Square Enix’s new president, Yosuke Matsuda, declared in the company’s annual report released on September 9 that the unprofitability of AAA titles is “a structural problem in the HD business”. Citing the financial disappointments that were Tomb Raider, Hitman: Absolution, and Sleeping Dogs, he noted that the industry has become so competitive and development costs have soared so much that the current disc-based revenue model is unsustainable.
He’s only stating what a lot of people have recognized for a while. A few news outlets have framed it to be Square-specific, such as The Escapist’s deceptive title “Square Enix: Disc-Based Sales are Killing Us” (bold added for emphasis). However, this is a phenomenon whose various tendrils have been felt over this entire console generation: greater manpower required (and associated costs), longer development cycles, soaring marketing budgets, and an increasingly cutthroat competition at retail have all resulted in one clear fact: in many cases, the traditional AAA game is unprofitable.
The videogames industry has always functioned much like a pharmaceuticals business, where researchers spend years and mind-boggling sums of money to develop drugs and get regulatory approval. Similarly, developers spend years and millions creating games and preparing them for launch day. The principal differences lie in distribution and lifespan. Both models involve huge fixed costs in creating the product; however, since the variable costs are low, companies make it up by charging huge premiums for each unit.
In medicine, patents allow drug makers to monopolize segments of the market for years on end, and they earn huge profits on every drug dose. Videogames, however, are largely interchangeable with each other, and titles only have 1-2 months max to make up for all of the costs (and hopefully turn a profit) before newer titles steal the limelight.
Further complicating the journey to profitability are the hurdles companies face in getting enough units in retail stores. Because there are so many titles coming out every month, stores are getting ever-pickier about which titles, and how many copies of each, they’ll stock. Square Enix was thus forced to make a number of concessions to retailers that crippled its profit margins.
Matsuda mentioned three things in particular: price protection guarantees, back-end rebates, and promotional cooperation costs. To use the example of Square Enix and GameStop in explaining these systems:
- Price Protection Guarantees – Whenever Square Enix lowers prices, they must pay GameStop a rebate for every copy of the game they still have in stock. This muddies up the market a lot. Normally, publishers lower prices for two reasons: to entice consumers who aren’t willing to pay the full $60, but who might pay $50 or $40, and to undercut the used games sector, so it doesn’t cannibalize sales of new copies. Every publisher practices price discrimination to maximize revenue. However, because of the price protection, Square Enix now must bear an additional cost for conducting normal business practices.
- Back-end rebates: Square must pay GameStop whenever they move a certain number of units. It’s an incentive program that encourages retailers to promote a particular company’s games, but it reduces the profit margin of each unit.
- Promotional Cooperation: Joint marketing efforts, from what I’ve found. (There’s not much I can find.) I’ll surmise that Square Enix pays for featured mentions in Gamestop’s weekly ads or in issues of Game Informer.
All these factors greatly increase distribution costs of physical games and reduce the profit margin on each copy sold.
Matsuda’s other main issue with HD development is that it takes much more time, prolonging the date at which Square can begin generating revenue from its investments. While part of that is Square Enix’s unique difficulties – they’ve had a rougher transition than most, as Final Fantasy XIII and Final Fantasy XV’s continuing development show – it is true for most publishers.
Not everyone can be Ubisoft, pushing out an Assassin’s Creed every October like clockwork, with hundreds of employees scattered across the globe working in synchronicity. (Hiring/Poaching the people who put that together would be well worth the cost, though.)
At the same time, as XIII-2, XIV:ARR, and Lightning Returns show, Square has certainly improved in regards to time. Even XV has only been in full production for two years, and I’m betting it’ll be out around Q1 2015, making it a 3 year full cycle. Soon, Square will be at the point of diminishing returns, where they’ll do better to spend their resources on aspects other than reducing development cycle length.
In the meantime, there are a lot of straight-forward ways that Square could improve their future financial prospects.
There are a couple steps Square could take to generate more revenue from HD games. The first one is via print media: publishing licensed books based on their IPs. Technically, they’ve done this before; a Kingdom Hearts manga has been around in Japanese for years, and after a few legal tussles regarding expired licensing rights, many volumes are now being released in English.
However, I’m thinking more along the lines of Bioshock: Rapture or Ico: Castle in the Mist. Full-length, well-written novelizations and in-universe stories. (Heck, I’d pay serious money to have the remaining novellas from FFVII: On the Way to a Smile released in English.) Ubisoft does this well with the Assassin’s Creed series. Oliver Bowden may write the AC novels horribly, but they still rake in a pretty penny for the publisher. Novelizations are generally released in tandem with a game’s launch, but they nonetheless provide a supporting revenue stream.
Square Enix already has a manga-publishing arm. The division, Gangan Comics, is responsible for Fullmetal Alchemist, Black Butler, Soul Eater, and others. They can easily leverage that, not just for manga like Dragon Quest and KH, but to publish novels based on their IPs.
Another avenue lies in merchandising, which Square has been aggressively expanding recently. (I can’t stop eyeing the Trading Arts Kai figurine of Cloud.) However, the Square Enix online store is pretty bare beyond OSTs and games. There’s not much in the way of apparel or posters, and even plushies are sparse once one ignores the singular chocobo and moogle available.
Between expanding their merchandise section – posters, figurines, plushies, etc – and improving the efficiency and overall experience of their online store, Square could revitalize a stagnant revenue channel.
A third option lies in spin-offs and multi-platform strategies. Activision brought this to the forefront recently by releasing an iOS Call of Duty game, and CCP Games is pushing the current boundaries with Dust 514, a game that directly interacts with its MMO Eve Online. Square’s Kingdom Hearts chi is yet another instance of spin-offs. Yet there’s a forgotten variant in this equation: Compilations.
As a whole, the Compilation of Final Fantasy VII involves a movie, a novella, two short films, and four full-length games. Each piece has been successful and profitable in its own right, and they work together to create a massive universe that still keeps fans engaged. Square Enix has already hinted that, as with XIII, Final Fantasy XV’s universe will have multiple games. Why not develop small spin-off titles in tandem with XV-2 and XV-3?
Outside of generating additional revenue, Square still has several steps it can take to improve its finances and reduce its reliance on brick-and-mortar retailers who require unfeasible concessions. In short, Square needs to establish a greater presence in the digital marketplace.
What Nintendo has done since the Wii U’s launch is to partner with retailers in boosting online sales. Since the primary concern for retailers is shelf-space, they would welcome a greater emphasis on POSA (Point of Sale Activation) cards, which take up little room. (A POSA card includes a code that can be redeemed on a console’s online store for a specific game. Ex. GameStop selling codes for XBLA Minecraft.) A greater digital footprint would also reduce manufacturing and distribution costs of physical, disc-based games, and it would accustom customers to the concept of downloading digitally, as opposed to owning a disc. They would be more likely to buy directly from either Square’s online store or the PSN/XBLA/eShop in the future.
One factor that dovetails into this is maintaining a user-friendly, easy online store. However, Square Enix’s online store, as it currently stands, is anything but. There are a number of glaring flaws that I have experienced. Last year, I tried to purchase TWEWY, Crisis Core: Final Fantasy VII, and Kingdom Hearts: Birth by Sleep when Square was running a 30% off sale. However, after 4 weeks without even a shipping confirmation email, I had no choice but to call customer service.
Here’s the scoop: Square Enix outsources their merchandising operation. Unfortunately, the company that handles orders is so thoroughly incompetent – they were unable to even estimate a future shipment date for my month-old purchase – that I promptly cancelled my order. (I’ve since acquired the games via other retailers.) Anything to improve their fulfillment operations, be it regular customer feedback, quality control checks, etc., would be highly beneficial for Square.
A final strategy that would benefit Square is a shift in their marketing efforts. A study by Deloitte Consulting found that spending money on increasing positive tweets about games can be as much as nine times more effective at increasing sales than simply increasing a traditional advertising budget by the same amount. The study also found that a tweet’s effect lasts longer than a normal ad campaign.
Certainly, there’s a lot more that Square Enix, and the industry in general, could do to improve marketing and better allocate advertising budgets, but this is a simple place to start.
Having outlined those suggestions, there are still a couple of major concerns that Square should do to assuage both investors and consumers.
On the investor side, Square needs to prove that it is revising and is demonstrably improving its methodology for sales projections and expectations. The three biggest money-losers this year – Sleeping Dogs, Tomb Raider, and Hitman: Absolution – all sold in excess of one million copies, which suggests tens of millions of USD in revenue. Tomb Raider sold almost 4 million copies at its full $60 price. It’s embarrassing, both from a financial and reputational standpoint, that all three titles only sold about half as many copies as Square had expected them to.
If Square had had lower sales expectations, that would most certainly have altered decisions during development, the marketing allocation, and the number of copies printed. Just take the example of a price protection guarantee: If Square prints 7 million copies of Tomb Raider, to perfectly meet their sales projections, but the game only sells 4 million copies, then in order to effect a price drop of, say, $10, the company is obligated to give GameStop a $10 rebate for every copy still in stock.
3 million copies x $10 per copy = $30 million
Say that, through improved (but not perfect!) sales projection methodology, Square Enix had expected to sell 5 million copies. If the company had printed just 5 million copies instead, then it could’ve saved $20 million just on the price protection guarantees. Differences in the thresholds for back-end rebates, development cycle decisions, and marketing would only add to what Square could have saved through reduced spending.
Keep in mind that $20 million is 13.3% of the company’s annual loss. Investment in methodology improvements, which would apply to every title that Square publishes, would reap massive financial rewards, yet the company hasn’t made any public announcement that they are taking this step.
At the same time, Square massively undershot its sales projections for Final Fantasy XIV: A Realm Reborn. The release went so well that Square’s servers were overloaded, preventing many from playing the game at all. While this doesn’t match the PR hit that SimCity was for EA, Square was dogged by over a week of negative press for something that should have been a positive development. Instead of dominating gaming news with the fact that XIV sold incredibly well, we were instead treated to a slew of critics eager to cut Square Enix off at the knees, turning the release into a PR debacle full of apocalyptic, doom-filled predictions.
A second suggestion, which mostly concerns non-Japanese gamers, regards Square Enix executives’ recent talk about catering to specific regions:
Let me wrap up with one more major theme—the issue of locality. Marketing AAA titles on a global basis was one of our strategic initiatives. I, however, have to admit that titles appealing to a global audience are very limited, with a few exceptions.
– Yosuke Matsuda, Square Enix President, FY 2013 Annual Report
While Mr. Matsuda’s comments are true, the flip-side of his argument is that games should be limited to the regions they are developed for. This would fly in the face of evidence over the past several years that worldwide releases are profitable, even when games are designed only for a Japanese audience.
There are enough consumers in every major market who would buy games, however niche they may be, in a sufficient quantity to make localization profitable. Operation Rainfall proved that; North American sales of Xenoblade were greater than those of Japan and Europe combined. The Last Story sold so well in North America that XSEED has called the game its most profitable title in the company’s history – so much so that the company decided to publish the third OpRa title, Pandora’s Tower.
I would caution Square Enix – and all companies grappling with localization decisions – to recognize fans outside of their main domestic market. There are financial opportunities present in localization. Any given title can be profitably localized, and a company obtains significant goodwill from their fans, which will translate into future financial returns. XSEED has been the equivalent of a rockstar for Japanese RPG fans, and that carries significant benefits. Their decision to localize Trails in the Sky this month had significant press coverage and consumer response, largely as a consequence of their decision to publish The Last Story and Pandora’s Tower.
Even a limited printing with an online store counterpart can be modestly profitable. It would be foolish to ignore real segments of the market, niche as they may be, when one knows that they exist.
In any case, the release of Lightning Returns this fiscal year will ensure Square Enix a profitable fiscal year; XIII-2 performed the same role back in FY 2012. Beyond that, however, Square Enix must make adjustments to remain an important player in the industry.