Midway Games, Inc.

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Midway Games, Inc.

3401 North California Avenue
Chicago, Illinois 60618
U.S.A.
(773) 961-2222
Fax: (773) 961-1099
Web site: http://www.midway.com

Public Company
Incorporated: 1988
Employees: 553
Sales: $388.2 million (1996)
Stock Exchanges: NYSE
Ticker Symbol: MWY
SICs: 3651 Household Audio & Video; 3999 Manufacturing Industries, Not Elsewhere Classified; 7372 Prepackaged Software; 7993 Coin-Operated Amusement Devices; 7999 Amusement & Recreation, Not Elsewhere Classified

Midway Games, Inc., is one of the world’s leading producers of video games. The company designs, publishes, and markets games for coin-operated arcade machines as well as for home video game consoles and personal computers. Midway has published or distributed some of the most popular games in the industry, including the “Mortal Kombat” series, “Cruisin’ USA,” “NBA Jam,” “Defender,” and “PacMan.” The “Mortal Kombat” line alone has sold more than 14 million units. It has brought Midway over $1 billion and at the beginning of 1998 accounted for more than 20 percent of the company’s annual revenue. In the early years of its development Midway produced games exclusively for arcades and was the number one company in the coin-op market. Through its subsidiary Midway Home Entertainment, however, it has moved aggressively into the home market. Midway makes its home games in formats compatible for all the leading game models, including the popular Nintendo 64, Sony PlayStation, and personal computers.

Company Roots: 1969–1988

In 1969 the Midway Manufacturing Company, a maker of amusement machines, was acquired by Bally, one of the nation’s leading manufacturers of gaming pinball machines. In 1988 Bally’s amusement game divisions were purchased for $8 million by its main competitor in the arcade game industry, WMS Industries of Chicago. That same year Midway Manufacturing Company was incorporated as a wholly owned subsidiary of WMS. Midway worked on some WMS pinball games, but the company primarily designed and produced video games for arcades.

“Mortal Kombat” Revives Industry: 1992

Video games were going through a slump as the 1980s turned to the 1990s, but the entire industry revived abruptly when Midway introduced “Mortal Kombat” in 1992. The game achieved notoriety inside and outside the gamer community when it became known that secret codes had been programmed into the game: when activated, the codes changed “Mortal Kombat” from a run-of-the-mill kick-and-punch match between mutants into a bloody battle to the death at whose conclusion the victor would rip the still-beating heart from his vanquished opponent’s chest, or tear his hapless opponent’s spine out and hold it triumphantly aloft, or blast his prostrate opponent to ashes.

The game unleashed a debate over the effect of violent video games on children, which continued throughout the 1990s. But the immense popularity of “Mortal Kombat” guaranteed that other games would compete to outdo it in both violence and realism. The game established Midway as a major force in the video game field and provided the company with the financial resources to develop new games and eventually expand beyond the arcade market.

In March 1994 Midway and Nintendo formed a 50-50 joint venture. Under its terms, Midway was to develop video games for new game machines being developed by Nintendo, among them the Nintendo 64, a home game console for which Midway agreed to develop a version of “Cruis’n USA.” The agreement gave the joint venture the distribution rights for home versions of any “Cruis’n” sequels developed for coin-op machines. It also had first rights for negotiating distribution of the games Midway designed for Nintendo’s next coin-operated system. As of early 1997 the joint venture had not yet released any home video games, but the deal was an early step for Midway into the blossoming home video game market.

Expansion in the Mid-1990s

Midway moved more decisively into the home market in April 1994 when it acquired three companies, Tradewest Inc., Tradewest International Inc., and the Leland Corporation, known collectively as Tradewest. Tradewest, located in Corsi-cana, Texas, designed and manufactured home video games. The initial price was $15 million with the remainder calculated as a percentage of future annual revenues. In June 1998 when Midway made the final payment, those additional costs had totaled $37 million. Tradewest retained its autonomy within Midway. Its fifty-person staff formed the core of a new Midway subsidiary which, like Tradewest, developed home video games. Midway’s most profitable unit, Tradewest was eventually renamed Midway Home Entertainment.

Midway’s decision to begin producing its own home games followed the incredible success of the first two “Mortal Kom-bat” games. Those games, like all Midway’s games at the time, were originally developed as arcade games. The home rights to Midway games were licensed to another game developer, Acclaim Entertainment, in 1989, a time of uncertainty in the home video game market. Acclaim sold five million copies of “Mortal Kombat” at a retail price of about $65 each.

Midway ended its licensing relationship with Acclaim in 1993. The marketing strategy it adopted when it began producing home video games was one Acclaim had pioneered with a great deal of success. Home games were released simultaneously in versions for all the popular home game systems. Midway Home Entertainment’s staff was ideally suited for the strategy, because Tradewest had specialized in developing games for multiple platforms. The cross-platform strategy was extremely effective: it enabled the company to hit every potential market while a game was still popular; development, advertising, and promotional expenses could be spread out over more game units, lowering costs; and a successful arcade version operated as advertising for all home versions.

Midway’s leadership in the arcade field gave it an additional advantage. Acclaim established earlier that successful arcade games almost invariably went on to be successful home games. Its arcade sales thus functioned as market research, reducing the likelihood that a home game would not pay back its development costs. In September 1995, Midway released “Mortal Kombat 3,” the first home video game that it had developed in house. Despite its release so late in the year, the game went on to be the nation’s best-selling home video game in 1995, according to TRSTS Reports, an industry magazine.

In March 1996, Midway purchased Atari Games from Time-Warner. Midway paid $2 million up front for Atari, which had been experiencing problems since the early 1980s, and additional costs linked to the division’s performance through the year 2000, with the total price paid estimated to have been $24 million in all. Midway obtained Atari’s game development capability and its full library of classic video games like “Pac-Man” and “Centipede,” as well as the right to use the Atari name on its coin-operated games. After the acquisition, the Atari division in Milpitas, California, remained an autonomous operation within Midway Games.

1996 IPO

On September 13, 1996, Midway filed its intention with the Securities and Exchange Commission to make an initial public offering of 5.1 million shares of common stock. Less than 15 percent of Midway common stock was being offered, with WMS Industries, Midway’s parent company, continuing to hold approximately 33.4 million shares. The offering was greeted favorably by investors, because Midway seemed to be a strong presence in the video game market. Sales had increased to $245.4 million annually by June 1996, which represented fivefold growth since 1992. An important reason was the “Mortal Kombat” series, which accounted for 17 percent of Midway’s sales in 1995 and 35 percent in 1996.

Midway’s increasing involvement in home games was also a positive factor for investors. Midway Chairman Neil Nicastro told Grain’s Chicago Business, “The home business provides superior earnings potential. It’s so much bigger a market.” Indeed, in 1996 there were 15,000 arcades in the United States, but 35 million homes with video games. Furthermore, the coin-op business had begun to erode at a rate of 10 to 15 percent a year. By contrast, in 1994 home video games had accounted for 20 percent of Midway’s total revenues, and by 1996 they made up 63 percent. In addition, Midway was the only American Video game manufacturer that was strongly established in the arcade market, the testing grounds for home games.

Company Perspectives:

The key to success in the video game business is to produce games that are the most fun and exciting to play. This requires the creative talents of experienced game designers. Midway employs over 300 game design personnel who operate in a studio environment that encourages creativity, pro-ductivity, and cooperation. Midway believes successful games are coin-operated video games that sell at least 5,000 units and home games that sell at least 100,000 units per platform. Each of the coin-operated video games released by Midway since 1993 which has sold at least 5,000 units has gone on to sell at least 100,000 units for each major home system for which it was released.

Investors had questions about Midway as well. Would the untested company be able to get home products out on schedule? How would the added administrative, R&D, and marketing costs associated with the shift in focus to home video games affect Midway’s financial performance? Those costs had already grown significantly. Between June 1995 and June 1996, the company’s annual R&D outlays increased from $8.4 million to $32.5 million, while marketing costs jumped from $1.6 million to $22.8 million.

The offering was completed on October 29,1996. The stock went for $20 a share and raised $108 million. According to Crain’s Chicago Business, investor confidence in Midway was high, as indicated by the level of trading in the weeks immediately after the spin-off, and within two months the value of Midway stock was 15 percent higher. The company changed its name at the same time from Midway Manufacturing Company to Midway Games. All pinball operations handled by Midway for WMS were transferred to another subsidiary just prior to the public offering.

Midway’s fall 1996 home video line was marketed exclusively under its own trademark. Prior to that, its products had carried the Williams, Tradewest, Tengen, and Time Warner Interactive trademarks. Midway Games had a number of achievements during its 1996 fiscal year. It released five coin-operated games under its own name; it published eight new home games, including one of its most popular, “Mortal Kom-bat 3”; it released the Touchmaster, a coin-op game platform with a touchscreen; and “Cruis’n USA” won awards for innovation from various industry groups.

Three months after Midway’s public offering, investors noted a strange discrepancy in the stock prices of Midway and its parent company, WMS. When Midway went public, WMS retained just over 86 percent of the total shares. Based on that figure, analysts calculated, each WMS share effectively owned 1.38 shares in Midway. At the mid-January 1997 price of $20 for a Midway share, every WMS share owned about $27.95 worth of Midway stock. WMS, however, was selling for only $23. The primary factor holding down the price of WMS shares, analysts reasoned, was the large percentage of Midway shares it held. That was Midway stock that was inaccessible to the market and investors could not arbitrage the difference in prices.

WMS Industries was itself uncertain how to deal the problem. Keeping its Midway holdings would continue to depress its own value, but if WMS sold its Midway holdings it could end up paying 40 percent of the proceeds in taxes, and if it distributed the stock among its shareholders they could be liable for taxes. On August 11,1997, WMS announced that it had decided on the latter course. It stockholders would receive the company’s Midway stock on a pro-rata basis. The proposed spin-off hinged upon an Internal Revenue Service ruling over whether the deal would be tax free to WMS and its stockholders. The company hoped everything would be completed by early 1998. Thereafter Midway would be listed as a “discontinued operation” on WMS’s financial records.

Midway Games has developed or licensed a broad line of games, including sports games, like “Wayne Gretzky’s 3D Hockey,” racing games like “San Francisco Rush,” and fighting games like “War Games,” and “Mace.” But the most successful of all Midway’s game titles has been the “Mortal Kombat” line. “Mortal Kombat” ushered in boom times in the video game market, in particular for Midway Games. More than 15 million “Mortal Kombat” home games were sold. The game spawned a series of sequels, including versions 2, 3, and 4, “Ultimate Mortal Kombat,” “Mortal Kombat Trilogy,” and “Mortal Kombat Mythologies: Sub Zero.” By the beginning of 1998 Midway had earned a net $1 billion from all the “Mortal Kombat” arcade games. “Mortal Kombat” 3 sold 250,000 units and brought in $15 million during its first weekend on the market. In 1997, after other popular games appeared, the percentage was still 22 percent.

Debate over Violence in the Late 1990s

The debate about violent games was resumed after a series of schoolyard shootings in 1997 and 1998, after it was discovered that some of the boys involved in the shootings had played “Mortal Kombat.” Experts, however, were divided on the degree to which such games actually influenced violent behavior. What was important for game makers was the enthusiasm of video game players for carnage, and they began incorporating it into other games. Midway Games was no exception, producing “Blitz,” a no-holds-barred contest in which players maim and dismember opponents, and “Bio Freaks,” in which players can decapitate opponents.

In 1994 Midway licensed multimedia rights to “Mortal Kombat” to Threshold Entertainment, which turned the license into a property worth $3 billion. According to Threshold CEO Larry Kasanoff, “Mortal Kombat” has become the fifth-largest entertainment franchise in the world, ranking just after “Batman” and “Star Trek.” In all there are over 100 licensed “Mortal Kombat” products on the market. Threshold released two “Mortal Kombat” movies, the first of which made $100 million worldwide in 1995, the second of which was the country’s number one movie the weekend it opened in November 1997. Besides the movies, Threshold produced an animated TV series, a “Mortal Kombat” stage show at Radio city Music Hall, a “Mortal Kombat” CD-ROM, a “Home Mortal Kombat Special” on DIRECT TV, three soundtrack albums, one of which went platinum (one million copies sold), a live action TV show, and one of the Internet’s most popular websites, mortal-kombat.com

In October 1997 the arcade version of “Mortal Kombat 4” was released. The game, which the company dubbed “the final version” in press releases, was the first to utilize Midway’s new Zeus Chip. The chip was the key to a powerful new graphic system that enabled the game to process visual data about ten times faster than other systems, increasing the levels of realism proportionately. In 1998 Midway began pushing the Nintendo 64 version of “Mortal Kombat 4” more aggressively than ever, weeks before the game was due to be released. A multi-million dollar, music video-style television ad campaign coincided with the airing of the first “Mortal Kombat” movie on TBS, a film shown five times during May 1998. Midway also lowered the suggested retail price of “Mortal Kombat” 4 from $59.95 to $49.95. The game itself was scheduled to be released on June 29.

At the end of 1997, Midway announced that revenues had risen 13 percent to $73.7 million during its July-September 1997 quarter. During the same period, however, home game revenues fell from $47.6 million to $40.1 million, largely because the company had postponed the release of “Top Gear Rally” and “Mace: The Dark Age” until the end of September. Nonetheless, TRSTS Reports ranked Midway Games fourth among 62 video game companies in sales of 32- and 64-bit home video games for fiscal 1997, up from seventh place the previous year. The company released seven new arcade games and fifteen new home games. In 1997 Midway released more games for the new Nintendo 64 system than any company except Nintendo itself.

In February 1998, Midway broke with its previous marketing strategy and announced that the following summer it would release home versions of the game “Bio Freaks” before an arcade version had appeared. According to a company spokesperson, Midway had made the decision in response to high consumer demand for a new fighting game that took advantage of the graphic possibilities of the next generation game systems like the Sony PlayStation and Nintendo 64. The company described the release as additional evidence of its commitment to the home market it was courting.

In March 1998 Midway expanded its product line into the market for personal computer games. It purchased back North American and Japanese distribution rights to Midway personal computer games that the company had granted to GT Interactive Software in 1995, a time when it was focusing its attention on the home console market. GT retained rights to distribute Midway personal computer games outside North America and Japan.

The Internal Revenue Service finally issued its ruling that the company’s proposed spin-off would be tax free. On April 6, 1998, all Midway shares held by WMS were distributed among its shareholders. Each WMS share received 1.19773 Midway shares, and fractional shares were paid out in cash. Upon completion of the spin-off, Neil NiCastro resigned his positions as president, CEO, and chief operating officer of WMS to take over the chairmanship of Midway Games.

Focus on R&D in the Late 1990s

Midway significantly boosted its outlay for R&D from $32.5 million in fiscal 1996 to $55.9 million in 1997. Part of that was for advanced technologies whose ultimate marketability would only be proved in the indeterminate future. One example was WaveNet, a system for interactive video gaming. Once in place, WaveNet would comprise a private network of arcades linked electronically. Gamers would be able to play video games against opponents in different arcades, and even in different cities. Test arcades were set up in San Francisco and Los Angeles, but as of mid-1998 Midway was still evaluating the feasibility of the system and the company had no plans for national deployment.

The trends evident at Midway Games over the previous two years showed no sign of abating in summer 1998. Total revenues grew by about ten percent and the company expected its home video game revenues to double from the same quarter a year earlier, thanks to sales of games for the so-called “new generation” video consoles manufactured by Nintendo and Sony. Midway’s arcade business continued to shrink, dropping by 25 percent compared to the previous year.

Midway planned, in fiscal 1999, to continue its strong presence in the Nintendo 64 and Sony PlayStation markets by releasing 28 new home video games, while planning 11 new arcade games. Midway was looking to become more active in other markets it had neglected. For example, the company planned to release twelve personal computer home games, in comparison to the previous year’s total of two. Midway was also developing four games for the Game Boy system.