Finally most of the cards are on the table and we can start making some more definitive statements about where we think the video game market is going. DFC Intelligence is always adjusting its forecasting model based on changes in the marketplace. Suffice to say events of the past six months have forced us to overhaul our models like never before. 

It now appears clear that this new generation of console systems is going to result in a big shake-up in the game industry power structure. While it has always been clear that Sony’s dominant market share was destined to decline, there now appears to be the distinct possibility the PlayStation 3 could end up third in market share behind both the Xbox 360 and Nintendo Wii.

However, we should emphasize a third place finish for Sony is only one of several possible scenarios. Unlike many market prognosticators, DFC does not claim to know exactly how the market will shakeout. We have no way of knowing exactly what sales will be and which platform will be the market leader. When we release forecasts we use multiple scenarios that adjust for different factors like price decreases, hit software titles, market competition etc. In the entertainment market there are always unknowns when it comes to consumer behavior and we like to build that uncertainty into our forecast models. When we say the PlayStation 3 could end up in third place that is a worst case scenario for Sony. Furthermore, much will depend on variables such as Sony’s execution and most importantly how rapidly they can bring down the PS3 price.

When building forecasts we use several factors to estimate how well a system will do. Many of the variables in our forecasts are assumptions of future performance. By changing these future assumptions we can build different scenarios. Obviously, the more factors that are set in stone the more confident the forecast. When it comes to forecasting video game hardware performance the key factors include:

1. Brand, Current Market Position and Past Consumer Behavior relative to all players in the marketplace.
2. Current Software including Software Diversity, Third Party Support, Exclusives and Big Hits.
3. Current Software for the Competition looking at all the above factors.
4. Expected Upcoming Software looking at all the above factors.
5. Expected Upcoming Software for the Competition looking at all the above factors.
6. Current Price
7. Current Price for the Competition.
8. Expected Future Price.
9. Expected Future Price for the Competition.
10. Hardware, Extra Features, the “Wow Factor,” Intangibles and the Ability to Pull a Rabbit Out of a Hat.

In looking at all these elements, Sony’s clear strength is the first factor: brand strength and current market position. The glaring weakness of the PlayStation 3 is price, especially when compared to the competition. However, it is more than just an issue of whether the PlayStation brand strength can justify a premium price. Of course, Sony would like to point to the hardware horsepower and extra features like Blu-ray. The problem is that is only one factor in our forecasting matrix. Furthermore, with the competition having features like Xbox Live and the Nintendo Wii controller, the PS3 may not have that much of an advantage in the elusive “Wow Factor.” That gets to the heart of the biggest concern with the PlayStation 3. Sony has done very little to justify why the system is worth a premium price for consumers that don’t care about raw hardware performance and are not hard-core audio/visual consumers. Unfortunately we believe that represents over 90% of the consumers in the marketplace.

It has often been said that it all comes down to software, i.e. the games. While our matrix has only 4 out of 10 variables that deal with software, obviously software is crucial. When talking about entertainment software, people often refer to the “killer application,” or the hit product that drives a system’s sales. However, we think hit software is only one part of the equation. It is our view that the PlayStation systems have been successful not because of hit software but mainly because of software diversity and third-party support. In essence, Sony helped expand the market by reaching a more casual consumer that wasn’t so concerned with the latest big hit.

Of course, the PlayStation 2 had more than its share of big hits, most notably the Grand Theft Auto series. However, we estimate that less than 20% of PlayStation 2 owners bought a GTA game. Meanwhile the Xbox with Halo and Nintendo’s lineup of mega-franchises were nothing to sneeze at in the hits department. Without GTA buyers, the PS2 would still have outsold the competition by more than 3 to 1. The secret to the PS2′s success was more in the wide range of product offerings: all kinds of sports games, racing games, RPGs, action titles, big name licenses, kid friendly products, RPGs with Disney characters, etc. Japan had Final Fantasy and Dragon Quest, Europe had EyeToy and SingStar. In all markets, the PlayStation2 was a complete entertainment system for the family priced under $300.

It now appears all that wasn’t good enough for Sony. With the PlayStation 3 the company is going after the high-end power user. It is almost as if Coca-Cola not only decided to go with a new formula, but also decided to exit the low brow soft drink business to go into high-end wines. Of course, there is a market for high-end products but it is 1) a very different consumer type and 2) not nearly as big as the blue collar mass market. Wal-mart sells more toys than FAO Schwartz and McDonald’s sells more beef than Ruth’s Chris Steak House.

Looking at Sony’s portable PSP system shows some other dangers in trying to be too many things at once. The PSP is designed to be much more than a game system, it is a complete portable entertainment package. With a beautiful, sleek look, the ability to play music, movies, games, wi-fi connectivity etc, the PSP seemed like a bargain at $250 and less.

On the surface it seems like the PSP has been a huge success. By the end of fiscal 2006, Sony announced they had shipped over 17 million PSP systems worldwide. This was comparable to the Nintendo DS shipments at almost twice the price. However, underneath the surface the PSP seems more about style than substance. The system truly excels at none of its functions. Meanwhile, the DS seems to be really expanding the market where the PlayStation brand had been dominant. Titles like Nintendogs and Brain Age add the type of product diversity that drove over 100 million consumers to buy each of the first two PlayStation systems.

Right now, the Nintendo DS is having some of its strongest success in Japan, while the PSP holds its own in North America and Europe. However, Japan’s trend conscious consumers are often a harbinger of worldwide success. In the 1990s, Nintendo’s business in Japan started to decline faster than it did in North America. Could the PSP’s performance in Japan be a harbinger of things to come for Sony?

Of course, the big problem with the PlayStation 3 is price, and in theory that can be easily solved by simply lowering the price. There is always that core group of consumers that will rush out to buy a new PlayStation system no matter what the price. So it would make sense for Sony to gain as much revenue as possible from those consumers before lowering the price. The vast majority of consumers will not be in the market for a new system until holiday 2007 or later.

Our concern is that 1) Sony’s hands may be tied in regard to price cuts and 2) Sony drastically underestimated the competition. The price of the PlayStation 3 does not exist in a vacuum and consumers will clearly look at the competitive alternatives. Right now both the Xbox 360 and Nintendo Wii are looking like much better alternatives than they did a year ago. Core PlayStation franchises like Grand Theft Auto, Final Fantasy, Dragon Quest and others are starting to appear on other systems. In short, we have seen absolutely nothing that would justify a $200 price difference.

Can Sony afford to lose its position in the video game marketplace for a generation of game systems? That is becoming a crucial question. If Sony took a $200 loss on every system to become more price competitive and maintain market share that works out to $2 billion for every 10 million units. Will Sony investors swallow that type of loss?

In forecasting the market we can say this with confidence: a $600 price point is okay for launch but it will not fly in holiday 2007. If Sony wants to drive unit volume 2007 needs to be not only the year of price cuts, but the year of drastic price cuts. There is going to be a shakeup in the video game industry and even if Sony executes perfectly there could be a new market leader in two years. Stay tuned, next month we will formally unveil some of the actual numbers in our forecasts. This month we will just say that yes, Sony could easily go from first to worst in the video game market.