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Evaluate the attractiveness of the video games consoles industry


to Microsoft’s entry. Is this an attractive, moderately attractive or unattractive industry for Microsoft to diversify into? Explain why.

Evaluate Microsoft’s resources, capabilities etc. and whether those will allow it to do “well” (i.e., whether it will win) once it enters the industry. You may use any of the internal analysis tools we have discussed in class (and in the textbook), such as the resources and capabilities framework (VRIN), its strengths and weaknesses pertaining to its resources and capabilities in this new industry, or a value chain analysis (or all three).

Evaluate the long-term profitability of Microsoft in this new industry. What is likely to happen to this industry


Microsoft enters? Here you can evaluate the financial forecasts of Microsoft and in the industry, consider retaliation by competitors, how the industry structure changes favorably or unfavorably, or do some sensitivity analysis on the financials and profitability forecasts.

Given your analysis above, was Microsoft’s decision to diversify (enter) into the video games console business a good decision or not? Take a definitive stance (yes or no).

Xbox Online
December 14, 2001
Microsoft Xbox Online
Greg Canessa gazed at the Cascade Mountains as the evening sun settled in the west. Canessa, Business
Development Manager and Lead Planner for Online Games (and a lifelong gamer), was contemplating the
outcome of the online strategy the team had selected for the console. The brief historical landscape of
online video games was strewn with failed ventures, but Microsoft was counting on a new technology
environment to create a golden era of global multiplayer interaction. For a company that could easily rest
on its laurels, Microsoft was taking a huge and very public gamble that a game console would become a
centerpiece of delivering online gaming.
Microsoft was a behemoth in the software industry. The company frequently recorded more annual
profits than the rest of the software industry combined and was sitting on a $36.2 billion war chest of
cash.i By 2001, the ubiquitous Windows operating system ran nearly 95% of the personal computers in
the world.ii Since Bill Gates and Paul Allen founded Microsoft in 1975, the company had always been
noted for being aggressive in defending its “home turf,” and relentless in attacking new ones. However,
this entry into the gaming business was Microsoft’s biggest leap ever outside of its core software
business, putting the company in an unfamiliar role as a consumer electronics and game maker.
Why was Microsoft betting so much on the home gaming console industry? The industry appeared to be
attractive, but a respected competitor had recently exited the market. Was there enough market potential
to justify Microsoft’s hefty investment? Would online gaming provide a market opportunity for
consoles? There were many PC gamers online, but fewer than 1 million were paying for access. Could
the game console potentially reduce the importance of the PC? Sony was betting that the multimedia and
online capabilities of the PS2 would move the consumer away from the computer and in front of the
television. Would the Xbox, with its advanced technology and online capabilities, trump the
Greg leaned back and wondered whether the Internet-connected Xbox would preserve Microsoft’s place
at the top of the technology food chain for a third decade.
The Video Game Industry
In 1975, an agreement between Sears Roebuck & Co. and Atari ignited the home video gaming industry.
Sears gained exclusive rights to sell a console that played Pong to the home consumer, and consequently,
Atari reached overall sales close to $40 million.iii This milestone marked the beginning of the highly
profitable home computer and video game console industry. In the late 1970’s, Atari launched the 2600,
a gaming console that played games on cartridges. While not the first cartridge system, the 2600 was the
first commercially successful console, with high sales and market penetration. Meanwhile, the precursor
to modern online gaming emerged in the form of Multi-User Dungeons (MUDs), which offered users
This case was prepared by Ira Hall, David Ibrahim, Hemant Mandal, Clint Perez, Bryan Richards and
John Schumacher under the direction of Professor Allan Afuah at the University of Michigan Business
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December 14, 2001
access to a shared adventure game over a computer network. Most MUD gamers were university students
and research scientists from the 1970s through the 1990s.
In 1985, the introduction of the 8-bit Nintendo Entertainment System propelled the mainstream consumer
gaming industry to new heights. Soon thereafter, Sega launched its highly popular 16-bit Genesis. In
1995 and 1996, game hungry consumers rushed to purchase Sony’s PlaysStation1 console and Nintendo’s
N64, ushering in yet another generation of video game consoles. The industry reached loftier heights
with the appearance of Sega’s 128-bit Dreamcast console in 1999 and Sony’s PlayStation2 (PS2) in fall
2000. The Dreamcast included a 56-kilobyte modem for online gamingiv and the PS2 allowed users not
only to play games, but also watch DVDs and listen to audio CDs.v
Online Gaming
By the late 1990s, online gaming had begun to show potential for mass consumer appeal. According to
the Interactive Digital Software Association (IDSA), approximately one third of Internet users regularly
played online games. 43% of those playing online games had been doing so for less than a year, a signal
that this form of entertainment was in an early stage of growth. 79% of online gamers were between the
ages of 25-55, with 60% of those in the 25-44 year old demographic. The IDSA study showed the
potential of the online game market, but it also offered a cautionary note: 89% of those who played games
online indicated that they were not willing to pay to do so, and only one in ten online game players paid
for a subscription to any of the online game services.vi Leading technology analysts predicted that the
American video game market would grow to $40 billion by 2003. They also forecasted that online
gaming subscription revenues in the US would grow from $270 million in 2001 to $4.6 billion in 2005.vii
Low broadband1 penetration restricted online gaming to parlor games that required little bandwidth over
phone/modem lines (e.g. Solitaire). In 1997, two role-playing games achieved popularity online in the PC
arena, primarily across narrowband modem lines. Electronic Arts’ Ultima Online and Sony’s EverQuest
each attracted 200,000 to 250,000 subscribers at $9.95 per month. The combination of Ultima Online and
EverQuest generated 55% of online gaming revenues in 2000, which were $106 million in 1999.viii By
2001, the two most comprehensive gaming websites were the Microsoft Game Zone (“the Zone”) and
EA.com, Electronic Arts’ online and e-commerce business. The Zone and EA.com offered to connect PC
gamers to other players who had the same game installed on their PCs. They also offered games directed
towards families and casual players. These online communities were counting on rising broadband usage
to trigger heavy usage. By 2001, 21 million households had gained broadband Internet access.ix
Industry Segments
While online gaming was beginning to attract attention, in 2000 the home video game industry consisted
primarily of three main segments: hardware, software and accessories. The hardware segment included
game consoles (e.g. the Sony PlayStation), portable game players (e.g. the Nintendo GameBoy) and
personal computers. The software segment featured the games that ran on the hardware. The accessory
segment consisted of game controllers and other peripherals. Online communities had just entered the
stage. These communities ran games through the Internet but did not sell hardware or software. See
Exhibit 1 for a breakdown of 2000 industry revenues for these segments.
Business Models and Pricing
Software generated 70% of the total revenues for the home video game industry. Console manufacturers
sold hardware for minimal to negative margins and then earned higher margins on sales of video games
and accessories for the consoles.
Broadband is considered any service that provides 128kbps bandwidth or higher.
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Historically, console makers profited from this loss leader strategy in three ways:
1. Console manufacturers produced game software and earned revenues directly from the game
2. Console manufacturers negotiated royalty agreements with 3rd party software publishers to
publish games for their system. Console manufacturers received payments upon the sale of each
game. 3rd party software game sales accounted for 75% of all video game sales in 2000.x Exhibit
2 shows market share for the biggest software publishers.
3. Console manufacturers profited from selling accessories and peripherals for their systems. They
also licensed rights to create accessories to 3rd party hardware manufacturers like MadCatz and
Industry observers monitored the success of the loss leader strategy through metrics such as the “attach
rate.” This rate measured the number of games sold for each individual console in a given year. The
greater the attach rate, the greater the likelihood the console maker would achieve its profitability goals
via the loss leader strategy. Exhibit 3 charts historical attach rates for three of the leading consoles from
1995 to 2000.
Online gaming communities were all PC-based to date and some charged subscription fees for the use of
their services. For example, EA.com charged individuals a $10 monthly fee for each premium game title a
user wanted to play online, and allowed the user to play less popular games for free. In other cases, users
had access to free online games, usually through an individuals’ private server. A gamer might host a
game like Quake, with other users buying a CD version of the game and playing online through the host’s
server without additional fees. Under a third model, game publishers sold titles through retail stores and
then matched gamers against one another at no additional charge. The gamers were responsible for
finding servers and Internet connections through which they could play online. Games such as Blizzard
Entertainment’s Starcraft used this model, though its Battle.net website auto-assigned servers.
Unique Online Gaming Challenges
As console makers, software developers and online communities sought new online gaming
opportunities, they grappled with two major points of uncertainty. These companies questioned how
readily consumers would change their video game playing behavior. Gamers were accustomed to playing
at home by themselves or against visiting friends by simply inserting a disk or cartridge into the console
and starting a game. They were used to using the Internet for web browsing or electronic mail exchanges.
Microsoft and its rivals were betting these individuals would comfortably move online to play against
unseen competitors.xi These companies were also uncertain about whether traditional offline console
gamers would pay to play for the extra features online gaming offered.
Competitive Landscape
Microsoft’s Xbox would face competition on various fronts. At the start of the 21st century, two players
dominated the game video game console market. Sony and Nintendo, both Japanese manufacturers,
controlled roughly 70% of worldwide industry revenues in June 2001 through their PlayStation (1 and 2)
and N64 lines.xii The companies enjoyed extensive user bases, popular products, tremendous brand
recognition, and widespread distribution.
Console manufacturers also faced competition from the game software industry. Software accounted for
70% of the total industry’s revenues in the U.S.xiiiWith the bulk of profits coming from royalties on video
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game sales, Sony and Nintendo published their own titles and relied upon 3rd party software developers to
broaden the product line. While 3rd party support was vital for console survival, 1st and 3rd party games
often competed with each other for sales. The 3rd parties were responsible for 76% of all retail games
sales with the remaining 24% coming from the manufacturers’ in-house game development.xiv
Competition in the software arena came from games developed by Sega, Electronic Arts, Activision, and
Take-Two Interactive Software, among others.xv Popular titles sometimes became “franchises” in their
own right. Franchises commanded premiums for developers and even drove sales of consoles via
increased user loyalty. See Exhibit 4 for a list of some popular game franchises.
Together the hardware and software companies competed for an $18.7 billion worldwide market in
2000.xvi With the 2000 release of Sony’s PS2, the June 2001 release of Nintendo’s Game Boy Advanced
hand-held system, and back-to-back launches of Microsoft Xbox and Nintendo GameCube in November
2001, the competition had reached an epic scale. “We are entering a golden age of video games!”
exclaimed John Steinbrecher, CEO of Electronics Boutique Great Britain, a mall based game retailer.
“You get a big console release. You sell a lot of hardware that year. The following two years you sell a lot
of software to support it. We have an 18-month period where there will be four console releases. That’s
unheard-of in my 15 years in the industry.”xvii
Online communities added a new twist to the video game industry. These communities frequently hosted
video game competitions via the Internet that featured PC gamers from across the globe. MSN Gaming
Zone, EA.com and Gamespy emerged as early pioneers in this area. In addition, these sites offered free
and subscription-based services that either complimented CD-based games or stood alone as
entertainment products. EA’s Majestic was one such product that combined a $9.95 per month
subscription with CD-based content. Microsoft and Sony both saw potential for adding an Internet
subscription model to their game consoles.
Video Game Systems
Sony towered over the video game system industry. Between 2000 and 2001, it had sold over 20 million
PS2 consoles worldwide. Between PS1 and PS2, Sony had achieved 50% market share throughout the
world, with its largest sales volume coming in the United States and Japan.xviii
Sony, a consumer electronics and entertainment colossus (with total dollar sales double those of
Microsoft), distributed its products through national American consumer retailers (Wal-Mart, Best Buy,
etc.), specialty gaming retailers (Electronics Boutique, Funco), online retailers (Amazon.com, etc.) and
Sony’s Playstation.com web site.xix Sony stimulated frenetic demand for PS2 by undersupplying its
consoles during the October 2000 product launch, creating long lines and shortages to heighten consumer
Sony began establishing an online gaming presence for its console in 2001. Sony partnered with Cisco
Systems to offer high-speed Internet access and joined America Online in developing e-mail and instant
messaging.xx Sony aimed to get PS2 users online in 2002 through the sale of a broadband attachment for
the console.xxi
Nintendo had successfully entrenched itself in the console market, displacing earlier manufacturers like
Atari and Intellivision. Nintendo introduced the N64 in 1996, expecting it to be the market leader. To the
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industry’s surprise, Sony’s Playstation1, introduced a year earlier, took the lead instead. Hobbled by
reliance upon cartridges, the N64 endured higher production costs than Sony, which played games on
cheaper, higher-memory CD-ROMs.xxii
Over the years, Nintendo’s in-house development efforts spawned several popular franchises such as
Super Mario Brothers, Zelda, and Pokemon.xxiii Nintendo also expanded its scope with its wildly
successful Game Boy hand-held system. GameBoy sold 100 million units worldwide and controlled 95%
of the hand-held gaming market.xxiv
By the fall of 2001, Nintendo was preparing to launch a new console, the GameCube. Applying lessons
learned from the N64, Nintendo duplicated on proprietary DVD’s and planned to increase its portfolio
through greater reliance upon 3rd party developers. In fact, only two of the 15 launch titles would be inhouse games, the rest coming from external developers like Electronic Arts and LucasArts.xxv
Additionally, Nintendo would leverage its installed base of GameBoy Advanced users by allowing the
new GameBoy and GameCube to interact with each other.
Over 60% of Nintendo’s consumers were under eighteen. The company intended to use that segment as a
starting point for future growth. As one Nintendo executive explained, “Our goal is to keep the core
demographic we’re so strong in and build on it by having more games for older audiences. We’d like to
keep them for a lifetime by getting them while they’re young, but we want to compete in the entire
GameCube also featured an expansion port for future modem / broadband adapter to permit play over the
Internet.xxvii Still, Nintendo showed little faith in this prospect. “The revenue model for online gaming is
still uncertain,” argued Atsushi Asada, Executive Vice President at Nintendo. “It may have some potential
in the future, but it will take time. The infrastructure simply does not exist.”xxviii Nintendo was also
concerned about its young core audience. These young consumers had little disposable income and no
credit cards to buy online services.xxix
Through deals with companies such as Activision, Take Two Interactive and LucasArts, the three console
makers hoped to convince consumers they offered the greatest variety or quality of video games. Some
deals were for exclusive rights to a game. Others were non-exclusive and allowed developers to create
game versions for all three consoles. Each console manufacturer sought exclusive titles that could attract
more consumers to their machines.
An international leader in the arcade and home video game industries throughout the 1980s and 1990s,
Sega had recently fallen upon hard times. Sega was in the console business until its Dreamcast product,
launched in late 1999, failed on the worldwide market. Although it sold 2.9 million units in the U.S.,
Dreamcast suffered from a lack of 3rd party developer support (EA did not develop games for Dreamcast).
Additionally, its launch was so close to PS2’s that many consumers simply held out for Sony’s product.
Dreamcast was the first product to offer Internet access through a built-in modem. Sega built SegaNet, an
online network for Dreamcast players to play each other online, which cost $100 million to develop.
While a first mover in online gaming for consoles, Sega ultimately suffered $420 million in losses in
2000 and terminated production of the console.xxx, xxxi, xxxii
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In 2001, Sega decided to focus on developing games for Xbox, PlayStation2, and the GameCube.xxxiii
Sega agreed to produce thirteen games for the Xbox during 2001, and signed agreements to provide
additional gaming software for both PS2 and GameCube. All three console makers sought Sega’s
software due to the company’s groundbreaking success in building three-dimensional graphics and voicerecognition software into video games. According to an executive at Electronic Boutique: “There’s good
will toward Sega from consumers. The quality of their game play is top-notch, and they have great
franchises.”xxxiv With high quality games, Sega could draw many consumers toward the Xbox, or it could
lure them toward PlayStation2 or GameCube.
Electronic Arts
With $1.3 billion in annual revenue, Electronic Arts (EA) was the top independent game publisher
worldwide. EA was known for successful sports franchises such as FIFA Soccer, Madden NFL Football
and NHL Hockey, which had large followings in the console market. EA was also known for PC games,
including Ultima Online and The Sims (developed through its Maxis subsidiary). EA had the resources to
develop games for all three next generation consoles at once. Microsoft, Nintendo, and Sony all expected
to win console buyers and software royalties through the games, but it was not clear whether consumers
would gravitate towards one console or another based on the fact that EA planned to produce for all three.
All three manufacturers hoped to sign agreements for exclusive rights to certain EA games in the future.
Companies like EA emphasized both online and offline gaming. Even though console games sold more,
the game product life cycle was much shorter than that of online games. The typical life cycle of an
offline console game was six months as compared to several years for an online game. On average, a
company such as EA would invest $10-20 million to develop a high quality game. Developers could
prolong life cycles by offering upgrades and updates. Even if companies initially sold fewer copies, they
could expect residual revenues for several more years.
Online Communities
AOL Time Warner
Sony partnered with AOL Time Warner to create a broadband strategy that would bring AOL’s
electronics, media, and communications businesses to Sony devices via four gateways: TVs, PCs,
PlayStations and mobile phones. Under the agreement, Sony would incorporate AOL tools and features
into the PS2 platform, enabling consumers to use instant messaging, chat and email on their gaming
systems. The alliance provided Sony with access to AOL’s 32 million online subscribers and Time
Warner’s 12.7xxxv million cable television subscribers. AOL Time Warner also owned substantial content
in the form of magazines, movies, music, television and the web. In addition to the Sony alliance, AOL
had an existing online entertainment agreement with Electronic Arts, which ran the AOL games channel.
Yahoo! created and maintained its own online gaming site for members of the Yahoo! community. With
2.8 million users per month, Yahoo! Games tended to offer low-tech parlor games like backgammon and
hearts that could be played with other members of the community.xxxvi While Yahoo! had no plans to
create a community for more sophisticated PC and console gaming, it did have an alliance to manage,
maintain and co-brand with many of Sony’s web sites.
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Other Online Communities
Many smaller gaming communities existed on the Internet with varying degrees of success. Some
communities like Gamespot (owned by Ziff-Davis Publishing) and Adrenaline Vault existed as game
information services, posting game reviews, previews and forums for players to communicate with each
other. Other communities were more robust, offering software that allowed gamers to connect to and play
each other online. Gamespy was one such community, offering Gamespy Arcade for Windows PC users.
Xbox Console
“The future of gaming starts today, and it starts with Xbox. Xbox is a key part of our strategy
to drive the digital entertainment revolution and deliver the future of interactive
entertainment to the home. It’s a great example of how Microsoft is innovating. But, most
important, it’s incredibly cool.”xxxvii
– William H. Gates III, CEO of Microsoft
Xbox Launch
Against the backdrop of stiff competition, Microsoft muscled its way onto the scene with a $500 million
marketing campaign and a rumored $2 billion in development costs. Microsoft entered with only a
modest history in designing video games for PCs, with 4% market share for the PC game industry.xxxviii
Microsoft had no experience in manufacturing game consoles. Even so, the company brought its Xbox to
market in mid-November of 2001 and garnered high initial praise from the industry and gamers alike.
Sony watched Microsoft’s entry with a combination of confidence and concern. The Japanese rival
wondered whether its new competitor might fundamentally alter the industry. Sony CEO Kunitake Ando
cautioned, “The biggest threat to PlayStation2 is that the Xbox changes the industry’s life cycle. It is
unclear how long we can keep [our] business model.” Traditionally, consoles sold in five-year product
life cycles, allowing manufacturers time to recover startup costs for hardware, but Xbox might reduce the
life cycle to three years or even less. Similarly, if Sony were to respond by unveiling a PlayStation3 on a
shortened production schedule, it could jeopardize Microsoft’s ability to recover the Xbox’s high entry
costs.xxxix In the meantime, Sony prepared to defend its flagship product with a $750 million worldwide
marketing assault and an army of gaming software developers.xl
Factors Fueling the Xbox Launch
Industry analysts pointed to three major factors driving the company’s product launch decision:
Booming Industry. According to Banc of America, the industry would generate $18.7 billion in
revenues during 2001 – more money than the entire Hollywood movie industry would generate
that year.xli The revenues would derive from the sale of video game consoles, console games,
personal computer games, and arcade games. The U.S. market alone was worth $8.1 billion in
Trojan Horse Strategy. Video game consoles demonstrated a growing breadth of functionality.
In the 1999 Comdex trade show, Sony CEO Nobuyuki Idei declared, “The PlayStation2 is more
than a game machine. It can be more than a communications product…more than a personal
computer!”xlii This statement concerned Microsoft executives. In 2001, Microsoft’s Windows
software loaded on consumer PCs was the company’s fortress into the home market, with 95%
market share in operating systems. Sony’s statement signaled a new threat to this dominance.
Perhaps Sony would soon offer a potent substitute to the home PC, directly challenging
Microsoft’s lock on the home market.
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Supplement “PC” Revenue Stream. The PC industry was in its fourth decade and as such was
beginning to show signs of saturation and maturity, lowering growth rates and hurting
profitability. See Exhibit 16.
Building the box
With design feedback from developers, the Xbox team set out to engineer the actual console. The
company had to overcome two major hurdles. First, its competencies were firmly grounded in software
development, not hardware. Second, PS2 had a one-year head start. The Xbox team had to create a
quality product quickly before Sony’s PS2 built an insurmountable lead in the market.
Microsoft first focused on deepening its team. The company scored a coup by hiring away two Sony
veterans, Toshiyuki Miyata and Naoto Yoshioka, to work on designing and developing the Xbox. Both
men had been instrumental in the launch of Playstation1, and they would greatly shorten the development
Next, the Xbox team faced a critical design decision: should the console’s internal chips be created from
scratch; use existing, off the shelf technology; or use some mixture of the two? The biggest concern was
the console microprocessor. Sony had partnered with Toshiba to design and manufacture custom
microprocessors for its consoles, while Nintendo had partnered with IBM. These companies engineered
their microprocessors from the ground up to achieve high-quality CD sound and fast processing of
complex graphics. Though creating a custom processor might seem ideal, development time and costs
dictated otherwise. Microsoft settled on a processor already on the market, the Intel 733 MHz Pentium
III, which was slightly modified for the Xbox. The Intel chip also guaranteed that the system would be
able to run a stripped down Windows operating system.
Using a Windows/Intel environment had three beneficial effects. First, Microsoft could shortcut a lengthy
and expensive operating system development process by just adapting its established Windows 2000
software. Second, developer tools would be more “PC-like”, giving some game programmers an instant
familiarity with the design process. Third, Windows-based tools would draw in PC game developers who
had never created or ported games to consoles before. “We can do our next Doom on the Xbox, but it
won’t run on the PlayStation2,” explained John Carmack, cofounder and owner of id software, the
company responsible for the wildly popular Doom and Quake series for PC’s.xliii
Microsoft contracted NVIDIA Corp. to manufacture a derivative of its high-end GeForce3 chip for
graphics processing. One of the most costly components to the system, the NVIDIA chip allowed the
Xbox to render polygons2 at twice the speed of PS2. Other off-the-shelf components would allow the
Xbox to get to market quickly while trimming development costs.
Cracking the Consumer Electronics Business
Microsoft now sought to enter a market dominated by two highly respected companies, Nintendo and
Sony. Over the past twenty years, the console gaming industry had existed as a duopoly, with two
console makers dominating the market at any given time. Microsoft had some experience in the PC
gaming and peripherals space, but home consoles would present a different set of challenges for the
organization. On top of that, Microsoft sought to penetrate the online gaming sector, which had its own
set of competitive dynamics.
Polygons are the most basic element in creating 3D video game graphics. Programmers can greatly increase a
game’s realism by “painting” more polygons per scene.
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For Microsoft to build a sustainable and profitable Xbox customer base, it faced issues regarding:
• Targeting a Market
• Developer Support
• Pricing Against Competition
• Product Differentiation
Identifying a Target Market
Both Nintendo and Sony had been successful because they realized early on who their target consumers
were. Nintendo attracted adolescents, typically aged 6 to 14. The Sony PlayStation1 and PS2 attracted
older, more casual gamers aged 18 to 34. Both companies’ consoles also sold well beyond their target
markets. Significant crossover existed between age groups and levels of interest.
After lengthy discussions, Microsoft decided to position the Xbox to attract older gamers, aged 18 to 34.
Market research indicated that these players were key influencers for younger players. By targeting this
segment, Xbox would compete head to head with PS2.
Priming the Developer Pump
In order to concentrate on bringing Xbox successfully to market, Chief Xbox Officer Robbie Bach moved
his handpicked team from the company’s main headquarters to its own office a few miles down the road
from the Microsoft campus headquarters. This move allowed Bach’s team to focus solely on developing
the Xbox apart from Microsoft’s famously strong culture.
Traditionally, Microsoft was a tough negotiator with software developers, extracting very favorable
terms. In the console market, the tables turned. Microsoft had little market power in video games, but
desperately needed a network of third-party developers. Ed Fries, VP of games publishing, pushed the
organization from dictating terms to listening to developers:
“We were the new guys, and everybody was really anxious to tell us what was frustrating and
limiting about the development process with the existing consoles. Then we went out and built
the system they said they needed to make great games.”xliv
The Xbox team not only abandoned the company’s usual hard-nosed tactics, but even consulted with
industry game developers for nearly a year before beginning design work. By fall 2001, Microsoft had
signed agreements with over 200 companies to develop games for the Xbox. Sony had approximately
300 developers at that time. Microsoft’s contractors ranged from small development firms to
powerhouses like Activision and Electronic Arts.
While the Xbox team seemed to be attracting significant interest in the developer community, the
question still remained about how to differentiate the console from the PS2 and GameCube. After all,
major developers could easily place their bets on all three consoles to maximize their profits and hedge
their bets against any one console failing. Without differentiating factors, there would be little reason for
consumers to buy the Xbox, especially from an untested newcomer. Gamers would likely continue
flocking to the PS2 with its huge installed base of titles and backward compatibility with PS1 games.
Pricing Against Competition
The Xbox would enter the market at a price of $299. The GameCube would enter the U.S. market at
$199 during the same week as the Xbox, and Sony was already selling its PS2 for $299 in the U.S. To
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remain competitive, Microsoft would have to monitor how the market responded to the aggressive
GameCube pricing, and how Microsoft priced online services and accessories for the Xbox.
Achieving Differentiation
To differentiate itself from the pack, Xbox’s design team inserted an Ethernet port for broadband Internet
access and an 8-gigabyte hard drive directly into the console. Broadband access would allow Xbox users
to play games online, talk to other gamers over the Internet, surf the World Wide Web, and download
game enhancements. The hard drive would allow users to store digitized music, create and save
personalized game scenarios, load detailed graphics more quickly, and add other applications to Xbox in
the future.
Not to be outdone, Sony announced the release of a broadband/hard-drive add-on module for the PS2 for
early 2002. Users would have to purchase the module at an additional cost, estimated to be between $100
and $150. Nintendo also planned to release a broadband adapter for the GameCube at some point in the
future, but was intent on developing an online gaming strategy first. Clearly, the next battleground for
console manufacturers would be fought online. However, add-ons traditionally sold poorly in the console
market, never penetrating more than 20% of the installed user base.
Microsoft Online Gaming
Getting Into the Zone
Electric Gravity, Inc. created the Internet Gaming Zone (later known as the Zone) in October 1995. With
slow connection speeds, the website offered turn-based games such as bridge and chess to about 1,500
gamers. Microsoft purchased “the Zone” – as it was casually known – in June of 1996. AOL and
CompuServe had also offered similar gaming options for several years. Meanwhile, Doom by id
Software was taking the PC gaming world by storm. This program offered fast-paced, first-person,
shoot’em-up style action, and, for the first time, a killer app for online gaming. The ggame allowed
players to fight each other in real-time.
In 2001, the Zone was the largest online gaming site on the web. Choices for entertainment ran the full
spectrum from puzzle and card games for beginners, to complex strategy and action games such as
MechWarrior for hard-core players. The site counted more than 22 million gamers as members, with 800
weekly tournaments and 130 games.xlv Many of the major game titles even had annual online
championships that crowned supreme gamers and handed a check for $50,000. For 9 of the titles,
Microsoft requires individual subscriptions ranging from $1.95 for 24-hour access to $99.95 for a year
(exhibit 6).
Together with a game development and publishing unit, Zone.com and Xbox form Microsoft’s Games
Division.3 This division was separate from the MSN division, though there were overlapping interests
and technologies. The MSN website is the home page for Microsoft’s Internet Service Provider (ISP)4
Zone.com is part of the Online Games Group, which owns the Zone.com, plus online infrastructure and
technologies for all Microsoft first party games (i.e. client server and peer-to-peer matchmaking, statistics and
tournament systems, back end support infrastructure, etc.). Online Games Group also manages the out-of-game
experiences and community features for these games. – Greg Canessa, Microsoft
ISPs connect end-users to the internet via modem (dial-up, cable or DSL) for a monthly fee. The largest in the
U.S. is AOL Time Warner with a reported 32 million users as of 11/01.
– 10 –
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arm. From all outward appearances, the Zone.com fit smoothly into the MSN general site. Microsoft’s
aim was to offer exciting content and a compelling community, thereby driving eyeballs to MSN.com.
Widening the audience also required MSN to put a more beginner-friendly face on the site. According to
Eddie Ranchigoda, a product manager for the Zone.com, “We’ve always had a strong hard-core following,
but in the last year or so we’ve really seen a spike in casual gaming, mostly due to our puzzle
games…Casual gamers tend to “turn and run” when they see a registration process or a dark, gloomy
hard-core gaming site”.xlvi
Microsoft Television Interests and Investments
Microsoft’s other foray into consumer electronics was in the cable television and direct broadcast satellite
market. Microsoft offered a digital video recorder/interactive television appliance for sale to consumers
known as Ultimate TV. In 2001, the company offered the product to DirecTV satellite cable service
subscribers only. For the television system operators (cable companies, satellite companies, terrestrial
broadcasters), Microsoft offered the Microsoft TV Platform. The platform allowed system operators to
develop a variety of interactive TV services for consumers, including email, Internet, interactive
programming, electronic program guides, and digital video recording.
Additionally, Microsoft invested in various system operators. Microsoft made a $3.0 billion investment
in Telewest, the number-two cable TV operator in the United Kingdom, a $1 billion investment in U.S.
cable operator Comcast Corp, and a $5 billion investment in AT&T.xlvii Microsoft also publicly
announced its intention to support either Comcast or Cox Communications in their bid to buy the AT&T
Broadband cable business, the largest cable operator in the United States.
Where To Go From Here?
Canessa noted that “the Zone is really the only successful example in the games business of a ‘hybrid
gaming site’ — meshing a web-based card, board and puzzle game experience for casual gamers with a
premier PC gaming destination for hard-core gamers.” It might be unwise to upset this successful
formula. On the other hand, the Zone.com could return to its roots as a hardcore player destination, more
in line with the Xbox demographic. Could Microsoft MSN find a balance mass appeal with gamer cool?
With complete system control and significant influence over developers, Microsoft might limit online
Xbox play to the Zone. Alternatively, Microsoft could opt for an “open” platform allowing players to
choose any online community, including EA.com. Theoretically, this would allow Xbox consoles to play
against PS2, GameCube, even PC gamers.
Moreover, there was a question of pricing. Only a handful of MSN’s games had subscription pricing and
those generated little in the way of revenues. The MSN division compounded the challenge with
expensive pricing schemes for broadband access (Exhibit 5). Although the Zone could generate more
revenues through a subscription model, gamers might not be willing to pay additional fees. Conversely,
offering free access would generate a huge community, but Microsoft’s bottom line would hinge on
volatile banner ad revenues. Could either model compensate for per unit losses Microsoft incurred on
console sales?
Now that the Xbox had launched, Greg knew there would be tough decisions ahead. As he turned back to
his desk, he thought about capturing his ideas in a memo to his boss.
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Xbox Online
December 14, 2001
Exhibit 1 – Video Game Product Segments
Exhibit 2 – Software Publishers Market Share
This case was prepared by Ira Hall, David Ibrahim, Hemant Mandal, Clint Perez, Bryan Richards and
John Schumacher under the direction of Professor Allan Afuah at the University of Michigan Business
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Xbox Online
December 14, 2001
Exhibit 3 – Historical Software Attach Rates
Exhibit 4 – Game Franchises
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Xbox Online
December 14, 2001
Exhibit 5 – MSN Pricing (as of 11/15/01)
MSN Internet Access Plans and Pricing
3 months free dial-up service
Your first 3 months of unlimited access are free!
Low monthly rate of $21.95 a month guaranteed until 2003
Offer ends December 31, 2001
Learn more about this plan
MSN Broadband 2 months free when you sign up for a year!
Get 2 months free when you sign up for 1 year of MSN Broadband
Free self-installation kit including use of DSL modem (a $395 value!)
Free activation (a $99 value)
Pricing starts at just $39.95 a month
$1.50 each additional hour after 10 hours
Offer ends December 31, 2001
Learn more about this plan
MSN® TV (WebTV): 2 months free and $50 savings
Get affordable Internet access without a computer
Save $50 with a mail-in rebate
Offer includes 2 months free MSN TV Service
Hurry, offer ends January 31, 2002.
Learn more about this plan
MSN Internet Access dial-up hourly plan
$9.95 per month for 20 hours of Internet access
$1.50 each additional hour after 20 hours
Learn more about this plan
MSN Broadband free use of modem and no term commitment
Use of DSL modem, self-installation kit, and 10 hours monthly
dial-up service included free
$99 activation charge
Pricing starts at just $39.95 a month
$1.50 each additional hour after 10 hours
No term commitment
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Xbox Online
December 14, 2001
Offer ends January 31, 2002
Learn more about this plan
MSN Broadband basic plan
$199 self-installation kit including use of DSL modem
$99 activation charge
Pricing starts at just $39.95 a month
$1.50 each additional hour after 10 hours
No term commitment
Offer ends June 30, 2002
Source: MSN Website
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Xbox Online
December 14, 2001
Exhibit 6 – Zone.com Game Subscription Plans (as of 11/15/01)
Subscription Name
Price ($US)
Seek adventure in this online role-playing game! Your first
month is free. This subscription renews monthly.
3 Month Subscription
Yearly Subscription
Play and participate in all of the Bridge Club game rooms
and tournaments! This subscription renews every three
Rack, stack, shuffle the cards all year around with your
Bridge partner! All tournaments and game rooms are open
to all Bridge Club members.
Asheron’s Call
1 Month Subscription
Bridge Club
CyberStrike 2
Monthly Subscription
Get full access to all combat modules for your CyberPod.
This subscription renews monthly.
Enter the doorway to the mythical world of Elanthia a
stormy realm of enchantment, danger and intrigue. This
subscription renews monthly.
Monthly Subscription
1 Day Subscription
6 Month Subscription
Signup for unlimited thrills and adventure. This
subscription renews monthly.
Brace yourself for 24 hours of unlimited action.
Enjoy six months of flying at a discounted rate.
Monthly Subscription
Fighter Ace
GemStone III
Monthly Subscription
Enter the living world of swords and sorcery. This
subscription renews monthly.
Journey back in time to a land filled with powerful deities,
villainous monsters, and mystical phenomena. This
subscription renews monthly.
Monthly Subscription
1 Day Subscription
6 Month Subscription
Pilot your customized tank through a city at war. This
subscription renews monthly.
Wreak maximum havoc for 24 hours.
Enjoy six months of climbing the ranks and earning your
reputation as the terror of the city.
Source: Zone.com website
Hercules & Xena
Monthly Subscription
This case was prepared by Ira Hall, David Ibrahim, Hemant Mandal, Clint Perez, Bryan Richards and
John Schumacher under the direction of Professor Allan Afuah at the University of Michigan Business
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December 14, 2001
Exhibit 7 – Product Spec Comparison
Hardware cost
Average game cost
Games available
(expected by
Christmas 2001)
Central Processing
Unit speed
Graphics processor
Polygon / second
Audio channels
Online gaming
DVD playback
Total memory
Built-in hard disk
U.S. release date
Microsoft Xbox
Nintendo GameCube
Sony PlayStation2
733 MHz
485 MHz
912 MHz
233 MHz
116.5 million/second
64 MB
November 15, 2001
162 MHz
6-12 million/second
40 MB
November 18, 2001
147 MHz
66 million/second
23 MB
October 2000
Exhibit 8 – The Consoles
Microsoft Xbox
Nintendo GameCube
– 17 –
Sony PlayStation2
Xbox Online
December 14, 2001
Exhibit 9 – Lehman Brothers Report
Microsoft has clearly made a strong marketing commitment to Xbox, and in fact, it is estimated the
company will lose $125 on each Xbox sold. We point out that retailers announced in early September that
they had sold out of Xbox pre-order bundles, which retail at $499 each, and include extra controllers and
a few games. We expect approximately 15-20 games to be available or the Xbox game system at launch,
and approximately 30 games by year-end, likely supporting revenues after the sale of the hardware. We
expect the most popular software titles to retail at roughly $50 each, with low-to-mid-range price points
of approximately $25-$30.
Exhibit 10 – Game Margins (3rd Party Titles)
Exhibit 11 – Software Value Chain
Take Two
Electronic Arts
Best Buy
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Xbox Online
December 14, 2001
Exhibit 11 – Software Value Chain (cont’d)
Developers: Game Developers designed and wrote the software code for Video Games.
Distributors: Game distributors distributed the game titles to retailers.
Publishers: Publishers produced, marketed and distributed the titles created by the developers. Most
publishers were also developers and distributors. Some analysts also estimated that publishers themselves
developed 50% of all game titles. This trend was due mainly to the fact that in-house development of
software was more profitable than third party software, and publishers desired a steadily growing
inventory of titles.
Retailers: Retailers were the front-end to the consumers. The major retail distributors, like Wal-Mart,
had a growing influence and were demanding greater discounts on game titles.
Exhibit 12 – Online Gaming Value Chain
Consumer A
Internet Svc.
Provider A
Consumer B
Internet Svc.
Provider B
Best Buy
AOL Time Warner
Sony/SonyStation.com (Yahoo!)
Electronic Arts/EA.com
Retailers: Retailers were the front-end to the consumers. The major retail distributors, like Wal-Mart,
had a growing influence and were demanding greater discounts on game titles.
Internet Service Provider (ISP): ISPs provide consumer the means to access the Internet. This is
accomplished with dial-up or broadband modems on the consumer side, and connection/hosting hardware
on the ISP end (modems, servers, etc.). Comcast is an example of Broadband only service provisioning
through their cable network.
Website: These are web-based communities that host games, usually charging a monthly fee for
premium games. Gamers can meet and play interactively either using local PC game CDs or entirely online using a browser.
– 19 –
Xbox Online
December 14, 2001
Publishers: Publishers produced, marketed and distributed the titles created by the developers. Most
currently available games have on-line gaming code built in to allow interactivity. Publishers provide
technical support and co-branding to online communities.
Exhibit 13 – Narrowband versus Broadband
Gaming is one of the most popular application and one of the activity drivers for broadband.
% of time spent while on narrow
band – 3/2000 (15.9 hrs/month)
% of time spent after switching
broadband – 9/2000 (21.4 hrs/month)
32% – Composition of the time increase:
Adult sites
*Includes e-mail, chat, personal web hosting, and interest group
**Includes animation, multimedia, television, kids, hobbies, and lifestyle content
Source: McKinsey & Company
Exhibit 14 – Gamer Profiles
Gamers can be distinguished along two dimensions.
Pay nothing
Online (currently PC only)
Play on PC or handheld Play classic and casino games
Example: puzzle, bridge
Pay software
Play on console
4 to 32 players
Private individual host own servers
Gamers find a server with lower ping
to reduce latency
Game publishers like EA.com host
match-making service with “game
rooms” at their own cost
Example: Quake, Unreal
From a few hundred to few thousand
Subscription for playing online
Hosted by game publishers
Example: EverQuest
4 to 8 players
Subscription for playing online
Hosted by game publishers
Pay software + subscription
Pay subscription
– 20 –
Xbox Online
December 14, 2001
Example: Need for Speed
Source: McKinsey & Company
Exhibit 15 – Online Adventure Worlds
Today, three major pay-software+subscription games generate $30mn in cumulative retail sales
and $70mn in annual subscription fees. (The total annual sales of game software in 2000 was
$6.5bn – WSJ 2001) (About 35.1mn people play online games – Jupiter Media Metrix)
Ultima Online
Asheron’s Call
Verant Interactive (Sony)
Electronic Arts
Turbine Entertainment (Microsoft)
Source: McKinsey & Company
Exhibit 16 – PC Unit Sales
– 21 –
FY ’03
FY ’04
FY ’05
– 22 –
Notes and Sources
1 Microsoft’s fiscal year ends on June 30th
2 Figures are a conservative composites of data from various media, broker and market research sources
FY ’06
1 Assumes wholesale price is 70% of retail price
2 Assumes 75% 3rd party software sales with royalties of $7/game for Microsoft, and 25% sales of in-house software with $30 gross margin
for Microsoft
Software/Game Prices and Costs
Retail $ price per unit
Production $ cost per unit
Software Game Sales (“Attach Rates”)
Unit game sales per customer in first year of a customer’s Xbox ownership
Unit game sales per customer per year after first year of Xbox ownership
Console Prices and Costs
Retail price per unit
Wholesale price per unit
Production cost per unit
Console Sales
Unit sales (# of Xbox units sold in millions)
Exhibit 17 – Xbox Financial Data
December 14, 2001
Xbox Online
Xbox Online
December 14, 2001
Microsoft 10-K. September 30, 2001
Deutsche Bank Alex. Brown analyst report, Sept 25, 2001; p.19
“I.C. 1977,” Donald A. Thomas Jr., www.icwhen.com; revised 1/12/01
“Gaming Experience,” Stanley A. Miller, Milwaukee Journal. November 20, 2001
“State of the Industry Report”. Interactive Digital Software Assoc. 2001
“X Marks the Spot.” Rodney Chester, Courier Mail. November 17, 2001
Bank of America Analyst Report, p. 68. May 2001
“Report: Broadband Home Users Jump”. Alorie Gilbert, News.com. December 11, 2001
Bank of America; May 5th, 2001, p. 35
Bank of America; May 5th, 2001, p. 35
Deutsche Bank , Sept 25, 2001; p.19
Bank of America, May 5th, 2001 p. 30
Bank of America, p.35
“Video games are hot”. Larry MacDonald, Montreal Gazette. November 21, 2001
Bank of America; May 5th, 2001, p. 29
“Good at Games”. Catherine Wheatley, The Independent (London). June 13, 2001
“This 3-Way Slugfest is No Game,” Black, Jane; Business Week Online, Dec. 13th, 2001
“Scoring the Game”. Lila LaHood, Fort Worth Star Telegram . October 27, 2001
“Playstation Wins More Net Support”. Melanie Farmer, CNET News.com, May 16, 2001
“Where the Net’s Your Playing Field”. Alex Pham, Los Angeles Times. November 8, 2001
“Let the Games Begin”. Sharon Pian Cain, The Seattle Times. October 25, 2001
“Have a Super Monkey Ball With the Cube”. Tom Ham, Washington Post.
November 16, 2001
“Let the Games Begin”. Cain.
“GameCube Stripped for Action”. Alex Lau, The San Francisco Chronicle. November 14, 2001
“Gaming War Faces Fresh Battles”. Paul Abrahams, The Irish Times. May 25, 2001
“Where the Net’s Your Playing Field”. Pham.
“Gaming Experience”. Stanley A. Miller II, Milwaukee Journal Sentinel . October 25, 2001
“Sega to Charge for SegaNet Access”. Alex Pham, Los Angeles Times. October 25, 2001
“Corporate Spotlight: New Path for Sega”. Kelly Zito, The San Francisco Chronicle. August 12, 2001
“Sega Sports Titles Go Multiplatform”. Tommy Cummings, The San Francisco Chronicle. November 22, 2001
“Corporate Spotlight: New Path for Sega”. Zito.
“Who Will Sign Up for AT&T Broadband?”. Robert, Frank, The Wall Street Journal. December 13, 2001
Nielsen/Netratings, June 2001
“X Marks the Spot.” Chester.
Prudential Financial Analyst Report, p. 7
“Gaming War Faces Fresh Battles”. Abrahams.
“The Game of War”. Dean Takahashi, Red Herring. November, 2001.
“The Paranoia Principle”. James Surowiecki, The New Yorker. November 26, 2001.
“The Game of War”. Takahashi.
“It’s a New Playing Field for Microsoft”. David Becker, Zdnet. November 15, 2001
“Microsoft’s Zone.com offers easy intro to online games”. Bill Hutchens, The News Tribune. November 2, 2001
“Software Giant to Pay $3 billion for British Concern,” Reuters, October 23rd, 1999
– 23 –

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