Development, video games

Outsourcing – Part 2: Next-gen consoles turbo-charge the outsourcing market

April 2006

If recent guidance from many of the industry’s largest companies is correct, 2006 will be a particularly tough year. Cyclical games market stagnation has already driven down publishers’ sales, impacted by the traditional hype around next-gen consoles that have failed to arrive on time or in adequate numbers. Sony’s bizarre denials of any delay to its impossible Spring launch until days before announcing six months’ postponement have only worsened the industry’s predicament. Meanwhile Microsoft’s cutting edge image is suffering from delivering 360 with games that have largely failed to deliver the promise of high quality, high definition graphics, and which have barely shifted the goal-posts of innovation in genre or gameplay.

The industry has nervously moved into wide-scale next-gen development, despite the fact that, with Sony’s delays, mass market consumer adoption of next-gen consoles has also been pushed back until 2008 at the earliest. Sony has forecast shipping just 6 million PS3 units by 31st March 2007. Microsoft will no doubt fare better in the vacuum, but, despite celebrations in Redmond at Sony’s delay, it is targeting an installed base of just 10m 360s in the same time frame. These limited installed bases cannot deliver strong software sales across a publisher’s portfolio.

In parallel with reduced sales expectations, production costs have risen inexorably, in some cases by 50%, with content generation largely responsible. Team sizes are rising, driven by higher requirements for high-res art for next-gen titles. Few studios can afford to assign 30+ artists to a single medium-budget next-gen title without reducing their ability to produce games for older platforms with commercially viable consumer bases.

Margins are already under pressure. The latest results are sobering. Take Two’s sales for Q1 2006 were just 52% of the equivalent quarter in 2005, with losses forecast for two or more quarters. EA reported a 31% year-on-year fall in quarterly revenue, prompting 5% job cuts and reductions in last-gen RRPs. Activision has already cut 7% of its workforce. Midway admitted losses of $112 million in 2005. Infogrames makes this consolidation look rosy, and is facing delisting of its Atari subsidiary from Nasdaq, 20% staff cuts and the fire-sale of its studios.

Key differentiators of successful publishers at this particular point in the cycle are cost control, the performance of major franchises and diversification. VUG exemplifies these factors. It successfully lowered operational costs through 2004-2005. Its cash cow, World of Warcraft, which is a paradigm of diversification, is booming, with 6m subscribers globally. VUG’s revenues have grown impressively in the same period.

One way to survive this kind of resource pressure and increase operational efficiency is to use outsourcing to control spiralling costs. THQ recently announced XDG, an outsourcing unit designed to implement company-wide outsourcing, thereby increasing cost efficiency. This and many other initiatives indicate that outsourcing is becoming a crucial strategy. As the author of Screen Digest’s recent Games Outsourcing report, I forecast that outsourcing would grow to over $1bn by the end of 2006, driven by next-gen production and the increasing maturation of the games supply chain.  Outsourcing providers are some of the few real beneficiaries of this industry cyclicality, but there are not enough experienced outsourcing providers to supply the rapidly growing demand, and this under-supply will inevitably cause problems. With multi-billion dollar companies such as Technicolor entering the market, the outsourcing sub-sector will change fundamentally. Those providers most in demand are those that can reduce the cost of content creation for next-gen titles. The value of the outsourced art sector alone is set to soar to over $300 million in 2006, and double again by 2008.

Few have been as bold as THQ in establishing a dedicated division in a subsidiary, which could trigger ownership problems. Studios that have successfully used outsourcing have almost always integrated its practice into their core studios. With THQ and others talking about long-term, exclusive relationships with their outsourcing partners, this is one of the few games sub-sectors that’s booming.

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