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Home , Backward compatibility, Console Wars (book), Donkey Kong (character), E3 2011, Fusajiro Yamauchi, Hiroshi Yamauchi

2. : FIGHTING THE CONSOLE WARS1

2.1. Introduction

The 2011 Electronic Exposition () in was a moment of truth for

Nintendo, video ’ most iconic company. Despite the recent of its product, the console, Nintendo was facing decreasing sales and lower revenues. The company’s hardware sales were down by 10 million units compared to 2009, and sales were down by 30 million units compared to 2009. Income was in decline, and shares seemed to be in permanent retreat. Nintendo’s stock had retreated to levels not seen since the company’s mediocre performance before the launch of the Wii.

--- INSERT FIGURE 2.1 HERE ---

Nintendo’s problems were taking place at a time when the ’s business model was being transformed by online social, and mobile gaming – market segments that

Nintendo had been reluctant to enter. For many observers Nintendo’s problems could be traced back to Nintendo’s conservative management style and incremental policy.

Nintendo was still very much a family-owned and managed business. Long time CEO Hiroshi

Yamauchi, great-grandson of Nintendo founder , continued the top-down management style that traditionally prevailed in the company since its incorporation in 1889.

He moved away from day-to-day control of operations when in 2002, , until then

Head of Corporate Planning, took over as the first ever non-family President in the history of the company.

1 This chapter was written under the supervision of Professor Joseph Lampel at Cass Business School. The manuscript was submitted and accepted for publication in February 2013 as an invited teaching case in The Strategy Process (ed. Lampel, J. and Mintzberg, H.). The chapter’s preferred reference is:

Rietveld, J. and Lampel, J. (2014). Nintendo: Fighting the , The Strategy Process (in ed. Mintzberg, H. et al.), Fifth Edition, FT Press.

This dissertation chapter was revised from the teaching case with cosmetic edits to improve readability. Iwata went on to successfully turn around Nintendo’s fortunes with the Wii console launched 2006. He was now determined to do it again with the WiiU, Nintendo’s next generation video game console. To create maximum buzz, Iwata chose the June 2011 E3 conference in Las Vegas to make the announcement. The game plan was clear: Nintendo was out to remind industry analysts, and through them shareholders, that the WiiU could count on the 87 million owners of Wii consoles to rebuild its market position.

2.2. Swimming Up River

The company behind some of entertainment’s most famous fictional characters such as and began as a playing cards company in in 1889. When Hiroshi

Yamauchi took over presidency from his great-grandfather Fusajiro Yamauchi in 1949,

Nintendo moved from playing cards to electronic toys to handheld gaming devices (Game &

Watch) and arcade games (Donkey Kong) before entering the video game console market in the early eighties.

American companies such as Coleceo and dominated the video game console industry in the late seventies and early eighties, producing the first, and then second, generation of video game hardware. By 1983 however, the industry was in crisis. An influx of new video game consoles with poor quality, questionable publishing practices, and the commercial failure of movie tie-in games such as E.T. the Extra-Terrestrial, marketed by

Atari, led to a loss of consumer trust and the collapse of sales.

It was against this background that Nintendo released its 8bit cartridge-based Nintendo

Entertainment System (NES) video game console in 1983, first in Japan, and two years later in the U.S. Almost immediately, sales of the NES took off in Japan, but success in the U.S. was much harder to achieve. The 1983 industry was still vivid in the memory of U.S. based distributors, retailers, and most importantly, consumers. As the first company to launch new hardware after the crash, Nintendo faced an uphill struggle. Nintendo had to rebrand the

NES twice, sell the console to retailers on a consignment basis, and spend $5 million dollars on marketing during launch in the area alone. To reassure retailers that unlike many other console makers that went out of business, Nintendo was here to stay, the company also offered buy-back guarantees for its products. Gradually retailers started stocking and eventually selling the new video game console. The efforts paid off, not only for Nintendo, but also for the infant industry that had been struggling under adverse publicity and consumer skepticism.

Nintendo’s NES differentiated itself from the home industry by innovative controller design and processing chip utilization that delivered exceptionally sharp .

These advantages, however, were soon challenged by the 1986 introduction of the

Master System in the U.S. Sega’s console imitated NES’s controller design, but used a processing chip that was twice as powerful. The company was no stranger to the video games industry, having been active both in the Japanese coin-op arcades and the video game console markets.

Sega’s challenged Nintendo in the hardware market. Contrary to other hardware manufacturers, however, Nintendo considered hardware as less important than software. The company put atop its agenda, whereas, to quote the company’s president , hardware was a “necessary evil” – necessary for delivering superior software performance, but not Nintendo’s main business. Putting software first meant drawing on Japan’s longstanding tradition in to create visually appealing games. Employees with a background in art and animation, rather than , as was common in the U.S., allowed Nintendo to differentiate itself by focusing on character and plotline development. This led to iconic video game franchises such as (1987), (1986), and ’s Punch Out (1987), games that sold in excess of a million cartridges and with highly profitable sequel spin-offs.

Nintendo further consolidated its strong software by forging exclusive partnerships with Japanese software developers such as , , Hudson, , and . The company set a maximum amount of five games published per year for each publisher, in addition to imposing a two-year exclusivity clause that prevented the release of games on other platforms. Nintendo also set minimum quantity production orders for cartridges. With these restrictions the company was signaling to game publishers that they were expected to meet consumer quality expectations if they wished to do business with

Nintendo. While the new policies delivered higher quality games, they also led to discontent among game publishers who chafed under Nintendo’s restrictive licensing practices.

The period between 1986 and 1991 marked an era in which Nintendo further refined its business practices. To protect its video game consoles against unlicensed publishing practices

Nintendo prohibited production of cartridges by companies other than itself. Starting in 1991

Nintendo also discontinued working with its distributor, , deciding instead to bring in- house all marketing and distribution activities. External software development support for

Nintendo’s system increased as game publishers were attracted to the console’s growing customer base. To retain consumer interest Nintendo launched , a magazine aimed at young consumers, with at its peak had over 4 million subscribers. This customer paid off handsomely for the company as it used the publication as a for product announcements and advertisements. Total console sales for the NES reached

61.91 million units worldwide. By 1989 Nintendo was generating ¥34,271 million ($446 million) in profits. In the third generation video game consoles, Nintendo attained an 83% worldwide market share, largely due to its exceptional in-house capabilities, and strong alliances with external game development companies. --- INSERT FIGURE 2.2 HERE ---

2.3. Jockeying for Position

As confidence grew, so did the threat from outside competition as the thriving game industry attracted new entrants such as SNK, NEC, and who became active manufacturers during the fourth generation video game consoles. Nintendo was also facing additional competition from established rivals such as Sega who was planning to release a new video game console, and who was making concerted efforts to expand its position in the . Notwithstanding the changing competitive landscape, Nintendo steadfastly held fast on the strategy it set during the second half of the eighties.

In 1989 Sega released the , a next generation 16-bit video game console that was more than four times as powerful as Nintendo’s 8-bit NES console. Sega also made its

Genesis console backward compatible, meaning that its users could switch to the new console without rendering their existing games collection obsolete. Additionally, Sega successfully imitated Nintendo’s game development strategy by establishing alliances with external developers, and developing iconic games in-house such as . Sonic The

Hedgehog for the Genesis sold over 15 million copies and the franchise still is Sega’s best- selling franchise to date.

Nintendo was slow to respond to Sega’s challenge. Riding on the success of the NES,

Nintendo delayed releasing a successor to the NES until 1991 out of fear of cannibalizing its own market. When Nintendo released the SNES, the new video game console lacked the that made older games playable on the new system. Nintendo watched its market leadership slipping away as Sega’s Genesis sales kept rising, fuelled by a strong -up of games. What turned the tide for the company was the release of the bestseller video game

Donkey Kong Country in 1994. The technically superior game was based on one of

Nintendo’s iconic franchises from its NES heyday. The release marked a turning point for

Nintendo’s fortunes. The company recaptured market leadership in the important American and Japanese markets and in most of the European countries. After ’s release, hardware sales for the SNES rose dramatically accumulating 49 million units worldwide by comparison to ’s 28.5 million units sold. This reversal of fortunes was especially significant in the U.S. where Sega only managed to obtain a market share of

37%, with Nintendo essentially capturing the remaining 63%.

--- INSERT FIGURE 2.3 HERE ---

Although Nintendo was rapidly regaining its former strength, the company was not resting on its laurels. In January 1989 Nintendo concluded a strategic partnership with Sony aimed at developing a CD-ROM based add-on for the SNES. Sony was already a component supplier, or Official Equipment Manufacturer (OEM) to Nintendo, providing the for the SNES. By 1991 negotiations on a cross-compatible CD-based console project had reached a critical stage. The two sides agreed that Nintendo would secure technical compatibility with a Sony CD-ROM for its SNES console. For its part Sony would produce its own console, codenamed Station. The Play Station was expected to play technically and graphically advanced CD-ROM games, on top of SNES cartridge-based games. In a break with past practice, Nintendo allowed Sony to retain licensing rights and publishing income derived from all CD-ROM games, regardless of platform.

Nintendo’s concessions made this agreement irresistibly attractive to Sony. Reflecting back on the deal, Sony’s director responsible for the Play Station project emphasized the magnitude of the opportunity: “We could [now] join forces with -performing company in the field. We would

sell them our , establish a track-record, and use that as the springboard to

future success” (Asakura, 2000: p. 29).

Sony announced the joint venture with Nintendo during the 1991 Consumer

Show in . The very next day one of Sony’s main rivals, Philips, unexpectedly made a similar announcement claiming that it, too, was developing a CD-ROM peripheral for

Nintendo’s SNES console. Nintendo would support Philips’ CDi system with licensed software from Nintendo’s library of successful franchises. The deal with Philips differed from the one that Nintendo had concluded with Sony in that Nintendo would retain licensing rights for the disc based video games.

By the time the Nintendo – Philips alliance was announced, the Nintendo - Sony relationship was no longer in the cards. Nintendo discontinued the negotiation with Sony, much to the dismay of Sony who made every effort to revive the contract. Finally, by 1992,

Sony decided to go it alone, using proprietary technology to develop its own video game console. Nintendo’s partnership with Philips, on the other hand, was subsequently abandoned.

The disc-based peripheral for SNES was never launched, and Philips’ CDi system, lacking

SNES compatibility altogether, was a commercial failure.

Having called off one alliance, and been disappointed in another, Nintendo decided to go it alone. Discontinuing disc-based hardware development, Nintendo instead released its third cartridge-based video game console, the N64, in 1996. It was not until 2001, more than ten years after the agreements with Sony and Philips, and long after other competitor Sega had released CD add-ons to its consoles, that Nintendo released a disc-based video game console, the GameCube. Consequently, Nintendo was now trailing far behind old rival Sega, and the newly arrived competitor, Sony. Nintendo’s technological disadvantage put off consumers who wanted the latest technology in their video game consoles. And it also affected relationship with the company’s longstanding software suppliers who were increasingly critical of Nintendo’s lack of innovation.

While Nintendo focused on incremental innovation, Sony used 3D graphics and disc- based game distribution as a springboard to change the market. Sony managed to convince game publishers to supply Sony with quality content by offering technically superior hardware. Equally important, Sony offered less restrictive licensing terms, and developed a more mutually beneficial business model for software distribution. No longer did game publishers need to give up exclusivity for their content, and the up-front investment required for producing CDs was much lower than cartridge production. As a result, many long-term

Nintendo licensees, among them , Square, , and Konami, moved over to Sony, publishing numerous hit products on the PlayStation platform. In an ironic reversal of fortunes, Sony who five years earlier was snubbed by Nintendo, had gone from being a

Nintendo component supplier to becoming its main rival.

Nintendo had traditionally positioned its game consoles as toys, targeting primarily children and adolescents. Sony by contrast saw the PlayStation console as targeting ‘young adults’, between 21 and 29, who spend heavily on entertainment. This paid off for Sony’s

PlayStation, which became the best-selling video game console at the time with over 102 million units sold. By contrast, despite the growing market for video games, Nintendo lagged far behind. The N64 console sold fewer than 33 million hardware units during its lifetime.

Only 225 million games were sold on the N64 platform, less than half of the games sold on the NES console. Sony now had 71% of the market, while Nintendo was far behind with 23% market share in the fifth generation video game consoles.

--- INSERT FIGURE 2.4 HERE --- Nintendo seemed to be in inexorable decline. By the time the firm released the Nintendo

GameCube, its own disc-based video game console in 2001, developers had overwhelmingly switched to Sony, and new entrant who had launched its console late 2001 in the U.S. To make matters worse, GameCube lacked technically innovative hardware design, and according to industry experts was confusingly marketed without communicating a clear value proposition to consumers. GameCube sold just over 21 million units, making it

Nintendo’s worst-selling game console. Sony, on the other hand, reinforced its market position with the backward compatible, DVD enabled, PlayStation 2. The console sold

150 million units, by far the best-selling game console in the video games industry to date.

This pushed Nintendo’s market share in the sixth generation video game consoles to 11%, in marked contrast with Sony’s 73% market share.

--- INSERT FIGURE 2.5 HERE ---

While the console market had grown 275% since the NES era, GameCube sales were only a third of Nintendo’s first console, and accumulated software sales were less than half compared to NES’ game sales. Operating profits had not increased since 1993, and stock growth was sluggish. For Nintendo’s top management it became increasingly clear that the company needed to overhaul its strategy if it wished to stay in the home console business.

2.4. The Comeback

In May, 2002, Satoru Iwata, until then Head of Corporate Planning, took over as the first ever non-family President in the history of the company. Iwata was a recent arrival at Nintendo.

Originally from Nintendo’s long-time software partner HAL Laboratory, Iwata had plenty of opportunities to observe Nintendo’s decision making at close quarters. Upon assuming presidency he set about changing the traditional top-down management style of the company.

Reflecting on the magnitude of the challenge facing Iwata, Nintendo’s Creative Director, and creator of game franchises such as Mario, Zelda, and Donkey Kong, , had the following to say about the changes that the new president was effecting:

“…in a sense, Nintendo’s history had always been dictated by the single person at the

top, and there were aspects of that tendency that were rather stuffy. But Iwata coming

in with his outsider’s perspective improved the ventilation, so to speak, and I get the

feeling that the employees’ understanding of management’s policies became much

deeper thanks to that” (Inoue, 2010: p. 84).

Iwata wanted to extend gaming to a wider population, just as the NES and PlayStation consoles had done before, by adopting what he called ‘Gaming for Everyone’. Achieving this goal required the development of game consoles that were easy to use and offered entertainment value for everyone in the family. Before implementing the new strategy to a video game console, the ‘Gaming for Everyone’ strategy was tested on Nintendo’s next generation handheld device, the Nintendo DS, which was released in 2004.

Development of the DS coincided with Iwata’s focus on blurring the boundaries between the hardware design and departments. The goal, as creative Director Shigeru

Miyamoto put it, was to encourage greater involvement of software development teams in hardware design decisions:

“Collaboration between the hardware teams and software teams became much

stronger once we started to do the DS. I’d always thought of that as a strength of ours,

but it was really with the DS that the company started to move” (Miyamoto in Inoue,

2010; p. 82).

The DS project marked a return to Nintendo’s former role as industry leader. The DS quickly became the best-selling handheld gaming device in the history of the video games industry, selling over 147 million units and 851 million games cumulatively. Nintendo’s ‘Gaming for Everyone’ strategy is illustrated by the DS’ software line-up. The DS reached out to women and younger kids with accessible titles such as brain training game

(18.96 million units sold) and virtual pet (23.64 million units sold).

Whereas innovation in the video game console market traditionally revolved around graphical prowess, for its latest video game console Nintendo concentrated its R&D efforts on off-screen innovation. The resulting console, the Nintendo Wii, was designed around controller-centric innovation using motion sensitive technology to control games rather than player input via buttons. Nintendo set itself apart from main its competitors, Sony and

Microsoft, who focused their efforts on on-screen improvements in an arms race for the best graphics. Nintendo’s game development divisions were put to work to create a series of games representing real-life pastime activities (including running, bowling, , and golfing), which supported and utilized the console’s motion sensitive remote-like controller.

Despite a year’s head start for Microsoft’s console, Nintendo’s Wii quickly regained market leadership over Microsoft, selling over 87 million units and 729.53 million games by the end of 2011. Wii’s success is underpinned by a strong software line-up of accessible games that mimic past time activities utilizing the motion sensitive controller. By the end of 2011, Nintendo’s Wii sold 76.76 million copies, sold 28 million copies, and, sold 22.67 million copies. All of these games target consumers that were not traditionally considered as part of the gaming market. Nintendo’s digital strategy of selling back-log video games from previous generations as paid-for downloads proved successful too. By early 2008, roughly a year after Wii’s market introduction, Nintendo had sold over 16 million digital games. The impact on Nintendo’s market share and financial performance was dramatic. The company’s market share surged to 45% in the seventh generation video game consoles, while Sony’s share fell to 27%. Likewise, profits rose sharply, reaching ¥279,089 million ($3,645 million) in 2009. --- INSERT FIGURE 2.6 HERE ---

In response to Nintendo’s success, Sony and Microsoft gradually followed suit, applying

Nintendo’s strategies to their own consoles. Microsoft’s motion-sensitive peripheral sold over 10 million units half a year of its release ate 2010. For its part, Sony’s re- release of blockbuster video games with updated graphics, under the HD collection label has been positively received by consumers. This allowed Sony to reinvigorate sales of its God of

War, , and Solid franchises in HD on the PlayStation 3. Ironically, however, while Microsoft and Sony were successfully deploying a similar strategy as

Nintendo - targeting ‘new’ audiences and re-releasing games from their backlog catalogs – the firm’s biggest threat was coming not from familiar rivals but from new entrants.

2.5. Looking to the Future

The video game console was the foundation of Nintendo’s video game strategy. However, as technologically advanced mobile phones and tablet devices were becoming an increasingly effective means for distributing video games, the company faced competition from new entrants such as Apple and . These companies could use these new distribution channels, and their large customer base, to outflank companies such as Nintendo that relied heavily on consoles to defend their market position. In 2008, Apple created a viable platform for games on its mobile (iOS). Within a year Apple was selling approximately 5 million games every day on the store to a customer base of 63 million . The challenge to the video console market became even more direct after

Apple introduced the iPad. With over 55 million units sold, and 90,000 dedicated applications, the Apple iPad is a threat that Nintendo cannot ignore. At the same time,

Facebook’s social gaming platform launched in 2007 proved wildly successful with the company’s 800 million active customer base. In 2012, one out of four users visited the for gaming purposes.

The popularity of these emerging markets for gaming has come at the expense of growth in the traditional console games market. Nintendo’s Wii year-to-date sales figures are down

11% for hardware and 21% for software. For the first time since entering the video game console market, Nintendo is projecting an operating loss for the financial year ending March

31st 2012. Nintendo is seeing its customers migrating to the Apple and Facebook platforms.

But what is of greater concern in the long run, is the trend among game developers and publishers to focus on mobile and social games – a move that threatens to starve Nintendo of the new games it needs to keep customers buying new consoles.

--- INSERT FIGURE 2.7 HERE ---

Plunging sales, and the advent of Facebook’s and Apple’s gaming platforms, has led to investors rapidly losing trust in Nintendo’s ability of replicating its unprecedented performance with its next generation gaming devices. As share prices hit a five year low,

Iwata confronts pressures to move into the rapidly expanding mobile and social gaming markets. But abandoning hardware production for game distribution on third party platforms goes against Nintendo’s long tradition of joint production of gaming devices and software.

It was against this background that Nintendo announced a special investor event shortly after the conference. Nintendo’s creative director, Shigeru Miyamoto, took the stage at the event September 13th in Japan. Miyamoto was intent in dispelling perception that the

Wii’s was losing out to social gaming platforms. Showcasing the console’s swansong, ‘The

Legend of Zelda: Skyward Sword’, was meant to signal Nintendo’s commitment to the Wii.

Subsequently, an impressive list of internally developed games based on Nintendo’s hit franchises was announced. While the scope of the announcements was ‘unprecedented’, the absence of Nintendo’s popular franchises on the Apple and Facebook platforms left industry analysts and shareholders alike unimpressed. In the days that followed, Nintendo’s shares declined even further.

2.6. Figures

Figure 2.1: Nintendo’s stock price ($) in January 1st 2007 – December 30th 2011

Nintendo Stock Closing Price in USD ($)

90 80 70 60 50 40 30

Stock price (USD$) price Stock 20 10 0 03-01-2007 03-01-2008 03-01-2009 03-01-2010 03-01-2011 Date

Figure 2.2: Market shares for third generation video game consoles

Third Generation (74,910,000 units) Nintendo Entertainment System (NES) (1985) Sega Master System (SMS) (1986)

17%

83%

Figure 2.3: Market shares for fourth generation video game consoles

Fourth Generation (77,640,000 units) Super Nintendo Entertainment System (SNES) (1991) Sega Genesis (GEN) [MegaDrive] (1989)

37%

63%

Figure 2.4: Market shares for fifth generation video game consoles

Fifth Generation (144,230,000 units) (N64) (1996) Sony PlayStation (PSone) (1995) (SAT) (1995)

6% 23%

71%

Figure 2.5: Market shares for sixth generation video game consoles

Sixth Generation (204,510,000 units) Nintendo GameCube (GC) (2001) Sony PlayStation 2 (PS2) (2000) Microsoft Xbox (XB) (2001) Sega (DC) (1999)

4% 12% 11%

73%

Figure 2.6: Market shares for video game consoles, seventh generation hardware

Seventh Generation (195,720,000 units)

Nintendo Wii (Wii) (2006) Microsoft Xbox 360 (X360) (2005) Sony PlayStation 3 (PS3) (2007)

27% 45%

28%

Figure 2.7: Nintendo’s net profit (in million Yen) in 1987 - 2012

Nintendo's Net Profit (¥ '000) 300.000

250.000

200.000

150.000

100.000

50.000

0

-50.000

FY3/1996 FY8/1987 FY8/1988 FY8/1989 FY3/1990 FY3/1991 FY3/1992 FY3/1993 FY3/1994 FY3/1995 FY3/1997 FY3/1998 FY3/1999 FY3/2000 FY3/2001 FY3/2002 FY3/2003 FY3/2004 FY3/2005 FY3/2006 FY3/2007 FY3/2008 FY3/2009 FY3/2010 FY3/2011 FY3/2012*

* Nine months ending December 31st 2011