Case Study #2 (10-15 Pages) A thorough analysis is expected. Below is a suggestion on how to structure your write up and key questions to consider at each stage.

1. The history, development and growth of the company over time (4 marks~2 pages)

– Intro Paragraph

– Chart critical incidents for the industry as a whole (bullet form OK- do not need to restate all facts written in the case – just critical ones)

Questions to consider: a. Why the 82-85 Collapse of Atari b. What drove Microsoft’s decision to enter the industry with its Xbox offering?

2. SWOT analysis (4 Marks 1-2 Pages)

– The identification of the company’s internal strengths and weaknesses

– The nature of the external environment surrounding the company

• The SWOT Checklist Pg C4 provides detail

3. Evaluate the SWOT analysis (4 Marks 1-2 Pages

– Is the company in an overall strong competitive position?

– Can it continue to purpose its current business or corporate level strategy profitably?

– What can the company do to turn weaknesses into strengths and threats into opportunities?

– Can it develop new functional, business or corporate strategies to accomplish this change?

Questions to consider: a. Evaluate the competitive strategy of 3DO? What was 3DO’s strategy? What are the problems with this strategy? What flaws can you see in 3DO’s approach? b. Why has Sony PlayStation succeeded where 3DO failed?

4. The kind of corporate level strategy that the company is pursuing & the nature of the company’s business-level strategy. (6 marks 2-3 Pages)

– Define the companies mission and goals

– Debate merits of their current strategy.

– Identify the company’s generic competitive strategy – differentiation, low-cost, or focus – and its investment strategy, given its relative competitive position and the stage of the life cycle.

– Identify functional strategies that a company pursues to build competitive advantage through superior efficiency, quality, innovation, and customer responsiveness.

Questions to consider: c. How did Nintendo successfully recreate the home video game business following the Atari-era boom and bust? d. How was Nintendo able to capture value from the home video game business?

e. How was Sega able to gain market share from Nintendo?

5. Make Recommendations (4 Marks -2 Pages)

– Recommendations are directed at solving whatever strategic problem the company is facing and increasing its future profitability.

Questions to consider:

a. What lessons can be learnt from the history of the home video game industry that were used to help launch the Sony PlayStation II and Microsoft’s Xbox? Do Microsoft and Sony appear to have learnt and applied these lessons? b. Evaluate the introduction of the Xbox 360, Sony PlayStation 3, and Nintendo’s Wii. What lessons can be learned from these events? How did Nintendo re-establish itself in this market with the Wii?

An Industry Is Born In 1968, Nolan Bushell, the 24-year-old son of a Utah cement contractor, graduated from the University of Utah with a degree in engineering.1 Bushnell then moved to California, where he worked briefl y in the computer graphics division of Ampex. At home, Bush- nell turned his daughter’s bedroom into a laboratory. There, he created a simpler version of Space War, a computer game that had been invented in 1962 by an MIT graduate student, Steve Russell. Bushnell’s version of Russell’s game, which he called Computer Space, was made of integrated circuits connected to a 19-inch black-and-white television screen. Unlike a computer, Bushnell’s invention could do nothing but play the game, which meant that, unlike a computer, it could be produced cheaply.

Bushnell envisioned video games like his stand- ing next to pinball machines in arcades. With hopes of having his invention put into production, Bushnell left Ampex to work for a small pinball company that manufactured 1,500 copies of his video game. The game never sold, primarily because the player had to read a full page of directions before he or she could play the game—way too complex for an arcade game. Bushnell left the pinball company and with a friend, Ted Dabney, put up $500 to start a company that would develop a simpler video game. They wanted to call the company Syzygy, but the name was already taken, so they settled on Atari, a Japanese word that was the equivalent of “check in the go.”

In his home laboratory, Bushnell built the sim- plest game he could think of. People knew the rules

immediately, and it could be played with one hand. The game was modeled on table tennis, and players batted a ball back and forth with paddles that could be moved up and down sides of a court by twisting knobs. He named the game “Pong” after the sonar- like sound that was emitted every time the ball con- nected with a paddle.

In the fall of 1972, Bushnell installed his proto- type for Pong in Andy Capp’s tavern in Sunnyvale, California. The only instructions were “avoid miss- ing the ball for a high score.” In the fi rst week, 1,200 quarters were deposited in the casserole dish that served as a coin box in Bushnell’s prototype. Bushnell was ecstatic; his simple game had brought in $300 in a week. The pinball machine that stood next to it averaged $35 a week.

Lacking the capital to mass-produce the game, Bushnell approached established amusement game companies, only to be repeatedly shown the door. Down but hardly out, Bushnell cut his hair, put on a suit, and talked his way into a $50,000 line of credit from a local bank. He set up a production line in an abandoned roller skating rink and hired people to assemble machines while Led Zeppelin and the Rolling Stones played at full volume over the speaker system of the rink. Among his fi rst batch of employees was a skinny 17-year-old named Steve Jobs, who would later found a few companies of his own, including Apple Computer, NeXT, and Pixar. Like others, Jobs had been attracted by a classifi ed ad that read “Have Fun and Make Money.”

In no time at all, Bushnell was selling all the machines that his small staff could make—about

This case was prepared by Charles W. L. Hill, the University of Washington. This case is intended to be used as a basis for class discussion rather than as an illustration of either effective or ineffective handling of the situation. Reprinted by permission of Charles W. L. Hill.

The Home Video Game Industry: Atari Pong to the Nintendo Wii

C35

3

C36 Section A: Business Level Cases: Domestic and Global

10 per day; to grow, however, he needed additional capital. The ambience at the rink, with its mix of rock music and marijuana fumes, put off most potential investors, but Don Valentine, one of the country’s most astute and credible venture capitalists, was impressed with the growth story. Armed with Valentine’s money, Atari began to increase produc- tion and expand its range of games. New games included Tank and Breakout; the latter was designed by Jobs and a friend of his, Steve Wozniak, who had left HP to work at Atari.

By 1974, 100,000 Pong-like games were sold worldwide. Although Atari manufactured only 10% of the games, the company still made $3.2 million that year. With the Pong clones coming on strong, Bushnell decided to make a Pong system for the home. In fact, Magnavox had been marketing a similar game for the home since 1972, although sales had been modest.2 Bushnell’s team managed to compress Atari’s coin-operated Pong game down to a few inexpensive circuits that were contained in the game console. Atari’s Pong had a sharper pic- ture and more sensitive controllers than Magnavox’s machine. It also cost less. Bushnell then went on a road show, demonstrating Pong to toy buyers, but he received an indifferent response and no sales. A dejected Bushnell returned to Atari with no idea of what to do next. Then the buyer for the sport- ing goods department at Sears came to see Bushnell, reviewed the machine, and offered to buy every home Pong game Atari could make. With Sears’s backing, Bushnell boosted production. Sears ran a major tele- vision ad campaign to sell home Pong, and Atari’s sales soared, hitting $450 million in 1975. The home video game had arrived.

Boom and Bust Nothing attracts competitors like success, and by 1976 about 20 different companies were crowd- ing into the home video game market, including National Semiconductor, RCA, Coleco, and Fair- child. Recognizing the limitations of existing home video game designs, in 1976, Fairchild came out with a home video game system capable of playing mul- tiple games. The Fairchild system consisted of three components—a console, controllers, and cartridges. The console was a small computer optimized for

graphics processing capabilities. It was designed to receive information from the controllers, process it, and send signals to a television monitor. The control- lers were handheld devices used to direct on-screen action. The cartridges contained chips encoding the instructions for a game. The cartridges were designed to be inserted into the console.

In 1976, Bushnell sold Atari to Warner Com- munications for $28 million. Bushnell stayed on to run Atari. Backed by Warner’s capital, in 1977, Atari developed and brought out its own cartridge-based system, the Atari 2600. The 2600 system was sold for $200, and associated cartridges retailed for $25 to $35. Sales surged during the 1977 Christmas season. However, a lack of manufacturing capac- ity on the part of market-leader Atari and a very cautious approach to inventory by Fairchild led to shortages and kept sales signifi cantly below what they could have been. Fairchild’s cautious approach was the result of prior experience in consumer elec- tronics. A year earlier, it had increased demand for its digital watches, only to accumulate a buildup of excess inventory that had caused the company to take a $24.5 million write-off.3

After the 1977 Christmas season, Atari claimed to have sold about 400,000 units of the 2600 VCA, about 50% of all cartridge-based systems in American homes. Atari had also earned more than $100 million in sales of game cartridges. By this point, second-place Fairchild sold about 250,000 units of its system. Cartridge sales for the year totaled about 1.2 million units, with an average selling price of about $20. Fresh from this success and fortifi ed by market forecasts predicting sales of 33 million car- tridges and an installed base of 16 million machines by 1980, Bushnell committed Atari to manufactur- ing 1 million units of the 2600 for the 1978 Christ- mas season. Atari estimated that total demand would reach 2 million units. Bushnell was also encouraged by signals from Fairchild that it would again be lim- iting production to approximately 200,000 units. At this point, Atari had a library of nine games, while Fairchild had 17 games.4

Atari was not the only company to be excited by the growth forecasts. In 1978, a host of other com- panies, including Coleco, National Semiconductor, Magnavox, General Instrument, and a dozen other companies, entered the market with incompatible cartridge-based home systems. The multitude of choices did not seem to entice consumers, however,

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C37

and the 1978 Christmas season brought unexpect- edly low sales. Only Atari and Coleco survived an industry shakeout. Atari lost Bushnell, who was ousted by Warner executives. (Bushnell went on to start Chuck E. Cheese Pizza Time Theater, a restau- rant chain that had 278 outlets by 1981.) Bushnell later stated that part of the problem was a disagree- ment over strategy. Bushnell wanted Atari to price the 2600 at cost and make money on sales of soft- ware; Warner wanted to continue making profi ts on hardware sales.5

Several important developments occurred in 1979. First, several game producers and program- mers defected from Atari to set up their own fi rm, Activision, and to make games compatible with the Atari 2600. Their success encouraged others to fol- low suit. Second, Coleco developed an expansion module that allowed its machine to play Atari games. Atari and Mattel (who entered the market in 1979) did likewise. Third, the year 1979 saw the introduc- tion of three new games to the home market—Space Invaders, Asteroids, and Pac Man. All three were adapted from popular arcade games and all three helped drive demand for players.

Demand recovered strongly in late 1979 and kept growing for the next three years. In 1981, United States sales of home video games and cartridges hit $1 billion. In 1982, they surged to $3 billion, with Atari accounting for half of this amount. It seemed as if Atari could do no wrong; the 2600 was every- where. About 20 million units were sold, and by late 1982, a large number of independent companies, including Activision, Imagic, and Epyx, were now producing hundreds of games for the 2600. Second- place Coleco was also doing well, partly because of a popular arcade game, Donkey Kong, which it had licensed from a Japanese company called Nintendo.

Atari was also in contact with Nintendo. In 1982, the company very nearly licensed the rights to Nintendo’s Famicom, a cartridge-based video game system machine that was a big hit in Japan. Atari’s successor to the 2600, the 5200, was not selling well, and the Famicom seemed like a good substitute. The negotiations broke down, however, when Atari discovered that Nintendo had extended its Donkey Kong license to Coleco. This allowed Coleco to port a version of the game to its home computer, which was a direct competitor to Atari’s 800 home computer.6

After a strong 1982 season, the industry hoped for continued growth in 1983. Then the bottom dropped

out of the market. Sales of home video games plunged to $100 million. Atari lost $500 million in the fi rst nine months of the year, causing the stock of parent company Warner Communications to drop by half. Part of the blame for the collapse was laid at the feet of an enormous inventory overhang of unsold games. About 15 to 20 million surplus game cartridges were left over from the 1982 Christmas season (in 1981, there were none). On top of this, approximately 500 new games hit the market in 1993. The average price of a cartridge plunged from $30 in 1979 to $16 in 1982 and then to $4 in 1983. As sales slowed, retailers cut back on the shelf space allocated to video games. It proved diffi cult for new games to make a splash in a crowded market. Atari had to dispose of 6 million ET: The Extraterrestrial games. Meanwhile, big hits from previous years, such as Pac Man, were bundled with game players and given away free to try to encourage system sales.7

Surveying the rubble, commentators claimed that the video game industry was dead. The era of dedi- cated game machines was over, they claimed. Per- sonal computers were taking their place.8 It seemed to be true. Mattel sold off its game business, Fairchild moved on to other things, Coleco folded, and Warner decided to break up Atari and sell its constit- uent pieces—at least, those pieces for which it could fi nd a buyer. No one in America seemed to want to have anything to do with the home video game busi- ness; no one, that is, except for Minoru Arakawa, the head of Nintendo’s United States subsidiary, Nintendo of America (NOA). Picking through the rubble of the industry, Arakawa noticed that there were people who still packed video arcades, bring- ing in $7 billion a year, more money than the entire movie industry. Perhaps it was not a lack of interest in home video games that had killed the industry. Perhaps it was bad business practice.

The Nintendo Monopoly Nintendo was a century-old Japanese company that had built up a profi table business making playing cards before diversifying into the video game busi- ness. Based in Kyoto and still run by the founding Yamauchi family, the company started to diversify into the video game business in the late 1970s. The

C38 Section A: Business Level Cases: Domestic and Global

fi rst step was to license video game technology from Magnavox. In 1977, Nintendo introduced a home video game system in Japan based on this technology that played a variation of Pong. In 1978, the com- pany began to sell coin-operated video games. It had its fi rst hit with Donkey Kong, designed by Sigeru Miyamoto.

The Famicom In the early 1980s, the company’s boss, Hiroshi Yamauchi, decided that Nintendo had to develop its own video game machine. He pushed the company’s engineers to develop a machine that combined supe- rior graphics-processing capabilities and low cost. Yamauchi wanted a machine that could sell for $75, less than half the price of competing machines at the time. He dubbed the machine the Family Computer, or Famicom. The machine that his engineers designed was based on the controller, console, and plug-in cartridge format pioneered by Fairchild. It contained two custom chips—an 8-bit central processing unit and a graphics-processing unit. Both chips had been scaled down to perform only essential functions. A 16-bit processor was available at the time, but to keep costs down, Yamauchi refused to use it.

Nintendo approached Ricoh, the electronics giant, which had spare semiconductor capacity. Employees at Ricoh said that the chips had to cost no more that 2,000 yen. Ricoh thought that the 2,000-yen price point was absurd. Yamauchi’s response was to guar- antee Ricoh a 3-million-chip order within two years. Since the leading companies in Japan were selling, at most, 30,000 video games per year at the time, many within the company viewed this as an outrageous commitment, but Ricoh went for it.9

Another feature of the machine was its memory—2,000 bytes of random access memory (RAM), compared to the 256 bytes of RAM in the Atari machine. The result was a machine with superior graphics-processing capabilities and faster action that could handle far more complex games than Atari games. Nintendo’s engineers also built a new set of chips into the game cartridges. In addi- tion to chips that held the game program, Nintendo developed memory map controller (MMC) chips that took over some of the graphics-processing work from the chips in the console and enabled the system to handle more complex games. With the addition of the MMC chips, the potential for

more- sophisticated and complex games had arrived. Over time, Nintendo’s engineers developed more powerful MMC chips, enabling the basic 8-bit sys- tem to do things that originally seemed out of reach. The engineers also fi gured out a way to include a battery backup system in cartridges that allowed some games to store information independently—to keep track of where a player had left off or track high scores.

The Games Yamauchi recognized that great hardware would not sell itself. The key to the market, he reasoned, was great games. Yamauchi had instructed the engineers, as they were developing the hardware, to make sure that “it was appreciated by software engineers.” Nintendo decided that it would become a haven for game designers. “An ordinary man,” Yamauchi said, “cannot develop good games no matter how hard he tries. A handful of people in this world can develop games that everyone wants. Those are the people we want at Nintendo.”10

Yamauchi had an advantage in the person of Sigeru Miyamoto. Miyamoto had joined Nintendo at the age of 24. Yamauchi had hired Miyamoto, a grad- uate of Kanazawa Munici College of Industrial Arts, as a favor to his father and an old friend, although he had little idea what he would do with an artist. For three years, Miyamoto worked as Nintendo’s staff artist. Then in 1980, Yamauchi called Miyamoto into his offi ce. Nintendo had started selling coin- operated video games, but one of the new games, Radarscope, was a disaster. Could Miyamoto come up with a new game? Miyamoto was delighted. He had always spent a lot of time drawing cartoons, and as a student, he had played video games constantly. Miyamoto believed that video games could be used to bring cartoons to life.11

The game Miyamoto developed was nothing short of a revelation. At a time when most coin- operated video games lacked characters or depth, Miyamoto created a game around a story that had both. Most games involved battles with space invaders or heroes shooting lasers at aliens; Miyamoto’s game did nei- ther. Based loosely on Beauty and the Beast and King Kong, Miyamoto’s game involved a pet ape who runs off with his master’s beautiful girlfriend. His master is an ordinary carpenter called Mario, who has a bul- bous nose, a bushy mustache, a pair of large pathetic

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C39

eyes, and a red cap (which Miyamoto added because he was not good at hairstyles). He does not carry a laser gun. The ape runs off with the girlfriend to get back at his master, who was not especially nice to the beast. The man, of course, has to get his girlfriend back by running up ramps, climbing ladders, jump- ing off elevators, and the like, while the ape throws objects at the hapless carpenter. Since the main char- acter is an ape, Miyamoto called him Kong; because the main character is as stubborn as a donkey, he called the game Donkey Kong.

Released in 1981, Donkey Kong was a sensation in the world of coin-operated video arcades and a smash hit for Nintendo. In 1984, Yamauchi again summoned Miyamoto to his offi ce. He needed more games, this time for Famicom. Miyamoto was made the head of a new research and development (R&D) group and told to come up with the most imagina- tive video games ever.

Miyamoto began with Mario from Donkey Kong. A colleague had told him that Mario looked more like a plumber than a carpenter, so a plumber he became. Miyamoto gave Mario a brother, Luigi, who was as tall and thin as Mario was short and fat. They became the Super Mario Brothers. Since plumbers spend their time working on pipes, large green sewer pipes became obstacles and doorways into secret worlds. Mario and Luigi’s task was to search for the captive Princess Toadstool. Mario and Luigi are endearing bumblers, unequal to their tasks yet surviving. They shoot, squash, or evade their enemies—a potpourri of inventions that include fl ying turtles and stinging fi sh, man-eating fl owers and fi re-breathing dragons— while they collect gold coins, blow air bubbles, and climb vines into smiling clouds.12

Super Mario Brothers was introduced in 1985. For Miyamoto, this was just the beginning. Between 1985 and 1991, Miyamoto produced eight Mario games. About 60 to 70 million were sold world- wide, making Miyamoto the most successful game designer in the world. After adapting Donkey Kong for Famicom, he also went on to create other top- selling games, including another classic, The Legend of Zelda. While Miyamoto drew freely from folk- lore, literature, and pop culture, the main source for his ideas was his own experience. The memory of being lost among a maze of sliding doors in his family’s home was re-created in the labyrinths of the Zelda games. The dog that attacked him when he was a child attacks Mario in Super Mario. As a child,

Miyamoto had once climbed a tree to catch a view of far-off mountains and had become stuck. Mario gets himself in a similar fi x. Once Miyamoto went hiking without a map and was surprised to stumble across a lake. In the Legend of Zelda, part of the adventure is in walking into new places without a map and being confronted by surprises.

Nintendo in Japan Nintendo introduced Famicom into the Japanese market in May 1983. Famicom was priced at $100, more than Yamauchi wanted, but signifi cantly less than the products of competitors. When he intro- duced the machine, Yamauchi urged retailers to forgo profi ts on the hardware because it was just a tool to sell software, and that is where they would make their money. Backed by an extensive advertising cam- paign, 500,000 units of Famicom were sold in the fi rst two months. Within a year, the fi gure stood at 1 million, and sales were still expanding rapidly. With the hardware quickly fi nding its way into Japanese homes, Nintendo was besieged with calls from des- perate retailers frantically demanding more games.

At this point, Yamauchi told Miyamoto to come up with the most imaginative games ever. However, Yamauchi also realized that Nintendo alone could not satisfy the growing thirst for new games, so he initiated a licensing program. To become a Nintendo licensee, companies had to agree to an unprecedented series of restrictions. Licensees could issue only fi ve Nintendo games per year, and they could not write those titles for other platforms. The licensing fee was set at 20% of the wholesale price of each cartridge sold (game cartridges wholesaled for around $30). It typically cost $500,000 to develop a game and took around six months. Nintendo insisted that games not contain any excessively violent or sexually sugges- tive material and that they review every game before allowing it to be produced.13

Despite these restrictions, six companies (Bandai, Capcom, Konami, Namco, Taito, and Hudson) agreed to become Nintendo licensees, not least because millions of customers were now clamoring for games. Bandai was Japan’s largest toy company. The others already made either coin-operated video games or computer software games. Because of these licensing agreements, they saw their sales and earn- ings surge. For example, Konami’s earnings went from $10 million in 1987 to $300 million in 1991.

C40 Section A: Business Level Cases: Domestic and Global

After the six licensees began selling games, reports of defective games began to reach Yamauchi. The original six licensees were allowed to manufac- ture their own game cartridges. Realizing that he had given away the ability to control the quality of the cartridges, Yamauchi decided to change the contract for future licensees. Future licensees were required to submit all manufacturing orders for cartridges to Nintendo. Nintendo charged licensees $14 per car- tridge, required that they place a minimum order for 10,000 units (later the minimum order was raised to 30,000), and insisted on cash payment in full when the order was placed. Nintendo outsourced all man- ufacturing to other companies, using the volume of its orders to get rock bottom prices. The cartridges were estimated to cost Nintendo between $6 and $8 each. The licensees then picked up the cartridges from Nintendo’s loading dock and were responsible for distribution. In 1985, there were 17 licensees. By 1987, there were 50. By this point, 90% of the home video game systems sold in Japan were Nintendo systems.

Nintendo in America In 1980, Nintendo established a subsidiary in America to sell its coin-operated video games. Yamauchi’s American-educated son-in-law, Minoru Arakawa, headed the subsidiary. All of the other essential employees were Americans, including Ron Judy and Al Stone. For its fi rst two years, Nintendo of America (NOA), based originally in Seattle, struggled to sell second-rate games such as Radarscope. The subsid- iary seemed on the brink of closing. NOA could not even make the rent payment on the warehouse. Then they received a large shipment from Japan: 2,000 units of a new coin-operated video game. Opening the box, they discovered Donkey Kong. After playing the game briefl y, Judy proclaimed it a disaster. Stone walked out of the building, declar- ing that “It’s over.”14 The managers were appalled. They could not imagine a game less likely to sell in video arcades. The only promising sign was that a 20-year employee, Howard Philips, rapidly became enthralled with the machine.

Arakawa, however, knew he had little choice but to try to sell the machine. Judy persuaded the owner of the Spot Tavern near Nintendo’s offi ce to take one of the machines on a trial basis. After one night, Judy discovered $30 in the coin box, a phenomenal

amount. The next night there was $35, and $36 the night after that. NOA had a hit on its hands.

By the end of 1982, NOA had sold more than 60,000 copies of Donkey Kong and had booked sales in excess of $100 million. The subsidiary had outgrown its Seattle location. They moved to a new site in Redmond, a Seattle suburb, where they located next to a small but fast-growing software company run by an old school acquaintance of Howard Philips, Bill Gates.

By 1984, NOA was riding a wave of success in the coin-operated video game market. Arakawa, however, was interested in the possibilities of sell- ing Nintendo’s new Famicom system in the United States. Throughout 1984, Arakawa, Judy, and Stone met with numerous toy and department store rep- resentatives to discuss the possibilities, only to be repeatedly rebuffed. Still smarting from the 1983 debacle, the representatives wanted nothing to do with the home video game business. They also met with former managers from Atari and Coleco to gain their insights. The most common response they received was that the market collapsed because the last generation of games were awful.

Arakawa and his team decided that if they were going to sell Famicom in the United States, they would have to fi nd a new distribution channel. The obvi- ous choice was consumer electronics stores. Thus, Arakawa asked the R&D team in Kyoto to rede- sign Famicom for the United States market so that it looked less like a toy (Famicom was encased in red and white plastic), and more like a consumer elec- tronics device. The redesigned machine was renamed the Nintendo Entertainment System (NES).

Arakawa’s big fear was that illegal, low-quality Taiwanese games would fl ood the United States market if NES was successful. To stop counterfeit games from being played on NES, Arakawa asked Nintendo’s Japanese engineers to design a security system into the U.S. version of Famicom so that only Nintendo-approved games could be played on NES. The Japanese engineers responded by design- ing a security chip that was embedded in the game cartridges. NES would not work unless the security chips in the cartridges unlocked, or shook hands with, a chip in NES. Since the code embedded in the security chip was proprietary, the implication of this system was that no one could manufacture games for NES without Nintendo’s specifi c approval.

To overcome the skepticism and reluctance of retailers to stock a home video game system, Arakawa

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C41

decided in late 1985 to make an extraordinary com- mitment. Nintendo would stock stores and set up displays and windows. Retailers would not have to pay for anything they stocked for 90 days. After that, retailers could pay Nintendo for what they sold and return the rest. NES was bundled with Nintendo’s best-selling game in Japan, Super Mario Brothers. It was essentially a risk-free proposition for retailers, but even with this, most were skeptical. Ultimately, thirty Nintendo personnel descended on the New York area. Referred to as the Nintendo SWAT team, they persuaded some stores to stock NES after an extraordinary blitz that involved 18-hour days. To support the New York product launch, Nintendo also committed itself to a $5 million advertising campaign aimed at the 7- to 14-year-old boys who seemed to be Nintendo’s likely core audience.

By December 1985, between 500 and 600 stores in the New York area were stocking Nintendo sys- tems. Sales were moderate, about half of the 100,000 NES machines shipped from Japan were sold, but it was enough to justify going forward. The SWAT team moved fi rst to Los Angeles, then to Chicago, then to Dallas. As in New York, sales started at a moderate pace, but by late 1986 they started to accel- erate rapidly, and Nintendo went national with NES.

In 1986, around 1 million NES units were sold in the United States. In 1987, the fi gure increased to 3 million. In 1988, it jumped to over 7 million. In the same year, 33 million game cartridges were sold. Nintendo mania had arrived in the United States. To expand the supply of games, Nintendo licensed the rights to produce up to fi ve games per year to 31 American software companies. Nintendo contin- ued to use a restrictive licensing agreement that gave it exclusive rights to any games, required licensees to place their orders through Nintendo, and insisted on a 30,000-unit minimum order.15

By 1990, the home video game market was worth $5 billion worldwide. Nintendo dominated the industry, with a 90% share of the market for game equipment. The parent company was, by some measures, now the most profi table company in Japan. By 1992, it was netting over $1 billion in gross profi t annually, or more than $1.5 million for each employee in Japan. The company’s stock market value exceeded that of Sony, Japan’s premier consumer electronics fi rm. Indeed, the company’s net profi t exceeded that of all the American movie studios combined. Nintendo games, it seemed, were bigger than the movies.

As of 1991, there were more than 100 licens- ees for Nintendo, and more than 450 titles were available for NES. In the United States, Nintendo products were distributed through toy stores (30% of volume), mass merchandisers (40% of volume), and department stores (10% of volume). Nintendo tightly controlled the number of game titles and games that could be sold, quickly withdrawing titles as soon as interest appeared to decline. In 1988, retailers requested 110 million cartridges from Nin- tendo. Market surveys suggested that perhaps 45 million could have been sold, but Nintendo allowed only 33 million to be shipped.16 Nintendo claimed that the shortage of games was in part due to a worldwide shortage of semiconductor chips.

Several companies had tried to reverse-engineer the code embedded in Nintendo’s security chip, which competitors characterized as a lockout chip. Nintendo successfully sued them. The most notable was Atari Games, one of the successors of the origi- nal Atari, which in 1987 sued Nintendo of America for anticompetitive behavior. Atari claimed that the purpose of the security chip was to monopolize the market. At the same time, Atari announced that it had found a way around Nintendo’s security chip and would begin to sell unlicensed games.17 NOA responded with a countersuit. In a March 1991 rul- ing, Atari was found to have obtained Nintendo’s security code illegally and was ordered to stop selling NES-compatible games. However, Nintendo did not always have it all its own way. In 1990, under pres- sure from Congress, the Department of Justice, and several lawsuits, Nintendo rescinded its exclusivity requirements, freeing up developers to write games for other platforms. However, developers faced a real problem: what platform could they write for?

Sega’s Sonic Boom Back in 1954, David Rosen, a 20-year-old American, left the U.S. Air Force after a tour of duty in Tokyo.18 Rosen had noticed that Japanese people needed lots of photographs for ID cards, but local photo studios were slow and expensive. He formed a company, Rosen Enterprises, and went into the photo-booth business, which was a big success. By 1957, Rosen had established a successful nationwide chain. At

C42 Section A: Business Level Cases: Domestic and Global

this point, the Japanese economy was booming, so Rosen decided it was time to get into another business—entertainment. As his vehicle, he chose arcade games, which were unknown in Japan at the time. He picked up used games on the cheap from America and set up arcades in the same Japanese department stores and theaters that typically housed his photo booths. Within a few years, Rosen had 200 arcades nationwide. His only competition came from another American-owned fi rm, Service Games (SeGa), whose original business was jukeboxes and fruit machines.

By the early 1960s, the Japanese arcade market had caught up with the United States market. The problem was that game makers had run out of excit- ing new games to offer. Rosen decided that he would have to get into the business of designing and manu- facturing games, but to do that he needed manufac- turing facilities. SeGa manufactured its own games, so in 1965 Rosen approached the company and sug- gested a merger. The result was Sega Enterprise, a Japanese company with Rosen as its CEO.

Rosen designed Sega’s fi rst game, Periscope, in which the objective was to sink chain-mounted cardboard ships by fi ring torpedoes, represented by lines of colored lights. Periscope was a big success not only in Japan but also in the United States and Europe. It allowed Sega to build up a respectable export business. Over the years, the company contin- ued to invest heavily in game development, always using the latest electronic technology.

Gulf and Western (G&W), a United States con- glomerate, acquired Sega in 1969, with Rosen running the subsidiary. In 1975, Gulf and Western (G&W) took Sega public in the United States but kept Sega Japan as a G&W subsidiary. Hayao Nakayama, a former Sega distributor, was drafted as president. In the early 1980s, Nakayama pushed G&W to invest more in Sega Japan so that the company could enter the then-booming home video game market. When G&W refused, Nakayama suggested a management buyout. G&W agreed, and in 1984, for the price of just $38 million, Sega became a Japanese company once more. (Sega’s Japanese revenues were about $700 million, but by now the company was barely profi table.)

Sega was caught off guard by the huge success of Nintendo’s Famicom. Although it released its own 8-bit system in 1986, the machine never commanded more than 5% of the Japanese market. Nakayama, however, was not about to give up. From years in

the arcade business, he understood that great games drove sales. Nevertheless, he also understood that more powerful technology gave game developers the tools to develop more appealing games. This phi- losophy underlay Nakayama’s decision to develop a 16-bit game system, Genesis.

Sega took the design of its 16-bit arcade machine and adapted it for Genesis. Compared to Nintendo’s 8-bit machine, the 16-bit machine featured an array of superior technological features, including high- defi nition graphics and animation, a full spectrum of colors, two independent scrolling backgrounds that created an impressive depth of fi eld, and near CD quality sound. The design strategy also made it easy to port Sega’s catalog of arcade hits to Genesis.

Genesis was launched in Japan in 1989 and in the United States in 1990. In the United States, the machine was priced at $199. The company hoped that sales would be boosted by the popularity of its arcade games, such as the graphically violent Altered Beast. Sega also licensed other companies to develop games for the Genesis platform. In an effort to recruit licensees, Sega asked for lower royalty rates than Nintendo, and it gave licensees the right to manufac- ture their own cartridges. Independent game devel- opers were slow to climb on board, however, and the $200 price tag for the player held back sales.

One of the fi rst independent game developers to sign up with Sega was Electronic Arts (EA). Estab- lished by Trip Hawkins, EA had focused on designing games for personal computers and consequently had missed the Nintendo 8-bit era. Now Hawkins was determined to get a presence in the home video game market, and aligning his company’s wagon with Sega seemed to be the best option. The Nintendo playing fi eld was already crowded, and Sega offered a far less restrictive licensing deal than Nintendo. EA sub- sequently wrote several popular games for Genesis, including John Madden football and several gory combat games.19

Nintendo had not been ignoring the potential of the 16-bit system. Nintendo’s own 16-bit system, Super NES, was ready for market introduction in 1989—at the same time as Sega’s Genesis. Nintendo introduced Super NES in Japan in 1990, where it quickly established a strong market presence and beat Sega’s Genesis. In the United States, however, the company decided to hold back longer to reap the full benefi ts of the dominance it enjoyed with the 8-bit NES system. Yamauchi was also worried about

Case 3 The Home Video Game Industry: Atari Pong to the Nintendo Wii C43

the lack of backward compatibility between Ninten- do’s 8-bit and 16-bit systems. (The company had tried to make the 16-bit system so that it could play 8-bit games but concluded that the cost of doing so was prohibitive.) These concerns may have led the com- pany to delay market introduction until the 8-bit mar- ket was saturated.

Meanwhile, in the United States, the Sega band- wagon was beginning to gain momentum. One devel- opment that gave Genesis a push was the introduction of a new Sega game, Sonic the Hedgehog. Developed by an independent team that was contracted to Sega, the game featured a cute hedgehog that impatiently tapped his paw when the player took too long to act. Impatience was Sonic’s central feature—he had places to go—and quickly. He zipped along, collect- ing brass rings when he could fi nd them, before roll- ing into a ball and fl ying down slides with loops and underground tunnels. Sonic was Sega’s Mario.

In mid-1991, in an attempt to jump-start slow sales, Tom Kalinske, head of Sega’s American sub- sidiary, decided to bundle Sonic the Hedgehog with the game player. He also reduced the price for the bundled unit to $150, and he relaunched the system with an aggressive advertising campaign aimed at teenagers. The campaign was built around the slo- gan “Genesis does what Nintendon’t.” The shift in strategy worked, and sales accelerated sharply.

Sega’s success prompted Nintendo to launch its own 16-bit system. Nintendo’s Super NES was introduced at $200. However, Sega now had a two- year head start in games. By the end of 1991, about 125 game titles were available for Genesis, compared to 25 for Super NES. In May 1992, Nintendo reduced the price of Super NES to $150. At this time Sega was claiming a 63% share of the 16-bit market in the United States, and Nintendo claimed a 60% share. By now, Sega was cool. It began to take more chances with mass media-defi ned morality. When Acclaim Entertainment released its bloody Mortal Kombat game in September 1992, the Sega version let players rip off heads and tear out hearts. Refl ecting Ninten- do’s image of their core market, its version was sani- tized. The Sega version outsold Nintendo’s two to one.20 Therefore, the momentum continued to run in Sega’s favor. By January 1993, there were 320 titles available for Sega Genesis and 130 for Super NES. In early 1994, independent estimates suggested that Sega had 60% of the United States market and Nin- tendo had 40%, fi gures that Nintendo disputed.

3DO Trip Hawkins, whose fi rst big success was EA, founded 3DO in 1991.21 Hawkins’s vision for 3DO was to shift the home video game business away from the existing cartridge-based format and toward a CD-ROM-based platform. The original partners in 3DO were EA, Matsushita, Time Warner, AT&T, and the venture capital fi rm Kleiner Perkins. Collec- tively, they invested more than $17 million in 3DO, making it the richest start-up in the history of the home video game industry. 3DO went public in May 1993 at $15 per share. By October of that year, the stock had risen to $48 per share, making 3DO worth $1 billion—not bad for a company that had yet to generate a single dollar in revenues.