Tuesday, April 21, 2009

A Costly Price War

I've talked quite a bit in the past about the turning point that the year 2004 represented in the video game business. To recap, in that year the internet revolution finally rocked the game business to its core, with electronic distribution and new business models reaching mainstream acceptance. Between the release of World of Warcraft, the launch of Half Life 2 through Steam, the Shanda, TenCent and JAMDAT IPOs, and several other events, 2004 was a watershed year for the industry. I've argued that the nature of value creation in the video game business, traditionally grounded on intellectual property ownership and retail distribution, was forever disrupted.

But something else of great importance happened in 2004 that often gets overlooked in critical reviews of the business. It was much more subtle and easy to miss -- a publisher launched a super high quality product and offered it for sale at a very low price. This relatively small act of busting the pricing cartel and using QPR (quality/price ratio) as a competitive weapon had profound implications for one of the industry's great companies.

The game was Sega/Take-Two's ESPN NFL 2K5. This American football simulation, developed by Visual Concepts, was first launched on the Sega Dreamcast in 1999. It was considered innovative, but hampered by it's exclusive association with Sega's poorly-accepted hardware platform. In 2001, the franchise went multi-platform, and in 2003 added the ESPN branding to its NFL license. Sega aimed the product directly at one of the most popular and successful video games of all time, EA Sports John Madden NFL Football, with limited results. In 2003, Madden outsold 2K4 over 10-to-1.

In 2004, Sega agreed to co-publish 2K5 with Take-Two. The companies, faced with a daunting entrenched competitor but possessing a high quality product, took an innovative approach: they offered the game at retail for $19.99, less than half the price of Madden. And they sold boatloads. They went from less than 10% unit share of the football category, to well over 30%, and expanded the overall market.

The success of the 2K5 strategy provoked an extremely aggressive response from EA. By the end of December 2004, EA announced a five year exclusive licensing arrangement with the NFL and the NFL Players' Association. By the end of January 2005, they added a 15 year deal with ESPN, effectively stripping the 2K franchise of its branding (and most of it's legitimacy as a football simulation).

But EA accomplished this at tremendous cost. At the time of the deal, there was speculation that EA paid in excess of $300MM for these rights. Let's do some math. Let's assume, for the sake of argument, that number is correct. It creates a royalty burden of $60MM per year for each of the five years of the deal, that must be amortized across units sold. Assuming 5 million units sold at $35 wholesale (it's likely more units at a blended lower wholesale), that's a royalty burden of $12 per unit, or over 33%. Based on my direct experience as an NFL/NBA/MLB licensee at JAMDAT, that's almost twice what we paid for non-exclusive rights to the league and players' association in a typical deal.

Play that out a little further. That's over $25MM annually that would have dropped to EA's bottom line, or around 8 cents per share. Just to give you a little perspective, EA earned 75 cents per share in fiscal '06 and 24 cents per share in '07. They lost $1.45 per share in fiscal '08.

EA accomplished their goal of eliminating the 2K series as a competitive threat (in fact, they eliminated it as a product altogether), but at tremendous cost to profitability from one their most reliable profit contributors, Madden. At the time, the analysts lined up to praise the deal, assuming that EA knew what it was doing and that they could grow the football market to accommodate the increased royalties. But I wonder how many of them would think it was anything other than a Pyrrhic victory now.


Ben said...

Great post Mitch. I would also add Take Two answered EA's knee-jerk exclusive with the NFL with a truly absurd exclusive with MLB that didn't lock out 1st parties. Take Two has lost $$$ every year on that deal while Sony continues to be the class of the baseball world with their last man standing team in San Diego that devs "The Show".


A costly relo for your next blog post would be the story of how EA lost the Medal of Honor team to Activision by insisting they relocate to their Los Angeles office from Oklahoma.

S. Foust said...

Interesting post Mitch.

I imagine there is a pretty complex cost-benefit analysis in determining whether to go with licensed IP or internally developed IP.

How often do you think the costs of licensing undermine the profitability of a game and the longevity of a franchise? It seems like there is an immediate benefit in terms of ready access to a built-in audience for an established IP, but I suspect there is also a significant risk that a burgeoning franchise can be held hostage by its own success come renegotiation.

What's the solution here? Develop your own IP? Do a blend of licensed IP to build up capital to fund internal IP? Is one model better than the other?

kelly said...

It's not unlike the strategy EA/JR employed a few years earlier against Sony's NFL Gameday. EA's marketing costs for the inferior Madden 98 --- the last non-polygonal Madden --- were astronomical compared to their previous spends. In addition, EA engaged in the highest level of ass-kissing/arm-twisting any third party ever did to curry the favor of Sony. Add in that SCEA's Japanese management didn't care at all about the U.S. sports category (look at the original PlayStation One package --- includes screenshot of a Madden game that didn't ship and omitted the first NFL Gameday that shipped within weeks of the hardware) and you have the seeds of EA's victory. EA nearly lost football hegemony then, and the fact they over-reacted to Sega/2K's Football has its roots in how EA competed with SCEA and later 989 Sports. The only downside to EA having to cough up most of their profits to the NFL is that, well, the NFL isn't such a nice group of fellas either...

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