DBST Case Submission

Electronic Arts in Online Gaming

Case Submission

1) Microsoft’s Xbox has accrued cumulative operating losses of $3.5 billion through
mid-2004. Is this investment justified?

Number of U.S. Households with Internet-Ready Game Consoles and Online

Game Consoles, 2000 to 2006
25

20

15

10

0
1999 2000 2001 2002 2003 2004 2005 2006 2007

Online Game Console Households

Internet-Ready Game Console Households

Microsoft was building momentum through its powerful internet enabled Xbox
console and had formed marketing and technology relationships with broadband
providers to ensure their compatibility with online gaming platforms. The video game
industry was growing at a steady pace as it provided a combination of realistic
graphics, complex story lines and a dynamic game design which appealed the masses.
Sales from video game hardware and software were growing, which was correlated
with the installed base of video game i.e. consoles. Thus, video game development
was turning out to be a hit business. Th number of households with internet ready
game consoles had an exponential growth.

As per its vision, Microsoft had positioned its Xbox as a media and entertainment
hub, which was a part of the convergence between computing and entertainment.
They visualized entertainment to become a software business and wanted to create a
platform through Xbox Live where they could sell music, movies etc. Though
Microsoft was incurring losses for the past 3 years, the investment seems justified.
EA had a major market share in the console software market, therefore there was an
opportunity for Microsoft to leverage EA’s reach. The investment in Xbox was
projected to be $3billion at the end of 2004.

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 Console Software Market Share
in 2003
25.00%
20.00%
20.00%
15.00% 11.80%
10.00% 6.90% 6.20% 6.00%
4.60% 4.50% 4.40% 4.00% 4.00%
5.00% 3.10% 2.90% 2.90% 2.60% 2.00%
0.00%
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2003 Share

Electronic Arts: North American Market Share by

Platform
Nintendo 64 games

Nintendo GameCube games

EA’s market share in North
Microsoft Xbox games
America with Xbox as its
PlayStation games
platform was around 18% in
PlayStation 2 games 2001, thus surpassing major
PC games competitors such as Nintendo 64
0% 10% 20% 30% 40% 50% 60% 70% 80% games.
1998 1999 2000 2001

1st- vs. 3rd-Party Origin for Top 25 Titles by

Platform
3rd Party Non-Exclusive Moreover, since the console
makers earned revenue through
3rd Party Exclusive the royalties collected from third
party publishers, there was an
1st Party
opportunity for Microsoft in this
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%100%
segment as it promoted the third
party apps on its platform.
PS2 Xbox GameCube

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 The Xbox Live subscription based model ensured customer retention and a continuous source
of income. Through “Gamertag”, Microsoft wanted to build a thriving gamer community
where the users could create a common ID and password to access various games across sites
and therefore the inconvenience of establishing different IDs and password as in PS2 was
eliminated.

No. of Microsoft Xbox Live subscribers in January 2004 = 500,000

Projected subscribers by June 2004 = 1 million ; 10 million following the launch of the
Xbox2 in late 2005.

Xbox Live bundle Cost = $180

Yearly Subscription cost =$50

Premium downloads cost =$5

Total expected revenue per user =$235

Projected Revenue by 2004 = 235 * 1 million = 235 million

Projected Revenue by 2005 = 235 * 10 million = 2.35 billion

Current projected investment = $3 billion

Therefore, though Microsoft would not recover its initial investment even by 2005, but post
that, all of its investment will be recovered and there for be profits. Thus, considering the
aspect of long-term again, the investment by Microsoft is justified.

2) Why do video game platform providers choose to sell consoles at breakeven or loss-
making prices, profiting instead from royalties charged to game publishers?

The video game platform providers choose to sell consoles at breakeven or loss-making
prices, profiting instead from royalties charged to game publishers primarily because of the
following reasons.

 The console market has a very limited number of players, and a console typically has
an average lifetime of 4-6 years. Hence, once a customer has been acquired, it is a
done deal for 4-6 years for every customer acquired by the console manufacturer.
Hence, the lower price point of the console is one of the most important aspects here
that will make or break the customer acquisition process. Once a customer has been
acquired for such a long time, revenues can be generated periodically by either selling

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 new game titles or subscriptions to the online gaming platform. This strategy ensures
lower customer acquisition costs and higher customer lifetime value. As more of this
happens, the cost will decrease due to economies of scale.
 Because of the 4-6-year console life cycle, consumers often delay purchases in
anticipation of the next-generation consoles. Hence, a lower selling price of the
console could force customers from this category to buy consoles to some extent and
minimize the uncertainty for developers, publishers, and retailers, who had to allocate
scarce capital and human resources across existing and future platforms months or
even years in advance because of the delay I purchase from the customers.
 The profits from royalties charged to game publishers also mean that the video game
platform provider will be more motivated to ensure a rapid expansion of its game
titles, eventually encouraging and supporting more developers in the process to
produce more games. Hit game titles often lead to a greater network effect, thus
increasing paying customers in the long run.
 One of the key parameters for a console’s success is the network effect. The higher
the network effect, the greater the value that a user will derive from the console.
Hence, consoles are often sold at loss-making prices to lure consumers into buying
their products and creating a strong network effect. Eventually, the console
manufacturers try to make up for the losses as more units get sold.

3) Analyse the economics of title exclusivity, i.e an agreement that limits a game’s
availability to a single console. How much could Sony and Microsoft each afford to pay
for exclusivity? How much would publishers demand from each platform provider? For
purpose of analysis, assume:

a) A game costs $6 million to produce, and $1 million to port to each additional

platform.

b) A publisher realizes $20 variable contribution margin on each unit sold(reflecting a

$40 wholesale price, less a 10% IP licencing fee, 12.5% console royalty, 5%
manufacturing cost, 12.5% royalty to studio, and 10% marketing cost; assume for
convenience that these expenses are fully variable, regardless of sales volume).

c) If the game is not exclusive, its publisher expects to sell 500,000 units, with 75% share
to PS2 and 12.5% share each to Xbox and GameCube.

d) If offered on exclusive basis, a console maker’s extra marketing “push” would result
in 400,000 unit sales for PS2 or 100,000 units for either Xbox or GameCube.

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 Non exclusive
Units sold 500000
Market share
XBOX 12.50%
PS2 75%
Game cube 12.50%

    Cost ($)
Content licensing cost 10% 4
Studio revenue 20% 8
Publisher cost 5% 2
Retailer 20% 8
Total retail price   62

Exclusive Calculations –

  For PS2      
   
Units sold 400000  
  Retail price 62  
       
  Total sales revenues 24800000  
  PS2 royalty 3720000 (15% royalty)
Marketing campaign
  cost 5000000 (Top 10 entrant)  
  Difference 1280000  
   
To maintain exclusivity, PS2 can go for as low as $1.28 million
  Game cube      
  Units sold 100000  
  Retail price 62  
       
  Total sales revenue 6200000  
Assuming 12.5%
  Royalty 775000 royalty  
Marketing campaign Assuming top 10
  cost 5000000 entrant  
  Difference 4225000  
   
To maintain exclusivity, Game cube can go for as low as $4.22 million

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  XBOX      
  Units sold 100000  
  Retail price 62  
       
  Total sales revenue 6200000  
  Royalty 620000 Assuming 10% royalty  
Marketing campaign Assuming top 10
  cost 5000000 entrant  
  Difference 4380000  
   
Thus, for XBOX to maintain exclusivity they can go for as low as
  $4.38 million

Exclusive
  PS2 XBOX GameCube
Units sold 400000 100000 100000
Unit contribution $20.00 $20.00 $20.00
Revenue $80,00,000.00 $20,00,000.00 $20,00,000.00
Cost $60,00,000.00 $60,00,000.00 $60,00,000.00
Profit $20,00,000.00 -$40,00,000.00 -$40,00,000.00
   
Non exclusive
Units sold 500000  
Unit contribution $20.00  
Revenue $1,00,00,000.00  
Cost $80,00,000.00  
Profit $20,00,000.00  
   
Royalty PS2 XBOX GameCube
Exclusive $20,00,000.00 $5,00,000.00 $5,00,000.00
Non exclusive $18,75,000.00 $3,12,500.00 $3,12,500.00
Total non-exclusive     $25,00,000.00
       
Exclusive - Non exclusive $1,25,000.00 $1,87,500.00 $1,87,500.00
Publishers demand 0 $60,00,000.00 $60,00,000.00

4) Will console-based online gaming emerge as a mass-market phenomenon? How

important is network effect?

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Yes, the market signs & consumer behaviour in 2002 were pointing towards this
phenomenon. Video game related revenues had grown rapidly over the turn of the century
and had reached a total of $10.3 billion in 2002 which remarkably was greater than motion
picture box office revenues. Console game software accounted for a total of $5.4 billion
(52%), console hardware was worth $3.4 billion (33%).

Sony’s PS2, which was launched in October 2002 had a one-year head start with respect to its
main competitors Xbox & GameCube. This gave it a bigger and broader player base of over
60 million across the world. The “Tie ratio” of PS2 which can be interpreted as the average
number of games sold per console was forecasted to cross the previous generation’s high of
10.4 and reach an all-time high of 12.8 by the end of its life cycle.

All these factors along with the huge market being dominated by PS2, gave an attractive
starting point for video game developers, whose process was heavily dependent on a hit-
refund new titles cyclic approach. The market however favoured capital heavy firms as the
production & licensing costs increased over the years which made the smaller firms fight for
survival. Along with this, there was the smaller life cycle of consoles and other platforms
which delayed purchases causing difficulty for the firms in resource allocation for current and
next-gen platforms well in advance. One major concern which wasn’t in the control of the
industry was the penetration of Internet broadband connection in the U.S households. By
October 2003, only 20% of all U.S households and 40% of the ones with internet access had
a digital subscriber line (DSL) which was the driving force behind subscription based online
gaming adoption by the mass market.

As the newer generation was more tech savvy & outdoor activities kept reducing over the
2010’s, the visibility of sports stars frequently on television led the millennials to participate
in MMORPG’s (Massive Multiplayer Online Role-Playing Games) such as NFL, MADDEN,
FIFA etc., all of which were licensed products. Fantasy adventure titles were also gaining
popularity such as World of Warcraft, movie-based Harry Potter series etc., Key USP’s were
the realistic graphics, the ability to skip reality & enter into a fantasy world as wished for by
the player.

Significance of the Network Effect:

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Network effect was very significant in the case of MMORPGs as these were typically played
by “Hard Core” gamers and were hosted on dedicated servers running 24*7. Empty servers
without players were abandoned as they lacked appeal, the USP was the player-to-player
interactions & experiences. Gaming communities were a common theme amongst successful
titles where players from across regions chatted with each other, and as the community grew,
so did the industry and its attention towards it. Physical events were starting to be organized
where developers previewed in-development titles to players amongst other activities.

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