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Video games are a fast growing form of entertainment and have captured a similar market size as the movie box office and music sales. In 2008, the North American video game market reached $21.33 billion and people continued to spend a greater portion of their free time playing them.^[1] As of August 2007, Nintendo has become the best selling console in the world (9 million units sold worldwide), with Microsoft's Xbox 360 (8.9 million) and Sony's PlayStation 3 (3.7 million) trailing. ^[2] The Wii's performance is impressive considering that Microsoft launched 12 months ahead of both the Wii and PS3.

Video game console wars heated up to new levels in November 2006 with the launch of Sony's advanced PlayStation 3 (PS3) and Nintendo's Wii. Both Sony's and Microsoft's console offerings upped the ante by producing advanced and expensive hardware which took advantage of the trend towards high-definition media (e.g., HDTV). It is widely believed that both high-end consoles are subsidized by their respective manufacturers in order to gain market share and appeal to consumers who would not pay their high prices otherwise; the base PS3's retail price is currently $499 and the base Xbox 360 costs $399 (as of July 2007). The Wii, on the other hand, delivered a lower cost platform ($249 base) with a highly interactive controller technology. It is believed that Nintendo makes a sizable gross margin (about $100) from the sale of each console hardware unit.

Much is at stake in the battle of video game consoles. The adoption of consoles depends heavily on the content available for them, as video games--like movies--have become increasingly hit-driven. All three companies publish a catalog of their own video game software as well as receive royalties from video game companies such as Electronic Arts and Activision (ATVI), the market leaders. In addition, both Sony and Microsoft have placed a significant bet on gaining entrance into the home entertainment market as both the Xbox 360 and PS3 consoles play music and movies as well as connect to the Internet. Sony in particular is leveraging the PS3 to propagate its Blu-Ray technology, a media format for high-definition video; if the PS3 succeeds, then Sony will reap benefits not only from video games but also from licensing Blu-Ray technology for movies and other digital media using its proprietary format.

Microsoft Xbox 360

Microsoft is obviously the primary beneficiary if the Xbox 360 platform "wins" the console wars. Its platform had a 12 month headstart on Sony's PS3 and Nintendo's Wii. However, the Wii outsold this console in January and February of 2007. Microsoft also published several popular games, including the Halo franchise. Halo 3 exceeded sales of $125 million on its first day of release--better than any video game in history.

Microsoft is currently leading the next-generation console competition with 5.4 million units sold as of the end of April 2007. In contrast, the PS3 had sold approximately 1.3 million units and the Wii sold about 2.5 million units.

In 2007, Microsoft wrote down $1.5BN in Xbox 360 related charges, as technical design flaws led to widespread product defects. The charge was mostly composed of the cost of repairing defective systems.

• Lite-On IT, a Taiwanese company (TPE: 8008) manufactures HD-DVD optical disk drives for Xbox. This benefits the disk maker because of the console's large installed base, but Microsoft has been pushing its components makers to decrease prices by 5-15% on a quarterly basis.

• Logitech International, a manufacturer of peripheral electronic equipment (e.g., computer mice and video game controllers) owns the exclusive rights to manufacture third-party wireless controllers for the Xbox. The company depends not only on the success of the platforms but also on the content created. For example, the company increased its unit sales of console gaming peripherals from FY 2005 to FY 2006 (ending March 31) by 21% but saw its revenue decline by 7%. The reason for this apparent contradiction was that it sold many fewer expensive racing wheels due to the lack of popular racing games available on the Xbox 360. The company also offers accessories for Sony's PlayStation 2 & 3 as well as the PSP platform. Overall video game sales made up 7.2% and 6.1% of the total sales for the company during FY 2007 and 2008, respectively.^[3]

Sony PlayStation 3

Sony boasts the largest installed base for a video game console with over 140 million units^[4] of its previous generation PS2 platform. However, since its release in November 2006, Sony's next-generation PS3 has lagged behind both Microsoft's Xbox 360 and Nintendo's Wii in terms of overall unit sales. The PS3 had sold approximately 1.3 million units as of the end of April 2007 compared to about 2.5 million for the Wii and 5.4 million for the Xbox 360, which was released 12 months before the other two consoles.

It has been widely reported that Sony is subsidizing the cost of its hardware in order to gain market penetration. The video game business not only represents a significant portion of its business, but the company is using the PS3 as a platform to propagate its high-definition DVD format, Blu-Ray. If the PS3 succeeds, then the company will likely profit from the adoption of this format, as Sony would be making significant licensing fees from movies, games and other media which utilize it.

As of early July 2007, Sony dropped the price of its existing stock of PS3 game console s from $599 to $499. It was initially speculated that the move was precipitated by the PS3's poor sales, with the console being outsold by a factor of 4 to 1 by the Wii and nearly 2 to 1 by the Xbox 360 in May 2007. ^[5] Others in the industry have pointed out that Sony simultaneously released an updated version at the original $599 price point and may simply have been attempting to clear out existing inventory. Updates include increased storage space and lack of backwards compatibility with Sony's top-selling PS2.

Sony's redaction of backwards compatibility could potentially be traced to two strategic objectives. The first objective may have been the reduction of its high manufacturing costs, which have caused Sony to lose a significant dollar amount per console sale. The second objective may have been to halt potential cannibalization of its PS2 sales, which are currently much higher in volume and far more profitable.

• Toshiba and IBM jointly create the Cell processor for Sony's PS3. Interestingly, Toshiba has played a large role in the development of the HD-DVD format, which is a competitor to Sony's Blu-Ray format integral to the PS3.

• Rambus Inc's XDR DRAM is the main memory solution for the PS3. Rambus' FlexIO Processor Bus also provides the interface between the graphics processor and other chips.

• Logitech International, a manufacturer of peripheral electronic equipment (e.g., computer mice and video game controllers) offers accessories for Sony's PlayStation 2 & 3 as well as the PSP platform. The company offers a wide range of peripherals that take advantage of the PS3's multimedia capabilities; these peripherals include various wireless controllers, keyboards, headsets and high definition HDMI video cables (it also owns the exclusive rights to manufacture third-party wireless controllers for the Xbox). Overall video game sales drove 7.2% and 6.1% of the total sales for the company during FY 2007 and 2008, respectively. Logitech also stands to benefit peripherally--pun intended--from an increase in Blu-Ray because it offers several high-end universal remote controls for home entertainment centers.

• Electronic Arts is the largest video game producer in the world, with $3.66 billion in FY 2008 sales (ending March). While the company produces a wide range of video games for different platforms (consoles, online, PCs, portables, etc.), Sony's previous generation PS2 generated nearly one-third of FY 2006 revenues. Not surprisingly, their fortunes are closely tied to the success of the PS3 because of the significant resources it had allocated towards that platform. The company has lagged growth compared to the overall industry because of the popularity of the Wii, and the company has scrambled to get resources towards building games for Nintendo's platform.

• Gamestop (GME) is a worldwide retailer of video game hardware, software, and accessories. The company benefits from the new video game cycle, and attributed the same store sales growth for the quarter ended August 2007 to strong sales of the Playstation 3 and Nintendo (NTDOY) Wii. ^[6].

• OmniVision Technologies (OVTI) is a CMOS image sensor designer and marketer who currently provides the image sensors for the PlayStation Eye.

Nintendo Wii

Nintendo's Wii has been acknowledged as a forerunner of the console game war, having outsold Sony's PS3 by a factor of nearly 2 to 1. In addition, Nintendo generates a positive gross margin on its consoles, while Sony does not for its PS3 units. The Wii accounted for 55% of all next gen console sales in 2008.^[7]

Detractors point to the fact the Nintendo's technology does not take advantage of improvements in technology, specifically high-definition television; on the other hand, both Sony and Microsoft offer some version of high-definition media with their console units.

• Analog Devices develops an accelerometer chip that measures movement for the Wii's remote (the Wiimote). The Wiimote is one of the biggest differentiating factors compared to other video game consoles.
• Ubisoft made one of the earliest bets on the Wii platform and has reaped the most benefits of video game manufacturers to date. Its games for the Nintendo console contributed to a 24% increase in sales during the holiday season in 2006 and the company has raised its revenue forecast for 2007. Ubisoft has a library of 12 Wii games available on its website as of early June 2007.
• Electronic Arts suffered a 25% decrease in February 2007 sales compared to the same period in 2006 because the company had underestimated demand for the Wii. On the other hand, sales for the industry rose nearly 30%. The company has scrambled to get content for the Wii and acquired Headgate Studios in November 2006 to accelerate its development for Nintendo's platform.
• Take-Two Interactive, like Electronic Arts, is another video game producer that underestimated the popularity of the Wii. The company had no titles for the Wii during the launch of the console and rushed to get three to be published this year.
• Gamestop (GME), a video game retailer that has captured about 25% of the U.S. market, benefits from the overall increase in console games. However, Nintendo's Wii has been one of their biggest drivers of growth and generated 11% of all purchases in FY 2006, up significantly from the previous year. In comparison, Sony decreased from 18% sales contribution in FY 2005 to 13% in FY 2006. Microsoft stayed relatively flat around 13-14%. In addition, GameStop recently announced that it was producing its own branded line of Wii accessories.
• Delta Electronics is a Taiwanese company that makes power supplies for the Wii.

Content Drives Hardware Adoption

One significant unknown factor driving the success consoles is content. For example, many believe that Microsoft's previous generation Xbox console would not have been nearly as successful if it were not for its Halo franchises, one of the best selling franchises in the history of video games; the Halo 2 title exceeded sales of $125 million on its first day of release--better than any video game in history. However, in 2008, Wii topped all others in the software arena with the four top selling video games of the year. Wii Play reigned king of 2008 selling 5.28m units.^[8]

Software has historically generated two-thirds to three-fourths of the overall video game market, which was approximately $40 billion in the U.S. in 2008. Console games accounted for about two-thirds of software sales with the rest coming from PC and hand-held software.

Like the movie industry, the video game content sector is becoming hit-driven, where a few titles make up the bulk of all sales. In addition, production costs for video games has increased significantly--again, like movies--such that certain franchises have become extremely valuable and depended on for success.

• Electronic Arts is the largest video game company in the world is well-positioned to leverage its significant portfolio of games for the next generation of consoles.

• Take-Two Interactive published the popular Grand Theft Auto series, which was one of the top sellers in 2008 (over 5 million units sold on XBox 360)

• Microsoft acquired Bungie Studios in 2000 and owns the rights to the popular Halo franchise.

Threats to Console Video Games

Massive Multiplayer Online Games (MMOG)

One threat to the overall video game console market is the rise of massive multiplayer online games (or MMOGs). While both the Xbox 360 and PS3 have Internet capabilities, MMOGs are based on the Internet and are a potential disruptive threat to console games because they require no hardware or software purchases. Instead, these popular games typically run on a subscription-based model.

• Activision Blizzard produces the most popular MMOG called World of Warcraft. This $250 million per year franchise is especially popular in East Asia (e.g., China and South Korea) and is growing in popularity in the U.S. MMOGs have a small but rapidly growing market of around $2 billion as of 2005.
• Electronic Arts, the largest video game producer in the world, acquired Mythic Entertainment in 2006 to dip its toe into the MMOG industry. Mythic is the studio that produced several popular MMOGs, including Dark Age of Camelot and the forthcoming Warhammer Online.

Mobile Gaming

Mobile games has grown rapidly--tripling in the last 5 years to around $2-3 billion in 2006--as part of a growing trend of casual gaming. Mobile games have the advantage of an extremely large installed base of over 2 billion users worldwide.

• Vivendi Universal have invested significant resources to build mobile games.
• Nokia is the world's biggest mobile handset manufacturer and stands to benefit from an increase in mobile gaming, especially as users demand improved hardware.

Traditional Toy Companies Suffer from Increase in Video Games

• Mattel and Hasbro are two traditional toy companies that suffer from an increase in video game usage, as children and teens move away from spending time playing with dolls, board games and model cars towards playing video games
• Leapfrog is a toy company less affected by a rise in console video games because it targets a younger demographic that has not adopted video games as readily as older children and teens.

Notes

For more on video gaming, see Rock Band vs. Guitar Hero.

1. ↑ mcvuk.com, 2008 Video Game Revenues top 21 billion, 1/16/2009
2. ↑ http://arstechnica.com/journals/thumbs.ars/2007/09/12/financial-times-nintendo-wii-is-now-the-best-selling-console-in-the-world
3. ↑ Logitech International 2008 10-K, pg. 36
4. ↑ FT.com, Sony Sets 150m Sales Target for PS3, 7/20/2008
5. ↑ http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/07/09/BUGPUQSED41.DTL
6. ↑ GME Aug. 2007 10Q pg. 24 http://edgar.sec.gov/Archives/edgar/data/1326380/000095013407019687/d49727e10vq.htm
7. ↑ gameinfowire.com, Wii & Nintendo DS Set New Industry Records, 1/21/2009
8. ↑ Shacknews.com, NPD Reveals 2008's Best Selling Console Games, 1/15/2009