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Red Dead vs. Red Ink


Strauss Zelnick, the chairman of Take-Two Interactive (TTWO), sits in a soundproof room enjoying a moment of professional success and a cookie. The room is part of a lavish Take-Two installation at Electronic Entertainment Expo, aka E3, the annual video game conference that's held each June in Los Angeles.

You've got to spend money to make money, he explains between bites, referring to the elaborate setup outside, where an endless stream of conference-goers, mostly geeky guys in jeans, are posing for pictures with Tommy gun-toting Playmates hired to promote Take-Two's upcoming Mafia II game.

Zelnick doesn't look much like his customers. He's 53 years old, dressed in a dark suit and pin-striped shirt, and sufficiently tanned and fit to have made the November 2008 cover of Men's Fitness magazine. Although Zelnick is looking good, his business is looking&hellips;uncertain. Video games, once considered recession-proof, are stumbling, and while Take-Two has produced a hit with Red Dead Redemption, the company is still struggling toward profitability. Sales of all but the hottest, most-hyped games have tanked since 2009. Wedbush analyst Michael Pachter says July marked the fifth straight month that overall title sales have fallen. "Some of our competitors who put out modestly good games this year, they got clocked," Zelnick says. "They're not developing great products, they're delivering good products. Good is the new bad."

Just now, though, Zelnick has a product to celebrate, and it's better than good. Red Dead Redemption has become the industry's summer blockbuster. And it happened in large part because Zelnick stayed with a project that was overdue and over budget.

Red Dead, conceived before Zelnick took over in 2007, is one of several long-gestating and expensive games Take-Two hopes will break its reliance on its popular, and often controversial, Grand Theft Auto franchise, which had its debut in 1997.

Since its release in late May, Red Dead, a $59.99 game, has shipped more than 5 million copies. Few games are as chaotically dynamic and stylishly cinematic (think Clint Eastwood's Unforgiven) as Red Dead. Seth Schiesel of The New York Times called the game a "tour de force" and "the new standard for sophistication and ambition in electronic gaming." Set in the early 1900s, it's a gloriously rendered "open" world that allows players to roam parts of the Western U.S. and Mexico and to do as they please. Skin a dead wolf, and blood spatters on the screen. Gallop into a lush red sunset, and dust rises on the trail. As in Grand Theft Auto, players get to choose how moral they want to be, this time while standing in a six-shooter's shoes. People die. Lots of them. Six Dutch gamers were so taken with it that in July they played Red Dead for 50 hours straight and broke the Guinness World Record for nonstop gaming.

In the best case, Red Dead may be that wonderful phenomenon in the video game world, the "franchise" game that fuels a long cycle of sequels. With Red Dead, Zelnick also aims to prove that the Hollywood-style formula of producing epic games, coupled with budgets to match, still works at Take-Two Interactive. And Red Dead's success marks a turnaround for a game that was starting to look like gaming's Heaven's Gate, the too-long and too-late Michael Cimino western that helped break the back of United Artists in 1980.

If creativity thrives on chaos, Take-Two Interactive has been creating the conditions for artistic genius. For years the Manhattan-based company has attracted critics, among them the Securities & Exchange Commission, Hillary Clinton, and a group claiming to be programmers' wives, which in January of this year posted an anonymous open letter damning the company's labor practices.

Grand Theft Auto has long appealed to outraged citizens as well as fans. In 2005 players uncovered a hidden mini-game in Grand Theft Auto: San Andreas, dubbed Hot Coffee, that allowed them to have virtual sex with their in-game girlfriends. A grandmother in New York filed a class action that was later settled; she had bought a copy for her grandson. Hillary Clinton, then a New York senator, called for a federal investigation.

In 2005, Take-Two paid $7.5 million in penalties to settle a case brought by the SEC alleging that officers of the company, including founder Ryan Brant, engaged in "fraudulent accounting practices designed to inflate its reported revenue during fiscal years 2000 and 2001." The SEC alleged that the company was recognizing revenue from "parking" transactions—shipping hundreds of thousands of games to distributors and repurchasing them after they had booked the sales, disguising the repurchases as "assorted product." In the settlement, Take-Two did not admit wrongdoing.

In 2007, Brant, who had resigned from the company, pleaded guilty to falsifying records in a stock option backdating scandal and paid a fine of $7.26 million. Company spokesman Alan Lewis says that's old news. "It's not who the company is today," he says. "We've moved beyond that."

In 10 of the last 13 quarters since Zelnick became chairman in 2007, the company has lost money. In 2008, Zelnick stunned Wall Street when he and the newly installed board rejected a $2 billion takeover bid by Electronic Arts (ERTS), then the largest independent video game publisher. Zelnick says the bid undervalued Take-Two. "It was a highly conditional tender offer," he adds, "and the conditions were never removed." Today, Take-Two's market value is around $700 million. The stock, trading at about $12 a share last November, goes for around $8 now.

The company's poor performance attracted corporate activist Carl Icahn, who has built a significant stake in Take-Two. He owns almost 14 percent of the company (as of June 30) and has installed three board members, including his son, Brett, who works at his investment firm; SunghWan Cho, a former director of finance for Atari who also works for Icahn; and James L. Nelson, a director at Icahn Enterprises. In an industry ripe for consolidation as development costs soar, he stands to make money if Take-Two is purchased, according to a source familiar with his thinking. And given Take-Two's reputation for big budgets and overdue games, Icahn may see room for cost savings.

Both Grand Theft Auto and Red Dead are the creations of the London-born brothers Sam and Dan Houser, who started work on Red Dead amid Take-Two's turmoil in 2005. Gamers might not know Hitchcock, Cimino, or even Tarantino, but they know the Houser brothers. The reclusive leaders of Rockstar Games create cinematic takes on American culture. Vice-President Sam, 38, looks like a rock star himself with shoulder-length hair, a scruffy beard, and sunglasses. Creative director Dan, 36, is the opposite, with a shaved head and a boyish appearance.

The Housers declined to comment for this article. In the past, however, they've made their philosophy clear: We will sell no game before its time. Dan Houser summed it up in a May 2008 interview in New York magazine. "F&mdash- all this stuff about casual gaming," he said. "I think people still want games that are groundbreaking. We always said: We're not going release a large number of games. They're going to have the production values of movies."

Much of the work on Red Dead was done at Rockstar San Diego, which occupies an unremarkable office building in the suburb of Carlsbad. Rockstar San Diego took more than five years to finish Red Dead, on a budget that Mike Hickey, an analyst at Janco Partners, estimates may have exceeded $70 million.

Some analysts blame Zelnick for being too accommodating of his enfants terribles at Rockstar. "There's no adult supervision over there," says Wedbush's Pachter, a frequent critic. "The Rockstar guys are able to do whatever they want. They should produce a couple of 90-rated games in three years instead of a single 95-rated [game] in six." (Ratings on metacritic, a website that aggregrates reviews, range from 0 to 100 and have become crucial to a title's success.)

Zelnick counters that he supports the Houser brothers' creative viewpoint. Still, he says, "You never, ever want to say we do such a great job [that] we don't have to have discipline."

In 2009, after four years without a release, Red Dead appeared to be one of those inspired projects that never gets finished, like Duke Nukem Forever, also in the Take-Two stable, a much-anticipated game that has been in development for 13 years. Then last November, Leslie Benzies, president of Rockstar's Scotland studio, which leads development on the Grand Theft Auto franchise, arrived in San Diego to take charge in an office off the production floor, from which he oversaw 200 employees.

Months later, in January, people calling themselves spouses of Rockstar employees in San Diego complained of terrible working conditions. A blog posting on the gaming website Gamasutra described how employees toiled away in their cubicles for 12 hours a day, with mandatory Saturdays; a response compared the New York offices to the Eye of Sauron that dominates Middle Earth in the Lord of the Rings trilogy.

At the time, Rockstar made light of the allegations by creating three downloadable computer screen wallpapers depicting an all-seeing eye with the Rockstar logo. "This was someone lobbing a grenade over the wall and posting it publicly," Zelnick says. "Lord knows, we make mistakes now and then. In this particular instance, we couldn't come up with any mistakes that had been made."

Red Dead's release continued to be pushed back, while Rockstar worked to fix more than 200,000 bugs, some of them as minor as the color of dust. Apr. 27 came and went, but the Manhattan billboard with that date on it—a three-story high advertisement depicting Marston with a bandolier around his chest, aiming a revolver—remained.

Janco analyst Hickey estimates that Red Dead Redemption will break even at 4 million copies. Supporting the development of the next major epic is another matter. The gaming industry, as analyst Pachtel suggests, is moving toward less ambitious projects. With thinner wallets, even hard-core gamers are getting choosy. Facebook and other platforms are sapping available dollars, and hours, with more "casual" games selling for $1.99. Then there's the increasing payday that celebrity developers like the Housers command. In 2008 the Housers signed a new deal with Take-Two that, in addition to licensing rights, gives them a share of profits generated from each game they release. That deal expires in January 2012, and Take-Two likely will have to cough up even more to keep the Housers from bolting to a rival.

Zelnick won't say whether he's already opened contract negotiations with the Housers, though even the possibility of their defection should be frightening. In 2003, when Electronic Arts, the maker of Madden NFL, saw its Medal of Honor development teams jump ship, sales of that franchise tumbled 40 percent. Those teams then produced the Call of Duty franchise, which has consistently outsold Medal of Honor since their departure. During E3, the industry buzzed with reports that Activision CEO Bobby Kotick had hosted the Housers in his box at a concert. Kotick and the Housers did not respond to requests for comment.

"I do pride myself on creating environments that attract and keep the best and brightest in the industry," says Zelnick. "You can never underestimate the blood, sweat, and tears that the creative team put in to make it happen. No one would have congratulated us on releasing Red Dead three months earlier."

Cliff_edwards
Edwards is a reporter for Bloomberg News and Bloomberg Businessweek in San Francisco.

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