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.