Cd Ro Ms: The Giants Rule

And even the game world's predators are feeling the pinch

A few years ago, the market for multimedia entertainment software looked so hot that even Hollywood big shots were jumping in. The crowning glory came in March, 1995, when Steven Spielberg, Jeffrey Katzenberg, and David Geffen's DreamWorks SKG teamed with software powerhouse Microsoft Corp. to create DreamWorks Interactive. Surely, that combined talent would unleash hits consumers would snap up by the millions.

KEEP DREAMING. The joint venture delivered its first four titles last year--including an animated cookbook for the kindergarten set and a claymation title. While they got kudos from critics, all but one, Goosebumps: Escape from Horrorland, have been commercial flops. If the Dream Team can't cut it, who can?

The truth is, not many. Developing entertainment and educational software is a brutal business. A glut of titles has forced prices down at the same time that the cost of producing and marketing CD-ROMs has soared into the millions of dollars. Only about 4% of consumer titles make money, figures Dan Lavin, an analyst with Dataquest Inc. As a whole, he says, CD-ROM companies spent more money last year on production than the sales they took in. Last Christmas, software makers flooded the market with more than 5,000 titles. Most of those never came near a retail shelf and, of the 500 or so that did, all but a few were financial duds.

The resulting shakeout is still being felt across the software world. Hundreds of tiny developers have shut their doors or focused their energies elsewhere. Since early this year, giants such as Time Warner, Viacom, BMG, Turner Broadcasting, and GTE have pulled the plug on their CD-ROM publishing ventures. Even Walt Disney Co., whose titles such as Aladdin have topped the charts, is retrenching. In April, it laid off some 250 workers, figuring it could make more money by licensing its characters than by publishing them.

The upside: A yearlong consolidation has weeded out the weak players, allowing the survivors to carve out profits. "A lot of companies who had no business in the market have gotten out," says David F. Cole, interactive-entertainment analyst at DFC Intelligence in San Diego. "And this year, expectations are much more in line with reality."

LOWBALLERS. And that's still tough. While sales of games and educational software are expected to grow 22%, to $1.7 billion, this year, that's down from 47% growth last year and 128% growth in 1995. Thank falling software prices. The writing was on the wall last year when SoftKey International Inc., known for budget titles, acquired Learning Co., a maker of high-end children's educational software. The combined company, which goes by The Learning Co., went with a lowball pricing strategy. Its tactics--such as slashing some prices to $14.95--have squeezed margins.

Only the biggest players can withstand such economics, which has triggered a frenzy of acquisitions. Take CUC International Inc. The direct marketer got into the business by buying gamemaker Sierra On-Line and edutainment pioneer Davidson & Associates. This year, it bought five more companies, including Knowledge Adventure and Berkeley Systems. "We saw a market ripe for consolidation and more professional management," says Christopher McLeod, CEO of CUC Software.

GT Interactive Software Corp., an emerging powerhouse in the games market, got its start as a distributor, then began publishing such hit titles as id Software Inc.'s Doom II. To fuel its appetite for growth, GT went public in 1995 and quickly gobbled up Humongous Entertainment and Time Warner Interactive Europe. "It's a minefield out there for small and midsize publishers," says Ronald W. Chaimowitz, CEO of GT. As marketing costs rise, he says, "the industry will consolidate even further."

The pot will increasingly be split among these few dominant players. In educational software, just three companies--CUC International, The Learning Co., and Disney--account for more than half of retail sales, according to market researcher PC Data Inc. The PC game business is more fragmented, since, like the movie business, it's driven more and more by hits. Still, a third of the market in the first half of the year also went to three companies: CUC, GT Interactive Software Corp., and Electronic Arts Inc.

Investors have caught the drift. Shares of The Learning Co. have almost tripled lately, from around 6 in April to 15. In the same time frame, GT shares have doubled to about 12.

Now, the big players are adding titles, but there's a difference this time. Rather than spread around development and marketing spending, they're focusing on a few potential hits. DreamWorks Interactive has trimmed the number of titles it will create to six or eight a year, from its initial target of a dozen.

Microsoft, too, has pruned its titles from 50 or so two years ago--including such mass-market misses as Dogs and Baseball--to 20 today. But Robbie Bach, vice-president of the company's six-month-old Learning and Entertainment Div., plans to ship 13 new or updated titles before Christmas. My Personal Tutor, for 4- to 7-year-olds, will cover four subjects (numbers, letters, reading, and math) in a four-CD set priced at $49. In games, a brand-new version of Flight Simulator--which has sold some 10 million copies to date--is planned for Windows 98. Bach says he'll pull in some $300 million in sales this fiscal year.

Not bad, but rivals such as Electronic Arts, Learning Co., and CUC will sell even more. "It's a great business for companies that know how to take advantage of it," says analyst Michael P. Wallace of UBS Securities. And this year, there are a few that do.

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