potentially an important one, though–it’s the question of who controls the revenues from the online community surrounding a specific game, as well as whether a console maker collects a per unit royalty (if my figures from the prior post are accurate (and I’m pretty sure they are) unit profits are 25% higher for the developer if no royalty payment is due).

Effects of rising development costs

Three immediate consequences of the rise in development costs are:

1.  fewer games will be made;

2. this will put some game developers out of work, therefore making them available to do unconventional things–especially in Asia, where Sega shut down its video game operations and many arcade game developers apparently opted not to take jobs at Sammy; and

3. marketing and distribution become more vital, so it’s much harder for an independent to succeed outside a partnership with one of the console makers or one of the big independent developers (who all have large distribution arms).

The hard core vs. everyone else

There’s also an important decision to be made about the hard core gaming community.  This market segment consists of avid game players who have developed considerable skill in playing games.  They want intense, time-consuming, difficult offerings that challenge those abilities.  Casual gamers, i.e. everyone else, probably don’t have the dedication, or desire to develop the manual dexterity, needed to play hard core games successfully.

The big industry issue

Here’s the dilemma:  make a game for hard core gamers and run the risk that it appeals to no one else; or court the casual audience and forego the “guaranteed” 350,000 unit sales.

Solutions:

For some firms, this was not a relevant issue, because there is no way they could raise the money to develop a traditional shrink-wrapped game.  In 2004, a Korean company, Nexon, came up with an innovative new way with its very successful Kartrider online game.

Online casual games have been around for a long time, but companies like Electronic Arts hadn’t seemed to make much money from them.  Fantasy games like Ultima and Everquest also have considerable history, but require a monthly subscription fee and typically have extremely devoted hard core players.

Kartrider

Kartrider, which loosely resembles Nintendo’s Super Mario Kart, is a multiplayer online racing game.  Development costs were low and server capacity  relatively cheap.  The game’s innovation is that it generates revenue through microtransactions. To play, a new person just creates an avatar and buys a racing car, which could be done for about $2.  Players can accessorize their avatars or improve their car’s performance for similarly small amounts of money.  What woke the rest of the world up to the potential of this idea, I think, was the company’s announcement that it had offered one December to put Santa hats on avatars for about $1 each, and had had 8,000,000 buyers.

Mobage-town

Around the same time, DeNA (I own the stock), a Japanese mobile online auction company, was looking for a way to retain users, who paid a small monthly fee, during months when they were not participating in auctions.  So it created Mobage-town, an internet portal and game site for subscribers that has “accidentally” become the largest social networking site in Japan.  Facebook has done something similar in the US, although games aren’t all free.

Worlds of Warcraft

One more thing about online games:  Worlds of Warcraft, an online role-playing game from Blizzard Entertainment, which is now part of Activision. What is unusual about WoW is its global popularity.  Prior role-playing games from Asia didn’t transfer well into Europe and the US, and vice versa.  But W0W has been popular worldwide, with 11.5 million subscribers at yearend 2008.  If we figure an average monthly subscription of $10, that would be about $1.4 billion in yearly revenue.

How have the biggest players responded?

This is my perception:

Nintendo:  Perhaps scarred by the failure of Gamecube, and at the urging of the company’s founding family, Nintendo has decided to drop out of direct competition with its larger rivals, Microsoft and Sony.  Its rejection of the development cost arms race has led to the Wii console machine aimed at the widest possible group of casual users.  Perhaps less noticed, the hand-held DS has introduced a broad array of educational software, from a kanji dictionary and language instruction, to cooking lessons and vision training.  It has, I think, the strongest committment to near-term profitabiity of any of the console makers.

Microsoft:  It’s now the leading console maker.  This is not simply by default.  After a very rocky start with the X-Box, MSFT has done a lot of things right, especially with its online community.  Too bad this rising star is imbedded  in a much larger company.  On the other hand, the MSFT game business has enough financial backing from its parent that the dilemma I talked about above doesn’t have the crucial importance for it that it has for other market entrants.  The game division is now making money.

Sony:  a hard company to figure.  Over the past decade it has lost its leadership in portable music to Apple, its TV preeminence to those who anticipated flat panels better, and its video game dominance to MSFT.  It has chopped its game division operating losses from about $2.5 billion in fiscal 2006 (Sony’s fiscal year ends on March 31 of the following calendar year) to about $600 million in fiscal 2008.  I’m not sure how to describe its strategy, which is a probably a comment in itself.  My best guess is that the company thinks technologically superior hardware with a Blu-Ray player will ultimately win out, and it will collect a superior stream of royalty income.

Electronic Arts:  the long-time dominant force in the shrink-wrapped software market, noted for its sports games.  the company has been aware of the potential of the online market for years, but has had trouble getting a foothold.  ERTS and MSFT both appear to have had a chance to acquire Vivendi’s software business, including Blizzard, in 2004.  Vivendi, as I recall it, announced in the press it was asking for $1 billion+ in cash; ERTS publicly offered much less, and at least part in stock.  Who knew how successful Worlds of Warcraft would be?  ERTS recently hired John Riccitello as CEO to help the company cope with a rapidly changing video game environment.  Riccitello had left the company earlier in the decade after ERTS deemphasized his online unit after continuing large losses.

Activision (I own the stock):  long the number two to ERTS among independent video game makers, ATVI answered my dilemma question in two ways.  It thought out of the box by launching Guitar Hero, and it merged with Vivendi’s games business, thus acquiring the extremely cash-generative Warcraft franchise.  So it can continue with games like Call to Duty, but the risk to the company of a potential misstep is reduced.  One should note that although Vivendi is the majority owner, the former Activision management remains in charge.

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