Video Gaming's Big Three Betting the Future Is Online - TheStreet

For the past couple of years, the big three video-game companies regarded making money through online gaming about as likely as a 50-year-old newbie player making it to level nine on

The Legend of Zelda

.

After all,

Sega

(SEGNY)

tried it with Sega.com and lost its shirt -- the $100 million it put into the ambitious online gaming network for its Dreamcast.

But when the lights dim onstage at the Los Angeles Convention Center Tuesday at E3, the interactive entertainment industry's annual trade show, the big three console companies --

Sony

(SNE) - Get Report

,

Nintendo

(NTDOY)

and

Microsoft

(MSFT) - Get Report

-- are planning to convince investors and the industry's players that it's going to work this time.

Despite appearances, it's not the first time they've talked about the topic over the past few years. "It's the crawl-walk-run analogy," said Gartner Group games research director P.J. McNealy. "We're in the crawl mode now." But what's different this time around is the big three's unwavering urgency to actually deliver.

Microsoft Makes an Early Move

Leading the charge, Microsoft has been touting its upcoming Xbox Live games service since the beginning of this year. Details remain sketchy, but analysts said it will be a closed-gate service -- a la

AOL Time Warner's

(AOL)

America Online -- devoted to gaming over broadband connections and requiring consumers to pay upfront. Economically, the network is modeled after the cable distribution system, in which game developers will operate their games in the network for a share of the revenue. The service is expected to launch sometime this summer. The Xbox has the advantage of being the only one of the three machines to have built-in online gaming capabilities -- a hard drive and Ethernet port. The company declined to be interviewed before the trade show.

Sony, which has spread the gospel about online playing since before the launch of the PlayStation 2, is finally ready to take baby steps into the arena with plans to appeal to consumers on two levels. Over the past few months, it has put out an open call to developers to support online gaming features for the PS2. Software giant

Electronic Arts

(ERTS)

answered the call, announcing it plans to support online gaming on the PlayStation 2, but not on the Xbox or GameCube for now.

Sony will begin selling an Ethernet adapter by late summer. Unconfirmed rumors leaked out of Tokyo last week indicated that a future version of the PlayStation may eschew physical media altogether, preferring instead to deliver the whole shebang through broadband. So it's no surprise that high-speed Internet has become a corporate initiative, as analyst briefings on corporate strategy on two continents prove.

The wild card among the three is Nintendo, which has adopted an even more laissez-faire attitude than Sony, leaving it up to developers to figure it out. It plans to team with Sega to release

Phantasy Star Online

episodes I and II for the GameCube. Sega also plans to release a version, as well as a competing football game, for the Xbox.

Nintendo remained tight-lipped on the matter, but Sega Vice President Charles Bellfield shed some light, saying the two companies have been working together in Japan to develop an online gaming system that piggybacks on Sega.com, Sega's older product. Sega.com, Bellfield said, never actually shut down but continued to charge subscription revenue of about $5 a month for Dreamcast diehards who continue to pay. At least hypothetically, Sega executives said, other game publishers would be able to run their online games on the Sega/Nintendo co-developed online service

"I laughed at some of the press releases

from competing publishers," Bellfield said. "While everyone is still crawling around, Sega has been up and running."

Separately, Sega said it will deliver 10 games with online capabilities, split among the three consoles, this year. The details of its partnerships also begin to sketch where the competitive axis is being drawn. Players of some of Sega's games on the PS2 and GameCube will be able to compete against each other, across platforms. Sega's games on the Xbox will not include this feature.

It's fair to ask, why, amid a gut-wrenching downward spiral in technology spending, is the gaming industry treading a well-worn path and pitching development dollars into the potentially bottomless dot-com expenditures pit?

It has everything to do with the evolutionary cycle in the business. Typically, the lifespan of a game machine runs about five years. Sony, the earliest of the three to launch a next-generation machine, is in year two of the five-year cycle, with the crest being somewhere between three and four. Unlike the rest of the tech sector, the game industry is about a year away from the peak of the hardware console product cycle, in which game companies rake in the highest return on investment. In a way, they can afford to experiment for the time being, in order to earn a competitive edge for the next product cycle, in which both broadband and online gaming are projected to take center stage.

"It's clear to me that online gaming is part of their strategic plan going forward," said Felicia Rae Kantor, a consumer leisure equity analyst at Lehman Brothers. "That's the wave of future for gaming." Lehman Brothers has not done any banking for any of the big three.

The gaming industry is also fired up about this year's fourth quarter, which will be the first holiday shopping season in which all three companies will have launched their products and will finally be competing on a level playing field.

So, Who's Got Game?

At the outset, some market analysts believe that of the three, Microsoft may have the best potential to actually make money from online games because immediate financial incentives for both the company and participating third-party developers are clear. Microsoft is also planning to charge consumers from the beginning for online game play, and not repeat Web businesses' mistake of giving away content for free. Sony has not made clear where the incentives are for third-party developers, possibly keeping early movers away from the concept until it has matured. With Nintendo, it's anyone's guess.

Still, the software development community is fonder of open-access models of online gaming, such as those being considered by Sony and Nintendo, than of Microsoft's walled-community model, according to software industry sources. And generally speaking, in gaming, the platform that wins is the one that has the best support from software developers.

What's worth noting is that when console companies launch online games services, it creates a complex dynamic, pitting developers and publishers against hardware makers, and every permutation in between. For instance, Electronic Arts, which operates an immensely profitable software publishing business in addition to a growing online gaming service, will be providing games for all of the hardware companies offline, but it will also compete with their business partners online through EA.com. Sony, which operates a game console and software unit and a separate PC online gaming division, will be both a partner and a competitor for consumer dollars.

To bean counters, online gaming is a double-edged sword: a potential source of incremental revenues, but also a possible cause of expenditures spun out of control. Estimates of development costs are hard to come by, but Lehman Brothers' Kantor points to Electronic Art's EA.com, which has cost an estimated $350 million to $400 million. A

New York Times

report on Monday estimated that Microsoft is spending more than a billion dollars for XBox Live.

Cycling Ahead

Despite the momentum being played out in the press, online games have yet to spur traditional developers to leap onto the bandwagon because the financial upside remains to be seen. "This is going to be a small market for the next several years," said Schelley Olhava, a senior analyst covering the gaming market at International Data Corp. It will be "a while before we see millions of PS2, Xbox and GameCube players online." In total, IDC estimates that only about 500,000 consoles will be playing online in 2002, with that number ballooning to 12 million consoles by 2005.

While broadband usage is growing, it remains a small slice of Internet usage. According to a March Nielsen/NetRatings study, the number of households with broadband jumped 67% in January this year compared with the same period last year. But broadband usage is dwarfed by the more than 82 million unique households dialing up via conventional modems. Online gaming is clearly a force for the future. According to Jupiter Research, broadband penetration in U.S. households will grow at a slower pace every year through 2006. By 2006, Jupiter expects that about 35.1 million households will have broadband access.

In a report last November, Gartner Group estimated that online console gaming revenues will jump from a projected $138 million in 2002 to $2.3 billion in 2005. But McNealy, who put together the report, said all those projections will be scaled back in an update in a few weeks.

So, investor beware: Despite the intense buzz, online gaming on the console is not entirely unlike "three huge bodybuilders flexing in the mirror -- the steroids are working, but the competition doesn't start for another three years," said Jeff Brown, Electronic Arts' vice president of corporate communications. "Console gaming won't be a practical consumer or business application until 2005."