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EA: Gaming For Console Domination

The months before the launch of new gaming consoles are risky times for electronic-game publishers. The challenge: deliver flashy games for the new systems in a bid to grab market share from competitors fast. But with sharply higher game-development costs tied to next-generation games, new titles are almost certain to lose money at the outset.

At the same time, publishers can't neglect the millions of game buyers wedded to the current generation of consoles, many of whom won't make an immediate upgrade. Adding to the uncertainty, a lot of players delay purchases in the period prior to a console's introduction. (And this year's holiday season is especially choppy, with no home-run hits like Grand Theft Auto or Halo II taking the console market by storm, as was the case in 2004.)

Electronic Arts (ERTS), the world's largest game maker, is no exception to that list of rules. On Nov. 1, it announced that fiscal second-quarter profit dropped to $51 million, or 16 cents a share, from $97 million, or 31 cents, a year earlier.

LEARNING THE ROPES. Though it wasn't as sharp a drop as analysts expected, the decline partly reflects higher costs associated with new game development. Sales slipped 6%, to $675 million, a sign some customers are holding out for the introduction of new consoles, such as Microsoft's (MSFT) Xbox 360, due to be released Nov. 22. The quarter saw EA falling back on perennial favorites, like the latest installment of its popular Madden NFL franchise. A year earlier, results were bolstered by the release of its megahit Sims 2.

So what does the introduction of the Xbox 360 mean for game makers this season? There will certainly be a lot of buzz as the holidays approach. Still, with only about 1.5 million new Xbox 360 units likely to be sold before January, games associated with the console will generate less than 10% of publishers' revenue in the final quarter of 2005, says Evan Wilson, an analyst at Pacific Crest Securities. Meanwhile, with programmers facing a steep learning curve as they develop titles for the new Xbox 360 architecture, development budgets for new games will be 30% to 50% higher than for current-generation games, says THQ Chief Executive Brian Farrell.

Reflecting the uncertainty of the coming months, EA gave itself some breathing room at the lower end of its sales forecast for the year. It now predicts sales of $3.25 billion to $3.4 billion, vs. a previous estimate of $3.3 billion to $3.4 billion.

"A final word of caution," EA Chief Financial Officer Warren Jenson told analysts on a conference call the day earnings were released. "Expect the unexpected. We are in transition. We could experience production or development snags, or abrupt changes in pricing or demand" as consumers switch over to the new models, he said.

SWITCHED TOO SOON? EA should know. Half a decade ago, EA's had a bumpy ride following the release of Sony's (SNE) PlayStation 2. The company pumped money into developing more sophisticated next-gen games, even though it probably wouldn't be able to sell them at the same volume as simpler games for the first PlayStation.

In the long run, the gamble paid off: Sharp new games such as Madden NFL became the most popular sports titles on Playstation 2 and solidified EA's dominance in sports. But EA earnings suffered for three straight quarters in 2000 and 2001, in part due to the higher research and development costs.

Meanwhile, rival Activision (ATVI) earned steady profit because it continued cranking out new games for the PS One when EA and other publishers were neglecting the console. EA "left a lot of money on the table because they switched too soon last time" says Wilson.

PLAYING BOTH SIDES. EA vows not to make the same mistake again. The company won't say how many titles it plans to release in the next fiscal year, but it currently has roughly a dozen new games for current-generation consoles slated for the next quarter, in addition to its planned launch titles for the Xbox 360.

But now, with a development budget nearly two and a half times what it was in 2000 -- amounting to a total of $633 million in 2005 -- it doesn't have to leave gaps in its development resources. Total research and development staff grew by 39% from last year, boosting total headcount to 4,700.

So while EA will likely lose money in the early stages of its initial investment on next-generation games, it has the development firepower to take advantage of the current market, too. "We know that the bulk of the market is [still] going to be PS2 and Xbox, and we know how important that is" says John Schappert, general manager of several EA development studios. "We're looking for a fully diversified investment strategy."

SAFE BETS. And its early Xbox 360 investment will be far from a total loss. Analysts expect EA to be a dominant force in next-gen consoles, with five dependable hits -- including Madden NFL, Need for Speed, and NBA Live -- slated to launch with the new Xbox. "The sports franchises give them a huge leg up over all [of their competitors]... and they're very diversified across platforms," says David Cole, president of research firm DFC Intelligence. "They're better positioned than almost anybody else."

EA's position in the market isn't unassailable. While its strategy of releasing tried-and-true sports titles will make it a safe bet for success on the next-gen Xbox 360, so far it isn't venturing beyond its core franchises with risky, innovative games. That leaves the door open for struggling competitors to snatch a chunk of share from the industry stalwart if they can score the next must-have title.

After all, it has happened before: One year into the PlayStation 2 launch, Take-Two Interactive (TTWO) took a gamble on a cutting-edge and brutally violent game that let the user wander aimlessly throughout a city, killing and running people over. That game, Grand Theft Auto III, grossed hundreds of millions in revenue, and solidified the beleaguered company as one of the industry's most substantial players. The GTA franchise still made up 30% of its sales last year.

DIFFERENT APPROACHES. Smaller players, like THQ (THQI), are poised to make the most of next-gen consoles, too. On Oct. 27, THQ said its fiscal second-quarter loss narrowed, as revenue rose 48% from the same period a year earlier. "Our job in the next generation is innovating. And [our games], the artificial intelligence, everything, will be very, very different," says THQ's Farrell.

In the second quarter of 2006, THQ plans to release Saint's Row, an open-world gang-war game that Farrell says will cost the company between $15 million and $25 million. "Whether it's EA or Activision or anybody else doing nothing but sequels -- that creates a tremendous market opportunity for THQ," he says.

Whether it's with bold new games or tried and true titles, publishers are busy trying to find their place in the next generation.


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