Console Makers Online and On Top
DFC Intelligence has spent a great deal of time researching the online game market and making forecasts on not only how this market is likely to grow, but also how it is likely to integrate into the existing video game and interactive entertainment market. One of the key areas of interest in today's market is how important will online games be for the new console systems coming on the market. The short glib answer is that online games will probably be a more important feature for console systems over the next several years, but once again the traditional retail model is likely to be the dominant driving factor when it comes to how the new game systems build an installed base. Over the past six years, all facets of online games have come a long way. However, online games are nowhere close to being the tail that wags the dog that many were predicting.Many hardware systems The goal of the three big hardware manufacturers (Microsoft, Nintendo and Sony) is to sell as many hardware systems as possible to build the largest possible installed base. Online games are only effective to the extent that they help accomplish this goal. This is especially true considering the current situation where an online service is expensive to build and maintain and even a full-fledged service like Xbox Live commands a low subscription rate. In other words in the reality of today's marketplace, most online console game services are loss leaders. We currently know Microsoft's online strategy, but things are a little more hazy when it comes to Nintendo and Sony. In March Sony did reveal some of their online plans and that has led many to argue that Sony is planning to go head-to-head with Microsoft on online games. On the contrary, we think that the sketchy announcements so far seem to indicate that Sony is looking at putting more of the emphasis on the raw horsepower of the PlayStation 3, with a limited emphasis on online games. Obviously many details have yet to be revealed, but so far that is the way it is looking and Sony clearly has some solid tactical and strategic reasons for not investing heavily in online games. In our view what Sony has announced so far for the PlayStation 3 and online connectivity looks a lot like the PlayStation 2 with an online store and some inexpensive community features added on. Open Internet Once again, with the PlayStation 3, Sony is emphasizing the open Internet idea. In our view this translates into: "we are not spending a lot on online services, but we will let others build it if they want to." Clearly this is not what Sony is actually saying, but like the PlayStation 2 the main point is that online game play is free right out of the box. If third-parties desire to build their own services and charge for them then they are welcome to do so. Sony is spending a great deal of money to build the basic system that makes the PlayStation 3 the raw horsepower leader. Right now they probably don't need the added expense and headache of a full-fledged online service, especially if there is no evidence it will get them to their goal of selling more hardware systems. We should emphasize that this is just our view and many will argue that the Sony PlayStation 3 Network Platform (the working name) will offer a more robust solution than Xbox Live. Online games were fairly prominently featured in Phil Harrison's recent GDC keynote. This has led many to speculate that Sony has finally become a convert to the online world. Harrison talked about such concepts as episodic content and games starting to have the social currency of TV shows like Lost and 24. It is the idea of a shift from a disc-based world to a network-based service business. This all sounds very cutting-edge, but it also gave us a strong sense of déjà vu. At GDC 2006 we started to wonder if we were back at GDC 2000.
Rather fuzzy Memories of 2000 are admittedly rather fuzzy, but luckily we do have some notes to help refresh our memory. Seven months before the fall 2000 launch of the PlayStation 2, Phil Harrison spoke at GDC about the upcoming launch. At this keynote, the roles were somewhat reversed. Harrison was having to follow Bill Gates' keynote where he had spoke about the Xbox, which would launch after the PlayStation 2. It appeared that in terms of raw horsepower, the Xbox would have the advantage over the PS2. Therefore an emphasis of Harrison's 2000 GDC keynote was on how Sony had a full broadband network strategy for the PlayStation 2 which would trump any advantage the Xbox had in terms of raw horsepower. At the 2000 GDC, Harrison talked about the idea of digital downloads for classic PlayStation games and the concept of "episodic entertainment" where games are released in continuing episodes like a television series. Comparing 2000 and 2006, we have a hard time saying that Sony has become a sudden convert to the possibilities of online games.Consumer technology What Sony has been is very realistic about what it takes to sell systems and build an installed base. Sony has also become more realistic about where its strengths are in relation to Microsoft. Sony is a world leader at selling high-end consumer technology, primarily at retail stores. On the other hand, Microsoft is much stronger at providing and selling services and retail is only one part of its distribution mix. In fact, retail is becoming less important to Microsoft as they have numerous alternate distribution channels. A consumer walking into a Best Buy will likely be hit by Sony everywhere: cameras, televisions, DVD players, stereo systems, computers, not to mention software (games, music, movies, etc). Of course, a consumer can buy Microsoft software at that Best Buy, but they are probably just as likely to get it from buying a Sony Vaio computer with Windows XP pre-installed and Microsoft Office available to be unlocked by going online and getting a product key. In other words Sony's strength is retail and pushing hardware. Trying to compete head-to-head with Microsoft on a sophisticated network service does not necessarily make sense given current market conditions. It would be different if online connectivity was a key selling point for a game system, but right now it isn't. The lack of online connectivity may be a weakness, but the PlayStation 3 will have online connectivity. Furthermore, the bulk of consumers may have a hard time distinguishing between online services.Motivate a consumer This leads to the question of what does sell game systems. When the PlayStation3 launches it is almost guaranteed to be behind on software and could possibly be more expensive. So what would motivate a consumer to buy a PlayStation 3 over an Xbox 360 or Nintendo Revolution? It is likely that getting consumers to buy the PlayStation 3 will come down to an emphasis on the Sony PlayStation brand, customer loyalty and the promise of horsepower performance that will guarantee great games to come. As for an online service, the PlayStation 3 will be online right of the box. Does it matter if the Xbox Live has a more robust, fully featured service? Not necessarily. Most console consumers are not even in a position to evaluate online services as they currently appeal to a subset of a subset. Imagine Average Joe consumer standing in a Best Buy or GameStop this holiday season and asking a sales clerk about the differences between the Xbox 360 and the PlayStation. Consumer: "wow, the Xbox 360 sure has a lot more games." Clerk: "well the 360 has more games now, but the PS3 is newer and more powerful." Consumer: "do these systems go online?" Clerk: "yes, they both go online, but the PS3 is free, you have to pay extra with the Xbox 360.
" The issue of which online service is actually better is not even likely to come up in this scenario. In the consumer's mind it is included for free with PS3 versus you must pay extra with the Xbox 360. That could even explain why a PlayStation 3 would cost more, Sony was nice enough to throw in the online service for free. Genre questions Of course, there is that core group of consumers that will pay attention. But how big is that core? Outside of casual games, online games currently are strong in two major categories: first-person shooters and massively multiplayer online games (MMOGs). In North America an MMOG like World of Warcraft can now command over one million subscribers. A great business, but when you convert that to hardware sold, losing that entire installed base is not that big a deal. Furthermore, an MMOG like WoW can work on any system with built-in online connectivity. The developer of an MMOG is already having to build out a fairly robust online service so something like Xbox Live does not add as much value. In fact an "open Internet" model may work better for that type of product. First-person shooters (FPS) are probably a more important category for the console game market and are a type of game that can greatly benefit from a service like Xbox Live. However, even here the numbers are not yet all that compelling. Some of the biggest FPS names like Valve's Half-Life series are still basically non-players on the console side. Sure everyone knows about Halo 2. But even with all its success Halo 2 sold to only about a third of the Xbox installed base. And of that third only about another third (at most) were Xbox Live subscribers. So we are still talking about a subset of a subset. When you are dealing with the type of hardware numbers Sony is looking for with the PlayStation 3, the Xbox Live subscriber base is a rounding error. Compelling argument Of course, if you are looking at it from Microsoft's side one can see the advantages of focusing on a service like Xbox Live. The big argument is that Microsoft is pushing the innovation curve and appealing to the core early adopters that will drive the direction of the market via the snowball effect. This is a very compelling argument, but it is also a long-term strategic approach. Microsoft is clearly stronger in delivering software and network services, but this is still a hardware intensive, retail business. There is also the argument that as the world goes from a retail-driven business to more of a networked-service driven business Microsoft will be much better positioned because of what they have learned from Xbox Live. It is very possible that Sony could win the short-term hardware battle, but lose the long-term war for the living room as the network becomes more dominant. On the other hand, looking back to what Sony was talking about in 2000 it is clear that Sony has not been ignoring the online world. Sony can very well make an argument that with basic online connectivity they are well-positioned to provide a full-featured network service if that is what consumers demand. Furthermore, the track record of companies pushing the consumer technology curve is not necessarily that compelling. Innovative and expensive If pushing the consumer technically curve with innovative and expensive trials was an indication of success, Time Warner would be the current market leader in interactive entertainment. Take just one example among Time Warner's many experiments in expanding network services, the Full Service Network (FSN) from the mid-1990s. Though now long forgotten, the FSN was big news back in its day. The goal was to provide a full broadband home network that allowed for hundreds of cable channels, as well as interactive services like video games on demand, movies on demand, interactive shopping and other information services. Time Warner had plans to spend around $5 billion in what was anticipated to be a 5-year build-out of the FSN.
The FSN launched to much fanfare in late 1994 in a limited 4,000 household trial run in Orlando, Florida. However, the variable cost per household was estimated to be as high as $5,000 and Time Warner eventually scrapped FSN as losses started to mount. Of course, FSN could still be considered a success if Time Warner was able to build on lessons learned. Flash forward ten years and how far along has Time Warner come? Leaving AOL aside, Time Warner Cable is a leader in providing interactive services with over 5 million subscribers to its digital video services and another 5 million for its broadband services.
However, in terms of product offerings does Time Warner have a big edge over such competitors as Comcast, DirecTV and DSL providers? Meanwhile, Time Warner's Turner Broadcasting division is heavily advertising its cutting edge games-on-demand service GameTap. GameTap is a broadband subscription games service that follows right along the vision set by FSN. Of course, if one actually goes to GameTap they could be forgiven for thinking they had flashbacked to 1995. Many of the initial games on GameTap may have seemed cutting-edge back in 1995, but we get the feeling that many of them would have seemed dated even back then. Did Time Warner really learn anything from experiments like FSN, or did they just throw their service in the freezer to be defrosted at a later date? We would be willing to buy the argument that GameTap is just getting started and can't be fully judged until content can be ramped up. However, this would ignore the fact that Time Warner heavily promoted GameTap in late 2005/early 2006 with expensive television advertising in prime spots like NFL football games. Most likely this had the result of driving millions of consumers to a 1995 time capsule where after a test drive they could confidently say "I don't need this digital distribution, games on demand stuff, my PlayStation 2 already is way beyond this." GameTap clearly shows that even in 2006 powerful hardware still easily trumps network services. Back to Xbox Live Unlike GameTap, Xbox Live is a full-featured, robust, reasonably priced online service. We may be wrong and Sony may launch a more robust service for the PlayStation 3, but, based on current market conditions, we think that, for online game play, the Xbox 360 is likely to be the leader. However, how much difference this makes when it comes to hardware sales remains to be seen. In a recently released report on the subject, DFC Intelligence forecasts strong growth for online console games. However, even with our strong growth forecasts we estimate that less than 25% of the new console systems get connected to an online service by 2011. Of course, if the Xbox 360 can see several more months like this past March things could start to change pretty fast. In the past month, the Xbox 360 saw the release of both a monster online heavy hitter in Ubisoft's Tom Clancy's Ghost Recon Advanced Warfighter and an epic single-player RPG in Bethesda Softworks' Elder Scrolls IV: Oblivion. In 2006 it is still that type of product line diversity that makes a system successful. How much has changed from March 2000 to March 2006? Time Warner's market value is about one-fourth of what it was back in 2000, Sony's stock about one-third. In this race Microsoft really looks like a champ, the company has only lost about half of its market value over the past six years. Nintendo's offering Meanwhile, despite finishing third in the last console race, Nintendo who focused on current profits over market share, has only lost about 10% of market value. The big winner in this past generation, Electronic Arts has seen its stock more than double since 2000. It seems clear that what has changed from 2000 to 2006 is that the market now clearly rewards current performance over long-term vision. Phil Harrison's GDC 2000 vision remains very much alive six years later, but patience is now firmly established as the operative word and some are thinking that maybe that tortoise and hare fable did have some ring of truth. The war to deliver interactive services to the living room is of crucial strategic importance. However, it is clear that this war will be fought over many battles, of which video games are just one. When one considers that so far this century Sony, Microsoft and Time Warner have lost over a combined $500 billion in market value (or half a trillion), one can see why, as casualties mount, investor patience for this war is wearing thin. DFC Intelligence's research services provide detailed strategic analysis of the interactive entertainment industry.