Top Stories of 2001, #9: Expanding Video-Game Market Brings Microsoft Home for the Holidays

From the perspective of the PC market, video-game consoles have always been on the periphery, even though they use similar technology. But in recent years, as video-game hardware has caught up and, in some cases, exceeded the hardware available on the PC, and as the power of these devices has increased, a showdown was inevitable. More importantly, the video-game market is lucrative--more lucrative, in fact, than even the movie industry. Video games made more money during each of the past few years than did all of Hollywood's movies combined: The video-game market was estimated to be worth $15 billion to $20 billion worldwide in early 2001.

Enter Microsoft and its Chairman and Chief Software Architect Bill Gates. Never one to leave an untapped market, well, untapped, Gates green-lighted the secret development of a Microsoft video-game console (code-named Xbox) that would take on the market leaders. Originally conceived as an all-in-one set-top box that would provide Internet connectivity, sharing, and gateway features, the Xbox was eventually (and wisely) scaled back to focus on one key task: playing killer games. And people thought the code name was so cool that the company kept it for the final product.

But Microsoft faced one problem. The video-game market has always been cyclical, from the domination of Atari in the early 1980s to the Nintendo, Sega, and Sony dynasties of more recent years. This market has always shaken out so that a dominant player--Sony, currently--controls most of the market, and a second-place finisher--Nintendo, recently--controls most of what's left. As the 2000 holiday season came to a close, Sega's Dreamcast was playing catch-up to Sony and Nintendo, despite the fact that it offered superior technology compared to the competition. Whether there was room in this market for Microsoft wasn't clear; the company desperately needed to diversify its operations to survive the PC sales slump that started that season and gripped the entire industry by late 2001.

Microsoft got its first break in January 2001, although it wasn't evident at the time: Microsoft partner Sega announced that it planned to discontinue production of its Dreamcast game console so that it could focus on creating software for other platforms and return to profitability. Sega took a massive $688 million loss unloading the Dreamcast hardware, which had already caused losses of almost $1 billion during the previous few years. Over the course of 2001, Sega dropped Dreamcast's price several times, until the company moved out the remaining inventory at $50 a pop. Rumors that Xbox would run Dreamcast titles proved to be just that--rumors.

A March report highlighted a basic misunderstanding of the market Microsoft was about to enter. Merrill Lynch high-tech watcher Henry Blodget said that Microsoft would take a financial soaking on Xbox in the short term to attain market share and the number-two spot behind the market leader, which he expected to be the recently released Sony PlayStation 2. Blodget said that Microsoft would lose $2 billion on the Xbox before 2005, or $125 per console; his report set off a year of stories about Microsoft's money-losing proposition. What Blodget didn't say, however, was that this situation is the status quo in the video-game industry, and all the hardware makers--Nintendo, Sega, and Sony included--have always lost money on each console. The goal, of course, is to make up that loss in software sales: Customers typically buy only one console, but they purchase numerous software titles.

Sony's PlayStation 2 got off to a rough start in the United States when the company couldn't meet demand, although it quickly sold 8 million units. The PlayStation 2's head start over next-generation competition from Microsoft and Nintendo didn't hurt, either.

In May, Microsoft announced that Xbox would ship November 8 and sell for $300. Hours later, Nintendo announced that its next-generation device, the GameCube, would go on sale November 5, 3 days earlier than Xbox. Nintendo eventually missed that target, but the May announcements were full of bravado about the future and Internet-based gaming features, although only the Xbox shipped with such capability out of the box. A day after the announcements, Sega said it would port its vast software library to other gaming systems, including old rival Nintendo's GameCube and GameBoy Advance, a powerful new handheld device.

Most of the rest of the year was relatively quiet as Sony slowly built up its lead and Nintendo and Microsoft rushed to get their devices to market. Microsoft fended off reports that it had run into an Xbox manufacturing snag in Mexico (although it had) and subtly detuned some of the device's features (e.g., reduced the 10GB hard disk to 8GB) to cut costs. But when November rolled around, both Nintendo and Microsoft were ready.

Sales of the new video-game machines got off to a strong start; both Nintendo and Microsoft nearly sold out of units within the first week of availability. The Xbox went on sale first; Nintendo's new GameCube hit US stores 3 days later. Retailers such as Electronic Boutique, Kmart, Toys "R" Us, and Wal-Mart reported that Xbox and GameCube consoles were completely sold out within a week. Microsoft said it immediately sold all 300,000 available units; Nintendo expected consumers to snap up its 700,000 units by the following weekend. These numbers compared with the 500,000 PlayStation 2 units Sony sold when that machine arrived in 2000. Both Nintendo and Microsoft noted that their sales far outpaced the box-office receipts for the Harry Potter movie that broke sales records that weekend.

But despite strong holiday sales by both Nintendo and Microsoft, the suddenly venerable PlayStation 2 won the 2001 holiday season. According to market-tracking reports, Sony's PlayStation 2 outsold Xbox and GameCube, selling 1.4 million units through December 8, compared to 934,000 Xboxes and 615,000 GameCubes; that trend continued throughout the holidays. Sony's box benefited from a wider range of software titles and peripherals because it had been on the market for so long by that point. And Sony also racked up some sales from people who came into the store to buy an Xbox or GameCube, only to find them sold out.

Will the video-game market bear three players? That remains to be seen, but Microsoft's Xbox appears to be an unqualified success, given the company's quick entry into the market and success in wooing developers. However, as it does with most products, Microsoft delivered the Xbox before the product was ready. The system lacked the necessary supporting software to make it a must-have device, although a second generation of Xbox titles coming this spring should garner more converts.

Most important, the Xbox points to a wider technology move to the living room. The Xbox is essentially a PC, and although the game system doesn't yet include home-gateway or digital video recorder (DVR) capabilities, it would be well suited to both. Expect Microsoft to expand the Xbox platform in 2002 with a HomeStation device that offers a larger hard disk, dual Ethernet capabilities, DVR features, and maybe, just maybe, Freestyle digital-media compatibility. The strategy is classic Microsoft: Enter the market with a first-generation product and then build a bigger and better version.

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