It seems a lack of forward planning and business-minded thinking is to blame for the prolonged transition period hitting the games market.

To describe the recent fortunes of various games companies as a tale of woe would be a huge understatement. In the context of the latest bad news concerning Gameplay going up for sale, Eidos shedding staff and Pure Entertainment winding down, not to mention the continued poor stock market performance of a number of games companies, including Rage Software and Argonaut Games, the industry is looking in pretty dire straits.

The excuses made last year along the lines of it being a period of transition - PlayStation sales slowing down as the industry geared up for the launch of PS2 - are starting to wear a bit thin.

PS2 is now arriving on the market in greater numbers and there's an abundance of PS2 and original PlayStation titles that should all be selling well. But surely this momentary lapse in sales should have been anticipated.

Al King, marketing director at publisher Electronic Arts (EA) UK, suggests many companies have failed by simply not taking into account the inevitable slump in games sales that occurs during a period of transition. "The brutal truth is a lack of planning and cost control disciplines," he states. "It's not difficult to see these transitions coming and react accordingly. The transition 'year' is lasting for two."

Gary Williams, managing director at budget PC games publisher Sold Out, also argues that poor management is partly to blame for the general downturn in companies' fortunes. "The problem with a lot of these companies is that when they should have been cutting back and doing less, in other words battening down the hatches for the transition, they didn't," he argues.

"They went to five formats and spread their net wide. Companies were doing WAP mobile phones, Game Boy Advance and initial GameCube development. They had five or six skews, when they should have been concentrating on one, perhaps two. But it's easy to do, because you get carried away on the euphoria of growth."

Getting the right balance
The dilemma companies face is they can never be sure how long the existing market is going to last and how fast the new one will pick up. It's risky for a company to develop too many games for a new console such as PS2 before it has reached critical mass.

"You end up with a dip in your revenues, but you just have to take that hit," says Jez San, CEO of developer Argonaut Games. "It's painful to manage through the transition, but eventually the market for the new consoles becomes very large - usually in a year or two. The companies that don't have the cash reserves to last until then will suffer." He cites the transition five years ago as an example of history repeating itself: "Acclaim was a billion dollar company. It managed the transition very badly and it's now worth barely $50m."

Simon Little, business affairs director at publisher Take 2 Interactive, also believes companies have failed to plan in line with forecast trends and manage costs accordingly. He adds they have not been aided by the disintegration in the capital markets.

"Part of the failure is the lack of a robust business model," he says. "If you run the business correctly, it is possible to make money publishing video games. No one has yet proved that it is possible to make money giving games away for free like Pure did."

San insists a distinction should be made between games companies and the likes of Gameplay, Pure Entertainment and Rage, who have all been relying, to a lesser or greater extent, on generating revenue via the Internet. "I would say the games companies are doing reasonably. Obviously they could be doing better, but most of the casualties are ones with unusual business models. Rage, for instance, was flying high and doing incredibly well as a developer, but when it changed to Internet distribution and became a publisher, it stopped doing so well," he says.

San maintains there has been an over-reaction against the games industry and a lot of the negative sentiment surrounding publicly listed companies is misplaced. "There are some perfectly good companies out there that are currently valued in peanuts. If you look at Argonaut, its valuation is not that much more than the cash in the bank, but at least it has a lot of cash in the bank, so its future is quite secure," he says.

Growing pains
Some argue that the failure of a number of companies is due to the fact they have been asked to grow up too quickly - the games industry moving rapidly from niche to mainstream - and it is showing in their poor financial performance.

Associated with this is the notion that a lot of companies were founded by games aficionados, not businessmen, and possibly the business basics have been neglected. EA's King and Sold Out's Williams both favour this view.

"What the industry has done is grow and not take the consumer with it," says Williams. "I think that's been its main failing. Yes, we've seen great growth and it's hit the mainstream, but when it hit the mainstream it didn't know how to perform. You had people who were used to games, not controlling the stock market.

"I know a lot of companies were focused on their share price, rather than their day-to-day activities. Their announcements became more about stock market gain than about fulfilling any entertainment requirements. But I wouldn't blame them for it because once you take that money from the City, you're on a treadmill. I think that's a problem a lot of people didn't appreciate."

Take 2's Little also thinks the downturn is an inevitable consequence of the industry's rapid growth. In short, it is suffering from growing pains. "Accelerated growth is part of the problem. Most fast-growing companies come off the rails when the growth stops suddenly. Look at the pain the US telco manufacturers or the mobile handset people are going through right now," he argues.

It has also become more difficult to extract sales in the old PlayStation games because there's so much competition making it harder to stand out. Added to which, publishers have been pulling their marketing budgets so they can conserve their cash for marketing PS2 games.

That said, some developers, such as PS2, X-Box and GameCube, have been too eager to move onto new technology when there are still substantial gains to be made from the existing PlayStation user base. "Sony called a bunch of developers and publishers in last week to cite market stats and remind them the PlayStation market is still huge and anyone that throws the towel in on one and jumps straight into two is premature," says San.

Another characteristic of transitional periods is that while games sales plummet, development costs are at their highest as new titles are developed. "Transitions should be factored into companies' business models, but it is much easier said than done. Cutting costs is a difficult and unpleasant business. Surviving the transition means investing large sums of money - often when you can least afford it," comments Little.

Alex Davies, games analyst at stockbroker Teather and Greenwood, makes the point that the situation has been compounded by the delayed release of PS2 and X-Box. "Microsoft has said no titles will be launched on X-Box unless they're launched simultaneously on PlayStation2. That's good for Microsoft, but it means higher development costs. The larger companies are better able to cope if a game isn't successful, but the smaller developers are at greater risk," he says.

EA's King suggests smaller developers are suffering more because they lack the size of catalogue that major players such as EA are able to fall back on. A concern now has to be whether cashflow is becoming a problem for some of the smaller developers hit hardest by the longer than anticipated downturn.

Things are looking up
Davies takes a more positive stance, arguing that cashflow isn't much of an issue for smaller developers because they should have new PS2 and X-Box games in the pipeline, more or less ready for release due to the consoles' slippage. "If a company is running low on cash, it can simply sell a game to a big publisher such as Eidos," he says.

Clearly, this has been a more painful transition than most, not aided by the slump in technology stocks. Until enough PS2 units are sold, companies will continue to struggle, but it's pretty much a given that not only PS2, but also the forthcoming X-Box and Nintendo's GameCube will sell enough for there to be a market for each.

However, with the X-Box and GameCube still a long way off -both due for release next year - and the possibility that PS2 might not make as big an impact as many had hoped, it is likely we will see more bloodshed this year. "We will see a very strong recovery for companies in a position to take advantage, but I'm sure we will see more casualties in the meantime," Little predicts.

But this cloud could have a silver lining. Games retailer Electronics Boutique has just announced annual earnings in line with analysts expectations - for the 12 months to 31 January, its pre-tax profit was £7.9m, up a massive 182 per cent on the previous year - and it gave a bullish assessment of the future.

The company has plans for expansion, with between 15 and 25 new stores due to open this year (to add to the 311 existing ones). Its link with supermarket chain Sainsbury's has also been boosted with 66 stores now carrying its games, up 26 on last year. It also has plans to grow through acquisition, with Gameplay mooted by analysts as a possible takeover target.

Many of the larger games companies also continue to thrive. "US companies such as THQ are doing well, with market valuations of between £500m and £600m. And if you look at Electronic Arts, its market cap is $7bn with a P/E of over 250, so it's not all doom and gloom," adds Argonaut's San.

By common consensus, PS2 sales are excellent, but PS2 game sales aren't, because the installed base isn't out there yet. But by the end of this year, the situation should have improved in Europe and companies that have been tightening their belts will start to pick up.

Games have been successful ever since they were invented and the games market shows growth every year. The financials of publishing games are based on the same principles as publishing books, music and video, so the model is well proven. But the only thing that will instigate more positive sentiment is profit and there isn't going to be much of that around this year.

Some companies have been guilty of gross naivety; losing their focus on entertainment and investing too much energy chasing their stock market price. Add to this some poor management decisions, in terms of lack of planning, cost control and chasing fledgling formats still to prove themselves (such as WAP), and some companies have dug a large hole for themselves from which they'll find hard it to escape.

It's worth remembering, however, that to date, barely one million PS2 units have been sold in Europe, whereas there are more than 31m original PlayStations on the market. So while it would be premature to write the obituaries just yet, games companies have a lot to prove in the next 12 months.

Rob Furber

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This was first published in May 2001

 

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