Corporate Strategy, Video Games in 2012

NES 1985 Released in the US (image courtesy: http://en.wikipedia.org/wiki/History_of_Nintendo)

1. How do you enter a market?
2. The following article was provided by Prof. Chris Carr, and was authored within the Edinburgh University Business School. It was used for the following course: Corporate Strategy (MBA) [BUST11195] (2011-2012 [SV1-SEM2])

Video Game Console Industry in 2012: The Next Round

At the beginning of 2012, the three remaining suppliers of video game consoles were
preparing for a new round of competition with the advent of the next generation of video
game consoles—the eighth since the beginnings of the industry in 1972. Nintendo was the
only one of the three to have announced its new model: the Wii U would be launched late in
2012. Sony and Microsoft had said little about their new models, though both were known to
new models under development. It was anticipated that these new models would not be
launched until late in 2013.

The reluctance of either Sony or Microsoft to make announcements concerning their next
generation of consoles was indicative of the uncertainly that surrounded the console market in
2012. Both companies had been shocked by the outcome of the current round of competition:
the remarkable success of Nintendo’s Wii, which had outsold the more sophisticated and
powerful consoles of Sony and Microsoft had overturned much of the conventional wisdom
concerning key success factors in the console market. Both Sony and Microsoft had based
their strategies on the assumptions that, first, consoles were increasingly becoming
multifunctional home entertainment platforms and, second, that their primary target markets
were “hard core” gamers—primarily males aged between 13 and 30. The Nintendo Wii had
shown that an easy-to-use, dedicated console targeted towards the casual user could out-sell
more technologically-advanced machines from Sony and Microsoft. Was Wii an aberration or
did it point to a new evolutionary path for the video console market?

Despite considerable speculation among industry watchers, neither Sony nor Microsoft had
offered any indication of the features of the new models that were currently under
development. For Nintendo the situation was different: as sales of the Wii went into rapid
decline, it needed a successor. While Sony and Microsoft sought to extend the lives of their
PS3 and Xbox 360 models (Sony had committed to a 10-year life-cycle for PS3), neither
company wished to leave the field clear for Nintendo. Moreover, there was a risk that, unless
the console markers could sustain the interest of users, they would increasingly lose the video
game market to other hardware devices—notably mobile devices such as smartphones and
tablet computers. All three companies kept a wary eye on Apple. After dominating the music
business with iPod and iTunes, video games seemed a natural extension to Apple’s ambitions
in home entertainment. Already its iPad was being positioned as a game-playing device.
Increasing competition between different types of hardware—video game consoles, PCs,
portable game players (such as the Nintendo DS and the PlayStation Portable), mobile
phones, and tablet computers had implications for the console makers’ market positioning.
The success of the Wii was primarily due to its appeal among causal video game players.
However, these casual players were increasingly playing video games on multifunctional
devices such as PCs, smartphones and tablet computers than on dedicated video game
consoles.1 If consoles were to lose casual game players to other hardware devices, the console
makers might be inclined to return to their traditional focus: the hard-core video games users
for whom the video games console offered unparalleled speed and graphical realism.
History of the Video Game Industry, 1972–2012
The history of the video game consoles comprised a series of product generations, each
defined by the power of the microprocessors used in the consoles and each lasting about five
years.

 Figure 12.1 Worldwide unit sales of video game consoles by product generation 
(Source: Wikipedia.)

The first and second generations, 1972–1985: the Atari era

The home video games market emerged during the 1970s as an extension of arcade video
games. The first generation of home video consoles were dedicated machines that embodied a
single game. One of the first was Pong, created by Nolan Bushnell in 1972. He formed Atari
to market this game player. The second generation of players featured 4-bit processors and
interchangeable cartridges. The Atari 2600 unleashed a craze for video games driven by
Space Invaders (released in 1979) and Pac-Man (1981). Atari was unable to prevent
independent software developers from marketing games for the Atari 2600. During 1982, 20
new suppliers of Atari-compatible consoles entered the market and 350 new game titles were
released in that year. With declining sales of consoles and oversupply of games, Atari’s
parent, Warner, incurred massive losses.

The third generation, 1986–1991: the Nintendo era

In 1983, Nintendo, the leading Japanese supplier of arcade video games, released its 8-bit
Famicom home video system. In 1985, the Famicom—renamed the Nintendo Entertainment
System (NES)—was launched in the US. By 1988, Nintendo held 80% of the $2.3 billion US
video games industry—chiefly as a result of the hugely popular games created by Nintendo’s
legendary games developer, Sigeru Miyamota: Donkey Kong, Legend of Zelda and Super
Mario Brothers.

Nintendo's market dominance and huge profits rested upon its careful management of the
relationship between hardware and software. Nintendo kept tight control of the supply of
games, managing their quality and their releases. Developers were required to follow strict
rules for the creation and release of games for the NES console. Cartridges incorporated a
“security chip” that ensured that only cartridges manufactured by Nintendo could run on the
NES. Nintendo charged games publishers a 20% royalty and a manufacturing fee of $14 per
cartridge (the manufacturing cost was $7). The minimum order—10,000 cartridges for the
Japanese market and 50,000 for the US market—had to be paid in advance. Any game
developed for the NES could not be released on a competing system for two years.
By 1991, Nintendo's sales exceeded $4.4 billion, its stock market value exceeded that of
Sony, and about one-third of US and Japanese households owned an NES.

The Fourth Generation, 1991–95: Sega vs. Nintendo

Sega, like Atari and Nintendo began in arcade games. In October 1988, it launched its 16-bit
Genesis home video system in Japan and in the US in September 1989. With the introduction
of Sonic the Hedgehog in June 1991 and with strong support from independent games
developers, sales of the Genesis took off.

Nintendo launched its 16-bit Super-NES, in September 1991. Its huge strength in its home
market allowed it to maintain its leadership in Japan, but in the U.S. and Europe, Sega's
bigger library of 16-bit titles (by January 1993 it offered 320 games, compared to 130 for
Nintendo) allowed it rival Nintendo for market leadership.

The Fifth Generation, 1995–8: Sony PlayStation
With the launch of its 32-bit Saturn console in November 1994, Sega sought to build on the
success of its Genesis console. However, a month later Sony introduced its PlayStation
console—the result of a six-year development effort led by Sony's video games guru, Ken
Kutaragi. Both PlayStation and Saturn used CD-ROMs rather than cartridges. However,
PlayStation was launched with an impressive number of new game titles—the result of
courting top games developers, financing game development and providing comprehensive
software development tools. Sony also entered with a powerful array of resources: a strong
brand reputation, global distribution capability and content from its movie division.
Compared to Sega’s ill-coordinated Saturn launch (few game titles and haphazard
distribution), the launch of PlayStation was well-orchestrated and supported by massive
advertising—including cryptic prelaunch advertisements that fueled a buzz of anticipation
within the gamer community. Meanwhile, Nintendo attempted to recapture market leadership
by leapfrogging Sony in technology. Its 64-bit N-64 console was released in June 1996 at a
low price ($199 compared to $299 for PlayStation), but retaining its cartridge system which
involved higher manufacturing costs and less flexibility in meeting unexpected demand for hit
games. The lower fixed costs of producing and distributing CDs allowed Sony to compete by
offering a much bigger library of games than Nintendo—many of which targeted niche
markets and minority interests.2 By 1998 PlayStation was leader in most of the world's major
markets.

The sixth generation, 1999–2005: Sony versus Microsoft
With the launch of its Dreamcast console in November 1998, Sega once again led the new
generation of video game consoles. Fifteen months later Sony launched PlayStation 2 (PS2).
Kutaragi's brief had been to design a games machine with performance that exceeded any PC
and with graphics processing power ten times that of the original PlayStation. With cinematicstyle
graphics, a DVD player and the potential for internet connectivity, PS2 aspired to be a
multifunctional entrainment device. However, the technical complexity of PS2 created
problems both for the supply of key components and the availability of new games, resulting
in a hesitant launch.
In 2001 the industry's competitive landscape was transformed by the exit of Sega, which
announced its intention to focus exclusively on games software, and the entry of Microsoft.
Despite just 19 games and a poor reception in Japan, Xbox combined three key strengths: its
technological advances (an internal hard disk, a 733MHz processor, 64MB of memory, a
DVD player, and an ethernet port), the hit game Halo, and Microsoft’s online capabilities. In
November 2002, Microsoft launched its Xbox Live which allowed online interactive gaming
and direct downloading of games. Nintendo, with its GameCube console, was the last to join the new generation of video game
consoles.

By 2004, Sony had emerged as the clear market leader with Microsoft a strong second in the
US and Europe and Nintendo a strong second in Japan.

The seventh generation, 2006-11: Nintendo’s renaissance. Microsoft Xbox 360
Building on the momentum from its successful launch of Xbox, Microsoft led the new
generation of consoles with its Xbox 360 released on November 25, 2005—the first ever new
console with a near-simultaneous global launch as opposed to a phased rollout. Xbox 360
represented a shift in market positioning by Microsoft. While the original Xbox emphasized
processing power and focused on hardcore gamers, Xbox 360 emphasized versatility, design,
and coolness with a particular focus on its multiplicity of entertainment and online
capabilities—including viewing high-definition TV shows.

Sony PS3
The launch of PS3 fell victim to Sony’s technological ambitions—notably its decision to
make PS3 the flagship for Sony’s Blu-ray DVD drive and is adoption of an advanced
multicore cell processor, developed jointly with IBM and Toshiba. PS3 imposed large losses
on Sony: in addition to launch costs, the component cost of each PS3 was estimated at over
$800 compared to a retail price of $499.3 In addition, the high cost of developing games for
the PS3 meant that, Sony was obliged to cut its royalty rate to encourage developers to write
for PS3.

Nintendo Wii
Nintendo’s launch of is Wii console in November 2006 was overshadowed by attention given
to the PS3. Nintendo had been largely written off by most industry observers—it had neither
the financial nor the technological resources to match those of Sony and Microsoft. Yet, the
Wii proved to be a sensation. Technologically, the Wii was backward— compared to PS3 and
Xbox 360 it was seriously underpowered in terms of both speed and graphics, and it lacked a
hard drive, DVD player or Ethernet port. Its innovative feature was its remote wand-like
controller that was sensitive to a range of hand movements. This allowed Wii to be used for a
whole range of new sport and exercise applications—Wii Fit was one of the biggest selling
titles of 2008-10. Wii was also more accessible and easy to use than other consoles. This
attribute was exploited by a marketing strategy that targeted a very broad demographic—
including older people. During 2007 and 2008, Wii established a clear market lead over the
PS3 and Xbox 360, which it maintained during 2009 and 2010—though only in unit sales—in
terms of revenue it was overtaken by both Sony and Microsoft.
The success of the Wii challenged the conventional wisdom of the industry that the primary
market was males aged between 11 and 30 and that the key to accessing this demographic
group was to court “hardcore gamers” when developing and launching new models. This
required a combination of hardware with immense processing power and brilliant graphics
and games that combined cinematic-quality, graphic realism, strong characters, and complex
storylines.

The Video Games Industry in 2012
The market for video games
At the beginning of 2012, video games continued to be a growth industry. Worldwide sales of
video game software and dedicated hardware (both consoles and handheld game players) was
estimated by DFC Intelligence at $66 billion worldwide in 2010 and expected to grow to $81
billion by 2016.4 Most of this growth would be outside the mature markets of North America,
Europe and Japan; indeed, US consumer expenditures on video games had been in decline for
several years. (see Figure 2).
Figure 2. US consumer expenditure on video game hardware and software, 1990–2011
Nevertheless, even within the US, games playing remained a major leisure pursuit. Over 40%
of households owned video game consoles and 67% of households played video games.
Worldwide, the user base of video game players was broadening. Once the preserve of
teenage boys, by 2011, the majority of the age group 18–44 played video games and even
among 55–64 year olds, 26% played video games. Female participation had also increased
strongly. However, in terms of intensity of game playing, teenage boys remained clear
leaders: US males between 12 and 17 with a video game console in their home spent an
average of 14 hours a week playing video games.
The composition of the market was changing rapidly in terms of both hardware and software.
Video games were shifting from home-based devices such as consoles and PCs to mobile
devices, while the distribution of games was shifting from packaged software sold by retail
stores to direct downloads, subscriptions and cloud access.

Software
Each video game console supplier (“platform provider”) licensed third-party software
companies to develop and distribute games for its system. Two types of company were
involved in video games software: video game publishers, which were responsible for
financing, manufacturing, marketing and distributing video games; and video game
developers, which developed the software. Publishing was increasingly dominated by a few
large companies (see Table 4). Typically, the software publisher submitted a proposal or a
prototype to the console maker for evaluation and approval. The licensing agreement between
the software company and the hardware provider gave the console maker the right to approve
game content and control over release timing, and provided for a royalty payment from the
software company. Game developers were paid a royalty, typically between 5% and 15%,
based on the publishers' revenues from the game. The console makers were also major
developers and publishers responsible for some of the most popular video games (see Table
5).

Escalating game development costs were a result of the demand for multifeatured, 3-D,
cinematic-quality games that could utilize the potential of increasingly powerful consoles.
Atari's Pac-Man released in 1982 was created by a single developer and cost about $100,000.
Activision’s Call of Duty: Black Ops involved over 100 software engineers, about three years
in development, about $28 million in development cost and about the same in launch
promotion. When released in November 2010, it generated $650 million of sales in its first
five days. In terms of both cost and revenue patterns, video games closely resembled movies:
they incurred substantial upfront costs and a mere few became money-spinning blockbusters.
Most successful new releases were sequels to earlier games--this created valuable brand
franchises (such as Super Mario Brothers, Grand Theft Auto, Call of Duty, and Halo).

Source: VGCharz Worldwide Yearly Chart, http://www.vgchartz.com/yearly.php

The past generation of consoles had seen a major shift in the balance of paper between
console makers and the games publishers. In earlier generations, the console makers were
dominant—enforcing exclusivity and imposing heavy royalty payments on the publishers.
Consolidation among publishers (caused by rising development costs) and increased
competition from different types of hardware platform had changed all that. Exclusivity ties
had disappeared from most licensing contracts—most leading games titles were crossplatform.
the only popular games exclusive to a single platform were typically those
developed in-house by the console makers.

At the same time, the games publishers were also facing new pressures. The licensing fees
paid by software publishers for exclusive rights to the intellectual property of media
companies and sports organizations grew substantially between 1998 and 2002. the rights to a
game based on a hit movie (e.g. Harry Potter) could cost several million dollars. For sports
games, the major leagues (NFL, NHL, MLB, NBA, FIFA) required an upfront payment, plus
a royalty of 5% to 15% of the publisher’s revenue from the game. They were also facing
increased competitive pressure from software companies offering free games over the
internet. Bigpoint, with some 150 million subscribers, offers games free but earns about $20
monthly per subscriber from the sale of add-ons and special features.

Not only did software sales exceed hardware sales—software was responsible for virtually all
of the industry's profit. The console makers followed a “razors and blades” business model:
the consoles were sold at a loss; profits were recouped on software sales—both games
developed internally and royalties received from third-party games publishers. The result was
strongly cyclical earnings for the platform providers: the launch of a new console would result
in massive cash outflows; only with a substantial installed base would the platform provider
begin to recoup the investment made.
The Console Makers
For the console suppliers, the period 2006-11 had been a difficult one. Sony's experience with
its PS3 demonstrated how the deteriorating economics of the console business meant that it
was increasingly difficult to recoup the massive expenditures needed to launch a
technologically-ambitious new model. While Sony’s original PlayStation and its PS2 had
been highly profitable, since the launch of PS3, Sony’s video games business had incurred
substantial losses. While Microsoft had the satisfaction of achieving its goal of establishing
itself as a major force within the video games business, the costs were high—it has incurred
substantial losses since entering the video games business in 2001. While Nintendo had been
the winner of the current round of competition in terms of unit sales, it had failed to achieve
either the market dominance or the financial returns that market leaders had achieved during
earlier generations.

Reluctance to incur the costs of developing new models was the major motivation behind
Sony and Microsoft’s desire to extend the lives of their current models. In 2011, both
followed Nintendo in releasing motion-sensitive controllers for their consoles. The release of
Microsoft’s Kinect and Son’s Move coincided with a steep decline in Wii sales.
One bright spot was the growth in online, interactive game playing which offered an
additional revenue source for the console makers. Microsoft’s Xbox Live and Sony’s
PlayStation Network earned revenues from subscriptions and third-party royalties. However,
the risks in this business became apparent when Sony was forced to shut down its PlayStation
Network during April 2011 following a cyber-attack in which he credit card details of
subscribers were stolen.

Looking to the future
As the three leading console providers planned for the next generation of consoles, they
realized that their strategies needed to take careful account of the changing dynamics of
competition in the industry. The weakening of the console makers relative to the games
publishers—in particular, their inability to force exclusivity upon the publishers—implied that
video games would no longer be a winner-take–all industry as during the 1980s and 1990s.
Moreover, the expanding number and variety of video game players suggested that the market
was segmenting—for example, the Wii appealed to different users than the Xbox and
PlayStation.

The future role of the games console as a home entertainment device was also unclear. Sony
and Microsoft had envisaged their video game consoles as multifunctional home
entertainment devices. The willingness of Sony and Microsoft to devote so many resources to
their video games businesses was because they viewed the video game console, not just as
important product in its own right, but as a basis for building their strategic positions within
market for home entertainment. Yet, the Wii was essentially a dedicated games console. To
what extent would video consoles become devices for playing movies, downloading and
storing entertainment content and interacting remotely as opposed to specialized gaming
machines?

Appendix: Financial Data for the Leading Console Makers