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Sega!


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SEGA!

It's a typical grind-it-out afternoon in Haneda, a drab industrial district on the southwest rim of Tokyo Bay. Gray, methodical, efficient. But step inside a nondescript eight-story building on the main road, and you're plunged into a frenzied milieu of colors and sounds: the headquarters of video-game powerhouse Sega Enterprises Ltd. Visitors from France gawk at a big-screen display of animated martial-arts experts facing off before a blazing sunset. Four stories up, young game creators in T-shirts peck away at Silicon Graphics Inc. workstations, putting semihuman figures through movements that defy gravity and logic.

Sega has built a $4 billion company on escapism. But suddenly, it needs to engineer an escape of its own. After three years in which it increased revenues fivefold and profits sixfold and wrested gobs of market share from Nintendo Co., this spinner of video fantasy is tasting reality. Thanks mainly to a bloody price war with Nintendo in Europe, Sega's profits may plunge 63% in the current fiscal year ending Mar. 31, according to new estimates by Goldman, Sachs & Co. For the coming year, excessive inventories should permit a 52% rebound at best. The current generation of video games is losing steam, it seems: Many customers are waiting for new machines due late this year or in 1995.

PRICKLY CRITTER. Faced with similar challenges, Nintendo is responding as companies usually do: holding down expenses, cutting prices, and sticking to its strength--cartridge-based games (page 71). Not Sega. With the joie de vivre of Sonic the Hedgehog, its electric-blue mascot, it is pursuing a two-pronged campaign to reignite earnings. To broaden the market for video games, it is finishing up a compact-disk machine, code-named Saturn, that will play more realistic games than the ones on current CDs or cartridges. Saturn may reach market in limited quantities by Christmas--up to a year ahead of Nintendo's next box.

Beyond that, Sega has embarked on a grand plan to use the profits and knowhow garnered from video games to help it build an entertainment empire. It wants to challenge Walt Disney Co. with virtual-reality theme parks, take on Hasbro Inc. with electronic toys, and lure viewers from TV networks by jumping onto the Information Superhighway with a new category of interactive entertainment.

In short, to paraphrase its advertising slogan, Sega is aiming for the next level. To get there, it will rely on its twin strengths: computer prowess and a deep bond with the most wired generation in history--your children. Sega knows what kids find cool, from its new game ToeJam & Earl in Panic on Funkatron, to Mortal Kombat, the bloody bestseller from Acclaim Entertainment Inc. that Sega, unlike Nintendo, left uncensored. Now, its wider ambitions mean going after parents.

Despite its profit slump, Sega has a better shot than many other multinationals that are also groping their way through "convergence"--the collisions involving the worlds of computers, communications, and entertainment. Sega--even more than Nintendo--successfully straddles different worlds. In contrast to, say, TV, where one company produces the sets and another the programs, Sega works both sides. It can jigger hardware and software to work together at peak performance.

In Sega's favor, too, is its trans-Pacific style--call it NEC meets MTV. Sega combines Japanese patience with American entrepreneurship. In U.S. fashion, it's doing deals with collaborators as varied as American Telephone & Telegraph, Time Warner, Tele-Communications, Hitachi, and possibly even Microsoft. That's in sharp contrast to Nintendo, where President Hiroshi Yamauchi rules with an iron hand. The hand is about to squeeze harder--especially in the U.S. market, where Goldman Sachs estimates that Nintendo's sales of 16-bit game machines slipped from a 60% share to 37% by the end of 1993--with Sega picking up the slack. Nintendo still claims a slim full-year lead in shipments to the U.S. (chart), but its products are piling up in inventory. "Sega is chewing Nintendo alive," says one software executive who develops games for both companies.

For its next meal, Sega will try to take a bite out of Disney. It will try to exploit the efficiency of electronics over iron and steel to create a new entertainment form: virtual-reality (VR) theme parks. Instead of building roller coasters and ersatz Bavarian castles, it will place visitors inside windowless, truck-size capsules and make them feel as though they're driving a race car or piloting a spaceship. Sega VirtuaLand, an experimental arcade at the new Luxor Las Vegas hotel, gives a sense of what's to come.

Stationary VR "rides" will dazzle customers cheaply--with the help of advanced computer graphics from Martin Marietta Corp. Parks packed with them will occupy perhaps 3% of the land area of Florida's Disney World, so they can be put in densely populated areas. They'll be cheaper to build, typically $20 million to $40 million apiece. And they'll be renovated with just a change of software. The first two are set to open this year in Osaka and Yokohama, and Sega hopes to have 50 by 1997. Goldman Sachs analyst Naoko Ito predicts that they will have gross profit margins above 30%, compared with less than 25% for Disneyland and Disney World.

RIDING HIGH. From VR entertainment, it's not such a long step to the business world. Sega executives envision a virtual-reality system for architects that lets you walk through a building before it is built or a training system for handling dangerous machinery. With expertise honed in the consumer market, Sega could bring down the cost of industrial systems that today may run hundreds of thousands of dollars.

To be sure, the hurdles that Sega must overcome to carry off its diversification plan might slow even the persistent Sonic. Sega has grown so rapidly that it looks overweight next to Nintendo. It has little experience in running amusement parks or working with live movie stars--filmed for parts in interactive games--who need more pampering than your average toon. As for VR, the foundation of Sega's theme parks, CEO Hayao Nakayama concedes that more research is needed on the long-term health effects of such systems.

The biggest worry, at least short term, is the cash-cow business that will fund these ventures. Thanks to the European price war--a Sega Genesis machine in Britain costs half what it did a year ago--Sega could lose $100 million in Europe in the year ending Mar. 31. New competitors are butting in, from Sony to a reborn Atari to an impudent U.S. startup, 3DO. Video-game aficionados are fickle: Sega could be deemed uncool as rapidly as it became cool. And some Sega attempts to find an older audience have backfired: Under pressure from Congress and children's advocates last month, it yanked Digital Pictures Inc.'s Night Trap game, which featured zombies attacking nightie-clad women.

Sega executives remain undaunted--perhaps because such ups and downs are mild by the standards of their company's tumultuous past. Nintendo's roots go back to Yamauchi's great-grandfather in 1889. But Sega was started in 1954--by an American, David Rosen, then a 20-year-old from Brooklyn who returned to Tokyo after a stint there with the Air Force. Today, Rosen is co-chairman of Sega of America Inc. and an adviser to CEO Nakayama. The impeccably suited executive has an office in Los Angeles' Century City and six homes from Hawaii to Palm Springs to Beverly Hills.

KEY LESSON. In his early days in Tokyo, Rosen learned a lesson that still guides Sega: Better technology wins markets. The first business of one-man Rosen Enterprises was importing and exporting art and other items. But soon he hit upon the idea of two-minute photo booths. He charged half as much as competing darkroom services that took hours or days.

The modern Sega began to take shape in 1956, when Rosen started importing mechanical coin-operated games, which were already popular on U.S. military bases in Japan. For a dime, players could hit baseballs or shoot moving targets with rifles. But the restless Rosen wasn't satisfied with the games then available from the leading manufacturers in Chicago. He decided to make his own and in 1965 acquired a factory through the purchase of a Tokyo jukebox and slot-machine maker. The company stamped Sega on its games--short for Service Games--and Rosen adopted the moniker. The next year, Sega produced Periscope, which let players torpedo ships by aiming through a periscope. The game became a worldwide hit. "We got letters saying Sega had saved the industry," Rosen recalls. He became a millionaire in 1971 when he sold out to Gulf & Western Industries Inc., staying on as CEO.

By the early 1980s, Sega was riding high along with the industry. Its revenues hit $214 million in the year ended June 30, 1982. Then came a crash, brought on by a surfeit of mediocre games. Arcades failed first, followed by the U.S. home market. Gulf & Western, which had spun off 20% of Sega, bought back the public shares and sold the U.S. assets to Bally Manufacturing Corp.

In Japan, however, Sega survived. One reason was that back in 1979, Rosen had acquired a distribution company founded by a brilliant young Japanese entrepreneur, Nakayama. Rosen joined Nakayama and other Japanese investors to buy the Japanese assets for $38 million. Nakayama became chief executive, and Rosen headed the U.S. subsidiary. Sega went public in Japan in 1986.

The near-death experience profoundly influenced Rosen and Nakayama: It taught them not to stick with one thing too long. Each generation of technology has a life and a death, concludes Rosen: "From those ashes, we have always had a stronger industry emerge."

TUBE TAMER? The company's next incarnation, Sega executives say, will be as a player on the Information Superhighway. They argue that entertainment--not shopping or education--will be the primary use for interactive communications at home. "I see us as a new form of entertainment company," says Thomas Kalinske, chief executive of Sega's U.S. subsidiary, Sega of America in Redwood City, Calif. "I don't think we should be happy until there are more people using our products than sitting down to watch Melrose Place or Beverly Hills 90210."

Kalinske was hired in 1990 precisely to achieve that vision. He was a marketer, not a techie, a former CEO of toymaker Matchbook International Inc. and before that, a 15-year veteran of Mattel Inc. Like his predecessor, Michael V. Katz, Kalinske aimed Sega at a slightly older market and slammed Nintendo with in-your-face advertising. A young San Francisco ad agency, Goodby, Berlin & Silverstein, established Sega as the coolest machine with its fast-paced, quirky TV spots. Goodby created instantly recognizable trademarks, such as the code-like layout of Sega's slogan:

WELCO

METOT

HENEX

TLEVEL.

Goodby also created the "Sega scream," in which wild-eyed, fast-motion characters from Tyrannosaurus rex to Joe Montana finish the ad by yelling into the camera, "Sega!"

Kalinske is heeding Rosen's early insight to seize opportunities wherever they appear. One Info Highway venture mates Sega of America with cable operators Time Warner and Tele-Communications to download video games into game machines over a pay-cable channel. Most games on the Sega Channel, starting late this summer, will be older titles whose sales are slipping. But some will be a peek at the latest releases. Goldman Sachs thinks the channel will make money in its first year--and earn $33 million its third.

DIAL AND DUEL. Another venture, with American Telephone & Telegraph Co., lets customers using a special modem called the Edge 16 play video games over phone lines. Eventually, Sega hopes to use its expertise in the interface between person and machine for interactive TV, where viewers could choose their camera angle or news coverage. Sega is even talking with software giant Microsoft Corp., whose smarts might be useful as Sega machines begin to draw on multiple streams of data for source material: from cartridges, CDs, or cable systems. Nakayama, however, isn't talking, and Microsoft Chairman William H. Gates III says not to put too much stock in the discussions.

Sega's contribution to these deals is its ability to create interactive software--games, that is--that consumers can use without a manual. That's the province of people such as Sega of America's technical wizard, Senior Vice-President Joseph B. Miller III. As a research scientist at Battelle Memorial Institute for five years in the 1970s, he helped NASA figure out how to keep space shuttle tiles from falling off. Now, multimedia has his attention. Says Miller: "We're in position to help design the look and feel of the [super] highway."

Doing that will be quite a leap for a company that was a flyspeck compared with Nintendo just six years ago. In the 1980s, Nintendo singlehandedly revived an industry that had collapsed under mismanagement and a mountain of bad games. It built a better machine than those of the Atari generation. It sold hardware at cost and made its profits from software. It also extracted heavy license fees--some 30% of revenues--from software makers to manufacture game cartridges for them.

Sega couldn't loosen Nintendo's grip until 1989--when it brought out a superior machine, the Genesis. It boasted 16 bits of processing power to Nintendo's 8 bits, allowing for faster, more lifelike action. Nintendo eventually matched Sega with its Super Nintendo Entertainment System, but Sega was in the game to stay. Sega also benefited from Nintendo's high fees, which alienated retailers and software developers. Sega's license fees were lower.

Nintendo, meanwhile, kept enthusiasm high for its games by limiting supply. But sometimes, says Stephen Sandberg, a co-owner of Sanco Toy Inc., which distributes toys to retailers throughout the Northeast, that went too far. "When you try to control a product, there's a thin line," says Sandberg. "You can absolutely kill a product by not shipping enough of it" if retailers lose sales. Nintendo's tactic made the retailers "more apt to look to someone else."

LONE SCOUT. By early 1992, Sega was firmly established as cool--which in financial terms means hot. But Nakayama, its elfin, fast-talking CEO, knew the good times wouldn't last forever. So some 18 months ago, he gave his top aides the word: "Newcomers will charge in. There will be excessive competition. Creativity will run into a wall. Games will become boring. What are you going to do?"

Nakayama then gave his answer: Make something that's hard to imitate, and make it on a large scale. That led to the idea of virtual-reality theme parks, more complicated than arcades and harder to perfect. It also led to Sega's Information Superhighway ventures and its first toy line--not large-scale, perhaps, but unique for now. The toys, being introduced this month, include a $160 learning game called Pico. Using an electronic pen connected to a TV, kids can touch a picture in a cardboard book and make the same thing appear on the screen. For teens, Sega will offer a $300 electronic planner that includes an infrared transmitter and receiver for passing messages. All the products will be out by Christmas.

ATARI RETURNS. Still, all these ideas depend on the cash-generation of Sega's home game business, which accounts for 66% of total revenue. And this time, Sega isn't the hunter, it's the quarry. Nintendo is determined to recapture market share with an advanced game machine it's developing with Silicon Graphics Inc., the maker of engineering workstations. Atari has jumped back into the video-game business under new management, offering a sleek system called Jaguar. Commodore International Ltd. and Philips have new machines that incorporate CD-ROM players for games on compact disks. And Sony has demonstrated a CD-ROM-based video machine with stunning graphics, for release in Japan late this year and in the U.S. next year. To create better games, Sony also plans to marshal the firepower of its Hollywood movie studio--something that Sega can't match.

Sega's not-so-secret weapon in the machine wars is Saturn. It plays both compact disks and cartridges, whereas Nintendo's new Project Reality player will at first handle only cartridges. Saturn's computing horsepower lets it create 3-D illusions based on "polygon" images composed of triangles and four-sided figures called parallelograms. Chips working at furious rates constantly recalculate the geometries as a player moves past them in virtual 3-D space. Nintendo and the rest are also working on polygons, but Sega believes it has an edge through the technology of its arcade business.

Still, Sega sees Saturn as the razor: Now, Nakayama wants better blades. He bemoans the scarcity of developers capable of creating blockbuster games. Customers, he says, are tiring of the same racing and fighting tricks and want something new--whether it's virtual reality or just better story lines. "The problem today," he says, "is that game software has run into a dead end."

To turn things around, Sega is pushing the efforts of software labs in Japan and the U.S. Teams of artists, programmers, and writers collaborate to create games. Musicians have their own studios to record game sounds. Sega has even set up a studio in Hollywood to produce interactive games, in which many possible outcomes are filmed and a player's actions determine which one appears on the screen.

From Sonic to Zanuck isn't an easy transition, even for a company with Sega's gung-ho spirit. Tom Zito, president of Digital Pictures Inc., which makes movie-style games for the CD-ROM add-on for the Sega Genesis, says he has great respect for Sega, but adds: "This is still very much a company that makes video games. Going from that to doing TV programming is a big leap."

Besides that, girding for all these ventures has sent Sega's costs soaring along with its revenues. Its worldwide employment has tripled in three years, to some 5,200. And not everyone is seasoned: One game producer says he often gets calls from complete strangers asking about his products--only to find they are newly hired Sega managers. In contrast to Sega's scattershot style, Nintendo prides itself on lean, tested management. With $5.2 billion in revenues, it has just 2,500 employees.

That said, most industry observers concur that Sega has been smart to bulk up with fresh talent for the grueling wars ahead. No less than a third of the company's employees work in research and development. Indeed, it is Nintendo rather than Sega that "has gotten flabby," says William M. "Trip" Hawkins III, chief executive of 3DO. "Sega is like an athlete ready for the Olympics."

In short, Sega has as good a chance as any company of grabbing some of the long-promised multimedia gold. After all, the world isn't exactly overflowing with multitalented companies that can pull off the convergence shtick. That's why so many corporations--from AT&T to Time Warner to Hitachi--are making deals with this Japanese-American 40-year-old overnight success.

AFTER THE 'SONIC' BOOM, HOW SEGA HOPES TO KEEP GROWING

DIVERSIFY

This year, Sega is going into two new businesses: Toys and indoor amusement parks. Its toy line will include books that interact with a TV through an electronic pen. Its computerized centers--a planned 50

by 1997--will have rides featuring windowless capsules that inexpensively create the illusion of intergalactic warfare or the Wild West.

FORM ALLIANCES

In contrast to Nintendo, Sega is a master collaborator. Among its partners are AT&T in communications, Hitachi in chips, Yamaha in sound, JVC in game machines, and perhaps Microsoft in future software developments.

Those ties should help Sega embed its core graphics

technology into a wide variety of products.

RIDE THE INFO SUPERHIGHWAY

Sega executives believe that the biggest use of the Information Superhighway will be entertainment. A special AT&T modem already lets Sega Genesis owners play games over phone lines while talking. With Time Warner and Tele-Communications, the company plans a cable Sega Channel to transmit game software.

KEEP TODAY'S PLAYERS HAPPY

This is the live-or-die issue. Players bore easily, so Sega needs a steady stream of attractive new games to keep its cash-cow business from running dry. It's counting on its Saturn game machine to rekindle enthusiasm--but volume sales are still a year off. Meanwhile, it's spending $200 million a year on R&D.

DATA: BUSINESS WEEKRichard Brandt in Redwood City and Neil Gross in Tokyo, with Peter Coy in New York and bureau reports


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