Packaged Goods

I got a lot of feedback about my EA post. Since this blog is normally read by around 50 people, I welcome the new visitors. But because many people are here for the first time with no context, I think it's important that I try to distinguish the forest from the trees. My 50 regular readers know what I mean by "transition to digital" but a lot of the first-time readers don't.

EA has in the past three years invested in a bunch of interesting original IP and has vastly improved product quality. They have many compelling packaged goods games in the pipeline. From a consumer's perspective, there's a lot to be said for that, and many of the comments I have gotten have been centered around EA's turn-around from the hard core gamer's perspective. They have created a ton of goodwill with core gamers.

My point was not about whether Dead Space was a good game or not. It is. But it's largely irrelevant, a bit like winning a hand at a blackjack table in Vegas. The odds are stacked against you long-term. And this is my view of the packaged goods business. We can argue about how long it's going to take, but at some point in the not-too-distant future, the packaged goods games business is going the way of music CDs and books. You may still be buying games for $50 and downloading them (although I kind of doubt that will be the winning model). But one way or another, the games BUSINESS is going to transform into an e-commerce business.

This has many important implications. In an e-commerce world, the mechanics of distribution are completely different. It's about clicks, and visits, and trial (free-to-play) and conversions, and customer acquisition costs. This is a totally different way of thinking about distribution. The old packaged goods mentality of sell-in, inventory management, and crescendo marketing is totally useless in this new arena.

In addition, I think it's highly likely that we see a contemporaneous disruption created by the rise of games-as-a-service. World of Warcraft has shown that you can create an enormous business around a game that was released 5 years ago and then refreshed, updated, and run as a service in the interim. The amazing Zynga has shown the combined power of virtual goods in the games-as-service environment, and the benefit of a blue ocean distribution channel on Facebook.

The digital revolution has struck most media businesses as a form of what I would call "un-bundling." In the music business, this has taken the form of the rise of the internet-distributed MP3 song over the store-bought CD (originally, and mostly illegally on Napster, more recently and legitimately on iTunes). In TV, it was the DVR and cable channel expansion that killed the bundle known as network primetime.

There has been a lot of speculation about what form "un-bundling" will take in the games business. My own perspective is that the internet and digital distribution will create an un-bundling of time in the games business. Right now, the big publishers charge $60 for 40-80 hours of game play. I pay this price whether I play the game for an hour or whether I play it for hundreds of hours. I think that the rise of virtual goods and free-to-play models are leading indicators of this shift to un-bundle game time. So are the rise of casual, social and even mobile gaming. They are ways to capture gamer interest, and willingness to pay, in a manner other than the traditional $60 for 40 hours.

It is my opinion that media companies facing these sorts of market disruptions do better by embracing them early and taking their medicine, even if that means taking the axe to some of your existing businesses and processes. A great example of this is the Chinese game publisher Shanda, who recently changed their business model, took a year of pain and diminished stock price to get there, and then came back stronger than before. It takes a lot of courage to do this, because it's unpopular with your team, unpopular with your investors, and even, short-term, unpopular with your customers.

The US packaged goods companies have collected some important assets that position them on this road to the future. Blizzard, and Playfish, and Pogo, and JAMDAT are all examples. But in my opinion true leadership in the games business is going to mean betting the farm on these models and abandoning the CD-ROM as anything other than an alternative to downloading. Nobody had done that yet. Either it will happen, or a company like Zynga will leverage it's highly-advantaged distribution position into the core games market. The fanboys are going to recoil in horror from that statement, but it may be a lot easier for Zynga to buy up independent core games with e-commerce models (like Global Agenda, for example), than it will be for the major packaged goods publishers to switch to e-commerce models.

EA's Miss

After the bell today, EA announced a massive miss for their fiscal year, reducing revenue and earnings per share expectations. CFO Eric Brown also said in a conference call that they expect the packaged goods business to be flat to down for Fiscal 2011.

For anyone paying attention to the larger trends in the video game market, this could hardly have come as a surprise. A few days ago, Gamestop, a key packaged goods distributor for EA, announced a similar miss. While Activision was setting sales records with Call of Duty: Modern Warfare 2, EA had no major hits -- although, in fairness the COD:MW2 revenue was probably just filling in a sinkhole at Activision created by a music game business that has fallen off a cliff. EA is in the wrong business, with the wrong cost structure and the wrong team, but somehow they seem to think that it is going to be a smooth, two-year transition from packaged goods to digital. Think again.

John Riccitiello, the EA CEO, took over the reins of the company almost exactly 3 years ago. I was a senior executive at EA just prior to JR's return, and had a number of conversations with then-CEO Larry Probst about strategy at that time. As those who follow my blog know, I believed that the video game business had experienced a sea-change beginning in 2004, one that required immediate and decisive action.

My argument to Probst in February of 2007 was to reduce expenses immediately by a minimum of $200MM annually by reducing headcount and cutting back on ridiculous expenditures on risky titles (during my tenure, Spore and Godfather budgets had ballooned to ridiculous levels, and even spending on middle of the road products like The Simpsons and Superman had reached appalling heights). Meanwhile, I advocated hyper-aggressive R&D investment and acquisitions in a transition to digital distribution and games-as-service; combined with an approach to Wall Street that would position EA as a smaller but significantly more profitable company in the near term, with substantially improved long-term prospects when the digital future arrived.

This suggestion was derided by EA execs at the time -- they literally couldn't imagine going to Wall Street with a message of increased profitability rather than top-line revenue growth. They wanted to make the transition to digital while continuing to grow the packaged goods business. Ironically, they saw their looming innovator's dilemma as clearly as any company in the video game business back in 2006. They just weren't bold enough to act on that knowledge.

The old EA model was a basically a three-legged stool: 1) a profitable, recurring sports business (Madden, FIFA); 2) franchise games that produced big hits on a less frequent basis (The Sims, Need for Speed, Command & Conquer); and 3) a collection of digital assets (e.g.: Pogo & JAMDAT, and now Playfish) and distribution/partnership titles (e.g.: Rock Band & Left 4 Dead). Of those, the only stool leg left intact is the third one. Without the digital assets and the EA Distribution titles, they'd be in even more serious hot water.

EA's sports business has been hamstrung by vastly increased licensing costs (as I've discussed before) and failure to transition to a subscription/variable pricing model. This has substantially reduced the profitability of a business that EA used to rely on to fund other, riskier bets.

But by far the greatest failure of Riccitiello's strategy has been the EA Games division. JR bet his tenure on EA's ability to "grow their way through the transition" to digital/online with hit packaged goods titles. They honestly believed that they had a decade to make this transition (I think it's more like 2-3 years). Since the recurring-revenue sports titles were already "booked" (i.e., fully accounted for in the Wall Street estimates) it fell to EA Games to make hits that could move the needle. It's been a very ugly scene, indeed. From Spore, to Dead Space, to Mirror's Edge, to Need for Speed: Undercover, it's been one expensive commercial disappointment for EA Games after another. Not to mention the shut-down of Pandemic, half of the justification for EA's $850MM acquisition of Bioware-Pandemic. And don't think that Dante's Inferno, or Knights of the Old Republic, is going to make it all better. It's a bankrupt strategy.

So now, a couple of months after the board granted JR another $7 million worth of restricted stock units in addition to 140,000 options and EA Games president Frank Gibeau another $2 million in RSU's, EA cuts financial estimates to the bone. And don't believe this is the end of the bleeding. This latest stock drop, if consistent with the after-hours trading, will wipe out virtually all of the gain from 2009. Unfortunately, the loss comes after one of my favorite EA execs, business warrior John Schappert, returned from Microsoft to take over as COO and started firing 15% of the workforce to reduce costs.

With EA's enterprise value down below $4 billion, it's remarkable that nobody has stepped in to put them out of their misery with an acquisition. Certainly, Disney has been looking at them since I was at the house of the mouse back in the early 90's. And there are Chinese companies, like TenCent, that could easily swallow EA whole.

It's equally amazing that the board continues to support the existing management team through this debacle. Since JR took over, the company has destroyed over $11 billion in market value. Certainly, some of that was the economy and the general erosion of value on NASDAQ, but Activision (the blue line below, vs. EA's red line) has experienced far milder effects from the recession:

It's remarkably hard to kill a company doing $4 billion in revenues. But with flat or down stock performance since Q3 2003, how long are the institutional investors going to continue to hope against hope for a turn-around?