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TEACHING NOTE: SM-24CTN DATE: 09/24/03 TEACHING NOTE FOR ELECTRONIC ARTS IN 2002 Electronic Arts is a highly successful creator of video games for consoles and PCs. The company also creates content for online gaming. EA occupies a unique place in the information processing industry. The company must have the skills of a Hollywood studio in order to create compelling content while at the same time negotiating technological change and uncertainty associated with the platforms (e.g., consoles, PC, Internet) used to operate and distribute the games. The case gives students the opportunity to evaluate the strategic challenges associated with operating at the nexus of information processing and entertainment industries. This case is often used in conjunction with Electronic Arts in 1995, SM-24A. While Electronic Arts in 2002 can be used by itself, use of the two cases together gives a good longitudinal perspective on the company, industry and technology. Instructors who use Electronic Arts in 2002 by itself should not use Question 1 below. (NB: The case Electronic Arts in 1999, SM- 24B is largely superceded by the Electronic Arts in 2002. The latter case covers the same themes and issues as the 1999 case.) In terms of the strategic dynamics framework, this case illustrates the challenges of trying to extend P-controlled changes into industries that are converging (or colliding). It also how EA is trying to transform itself, and realign its actions with strategy, as to take advantage of opportunities created by industry convergence. Preparation Questions: 1. By 1995, how successful has EA been? What has been their strategy? What strategic challenges do they face in 1995? 2. How should EA think about the platform development decisions it faces? 3. How has the Internet affected the video game industry? Why? 4. In 2002, what should EA’s corporate strategy be for the next 5 years? Why? How should it execute this strategy? This note was prepared by Professor Robert A. Burgelman and Philip E. Meza for the sole purpose of aiding classroom instructors in the use of Electronic Arts in 2002, GSB No. SM-24C. It provides analysis and questions that are intended to present alternative approaches to deepening students’ comprehension of the business issues presented in the case and to energize classroom discussion. Teaching Note for Case Electronic Arts in 2002, SM-24CTN p. 2 Analysis: 1. By 1995, how successful has EA been? What has been their strategy? What strategic challenges do they face in 1995? By 1995, EA has been very successful. Between 1990 and 1995, revenue has increased to $420 million and gross profit has increased to $195 million, each growing 500 percent in the period. Net profit has increased to $45 million between 1990 and 1994, or 800 percent. In 1994, EA sold over $400 m 53% Sega 22% Nintendo 3% 3DO 5% PC 8% Affiliated Labels EA had 85 titles in 1994, and 100 titles in 1995 ($120 million in development costs.) EA grew to four divisions: EA Sports Simulation and Interactive Movies EA Entertainment EA Kids EA developed a distinct competence at building a culture that is good at dealing with technical and market uncertainties. Key assets include: Product development, Marketing, Integrating creative, technical and business people into project management, Navigational competence, Salesforce for market competence, Top management that is knowledgeable about technology. Instructors who also use Electronic Arts in can ask students to recall the evolution of EA. Instructors can elicit salient points in EA’s history. For example, until 1989, the company’s strategy had been to develop games for the PC platform. However, by 1989 cartridge-based home video games had emerged as the dominant game platform. At that time, four million IBM PCs and compatibles had been sold creating a market of $230 million for PC-based games. This contrasted with as many as 22 million US households with 8-bit consoles, which generated a games market of $1.6 billion. Of course, the costs of developing games for the PC were very different from the costs involved in developing games for the then dominant Nintendo platform. That company demanded large up-front royalty payments and manufacturing fees as well as advance commitment to cartridge number. All of which raised the risks associated with developing for the Nintendo platform. These risks were similar to those EA faced when it bet on Sega during the transition to the 16-bit platform. Teaching Note for Case Electronic Arts in 2002, SM-24CTN p. 3 By mid 1995, EA faced four key strategic challenges. The company had to prepare for another platform transition, with the industry going to 32-bit processors, while at the same time maintaining leadership in the 16-bit platform. EA was also developing and leveraging intellectual property new intellectual property by co-branding with organizations such as the National Football League (NFL) and National Hockey League (NHL). By 1995, EA has also set its sights on international expansion. As before, the company also faced the usual strategic challenge of attracting and retaining key creative and engineering talent. 2. How should EA think about the platform development decisions it faces? Platform transitions are very risky periods for EA. The industry’s share of market goes up for grabs with each transition. For example, Nintendo dominated the 8-bit platform, while Sega dominated the 16-bit platform. By 2002, EA is facing a 128-bit platform transition. A transition requires EA to make a big bet on the company it thinks will win the transition. Instructors can highlight this point to asking students how much cash the company has and discussing the other cash needs the company must balance with transitions. Anything EA can do to help mitigate the risks associated with transitions will fall directly to the company’s top and bottom lines. How does EA manage and mitigate risk? The company has developed a capacity to predict technology and market direction through intelligence derived from development teams and the direct sales force. It has also developed the ability to move fast (make quick decisions), which confers 1st mover advantage – critical in this industry. In addition, EA developed the ability to port to different platforms, including proprietary hardware such as Artist’s Workstation. Instructors should discuss with students the concrete measures EA uses to evaluate which titles it chooses to produce. The most important metrics are: Contribution margin Tie ratio Share of market 3. How has the Internet affected the video game industry? Why? Online gaming represented a compelling opportunity for EA. The company could reach more game players through the Internet than it ever could through dedicated consoles. Online gaming also represented a unique opportunity to derive a regular stream of revenue through subscriptions paid by players for access to premium online gaming sites. Some of the following detail concerning online gaming at EA is not in the 2002 case, but can help give instructors a clearer picture of the challenges the company faces in this channel. Developing content for an online gaming site is very expensive. Games suitable for online play cost from $3 million - $8 million each to develop. Traditional console or PC games cost under $2 million each to develop. Any online site that EA developed would also compete against rival Teaching Note for Case Electronic Arts in 2002, SM-24CTN p. 4 sites operated by established portals, many of which had far greater financial resources. However, the risk from doing nothing was great. EA was well familiar with the power that shifts from content developers to successful aggregators. The example of AOL charging content providing developers for carriage, or the privilege of carrying their content, was a concern for EA’s management. Any comprehensive effort to aggregate EA’s broad titles, let alone offer other developers’ games (i.e., becoming an aggregator), could put EA in conflict with current or future competitors with vastly greater financial resources. For example, in 1999 some analysts speculated that EA would migrate some of their valuable branded sports content onto an online gaming channel. But such a move would put EA at risk of competing against powerful sports-related portals such as ESPNZone, CBS SportsLine, and Yahoo Sport, as well as against general online entertainment powerhouses like AOL, MSN and Sony Station. In August 1997, EA’s fully owned subsidiary Origin, launched the beta test of Ultima Online, a massively multiplayer persistent-world game site. Within two years the site boasted 135,000 subscribers, mostly in North America, paying $9.95 a month to participate. The site, or community, can support 22,500 users simultaneously and average session times range between three and four hours. In FY 1999, Ultima Online generated $12 million to $13 million in revenue, mostly from subscriptions. Sony’s rival online site, EverQuest attracted similar audience sizes. Sony indicated that its PlayStation 2 could also be used as a portal for these types of games. In 1999, EA sources believed that the total subscriber base of persistent-world games would grow to 5 million players by 2005. The company planned to release 1-2 games per year over the next 3 years for this online subset. Persistent-world games cost about $5 M each to develop, but gave contribution margin of 50% to operate. In addition, the lifetime per game/community was estimated to be as long as 3 years. Most of the data used in this type of gaming resided on the game CD and the player’s local PC, with comparatively little data transferred to the player from the server. EA planned to charge around $50 for the CD and first month subscription, and charge subscribers $10 per month thereafter. EA offered a service in the server-based subset. The company featured “multiplayer match-up” for about half of its PC games through its website. By the end of 1999, usage of EA’s service was very low, hosting an order of magnitude fewer sessions than the most popular rivals. The third online subset, game communities, were websites that that discuss, trade, customize and promote elements of popular games. About half of all PC gamers in the US (20 million) and around 10% of PC gamers in the rest of the world visit one of these sites per month. Game publishers attract only a minority of this traffic, with independent sites drawing most of the traffic. EA’s most popular community site was Simcity.com, which attracted 1 million users per month for its first 6 months. Traffic thereafter settled to 200,000 monthly visits. Teaching Note for Case Electronic Arts in 2002, SM-24CTN p. 5 4. In 2002, what should EA’s corporate strategy be for the next 5 years? Why? How should it execute this strategy? Discussion of EA’s strategy going forward should take into consideration its current strengths and the forces that will shape the company in the future. By 2002, EA’s scale allowed the company to leverage its intellectual properties across multiple platforms and geographies. The company’s prominence in its industry gave EA other benefits. EA had the potential to influence the success of a platform by its decisions to publish titles for it. Since the success of a platform was tightly linked to the number and quality of games available on them, EA was regularly consulted by hardware manufacturers concerning technical specifications. This enabled EA to develop titles faster and better prepare for transitions in the platform cycles. Online gaming will likely become more important to the company. But for this to happen, several forces exogenous to EA must come into place. These include greater ubiquity of broadband Internet connections in homes and continued development of Internet capabilities in consoles. Forces that EA can influence with respect to online gaming include the development of compelling content for multiplayer and massively multiplayer games that are particularly well suited to the online channel and creation of an online business model that will generate sufficient revenue to the company. Metathemes: Two important themes that weave through both the 1995 and 2002 cases are the role of organization and culture to EA, and sources of growth for the company. Indeed, the two themes relate to each other. Instructors can explore how EA’s organizational structure (small studios with a high degree of autonomy) interrelates with the company’s business management structure (e.g., financial oversight at the center, shared intelligence from the salesforce, etc.). This model allows EA to scale as it acquires new studios or develops them organically, while retaining financial controls at the corporate center. This is the model the company has used since the 1995 case. New growth, however, may present challenges that cannot be met by EA’s current structure. Where can EA go next in the entertainment industry? Perhaps there is sufficient growth to be had from EA’s efforts to develop online gaming as well as their other traditional sources of growth; but perhaps not. Instructors can explore the ways in which EA could find growth in fast- developing areas new to the company, such as digital animation. Could EA acquire a digital animation studio such as Pixar? (EA had a market capitalization of $13.2 billion compared to that of $3.9 billion for Pixar in September 2003.) Would it make sense for EA to be acquired by an entertainment company with content assets from movie and television production studios, which could lend themselves to video games? Disney is one possibility. Instructors can ask students to consider the benefits and drawbacks of such mergers, particularly in light of the difficulty Time Warner has had since its acquisition of AOL. Teaching Note for Case Electronic Arts in 2002, SM-24CTN p. 6 Electronic Arts Summary by Robert A. Burgelman 1. Technology-based companies face twin uncertainties: Technological uncertainty associated with platform changes; Market uncertainty associated with changing customer demand. 2. If there is no compatibility across platform generations, then platform changes are highly hazardous because they put market share into play, for example, 8-bit:Nintendo; 16- bit:Sega; 32-bit:Sony). 3. Periods of platform change pose difficult strategic challenges because companies must maintain their position on the current generation while making bets on prospective winners in the next generation. 4. To maximize their changes of correctly predicting the next generation of platform winners, companies ned to create a culture of intense collaboration between technical, sales/marketing (“business”), and design people in the organization. Such a culture constitutes an organizational capability and can be a source of competitive advantage. 5. Creating such a culture is a top management responsibility. Top management must create an atmosphere of mutual respect. This is facilitated of top management has direct experience and interest in the technical and creative side (e.g., consume their produce, in this case, play their own games). 6. Great multidisciplinary teams have strong cohesion and low turnover. This feeds on itself because the best professionals usually want to be with and stay with the best. 7. A company’s financial strategy must support its business strategy. A risky business strategy requires attention to adequate cash reserves. 8. It is extremely difficult to actively create a market (e.g., 3DO). 9. Others?
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