Home video game industry case study

CASE STUDY ON ATARI TO NINTENDO WII

Case Study #2 (10-15 Pages) A thorough analysis is expected. Below is a suggestion on how to structure your write up and key questions to consider at each stage.

1. The history, development and growth of the company over time (4 marks~2 pages)

– Intro Paragraph

– Chart critical incidents for the industry as a whole (bullet form OK- do not need to restate all facts written in the case – just critical ones)

Questions to consider: a. Why the 82-85 Collapse of Atari b. What drove Microsoft’s decision to enter the industry with its Xbox offering?

2. SWOT analysis (4 Marks 1-2 Pages)

– The identification of the company’s internal strengths and weaknesses

– The nature of the external environment surrounding the company

• The SWOT Checklist Pg C4 provides detail

3. Evaluate the SWOT analysis (4 Marks 1-2 Pages

– Is the company in an overall strong competitive position?

– Can it continue to purpose its current business or corporate level strategy profitably?

– What can the company do to turn weaknesses into strengths and threats into opportunities?

– Can it develop new functional, business or corporate strategies to accomplish this change?

Questions to consider: a. Evaluate the competitive strategy of 3DO? What was 3DO’s strategy? What are the problems with this strategy? What flaws can you see in 3DO’s approach? b. Why has Sony PlayStation succeeded where 3DO failed?

4. The kind of corporate level strategy that the company is pursuing & the nature of the company’s business-level strategy. (6 marks 2-3 Pages)

– Define the companies mission and goals

– Debate merits of their current strategy.

– Identify the company’s generic competitive strategy – differentiation, low-cost, or focus – and its investment strategy, given its relative competitive position and the stage of the life cycle.

– Identify functional strategies that a company pursues to build competitive advantage through superior efficiency, quality, innovation, and customer responsiveness.

Questions to consider: c. How did Nintendo successfully recreate the home video game business following the Atari-era boom and bust? d. How was Nintendo able to capture value from the home video game business?

e. How was Sega able to gain market share from Nintendo?

5. Make Recommendations (4 Marks -2 Pages)

– Recommendations are directed at solving whatever strategic problem the company is facing and increasing its future profitability.

Questions to consider:

a. What lessons can be learnt from the history of the home video game industry that were used to help launch the Sony PlayStation II and Microsoft’s Xbox? Do Microsoft and Sony appear to have learnt and applied these lessons? b. Evaluate the introduction of the Xbox 360, Sony PlayStation 3, and Nintendo’s Wii. What lessons can be learned from these events? How did Nintendo re-establish itself in this market with the Wii?

An Industry Is Born In 1968, Nolan Bushell, the 24-year-old son of a Utah cement contractor, graduated from the University of Utah with a degree in engineering.1 Bushnell then moved to California, where he worked briefl y in the computer graphics division of Ampex. At home, Bush- nell turned his daughter’s bedroom into a laboratory. There, he created a simpler version of Space War, a computer game that had been invented in 1962 by an MIT graduate student, Steve Russell. Bushnell’s version of Russell’s game, which he called Computer Space, was made of integrated circuits connected to a 19-inch black-and-white television screen. Unlike a computer, Bushnell’s invention could do nothing but play the game, which meant that, unlike a computer, it could be produced cheaply.

Bushnell envisioned video games like his stand- ing next to pinball machines in arcades. With hopes of having his invention put into production, Bushnell left Ampex to work for a small pinball company that manufactured 1,500 copies of his video game. The game never sold, primarily because the player had to read a full page of directions before he or she could play the game—way too complex for an arcade game. Bushnell left the pinball company and with a friend, Ted Dabney, put up $500 to start a company that would develop a simpler video game. They wanted to call the company Syzygy, but the name was already taken, so they settled on Atari, a Japanese word that was the equivalent of “check in the go.”

In his home laboratory, Bushnell built the sim- plest game he could think of. People knew the rules

immediately, and it could be played with one hand. The game was modeled on table tennis, and players batted a ball back and forth with paddles that could be moved up and down sides of a court by twisting knobs. He named the game “Pong” after the sonar- like sound that was emitted every time the ball con- nected with a paddle.

In the fall of 1972, Bushnell installed his proto- type for Pong in Andy Capp’s tavern in Sunnyvale, California. The only instructions were “avoid miss- ing the ball for a high score.” In the fi rst week, 1,200 quarters were deposited in the casserole dish that served as a coin box in Bushnell’s prototype. Bushnell was ecstatic; his simple game had brought in $300 in a week. The pinball machine that stood next to it averaged $35 a week.

Lacking the capital to mass-produce the game, Bushnell approached established amusement game companies, only to be repeatedly shown the door. Down but hardly out, Bushnell cut his hair, put on a suit, and talked his way into a $50,000 line of credit from a local bank. He set up a production line in an abandoned roller skating rink and hired people to assemble machines while Led Zeppelin and the Rolling Stones played at full volume over the speaker system of the rink. Among his fi rst batch of employees was a skinny 17-year-old named Steve Jobs, who would later found a few companies of his own, including Apple Computer, NeXT, and Pixar. Like others, Jobs had been attracted by a classifi ed ad that read “Have Fun and Make Money.”

In no time at all, Bushnell was selling all the machines that his small staff could make—about

This case was prepared by Charles W. L. Hill, the University of Washington. This case is intended to be used as a basis for class discussion rather than as an illustration of either effective or ineffective handling of the situation. Reprinted by permission of Charles W. L. Hill.

The Home Video Game Industry: Atari Pong to the Nintendo Wii

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10 per day; to grow, however, he needed additional capital. The ambience at the rink, with its mix of rock music and marijuana fumes, put off most potential investors, but Don Valentine, one of the country’s most astute and credible venture capitalists, was impressed with the growth story. Armed with Valentine’s money, Atari began to increase produc- tion and expand its range of games. New games included Tank and Breakout; the latter was designed by Jobs and a friend of his, Steve Wozniak, who had left HP to work at Atari.

By 1974, 100,000 Pong-like games were sold worldwide. Although Atari manufactured only 10% of the games, the company still made $3.2 million that year. With the Pong clones coming on strong, Bushnell decided to make a Pong system for the home. In fact, Magnavox had been marketing a similar game for the home since 1972, although sales had been modest.2 Bushnell’s team managed to compress Atari’s coin-operated Pong game down to a few inexpensive circuits that were contained in the game console. Atari’s Pong had a sharper pic- ture and more sensitive controllers than Magnavox’s machine. It also cost less. Bushnell then went on a road show, demonstrating Pong to toy buyers, but he received an indifferent response and no sales. A dejected Bushnell returned to Atari with no idea of what to do next. Then the buyer for the sport- ing goods department at Sears came to see Bushnell, reviewed the machine, and offered to buy every home Pong game Atari could make. With Sears’s backing, Bushnell boosted production. Sears ran a major tele- vision ad campaign to sell home Pong, and Atari’s sales soared, hitting $450 million in 1975. The home video game had arrived.

Boom and Bust Nothing attracts competitors like success, and by 1976 about 20 different companies were crowd- ing into the home video game market, including National Semiconductor, RCA, Coleco, and Fair- child. Recognizing the limitations of existing home video game designs, in 1976, Fairchild came out with a home video game system capable of playing mul- tiple games. The Fairchild system consisted of three components—a console, controllers, and cartridges. The console was a small computer optimized for

graphics processing capabilities. It was designed to receive information from the controllers, process it, and send signals to a television monitor. The control- lers were handheld devices used to direct on-screen action. The cartridges contained chips encoding the instructions for a game. The cartridges were designed to be inserted into the console.

In 1976, Bushnell sold Atari to Warner Com- munications for $28 million. Bushnell stayed on to run Atari. Backed by Warner’s capital, in 1977, Atari developed and brought out its own cartridge-based system, the Atari 2600. The 2600 system was sold for $200, and associated cartridges retailed for $25 to $35. Sales surged during the 1977 Christmas season. However, a lack of manufacturing capac- ity on the part of market-leader Atari and a very cautious approach to inventory by Fairchild led to shortages and kept sales signifi cantly below what they could have been. Fairchild’s cautious approach was the result of prior experience in consumer elec- tronics. A year earlier, it had increased demand for its digital watches, only to accumulate a buildup of excess inventory that had caused the company to take a $24.5 million write-off.3

After the 1977 Christmas season, Atari claimed to have sold about 400,000 units of the 2600 VCA, about 50% of all cartridge-based systems in American homes. Atari had also earned more than $100 million in sales of game cartridges. By this point, second-place Fairchild sold about 250,000 units of its system. Cartridge sales for the year totaled about 1.2 million units, with an average selling price of about $20. Fresh from this success and fortifi ed by market forecasts predicting sales of 33 million car- tridges and an installed base of 16 million machines by 1980, Bushnell committed Atari to manufactur- ing 1 million units of the 2600 for the 1978 Christ- mas season. Atari estimated that total demand would reach 2 million units. Bushnell was also encouraged by signals from Fairchild that it would again be lim- iting production to approximately 200,000 units. At this point, Atari had a library of nine games, while Fairchild had 17 games.4

Atari was not the only company to be excited by the growth forecasts. In 1978, a host of other com- panies, including Coleco, National Semiconductor, Magnavox, General Instrument, and a dozen other companies, entered the market with incompatible cartridge-based home systems. The multitude of choices did not seem to entice consumers, however,

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C37

and the 1978 Christmas season brought unexpect- edly low sales. Only Atari and Coleco survived an industry shakeout. Atari lost Bushnell, who was ousted by Warner executives. (Bushnell went on to start Chuck E. Cheese Pizza Time Theater, a restau- rant chain that had 278 outlets by 1981.) Bushnell later stated that part of the problem was a disagree- ment over strategy. Bushnell wanted Atari to price the 2600 at cost and make money on sales of soft- ware; Warner wanted to continue making profi ts on hardware sales.5

Several important developments occurred in 1979. First, several game producers and program- mers defected from Atari to set up their own fi rm, Activision, and to make games compatible with the Atari 2600. Their success encouraged others to fol- low suit. Second, Coleco developed an expansion module that allowed its machine to play Atari games. Atari and Mattel (who entered the market in 1979) did likewise. Third, the year 1979 saw the introduc- tion of three new games to the home market—Space Invaders, Asteroids, and Pac Man. All three were adapted from popular arcade games and all three helped drive demand for players.

Demand recovered strongly in late 1979 and kept growing for the next three years. In 1981, United States sales of home video games and cartridges hit $1 billion. In 1982, they surged to $3 billion, with Atari accounting for half of this amount. It seemed as if Atari could do no wrong; the 2600 was every- where. About 20 million units were sold, and by late 1982, a large number of independent companies, including Activision, Imagic, and Epyx, were now producing hundreds of games for the 2600. Second- place Coleco was also doing well, partly because of a popular arcade game, Donkey Kong, which it had licensed from a Japanese company called Nintendo.

Atari was also in contact with Nintendo. In 1982, the company very nearly licensed the rights to Nintendo’s Famicom, a cartridge-based video game system machine that was a big hit in Japan. Atari’s successor to the 2600, the 5200, was not selling well, and the Famicom seemed like a good substitute. The negotiations broke down, however, when Atari discovered that Nintendo had extended its Donkey Kong license to Coleco. This allowed Coleco to port a version of the game to its home computer, which was a direct competitor to Atari’s 800 home computer.6

After a strong 1982 season, the industry hoped for continued growth in 1983. Then the bottom dropped

out of the market. Sales of home video games plunged to $100 million. Atari lost $500 million in the fi rst nine months of the year, causing the stock of parent company Warner Communications to drop by half. Part of the blame for the collapse was laid at the feet of an enormous inventory overhang of unsold games. About 15 to 20 million surplus game cartridges were left over from the 1982 Christmas season (in 1981, there were none). On top of this, approximately 500 new games hit the market in 1993. The average price of a cartridge plunged from $30 in 1979 to $16 in 1982 and then to $4 in 1983. As sales slowed, retailers cut back on the shelf space allocated to video games. It proved diffi cult for new games to make a splash in a crowded market. Atari had to dispose of 6 million ET: The Extraterrestrial games. Meanwhile, big hits from previous years, such as Pac Man, were bundled with game players and given away free to try to encourage system sales.7

Surveying the rubble, commentators claimed that the video game industry was dead. The era of dedi- cated game machines was over, they claimed. Per- sonal computers were taking their place.8 It seemed to be true. Mattel sold off its game business, Fairchild moved on to other things, Coleco folded, and Warner decided to break up Atari and sell its constit- uent pieces—at least, those pieces for which it could fi nd a buyer. No one in America seemed to want to have anything to do with the home video game busi- ness; no one, that is, except for Minoru Arakawa, the head of Nintendo’s United States subsidiary, Nintendo of America (NOA). Picking through the rubble of the industry, Arakawa noticed that there were people who still packed video arcades, bring- ing in $7 billion a year, more money than the entire movie industry. Perhaps it was not a lack of interest in home video games that had killed the industry. Perhaps it was bad business practice.

The Nintendo Monopoly Nintendo was a century-old Japanese company that had built up a profi table business making playing cards before diversifying into the video game busi- ness. Based in Kyoto and still run by the founding Yamauchi family, the company started to diversify into the video game business in the late 1970s. The

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fi rst step was to license video game technology from Magnavox. In 1977, Nintendo introduced a home video game system in Japan based on this technology that played a variation of Pong. In 1978, the com- pany began to sell coin-operated video games. It had its fi rst hit with Donkey Kong, designed by Sigeru Miyamoto.

The Famicom In the early 1980s, the company’s boss, Hiroshi Yamauchi, decided that Nintendo had to develop its own video game machine. He pushed the company’s engineers to develop a machine that combined supe- rior graphics-processing capabilities and low cost. Yamauchi wanted a machine that could sell for $75, less than half the price of competing machines at the time. He dubbed the machine the Family Computer, or Famicom. The machine that his engineers designed was based on the controller, console, and plug-in cartridge format pioneered by Fairchild. It contained two custom chips—an 8-bit central processing unit and a graphics-processing unit. Both chips had been scaled down to perform only essential functions. A 16-bit processor was available at the time, but to keep costs down, Yamauchi refused to use it.

Nintendo approached Ricoh, the electronics giant, which had spare semiconductor capacity. Employees at Ricoh said that the chips had to cost no more that 2,000 yen. Ricoh thought that the 2,000-yen price point was absurd. Yamauchi’s response was to guar- antee Ricoh a 3-million-chip order within two years. Since the leading companies in Japan were selling, at most, 30,000 video games per year at the time, many within the company viewed this as an outrageous commitment, but Ricoh went for it.9

Another feature of the machine was its memory—2,000 bytes of random access memory (RAM), compared to the 256 bytes of RAM in the Atari machine. The result was a machine with superior graphics-processing capabilities and faster action that could handle far more complex games than Atari games. Nintendo’s engineers also built a new set of chips into the game cartridges. In addi- tion to chips that held the game program, Nintendo developed memory map controller (MMC) chips that took over some of the graphics-processing work from the chips in the console and enabled the system to handle more complex games. With the addition of the MMC chips, the potential for

more- sophisticated and complex games had arrived. Over time, Nintendo’s engineers developed more powerful MMC chips, enabling the basic 8-bit sys- tem to do things that originally seemed out of reach. The engineers also fi gured out a way to include a battery backup system in cartridges that allowed some games to store information independently—to keep track of where a player had left off or track high scores.

The Games Yamauchi recognized that great hardware would not sell itself. The key to the market, he reasoned, was great games. Yamauchi had instructed the engineers, as they were developing the hardware, to make sure that “it was appreciated by software engineers.” Nintendo decided that it would become a haven for game designers. “An ordinary man,” Yamauchi said, “cannot develop good games no matter how hard he tries. A handful of people in this world can develop games that everyone wants. Those are the people we want at Nintendo.”10

Yamauchi had an advantage in the person of Sigeru Miyamoto. Miyamoto had joined Nintendo at the age of 24. Yamauchi had hired Miyamoto, a grad- uate of Kanazawa Munici College of Industrial Arts, as a favor to his father and an old friend, although he had little idea what he would do with an artist. For three years, Miyamoto worked as Nintendo’s staff artist. Then in 1980, Yamauchi called Miyamoto into his offi ce. Nintendo had started selling coin- operated video games, but one of the new games, Radarscope, was a disaster. Could Miyamoto come up with a new game? Miyamoto was delighted. He had always spent a lot of time drawing cartoons, and as a student, he had played video games constantly. Miyamoto believed that video games could be used to bring cartoons to life.11

The game Miyamoto developed was nothing short of a revelation. At a time when most coin- operated video games lacked characters or depth, Miyamoto created a game around a story that had both. Most games involved battles with space invaders or heroes shooting lasers at aliens; Miyamoto’s game did nei- ther. Based loosely on Beauty and the Beast and King Kong, Miyamoto’s game involved a pet ape who runs off with his master’s beautiful girlfriend. His master is an ordinary carpenter called Mario, who has a bul- bous nose, a bushy mustache, a pair of large pathetic

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C39

eyes, and a red cap (which Miyamoto added because he was not good at hairstyles). He does not carry a laser gun. The ape runs off with the girlfriend to get back at his master, who was not especially nice to the beast. The man, of course, has to get his girlfriend back by running up ramps, climbing ladders, jump- ing off elevators, and the like, while the ape throws objects at the hapless carpenter. Since the main char- acter is an ape, Miyamoto called him Kong; because the main character is as stubborn as a donkey, he called the game Donkey Kong.

Released in 1981, Donkey Kong was a sensation in the world of coin-operated video arcades and a smash hit for Nintendo. In 1984, Yamauchi again summoned Miyamoto to his offi ce. He needed more games, this time for Famicom. Miyamoto was made the head of a new research and development (R&D) group and told to come up with the most imagina- tive video games ever.

Miyamoto began with Mario from Donkey Kong. A colleague had told him that Mario looked more like a plumber than a carpenter, so a plumber he became. Miyamoto gave Mario a brother, Luigi, who was as tall and thin as Mario was short and fat. They became the Super Mario Brothers. Since plumbers spend their time working on pipes, large green sewer pipes became obstacles and doorways into secret worlds. Mario and Luigi’s task was to search for the captive Princess Toadstool. Mario and Luigi are endearing bumblers, unequal to their tasks yet surviving. They shoot, squash, or evade their enemies—a potpourri of inventions that include fl ying turtles and stinging fi sh, man-eating fl owers and fi re-breathing dragons— while they collect gold coins, blow air bubbles, and climb vines into smiling clouds.12

Super Mario Brothers was introduced in 1985. For Miyamoto, this was just the beginning. Between 1985 and 1991, Miyamoto produced eight Mario games. About 60 to 70 million were sold world- wide, making Miyamoto the most successful game designer in the world. After adapting Donkey Kong for Famicom, he also went on to create other top- selling games, including another classic, The Legend of Zelda. While Miyamoto drew freely from folk- lore, literature, and pop culture, the main source for his ideas was his own experience. The memory of being lost among a maze of sliding doors in his family’s home was re-created in the labyrinths of the Zelda games. The dog that attacked him when he was a child attacks Mario in Super Mario. As a child,

Miyamoto had once climbed a tree to catch a view of far-off mountains and had become stuck. Mario gets himself in a similar fi x. Once Miyamoto went hiking without a map and was surprised to stumble across a lake. In the Legend of Zelda, part of the adventure is in walking into new places without a map and being confronted by surprises.

Nintendo in Japan Nintendo introduced Famicom into the Japanese market in May 1983. Famicom was priced at $100, more than Yamauchi wanted, but signifi cantly less than the products of competitors. When he intro- duced the machine, Yamauchi urged retailers to forgo profi ts on the hardware because it was just a tool to sell software, and that is where they would make their money. Backed by an extensive advertising cam- paign, 500,000 units of Famicom were sold in the fi rst two months. Within a year, the fi gure stood at 1 million, and sales were still expanding rapidly. With the hardware quickly fi nding its way into Japanese homes, Nintendo was besieged with calls from des- perate retailers frantically demanding more games.

At this point, Yamauchi told Miyamoto to come up with the most imaginative games ever. However, Yamauchi also realized that Nintendo alone could not satisfy the growing thirst for new games, so he initiated a licensing program. To become a Nintendo licensee, companies had to agree to an unprecedented series of restrictions. Licensees could issue only fi ve Nintendo games per year, and they could not write those titles for other platforms. The licensing fee was set at 20% of the wholesale price of each cartridge sold (game cartridges wholesaled for around $30). It typically cost $500,000 to develop a game and took around six months. Nintendo insisted that games not contain any excessively violent or sexually sugges- tive material and that they review every game before allowing it to be produced.13

Despite these restrictions, six companies (Bandai, Capcom, Konami, Namco, Taito, and Hudson) agreed to become Nintendo licensees, not least because millions of customers were now clamoring for games. Bandai was Japan’s largest toy company. The others already made either coin-operated video games or computer software games. Because of these licensing agreements, they saw their sales and earn- ings surge. For example, Konami’s earnings went from $10 million in 1987 to $300 million in 1991.

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After the six licensees began selling games, reports of defective games began to reach Yamauchi. The original six licensees were allowed to manufac- ture their own game cartridges. Realizing that he had given away the ability to control the quality of the cartridges, Yamauchi decided to change the contract for future licensees. Future licensees were required to submit all manufacturing orders for cartridges to Nintendo. Nintendo charged licensees $14 per car- tridge, required that they place a minimum order for 10,000 units (later the minimum order was raised to 30,000), and insisted on cash payment in full when the order was placed. Nintendo outsourced all man- ufacturing to other companies, using the volume of its orders to get rock bottom prices. The cartridges were estimated to cost Nintendo between $6 and $8 each. The licensees then picked up the cartridges from Nintendo’s loading dock and were responsible for distribution. In 1985, there were 17 licensees. By 1987, there were 50. By this point, 90% of the home video game systems sold in Japan were Nintendo systems.

Nintendo in America In 1980, Nintendo established a subsidiary in America to sell its coin-operated video games. Yamauchi’s American-educated son-in-law, Minoru Arakawa, headed the subsidiary. All of the other essential employees were Americans, including Ron Judy and Al Stone. For its fi rst two years, Nintendo of America (NOA), based originally in Seattle, struggled to sell second-rate games such as Radarscope. The subsid- iary seemed on the brink of closing. NOA could not even make the rent payment on the warehouse. Then they received a large shipment from Japan: 2,000 units of a new coin-operated video game. Opening the box, they discovered Donkey Kong. After playing the game briefl y, Judy proclaimed it a disaster. Stone walked out of the building, declar- ing that “It’s over.”14 The managers were appalled. They could not imagine a game less likely to sell in video arcades. The only promising sign was that a 20-year employee, Howard Philips, rapidly became enthralled with the machine.

Arakawa, however, knew he had little choice but to try to sell the machine. Judy persuaded the owner of the Spot Tavern near Nintendo’s offi ce to take one of the machines on a trial basis. After one night, Judy discovered $30 in the coin box, a phenomenal

amount. The next night there was $35, and $36 the night after that. NOA had a hit on its hands.

By the end of 1982, NOA had sold more than 60,000 copies of Donkey Kong and had booked sales in excess of $100 million. The subsidiary had outgrown its Seattle location. They moved to a new site in Redmond, a Seattle suburb, where they located next to a small but fast-growing software company run by an old school acquaintance of Howard Philips, Bill Gates.

By 1984, NOA was riding a wave of success in the coin-operated video game market. Arakawa, however, was interested in the possibilities of sell- ing Nintendo’s new Famicom system in the United States. Throughout 1984, Arakawa, Judy, and Stone met with numerous toy and department store rep- resentatives to discuss the possibilities, only to be repeatedly rebuffed. Still smarting from the 1983 debacle, the representatives wanted nothing to do with the home video game business. They also met with former managers from Atari and Coleco to gain their insights. The most common response they received was that the market collapsed because the last generation of games were awful.

Arakawa and his team decided that if they were going to sell Famicom in the United States, they would have to fi nd a new distribution channel. The obvi- ous choice was consumer electronics stores. Thus, Arakawa asked the R&D team in Kyoto to rede- sign Famicom for the United States market so that it looked less like a toy (Famicom was encased in red and white plastic), and more like a consumer elec- tronics device. The redesigned machine was renamed the Nintendo Entertainment System (NES).

Arakawa’s big fear was that illegal, low-quality Taiwanese games would fl ood the United States market if NES was successful. To stop counterfeit games from being played on NES, Arakawa asked Nintendo’s Japanese engineers to design a security system into the U.S. version of Famicom so that only Nintendo-approved games could be played on NES. The Japanese engineers responded by design- ing a security chip that was embedded in the game cartridges. NES would not work unless the security chips in the cartridges unlocked, or shook hands with, a chip in NES. Since the code embedded in the security chip was proprietary, the implication of this system was that no one could manufacture games for NES without Nintendo’s specifi c approval.

To overcome the skepticism and reluctance of retailers to stock a home video game system, Arakawa

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C41

decided in late 1985 to make an extraordinary com- mitment. Nintendo would stock stores and set up displays and windows. Retailers would not have to pay for anything they stocked for 90 days. After that, retailers could pay Nintendo for what they sold and return the rest. NES was bundled with Nintendo’s best-selling game in Japan, Super Mario Brothers. It was essentially a risk-free proposition for retailers, but even with this, most were skeptical. Ultimately, thirty Nintendo personnel descended on the New York area. Referred to as the Nintendo SWAT team, they persuaded some stores to stock NES after an extraordinary blitz that involved 18-hour days. To support the New York product launch, Nintendo also committed itself to a $5 million advertising campaign aimed at the 7- to 14-year-old boys who seemed to be Nintendo’s likely core audience.

By December 1985, between 500 and 600 stores in the New York area were stocking Nintendo sys- tems. Sales were moderate, about half of the 100,000 NES machines shipped from Japan were sold, but it was enough to justify going forward. The SWAT team moved fi rst to Los Angeles, then to Chicago, then to Dallas. As in New York, sales started at a moderate pace, but by late 1986 they started to accel- erate rapidly, and Nintendo went national with NES.

In 1986, around 1 million NES units were sold in the United States. In 1987, the fi gure increased to 3 million. In 1988, it jumped to over 7 million. In the same year, 33 million game cartridges were sold. Nintendo mania had arrived in the United States. To expand the supply of games, Nintendo licensed the rights to produce up to fi ve games per year to 31 American software companies. Nintendo contin- ued to use a restrictive licensing agreement that gave it exclusive rights to any games, required licensees to place their orders through Nintendo, and insisted on a 30,000-unit minimum order.15

By 1990, the home video game market was worth $5 billion worldwide. Nintendo dominated the industry, with a 90% share of the market for game equipment. The parent company was, by some measures, now the most profi table company in Japan. By 1992, it was netting over $1 billion in gross profi t annually, or more than $1.5 million for each employee in Japan. The company’s stock market value exceeded that of Sony, Japan’s premier consumer electronics fi rm. Indeed, the company’s net profi t exceeded that of all the American movie studios combined. Nintendo games, it seemed, were bigger than the movies.

As of 1991, there were more than 100 licens- ees for Nintendo, and more than 450 titles were available for NES. In the United States, Nintendo products were distributed through toy stores (30% of volume), mass merchandisers (40% of volume), and department stores (10% of volume). Nintendo tightly controlled the number of game titles and games that could be sold, quickly withdrawing titles as soon as interest appeared to decline. In 1988, retailers requested 110 million cartridges from Nin- tendo. Market surveys suggested that perhaps 45 million could have been sold, but Nintendo allowed only 33 million to be shipped.16 Nintendo claimed that the shortage of games was in part due to a worldwide shortage of semiconductor chips.

Several companies had tried to reverse-engineer the code embedded in Nintendo’s security chip, which competitors characterized as a lockout chip. Nintendo successfully sued them. The most notable was Atari Games, one of the successors of the origi- nal Atari, which in 1987 sued Nintendo of America for anticompetitive behavior. Atari claimed that the purpose of the security chip was to monopolize the market. At the same time, Atari announced that it had found a way around Nintendo’s security chip and would begin to sell unlicensed games.17 NOA responded with a countersuit. In a March 1991 rul- ing, Atari was found to have obtained Nintendo’s security code illegally and was ordered to stop selling NES-compatible games. However, Nintendo did not always have it all its own way. In 1990, under pres- sure from Congress, the Department of Justice, and several lawsuits, Nintendo rescinded its exclusivity requirements, freeing up developers to write games for other platforms. However, developers faced a real problem: what platform could they write for?

Sega’s Sonic Boom Back in 1954, David Rosen, a 20-year-old American, left the U.S. Air Force after a tour of duty in Tokyo.18 Rosen had noticed that Japanese people needed lots of photographs for ID cards, but local photo studios were slow and expensive. He formed a company, Rosen Enterprises, and went into the photo-booth business, which was a big success. By 1957, Rosen had established a successful nationwide chain. At

C42 Section A: Business Level Cases: Domestic and Global

this point, the Japanese economy was booming, so Rosen decided it was time to get into another business—entertainment. As his vehicle, he chose arcade games, which were unknown in Japan at the time. He picked up used games on the cheap from America and set up arcades in the same Japanese department stores and theaters that typically housed his photo booths. Within a few years, Rosen had 200 arcades nationwide. His only competition came from another American-owned fi rm, Service Games (SeGa), whose original business was jukeboxes and fruit machines.

By the early 1960s, the Japanese arcade market had caught up with the United States market. The problem was that game makers had run out of excit- ing new games to offer. Rosen decided that he would have to get into the business of designing and manu- facturing games, but to do that he needed manufac- turing facilities. SeGa manufactured its own games, so in 1965 Rosen approached the company and sug- gested a merger. The result was Sega Enterprise, a Japanese company with Rosen as its CEO.

Rosen designed Sega’s fi rst game, Periscope, in which the objective was to sink chain-mounted cardboard ships by fi ring torpedoes, represented by lines of colored lights. Periscope was a big success not only in Japan but also in the United States and Europe. It allowed Sega to build up a respectable export business. Over the years, the company contin- ued to invest heavily in game development, always using the latest electronic technology.

Gulf and Western (G&W), a United States con- glomerate, acquired Sega in 1969, with Rosen running the subsidiary. In 1975, Gulf and Western (G&W) took Sega public in the United States but kept Sega Japan as a G&W subsidiary. Hayao Nakayama, a former Sega distributor, was drafted as president. In the early 1980s, Nakayama pushed G&W to invest more in Sega Japan so that the company could enter the then-booming home video game market. When G&W refused, Nakayama suggested a management buyout. G&W agreed, and in 1984, for the price of just $38 million, Sega became a Japanese company once more. (Sega’s Japanese revenues were about $700 million, but by now the company was barely profi table.)

Sega was caught off guard by the huge success of Nintendo’s Famicom. Although it released its own 8-bit system in 1986, the machine never commanded more than 5% of the Japanese market. Nakayama, however, was not about to give up. From years in

the arcade business, he understood that great games drove sales. Nevertheless, he also understood that more powerful technology gave game developers the tools to develop more appealing games. This phi- losophy underlay Nakayama’s decision to develop a 16-bit game system, Genesis.

Sega took the design of its 16-bit arcade machine and adapted it for Genesis. Compared to Nintendo’s 8-bit machine, the 16-bit machine featured an array of superior technological features, including high- defi nition graphics and animation, a full spectrum of colors, two independent scrolling backgrounds that created an impressive depth of fi eld, and near CD quality sound. The design strategy also made it easy to port Sega’s catalog of arcade hits to Genesis.

Genesis was launched in Japan in 1989 and in the United States in 1990. In the United States, the machine was priced at $199. The company hoped that sales would be boosted by the popularity of its arcade games, such as the graphically violent Altered Beast. Sega also licensed other companies to develop games for the Genesis platform. In an effort to recruit licensees, Sega asked for lower royalty rates than Nintendo, and it gave licensees the right to manufac- ture their own cartridges. Independent game devel- opers were slow to climb on board, however, and the $200 price tag for the player held back sales.

One of the fi rst independent game developers to sign up with Sega was Electronic Arts (EA). Estab- lished by Trip Hawkins, EA had focused on designing games for personal computers and consequently had missed the Nintendo 8-bit era. Now Hawkins was determined to get a presence in the home video game market, and aligning his company’s wagon with Sega seemed to be the best option. The Nintendo playing fi eld was already crowded, and Sega offered a far less restrictive licensing deal than Nintendo. EA sub- sequently wrote several popular games for Genesis, including John Madden football and several gory combat games.19

Nintendo had not been ignoring the potential of the 16-bit system. Nintendo’s own 16-bit system, Super NES, was ready for market introduction in 1989—at the same time as Sega’s Genesis. Nintendo introduced Super NES in Japan in 1990, where it quickly established a strong market presence and beat Sega’s Genesis. In the United States, however, the company decided to hold back longer to reap the full benefi ts of the dominance it enjoyed with the 8-bit NES system. Yamauchi was also worried about

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C43

the lack of backward compatibility between Ninten- do’s 8-bit and 16-bit systems. (The company had tried to make the 16-bit system so that it could play 8-bit games but concluded that the cost of doing so was prohibitive.) These concerns may have led the com- pany to delay market introduction until the 8-bit mar- ket was saturated.

Meanwhile, in the United States, the Sega band- wagon was beginning to gain momentum. One devel- opment that gave Genesis a push was the introduction of a new Sega game, Sonic the Hedgehog. Developed by an independent team that was contracted to Sega, the game featured a cute hedgehog that impatiently tapped his paw when the player took too long to act. Impatience was Sonic’s central feature—he had places to go—and quickly. He zipped along, collect- ing brass rings when he could fi nd them, before roll- ing into a ball and fl ying down slides with loops and underground tunnels. Sonic was Sega’s Mario.

In mid-1991, in an attempt to jump-start slow sales, Tom Kalinske, head of Sega’s American sub- sidiary, decided to bundle Sonic the Hedgehog with the game player. He also reduced the price for the bundled unit to $150, and he relaunched the system with an aggressive advertising campaign aimed at teenagers. The campaign was built around the slo- gan “Genesis does what Nintendon’t.” The shift in strategy worked, and sales accelerated sharply.

Sega’s success prompted Nintendo to launch its own 16-bit system. Nintendo’s Super NES was introduced at $200. However, Sega now had a two- year head start in games. By the end of 1991, about 125 game titles were available for Genesis, compared to 25 for Super NES. In May 1992, Nintendo reduced the price of Super NES to $150. At this time Sega was claiming a 63% share of the 16-bit market in the United States, and Nintendo claimed a 60% share. By now, Sega was cool. It began to take more chances with mass media-defi ned morality. When Acclaim Entertainment released its bloody Mortal Kombat game in September 1992, the Sega version let players rip off heads and tear out hearts. Refl ecting Ninten- do’s image of their core market, its version was sani- tized. The Sega version outsold Nintendo’s two to one.20 Therefore, the momentum continued to run in Sega’s favor. By January 1993, there were 320 titles available for Sega Genesis and 130 for Super NES. In early 1994, independent estimates suggested that Sega had 60% of the United States market and Nin- tendo had 40%, fi gures that Nintendo disputed.

3DO Trip Hawkins, whose fi rst big success was EA, founded 3DO in 1991.21 Hawkins’s vision for 3DO was to shift the home video game business away from the existing cartridge-based format and toward a CD-ROM-based platform. The original partners in 3DO were EA, Matsushita, Time Warner, AT&T, and the venture capital fi rm Kleiner Perkins. Collec- tively, they invested more than $17 million in 3DO, making it the richest start-up in the history of the home video game industry. 3DO went public in May 1993 at $15 per share. By October of that year, the stock had risen to $48 per share, making 3DO worth $1 billion—not bad for a company that had yet to generate a single dollar in revenues.

The basis for 3DO’s $1 billion market cap was a patented computer system architecture and a copy- righted operating system that allowed for much richer graphics and audio capabilities. The system was built around a 32-bit reduced instruction set computing (RISC) microprocessor and proprietary graphics pro- cessor chips. Instead of a cartridge, the 3DO system stored games on a CD-ROM that was capable of hold- ing up to 600 megabytes of content, sharply up from the 10 megabytes of content found in the typical game car- tridge of the time. The slower access time of a CD-ROM compared to a cartridge was alleviated somewhat by the use of a double-speed CD-ROM drive.22

The belief at 3DO—a belief apparently shared by many investors—was that the superior storage and graphics-processing capabilities of the 3DO system would prove very attractive to game developers, allowing them to be far more creative. In turn, better games would attract customers away from Nintendo and Sega. Developing games that used the capabili- ties of a CD-ROM system altered the economics of game development. Estimates suggested that it would cost approximately $2 million to produce a game for the 3DO system and could take as long as 24 months to develop. However, at $2 per disc, a CD-ROM cost substantially less to produce than a cartridge.

The centerpiece of 3DO’s strategy was to license its hardware technology for free. Game developers paid a royalty of $3 per disc for access to the 3DO operating code. Discs typically retailed for $40 each.

Matsushita introduced the fi rst 3DO machine into the United States market in October 1993. Priced at $700, the machine was sold through electronic retailers that carried Panasonic high-end electronics

C44 Section A: Business Level Cases: Domestic and Global

products. Sega’s Tom Kalinsky noted, “It’s a noble effort. Some people will buy 3DO, and they’ll have a wonderful experience. It’s impressive, but it’s a niche. We’ve done the research. It does not become a large market until you go below $500. At $300, it starts to get interesting. We make no money on hardware. It’s a cutthroat business. I hope Matsushita under- stands that.”23 CD-ROM discs for the 3DO machine retailed for about $75. The machine came bundled with Crash ‘n’ Burn, a high-speed combat racing game. However, only 18 3DO titles were available by the crucial Christmas period, although reports suggested that 150 titles were under development.24

Sales of the hardware were slow, reaching only 30,000 by January 1994.25 In the same month, AT&T and Sanyo both announced that they would begin to manufacture the 3DO machine. In March, faced with continuing sluggish sales, 3DO announced that it would give hardware manufacturers two shares of 3DO stock for every unit sold at or below a cer- tain retail price. Matsushita dropped the price of its machine to $500. About the same time, Toshiba, LG, and Samsung all announced that they would start to produce 3DO machines.

By June 1994, cumulative sales of 3DO machines in the United States stood at 40,000 units. Matsushita announced plans to expand distribution beyond the cur- rent 3,500 outlets to include the toy and mass merchan- dise channels. Hawkins and his partners announced that they would invest another $37 million in 3DO. By July, there were 750 3DO software licensees, but only 40 titles were available for the format. Despite these moves, sales continued at a very sluggish pace, and the supply of new software titles started to dry up.26

In September 1996, 3DO announced that it would either sell its hardware system business or move it into a joint venture.27 The company announced that about 150 people, one-third of the workforce, would probably lose their jobs in the restructuring. According to Trip Hawkins, 3DO would now focus on developing soft- ware for online gaming. Hawkins stated that the Internet and Internet entertainment constituted a huge opportu- nity for 3DO. The stock dropped $1.375 to $6.75.

Sega’s Saturn 3DO was not alone in moving to a CD-ROM- based format. Both Sega and Sony also introduced CD-ROM-based systems in the mid-1990s. Sega

had, in fact, beaten 3DO to the market with its November 1992 introduction of the Sega CD, a $300 CD-ROM add-on for the 16-bit Genesis. Sega sold 100,000 units in its fi rst month alone. Sales then slowed down, however, and by December 1993 were standing at just 250,000 units. One reason for the slowdown, according to critics, was a lack of strong games. Sega was also working on a 32-bit CD-ROM system, Saturn, which was targeted for a mid-1995 introduction in the United States. In January 1994, Sega announced that Microsoft would supply the operating system for Saturn.28

In March 1994, Sega announced the Genesis Super 32X, a $150 add-on cartridge designed to increase the performance of Genesis cartridge and CD-ROM games. The 32X contained the 32-bit Hitachi micro- processor that was to be used in Saturn. Sega called the 32X “the poor man’s 32-bit machine” because it sold for a mere $149. Introduced in the fall of 1994, the 32X never lived up to its expectations. Most users appeared willing to wait for the real thing, Sega Saturn, promised for release the following year.

In early 1995, Sega informed the press and retail- ers that it would release Saturn on “Sega Saturn Sat- urday, Sept 2nd,” but Sega released the 32-bit Saturn in May 1995. It was priced at $400 per unit and accompanied by the introduction of just 10 games. Sega apparently believed that the world would be delighted by the May release of the Saturn. However, Saturn was released without the industry fanfare that normally greets a new game machine. Only four retail chains received the Saturn in May, while the rest were told they would have to wait until September. This move alienated retailers, who responded by dropping Sega products from their stores.29 Sega appeared to have made a marketing blunder.30

Sony’s PlayStation In the fall of 1995, Sony entered the fray with the introduction of the Sony PlayStation.31 PlaySta- tion used a 32-bit RISC microprocessor running at 33 MHz and using a double-speed CD-ROM drive. PlayStation cost an estimated $500 million to develop. The machine had actually been under devel- opment since 1991, when Sony decided that the home video game industry was getting too big to ignore. Initially, Sony was in an alliance with Nintendo to

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C45

develop the machine. Nintendo walked away from the alliance in 1992, however, after a disagreement over who owned the rights to any future CD-ROM games. Sony went alone.32

From the start, Sony felt that it could leverage its presence in the fi lm and music business to build a strong position in the home video game industry. A consumer electronics giant with a position in the Hollywood movie business and the music industry (Sony owned Columbia Pictures and the Columbia record label), Sony believed that it had access to signifi cant intellectual property that could form the basis of many popular games.

In 1991, Sony established a division in New York: Sony Electronic Publishing. The division was to serve as an umbrella organization for Sony’s multimedia offerings. Headed by Iceland native Olaf Olafsson, then just 28 years old, this organization ultimately took the lead role in both the market launch of Play- Station and in developing game titles.33 In 1993, as part of this effort, Sony purchased a well-respected British game developer, Psygnosis. By the fall of 1995, this unit had 20 games ready to complement PlayStation: the Haldeman Diaries, Mickey Mania (developed in collaboration with Disney), and Johnny Mnemonic, based on the William Gibson short story. To entice independent game developers such as EA, Namco, and Acclaim Entertainment, Olafsson used the promise of low royalty rates. The standard royalty rate was set at $9 per disc, although developers that signed on early enough were given a lower royalty rate. Sony also provided approxi- mately 4,000 game development tools to licensees in an effort to help them speed games to market.34

To distribute PlayStation, Sony set up a retail channel separate from Sony’s consumer electronics sales force. It marketed the PlayStation as a hip and powerful alternative to the outdated Nintendo and Sega cartridge-based systems. Sony worked closely with retailers before the launch to fi nd out how it could help them sell the PlayStation. To jump-start demand, Sony set up in-store displays to allow poten- tial consumers to try the equipment. Just before the launch, Sony had lined up an impressive 12,000 retail outlets in the United States.35

Sony targeted its advertising for PlayStation at males in the 18- to 35-year age range. The targeting was evident in the content of many of the games. One of the big hits for PlayStation was Tomb Raider, whose central character, Lara Croft, combined sex

appeal with savvy and helped to recruit an older generation to PlayStation.36 PlayStation was initially priced at $299, and games retailed for as much as $60. Sony’s Tokyo-based executives had reportedly been insisting on a $350 to $400 price for PlaySta- tion, but Olafsson pushed hard for the lower price. Because of the fallout from this internal battle, in January 1996, Olafsson resigned from Sony. By then, however, Sony was following Olafsson’s script.37

Sony’s prelaunch work was rewarded with strong early sales. More than 800,000 PlayStations and 4 million games had been sold in the United States by January 1996. In May 1996, with 1.2 million PlayStations shipped, Sony reduced the price of PlayStation to $199. Sega responded with a simi- lar price cut for its Saturn. The prices on some of Sony’s initial games were also reduced to $29.99. The weekend after the price cuts, retailers reported that PlayStation sales were up by between 350% and 1,000% over the prior week.38 The sales surge con- tinued through 1996. By the end of the year, sales of PlayStation and associated software amounted to $1.3 billion, out of a total for United States sales at $2.2 billion for all video game hardware and soft- ware. In March 1997, Sony cut the price of Play- Station again, this time to $149. It also reduced its suggested retail price for games by $10 to $49.99. By this point, Sony had sold 3.4 million units of PlayStation in the United States, compared to Saturn’s 1.6 million units.39 Worldwide, PlayStation had outsold Saturn by 13 million to 7.8 million units, and Saturn sales were slowing.40 The momentum was clearly running in Sony’s favor, but the company now had a new challenge to deal with: Nintendo’s latest generation game machine, the N64.

Nintendo Strikes Back In July 1996, Nintendo launched Nintendo 64 (N64) in the Japanese market. This release was followed by a late fall introduction in the United States. N64 is a 64-bit machine developed in conjunction with Silicon Graphics. Originally targeted for introduc- tion a year earlier, N64 had been under development since 1993. The machine used a plug-in cartridge format rather than a CD-ROM drive. According to Nintendo, cartridges allow for faster access time and

C46 Section A: Business Level Cases: Domestic and Global

are far more durable than CD-ROMs (an important consideration with children).41

The most-striking feature of the N64 machine, however, was its 3D graphics capability. N64 pro- vides fully rounded fi gures that can turn on their heels and rotate through 180 degrees. Advanced ray- tracing techniques borrowed from military simula- tors and engineering workstations added to the sense of realism by providing proper highlighting, refl ec- tions, and shadows.

N64 was targeted at children and young teen- agers. It was priced at $200 and launched with just four games. Despite the lack of games, initial sales were very strong. Indeed, 1997 turned out to be a banner year for both Sony and Nintendo. The overall United States market was strong, with sales of hardware and software combined reaching a record $5.5 billion. Estimates suggest that PlayStation accounted for 49% of machines and games by value. N64 captured a 41% share, leaving Sega trailing badly with less than 10% of the market. During the year, the aver- age price for game machines had fallen to $150. By year-end there were 300 titles available for PlaySta- tion, compared to 40 for N64. Games for PlaySta- tion retailed for $40, on average, compared to more than $60 for N64.42

By late 1998, PlayStation was widening its lead over N64. In the crucial North American market, PlayStation was reported to be outselling N64 by a two-to-one margin, although Nintendo retained a lead in the under-12 category. At this point, there were 115 games available for N64 versus 431 for PlayStation.43 Worldwide, Sony had now sold close to 55 million PlayStations. The success of PlaySta- tion had a major impact on Sony’s bottom line. In fi scal 1998, PlayStation business generated revenues of $5.5 billion for Sony, 10% of its worldwide rev- enues, but accounted for $886 million, or 22.5%, of the company’s operating income.44

The 128-Bit Era When Nintendo launched its 64-bit machine in 1996, Sony and Sega did not follow, preferring instead to focus on the development of even more powerful 128-bit machines.

Sega was the fi rst to market a 128-bit video game console, which it launched in Japan in late 1998 and

in the United States in late 1999. The Dreamcast came equipped with a 56-kilobit modem to allow for online gaming over the Internet. By late 2000, Sega had sold approximately 6 million Dreamcasts worldwide, accounting for about 15% of console sales since its launch. Sega nurtured Dreamcast sales by courting outside software developers who helped develop new games, including Crazy Taxi, Resident Evil, and Quake III Arena. The company had a goal of shipping 10 million units by March 2001, a goal it never reached.45

Despite its position as fi rst mover with a 128-bit machine, and despite solid technical reviews, by late 2000 the company was struggling. Sega was handi- capped fi rst by product shortages due to constraints on the supply of component parts and then by a lack of demand as consumers waited to see whether Sony’s 128 bit offering, the much anticipated Play- Station 2 (PS2), would be a more attractive machine. In September 2000, Sega responded to the impend- ing United States launch of Sony’s PS2 by cutting the price for its console from $199 to $149. Then in late October, Sega announced that, due to this price cut, it would probably lose more than $200 million for the fi scal year ending March 2001.46

Sony’s PlayStation 2 PS2 was launched in Japan in mid-2000 and in the United States at the end of October 2000. Initially priced at $299, PS2 is a powerful machine. At its core was a 300-megahertz graphics processing chip that was jointly developed with Toshiba and consumed about $1.3 billion in R&D. Referred to as the Emotion Engine processor, the chip allows the machine to display stunning graphic images previously found only on supercomputers. The chip made the PS2 the most powerful video game machine yet.

The machine was set up to play different CD and DVD formats, as well as proprietary game titles. As is true with the original PlayStation, PS2 could play audio CDs. The system was also compatible with the original PlayStation: any PlayStation title could be played on the PS2. To help justify the initial price tag, the unit doubled as a DVD player with picture qual- ity as good as current players. The PS2 did not come equipped with a modem, but it did have networking capabilities, and a modem could be attached using one of two USB ports.47

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C47

Nintendo GameCube Nintendo had garnered a solid position in the indus- try with its N64 machine by focusing on its core demographic, 7- to 12-year-olds. In 1999, Nintendo took 33% of the hardware market and 28% of the game market. Nintendo’s next generation video game machine, GameCube, packed a modem and a powerful 400-megahertz, 128-bit processor made by IBM into a compact cube. GameCube marked a shift away from Nintendo’s traditional approach of using proprietary cartridges to hold game soft- ware. Instead, software for the new player came on 8-centimeter CDs, which are smaller than music CDs. The disks held 1.5 gigabytes of data each, far greater storage capacity than the old game cartridges. Players could control GameCube by using wireless controllers.48

Nintendo tried to make the GameCube easy for developers to work with rather than focusing on raw peak performance. While developers no doubt appreciated this, by the time GameCube hits store shelves in late 2001, PS2 had been on the market for 18 months and boasted a solid library of games. Despite its strong brand and instantly recognized intellectual property, which included Donkey Kong, Super Mario Brothers, and the Pokémon characters, Nintendo was playing catch-up to Sony. Moreover, another new entrant into the industry launched its 128 bit offering at about the same time: Microsoft.

Microsoft’s Xbox Microsoft was fi rst rumored to be developing a video game console in late 1999. In March 2000, Bill Gates made it offi cial when he announced that Microsoft would enter the home video game market in fall 2001 with a console code named Xbox. In terms of sheer computing power, the 128-bit Xbox had the edge over competitors. Xbox had a 733-megahertz Pentium III processor, a high-powered graphics chip from Nvidia Corp, a built-in broadband cable modem to allow for online game playing and high-speed Internet brows- ing, 64 megabytes of memory, CD and DVD drives, and an internal hard disk drive. The operating system was a stripped-down version of its popular Windows system optimized for graphics-processing capabili- ties. Microsoft claimed that because the Xbox was based on familiar PC technology, it would be much

easier for software developers to write games for, and it would be relatively easy to convert games from the PC to run on the Xbox.49

Although Microsoft was a new entrant to the video game industry, it was no stranger to games. Microsoft had long participated in the PC gaming industry and was one of the largest publishers of PC games, with hits such as Microsoft Flight Simu- lator and Age of Empires I and II to its credit. Sales of Microsoft’s PC games increased 50% annually between 1998 and 2001, and the company con- trolled about 10% of the PC game market in 2001. Microsoft also offered online gaming for some time, including its popular MSN Gaming Zone site. Started in 1996, by 2001 the Web site had become the largest online PC gaming hub on the Internet, with nearly 12 million subscribers pay- ing $9.95 a month to play premium games, such as Asheron’s Call or Fighter Ace. Nor was Micro- soft new to hardware; its joysticks and game pads outsell all other brands, and it had an important mouse business.

To build the Xbox, Microsoft chose Flextron- ics, a contract manufacturer that already made computer mice for Microsoft. Realizing that it would probably have to cut Xbox prices over time, Microsoft guaranteed Flextronics a profi t margin, effectively agreeing to subsidize Flextronics if sell- ing prices fell below a specifi ed amount. By 2003, Microsoft was thought to be losing $100 on every Xbox sold. To make that back and turn a profi t, Microsoft reportedly had to sell between six and nine video games per Xbox.50

Analysts speculated that Microsoft’s entry into the home video game market was a response to a potential threat from Sony. Microsoft was worried that Internet-ready consoles like PS2 might take over many Web-browsing functions from the per- sonal computer. Some in the company described Internet-enabled video game terminals as Trojan horses in the living room. In Microsoft’s calcula- tion, it made sense to get in the market to try and keep Sony and others in check. With annual reve- nues in excess of $20 billion worldwide, the home video game market is huge and an important source of potential growth for Microsoft. Still, by moving away from its core market, Microsoft was taking a big risk, particularly given the scale of investments required to develop the Xbox, reported to run as high as $1.5 billion.

C48 Section A: Business Level Cases: Domestic and Global

Mortal Combat: Microsoft versus Sony The launch of Xbox and GameCube helped pro- pel sales of video game hardware and software to a record $9.4 billion in 2001, up from $6.58 billion in 2000. Although both Xbox and Nintendo initially racked up strong sales, the momentum started to slow signifi cantly in 2002. Microsoft, in particular, found it very diffi cult to penetrate the Japanese market. By September 2002, Sony had sold 11.2 million units of PS2 in the United States versus 2.2 million units of Xbox and 2.7 million units of Nintendo’s GameCube. Unable to hold onto market share in the wake of the new competition, Sega withdrew from the console market, announcing that, henceforth, it would focus just on developing games for other platforms.

In June 2002, Sony responded to the new entry by cutting the price for PS2 from $299 to $199. Micro- soft quickly followed, cutting the price for Xbox from $299 to $199, while Nintendo cut its price from $299 to $149.51 A year later, Sony cut prices again, this time to $179 a console. Again, Microsoft followed with a similar price cut, and in March 2004 it took the lead, cutting Xbox prices to $149. Sony followed suit two months later.52

Microsoft’s strategy, however, involved far more than just cutting prices. In November 2002 Micro- soft announced that it would introduce a new service for gamers, Xbox Live. For $50 a year, Xbox Live subscribers with broadband connections would be able to play online-enabled versions of Xbox games with other online subscribers. To support Xbox Live, Microsoft invested some $500 million in its own data centers to host online game playing.

Online game playing was clearly a strategic prior- ity from the outset. Unlike the PS2 and GameCube, Xbox came with a built in broadband capability. The decision to make the Xbox broadband capa- ble was made back in 1999 when less than 5% of United States homes were linked to the Internet with a broadband connection. Explaining the decision to build broadband capabilities into the Xbox at a time when rivals lacked them, the head of Xbox, Jay Allard, noted that “My attitude has always been to bet on the future, not against it.”53 While Sony’s PS2 can be hooked up to the Internet via a broadband connection, doing so requires the purchase of a spe- cial network adapter for $40.

By mid-2003, Xbox Live had some 500,000 sub- scribers, versus 80,000 who had registered to play PS2 games online. By this time there were 28 online games for Xbox and 18 for PS2. By January 2004, the comparative fi gures stood at 50 for Microsoft and 32 for Sony. By mid-2004, Xbox Live report- edly had over one million subscribers, with Sony claiming a similar number of online players.54 In May 2004, Microsoft struck a deal with EA, the world’s largest video game publisher, to bring EA games, including its best selling Madden Football, to the Xbox Live platform. Until this point, EA had only produced live games for Sony’s platform.

In spite of all these strategic moves, by late 2004, Xbox was still a distant second to PS2 in the video game market, having sold 14 million con- soles against Sony’s 70 million (Nintendo had sold 13 million GameCube consoles). While Sony was making good money from the business, Microsoft was registering signifi cant losses. In fi scal 2004, Microsoft’s home and entertainment division, of which Xbox is the major component, registered $2.45 billion in revenues, but lost $1.135 billion. By way of contrast, Sony’s game division had $7.5 billion of sales in fi scal 2004 and generated operating profi ts of $640 million.

Microsoft, however, indicated that it was in the business for the long term. In late 2004, the company got a boost from the release of Halo 2, the sequel to Halo, one of its best-selling games. As fi rst-day sales for Halo 2 were totaled, exec- utives at Sony had to be worried. Microsoft announced that Halo 2 had sales of $125 million in its fi rst 24 hours on the market in the United States and Canada, an industry record. These fi gures represented sales of 2.38 million units and put Halo 2 fi rmly on track to be one of the big- gest video games ever with a shot at surpassing Nintendo’s Super Mario 64, which had sold $308 million in the United States since its September 1996 debut. Moreover, the company was rumored to be ahead of Sony by as much as a year to bring the next generation video game con- sole to market. In late 2004, reports suggested that Xbox 2 would be on the market in time for the 2005 Christmas season, probably a full year ahead of Sony’s PlayStation 3 (PS3). Sony was rumored to be running into technical problems while develop- ing the PS3.55

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C49

The Next Generation As the battle between PS2 and Xbox drew to a close, it was clear that Sony was the big winner. From 2001 through the fall of 2006, when PS3 hit the market, Sony had sold about 110 million PS2 consoles, ver- sus 25 million for Microsoft’s Xbox and 21 million for Nintendo’s GameCube.56 Sony’s advantage in its installed base translated into a huge lead in num- ber of games sold: approximately 1.08 billion for PS2 by mid-2006 versus 200 million for the Xbox.57 With the console companies reportedly making an average royalty on third-party software of $8 per game sold, the fi nancial implications of Sony’s lead with PS2 are obvious.58 Indeed, in 2005 Sony’s games division contributed to 6.24% of the com- pany’s total revenue but 38% of operating profi t. In contrast, Microsoft’s home and entertainment divi- sion lost $4 billion between the launch of Xbox and mid-2006.

However, by 2006, this was all history. In November 2005, Microsoft introduced its next gen- eration machine, Xbox 360, beating Sony and Nin- tendo to the market by a solid year. The Xbox 360 represented a big technological advance over the original Xbox. To deliver improved picture quality, the Xbox 360 could execute 500 million polygons per second: a four-fold increase over the Xbox. The main microprocessor was 13 times faster than the chip in the Xbox. Xbox 360 had 512 megabytes of memory, an 8-fold increase, and a 20-gigabyte hard drive, 2.5 times bigger than that found on the Xbox. Xbox 360 is, of course, enabled for a broadband connection to the Internet.

The machine was made by Flextronics and Wis- tron, two contract manufacturers (a third started production after launch). Priced at $299, Xbox 360 was sold at a loss. The cost for making Xbox 360 was estimated to be as high as $500 at launch, fall- ing to $350 by late 2006. Microsoft’s goal was to ultimately break even on sales of the hardware as manufacturing effi ciencies drove down unit costs.

To seed the market with games, Microsoft took a number of steps. Taking a page out of its Windows business, Microsoft provided game developers with tools designed to automate many of the key software programming tasks and reduce development time and costs. The company had also expanded its own in-house game studios, in part by purchasing sev- eral independent game developers, including Bungie

Studios, makers of Halo. This strategy enabled Micro- soft to offer exclusive content for the Xbox 360, something that third parties were reluctant to do.

With the costs of game development increas- ing to between $10 and $15 million for more com- plex games, and development time stretching out to between 24 and 36 months, Microsoft also had to provide an inducement to get third-party develop- ers onboard. Although details of royalty terms are kept private, it is believed that Microsoft offered very low royalty rates, and perhaps even zero royal- ties, for a specifi ed period of time to game developers who committed early to Xbox 360. One of those to commit early was EA, the leading independent game development company, which reportedly budgeted as much as $200 million to develop some 25 versions of its best-selling games, such as its sports games, for Xbox 360. Microsoft budgeted a similar amount to develop its own games.59

In the event, some 18 games were available for the November 2005 launch of Xbox 360, and by the end of 2006, this fi gure had increased to about 160. Halo 3, which was expected to be one of the big- gest games for Xbox 360, was released in September 2007. Exclusive to the Xbox 360, Halo 3 racked in fi rst-day sales of $170 million, which was an indus- try record. Grand Theft Auto 4, the most popular franchise on PS2, was also launched simultaneously for both Xbox 360 and PS3 in 2007: a major coup for Microsoft.

The initial launch of Xbox 360 was marred by shortages of key components, which limited the number of machines that Microsoft could bring to market. Had Sony been on time with its launch of PS3, this could have been a serious error, but Sony delayed its launch of PS3, fi rst until spring of 2006 and then November 2006. By the time Sony launched PS3 in November 2006, some 6 million Xbox 360 consoles had been sold, and Microsoft was predicting sales of 10 million by the end of 2006.

As with Xbox, Microsoft pushed Xbox Live with Xbox 360. The company invested as much as $1 billion in Live from its inception. By late 2006 Microsoft was claiming that some 60% of Xbox 360 customers had also signed on for Xbox Live and that the service had 4 million subscribers. By early 2008, there were more than 10 million subscribers. Xbox Live allowed users to play against each other online and to download digital content from Xbox Live

C50 Section A: Business Level Cases: Domestic and Global

Marketplace. Looking forward, there is little doubt that Microsoft sees Xbox Live as a critical element of its strategy, enabling Xbox owners to download any digital content—games, fi lm, music—onto their con- soles, which could become the hub of a home digital entertainment system.

The business model for Xbox 360 depends on the number of games sold per console, the percent- age of console owners who sign up for Xbox Live, sales of hardware accessories (e.g., controllers, an HD-DVD drive, wireless networking adapter), and the console itself achieving break-even production costs. Reports suggest that Microsoft will break even if each console owner buys six to seven games, two to three accessories, and some 10 million sign on to Xbox Live (Microsoft splits Xbox Live revenues with game developers). By the end of 2006, it was estimated that some 33 million games had been sold for Xbox 360.60

Sony fi nally introduced PS3 on November 11, 2006 in Japan and November 17, 2006 in the United States. The delay in the launch of PS3 was due to Sony’s decision to bundle a Blu-ray drive with PS3, along with problems developing the “cell” proces- sor that sits at the core of the PS3. Blu-ray is Sony’s proprietary HD-DVD format. The company is cur- rently locked in a format war with Toshiba, which is pushing its rival HD-DVD format (which can be purchased as an accessory for the Xbox 360). Sony has argued that the combination of its cell proces- sor and Blu-ray DVD drive will give PS3 a substan- tial performance edge over Xbox 360. While this is true in a technical sense (the Blu-ray discs have fi ve times the storage capacity of the DVD discs for Xbox 360), few reviewers have noticed much in the way of difference from a game playing perspective— perhaps because few games were initially available that showed the true power of the PS3.

What is certain is that incorporating Blu-ray drives in the PS3 has signifi cantly raised the costs of the PS3. Sony is selling its standalone Blu-ray drives for $999, which suggests that the PS3, ini- tially priced at between $500 and $600 depend- ing on confi guration, is in a sense a subsidized Blu-ray player. Shortages of blue diodes, a critical component in HD-DVD drives, also limited sup- ply of the PS3 after its launch. Only 93,000 PS3 players were available for the Japanese launch. At launch, there were some 20 games available for the PS3. Sony also announced its own live offering to

compete with Xbox Live and stated that it would be free to PS3 users.

Nintendo is also back in the fray. In November 2006, it launched its own next generation offer- ing, Wii. When developing the Wii, Nintendo made a number of interesting strategic decisions. First, it decided not to compete with Microsoft and Sony on graphics processing power. Instead of devel- oping a high-powered machine crammed full of expensive custom-built components, they used off- the-shelf components to assemble a much cheaper machine that could be sold at a much lower price point (the initial price was $250). Although this machine did not offer the graphics processing capa- bilities of Xbox 360 or PS3, the games were cheaper to develop, about $5 million each as opposed to as much as $20 million for the PS3. Second, Nin- tendo decided to target a new demographic, indif- ferent people who had no interest in video games, as opposed to the stereotypical game player. Nintendo already had some evidence that this market could be tapped and would be extremely lucrative. In 2004, Nintendo had introduced a game for its handheld player, the DS, that was aimed not at its core 7- to 12-year-old demographic but at much wider mar- ket. The game, Brain Age, based on a brain training regime developed by a Japanese neuroscientist, was a huge hit in Japan, with sales of more than 12 million units. It made the DS a hit in such unlikely places as nursing homes. Third, rather than processing power, Nintendo decided to focus on developing a motion sensitive, wireless controller that could detect arm and hand motions and transfer them to the screen. This enabled the development of interactive games, with players physically controlling the action on screen by moving their arms, whether by swinging an imaginary bat, driving a go-kart, or slashing a sword through the air.61

By early 2007, it was clear that the Wii was turning into a surprise hit. The combination of low price, innovative design, and a portfolio of recogniz- able games based on Nintendo’s long-established franchises, such as Mario Brothers and Pokémon, helped to drive sales forward. Moreover, as planned, the Wii seemed to have appeal to a broad range of age groups and both genders. Soon articles started to appear explaining how retirement homes were buying the Wii so that residents could play virtual baseball with their visiting grandchildren, and sales started to accelerate.

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C51

By 2008, Nintendo had seized the leadership position in the industry (see Exhibit 1). Cumulatively, the Wii had sold some 32 million units worldwide by September 2008, compared to 20.6 million units for Xbox 360 and 15.3 million units for the PS3. More- over, Nintendo had established a strong position in all major markets, unlike Microsoft for example, which had been unable to garner signifi cant Xbox

360 sales in Japan. The popularity of the Wii helped to drive Nintendo’s sales and earnings to record levels, with net profi ts forecasted to reach a record $3.78 billion for the year ending March 2009. Nintendo’s market capitalization on the Japanese stock market surpassed Sony’s, and in September 2008 it was second only to Toyota. It would appear that Nintendo was back.

Exhibit 1 Cumulative Sales of Platform Through September 2008 (millions of units)

0 Wii Xbox360 PS3

5

10

15

20

25

30

35

Japan American Other

Source: Raw data from VG Chartz at http://www.vgchartz.com/.

Endnotes

8. M. Schrage, “The High Tech Dinosaurs: Video Games, Once Ascendant, Are Making Way,” Washington Post, July 31, 1983, F1.

9. D. Sheff, Game Over, New York: Random House, 1993.

10. Quoted in D. Sheff, Game Over, New York: Random House, 1993, 38.

11. D. Sheff, Game Over, New York: Random House, 1993.

12. D. Golden, “In Search of Princess Toadstool,” Boston Globe, November 20, 1988, 18.

13. N. Gross, and G. Lewis, “Here Come the Super Mario Bros.,” Business Week, November 9, 1987, 138.

14. D. Sheff, Game Over, New York: Random House, 1993. 15. D. Golden, “In search of Princess Toadstool,” Boston

Globe, November 20, 1988, 18.

1. A good account of the early history of Bushnell and Atari can be found in S. Cohen, Zap! The Rise and Fall of Atari, New York: McGraw-Hill, 1984.

2. R. Isaacs, “Video Games Race to Catch a Changing Market,” Business Week, December 26, 1977, 44B.

3. P. Pagnano, “Atari’s Game Plan to Overwhelm Its Com- petitors,” Business Week, May 8, 1978, 50F.

4. R. Isaacs, “Video Games Race to Catch a Changing Market,” Business Week, December 26, 1977, 44B.

5. P. Pagnano, “Atari’s Game Plan to Overwhelm Its Competitors,” Business Week, May 8, 1978, 50F; and D. Sheff, Game Over, New York: Random House, 1993.

6. S. Cohen, Zap! The Rise and Fall of Atari, New York: McGraw-Hill, 1984.

7. L. Kehoe, “Atari Seeks Way out of Video Game Woes,” Financial Times, December 14, 1983, 23.

http://www.vgchartz.com/
C52 Section A: Business Level Cases: Domestic and Global

16. Staff Reporter, “Marketer of the Year,” Adweek, November 27, 1989, 15.

17. C. Lazzareschi, “No Mere Child’s Play,” Los Angeles Times, December 16, 1988, 1.

18. For a good summary of the early history of Sega, see J. Battle, and B. Johnstone, “The Next Level: Sega’s Plans for World Domination,” Wired, release 1.06, December 1993.

19. D. Sheff, Game Over, New York: Random House, 1993.

20. J. Battle, and B. Johnstone, “The Next Level: Sega’s Plans for World Domination,” Wired, release 1.06, December 1993.

21. For background details, see J. Flower, “3DO: Hip or Hype?” Wired, release 1.02, May/June 1993.

22. R. Brandt, “3DO’s New Game Player: Awesome or another Betamax?” Business Week, January 11, 1993, 38.

23. J. Flower, “3DO: Hip or Hype?” Wired, release 1.02, May/June 1993.

24. S. Jacobs, “Third Time’s a Charm (They Hope),” Wired, release 2.01, January 1994.

25. A. Dunkin, “Video Games: The Next Generation,” Business Week, January 31, 1994, 80.

26. J. Greenstein, “No Clear Winners, Though Some Los- ers: The Video Game Industry in 1995,” Business Week, December 22, 1995, 42.

27. Staff Reporter, “3DO Says ‘I Do’ on Major Shift of Its Game Strategy,” Los Angeles Times, September 17, 1996, 2.

28. J. Battle, and B. Johnstone, “The Next Level: Sega’s Plans for World Domination,” Wired, release 1.06, December 1993.

29. J. Greenstein, “No Clear Winners, Though Some Los- ers: The Video Game Industry in 1995,” Business Week, December 22, 1995, 42.

30. D. P. Hamilton, “Sega Suddenly Finds Itself Embattled,” Wall Street Journal, March 31, 1997, A10.

31. S. Taves, “Meet Your New Playmate,” Wired, release 3.09, September 1995.

32. Kunni, I., “The Games Sony Plays,” Business Week, June 15, 1998, 128.

33. C. Platt, “WordNerd,” Wired, release 3.10, October 1995.

34. I. Kunni, “The Games Sony Plays,” Business Week, June 15, 1998, 128.

35. J. A. Trachtenberg, “Race Quits Sony Just Before U.S. Rollout of Its PlayStation Video-Game System,” Wall Street Journal, August 8, 1995, B3.

36. S. Beenstock, “Market Raider: How Sony Won the Con- sole Game,” Marketing, September 10, 1998, 26.

37. J. A. Trachtenberg, “Olafsson Calls It Quits as Chair- man of Sony’s Technology Strategy Group,” Wall Street Journal, January 23, 1996, B6.

38. J. Greenstein “Price Cuts Boost Saturn, PlayStation Hardware Sales,” Video Business, May 31, 1996, 1.

39. Greenstein, J., “Sony Cuts Prices of PlayStation Hard- ware,” Video Business, March 10, 1997, 1.

40. D. Hamilton, “Sega Suddenly Finds Itself Embattled,” Wall Street Journal, March 31, 1997, A10.

41. Staff Reporter, “Nintendo Wakes Up,” The Economist, August 3, 1996, 55–56.

42. D. Takahashi, “Game Plan: Video Game Makers See Soaring Sales Now—And Lots of Trouble Ahead,” Wall Street Journal, June 15, 1998, R10.

43. D. Takahashi, “Sony and Nintendo Battle for Kids under 13,” Wall Street Journal, September 24, 1998, B4.

44. I. Kunni, “The Games Sony Plays,” Business Week, June 15, 1998, 128.

45. R. A. Guth, “Sega Cites Dreamcast Price Cuts for Loss Amid Crucial Time for Survival of Firm,” Wall Street Journal, October 30, 2000, A22.

46. R. Guth, “Sega Cites Dreamcast Price Cuts for Loss Amid Crucial Time for Survival of Firm,” Wall Street Journal, October 30, 2000, A22.

47. T. Oxford, and S. Steinberg, “Ultimate Game Machine Sony’s PlayStation 2 Is Due on Shelves Oct. 26. It Brims with Potential—But at This Point Sega’s Dreamcast Appears a Tough Competitor,” Atlanta Journal/Atlanta Constitution, October 1, 2000, P1.

48. R. A. Guth, “New Players from Nintendo Will Link to Web,” Wall Street Journal, August 25, 2000, B1.

49. D. Takahashi, “Microsoft’s X-Box Impresses Game Developers,” Wall Street Journal, March 13, 2000, B12.

50. K. Powers, “Showdown,” Forbes, August 11, 2003, 86–87.

51. The Economist, “Console Wars,” June 22, 2002, 71. 52. R. A. Guth, “Game Gambit: Microsoft to Cut Xbox

Price,” Wall Street Journal, March 19, 2004, B1. 53. K. Powers, “Showdown,” Forbes, August 11, 2003,

86–87. 54. E. Taub, “No Longer a Solitary Pursuit: Video Games

Move Online,” New York Times, July 5, 2004, C4. 55. J. Greene and C. Edwards, “Microsoft Plays Video Leap-

frog,” Business Week, May 10, 2004, 44–45. 56. “Playing a Long Game,” The Economist, November 18,

2006, 63–65. 57. B. Thill, “Microsoft: Gat Game? Update on Vista, Xbox

and the Tender,” Citigroup Capital Markets, August 30, 2006.

58. Ibid. 59. D. Takahashi, The Xbox 360 Uncloaked, Spider Works,

2006. 60. B. Thill, “Microsoft: Gat Game? Update on Vista, Xbox

and the Tender,” Citigroup Capital Markets, August 30, 2006.

61. J. M. O’Brian and C. Tkaczyk, “Wii Will Rock You,” Fortune, June 11, 2007, 82–92.

Cover
Title Page
Copyright
Contents
Preface
PART ONE: INTRODUCTION TO STRATEGIC MANAGEMENT
Chapter 1 The Strategy-Making Process
Competitive Advantage and Superior Performance
Running Case: Walmart’s Competitive Advantage
Strategic Managers
The Strategy-Making Process
Strategy as an Emergent Process
Strategy in Action 1.1: A Strategic Shift at Microsoft
Strategic Planning in Practice
Strategic Decision Making
Strategic Leadership
Practicing Strategic Management
Closing Case: Planning for the Chevy Volt
Chapter 2 Stakeholders, The Mission, Governance, and Business Ethics