By Tim Weber
Business editor, BBC News website
Is the video games industry headed for a crash?
It's larger than Hollywood, its virtual stars may live happily on a diet of bits and bytes, but the video games industry has not been able to insulate itself from upheaval.
Yes, gamers are snapping up the new generation of games consoles - Microsoft's Xbox 360, Nintendo's Wii, and Sony's Playstation 3 [PS3], but at huge cost to the industry.
Hardware makers are losing hundreds of dollars on every console sold, and games publishers face an "increasingly difficult environment, as rising development costs and small user bases [mean] that return on investment in next generation games development is unlikely to be achieved before 2008," according to media analysts Screen Digest.
More importantly, though, the video games publishers are facing a revolution of their business model.
Not every video game sees arrests as peaceful as this one
Even the industry's undisputed giant, Electronic Arts (EA), is not immune from turmoil.
It's a "volatile" industry, acknowledges Gerhard Florin, executive vice president at EA and the general manager of its international publishing business.
More than double the size of its nearest competitor, the Redwood City, California, based company employs 7,200 people; 5,200 of them work on games development.
Titles like Fifa Soccer, Need for Speed, The Sims, and Command and Conquer games underpin the company's success.
The sequel syndrome
"Scale does matter" in this industry, says Mr Florin, because "the more complex games become" the more tools are needed "to keep costs under control".
VIDEO GAMES SALES
Source: Screen Digest
And selling software in a shrink-wrapped package just doesn't bring in enough money anymore.
The market for computer games is stagnating. Screen Digest predicts their sales to fall to $3.7bn this year - although they at least provide a stable stream of income, says Mr Florin.
The real money spinners are console games, but subject to the ups and downs of the hardware cycle as consoles launch or go out of fashion.
To ensure steady revenues, says Mr Florin, games publishers therefore have to build strong brands.
Franchises like Fifa Soccer are mainstays of EA's business
It may not be original, but no video games executive has yet been sacked for commissioning the annual upgrade to popular franchises like Fifa Soccer or Madden NFL.
Ed Barton, games analyst at Screen Digest, calls it "a common syndrome in the video games industry".
"Wonderful innovative titles are sometimes ignored [by consumers], while some repetitive titles with minor improvements in game play and graphics provide much better returns to the games publishers," he says.
He compares it to music publishers, who have Madonna or Elvis Presley "to keep the home fires burning," but also invest to freshen up the catalogue.
The next generation
The new generation of consoles is a prime opportunity for innovation, but have not made life easier for developers.
Founded in 1982
HQ: Redwood City, California
Revenue: $2.9bn (2006)
Main studios: Redwood Shores, Los Angeles, Orlando, Vancouver, Warrington
Right now video games use probably 30-40% of the power of the new hardware, says Mr Florin.
"You only learn what you can do with these platforms over time, and as a result using 100% of Playstation 2 [PS2] is nearly as good as today's starting point of PS3 games," says Mr Florin.
"We haven't even started to see PS3's power, it will take the longest to exploit in full," says Mr Florin.
Games publishers face a dilemma, though. To reduce cost, they would love to put their games on as many platforms as possible.
It used to be relatively easy to port a game from one console to the next. Nintendo's "Gamecube, the Xbox and PS2 were much more alike," says Mr Florin.
Next generation platforms are different, he says: "Now we have to have very distinctive games for each machine and can't port that much."
That plays into the hands of the console makers, who want exclusive games to lure gamers to their platform.
Standing on five legs
"Development times, team sizes and complexity have been exacerbated by increasingly demanding next generation games," says Ed Barton at Screen Digest.
He predicts that "only a tiny proportion of next generation titles are likely to achieve profitability in the near future".
To survive and expand, says Mr Florin, publishers have to move beyond console and computer games, and stand on three additional legs:
- Handheld games;
- mobile phones, which are "up and coming"; and
- the "fifth leg, online communities".
Mr Barton calls it the industry's "risk reduction strategy" - a combination of outsourcing, releasing games on as many platforms as possible and "making sequels to popular titles and producing games based on popular movies".
The biggest driver for change in the industry, however, is the internet .
Gamers are now "getting connected to the internet at a large scale," says Mr Barton. "We have only seen the beginning of this."
Here Microsoft is way ahead with its Xbox Live service. Sony's online gaming was launched fairly recently and is considered to be much less accomplished than Microsoft's.
Is she playing this game online?
Nintendo's efforts, scoffs Mr Barton, are "frankly stone age compared to the others".
But this is about more than using Xbox Live to play the shooter game Halo against friends at the other end of the world.
Games publishers can reach out to new consumers, for example with sites like EA's pogo.com, which is "purely advertising driven," and designed not for hardcore gamers but people who want to have a bit of fun in their lunch break.
They also discover novel ways to distribute games in regions like Asia, where EA did not really have any presence.
The benefits of software piracy
As it turns out, software piracy can be good for you.
"We have extremely strong brands [in Asia] thanks to the pirates; they have created millions of consumers - not customers," says Mr Florin.
The internet allows EA to tap into this market and make some money after all.
Next-generation games provide ever more realistic graphics
In South Korea, EA set up an online community based around the Fifa Soccer game. It was the firm's first venture in this market and has broken all records, with five million players or 12% of the population.
The Korean gamers are spending serious money on accessories and customisations of the online game.
"We now have to learn the business of running an online community," says Mr Florin.
He also has his eyes set on China, which has some 20 million players of football video games.
The next level
The online service model may even work in regions like Europe, where the old shrink-wrap content model still dominates.
"We have to find the right mixture of content and service," says Mr Florin.
In the future, believes Screen Digest's Ed Barton, companies will release barebones versions of games for free, and then make money by charging subscriptions for enhanced access or one-off payments for extra features.
Sony, meanwhile, is already thinking about the next step. Players will be able to create new levels for games and share them online. "Users could create revenue for games," says Mr Barton. "The potential for this is absolutely enormous".
Advertising: in-game and in real life
Bringing games online also allows publishers to venture into in-game advertising.
Soon in-game adverts will be much more valuable than this
If a snow board maker runs an advertising campaign, EA could offer space on billboards in its snowboard game, says Mr Florin: "For six weeks you would see the same advert in the real world and in the game."
Specialist companies like Massive and IGA predict that 2007 will be the year when this form of advertising will take off.
Not only can they segment gamers by location, the type of game and time of day, they also have a highly attentive audience.
In-game advertising is very effective, says Mr Florin. "When you are playing a game, you are completely engaged... and many studies show that you have high levels of retention."
Right now it is a tiny revenue stream. "Will it be 50% of EA's revenue?," muses Mr Florin. "I doubt it - but never say never."
The modern book burners
In their quest to expand the ranks of video gamers, publishing firms have also learned that it's not the high-end games that reap the biggest profits, says Mr Florin.
One of the big hits on the handheld Nintendo DS is Cooking Mama. "Making a cook book is not in our genes," says Mr Florin.
Nonetheless it shifted more than two million copies. He calls it "Pokemon and Mario numbers," in reference to two of the platform's biggest hits.
But when quoting these numbers, his real message is that video gamers are normal people.
"Games are blamed for plenty of ills in this world," says Mr Florin. "There is a discrepancy between gamers and their perception in society by non-gamers."
The typical gamer is not a spotty 16-year-old pondering how to kill his teacher.
Getting passionate, he compares the critics of video games to "modern book burners".
There are more than 50 million games consumers in Europe alone, half of them are adults, and only a tiny fraction of games on the market are rated 18+, argues Mr Florin.
And he issues a plea to them: "Tell your politicians 'I am 22, I play shooters, but I'm a normal person'."