NIGHTMARE IN THE FUN HOUSE

Everyone said Nintendo was zapped for good. Now it's rearmed for Mortal Kombat.

Step by electronic step, you advance through jungles, oceans, reefs and mines on Donkey Kong Island in the guise of an amiable ape. You jump off tires, climb vines, throw barrels and even ride fish and rhinos, all in an attempt to get back those bananas stolen by the Evil Kremlins. Suddenly the weather turns nasty. A blizzard howls, and day becomes night. But there's no time to seek shelter or you will lose your chance to do final battle with the Kremlin leader, King R. Cool, on his pirate ship.

The plot of Nintendo's new best-selling video game is just a pale flickering replica of the fierce struggle that video game king Nintendo itself has been engaged in lately. Four years ago, $4.7 billion-in-sales Nintendo controlled 90% of the video game business and was pulling in well over $1 billion a year in pretax profits, more than all the U.S. movie studios combined. Among American children Nintendo's main character, Super Mario, has a higher "Q" rating, which measures the popularity of public figures, than Mickey Mouse.

But these days many do not even expect Nintendo to make it to the final battle for dominance in the $15 billion industry it created almost single-handedly. Nintendo has lost half the European and American markets to its Japanese rival, Sega, and its mascot, Sonic the Hedgehog, in a brutal discounting war. Worse, Sony, 3DO, NEC, Atari and Philips are now in the field with newer technology. By November 1994 all of them had powerful new machines (or "platforms," in the parlance of video gamers). Except for Atari, all were equipped with sleek CD-ROMs. Nintendo's new platforms are not due to arrive until the fall. And they are still going to use cartridges.

"Now it is between us and Sony. Nintendo's window has passed," says Sega Executive Vice President Paul Rioux.

But the victor of this battle may not be winning much, analysts caution. That's because more and more games are being played on personal computers, which most analysts predict will soon replace the dedicated machines Nintendo and Sega sell, stripping them of their cash cows--royalty payments from software licensees.

Currently, about 35% of the software played on Nintendo's machines, and about 45% of Sega's software is written in-house; the rest comes from outside software companies. But Nintendo and Sega produce all the software cartridges and then sell them back to the software company with a stiff manufacturing fee. Nintendo derives almost all of its income from software and half of that from merchandising fees, which represent 20% of the retail price of a game, says Morgan Stanley's Mitsuko Morita.

To technology analysts it seems clear that Nintendo is going to get killed because it is essentially a one-product company. "They could be the next Wang," predicts Joseph Osha of Baring Securities. At S.G. Warburg, Barry Dargan agrees. "The future is so uncertain, I could not even estimate what kind of market share they will be left with," he says. "But I think anything over 35% is optimistic." In contrast, Sega will only be bruised by the changes sweeping the industry, analysts say, because at least it has a profitable arcade business, and it has been diversifying into such new markets as virtual reality theme parks, electronic toys for tots and cable gaming channels.

Naturally this talk has knocked Nintendo's shares down to half what they were worth 18 months ago. They currently sell at 14 times fiscal (March) 1996 earnings, which makes it one of the cheapest blue-chip shares in Japan.

And what does Nintendo have to say about all this? At the company's sterile, white headquarters in Kyoto, Hiroshi Imanishi, right-hand man to Nintendo's 66-year-old president, Hiroshi Yamauchi, for the last 32 years, dismisses the talk as nonsense. "The people who criticize us belong to another world," says Imanishi, who dresses in the same beige zippered company jacket that young staffers wear. "In this software-oriented market, it is not important to be faster with a new platform. The thought is completely ridiculous." In other words, video games are a razor-and-blade business, in which you give the machine away to sell the software. Hot software, in turn, sells the machines. A high installed base of machines attracts the best software houses. "The nature of Nintendo and these so-called competitors is completely different," says Imanishi. "Sony is just another hardware company and Sega is just an arcade company."

Imanishi has reason to be impatient with Nintendo's critics. While rival Sega's theme parks are indeed a positive, its shareholders might not be worse off if it stopped making video games altogether. In 1992, the year Sega smashed Nintendo's dominance in the U.S., Sega's U.S. video game sales rose 50%, but it barely made a profit on them. In 1993, Sega's earnings dropped 64%, to $112 million. In contrast, Nintendo profits fell 40% in 1993, but it still pulled in $500 million in net profits and over $1 billion in pretax profits. It also has no debt and $3.3 billion in cash, and controls 70% of the world video game market. Sega has $700 million in debt and about 25% of the world market.

While analysts criticize Nintendo for trying to milk its existing technology, the 16-bit machine, even as others were leapfrogging that technology by moving to 32-bit machines with a CD-ROM drive, the best-selling item in the industry this Christmas was Donkey Kong Country, a game written for that supposedly outmoded 16-bit platform. In the last 45 days of 1994, Nintendo's new game sold 6.1 million units, making it the fastest-selling game in the 20-year history of the video game industry and clearly a hotter item than Sega's new Sonic & Knuckles title. Visually, the game is at least as impressive as those played on 32-bit machines. Nintendo was able to produce the 3D graphics for this game with something called advanced computer modeling, developed by Nintendo's partners, Silicon Graphics and Britain's Real. Nintendo has an exclusive on the technology.

"I hope Donkey Kong Country has awakened the financial community to where the momentum is in this business," says Howard Lincoln, who was named chairman of Nintendo of America in 1994. "At the end of 1995 we will have the best lineup of software titles in Nintendo of America's history."

Lincoln has now switched to marketing those games Sega-style, which is to say in a tasteless manner. Sega was able to establish itself as the more hip brand in the U.S. by means of advertising that was truly obnoxious. One commercial Sega is particularly proud of is a grainy black-and-white video featuring an obese bully playing a Gameboy (Nintendo's portable monochrome machine) who has to club himself over the head with a dead squirrel in order to see color. All the ads end with Sega's trademark screeching scream.

To achieve an equivalent cachet with the bubble-gum set, Nintendo is lashing back with frenetic commercials mocking a mother who yearns for a successful kid--"a doctor in the family"--and a security guard who intones, "No running, no spitting, no loud music, no skateboarding, no skating." The ads feature rock music played by bands with kid-pleasing names like Sweaty Nipples, belching sounds and profound phrases like "hock a loogie."

Lincoln is also taking the wraps off on violence. Nintendo lost share to Sega in 1993 when it censored a hot new title by Acclaim called Mortal Kombat, in which players win by ripping out the hearts and spines of opponents. Nintendo let Mortal Kombat II run as is. Also, Lincoln finally gave in to Blockbuster and allowed video games to be rented, something Sega did long ago.

Sega heaps scorn on such me-too efforts by Nintendo. "There is nothing worse than someone who is not cool trying to pretend he is," says Sega of America's director of product development, Steven Payne.

But kids do not seem to have a problem with the effort, however amateurish it seems to Payne. In the summer, Sega had 60% of the U.S. market and Nintendo had 40%. Now the breakdown is 50%-50%. This year sales should be flat. But Lincoln predicts that the bolder approach and revamped product lineup will mean a 28% increase in sales for the year ending March 1996. Lincoln dismisses skepticism about Virtual Boy, a soon-to-be released 3D portable machine you look into like a microscope.

He's convinced that the new Nintendo momentum will carry over into 1997. "One of the things I find most incredible," he says, "is how anyone could possibly conclude that Nintendo will not have a predominant share of the next-generation platform. We have the best technology--namely Silicon Graphics' proprietary technology. Mr. Nakayama [Sega's president] wanted that technology as badly as Yamauchi, but Yamauchi got it," he says. "Sega and Sony have world-class 32-bit systems. But unfortunately for them, we will be marketing a world-class 64-bit system at the same time."

No one has yet seen what Nintendo's Ultra 64 looks like. But the company has been quick to form alliances to codevelop software, something Nintendo never did before. And, more important, the company has not forgotten who its core customer is. The platform will be reasonably priced at under $250.

The same cannot be said for the competition. 3DO's machine was supposed to set a new standard for the industry. But it flopped because it hit the market at $799. It is now selling for $399. Sony and Sega may be making the same mistake. They released their new 32-bit products in Japan this fall, and both are now selling well at about $400 a unit. But it is hard to know how long that will last. "Don't be mystified by these early numbers," warns Imanishi. "There are game fanatics who buy every new machine. When 3DO machines first went on sale in Japan, stores in Akihabara were sold out. But it has not penetrated the Japanese market at all."

Analysts now agree that in Japan, where Nintendo still has 90% of the market, most consumers will wait to see the Ultra 64 before buying a new machine. In the U.S., neither Sony nor Sega will have a head start. Their new platforms are being released in the U.S. this fall, the same time as the worldwide release of Ultra 64, a deadline Nintendo claims it will make.

Sony and Sega are already trying to prepare customers for high prices. At the consumer electronics show in Las Vegas in January, both companies emphasized that their new platforms will be priced between $300 and $500. Instead of marketing the machines as the replacement for current 16-bit systems, they are positioning the platforms as high-end machines for twentysomething gamers.

For its core users, Sega is offering a slew of cheaper transition products. The 32X is an attachment for Sega's 16-bit machine that gives games a 32-bit effect. It went on sale in the U.S. before Christmas for $160. The Sega Neptune, a package including the 16-bit system, the Sega CD-player and the 32X, will go on sale this summer for under $200.

Sega claims it is segmenting the market like General Motors. "The Saturn [the 32-bit machine] is the Cadillac, the Neptune is the Oldsmobile and the Genesis is the Chevrolet," says Rioux. Already analysts are worrying about this wide array of products. "There are too many planets, it is a confused strategy," says Edward Brogan of Jardine Fleming.

Baring's Osha also changed his mind about Nintendo's prospects after the show. "Sega's plan is disconcerting," he says. "They are not aggressively mass-marketing the Saturn, which will give Nintendo an advantage."

For Sony, software could also be a stumbling block. While Sony's Ridge Racer, developed by Namco, is definitely hot, the number of other titles is limited. Unlike Nintendo and Sega, Sony will have to rely exclusively on third-party houses. While Sony formed an internal software development division years ago, it has been conspicuously unsuccessful.

What makes Nintendo's platform so much cheaper than competing machines is the lack of a CD-ROM drive. Critics claim this is a great weakness. Everyone thinks the transition to CD-ROMs is inevitable because they can be manufactured much more quickly and inexpensively than cartridges. They also have much more memory, which allows developers to throw in movie and music clips. There is a problem, however. There is a difference in data-access speed of 1,000 times. To get around this, companies have had to build in lots of internal memory in the machines. But that is expensive. For software houses, it is cheaper to make CD games but Nintendo says its cartridges will be priced the same as CDs and that for hot titles there will be plenty of margin for profit.

Lincoln is convinced that Nintendo will soon be praised for its courage. "Judgment day will come in the CD-ROM business," he predicts. "There will be a glut of inferior software."

So at this sitting, it would seem that the price of Nintendo's system and the cutthroat competition will prolong the life of dedicated machines. Neither Sega nor Nintendo see PCs becoming a major threat for years.

The installed base of PCs may be high. But the installed base of PCs with the power, graphics and sound necessary to run popular game software is very low, especially outside the U.S. Such high-powered PCs, costing several thousand dollars, are generally bought by adults and are placed in a bedroom or study. It is unlikely that such machines will be willingly turned over to charged-up nine-year-old boys wanting to play Mortal Kombat for hours on end.

In contrast, Nintendo's new 64-bit platform will cost under $250 and all you have to do is plug it into the TV. For kids it is much more exciting to have their own machine and be able to blow each other away on the large-screen TV in the living room than on a PC they associate with school.

To keep kids playing games on the TV, Sega and Nintendo are both investing in on-line delivery channels. In the U.S., Sega has already rolled out the Sega Channel, which allows users to download old games and previews of new games onto their Genesis platforms. Nintendo will soon start delivering game previews by satellite in Japan and has established a joint venture in the U.S. with GTE to explore interactive possibilities.

Be that as it may, in three to eight years the dominant medium will probably shift to computers. The prices of PCs will keep falling while their sophistication increases. And since software houses pay no royalties for PC games, more and more games will be written for PCs.

What happens to Nintendo then is unclear. But so is the long-term future for most players on the information highway. At the very least, Nintendo will remain a top-notch entertainment software house.

"Nintendo's greatest asset, in addition to all that money, is its copyright library," says Lincoln. "The video game business is just like the movies. There is a Spielberg and a Lucas and there are not a lot of them. We have assembled the people who make great video games. If you have that, then the medium becomes irrelevant."

PHOTOS: Images courtesy of Nintendo and Sega

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by Kathleen Morris