Copyright 2001

[ December 15th 2001 ]

Tim Ayers is getting a PlayStation2 for Christmas. It will be his first game console, and he can't wait. Over the past few months, Ayers has been wowed by the sophistication of graphics in games such as Tony Hawk Pro Skater and Grand Theft Auto III.

No longer the exclusive realm of pimply teenage boys, video games have gone mainstream. According to the Interactive Digital Software Assn, an industry trade group based in Washington, D.C., about 60% of Americans - or 145 million people - now play computer or video games. The average player's age is 28, and 43% are women.

Gamers are such an attractive demographic, in fact, that traditional media companies are starting to compete for their attention. Last year, Hollywood turned out two shoot-'em-up action films based on popular games: Tomb Raider, with a busty Angelina Jolie playing heroine Lara Croft, and the animated Final Fantasy: The Spirits Within. Next spring, cable company Comcast will launch something called G4, a 24-hour TV network that provides news and information for the video-game set - a sort of E! Entertainment Network for gamers.


No doubt about it - interactive games have attained that exalted status known as big business. Research firm IDC reported that total domestic hardware and software sales for interactive games totaled $8.2 billion in 2000 - vs. just $7.75 billion in U.S. movie box-office receipts. In fact, IDC expects sales of game hardware and software to hit $11.4 billion this year - thanks in large part to torrid holiday sales.

Though IDC doesn't break out revenues by category, the IDSA estimates that sales of game software alone totaled $6 billion in 2000 - making it about 75% of the total games market. "This is our moment," enthuses Douglas Lowenstein, the IDSA's president. "At best, interactive games are poised to become the dominant form of entertainment. At worst, we'll be as important as any other form."

Xbox has been well received by analysts and hard-core gamers It's a good thing the pie is growing so fast, because the competition is, too. In November, Microsoft launched Xbox, its first foray into the video-game hardware market and a head-butt challenger to the console leader, Sony's PlayStation2. Microsoft's $299 console, which includes an Ethernet connection for when online games become available as well as a DVD player [as does PlayStation2], has been well received both by analysts and hard-core gaming enthusiasts. Gates & Co. expect to sell all the hardware it can produce this year - about 1.5 million consoles.

Nintendo, one of the original video-game companies, also has just launched a new console - the GameCube. At $199, with no DVD player, Nintendo GameCube targets a younger audience. It, too, expects to sell out, with 1.3 million GameCubes gracing holiday celebrations.


While Microsoft and Nintendo are generating most of the buzz, the market still belongs to Sony. PlayStation2 has been around since October, 2000, and Sony says it already has an installed base of 6 million Playstation2 systems in the U.S and expects to have an additional 1 million in American homes by yearend - 2.5 times the anticipated sales of Microsoft's and Nintendo's new platforms combined.

While Nintendo expects to have 20 or so games for its console by yearend and Microsoft plans close to 40, PlayStation2 has 280 designed especially for it. "The noise is around Xbox and GameCube, but the big money in holiday 2001 is going to be made on PlayStation," predicts Edward Williams, an interactive entertainment analyst with New York investment firm Gerard Klauer Mattison. In fact, Williams says the hype surrounding the Microsoft and Nintendo launches could boost also Sony, which isn't constrained by a limited amount of hardware. Sony says it expects to have more than 10 million PlayStation2 consoles shipped to retailyers by yearend.

Can Microsoft and Nintendo keep their consoles as hot sellers into 2002? In fact, whether Microsoft and Nintendo can catch Sony may not even be an issue until Christmas, 2002, when all three consoles will finally be stores in unlimited quantity - and probably at lower prices. By then, in a market that has never supported three hardware makers, the game of the year could become survival. In 2000, Sega stopped making video-game hardware after 11 years in the business - and just a year after the launch of its last console, Dreamcast.


In 2002, the test for Microsoft and Nintendo will be whether their units continue to fly off the shelves after the holiday season, when more than 60% of video games hardware and software are sold. If Xbox and GameCube continue to wow consumers, game publishers will develop new, hit titles for those platforms. "The key to success is having the best games," says Joe Fielder, editorial director of GameSpot, a Web site that offers news and reviews of video and PC games. "That's what will make someone spend $300 on a console."

Many observers, particularly gaming enthusiasts, initially dismissed Microsoft's foray into the market. How could the king of PC software understand what gamers want? It now appears that even the hardest-core gamers are welcoming Xbox. Its flagship game, Halo, where players battle alien invaders, is already a must-have for many serious gamers, according to GameSpot's Fielder.

J Allard, Microsoft's general manager for the Xbox platform, says Redmond's initial strategy was to create a portfolio that would appeal to hard-core gamers: "That sets the tone for younger gamers who aspire to be like their older siblings and older gamers who want to know what's cool and hip." But to really succeed, Microsoft knows it must also appeal to a broad selection of gamers - including women and casual players. Allard, who says he has been playing video games for more than 25 years, acknowledges that tech-savvy youngsters have dominated gaming until now. But going forward, he says, "we want to be what Disney is to theme parks. There has to be a spectrum of thrills - an opportunity for everyone."


From the horsepower standpoint, Microsoft has the platform to beat. Xbox has a 733-MHz Pentium III processor, an NVidia graphics chip, 64MB of memory, a built-in hard drive, and an integrated broadband connection that next year will allow players to compete over the Internet. Sony's PlayStation2, by contrast, doesn't include a hard drive and requires $40 add-on to make it Internet-ready. Allard says the Internet is central to Microsoft's strategy: "What was exciting in the last generation of hardware was the advance to 3D [graphics]. The revolution this cycle is online play."

So, can underdog Microsoft [imagine that] beat out Sony? Microsoft points out that in 1995, Sony itself was new to the console business and faced two entrenched competitors, Nintendo and Sega. By the end of 2000, Sony had gained a dominant market position, relegating Nintendo to No. 2 and driving Sega out of the hardware business.

Sony's move to disk-based games scored with developers who like their lower cost. Sony's success, however, had more to do with the economic incentives its platform offered to game publishers than with the PlayStation's feature set. Unlike Nintendo and Sega, which required game publishers to produce expensive cartridges that snapped into the game console, Sony offered a disk-based system. Brian Farrell, CEO of game publisher THQ says manufacturing a disk-based game costs from $3 to $6, vs. $20 to $25 for cartridges. Sony also offered a friendlier royalty structure to its partners than Sega or Nintendo did at the time, which encouraged publishers to develop games for PlayStation.


Neither Microsoft nor Nintendo has a similar trick up its sleeve this time - though both companies are rumored to be wooing publishers with co-marketing deals that help limit game publishers' risk. Instead, Microsoft and Nintendo must rely on brisk sales of their consoles to persuade publishers that it's worth their while to develop for the new platforms. If sales drop off, game publishers could abandon the loser. Just as in the software business, game "publishers are incentivized by where they get the biggest return," says THQ's Farrell. "The obvious answer is the largest installed base."

Witness Sega's experience after Dreamcast's launch in the autumn of 1999. Holiday sales were phenomenal: Sega sold 1.5 million consoles over the period. But in 2000, sales slowed sharply. According to IDC, Sega sold just 1.6 million more consoles. In January, 2001, the company exited the hardware market entirely - in large part because game publishers abandoned the platform.

If Microsoft and Nintendo succeed where Sega failed, Gerard Klauer Mattison expects that Nintendo's GameCube will hold 30% to 40% of the market by 2004. At the end of 2000, Nintendo's previous console, N64, had 42%. Microsoft in turn will nab 10% to 20%, with Sony continuing to hold 50% market share.

A hit can drive millions of gamers to buy new hardware Whether those predictions come true depends largely on the third-party game publishers who, for now, are the industry's kingmakers, since they can pick and choose which console-maker they want to deal with. "The last six years belonged to Sony. Now, with Microsoft in the game, publishers can play console makers against one another to extract better deals," says James Lin, an interactive entertainment analyst at Jeffries & Co.


The game-makers' leverage: A hit can drive millions of gamers to buy new hardware. Analysts attribute much of the success Sony will see this Christmas has to do with the release of Metal Gear Solid 2: Sons of Liberty for the PlayStation2. The $49.99 title, released in mid-November, had more than 2 million advance orders.

Game-makers can also spread their risk by developing for all three platforms. Electronic Arts' popular Madden NFL 2002, Activision's Tony Hawk Pro Skater series, and THQ's WWF Wrestling titles are available for PlayStation2, GameCube, and the Xbox - meaning that millions of copies should be sold. Such scale gives publishers more muscle in negotiating with retailers for shelf space - at least for a game's first eight weeks on the market, when as many as 80% of sales happen.

Scale also allows game publishers to rack up big profits, even in a slowing economy. On Dec. 11, Activision raised its guidance for net earnings and revenue in fiscal 2002 - and 2003. For the year ending Mar. 31, 2002, the Santa Monica [Calif.] game publisher raised its earnings estimate to 73 cents a share, on revenue of $725 million, from 67 cents a share on $620 million for fiscal 2001. Activision CEO Bobby Kotick attributed the better-than-expected projections to a 44% increase in sales during Thanksgiving week vs. the year-ago period.

Analysts expect Electronic Arts to report 68 cents a share for 2002, up from just 4 cents a share in 2001. THQ is expected to bring in $1.47 a share for 2002, up from $1.28 a year earlier.


For now, PlayStation2 has the best games, and Microsoft and Nintendo are battling for second place, according to GameSpot's Fielder. Just who will have the next "killer" game isn't yet clear. The best games usually aren't available until the platform has been on the market for at least six months because it takes time for developers to become comfortable with the console's architecture and learn how to best exploit it.

Both challengers are off to a good start, though. Next year, Nintendo plans to release sequels to its popular Pokemon, Legend of Zelda, and Mario Bros. titles, all of which have at one time or another topped the best-seller list. Microsoft is hoping that its exclusive deal with game publisher Interplay for a game based on the sci-fi movie hit The Matrix will lure gamers to Xbox.

Five years ago, a hit game could cost $1 million to develop. Today, it's 10 times that "MORE ROOM." Predicting the winner is no easy feat - especially because, with the cost of developing high-quality hits on the rise - publishers can afford to bet only on a console that's a winner. Five years ago, limited processing power meant that it took only three or four developers six months to build a hit game, at a cost of around $1 million. Today, development teams are often 20 to 30 people strong, including top sound engineers and Hollywood animators. A single game can take more than two years to develop and cost more than $10 million. In such an environment, Nintendo and Sony, which both have a history of successfully developing their own games, could have a leg up over Microsoft.

Of course, there's always a chance that the market could accommodate all three. While the Nasdaq has fallen 27% this year, Gerard Klauer Mattison's Interactive Entertainment index of 10 stocks is up 94%. "I'm not sure there's room for all three of us," says Perrin Kaplan, Nintendo's vice-president for corporate communications. "But with the pie growing, there's more room than ever before." And there's nothing like a multibillion dollar payoff to get more competitors into the game.

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