April 18, 2008: 5:45 AM EDT
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Guess who's rewriting the rules of gaming?

Girls, office drones, and other non-teenage boys hooked on new, free-to-play online games, that's who. It's bad news for giants like Electronic Arts and Activision; good news for startups and ... no joke ... Target.

By Devin Leonard, Fortune senior writer

(Fortune Magazine) -- The biggest story in the videogame business this year has been the way Activision and Electronic Arts, the industry's two dominant powers, are gobbling up smaller competitors that have developed hot-selling games. Activision, publisher of the billion-dollar Guitar Hero series, is seeking approval to join forces with Vivendi Games, maker of the bestselling World of Warcraft. Meanwhile, giant EA, purveyor of Madden NFL and other sports franchises, is making a $2 billion hostile play for Take-Two, which owns Grand Theft Auto.

But there's something going on behind the scenes that may turn out to be far more important than the latest flurry of mergers and acquisitions. It's the emergence on the Internet of a parallel gaming universe, a free-to-play movement pioneered in Asia and powered by business models that don't have anything to do with selling shrink-wrapped boxes for $59 each. The biggest players are not EA (ERTS) or the soon-to-be-rechristened Activision Blizzard (ATVI), but companies you've probably never heard of. The production quality of their games can be spotty, and most of them don't play on Sony (SNY), Microsoft (MSFT, Fortune 500), or Nintendo consoles. But the price is right, the players are enthusiastic, and the games have opened up a whole new world of online entertainment.

"If you're a game publisher and you are not looking into this new market and this new business model, you are becoming a dinosaur," says Billy Pidgeon, a game industry analyst at IDC. "If you are just selling software in a box, your time is limited. The growth potential is much more exciting on the Internet."

An excellent example of what's happening out there: MapleStory, a free-to-play online game from Asia that's catching on in America. The program, distributed by a privately held South Korean company called Nexon, is a multiplayer online role-playing game, a genre dominated by the brutal and enormously popular World of Warcraft. MapleStory, by contrast, is set in a sunny fantasy world where no repeat offenders or barbaric swordsmen roam, and its fans - 5.5 million in the U.S. and 83 million worldwide, many of them young girls - spend hours developing their online personas and shelling out large quantities of Nexon Cash to trick them out in the latest virtual fashions.

Nexon pioneered this business - hooking players with a seductive free game while urging them at every turn to purchase extras using prepaid debit cards sold at retail outlets like Target (TGT, Fortune 500). Nexon collects ad revenue in overseas markets, but in the United States the big money so far is in these microtransactions: $1.6 million a month. John Chi, CEO of Nexon America, says that the Nexon card is the second-best-selling prepaid card at Target - after the iTunes card. (Target will say only that Nexon cards are "doing really well.")

Nexon's games would never be mistaken for the slick, graphically intense entertainments produced for the most technologically advanced consoles, such as Microsoft's Xbox 360 or Sony's PS3. MapleStory is a crude two-dimensional scrolling game - not unlike one of those old Super Mario diversions that ran on Nintendo's handheld Game Boy.

But other online game companies are closing the graphics gap. One of them is WildTangent, a company based in Redmond, Wash., that offers about 500 free-to-play titles, from Battlestar Galactica to Nancy Drew: Curse of Blackmoor Manor, and draws some 12 million unique visitors a month to its Web site from the U.S. alone. WildTangent's newest offerings are starting to approach the quality players have come to expect on high-end consoles. CEO Alex St. John is especially excited about Polar Pool, his company's new entry for would-be digital pool hustlers. It's an easy-to-play, casual game that's not likely to blow the socks off fans of first-person shooter console games, but the graphics are surprisingly crisp.

WildTangent - which, like Nexon, is privately held - has a slightly different but equally unorthodox business model. It makes money two ways: by selling ads that are displayed on its site and by selling players ways to avoid having to look at those ads. For example, although the games can be downloaded for free, customers who pay $20 get a version that is advertising-free. Only 2% of WildTangent's customers choose to pay the $20, says St. John. But in December the company started selling its own prepaid cards at Target. With them, players can purchase "WildCoins" to shut off the ads during a play session.

The success of upstarts like Nexon and WildTangent has not gone unnoticed by the large, publicly held software publishers. They can't afford to miss the next gaming wave, especially after they stumbled on the last one. EA and Activision, having successfully pursued a strategy of creating the fastest, bloodiest, most lavishly illustrated games, invested heavily in products designed to take advantage of the high-end graphics capability of the PS3 and the Xbox 360. To their surprise the big winner in the current console war turned out to be the Nintendo Wii, a relatively low-powered machine that offered users clever games and innovative motion-sensitive controllers. In the process, Nintendo introduced an entirely new group of gamers to the industry, including the girls and women who are now flocking to the free-to-play games.

So THQ (THQI), publisher of gritty console-based blockbusters such as Saints Row and WWE Smackdown vs. Raw 2008, is getting into the free-game business, although it's sticking to a familiar genre. This fall THQ, based in Agoura Hills, Calif., will launch a free-to-play incarnation of its popular, World War II--inspired Company of Heroes. Like MapleStory, it will encourage players to spend real money - in this case to buy virtual weapons and enhance their characters' fighting abilities.

EA is also getting onboard. It's already active in the Asian free-to-play market and it plans to release a free online version of its Battlefield Heroes game in the U.S. this summer. The company will collect some revenue by running ads when users log on to the game's website. It hopes also to make money by nudging users to buy decorative items, such as moustaches and hats, with which to dress up their virtual characters. In other words, Battlefield Heroes will be a lot like MapleStory, except pitched to EA's core demographic.

So where are all those free games leading the industry? Analysts say it's only a matter of time before most games are delivered via the Internet instead of on disk. True, they've been saying that for years. But it really is bound to happen, and when it does, upstarts like Nexon and WildTangent could find themselves on nearly equal footing with the likes of EA and Activision; it will be hard for the off-line giants to charge $59 a game when their competitors are giving theirs away. Meanwhile, you can expect to see Target's prepaid-game-card business explode.

You may also be seeing more stories like this one: Recently the local Fox TV affiliate in Los Angeles aired an "investigation" about the way young MapleStory devotees were breaking into their parents' PayPal accounts to purchase "cool stuff" for their MapleStory avatars. "If you have kids, you know online games can be addictive," the anchor solemnly warned. "Parents say one game, in particular, has become a craze that is out of control."

At least it was a report about MapleStory and not another scandal about violent videogames. Then again, if the free-to-play movement takes off, it may not be long before hard-core gamers are ripping off their parents to buy virtual sawed-off shotguns for the thugs and pimps of Grand Theft Auto. Now that's a great Fox news story.

REPORTER ASSOCIATE Christopher Tkaczyk contributed to this article. To top of page