Zach Broderick

Paul Rabinovich

Nakul Sood

BUS10a - Bayone

5/3/07

The Console Wars: Sony’s Competitive Crisis

The March 2007 issue of Electronic Gaming Monthly contained a surprising quote from Sony Computer Entertainment Inc.’s CEO and President Jack Tretton: "If you can find a [Sony Playstation 3] anywhere in North America that's been on shelves for more than five minutes, I'll give you 1,200 bucks for it." Despite the fact that this was just one of many verbal gaffes that had become typical of Sony’s management, the internet seized on the opportunity to put Sony in its place, finding an abundance of PS3’s in more than half of retail stores and posting pictures of them on their sites1.

What happened? How did Sony, the dominant player in the video game console market for the last two generations, find itself being laughed at by the collective gaming blogosphere over mounds of unsold Playstation 3’s? After all, they had launched the highly anticipated console only four months prior, where it had sold out immediately to long lines and was selling fast on the gray market for over a thousand dollars. Why did sales drop off so quickly while its competitors, the Microsoft Xbox 360 (360) and the Nintendo Wii, continued to sell briskly? Most importantly, what can Sony do to regain its dominant competitive position?

1. Background: Sony Computer Entertainment (SCE)

Sony Computer Entertainment, Inc was founded in 1993 in Tokyo, Japan as a subsidiary of Sony, who wanted to test the waters of the rapidly growing video game market. Originally planned as an add-on to the Super Nintendo, in late 1995 the Sony Playstation was released as a standalone console and was met with enormous success, shipping over 100 million units to date [see Exhibit 1 for all sales data]. The key to the console’s dominance was the wide support from third party game publishers, which distinguished it from its competitors. The Nintendo 64 still used cartridges as opposed to CD-ROMs, which publishers disliked because of their expense, leading to a lackluster selection of games for the system. The Sega Saturn suffered from poor development tools that made it difficult to write games for, besides the fact it was $100 more expensive than the other consoles.

The success of the first Playstation was exceeded by its successor, the Playstation 2 (PS2), which became the highest selling console to date when it was released in 2000, selling over 115 million units as of 2007. The console was backwards compatible and was the first to play DVD movies. The competition was weak: Sega and its Dreamcast had failed and were out of the hardware market. Nintendo had unintentionally built a reputation for appealing to young kids, which caused the growing segment of older gamers to ignore its Gamecube console. The last competitor was Microsoft’s Xbox. While technically a more powerful system, Microsoft was a newcomer to the market and had not established as much customer loyalty and relationships with publishers as Sony had, resulting in a smaller selection of games and fewer sales, totaling 24 million.

These factors, combined with the enormous momentum of the brand made the PS2 one of the most successful consoles of all time. Sony hoped to repeat that performance six years later with its next generation Playstation 3 (PS3). As expected, when it was first announced at the Electronic Entertainment Expo in 2005 there was considerable excitement from the gaming community2. A few months later, the next generation console war officially began with the 2005 holiday release of Microsoft’s Xbox 360. While it experienced shortages and higher than average failure rates, problems that are typical of console launches, it was a critical and commercial success, featuring a rich online play system and high-definition gaming. Microsoft hoped to dethrone Sony by getting a one year head start; after 4 years in the market, MS was a now mature competitor, with a smaller but loyal fan base, strong relationships with third party publishers—many of which also developed games for Sony—and its own collection of exclusive titles.

Sony was not terribly worried about the early success of the 360. By releasing a year later, the PS3 would be polished and technically superior. They also had a very large and loyal fan base that was more than willing to wait for the successor to their favorite system. However, during 2006 there was a series of events that shook fans’ confidence in the company. The most significant was Sony’s announcement that the PS3 would cost $600 for the premium version and $500 for the basic version. This was because games for the console would be on Blu-Ray disc, the next generation hi-def DVD format Sony was pushing3. This required a very expensive Blu-Ray drive in the console, bumping the price up. In contrast, the premium version of the 360 was $400, and the basic only $300. The upcoming Nintendo Wii, which was also generating much excitement during 2006 for its revolutionary motion-controlled gamepad, would retail for only $250.

This announcement was followed by many arrogant comments from Sony’s upper management, especially Ken Katarugi, known as the “father of the Playstation” 4. He made several unfortunate remarks, including his belief that gamers would buy the PS3 no matter how much it cost, that further alienated fans who were still dumbstruck by the price. Even worse, news started pouring in that Sony had lost many of its exclusive titles to Microsoft, such as Grand Theft Auto, one of Sony’s flagship games that was now coming to both consoles. Fans were disappointed—they were appalled to learn, however, that many publishers had approached Sony about exclusive title arrangements, only to be ignored and snubbed by management5.

Despite these setbacks, the PS3 sold out immediately when it was launched in November 2006 with a total of 400,000 units6. This was partially due to an extreme shortage of available units, which further put off fans who could not get their hands on one, and whose only option was to buy one on the gray market for over $1,000. The shortage was the result of the scarcity of blue-laser diodes, which were required for the PS3’s Blu-Ray drive but were also in high demand by manufacturers of high definition DVD players. A buying frenzy ensued, with scalpers, remembering the 360 launch, buying as many consoles as they could and selling them at ridiculous markup to desperate parents whose kids wanted them for Christmas.

Only a few months later, however, scalpers found themselves unable to sell their PS3s even at retail price7. Many retailers had plenty in stock, but no one was buying. Meanwhile the Nintendo Wii, which had launched a few weeks after the PS3 with ample supply, was impossible to find8, and the 360 was still selling briskly. Many former Playstation fans, frustrated with the price of the PS3 and its earlier shortage, had bought a 360 or Wii instead. After all, it had lost most of its exclusives, why pay $200 more for a console that plays the same games as the others? The internet gaming community was already declaring the PS3 the losing console, and ridiculing Sony over its seeming disconnect with the reality of the situation9, as demonstrated by Jack Tretton’s statement. Sony was losing its dominance, and senior management was being purged, including Ken Katarugi himself10. What was the company to do?

In order to arrive at an answer to such a complex question, we must analyze Sony’s competitive position and using that information, arrive at a solution to improve it. We will use Michael Porter’s classic 5-point strategic analysis to find out how Sony relates in power to its suppliers, its customers, its substitutes, possibly new entrants, and the other major players. We will find which areas Sony is weakest and form a strategy to strengthen its competitive position within those segments, with the end result being Sony’s reemergence as the dominant player in the highly competitive video game hardware market.

2. Threat of New Entrants and Substitutes: The Video Game Industry

The video game industry has seen explosive growth throughout the last decade that continues to this day. Games are becoming more and more sophisticated, appealing to a broader demographic than ever before. An entire generation that grew up playing video games is now in adulthood, and many have not left there beloved childhood pastime behind. According to the NPD market research group, retail sales of video games and related hardware totaled $13.5 billion in 2006, an 18% increase over the previous year11. Gaming has become one of the dominant forms of entertainment among kids and young adults, especially males.

Video gaming does not face much of a threat from substitutes; rather, it tends to be the threat to other forms of entertainment, such as movies and especially watching TV, as well as playing outdoors. PC gaming, which has always been an alternative to consoles, has been in steady decline12. Facing increasing development costs, game publishers release titles for the platforms with the largest market share, and the PC gaming community is shrinking. Thus, the threat of substitute activities is almost nonexistent. One could argue that the most threatening substitute to the PS3 is the PS2, which due to the price and shortage of Sony’s next-gen console still boasts the largest sales and market share of all the consoles13. The PS2’s extensive library of games and continued support by publishers, combined with its reduced cost make it an attractive option for gamers on a tight budget. As always, support will eventually fade and this will cease to be a problem; however right now, the PS2 could very much be slowing sales of the PS3.

The threat of new entrants is also a minimal one, though it gives us extensive insight into the competitive factors of the video game industry. Certainly, it should not be ignored—after all, Sony was a new competitor when the Playstation was released and immediately became the dominant player in the industry. Microsoft was a new entrant with its Xbox, and is now an entrenched player. However, it should be noted that at any given time there are generally only three or less competitors in the console market, which is an amazingly small number for such a fast growing industry. Observe too that Sony and Microsoft were no small startups when they entered. Microsoft had to endure billions in losses in order to stay in the game and has only recently started turning a profit.

Why is the video game market so difficult to break into? Let’s take a look at Mr. Porter’s 6 factors that affect a firm’s ability to enter an industry:

1.  Economies of Scale: Video game consoles are typically sold at a significant loss initially in order to establish market share14. Profits are made on the sale of games; any publisher that wants to release a console game must pay the console’s developer a royalty on every game manufactured, often about $10 on each $60 game15. As the cost of the hardware decreases and game sales increase, these losses are turned to profits, but in order to get to this point the company must be able to sustain billions in losses, especially if it is not an entrenched player (for example, Sony lost 369 million in just one quarter16). Critical market share must be established—a console maker cannot survive as a small or “niche” player.

2.  Product Differentiation: Gamers are legendary for their rabid loyalty to a particular console, which makes establishing oneself difficult. Consumers are also reluctant to invest in an expensive newcomer that is likely to fail. Most gamers are aware that each console is essentially the same, and that their success will come down to available software. This makes acquiring exclusive titles particularly important, which is difficult for a newcomer; development costs are skyrocketing, and few publishers are willing to take such risk on an unproven platform.

3.  Capital Requirements: As we mentioned earlier, consoles are sold under cost, and therefore a firm must be able to sustain heavy initial losses. Research and development costs for hardware are also extensive, such as Sony’s $2 billion expenditure on the Cell processor17. First party titles must also be developed to support the console at launch. Most importantly, an extensive advertising campaign is needed to overcome customer loyalty and make consumers aware of the firm’s entry into the market. Small companies have little hope of succeeding.

4.  Cost Disadvantages Independent of Size: The success of a console is completely dependent on its games, and new firms traditionally struggle with getting third party support because they do not have established relationships and have not proven their success. Microsoft was an extremely large company when it introduced the first Xbox, but it still did not have the widespread support of publishers that Sony did.

5.  Access to Distribution Channels: The overwhelming majority of game sales are through large retailers, and without their support, the chance of a new firm succeeding is highly unlikely. This is especially true with Wal-Mart, whose power over the games industry is astonishing18. While hardcore gamers may shop at specialty stores, the general public does not, and they make up the majority of sales. Shelf space is very limited and extremely valuable, and a new, especially small company is less likely to obtain that space.

6.  Government Policy: Government policy has no significant impact on new entrants, even though the games industry is constantly threatened by politicians over allegedly objectionable content.

Overall, Sony’s downfall is not likely to be the result of substitutes or new entrants. The entrenched competition, however, is a different story.

3. Customer Power: The Competition