LEDZone, Pt 4: Namco's new business model put to the test

[Yesterday's Part 3 of this special report from Japan can be read here.]

TOKYO--Towards the end of our conversation, Tetsuo Tsuchiya got down to brass tacks. In response to a question about LEDZone’s sales, he explained a key difference in revenue growth between Counter-Strike Neo and standard arcade machines, as well as Namco’s plans to capitalize on that difference through licensing. By the time he was finished, he’d described a unique business plan that turns the traditional economics of arcade operation upside down.

He started by explaining that traditional arcade games are most profitable shortly after installation, and then suffer declining revenue until the arcade owner replaces them. He sketched a simple graph on the office whiteboard to illustrate his point, showing a line that began at the intersection of the two axes, spiked sharply upwards, and then gradually declined. “When you put in a new game, it takes a little while for people to find out about it and start playing it. Once it attracts a user base, a popular game peaks at about 10,000 yen [about $92] per day in sales. But that doesn’t last.”

According to Tsuchiya, arcade games suffer declining revenue over time for two reasons. First, people get better, so each game lasts longer. Second, as arcade operators continue installing new hardware, some players switch to newer games.

In contrast, revenue at LEDZone has grown consistently since the first store opened in July 2003. Tsuchiya turned to the graph and drew a second line showing LEDZone’s revenue growth. Starting at zero, it climbed at a slower rate than the line representing arcade games, but without turning downward. Eventually, it reached the same level as the peak of arcade game revenue--and it was still rising.

“Exactly where we are on this line right now is secret,” Tsuchiya smiled. “But I can tell you that at our current rate of revenue growth, we expect to reach per-console sales of 10,000 yen per day sometime in the first quarter of 2004.” He added that revenue growth at the second LEDZone is faster than at the first location, most likely due to higher foot traffic.

Of course, it helps that LEDZone charges its users based on how long they play, not how many games they play. Though each player’s first visit costs only 100 yen ($.90 cents)for two hours, subsequent visits are 300 yen for 30 minutes. This time-based pricing eliminates one source of declining revenue, and considering that one round of Virtua Fighter or Tekken in a Japanese arcade costs 100 yen, it’s a good value too.

Tsuchiya is confident that opening more LEDZones will accelerate revenue growth. He asked, “Are you familiar with Metcalfe’s Law?” Robert Metcalfe, inventor of Ethernet, said that the value of a network equals the square of the number of its users. “This applies to LEDZone too.” According to Tsuchiya, it’s a virtuous cycle: more locations will yield more CS Neo players, which will result in more competition for players of all levels, and a stronger community. If this model is correct, instead of constantly investing in new games, arcade operators that run a LEDZone will reap greater rewards by offering just one game: CS Neo.

Because of this understanding, building the user population through licensing LEDZone locations to third-party operators is a key part of Tsuchiya’s business model. Not only will this help build the user population faster, licensing represents a new, high-margin revenue stream. “If all the LEDZones are owned and operated by Namco, our infrastructure investment is high and margins are low. But if we license to third parties, they bear all the infrastructure costs, and we just sell them digital content like Counter-Strike Neo updates and new levels that we’ve already created for our own stores.” Distribution costs for digital content are near zero, and additional licensees create no new development costs, so licensing is a lucrative prospect for Namco.

But how will Namco win over the arcade operators? LEDZone is completely alien to them; they will need convincing proof before they remodel their arcades and replace all their hardware with LEDZone PCs. Tsuchiya believes that when daily per-machine revenue cracks 10,000 yen, many arcade operators will be willing to make the leap, but there’s a catch. “This first store is directly operated by Namco, so operators are skeptical about our revenue reports. They know that we stand to profit from licensing.” Apparently there’s some concern that Namco will fudge its figures in order to make LEDZone look more attractive.

But the Ikebukuro store is a license operation, run by a company that also operates some Namco amusement parks. Their results might be more credible--especially if they’re leaked. According to Tsuchiya, that’s exactly what happened. It was clear from his expression that this leak of sensitive information didn’t disturb him. In fact, we got the impression that when either LEDZone location hits the magic 10,000 yen per day mark, it’s a safe bet that another leak will spread that news to arcade operators.

Namco and Tetsuo Tsuchiya seem to have thought of everything. Their willingness to challenge the status quo is exciting, and the industry will be watching LEDZone’s progress with great interest over the next few years.