November 30, 2001

Article at Asiaweek

Playing the Field (cover story)

Alliances and battle lines are forming as Microsoft comes thundering into the $20 billion video-game industry. For once proud Sega, survival means staying neutral — and staying out of the console manufacturing business

A hospital room is not the best place to plot corporate survival strategy, but that's where Tetsu Kayama found himself late last December. Brought in to reverse the fast-fading fortunes of Sega, Kayama took to the bedside of ailing Sega president Isao Okawa to discuss how to restore the Japanese video-game maker to health after four consecutive years of losses. In that cheerless, antiseptic atmosphere, the pair made a decision that represented an unthinkable humiliation to the company's rank-and-file programmers: Sega, once the maker of the world's best-selling video-game console, would exit the hardware business. 

Okawa died of heart failure in March at the age of 74. Sega, rumored to be on the verge of bankruptcy, survives. By abandoning production of its money-losing Dreamcast console, Sega on Nov. 20 was able to report a surprising $46.9 million operating profit for the six months through Sept. 30. Now a software company that designs and publishes video games, Sega is not fully recovered: The company lost $169 million overall in the first half due to the plunging value of its investments, and its executives have said it could lose $123.8 million in its 2002 fiscal year. "We have to convince [game] developers that Sega is still strong and valuable with a bright future," Kayama says. But, assisted by a $692 million private donation Okawa made to the company before he died, "we have been able to make the turnaround to a financially safe situation," Kayama says. 

If there is a moral to the hospital room drama, it is this: The game console business is an elephant's burial ground — the most perilous sector of the $20 billion global video-game industry in which hefty companies can get trampled. This month, computer software behemoth Microsoft entered the business with the U.S. release of its first game console, the Xbox. Nintendo, the Japanese game juggernaut behind the PokEmon phenomenon, followed suit a few days later, introducing its new video-game machine called the GameCube. 

Meanwhile, consumer electronics giant Sony is trying to build on its leadership position behind its dominant PlayStation 2 console. None of the trio plan to profit by selling the boxes alone. Microsoft readily concedes its exotic Internet-enabled appliance will be bleeding money for years. But the company that wins enough converts to its game machines can expect to reap big rewards in years to come through the sales of the games that run on the machines. 

The central truth of the industry is that content is king — the money and margins are in the software. Now, as the giants of the computer and consumer electronics industries prepare for the latest round of hardware wars, it is independent game developers that find themselves in the role of kingmaker. Requiring hit titles to popularize their platforms, the console giants need companies such as the born-again Sega like a razor company needs blades. The console fight "is going to be about who has what titles," says David Wu, president of Montreal-based developer Pseudo Interactive, which just finished making a version of its Cel Damage game for the Nintendo console. "The technology has become a commodity. It's all about the games." 

While the industry chatter leading up to the debut of the Xbox dwelled in standard wonk fashion on the relative technical merits of Microsoft, Sony and Nintendo machines, behind the scenes the console makers have been competing to win the hearts and minds of the hot independent development houses. Above all, they want to prevent previously loyal game creators from bolting to another camp. Last year, U.S. developer Naughty Dog, creator of Crash Bandicoot titles, was reportedly considering bringing out games for the Xbox. Crash Bandicoot is one of the leading game series for the Sony PlayStation. The Bandicoot franchise is akin to Nintendo's Super Mario Brothers, Sega's Sonic the Hedgehog or, for that matter, Disney's Mickey Mouse. Rather than risk having a key brand identified with the competition, Sony bought Naughty Dog outright for an undisclosed sum. 

To further defend the PlayStation, Sony recently invested $125 million in Tokyo-based Square, the maker of the blockbuster role-playing Final Fantasy games. The deal does not lock Square into an exclusive development deal with Sony. But "to some degree there are financial incentives that can be provided to cause a game to go onto a single console," says Edward Williams, games analyst at investment bank Gerard Klauer Mattison & Co. Typically, game-machine manufacturers get a royalty of roughly 10% for every third-party game sold. "With Sony putting all that money into Square," Williams says, "it will not support — either officially or effectively — any of the other consoles." 

Score one for the entrenched incumbent. Sony currently dominates the industry because more than 100 million PlayStations and 20 million PlayStation 2s have been sold worldwide. There are well over 100 PlayStation games available compared with just a handful for the Xbox and the GameCube. But Microsoft and Nintendo are busily grooming their own talented stables to challenge Sony. Microsoft last summer purchased Bungie, a small U.S. shop that created Halo, a Marines-vs.-aliens shoot-'em-up that, with its dazzling graphics, is generating serious buzz for the Xbox. Meanwhile Nintendo is banking heavily on GameCube titles from its in-house superstar developer Shigeru Miyamoto, the inventor of Super Mario Brothers, The Legend of Zelda, and now Pikmin, a cartoonish role-playing game involving aliens and a downed spacecraft, which is being positioned as the flagship franchise for the GameCube.

Unlike Microsoft and Sony, Nintendo is relying heavily on internal game creation rather than independent developers to generate content for the GameCube. The model has been a profitable one in the past. Having a top developer or two in your back pocket helps secure a pipeline of blockbusters. In the late 1980s and early 1990s, Nintendo ruled the industry by zealously controlling all aspects of game creation, production and marketing (profit margins on games developed in-house can be as high as 70%). Sony's PlayStation relegated Nintendo to the No. 2 spot. But the company remains one of the world's top software publishers, holding 27 of the top 50 positions on Japan's all-time best-selling video games list, according to the the Computer Entertainment Software Association. Says Williams of Gerard Klauer Mattison: "Since they control the intellectual property — the Zeldas and Marios — the only way to play it is to go through them." 

Microsoft and Sony, meanwhile, depend more upon alliances with independent developers. They have to lobby harder and cajole more to convince developers to create for their platforms. "There's a marked lack of loyalty in this industry," says Jay Defibaugh, games analyst at Credit Suisse First Boston in Japan. "There is loyalty to particular games, but not to brands." 

With the entry of Microsoft's Xbox, independents, including Sega, are hedging their bets. Having sworn off hardware, Kayama, Sega's chief operating officer, has now assumed the role of a Swiss politician. The hard-charging, Peter- Drucker-quoting 41-year-old sees everyone as a potential ally. Sega will take a multiplatform approach, writing games not only for all three consoles but also for PCs, cellphones, handheld computers and whatever other gaming-capable devices come along. Never again, he vows, will Sega tie its fate to a single company or technology standard. "We try to look at the best strategic positioning for each platform," says Kayama. 

Building games for many different systems is expensive, even for Sega, which with 1,007 employees ranks as one of the largest independent video-game producers (U.S.-based Electronic Arts is No. 1). Sega does some in-house development but also acts as a game "publisher," a middleman between the giant console manufacturers and small independent shops. Currently Sega has 11 semiautonomous development studios, which Kayama says will be individually profitable by the end of the next fiscal year. To flourish, the company will need to spread its costs and its risks by partnering up with additional game creators holding the hottest hands and the most promising titles. 

Developing in-house remains the shortest path to profits. Sega's most important subsidiary is Sonic Team, home of Sega's flagship character Sonic the Hedgehog. The designer who created the game, Yuji Naka — president and CEO of Sonic Team — is busy these days doing what would have been anathema a year ago: making a Sonic variant for a former arch-enemy, Nintendo. Naka and his 72-member development team are also creating versions of the popular online game Phantasy Star for the GameCube, Xbox, and PC online platforms. 

Naka says the company's new multiplatform approach is giving him headaches. "Developing for just the Dreamcast was much easier," he laughs. But Naka, who never went to university, owes his illustrious Sega career to his eclectic programming experience. In a part-time job in high school, he converted computer games invented by his boss to operating systems for NEC, Fujitsu and other Japanese computers. He sees the value of an agnostic approach. "The ideal situation for Sega," he says, "is to make a game that's going to be successful on all the platforms." 

In addition to Sega's in-house stars, the company has loose affiliations with others. There's Tokyo's Yoot Saito, who represents how most people like to imagine game creators — quirky, eccentric bohemians working alone in disorganized studios. Saito wanted to be a movie director, but settled for the next-best thing. His claim to fame is Seaman, a bizarre video game for the Dreamcast console requiring players to feed and "talk" to a fishlike creature with a human face, which over time builds up a kind of personality. The fish "basically becomes an extension [of the player]," says Saito, "so it's impossible to ignore it." Seaman was a hit in Japan. Some 550,000 copies were sold for the Dreamcast. A PlayStation 2 version was released this month. 

Saito decided to build for Sony's platform for the same simple reason that most titles will continued to be made for the PlayStation 2 — it has the most users, by far. "What's important is installed base," says Sony spokesman Kenichi Fukunaga. "And that's why developers will choose us." 

But developers are also attracted to the Xbox, because it is the hardware du jour. With roughly twice the computing power of its competitors, the Xbox is powered by a Pentium III microprocessor paired with a graphics chip from Nvidia that can get so hot it requires an extra-large fan and special heat sink. The chip offers programmers the ability to produce games with Jurassic Park realism, and that's seductive. Another plus: Writing software for the Xbox isn't far different from writing games for personal computers. Last year's PlayStation 2 launch was hobbled by a lack of new games built specially for the system, because the box had a radical new architecture requiring programmers to learn new skills. In contrast, every major PC game developer is working on an Xbox title. 

Still, few believe the PlayStation 2's reign is in any immediate danger. The Xbox won't reach store shelves in Japan, which represents a third of the world market and hosts some of the best developers, until February. "The PS2 will continue to see the greatest number of titles and hits and superhits," says Arka Roy, a developer at Tokyo-based game developer Inis. Says Brian O'Rourke, senior analyst at Cahners In- Stat Group: "Nintendo will do well within its niche and might even expand to older teens with its GameCube, and Microsoft will do fine. But it's going to remain Sony first, Nintendo second, and Microsoft third through the next three to five years." 

Kayama, for his part, doesn't much care — as long as the most talked-about games come from Sega. Relieved of the drain of the high-stakes hardware race, the company can concentrate on its remaining strength. Sega plans to introduce 60 titles by next March; 11 are bound for the Xbox, among them Super Monkey Ball, a manic and promising puzzle game. The House of Sonic is also branching into online gaming, recently forming a joint venture with Taiwan's leading PC maker Acer and Japanese Internet conglomerate Softbank. Sega is making its first games for desktop PCs, and has a title in the works for Nintendo's handheld Game Boy Advance called The Pinball of the Dead. There are plans to launch 10 new game titles in the year ending March 2003 and 15 more the following year. "Without the presence of Sega on their consoles, the Xbox or PS2 will find it difficult to be truly successful," Kayama says. 

That statement may be a bit over-the-top. According to analysts, Electronic Arts is the top developer-publisher. "I don't think [Sega] is as much of a heavyweight as they imagine themselves to be," says Tokyo developer Roy. "They don't steer the industry as much as Electronic Arts or Activision — maybe they're one rank below that." Says Williams of Gerard Klauer Mattison: "Sega is in a pretty good position, but at this point I don't think their role is any different from any other third-party publisher." 

For now, Sega should just be thankful it has survived long enough to formulate a credible strategy. In an industry where content is king, the company may have found the key to winning the console wars — get rid of the console. 

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No-Fly Zones

Globalism and games don't mix in Asian markets teeming with counterfeiters

Bad news, Asian game addicts. You won't be able to get your thumbs on an Xbox until February at the earliest. That's when the hottest entrant to the console wars is scheduled to go on sale in Japan. Worse news: If you don't live in Japan, you may not be able to buy one at all, at least not through official channels, for the foreseeable future. Microsoft has yet to set release dates for the rest of the region.

Asia is nuts about video games, but for console manufacturers some regional markets are too small, too poor — or too risky — for distribution. Nintendo has an intentionally weak retail presence in parts of Asia because it does not want to see $50 game titles counterfeited and on sale in street stalls for $3. Sony doesn't distribute its PlayStation 2 console in markets such as Hong Kong either, even though the machine has been in stores elsewhere for more than a year. "We think it's important to do business where business itself is actually possible," says Kenichi Fukunaga, spokesman for Sony Computer Entertainment. "We're thinking about [distribution in] Hong Kong, Thailand, Malaysia and South Korea, but we have to make sure illegal copies won't go around."

Microsoft denies reports that it will never sell the Xbox in Hong Kong and China due to piracy concerns. But other manufacturers say that, because they tend to lose money on consoles and make money only on the games themselves, it's better to stay out of piracy havens entirely. Putting boxes on shelves not only costs money; it creates a market for fakes. "The more hardware we sell," says Nintendo spokeswoman Yasuhiro Minagawa, "the more copied software becomes available."

Once a console and its associated games become popular in Asia — this has been learned through experience — the machine itself might be knocked off. "The majority of Famicom consoles sold in China were fake," says Minagawa. (Nintendo introduced the Famicom in 1984.) "One of the original pirates sued another company for making different fakes. That's the kind of situation we're always facing in China." But shutting off the supply through authorized distribution channels is not a foolproof solution. Socalled gray market products — consoles bound for other regions that are diverted to out-of-bounds markets by middlemen — still find their way to shops in Hong Kong.

Yuji Naka, president of Sega's game development studio, Sonic Team, says the answer may be online gaming. Access to popular titles available only over the Internet is more controllable. The game code is harder to copy because it resides in a secure central "server" — a computer run by a trusted third-party such as an Internet service provider. "Whenever we detect illegal access," says Naka, "we can shut [unauthorized users] out."

This isn't mere theory. Online gaming is proving popular and even profitable in South Korea, and it is taking hold in China. Sega this month joined in a joint venture with Japan's Softbank and Acer of Taiwan to make and distribute games through speedy Internet services. "We see Asia as one of the biggest markets for the games industry from now on," says Naka. Hope hackers don't get wind of this.

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HOW THE BOXES STACK UP

MICROSOFT XBOX

POWERPOINTS: Best graphics, most processing power. Only console with a built-in hard drive

NETWORK READY? Yes

MULTIMEDIA: Doubles as DVD player, but only with separately sold remote

PRICE: $299

GAMES AVAILABLE: 25

STAR DEVELOPERS: Scores of PC game makers

HOT TITLES: Halo (Bungie Software). Takes the first-person shooter to new heights.

Dead or Alive 3 (Tecmo). Arguably the best graphics ever in a 3-D fighting game

NINTENDO GAMECUBE

POWERPOINTS: Least expensive, compact size, elegant design

NETWORK READY? No out-of-the-box broadband, but adapter is available

MULTIMEDIA: No DVD, no gimmicks

Price: $199

GAMES AVAILABLE: 14

STAR DEVELOPERS: Industry legend Shigeru Miyamoto, creator of Mario Brothers and Zelda franchise characters; Sega’s Yuji Naka, creator of Sonic the Hedgehog (Naka is also making games for Xbox and other platforms)

HOT TITLES: Star Wars Rogue Leader: Rogue Squadron II (LucasArts). The closest a video game has come to the magic of the original movie.

Super Monkey Ball (Sega). Simple yet addictive action, strong multiplayer functions. Sega’s first GameCube entry

SONY PLAYSTATION 2

Powerpoints: Critical mass of users, most titles available, but least processing power

Network ready? Broadband and hard drive add-ons sold separately

Multimedia: Doubles as DVD player

Price: $299

Games available: More than 150

Star developers: Hideo Kojima of Konami; Kazunori Yamauchi of Polyphony Digital, creator of popular Gran Turismo series

Hot titles: Metal Gear Solid 2 (Konami). One of most anticipated games ever. Players take on terrorists who’ve seized ship off New York.

Tony Hawk’s Pro Skater 3 (Neversoft Entertainment). Puts the first two versions, both good, to shame

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