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May 12, 2003
The Wall St. Journal
Copyright 2003

Videogame Giant Electronic Arts
Links With Sony, Snubs Microsoft
EA Shows Its Clout and Wariness
Of Letting Xbox Dominate Market


Electronic Arts Inc. became the king of videogames with the likes of Tiger Woods and John Madden. Now it's using these allies to challenge the king of software: Microsoft Corp.

The next great battleground for the $27 billion videogame industry is online games -- and there, Electronic Arts is about to throw its considerable weight behind Sony Corp. Tuesday, it plans to announce that when it takes the long-awaited step of putting its biggest blockbuster sports games online, they will be only in versions for Sony game machines.

The exclusive deal shuts out rival game-machine makers from access to the popular EA Sports line in its new online form. It's a particular rebuke to Microsoft, whose Xbox competes with Sony's PlayStation 2. In its drive for a dominant role in online games, Microsoft tried again and again during the past 18 months to persuade Electronic Arts to add its games to Microsoft's own online game service. But Electronic Arts executives decided Microsoft was demanding too much control over Electronic Arts' games and wasn't willing to pay the company for their use.

The snub by Electronic Arts puts Microsoft in an unfamiliar position. Accustomed to having the upper hand as the owner of software that all personal-computer makers need, Microsoft now confronts a cagey software maker that holds the best cards. Electronic Arts is the world's No. 1 game maker, thanks in large part to its sports hits such as Madden NFL and Tiger Woods PGA Tour.

The confrontation came to a head April 16 at the Redwood City, Calif., headquarters of Electronic Arts. Sitting in his boardroom with Robbie Bach, Microsoft's videogame chief, Electronic Arts Chairman Larry Probst gave his final word on the matter: Electronic Arts was going to "build something big," and it wouldn't be with Microsoft. "There's a 100-foot wall between us," Mr. Probst said in an interview in which he recounted that meeting. "We are not going to capitulate on this."

The decision to side with one partner is a break from Electronic Arts' longstanding practice of building games for all major players including the PlayStation 2, Xbox and Nintendo Co.'s GameCube. It continues to make games for Microsoft and Nintendo. But in the emerging online market, Electronic Arts says it will remain exclusive to Sony through next March. (Sony's success with PlayStation 2 is a rare bright spot for the trend-setting company.)

The clash is emerging at a critical juncture for the electronic-game industry, one that could determine winners and losers for years to come. Most consumers now play videogames as they have for two decades: alone or in pairs on home machines hooked to television sets. If the industry can get those gamers online, it could provide a steady revenue stream through subscriptions, helping level off an industry characterized by boom-and-bust sales cycles.

Electronic Arts has racked up $300 million in losses on several big online failures. Today it offers only a handful of games online in a service that hasn't taken off. But now with broadband connections becoming widely available and renewed online efforts by gamemakers, online games could finally be ready to catch on.

Microsoft has invested heavily in its Xbox Live online game service, as part of a broader mission: to control the direction of home entertainment in much the same way it does for personal computers.

As Microsoft envisions it, online videogames would create a path to sell a host of other subscription services as well as software that links game machines to PCs, handheld computers and other digital devices. Xbox Live could also put Microsoft in control of customer relationships with game buyers, wresting that role away from game makers.

"The time is right for us to establish a position [in online games] and start setting the agenda for what the future of the digital entertainment lifestyle holds," says J Allard, the Microsoft vice president in charge of Xbox Live.

Microsoft wanted Electronic Arts games on its network, but Electronic Arts executives say Microsoft wouldn't agree to share portions of the Xbox Live subscription fees with publishers of the games that are played. Electronic Arts and other publishers argue that could give Microsoft unfair control over pricing and influence over customers. Microsoft's strategy "is very simple," says Mr. Probst, the Electronic Arts chairman. "They collect all the money; they keep all the money."

Microsoft won't comment on its financial arrangement with specific game publishers. When asked about the dispute with Electronic Arts, Mr. Bach, the Microsoft games-division chief and senior vice president, says Xbox Live can help game makers by boosting their sales. To access the Xbox Live service, players must first purchase the individual games from publishers.

That Electronic Arts could simply walk away from the negotiating table with Microsoft is a sign of the videogame industry's new dynamics. Once a fragmented field with hundreds of small players, it now sees clout concentrated among a few big players who have the wherewithal to continually invest as much as $10 million to $20 million in single games and the sales volume to command shelf space at retailers. Sales of videogame hardware and software reached $10 billion last year in the U.S., compared with about $9 billion for movie-box-office receipts.

Electronic Arts has exploited those changes better than any game publisher. Years ago the company started signing deals with professional sports leagues such as the National Football League and big names including Messrs. Madden and Woods and more recently Jason Kidd of the New Jersey Nets and this year's No.1 NFL draft pick, Carson Palmer. Under Mr. Probst, a savvy negotiator and hard-nosed leader, Electronic Arts combined extensive market research with rigorous development schedules to turn its EA Sports brand into one of the most profitable and recognized game franchises. It dominates nearly every major category, including football, basketball, soccer, baseball and golf.

On that foundation, Electronic Arts has built other winning franchises, such as games based on movies including the Harry Potter and James Bond series. Last week Electronic Arts said for the year ended March 31 it posted a net profit of $317 million, a nearly threefold increase from the previous year, as the company benefitted from big sales of Playstation 2 games. Sales jumped 44% to $2.48 billion.

That caps 15 years of compounded annual growth in revenue of 30% and net income of 36%. At the end of March, the company held $1.6 billion in cash and had no debt. Its share price has more than doubled over the past five years. In 4 p.m. Nasdaq Stock Market trading Friday, Electronic Arts shares were off 24 cents at $61.55.

Game publishers such as Electronic Arts and makers of game machines -- Sony, Microsoft and Nintendo -- are co-dependent: Sales of one rely on sales of the other. That makes it hard for one side to strong-arm the other. Also, while Electronic Arts dominates its industry, surprise hits can come from nowhere. Grand Theft Auto, a driving-and-shooting game that outsold all other U.S. games in 2002, emerged from a once little-known New York publisher, Take-Two Interactive Software Inc.

Still, when Electronic Arts flexes its muscles, it can have stark results. The company's decision several years ago not to build games for Sega Corp.'s DreamCast game computer was one of the primary reasons that cutting-edge machine died, inflicting huge losses on Sega. When Sega countered last year, attacking Electronic Arts head-on in sports games, Electronic Arts batted it down. During an internal strategy session in Tokyo last year, Sega executives searched for sports areas that Electronics Arts doesn't dominate. One conclusion: swimming.

When Microsoft decided, in the summer of 1999, to build the Xbox, one of its first stops was Electronic Arts' headquarters. Electronic Arts announced in December 2000 that it would produce eight games for the Xbox. Both Mr. Probst and Microsoft's Mr. Bach emphasize that this side of the companies' relationship is still strong. Electronic Arts has some 15 to 20 Xbox games under development.
Larry Probst

But even as Electronic Arts and Microsoft prepared the Xbox games in 2001, differences surfaced in the online business.

One of the biggest obstacles to making online gaming more widespread has been the huge investment needed in servers and software to run the multiplayer games. Not wanting to take the risk, many game makers didn't invest. Those that did -- such as Electronic Arts -- couldn't make money at it.

Microsoft's answer to that problem was simple -- it would invite game makers to put their games on a central online service that it would run. With a single password, gamers would be able play games from any game maker on the Microsoft system.

Many publishers privately worried about the Microsoft model because it put Microsoft between publishers and their customers. In traditional videogames, publishers sell gamers disks at retail stores such as Wal-Mart. Under Microsoft's online plan, gamers still need the disks, but the entire online portion of the game would be in Microsoft's hands.

Enter Sony, which last year came up with a counterplan that alleviated such concerns. Its offering will allow game publishers to run their own computers and manage their own customers. Sony said it would just ship to retailers a $40 specialized modem and software for the PlayStation 2 that would let gamers connect using any online service.

The game publishers would still have to invest in Internet infrastructure to set up their online games, but they would maintain control of the revenue and the relationship with the game players. The publishers would pay a royalty fee to Sony -- which would help with the development and security of the gaming sites, shoulder some of the marketing costs and deliver its large audience to the gamemakers' doorstep.

The Sony plan appealed to Electronic Arts because it offered more flexibility and a bigger potential market, since the PlayStation 2 far outsold the Xbox. By spring 2002, Electronic Arts began publicly distancing itself from Microsoft in the online business.

That was clear last May at the Orpheum Theatre in Los Angeles. On the eve of the annual industry exposition, Microsoft pledged it would spend $2 billion during the next five years on the Xbox, including investment in Xbox Live. Microsoft shined spotlights on its supporters in the audience. Electronic Arts was conspicuously absent.

The same evening across town, Electronic Arts was preparing an online version of Madden NFL 2003 for a demo the following morning at a Sony strategy briefing. During the demo, Minnesota Vikings quarterback Daunte Culpepper had an online scrimmage with Tennessee Titans defensive end Jevon Kearse, thousands of miles away. Mr. Madden razzed the two pros via live video feed from San Francisco. When Electronic Arts opened the game to the public later in the year, it was one of the first videogame-machine blockbusters to go online.

Following the expo, Microsoft forged ahead with efforts to sign up games for its new service. But by October, when Electronic Arts shipped its first Xbox version of Tiger Woods PGA Tour 2003, Microsoft had still failed to woo Electronic Arts into its online camp.

In fact, Electronic Arts was growing closer to Sony. That month, executives at Electronic Arts approached Sony about moving the EA Sports franchise online in a more serious way. One reason: the strong response to the experiment with Madden NFL online. While the numbers weren't large, they showed Electronic Arts executives that the online market was emerging faster then they had thought it would.

So around that time, Electronic Arts and Sony started working out the financial details of the online service. Electronic Arts started making online versions of games that could handle both Sony's and Microsoft's online systems.

On Nov. 15, Microsoft opened Xbox Live to the world with plans to deliver up to 14 online games by year's end from game makers including Sega, Ubi Soft Entertainment and THQ Inc. It still had no deal with Electronic Arts.

As 2003 got started, Mr. Probst says, "it just became increasingly clear to us that we were not moving the needle toward our side" in discussions with Microsoft. In February, Sony announced details that Electronic Arts had requested: a royalty structure for its online business.

With the game exposition approaching in May, Electronic Arts executives at a meeting on March 10 pushed forward the talks to give Sony exclusive rights to EA Sports online, says a person at the meeting. With an exclusive deal with Sony in the works, developers scrambled to ready EA Sports games for the PlayStation 2 online, not Xbox Live.

The last meeting came in mid-April, when Microsoft's Mr. Bach and his team dropped by to brief Electronic Arts on the progress of the Xbox. Mr. Bach declined to comment on the meeting. After the team filed out of the room, Mr. Bach sat with Mr. Probst, who issued the warning that Electronic Arts was going to build a service. "Robbie, you don't need us, and we don't need you," Mr. Probst says he told the Microsoft executive.

At this year's videogame-industry convention in Los Angeles, Electronic Arts and Sony Tuesday will show how Tiger Woods gamers can golf against players across the Internet, create computer-graphics versions of themselves, shop at virtual pro shops and compete for real prizes in online tournaments. The game is scheduled to ship in the fall following the release of EA Sports' online versions of Madden NFL and a basketball title, NBA Live. The service will also include Electronic Arts' NHL 2004, MVP Baseball 2004, FIFA Soccer 2004 and NASCAR Thunder 2004.

Microsoft's Mr. Bach acknowledges the rift with Electronic Arts but says Microsoft is seeing stronger-than-expected growth in subscriber numbers to Xbox Live. "We're growing just fine without them, but I'd love to see them on the service," he says of Electronic Arts. He adds that by the end of the year, Xbox Live will feature 50 games.

"We just stay in discussions with everybody, and so far the people who've gotten on board have been very successful," Mr. Bach says.

Write to Robert A. Guth at rob.guth@wsj.com

Updated May 12, 2003 7:56 p.m.

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