This article originally appeared in 2000 in Wall Street Journal Interactive.

Electronic Arts Goes Gaga Over Online Games

On November 22nd, Electronic Arts (EA) announced that it was moving into online games in a big way.

It bought Kesmai, one of the oldest and most experienced online games company; they launched their first game in 1984, on CompuServe. Today, Kesmai runs many games on America Online as well as its own subscription service on the public Internet, Gamestorm. And EA partnered with AOL, becoming exclusively reponsible for content on all of AOL's brands--on AOL itself, CompuServe, AOL.com, Netcenter, and ICQ.

And for the cherry on top, EA said it would create a new class of common stock, called Electronic Arts B, that would track the performance of the company's "new Internet business unit," EA.com.

As part of the deal, AOL gets 10% of EA.com, warrants to purchase an additional 5% of iis stock, and a commitment from EA to pay AOL at least $81m over the next five years. News Corp, the former owners of Kesmai, gets 5% of the operation, and EA.com gets a nonexclusive distribution deal with News Corp to deliver Fox Interactive online games.

So what does all this mean?

You can take optimist's view, or the cynic's. Let's start by assuming that the glass is half full.

From an optimistic perspective, this deal validates the online games industry. It's hard to imagine something like this happening a year ago; a year ago, industry pundit Len Quam of Crossover Technologies, speaking at the Game Developers Conference, said "There is no working business model for online games." He was far from the only online game executive filled with doom and gloom; predictions by Jupiter and Forrester and other analysts that online gaming would be a $1.6b+ industry by 2000 were clearly not being borne out. In 1998, virtually nobody doing online games was profitable, and some operations were clearly on the verge of going out of business (as, indeed, DWANGO did).

But the last year has seen a turnaround; operations as different as Gamesville (bought by Lycos for $207m on November 23rd), Verant (developers of Everquest), and Simutronics moved into the black. Industry executives and investors began to sit up and take notice; there's a future in online games after all.

EA knows this particularly well, because its Origin unit has done very well off Ultima Online, the first massively-multiplayer roleplaying game to become a hit. Clearly, EA--the world's largest publisher of games for home computers and a major console game publisher--has decided it needs to be a major player in online games as well.

What does EA.com, the new unit have going for it? For one thing, the exclusive deal with AOL gives it direct access to AOL's enormous customer base, many of whom rarely leave the service for offerings on the public Internet. And AOL's games are charged; AOL members pay $1-$2 an hour, above and beyond their monthly subscription fee, to play most of the games on the service. This makes the AOL Games Channel potentially more profitable than most Internet-only game services.

For another thing, Kesmai has more than a decade of experience building and running online games; no operation in the world has a better sense of how to build customer loyalty and manage online games effectively. Yet under News Corp., a company with scant understanding of games or online, Kesmai has suffered badly, losing many of its key people--including Gordon Walton, a former vice president, and Jonathan Baron, former manager of Kesmai's flagship Air Warrior game, both of whom went to Origin.

EA knows games--and its Origin unit knows online games quite well. It seems likely that EA can work a turn-around at Kesmai, restoring staff morale and rebuilding its business.

If the glass is half full, EA.com looks like a potential winner, one of the firms likely to dominate online gaming as it grows, which indeed it seems poised to do.

But what if the glass is half empty?

One of the most suspicious aspects of EA's announcement is that its Origin unit will apparently not be incorporated into EA.com, even though Origin has previously announced that it will become an online-only firm. In other words, EA's sole profitable online games division will remain part of old-style EA--and EA.com is being loaded up with a bunch of money losing entities.

Now why would they do that?

Doubtless one reason is that EA doesn't want to hand a piece of Origin over to AOL and News Corp. But it's also clear that what EA is trying to do is establish its tracking stock as an Internet company, supporting Internet valuations instead of the more rational P/E ratios common for software and entertainment companies. The hope, presumably, is that people will pile into "EA Class B" because it's a hot, hip new company with the prospect of dominating Internet gaming, which will undoubtedly be a big part of the Internet revenue pie when the pie-in-the-sky that is profits on the Internet someday arrives.

Another reason to keep Origin out of the deal is that profits might actually queer the pitch; if you have profits, the Wall Street Journal prints the P/E ratio next to your ticker, and people can look at it and say that your valuation is way out of line. If you lose money, who knows, you're growing fast, you could be the next Microsoft. They print an "N/A", because you can't divide by zero. In the topsy-turvy world of Internet finance, EA.com might actually be more valuable without Origin's positive income.

If you're a cynic, EA's move looks like a cynical attempt to capitalize on Internet mania. And worse, if the recent past is any guide, it won't work.

This is basically what iEntertainment tried to do. iEntertainment, up until it changed its name earlier this year, was called i-Magic. It was a second-rank computer game publisher, run by "Wild Bill" Stealey, a big name in flight sims and one of the original founders of Microprose. Under Wild Bill, i-Magic made an extremely gutsy business move: It decided to transform itself into an online-only game operation, selling off its CD-ROM titles and development teams to UbiSoft, a major French games publisher, and buying MPG-Net, another old online games operation.

iEntertainment was trusting that, as an Internet company, it would achieve Internet valuations--giving it access to capital that would let it bootstrap itself into a major online games player.

It flopped. For whatever reason, the market was not willing to equate "online games" with Internet. iEntertainment's stock price dropped from 9 1/2 to 1/2--and trading was ultimately suspended by NASDAQ because the firm no longer retained the minimum asset value NASDAQ requires. "Will Bill" bailed.

Why is that relevant? Because EA.com looks suspiciously like iEntertainment: an unprofitable online-only game company shorn of profitable, conventional computer game assets.

So you can take your pick; either EA.com will be the first huge online games success, dominating an industry on the verge of a major boom--or it's doomed to crater by the ineluctable logic of history. Personally, this far into a bull market, I like less risky investment plays.

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