It has been a grisly week for Japan's electronic games industry. Sega, once a pioneer in the video games market, pulled the plug on its Dreamcast console. Sony cut the shipment forecast for Playstation 2 from 10 million to nine million units because of manufacturing problems. The week before, Square, on of Japan's largest independent game software developers, warned that it would fall into a loss this year because of delays with the latest instalment of the popular Final Fantasy years.
All this at a time when gamesmakers should be celebrating: the Christmas shopping season, after all, is supposed to leave the industry flush with cash.
What happened to sour their fortunes so fast? And what are the implications for the future of the $17 billion video game industry?
The short answer is that the industry is feeling the effects of the shift from 64-bit to 128-bit consoles. Product delays such as those at Sony and Square are common during a generational transition. Sega had trouble making the jump: it launched the 128-bit Dreamcast too far ahead of competitors (in 1998) and sales fell short of expectations almost immediately.
"This is a cyclical business, with mountains and valleys. We are in a transition phase," says Mitsuko Morita, games analyst at Morgan Stanley Dean Witter.
The longer and more troubling answer for investors is that the industry is beginning a painful transformation that will put increasing financial demands on every company in the sector. The problems at Sega, Sony and Square reflect trends that are likely to redraw the landscape of the sector in coming years.
The most immediate factor affecting the industry is the technological progress that has made home consoles look more like slick internet terminals than the plastic toys they were two decades ago. This has two implications for games-makers: they need access to cash for research and development and, as consoles include more complicated, they are more likely to have problems in production.
But to the consumer, the differences between one generation and the next are shrinking. For example, when games-makers upgraded from 8-bit to 16-bit consoles, there was a huge improvement in graphics, sound, and content. The 32-bit generation made images three-dimensional, but "the shift from 32-bit to 128-bit is not nearly as noticeable as was the case in the past," according to Shunji Yamashina, Societe Generale analyst.
At the same time, the demographics of the industry are evolving. Executives believe hard-core gamers - the enthusiasts who sustain the industry are losing interest. Hideki Sato, Sega vice-president, says: "People are sick of standalone games. They want to play against other people in a virtual environment."
Although PlayStation 2 has attracted more non-gamers than other consoles because of its built-in DVD, it is still unclear whether purchasers are playing games on the console or simply using it for videos. And although the proportion of women and older gamers has grown, developers have a poor understanding of the kind of games these new customers want to play.
"What the customers wanted has turned out to be different from what the hardware-makers thought they wanted," says one software executive. So far none of the games for PlayStation 2 has sold more than one million units, a critical industry benchmark. This has serious financial implications: games-makers have traditionally accepted losses on the hardware in return for bigger profits on software. Sony said last week that sluggish software sales contributed to losses of $119 million in its games division in the three months to December.
Meanwhile, the competition is heating up. This year, Microsoft is expected to weigh in with a powerful console known as XBox and Nintendo, father of Pokemon and the GameBoy, will introduce a 128-bit machine called the Gamecube.
More distressingly for the software-makers, online game sites and - particularly in Japan - mobile phone games are making inroads into the market. Although analysts estimate that only about 200,000 people play games online today, hardware and software developers have been forced to invest in Internet technologies to compete.
In theory, online games promise a steady revenue stream. But some executives doubt they will ever recoup their investment: " Nobody will ever spend as much online as they do on traditional software titles. The Internet is going to wipe out half the companies in this business," says one executive.
If he is right, Sega's restructuring is only the beginning. Investment banks expect consolidation. Share prices for game software-makers such as Square, Capcom and Namco have plummeted in recent months. Analysts, hoping to revive enthusiasm in the sector, are putting out reports with titles such as "No reason to panic."
To video game veterans, the events of the past week are nothing new. The industry is littered with stories of failure: Atari, Coleco and Bandai are among those that lost the battle for the home console. But if the sector is entering a period of consolidation as it moves online, the prizes for the eventual winners could be huge.
