Web Games Threaten the Console

The annual Electronic Entertainment Expo is supposed to showcase the video game industry at its most dazzling. This year's E3, held in June in Los Angeles, felt more like a throwback. Taking center stage was the Wii U, the upcoming successor to Nintendo's game console, and the PS Vita, a new handheld gaming device from Sony (SNE). Major game developers showed all the daring and originality of Hollywood, touting sequels to sequels such as Gears of War 3, an eighth Call of Duty, a new Tomb Raider and, yeah, even a game called Donkey Kong Country Returns.

Amid the new hardware and endless franchise extensions at E3 was also something else—a glimpse into a future in which the 40-year-old console business slowly dies, and even hardcore gamers spend most of their time playing games over the Web. Hot gaming startups such as Zynga, maker of social games FarmVille and CityVille, and mobile phone game makers such as Rovio (Angry Birds) were mostly absent from the show. But there were other publishers and distributors of online games, which now feature all the action and graphical richness of traditional shoot-em-ups and strategy games. Their pitch: games that constantly update online, stream into the home, and free users from having to head to the nearest GameStop (GME) to get their fix.

Riot Games, based in L.A., is among the companies hoping to kill the console, or at least compete with it. Its fantasy game League of Legends has amassed millions of users and is neck-and-neck in minutes played with Blizzard Entertainment's classic World of Warcraft, according to tracking site Xfire. Gamers adopt a character and battle live in five-on-five matches with swords, arrows, and magic spells. The game is free to play; Riot makes money by selling users virtual astronaut outfits and other gear. Tencent, the Chinese video game giant, paid $400 million to acquire a majority stake in Riot in February. Trion Worlds, based in Redwood City, Calif., has a similar-size hit with its online role-playing game, Rift, which officially launched in March. The game costs $15 a month and resembles World of Warcraft with richer graphics. Lars Buttler, Trion's chief executive officer, is betting other genres will shift to the Web. Later this year, Trion will release End of Nations, a strategy game where players can join battles with as many as 50 others for control of a futuristic world.

One of the biggest bets on Web-based games, and perhaps the loudest criticism of the console, comes from Steve Perlman, the founder of WebTV and a lead engineer behind Apple's QuickTime (AAPL) video technology in the 1990s. A decade ago, Perlman started developing a new type of compression technology that would make it possible to pump rich graphical games from data centers straight to people's living rooms. The work culminated with OnLive, an online gaming service he launched last year. Gamers pay $99 for the hardware, which includes a wireless controller and black TV plug-in about the size of a deck of cards. (OnLive is working on technology that dispenses with the hardware altogether.) Users can opt to rent standard console games such as Homefront or Tomb Raider for a few days, buy them outright, or pay $9.99 per month for unlimited play. The company continuously upgrades its servers, and Perlman argues this will allow OnLive to keep up with the coming wave of processor-hogging, photo-realistic games such as Warner Bros. Interactive Entertainment's (TWX) Batman: Arkham City. (Warner is an OnLive investor.)

Like the video service Netflix (NFLX), OnLive tends to offer older titles. It has yet to convince major game publishers to release their latest and greatest directly over the Web. Perlman argues that will change as the economics of the PlayStation and Xbox become unsupportable. "The bill of materials for the next-generation consoles will be $1,200 to $1,400," he says, predicting Sony and Microsoft (MSFT) will have to pack ever more firepower into their consoles and then offer subsidies to make them affordable.

Michael Pachter, an analyst from Wedbush Securities, agrees that a shift from hardware consoles to the Web is coming but says it will be gradual. "Just like one day no one will have a cable box and we'll get all our video from the Internet, people will get their video games from the cloud," he says, predicting that sales of console games, now flat, will begin to decline in two or three years. Pachter also believes the console makers are in denial about this shift, evidenced by the hardware introductions at E3. "Housewives are playing Angry Birds or FarmVille, not Wii Fit or Guitar Hero," he says.

Sony and Microsoft cater to hardcore gamers and have cultivated a more mainstream audience by turning their consoles into home entertainment hubs. Jack Tretton, CEO of Sony Computer Entertainment America, believes Web-only game systems will struggle to match that breadth. "I think the future is flexibility," he says.

Consoles may evolve, but one casualty seems certain: the shrink-wrapped game. "Video games are the last bastion of the shiny compact disc," says Brandon Beck, Riot's CEO. "It's the very last thing an American 18-year-old is going to the store to buy."

The bottom line: New video games based on cloud computing are as visually rich as console games. The future of consoles looks bleak.

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