Legend of the Fall; Gaming: Nintendo and other Japanese firms used to dominate the industry. But the world changed, and they didn't.(Cover Story)

Byline: N'Gai Croal (With Kay Itoi in Tokyo)

Nintendo's press conferences at the Los Angeles Electronic Entertainment Expo have always been more raucous than those of its competitors. But recently the company seems to be trying a bit too hard. Earlier this year, for instance, Reginald Fils-Aime, the new executive vice president for North America, stood before journalists and declared, "My name is Reggie and I'm about kicking ass." Then he showed footage from souped-up new versions of classic Nintendo heroes, like the gold-armor-clad heroine of Metroid Prime: Echoes and the daring fur ball Fox McCloud from Star Fox 2. The wildest applause of all was reserved for a trailer for the company's new Legend of Zelda game, which reduced some of the seemingly grown men in attendance to tears at the sight of their hero, Link, all grown up and rendered in stunningly believable 3-D. Was Nintendo trying to recapture the glory days, back in 1998, when it owned a quarter of the U.S. market and sold five of the top 10 video-game-console games?

What's clear is that those glory days are gone--not only for Nintendo, but for all Japanese game publishers. The North American videogame market--the world's largest--has been taking off in recent years, but Japanese publishers aren't reaping the rewards; their share of the U.S. market plunged to 29 percent in 2004, from 49 percent in 1998, according to John Taylor of Arcadia Investment Corp. The market share of Nintendo and Sony each halved. Western publishers took up the slack. U.S. firm Electronic Arts now has nine of the top 20 best-selling games, and other American and European firms like Activision and Take-Two grabbed another six. The Christmas season, usually boom time for game makers, looks bleak for Japanese firms. Meanwhile those companies can no longer rely on their home market to quickly recoup their investments in new games. Although Western publishers still don't pose much of a threat in Japan, console-software sales have shrunk from $3.4 billion in 1998 to $2.2 billion last year, a whopping 35 percent drop. "We need the U.S. in order to be profitable," says Namco vice president Yoichi Haraguchi.

How did Japanese game publishers, who dominated the videogame industry in the 1990s, lose their edge so quickly? Several trends have conspired to put Japanese firms --at a disadvantage. Better visual realism, for instance, has made cultural specificity of paramount importance--Mario, Nintendo's four-foot plumber that starred in many of the company's most popular games, doesn't have the universal appeal he once had. The Japanese firms are also suffering from a failure to stay relevant to Western consumers, either through their own design prowess or by courting partnerships. "There are three things that make a hit in the current market," says Simon Cox, editor in chief of the U.S. magazine Xbox Nation. "It's either culturally relevant, superrealistic, or tied to a strong license. Japan currently scores zero on all three of those with their games." In effect, the gaming industry changed and Japanese firms failed to adapt.

The divergence in taste between U.S. and Japanese gamers is partly a matter of demographics. Videogames started out as part of the toy business, and at first publishers targeted mainly 8- to 12-year-olds. Sony's PlayStation in 1995 convinced preteens that gaming was cool, and this generation is still playing into their 30s. "What's surprised people is that the age of gamers has gone up dramatically and how sustained it's been," says Arcadia's Taylor. Cute and cuddly cartoons like Mario and Zelda were the dominant figures of the '90s, but the icons of the new millennium are gun-toting tough guys like Grand Theft Auto Vice City's Tommy Vercetti invented outside of Japan.

All this has left Japanese firms in a precarious position, and many of them have been slow to respond. Sega and Namco, for instance, still cling to their roots as arcade-game companies, even though consoles have eclipsed arcades as the platforms of choice. Both firms stubbornly continue to release some of their most popular franchises in arcades first and only later on consoles, which works in Japan where the former are still popular. In the United States, on the ...