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The Video-Game Wars Explode Online

Brady O'Connell, a 20-year-old horticulture student in San Juan Capistrano, Calif., is a gaming connoisseur who has collected every console introduced by a major manufacturer since he was six. He "practices" 20 hours a week and beat 3,000 other contestants last year in a 48-hour, continuous gaming marathon in Los Angeles -- winning an Xbox console and a Ford Explorer. "I always beat everybody," O'Connell claims, though he hasn't often had a chance to prove that. Until recently, he could compete only when an opponent -- his younger brother, for instance -- was in the same room.

No longer. Over the past three months, the Big Three console makers -- Sony (SNE), Nintendo, and Microsoft (MSFT) -- have enabled their customers to go online. In August, market leader Sony unveiled a $39.99 network adapter that lets gamers hook up their PlayStation2s to the Net. The initial shipment of 250,000 units flew off the shelves. Then, in October, No. 2 Nintendo released its $34.95 adapter for the GameCube, another hot seller.

And on Nov. 15, software giant Microsoft, whose Xbox already features a built-in Ethernet port, went one step further: Whereas PlayStation2 and GameCube owners must go to game publishers' sites to sign up for games, Xbox owners can now prowl a proprietary, premium-priced Microsoft online-gaming service, called Xbox Live, which works only with Xbox consoles.

OPPORTUNITY AND NECESSITY. The initial batch of 150,000 Xbox Live starter kits -- $49.95 for a one-year online subscription plus a headset for talking with other gamers during online contests -- disappeared almost immediately. "After the first week, we've already exceeded our wildest expectations for the whole holiday season," says Scott Henson, director of platform strategy for Xbox, though he concedes it could take years for Microsoft to recoup its investment in Xbox Live.

O'Connell signed up the first day and soon found himself butting heads with people regarded as the world's best players. He even plays the robot battle game Unreal Championship with his 16-year-old brother -- who still lives at home. Incidentally, O'Connell still claims he always wins.

The Net strategies of console makers reflect opportunity -- and necessity. The opportunity is to grab more revenue from the 47 million people who already have a PlayStation2, a GameCube (10 million), or an Xbox (8.2 million). In just three months, some 400,000 gamers have outfitted their consoles to work on the Web, estimates Mike Cruz, an analyst with market consultancy GartnerG2. As yet, that's a drop in the ocean, vs. the 32 million North American households currently using PCs for online gaming.

DIFFERENT PATHS. The necessity is to reignite demand for game consoles, a $9.4 billion industry. About 65 million gamers already have consoles, which means the market for traditional versions is approaching saturation. Unless console makers find a way to stimulate sales, Cruz says their market penetration -- 29% of U.S. households -- will creep up to only 36% over the next five years.

Console makers are taking different paths to address this challenge. Sony is placing its bets on a multimedia console that can play games, music, and movies, says Andrew House, an executive vice-president with Sony Computer Entertainment America. PlayStation2 already features a built-in DVD player. However, it'll take several years until broadband adoption rises to the point where consoles would be used for an expanded roster of online applications. Neither Sony nor Nintendo now plans to introduce their own versions of Xbox Live.

Microsoft, though, is betting on online gaming, which Henson argues could have broader appeal than a game, music, and movie appliance because it offers greater social interaction. He foresees a day when a grandpa could play virtual football with his buddy in Australia and a mom could race cars against her cousin in another state. Henson even thinks such pursuits will compete with sitcoms and movies for family entertainment.

SLOW GROWTH? "We want to drive the gaming market in a fundamentally new direction," says Henson. "If you're going to blow video games beyond the niche they're in, [online gaming] is it." What remains unspoken is that Xbox Live is also an effort to transform the console, which debuted a year ago, from an also-ran into a worthy competitor. Online gaming alone probably won't do the trick, though: Five years from now only 10% of households with game consoles -- a projected 4 million -- will use them to play on the Web, believes David Cole, president of interactive entertainment consultancy DFC Intelligence in San Diego.

In part, that's because competition from PC-based online games will be a formidable obstacle for console makers to overcome. That's clear from the millions of consumers who already play online games on their PCs -- and do so without spending an extra $200 for an Xbox or a PlayStation2. "Still, many existing PC users (about 40% of those in the U.S., or more than 30 million people) don't use their PCs to play online," Cruz says. The console makers see those people as potential customers -- although another interpretation is that, if they do decide to play Net games, they'll simply use the computer they already have.

An even bigger issue for the console makers is whether they can earn a return from online gaming. According to some estimates, Microsoft poured $2 billion into Xbox Live -- a service that, in 2003, is likely to generate only $9.4 million in sales, Cruz estimates. Most analysts expect Redmond to quickly raise the fee for its service by up to 100%, to perhaps $10 a month or $100 for a discounted, full-year subscription.

CONSERVATIVE APPROACH. Still, experts think the only way that online gaming will be profitable for Microsoft is if it stimulates a huge increase in sales of Xbox consoles, which competitors argue is unlikely. "The momentum in video-game battles is decided within the first two years [of a new console's release]," declares Sony's House. "We believe the die is already cast." If so, Microsoft won't have a shot at winning more market share until the next generation of consoles comes out, probably in five years or so.

Given their market-share advantage, Sony and Nintendo have so far taken a conservative approach to online gaming -- limiting their involvement to Net adapters. Thus, for now, they're avoiding the millions of dollars in infrastructure costs that Microsoft is shouldering, and they're relying on game makers to determine what games will play best on the Net, to host them (Sega has a worldwide network of 100 Web servers, it says), and to provide support for users.

To stay on the cutting edge, Sega does extensive polling of its customers. In mid-November, its surveys turned up the fact that 21% of users wanted to play virtual football online. That was good news, since Sega had debuted Sega Sports NFL 2K3 in August.

CYBER-CHECKERS? In fact, game publishers are jumping online in droves. Some are releasing online-only, console-based games. Others increasingly offer video games with online features, such as special contests, updates, and additional downloadable characters. Some 5% to 10% of all video games sold in 2002 contain an online element, up from zero in 2001, estimates Cole. By yearend 2003, perhaps 20% of all video games sold will have online features, he says.

Microsoft is working furiously to speed that transition. It already has 11 titles available on Xbox Live, and it intends to introduce more over the next 18 months, perhaps even the venerable checkers, says Henson. It's also developing new features, one of which would allow fans of virtual car racing to design their own tracks -- specifying layouts and distances. Another would let a player who won a race send footage of the accomplishment to a friend for replay.

Microsoft faces another huge challenge: Broadband Net access -- required for Xbox Live -- is spreading more slowly than anticipated, and options for high-speed access remain limited in many areas of the country. "Online is an intriguing technology, but it's not a mass market," argues Jim Merrick, network marketing director for Nintendo in North America.

BUSTED DREAM. It's a point of view that Microsoft is determined to disprove, not the least because it doesn't want to be compared to a spectacular failure of a decade ago, when Sega introduced its Dreamcast console, equipped with a built-in dial-up modem, and offered an online service with 15 games. Neither the service nor the console succeeded -- in part, no doubt, because Sega tried the idea well before its time. Shaken by the experience, Sega exited the console market in 2001.

Microsoft isn't Sega. For one thing, its financial resources give it unequaled staying power. Yet it has boldly set out to play with the same fire. And it, too, could get burned. By Olga Kharif in Portland, Ore.

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