No ROM at the Inn Leaves CD Firms on Road to Consolidation

It was just a couple of years ago that the silvery disks known as CD-ROMs were being hailed as the next big thing in home entertainment, promising killer video games and a rich array of educational and cultural programs for anyone with a multimedia personal computer.

Start-up CD-ROM companies such as Digital Pictures, Rocket Science Games and Crystal Dynamics were in the vanguard of the much-hyped marriage of Hollywood and Silicon Valley.

But even though the home computer business has grown faster then even optimists imagined, and many more people are using CD-ROMs, the CD-ROM business has been a major disappointment. Digital Pictures filed for bankruptcy late last month; Rocket Science last week scaled back once again and is now a modest developer of Sega video games; Crystal Dynamics has laid off much of its staff and continues to cast about for a viable strategy.

Throughout the industry, a desperate wave of consolidation is now underway. “Virtually every company in the business is a buyer or seller,” says Dean Frost, managing director of the investment banking firm Frost Capital Partners in San Francisco. He estimates that about 200 transactions--including acquisitions and minority investments--will occur in the entertainment software industry this year, twice as many as last year.

Companies including Alameda-based Spectrum Holobyte, Calabasas-based NovaLogic and Glendale-based Knowledge Adventure are said by industry sources to be on the block. Executives from those companies wouldn’t comment. Even successful companies owned by big conglomerates--notably Psygnosis, a unit of Sony Corp.--are up for sale.

How did it all go wrong? On one level, analysts say, it was a simple and predictable set of problems with the business model. Too many CD-ROMs were chasing too little retail shelf space. Too many were being sold too cheaply as part of massive “bundles” with new equipment. And too much money was being spent on products that suffered a key limitation: They could only be used by people who owned a CD-ROM-equipped computer or video game machine.

“No matter what you do you lose money unless you have a hit,” says Josh Bernoff, an analyst with Forrester Research in Cambridge, Mass. He says publishers are forced to pay up to 10% of an order’s value to retailers in the form of “market development funds” to get shelf space. And production costs for a single title can run into the millions of dollars.

There were more fundamental problems too: In many cases, companies thoroughly misjudged what kinds of products would appeal to consumers. San Mateo, Calif.-based Digital Pictures, which filed for Chapter 11 bankruptcy protection July 29, was among the first companies to make so-called interactive movies using full-motion video. (Times Mirror Co., which publishes The Times, owns a stake in the company.)

But an industry executive familiar with Digital Pictures’ business says the company failed because it spent millions to create titles that lacked the fast-action game play of hits such as Doom and customers simply didn’t like them. Richard Adler, an attorney representing Digital Pictures, said only that the company’s problems reflect those of the industry in general.

Rocket Science, based in San Francisco, had similar failings. Its games were supposed to feature a whole new level of technology and storytelling, and they cost millions to create, but the first two titles--Loadstar and Cadillacs & Dinosaurs--failed to sell 8,000 units between them, according to industry tracking service PC Data.

Last week, Rocket Science said it’s shifting gears and will now act simply as a software developer with Sega Soft, a division of Sega Enterprises, publishing at least four of its titles. (Sega is an investor in Rocket Science, as is Times Mirror.) A Sega Soft spokesman said the approximately 20 members of the Rocket Science sales and marketing staff are being offered positions at Sega Soft.

Crystal Dynamics, for its part, made news in 1994 when Strauss Zelnick, then president of Twentieth Century Fox, abandoned Hollywood for Silicon Valley to take the reins of the fledgling software firm. But Zelnick left after little more than a year to return to the conventional entertainment industry as president of BMG Entertainment.

Meanwhile, Crystal Dynamics became further immersed in creating games for the “next generation” 32-bit video game machines--including the ailing 3DO Multiplayer and the more popular Sony Playstation--but failed to produce a blockbuster.

Over the summer, Crystal Dynamics laid off 30 people, installed one of its venture capitalists as its president and is now “seeking a partner to share distribution and inventory risk,” according to marketing director Scott Steinberg.

There are some buyers out there who see the shakeout as an opportunity. Earlier this year, educational software publisher Davidson & Associates and the entertainment software firm Sierra On-Line were purchased by CUC International, a direct-marketing firm, for approximately $1 billion each.

Last month, GT Interactive Software paid an estimated $76 million for Humongous Entertainment, best known for its Putt-Putt line of children’s products. SoftKey International, a budget software publisher, scooped up Compton’s NewMedia, which helped launch the industry with its Compton’s Interactive Encyclopedia, for about $100 million, and educational software company Compton’s Learning Co. for approximately $500 million, according to analysts.

“What we’re finding is companies that in the past weren’t interested in selling are looking to get out, to sell their assets, because they’re having difficulty finding shelf space,” said Ron Chaimowitz, president of GT Interactive Software.

According to Bernoff of Forrester Research, the top five CD-ROM publishers--Softkey International, Microsoft, Broderbund, Electronic Arts and Sierra On-Line--were responsible for 51% of all retail sales in the first quarter, up from 33% in 1994.

The business isn’t likely to get any easier. The Internet, online gaming and, in the future, the new high-capacity digital videodisc are all diminishing the viability of the CD-ROM, and competition from a voracious Microsoft will be a problem for many.

In the face of all this, CD-ROM developers are branching out, creating hybrid CD-ROMs with Internet capabilities.

“If you strike out with CD-ROM this Christmas, next year you’ll reinvent yourself as an online company--until the bloom’s off that rose,” said Robert Kotick, chairman of Los Angeles-based Activision. But no one’s certain whether yesterday’s CD-ROM players are today’s Internet surfers.

Digital videodisc is something of a mixed blessing: a new lease on life for those who are well-funded but oblivion for those who are not. DVD will have about seven times the storage capacity of the CD-ROM and will be loaded with video and 3-D graphics--driving production costs up even further.

“With DVD you’re not going to see such a high ratio of titles to shelf space,” said Ted Pine, chairman of Infotech, a Woodstock, Vt., research firm. “The barrier to entry to CD-ROM has been low, but it won’t be with DVD.”