Sega Games the Systems

Simon Jeffery, head of the software maker's U.S. arm, talks about the Sony PS2's staying power and where the money is in game development

In the video game industry, it's known as the transition. That's the months-long window when manufacturers Microsoft (MSFT), Nintendo (NTDOY), and Sony (SNE) launch their new breed of consoles and start phasing out the old. By now, investors know the drill: The companies will absorb big losses as they buy brand-new technologies, organize supply chains and assembly lines, and spend money on splashy ad campaigns.

But software makers don't have that luxury. They're expected to steadily rake in profits regardless of the transition. That can make it a nerve-wracking time to be a game software company. Just ask Simon Jeffery. As the chief operating officer of Sega of America, he's got to make fast, tough decisions. Among them: how to divvy up resources between games for the huge audience that owns older consoles, and games for a small group who are moving on to new consoles.

Jeffery's in a better position than most to make the call. Sega, the gaming division of Japan's Sega Sammy Holdings (SGAMY), is one of the few that has been on both sides. The Tokyo-based company was in the hardware contest until 2001, when it pulled out after sales of its critically acclaimed Dreamcast living room console fizzled. BusinessWeek's technology correspondent in Tokyo, Kenji Hall, recently spoke with Jeffery about creating games for Sony's PlayStation 2, the transition to next-gen consoles, and the challenges of staying ahead in an industry that can shift with unnerving speed (see, 12/28/06, "The PlayStation 2 Still Rocks").

Sony's PlayStation2 is now six years old, yet it's still going strong. How do you explain this?

The PS2's very large user base is partly the reason. It's also that Sony is still actively building, promoting, and selling the PS2. At its current price—we expect another price cut in the not-too-distant future—we believe the PS2 in November-December next year probably has the capacity to sell more than any other format. We think the PS2 will actively be sold for another two holiday seasons (2007 and 2008) and will continue to sell millions of units.

Is there anything different about this transition to a new generation of consoles?

This is an interesting transition in particular because the retailers themselves are affecting it. The original Xbox (from Microsoft) and (Nintendo's) GameCube are being delisted by retailers because of the competition for shelf space and the fact that there are so many different types of hardware now. And that means the software business for the Xbox and GameCube goes away overnight, which leaves one remaining console from the previous generation—PS2.

Ordinarily, when you go through a technology transition you're able to optimize your development budgets across a couple of the old platforms. But this time we can't do that because retail has effectively taken away the Xbox and GameCube market. We have to just build games for PS2. And that makes the PS2 games more expensive than they otherwise would be.

By having two consoles on the market at once, isn't Sony at risk of having one machine cannibalize the other's target audience? How can an older machine like the PS2 compete against newer, faster machines with better graphics?

We don't think people who are looking to buy an Xbox 360, Wii, or PS3 will buy a PS2. We think the people who will buy the PS2 already have a next-gen console but want something for the kids. The PS2 has become a mass-market machine for kids and families. It will be in bedrooms rather than downstairs on the big HDTV. It's more in competition with the Nintendo Wii or the Nintendo DS (portable console) than it is with the PS3 or Xbox 360.

What strategy should a software developer like Sega take?

We're really balancing our portfolio of games for old-gen and new-gen hardware. We're focusing our big investments on the next generation, and we're making sure we have a balanced portfolio of kids' games and family-oriented products and movie tie-ins.

The PS2 will become more of a multiplatform strategy and less of a single-platform strategy. Which means we're extremely unlikely to build a game just for the PS2 from this point on. But if we believe a game can be a hit with a young, low-price audience, then we'll build a PS2 game as well as a PS3 and Xbox 360 game. We'll produce games like Sonic on PS2 for at least another two years. They'll be bought at a lower price.

So you expect game software prices to fall along with the PS2's price?

You'll see price cuts for the PS2 along with cuts for games. That is the historical trend. There is now considerable pricing pressure on the PS2. So while the install base is huge and Sony will still sell millions of machines a year, there's strong downward pricing pressure on the games themselves—$19.99, $29.99. Developers will find it more difficult to invest a lot in titles unless they are guaranteed to make a big splash and sell large numbers of units.

In a past conversation, you mentioned that a PS3 or Xbox 360 game can cost $10 million to $20 million to develop. How high are software development costs for PS2 games?

There is actually a bit of inflation on PS2 games. It can vary depending on graphics and production, but PS2 games are costing well over $6 million each. We as an industry didn't want this to happen because with developers having five to six years of experience with the hardware architecture and graphics you would think that wouldn't be the case.

What targets has Sega set for its games?

We can't talk about specific targets for last year or this year. But we can say that we beat our targets last year thanks to the successes we saw with games like Sonic and Super Monkey Ball on the PS2 and GameCube.

How do you track market trends?

Every Tuesday we hold a market research session at our office in San Francisco, where we analyze trends and sales on every console. There are about 10 to 12 people in the room—senior marketing, research, sales executives, and me. The number of spreadsheets would make your eyes spin.

We look really hard at retailers like Wal-Mart (WMT) and Best Buy (BBY) and GameStop, but also at some of the gaming fan sites like GameSpot and IGN. They have metrics that show how many times gamers click on particular games. It's both an art and a science. This industry is so fast-paced that you need experience to be able to predict the future. It's all about what hardware is going to sell, what demographic it's going to sell to, what retailers are saying, what game genres are performing well on each of the consoles, how long the hardware is going to be viable at full price, when price decay occurs.

Can you offer a specific example of how this has helped?

We can detect drop-offs in sales fairly quickly. We anticipated that would happen to the Xbox and GameCube before it did. We stopped building Xbox games over a year ago and we stopped building GameCube games six months ago. We'll be looking carefully at the PS2, especially around key selling times, March-April and October-December.

The hard-core gamers were going away, migrating to next-gen. We invested in big-budget titles for the next-gen system, which was only Xbox 360 last year. And we brought out family games like Sonic and Super Monkey Ball and family packs for GameCube and PS2. And we absolutely benefited from that.

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