Santa Monica, California-based Activision (Nasdaq: ATVI) is one of the pioneers of the video game industry, its decade-old Pitfall tomb-raiding game still remembered fondly by those whose parents let the clunky, mysterious Atari 2600 into the house. Atari is gone and the industry is ruled by the likes of Sony (NYSE: SNE), Nintendo, and maybe soon Microsoft (Nasdaq: MSFT). We spoke with Activision Chairman and CEO Robert Kotick about his outlook for the industry over the next 10 years, as game consoles continue to improve and new delivery methods emerge.
TMF: I guess the best way to start is to have you give us an overall description of Activision.
Kotick: We are the number-two video game company in the world, with revenues a little over $500 million. NPD publishes a monthly sales report: We actually were the number-two overall publisher in July. Nintendo was first, we were second, Sony was third, and Electronic Arts (Nasdaq: ERTS) was fourth. We generally fluctuate between the number-two and number-four position as far as overall publishers of software.
TMF: What's your favorite game of all time?
Kotick: Ever? Defender's right up there. It's one of the great games. It's a great arcade game. I think Castle Wolfenstein, the original first-person "shooter." We're doing a remake of that.
TMF: When people buy those remakes of older games, do you find that a lot of people buy it because it is Castle Wolfenstein, or is it just because they know it's a new game, that it's a 3-D shooter?
Kotick: I would say about 50/50 on a product like that. We re-released Space Invaders last year, and I would say more people bought it for nostalgia than not.
TMF: Is there a common theme in the games you consider to be great ones? Do you think there is something, in general, that makes a great game?
Kotick: I couldn't tell you that there is a specific thing. It would be too general if I try and say, "Hey, here's one specific thing that you can incorporate into lots of different games." But, I think when you sit down and you look at kids playing games or now adults playing games, you can immediately tell something that's engaging that really captivates you versus something that doesn't. I think it would be the "Holy Grail" if we could actually tell you what that is. I look at games like Pitfall, which launched Activision in 1980. That game is still fun to play today.
Sometimes people get tripped up and sort of elevate production value as something that can really enhance the quality of the game. It can, but ultimately this is not a movie, it's not a television show, it's a game and that means it needs to engage you actively as opposed to sort of a suspension-of-belief passive experience. That's a big difference.
Most of the advances that we see in game systems have really been in enhanced graphics, enhanced audio, faster microprocessors. I wouldn't want to generalize, but I think the constant struggle is to try and create an experience so that, unlike television, the audience actually believes that they are doing whatever it is they set out to do in the game. So, if you're flying an airplane, driving a car, or playing a sport, then the ultimate goal of a realistic experience is really one of the things that distinguishes successful games.
TMF: But, at the same time though, your catalog at Activision is really diverse. I think your publicist sent me X-Men: Mutant Academy and Tony Hawk's Pro Skater. You throw something like Quake in there, or like Alundra, and you've got such different kinds of experiences, that I would think the way you have to present them to do that is quite a challenge.
Kotick: Well, you know, you get to a certain size -- for us, it was that $500 million mark -- where you're a lot like a movie studio. With the exception of Disney, I don't really think there are very many movie studios where the consumer is going out and saying "Hey, I've got to go see the next Paramount movie," or "Paramount's known for this." There are certain franchises that the company might control, like Star Trek -- which is actually something we have the rights to -- that people know them for.
But, beyond that, this business is, in part, about innovation... and I don't really think that we get pigeonholed into any sort of category. Now, having said that, there are probably four or five things that we, as a company, do focus on -- and extreme sports is certainly one of them.
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There's no reason why, once you have a really decent connection, you can't have advertising support for video games or subscription-based video games."
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TMF: My roommate loved Tony Hawk.
Kotick: I think it is one of the best games we've had in 20 years. Tony Hawk 2 is coming out in a couple weeks and it's really good. That's a challenge when you're doing a sequel: Can you deliver beyond the expectations of the audience? With Tony Hawk 2 we deliver, I think, beyond the expectations of the audience.
When we started looking at sports, that was the one category that we as a company were not in, and we aspired to be a leader in the category. You look at the number-one company in the category, which is Electronic Arts. Its business is built on the foundation of team sports and it does a really good job of football, baseball, basketball, and soccer. We really didn't feel we could add enough value that it would be worthwhile to get into that business.
The other thing is that we saw viewership of those sports declining and license fees increasing. And then, the main hardware companies, like Nintendo and Sony, also wanted to get into the sports thing. So, we went out and signed up more than 60 extreme athletes in every possible extreme sports category -- skiing, boarding, snowboarding, BMX biking, wave boarding, surfing.
Tony was sort of an experiment -- to take the guy who is the Michael Jordan of skateboarding. But, you know what? It's not a big sport. It's a very regionalized sport. It has its own sort of interesting subculture, which is one of the things that was attractive to us. But, at the end of the day, this is going to be something from a marketing standpoint that we had to really break through into the mainstream appeal and try to convince people that skateboarding can be as mass-marketed as any other sport.
We actually set out to do it over five years. We said at the very beginning this is going to be a five-year effort. It's going to have to be across multiple platforms. It's going to cost us a lot of marketing dollars. We're probably not going to get a big payback -- and we're going to have the obligation of creating extraordinary products. Frankly, we didn't think we would be able to create an extraordinary product right out of the gate, and the developer just hit the ball out of the park.
TMF: One of the interesting things to me about the game industry is that you create a game about something like skateboarding, and people will just flock to it even though people might not have even heard of Tony Hawk or any of the other skaters, or they might never have actually ever been on a skateboard.
Kotick: Yes, absolutely. We get back to fulfilling the fantasy that you are a great skater, you are a great surfer. Surfing I think, when they first proposed surfing, I remember sitting in one of the green-light meetings listening to what the risks were. And someone said the single biggest risk, and why surfing has never been done in a video game, is that we can't realistically simulate the waves. You can't break a wave in a way where the surfing experience would be fun or interesting.
When we got the PlayStation 2 development kits, it just so happens one of the guys tried to see whether he could physically recreate a wave that would break interestingly, and it does. That's again, I think, an example of where new game genres evolved as the technology evolved. You start to push the limits of technology in ways that maybe people previously hadn't been able to.
You guys are probably more interested in sort of the investor perspective of it. I didn't get into the video game business because I was so enthusiastic about games. I played games as a kid, I played games in college, but I was not what I consider a "gamer." I like this business because, at the time you saw this business, it had no real institutionalized competitors. You didn't really have any large-scale successes. The failure of Atari in the early '80s got most folks pretty skeptical about this business.
In 1991, Nintendo was just coming off a couple of years of great success, and they were the only game in town. They had 98% market share and they'd gone from zero to 25% penetration of households in the U.S. in like four years. Our feeling was that it was not another fad. This was not Atari happening over again -- Atari's failure was much more a result of bad management and not necessarily a declining market. In fact, if you look at the period from 1984 to 1989, when Nintendo really got off the ground with the Nintendo Entertainment System, people were still buying Ataris and Atari cartridges. They were just buying them at really low prices because there was no Atari to support the business.
And, I think that that's the biggest change that I've seen over the years. In 10 years, it's gone from an opportunistic entrepreneurial business, where you had a hard time predicting your financial results -- which, as an outside investor, I would have said "I have no interest in this category, it's too unpredictable, it's got the worst of technology and the worst of entertainment."
Now I think there's some better and some worse. The better is more like a packaged-goods business, where you have proven brands, proven franchises that actually can have repeatable success in the marketplace and have a reasonable ability to predict your operating results. We never did six, seven, eight years ago.
TMF: You're talking a little bit about Nintendo 10 years ago or so. We had Sony about five years ago, and now we have Microsoft coming into the scene. I've already heard that some people believe the X-Box is going to displace Nintendo as the number-two platform.
Kotick: I'll tell you why I think the fundamentals of our business are so good and getting better, and it's in part because there are so many different microprocessor-controlled devices that you actually can play games on. We've cut deals with Nokia (NYSE: NOK) on some games. But, when we start looking at the number of microprocessor-controlled devices out there, PCs have more-sophisticated microprocessors than any video game system out there today, and we're forgetting the base part of the business -- which is the PlayStation, Nintendo 64, the Game Boy -- and all these ancillary markets are just creating new opportunities.
And, then you've got Sony that was not in this business five years ago that's now managed to build the leadership position in a five-year period of time. And, they're about to introduce a device that's unlike any previous video game system. I think, when you're talking about the differentiation of that system, it points not just to the quality of the graphics and the quality of the audio, but that it's backwardly compatible.
Now it's a simple idea, but historically people have never been able to create backwardly compatible devices, so the value of your library as the software company basically diminished every time there's a new platform introduction. Now, for the first time, you've got the leader in the category introducing a system that's backwardly compatible, but also is a DVD player and also will be able to connect to the Internet -- for less money than you would actually spend as a consumer to buy a basic DVD player today.
TMF: I know, and I can't wait to buy one.
Kotick: Me too. They're the leaders, and they are likely to lead this next cycle of five or six years. Nintendo has created sort of a niche of themselves. They've gone from 95% market share to 25% market share, but they've done it in a way where they've actually been able to grow the business. They have a much higher percentage of software for their hardware; they do have studios that crank out some of the very best games in the world.
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I think Microsoft will introduce X-Box and learn a lot. When X-Box 2 comes out, they'll have a lot more success. And, when X-Box 3 comes, they'll probably be the leader.
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I don't know if you've ever played Goldeneye, but that game is outrageously good. And, between Pokemon and some of the other things that they've got, they are very good at making games. They'll probably be able to maintain their 25% or so market share during this cycle, and maybe grow a little bit.
Microsoft is sort of an interesting competitor. Microsoft has never been known for getting it right on the first try, and I don't think that the X-Box is going to be any different from their application products or some of their operating system products. It will be a very iterative process for them. I think they'll introduce X-Box and learn a lot. When X-Box 2 comes out, they'll have a lot more success, and when X-Box 3 comes, they'll probably be the leader. But that's a 10-year period probably.
I also think that, when X-Box comes out next year, it's not going to necessarily cannibalize Nintendo or Sony sales. Today, you have probably a 25% rate of crossover. That is 25% of Nintendo 64 owners also own a PlayStation, and I think that X-Box is going to be somewhat an incremental device. I think it's going to have educational software, creativity software, and entertainment software. Microsoft is approaching it more as sort of a low-end PC that plugs into a TV, as opposed to a dedicated gaming system. And, I think that's going bring a different consumer to the table -- which is great for us, because anything that we have in the way of incremental business is an additive.
But, I think among the three of them -- and I'm not in the day-to-day operations of the business anymore, so I spend more time than I probably have in the past thinking about the business from an investor and strategic perspective -- when I put my investor hat on, I say next year you have Sony, which derives 26% of it's operating contributions from video games. You've got Nintendo, which has never really had a meaningful down year, so they're going to do everything they can to launch Dolphin as a leading platform. And, then you've got Microsoft coming into the marketplace for the first time. So, among the three of them, they'll touch down somewhere between $800 million and $1 billion in advertising launching video game platforms.
I can't think of any better fundamentals for a business. Video games are going to be the most-marketed product besides automobiles next year.
TMF: You've talked a lot about the console industry, and that's obviously really where a lot of the attention is, but you also mentioned and talked a little bit about the PC and some of the other devices. Where do you find the most monetizable opportunity? I mean, we haven't even talked about online games.
Kotick: Our business is, and it's projected to be, about 75% console and 25% PC. That, in the next two or three years, will change. I think that as the line starts to blur between PC and console -- and all of these devices are capable of supporting a broadband type of connection -- you're going to start seeing some really interesting changes in the marketplace. That's where I think online gaming is going to have its impact.
I think today we're still in the earliest throes. Most online gaming experiences today are on a PC that sits on a desktop, which is connected to a modem, which has to go through an operating system and a bunch of low-level technology that's just not really that oriented towards a mass-marketed plug-and-play entertainment experience.
I think five years from now -- when you have broad-based adoption of DSL, cable modems, or other broadband connections -- you're going to start to see some really, really interesting changes and really great opportunities for content. Not just content, but also in the way we conduct business. Today, trials and sampling is a really hard thing to facilitate, and that's 75% of the market. If you want to try a video game before you buy it, you go to Blockbuster (NYSE: BBI) and you rent it or borrow it from your friends. I think if you have the ability to have free or low-cost trial and sampling in the video game business, that expands the market from what's been a historical barrier of about 25% of households to a much higher percentage.
VCRs are in, what, 95% of American households? Video games have never achieved more than a 25% household penetration. I think that's where the DVD component of these game systems and the future of online is going to really have an impact on the market. That, combined with some changes in the business model, and there's no reason why once you have a really decent connection you can't have advertising support for video games or subscription-based video games.
They're really making some interesting experiments in these areas, but I think it won't be for another five years before you see a meaningful impact on the market. Between now and then, I think you'll see continued growth and rates of growth that are roughly what they were in the last five years when Sony first introduced PlayStation.
So, it's probably a 22% or 23% annual growth rate over the last five years in the game business overall. I think you'll see that in the next five years. And, I think five years thereafter, the things that are going to be real catalysts for growth are going to be things like the online changes or wireless changes that I think will have a real positive impact on the business.
We posted more of the conversation between Kotick and Marino-Nachison on our Activision discussion board.
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