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Is Nintendo Playing The Wrong Game? Its competitors are turning their consoles into home entertainment centers. But Nintendo is sticking to games, a play-it-safe strategy that threatens to reduce the once-mighty company to irrelevance.
By Geoff Keighley

(Business 2.0) – If you want to see the future of videogames, there's no place like the annual Electronic Entertainment Expo. Each May the industry's heavyweights roll out their latest marvels, displaying their visions for the next year and beyond. This year's E3 was no exception. In one corner, J Allard, vice president for Xbox, took the wraps off Xbox Music Mixer, a karaoke system for Microsoft's game console. In another corner, Sony entertained the crowd with its new EyeToy, a camera that will add videoconferencing to the PlayStation 2. But that was just the beginning for Sony. Videogames chief Ken Kutaragi soon dropped the real bomb: Sony will take on Nintendo's mighty Game Boy with a new handheld. Finally, with anticipation at a crescendo, Nintendo CEO and president Satoru Iwata faced the crowd to meet his rivals' news with some of his own: Nintendo would soon release a four-way version of the arcade classic Pac-Man.

You could almost hear the air being sucked out of the room. This was a moment for vision and drama, a chance for Nintendo to dazzle the industry with its genius. Instead, Iwata served up four-way Pac-Man. The idea struck everyone as breathtakingly backward.

If ever there was a time for audacity, this is it. Nintendo once owned the videogame business. It was reputedly Japan's single most profitable company in 1991, with its game console in one of every three American homes. In fact, a 1994 book about the company was titled Game Over: How Nintendo Conquered the World. Now the company is on the ropes. In just a decade, its share of the U.S. console market has shriveled from 90 percent to just 15--nowhere near striking distance of Sony's dominant PlayStation 2. Though Nintendo is still profitable, nearly half of its earnings now come from the handheld Game Boy (see "Another Crisis on His Hands," page 114). And those earnings have taken a nosedive, plunging 37 percent from 2002 to 2003. The worst part? Nintendo managed all this in the midst of a videogame explosion--in the past seven years, worldwide sales have doubled, to $27 billion. In the United States, about half of all homes now have a videogame console; 30 percent of those have at least two.

How could Nintendo have let Sony devour its lunch? The short answer is that it stopped paying attention. The videogame business has changed, but Nintendo hasn't. In 1990, two-thirds of console players were younger than 18; today the opposite is true, and the average player is 29. Yet Nintendo has continued to serve kiddie fare almost exclusively. It resisted the transition from cartridges to CD-ROMs, which are far cheaper to produce and fatten the bottom line much faster. (Nintendo's GameCube now uses minidiscs.) And while its hardware competitors were making nice with third-party developers in order to expand their all-important game libraries, Nintendo continued to treat the developers as rivals. Now Sony and Microsoft are expanding the scope of the entire videogame business, morphing their consoles into all-in-one home entertainment devices in their battle to dominate the long-trumpeted but slow-to-arrive world of PC/TV convergence. Nintendo, meanwhile, is still a game company--and only a game company. Which is precisely the problem, according to most people in the industry. "The battle is over entertainment. Period," declares Jack Tretton, executive vice president at Sony Computer Entertainment America. "If you don't have that vision, you are forever going to be a niche player."

Given the circumstances, Iwata can be forgiven for squirming. Sitting in Nintendo's spartan U.S. headquarters in Redmond, Wash., one day in April, he freely admits that his rivals' grand vision for the future of the industry has brought on a "sense of crisis for us." But that doesn't mean he's ready to give up. He has a nice cushion--$6 billion in cash--and a decision to make. Will he take on Sony and Microsoft in the battle for control of the world's living rooms, or will he continue to focus exclusively on games? But there's an even bigger question now looming that could make all of the above moot: No matter which path he chooses, is it simply too late to turn Nintendo around?

No company knew home entertainment better than Nintendo. It began life in 1889 as a wildly successful maker of playing cards. But by the 1970s, Nintendo president Hiroshi Yamauchi was looking for new ways to grow. As David Sheff reported in Game Over, his first shots were misfires--instant rice, love hotels, a taxi service--and couldn't have come at a worse time. The oil crisis was choking everyone, and Nintendo's sales were so slow that the company nearly filed for bankruptcy. That scare left Yamauchi with little appetite for adventure; he vowed that Nintendo would always have plenty of cash on hand and would never take another chance on an unproven business.

So he returned to the firm's longstanding strengths: its experience in entertainment and its unparalleled pipeline into Japan's toy and department stores. Nintendo experimented with an oddball assortment of novelties--an extending gripper device, a periscope--that sold modestly well. The company's first electronic breakthrough was a toy gun that shot a beam of light. From there Nintendo moved into arcade games, which in the late 1970s were on a roll. In 1983, Nintendo's R&D department came up with a video arcade for the living room: the Family Computer--Famicom for short.

The Famicom was an overnight sensation in Japan. It had a tougher time cracking the U.S. market. American retailers, still bruised by the recent failure of Atari, weren't exactly enthusiastic about stocking another videogame system. But after a successful test rollout in New York in 1985, the renamed Nintendo Entertainment System (NES) quickly became the hottest toy on the market. Delighted retailers couldn't keep it in stock.

By the end of the decade, Nintendo pretty much was the videogame business. Its hold on the market was so overwhelming that even Wal-Mart cowered. When Sega wanted to launch Genesis, the first real challenge to Nintendo's videogame monopoly, the retailing superpower was leery; its relationship with Nintendo was too lucrative to jeopardize. (Sega had to unleash a marketing blitz on Wal-Mart's hometown of Bentonville, Ark.--buying up every billboard in town and slapping a logo on every seat cushion at the University of Arkansas football stadium--to finally land some shelf space.)

Dominance bred arrogance. Nintendo saw no reason to play nicely with others, especially third-party game publishers. Since the company sold its consoles at cost or slightly less and made its money on its games, the model dictated that it view third-party developers as a threat. Nintendo was also determined to avoid Atari's fate; that system died in large part because of its second-rate software. Maniacal about quality control, Nintendo meted out just a handful of extraordinarily restrictive NES licenses. "Nintendo said you could only make five games a year. It also insisted that your games had to be Nintendo exclusives for at least two years," recalls Greg Fischbach, former co-chairman of Acclaim, one of the lucky few to score a license.

The hardware was a different matter. When Nintendo went to develop the next-generation NES, it realized it didn't have the engineering know-how, so it looked outside for help. In 1988 it signed an agreement with Sony to create a CD-ROM drive for its next system, the Super Nintendo (SNES). The project's working name: the PlayStation. The plan was to merge Sony's hardware with Nintendo's software to create the ultimate gaming platform. But only days before the system was to be unveiled at the 1991 Consumer Electronics Show, Nintendo pulled the plug. Yamauchi couldn't bear to help Sony, a potential competitor, enter the videogame business. Ever since, Nintendo has given up any ambition of being a console innovator and outsources its hardware development to firms like IBM and ATI, a leader in graphics technology.

Nintendo gradually lost sight of its market. Gamers were getting older, but Nintendo didn't grow up with them. By the early 1990s, the kids who were once mesmerized by Donkey Kong and Schoolhouse Rock were now more interested in Nirvana and Wayne's World. Sega's line of games--led by a smart-aleck hedgehog named Sonic--held unmistakable teen appeal. "The way consumers saw it, Sonic was this edgy character and Mario was this round chubby plumber guy for kids," admits George Harrison, senior vice president for marketing at Nintendo of America.

And if the games were just for kids, so, evidently, was the hardware. Nintendo never bothered to make successive generations of consoles backward-compatible; when a new Nintendo machine came out, the controllers and software from previous Nintendo systems were useless. This meant that consumers could easily justify switching to a rival console. And switch they did. Before long, Sega had grabbed half the market.

For Sony, the timing could not have been better. In 1995, Nintendo's spurned partner exacted revenge by coming out with its own PlayStation. Having observed the gaming giant at close range, it was able to strike at each of Nintendo's weak spots. Sony made friends where Nintendo had made enemies, namely with third-party developers. Whereas Nintendo required developers to pay a $19 royalty per game, Sony charged only $9. By the end of the decade, PlayStation was home to some 1,000 titles, appealing to gamers of all ages. Nintendo's new N64, meanwhile, had just 225 titles, and those were on cartridges that cost developers $12 each to produce, compared with $1.50 apiece for PlayStation's CD-ROMs. It took just one generation for Sony to outstrip Nintendo: By 1999, PlayStation had already claimed 60 percent of the market, while N64 limped behind with 36 percent.

The march toward convergence began in 2000 with the release of the PlayStation 2, which quickly became a top-selling DVD player in Japan. Next year Sony will introduce PSX, a PlayStation souped up with a TV tuner, DVD recording, a 120-gigabyte hard drive, TiVo-like capabilities, and full broadband support. Microsoft crowded into the market in 2001 with Xbox, which can already play MP3s, CDs, and DVDs. Bill Gates has hinted that the next-generation Xbox will let users edit photos and video. Industry scuttlebutt also suggests that Xbox 2 will have video-recording technology and will even function as a Wi-Fi router.

As Sony and Microsoft continue to grab more of the market with their multimedia systems, Nintendo keeps plugging along with its single-purpose videogame technology. "Why would we ever include DVD playback in our videogame system?" asks marketing VP Harrison. "If someone buys a DVD and watches it on the Nintendo GameCube, we wouldn't receive any revenue from that. We'd rather have them play our games."

Maybe so, but the numbers suggest that Nintendo is simply playing the wrong game: Sony now owns 65 percent of the U.S. market. Microsoft has 20 percent, leaving Nintendo with the scraps.

This is the mess that Iwata inherited just over a year ago, when Hiroshi Yamauchi, son and grandson of Nintendo's two previous chairmen, reached outside the family and tapped Iwata, who'd been at the company barely three years. The 42-year-old director of corporate planning was stunned. "This was something I did not envision," he says. Yamauchi was clearly looking for a savior, for good reason. If current industry trends continue--and there's every reason to expect they will--Iwata will have to work miracles to put Nintendo back on top.

Iwata does have experience nursing ailing companies. He started out as a game developer at Hal Laboratory, a Nintendo affiliate. When a series of product delays drove Hal toward failure in the mid-1990s, Iwata reinvigorated the company and forestalled bankruptcy, earning himself a promotion to president and the nickname Director of Problem-Solving. Iwata's heroics got back to Yamauchi, and the chairman brought him into Nintendo in 2000. Now, faced with his biggest problem yet, he's taking a decidedly conservative approach: While Sony and Microsoft distract themselves with their fight over convergence, Nintendo will focus on videogames more than ever.

This more-of-the-same strategy certainly doesn't sound like a battle plan for winning back Nintendo's bygone dominance. Iwata argues that his company has no choice. He insists that Nintendo's $6 billion in cash couldn't buy it enough of a stake in the consumer-electronics business to make a credible run at Sony and Microsoft. "They have reserves so vast they make us look rather poor," he says. "We have to find a way to compete without making it a question of which company is richer."

Iwata is staking Nintendo's future on what might generously be termed a differentiation strategy. He concedes that Nintendo has focused too narrowly on kids, and he's now looking to expand. "My mantra is 5-year-olds to 95-year-olds," he says. In order to create a wider and more compelling software portfolio, Iwata is doing two things. First, he's investing in internal game development, including the buildout of a new R&D facility in Tokyo. It will open later this year and add 50 new developers to Nintendo's corps of 850. Its mission: "To provide entertainment to kids, adults, and even senior citizens," Iwata says.

In addition, Iwata is working hard to mend fences with important third-party publishers like Electronic Arts. "Our relationship with Nintendo in the past was a distant one that didn't work very well," says Bruce McMillan, EA's senior VP for worldwide studios. But Iwata has reduced the royalty rate Nintendo charges third parties and is even letting Shigeru Miyamoto--the famous creator of Super Mario and Zelda--do the unheard-of: consult with independent companies like EA on game design. In turn, EA is expected to add special features to the Nintendo versions of franchises such as Madden Football and the megahit domestic simulator The Sims. By continuing to focus on great games, Iwata argues, the company can survive no matter what the competition does. Iwata sees a time when Nintendo's games are so irresistible that even Xbox and PlayStation owners will buy a GameCube.

Some of Iwata's resolve to stay the course may come from the cautionary tale of Sega, the gamemaker that posed such a threat to Nintendo a decade ago. After a protracted period in third place in the console market behind Nintendo and Sony, Sega shut down its hardware division altogether in 2001 to focus solely on software. It has steadily lost market share ever since. Haunted by that specter, Iwata repeatedly vows he'll never give up the console business.

It's possible that convergence could backfire and create an opportunity for Nintendo. Consumers could get turned off by rising console prices as Sony and Microsoft pack more functions into their boxes. Or consumers might not really want an all-in-one entertainment machine. "Name all the hybrid consumer-electronics devices that have been successful," notes Michael Pachter, an analyst at Wedbush Morgan Securities. "There's just one: the clock radio."

But that's a minority view. Most in the videogame industry agree that Sony and Microsoft are on the right track. "I'm not sure there's room for a stand-alone game machine," says Brian Farrell, CEO and president of THQ, the independent publishing giant responsible for such hits as SpongeBob SquarePants and WWE Wrestling. Jeff Lapin, CEO of Take-Two Interactive, which created the blockbuster Grand Theft Auto franchise, agrees. "I think Nintendo is going to have to redefine its hardware if it wants to compete," he says. "The simple fact is that people are looking for extra features."

Iwata is betting that the rest of the industry is wrong. But that doesn't mean he isn't willing to hedge. "Another company could certainly take our game platform and use it in their products," he hints. In other words, Nintendo is willing to consider the TiVo model, building a stand-alone machine while making its technology available for incorporation in other kinds of hardware.

That opens up a world of possibilities. There are plenty of companies that want a piece of the convergence business and don't want to cede the living room to Microsoft and Sony; they include consumer-electronics giants such as Panasonic, Samsung, and Sanyo, as well as PC manufacturers like Dell and Apple. If Apple, flying high on its success with the iPod, wanted to introduce a set-top box, gaming technology from Nintendo would give the machine a fighting chance against the PlayStation.

There's already some precedent. In Japan, Panasonic sells a device called the Q, which combines a DVD player with a GameCube. Could there be a Q in the offing for the U.S. market? "Panasonic is one partner we would definitely be interested in working with again," Iwata says, cryptically. Panasonic admits that it has a "strong relationship" with Nintendo, but refuses to say anything more.

A joint venture or partnership may be Nintendo's only hope of reversing its decline. But all hinting aside, Iwata couldn't pull off a dramatic rescue without fundamentally shifting the company's values. Nintendo isn't likely to take any genuine risks that could jeopardize its existing business (it's still the world's second-largest game publisher) or dramatically deplete its reserves. So no matter what kind of partnership Nintendo forms, its main business will likely be videogames--still profitable, but shrinking in relation to competitors. A humbling fate, indeed, for a company that once conquered the world.

Geoff Keighley is a contributing writer for Business 2.0.