What Goes Up, Can't Go Down

Or: Why the Microsoft Kinect and the Playstation Move are doomed to fail*

Update 1:

I’ve realized I needed to make the definition of what ‘fail’ meant more explicit. In this case, ‘fail’ refers to catering to the non-gamer market. Considering the article is called “What Goes Up, Can’t Go Down”, I thought that was pretty obvious. If it wasn’t, I hope it is now. Monocle smile! 😉

Update 2 (12/18/2010):

Well, according to VGChartz, Microsoft’s Kinect did in fact eventually reach the milestone of 4 million units sold worldwide (2.6 million units in the Americas) in the week that ended on Dec. 11. Of units sold, 40% of them bundled with a Xbox 360 console, which indicates that there actually was an expansion of the console’s user base. The PlayStation Move, which didn’t get all the marketing support the Kinect did, has sold just over 900 thousand units so far.

So yeah, I was wrong. Colin Sebastian was right.

Shit. I hate being wrong.

However, I still don’t believe Kinect’s success has enough legs for the long run, since the arguments presented in that article below are all still valid.

Now leave me alone while I enjoy my grudge for not having my MBA funded by Lazard Capital Markets.

But hey! On the other hand, I’m not unemployed anymore. I got an actual paid job! But what a beautiful coincidence!

And now, our featured presentation:

After a good while without writing any kind of analysis on the game industry, I felt the bug bite my neck. Now I can’t stop itching. The only cure is to fetch the Nostradamus hat.

Created by Michel de Nostredame, the N-hat never went out of style

My Nostradamus hat is very competitive toward other analysts’ hats. It runs on jealously alright, but since what ultimately matters is its arguments and logic rather than its drive, I listen to it. That’s why the moment it heard Lazard Capital Markets analyst Colin Sebastian saying we’ll see 4 million Kinect devices sold in the fourth quarter of 2010 alone, it rang its bullshit alarm.

BeeeeepBeeeeepBeeeeep! BeeeeepBeeeeepBeeeeep! BeeeeepBeeeeepBeeeeep !

No, Colin. That won’t happen. Let me tell you why.

In order to see why the Microsoft Kinect and the Playstation Move are doomed to fail, we have to understand why the Nintendo Wii was a success. In order to do this, I’m using the framework provided by Clayton M. Christensen in is book The Innovator’s Dilemma.

The Nintendo Wii was a disruptive type of innovation. There are two kinds of innovation: sustaining and disruptive. A disruptive innovation is an innovation that offers a different set of values, while a sustaining innovation merely improves on the values already established. Whether or not the innovation is radical or incremental in nature is irrelevant. What matters is their value proposition.

Sustaining technologies is about improving product performance. You hear what your customer wants and give it to them. That improvement can be incremental (slightly better graphics) or radical (3D games instead of 2D), easy or difficult to achieve – but the values used to measure the product remain the same. Most technological improvements are like that – that’s also what companies are trying to do all the time: listening to their clients and improving performance to reach higher markets. Examples of sustaining innovations are the PS2, the Gamecube, the PS3 and both the original Xbox and the 360. All these products improved what their predecessor set out to do, delivering better graphics and more processing power.

Disruptive innovations, on the other hand, are usually very straightforward and use off-the-shelf components in a way that’s usually simpler than other approaches. The result is that they obviously cannot offer what the mainstream market wanted. That’s why they must target at other niches, which different values, that desire what the disruptive innovation offers.

In its efforts to stay ahead by developing competitively superior products, sustaining innovations make the companies move upmarket, eventually over-satisfying the needs of their original consumers. When the PS3 was first launched with a $600 price tag, that ended up created a vacuum at lower price point into which a company like Nintendo, employing disruptive technology was able to enter. Another good example of disruptive innovation is the Playstation One. It had graphics that were worse than the Nintendo 64 and it was cheaper too. The disruptive element? The media. CDs allowed cheaper development costs, which attracted developers. The Playstation One also targeted a niche: teens and young male adults who played games casually instead of the mainstream market of the time (children, geeks, etc). Eventually, these types of gamers became the new mainstream.

A neat visual example of how a disruptive innovation operates

So, here was the Nintendo Wii. It targeted the lowest part of the market, the non-gamer. Down and upmarket are simply points of reference. The downmarket is usually a smaller market with smaller typical gross margins. The upmarket is a bigger market with better gross margins. The lower you get to the market, the more price sensitive your clients are going to be. Sony and Microsoft are targeting the upmarket – hardcore gamers – with the better margins. Point in case: their games usually cost 50-60 dollars and more than ever they are relying on service revenues such as online subscriptions and DLC. Meanwhile the Wii has a 30-50 price range and very little focus on online gaming.

While it is natural for a potential Wii2 (or Wiii) to move upmarket, delivering better graphics, other gimmicks and whatnot in order to achieve the more profitable gamer (us), I believe that Nintendo will choose to stay where they are simply because they are in a very cozy position and virtually not being threatened by competition.

On the other hand, enhanced by this new market of non-gamers and casual opportunities, we see an effort from Sony and Microsoft to move downmarket. This is new. Until this E3, Microsoft’s strategy was completely different: to make its presence larger in the higher end markets of countries outside the AEJ belt (US, Western Europe and Japan). That strategy was apparently abandoned though. Microsoft may have realized that there is not much room to go upmarket anymore – and the option to reach that same segment in other regions might contain too many obstacles (taxes, piracy, government biases). Their current markets may offer the better margins now, but the emergent market of non-gamers grows faster and their tastes also evolve.

But here is the bump in my neck I can’t stop scratching: history has proven that while there is considerable upward mobility into the value networks of other markets; the mobility downwards into markets enabled by disrupting technologies is restrained.

In other words, what goes up can’t go down. Nintendo has better chances of going upmarket and targeting hardcore games than Sony and MS’ chances of reaching casual and non-gamers.

There are 5 reasons for this:

First reason: Sony and MS depend on us. This is pretty straightforward. We, the “hardcore gamers” are, as clients, holding Sony’s and MS’ business hostage. We value our games differently as non-gamers and thus we don’t want the kind of games they do. I, for example, don’t choose my games based on how easy it is to control them – but my mom would. Sony and MS are forced to use their resources on stuff we want because, right now, all their earnings come from us.

Nintendo didn’t even have that. Its Nintendo GameCube was a sinking ship and having failed to break into the more adult consumer base, it was supported mainly by its loyal but limited fan base who could heroically survive only with annual rations of Marios and Zeldas. In fact, some so-called analysts (yes, I’m aware I’m a hypocrite) even declared Nintendo should do a Sega and leave the videogame business altogether. Who looks silly now? Just to keep tabs, one of these guys was UBS analyst called Mike Wallace. Free from the shackles of hardcore gamers and with a devoted fan cult base that was sure to follow them wherever they would go, Nintendo had nothing to lose and everything to win. Sony and Microsoft, on the other hand, have a significant market they can’t afford to lose and very little to win, which brings us to the…

Second reason: A market with small gross margins won’t solve the growth needed by large companies. A company worth 1 million only needs 250.000 to grow 25%, while a company that’s worth 1 billion will need 250 million in order to achieve the same growth and keep their stockholders happy. Microsoft, for example, is still the most profitable technology company in the world – but their stocks (which represent the future value of a company) are worth less than Apple’s. This is because Microsoft hasn’t invented any products that will greatly increase their growth in a good while now, while Apple keeps bringing out new toys. This is even more troubling for Sony who until not long ago had their entire operation depending on their videogame business.

Third reason: Because we still don’t fully know who this “non-gamer” creature is yet, most of the process to reach them is by trial and error. Unless managers at Sony and Microsoft are willing to face failure – and they aren’t – they will be unable to find this market.

One of the ways to explain this would be to expand on intra-companies logic: best practices demand that best employees are rewarded by meeting goals, so it is logical that employees will choose to invest more on problems against which they are more likely to succeed – even if that means following a radical and risky sustaining innovation for a market they are already familiar with than trying to find a new market for a disruptive innovation. This means their own management will filter opportunities out in order to avoid the risk of failing and spoiling their careers. Another way to explain this is to tackle the process of finding new markets itself. This is a trial and error approach. You can’t rely on data nor consultants – simply because there can be no data for something that does not exist yet. What you can bet on is that every analysis on the new market is likely to be wrong.

Successful companies that cannot or should not tolerate failures in sustaining innovations will also find it difficult to tolerate them in disruptive innovations.

So what do we have? On one hand, the companies’ resources (money, manpower) will meet obstacles in order to reach their disruptive projects. On the other hand, the only way to reach new markets is by interactive learning which, by definition, condemns them to fail until they get it right. Their reward? Something that won’t satisfy the growth rates demanded by the company even if the project is successful. This is not a very encouraging scenario.

An example for why the Kinect/Move will be seen as failures – even if they sell enough to cover their costs – is the Apple’s first tablet, the Newton, which tried to boost the PDA (now evolved into smartphones) market. Although they sold almost the same number of units the Apple II did (also a product for an emergent market at its time), Apple was now simply too big to consider the Newton PDA’s revenue as a success.

Forth reason: Their processes, their cost structure, their values and all other things that establish the capability of a company were all defined around their current business model – selling consoles (or multimedia devices in Sony’s case) to hardcore games. That implies that same capability is NOT suited for business models – including the disruptive business model Nintendo is operating in.

This is something that happens in almost any industry. It is the high-end markets, willing to pay more for their games, what justifies the overhead costs Sony and Microsoft implemented in order to reach that market. Although it would be great to have games with low development costs being sold at high prices, this would only be possible in a monopoly scenario with clients willing to pay for such prices. So, assuming that there is a relation ship between the games’ price and the cost structure to reach that price and still get some profit, this leads to a situation where one company’s cost structure is structured to reach market A, but may not be appropriate to reach market B. Such is the case here.

Case in point is how the Xbox’s and PS3’s entire manufacturing line is still more costly than the Nintendo Wii’s. Considering the non-gamer market is much more sensitive to price, they are doomed either to continue to operate at a loss or to be ignored. No wonder Colin Sebastian is praying Microsoft to sell their Kinect only at $99 (while conveniently leaving him an excuse when his prediction turns up to be false: he can simply say he warned Microsoft that $99 was the sweet spot for it).

Fifth reason: Technology supply does not equal market demand. The technological attributes that make the Wii unattractive for us (e.g. tackled-on motion controls, encouragement for mini-games collections) are the same attributes that constitutes the greatest value for non-gamers. This means that their biggest selling point – from Kevin Butler’s own mouth “Who fights boxing by waving their arms?” – is void: non-gamers obviously like to fight like that.

So, Nostradamus hat, let’s take a peak into the future, shall we?

After realizing how successful the Nintendo Wii was, Microsoft and Sony had 3 options facing them:

1. Try to affect the growth rate of the emerging market, so that becomes meaningful enough for a big company.
2. Wait until the market was big enough and better defined.
3. Create smaller organizations to commercialize the disruptive technology in the growing market.

My opinion was that they went with a mix of #1 and #2 and decided that the non-gamer market was not big enough per se, but big enough so that they could enter it and improve its growth. I didn’t see any indication that number #3 happened. If it did (even if this “smaller organization” was merely a completely independent team inside the bigger company, borrowing its resources but ditching its processes and value), then kudos to you, bigger company; because #3 was the best option.

What we will see is likely to be a short me-too stage: with games similar to the Nintendo Wii being made for the Move and the Kinect – but then they will stumble to justify why the 360/PS3 costs so much more than the Wii.

So the price-sensitive casual market will ignore their products.

Then I bet they will try to make the hardcore gamers themselves buy the casual-aimed supplements. They are probably going to use some “reconnect to your family” or “Online now is to bring families together” marketing approach. Sebastian expects this heavy marketing to be the catalyst for his 4 million Kinect units being sold miracle.

This tactic won’t increase their user base, but may be the bait for the next console generation – but then you have 2 additional issues:

First: Will there be, in fact, a next generation and, if so, will casuals be willing to pay more for these new consoles then? I would say no. Casual players won’t (and why would them after being raised with me-too games?).

Second: Why would a hardcore gamer buy the supplements in the first place? Here’s where Nintendo first-mover advantages really shines: it’s likely they already have a Wii and, if they don’t, why would someone who chose not to get a Wii then get a Kinect now?

For Skittles

For hardcore gamers, Kinect only becomes interesting when its scope goes beyond games. Again: it is easier to move up-market than down-market. Microsoft has the chance here to move even move up-market, by selling Kinect as a motion/voice sensing device that will show up in connected TVs, living room PCs, set-top boxes and other consumer devices, thus targeting a tech-savvy user willing to pay a premium for experimenting new technologies before everybody else.

After failing to attract new casual games, my Nostradamus hat tells me Sony and Microsoft will try selling these devices to us, the hardcore gamer. In fact, if Kevin Butler’s almost schizophrenic E3 speech tells us anything, Sony’s marketing pitch is already made.

This brings us back to reason #1. The problem with this is conceptual: what defined the innovation as a disruption is the very fact hardcore gamers already value other stuff (story, length, gameplay mechanics) higher than the input method. Besides, normal controllers are already more convenient and reliable; whereas motion controls can sometimes still struggle with their performance. The technological offer of motion controls simply has not reached what our market level demands yet. Sony knew this after the Sixaxis fiasco – perfectly portrayed by the game Lair. Sony’s bet is that the Move will finally deliver what hardcore gamers want. When you take into consideration the many functions the Playstation Move has, aiming at hardcore games makes even more sense than casuals and non-gamers, who will see the product’s complexity (“Do I need 1 or 2 Navigation controllers? Just one Move? Or 2? Do I also need an EyeToy? What if I already have one? Are they different in any way?”) as a turn-off anyways. But can the Playstation Move deliver more than the DualShock? More enough to justify purchasing a couple of Move/Navigation pairs plus the EyeToy, that is? Unless Sony cannibalizes the DualShock and forces the new blockbuster games to use the Move only, I don’t believe they can convince us that the Move can deliver. Besides, considering Sony’s historical reluctance to cannibalize its own products (which was the reason Apple was able to steal their spotlight with the iPod, after years of Sony’s dominance with the Discman and the Walkman), I doubt they will be able to frame this decision for us gamers properly.

So that was it. The stage is set and I’ve already ordered my pieces to move. If I’m right, I will gloat and gloat as the sore winner that I am and claim all the non-existent glories my inflated ego will require. If I’m wrong, I will hope nobody remembers this text and I will probably silence whoever brings it up. In any case, here is the rundown:

Microsoft’s Kinect most viable path is upwards, not downwards.

Sony’s Playstation Move is still schizophrenically trying to unite two very distinct value propositions, without truly committing to neither.

Both Sony and Microsoft won’t be able to reach the casual and non-gamer market, because once a company goes upmarket, it doesn’t come down again.

In other words, Colin Sebastian is wrong because of the reasons raised from the innovator’s dilemma Microsoft now faces.

I will now attach this article at my resume, send it to Colin’s Lazard Capital Markets and ask them to fund my MBA (since my imaginary job of being jobless makes it kind of hard to fund it myself).

Because so it was foretold… by the almighty Nostradamus hat.