TOKYO -- In May, Sony CEO Kenichiro Yoshida faced his counterpart at Microsoft, Satya Nadella, on the sprawling campus in Redmond, Washington, that houses the world's largest software maker.

The meeting was the culmination of highly secretive talks about a joint venture in a market where they had previously been fierce rivals: video games. For nearly two decades the companies' consoles -- Sony's PlayStation and Microsoft's Xbox -- have competed for space in living rooms around the world, investing billions in technology and intellectual property to win over gamers. But, on May 17, the pair announced that they would now be collaborating, developing game and media streaming services based on Microsoft's Azure cloud computing platform.

The partnership even took company insiders by surprise.

"It was really shocking to see Yoshida and Nadella shaking hands," one executive at Sony Interactive Entertainment, the Japanese electronics and entertainment conglomerate's gaming unit, told the Nikkei Asian Review.

Once unimaginable, the tie-up between the two rivals was driven by a looming disruption to their console businesses, as the $130 billion video game industry finally faces its "Netflix moment." Just as the TV and music businesses have been reshaped by the streaming boom that has replaced CDs and DVDs with subscription services, advances in cloud computing could change how games are delivered to consumers, eroding -- or even entirely destroying -- the market for physical consoles and expensive downloads.

"It will have a profound impact on the industry in the next three to five years," said Luke Alvarez, founder and managing partner of Hiro Capital, an investor in gaming and esports startups. "It will open up the ecosystem. ... Companies will have to adapt."

Game-changers

The Sony PlayStation debuted in Japan in December 1994. Over the next decade, it shipped 100 million units, seeing off competition from established console companies, including Sega, which dropped out of the race in 2001 to focus on making software. Nintendo, at that stage the market leader, launched its Nintendo 64 console in 1996; Microsoft entered the fray in 2001, launching the Xbox just ahead of the Christmas rush. Before the platform was replaced by the Xbox 360 in 2005, it sold more than 24 million units.

The initial success of the PlayStation and the Xbox was in part due to their use of CDs as a medium for their games, replacing the older cartridge systems. CDs, and later DVDs, could hold more data than cartridges. That meant more complex games, better graphics and better performance, and attracted third-party games designers who were no longer shackled to the console makers' proprietary formats.

Sale day: Sony PlayStation 2 boxes are stacked high in a store in Akihabara, Tokyo, on the first day of release in March 2000. © Kyodo

Over the next two decades, the console makers released successive iterations of their platforms, each more powerful than the last, trying to attract customers with more realistic graphics and larger, more immersive virtual worlds in which to play. Microsoft's latest platform, the Xbox One X, has nearly 200 times the computing power of the original Xbox.

The games themselves became huge and expensive endeavors, with budgets that match Hollywood blockbusters. "Call of Duty: Modern Warfare 2," a popular war simulator, cost more than $250 million to produce and market in 2009, and shipped nearly 5 million units in the first 24 hours of its release. Last year's "Red Dead Redemption 2," an enormous "open world" game set in the Wild West, took 1,000 developers, designers and artists seven years to produce.

The sheer computing power needed to run these games has so far insulated the games industry from the streaming revolution, which has allowed Netflix and Spotify to steal a march on traditional music and movie studios. In a few short years, large swaths of media consumption has shifted from physical CDs and DVDs or digital downloads to "content as a service" platforms, where customers no longer pay to own a single recording of a song or an episode of a series, but instead pay a monthly subscription to be able to access a huge library of content.

For the full picture of gaming's journey to the cloud, click here.

Until now, that simply would not have been possible for blockbuster games titles, which rely on the high-speed processors and graphics cards contained within consoles in order to run. Cloud computing could change that, using the processing power of huge, remote data centers to perform the computational heavy lifting and streaming games to customers' devices.

As games market research company Newzoo said in a report last year, "Cloud computing effectively removes the need to own hardware, while a games subscription removes the need to own software."

Both Sony and Microsoft have already made moves into selling games as a service. Sony fully launched its "PlayStation Now" service in 2015, which allows customers to stream a selection of titles via their console or PC. The service already has 700,000 subscribers, paying around $20 per month.

Microsoft launched its "Xbox Game Pass" in 2017, offering access to more than 100 games for $9.99 per month.

Phil Spencer, executive vice president responsible for gaming at Microsoft, told Nikkei that the company sees streaming as a major part of the future of its gaming business, and that it believes its existing technology infrastructure, including its cloud computing platform, gives it a competitive advantage.

The opening up of the market has attracted some big-name competition. In March, Apple unveiled its Apple Arcade game subscription service that allows users to play over 100 new and exclusive titles on the iPhone, iPad, Mac and Apple TV. The service, to be launched in the autumn of 2019, will offer original games to be provided by reputed video game designers including Hironobu Sakaguchi, best known as the creator of the Final Fantasy series, which has sold more than 140 million copies.

Google, which operates data centers in more than 200 countries and territories around the world, signaled its entrance into the cloud gaming market in March with the announcement of its Stadia platform. The platform, launching later this year, will offer gamers access to content for a $9.99 monthly subscription.

An esports competitor at the 2018 Asian Games in Jakarta (Photo by Akira Kodaka)

At the Game Developers Conference in San Francisco that month, Phil Harrison, the Google vice president who heads the Stadia project -- himself a former Sony and Microsoft employee -- made the company's intentions clear. "The new generation of gaming is not a box," he said. "The data center is your platform."

Netflix has already begun distributing games based on popular movies for smartphones and other media, which some analysts have interpreted as the TV and movie streaming platform dipping its toe in the water ahead of a more substantial move into video games. There are also persistent rumors within the industry that the e-commerce giant Amazon.com is preparing to enter the market.

In March, the Chinese technology conglomerate Tencent Holdings, an early pioneer in the country's online gaming market, began early trials of a cloud gaming service called "Start." Its domestic rivals, Baidu and Alibaba Group Holding, both already run mobile gaming businesses and have large cloud computing arms.

Mobile advantage

However, moves by Google and Apple could be more concerning for Sony and Microsoft, because both have built powerful positions in smartphone and tablet markets.

Freed from the need to have huge amounts of processing power at the point of use, high-end games could become available on a broader range of devices, and could move out of the living room and onto mobile.

"The way we consume content will change," said Ozan Kocoglu, co-founder of game publisher Initiative Media. "It was done through hardware then software, then with the spread of the internet it became download. The next stage is where you need any kind of device and it's all streaming."

Microsoft, the second-biggest cloud services provider globally, is expanding: Last year, the company tested an underwater data center in the Northern Isles. (Photo courtesy of Microsoft)

Mobile games already make up more than half of the overall video game sector, and are the fastest growing segment by some way. Worldwide, revenues from mobile gaming are expected to hit nearly $70 billion in 2019, more than 40% higher than the revenues from console sales, according to data from Newzoo.

The research company also found that half of users of consoles and PCs consider themselves to be "casual gamers," making them susceptible to switching to mobile platforms.

The rollout of fifth-generation mobile networks, which will enable faster data transfer onto mobile devices, could help to further blur the lines between mobile platforms and desktops and consoles.

"Once 5G networks start rolling out, it will gain momentum," SMBC Nikko Securities' senior analyst Eiji Maeda said. "Sometime around 2025, cloud will become people's main source of gaming."

That will inevitably have an impact on those companies that produce gaming hardware. Microsoft is due to release a new Xbox console next year. The device will reportedly have data processing capacity four times that of its existing model, and will be capable of showing 8K ultra-high-definition videos.

Sony said last October that it has begun developing a successor to its current PlayStation model, but has still not announced a launch date.

Yoshida openly accepts that the console will shrink. "Consoles as a whole form a niche, rather than major, market," he told a press conference in May. "I think streaming and cloud will come forward in the long run, but it's difficult to set a time scale for them."

The erosion of the console market will, as a recent Morgan Stanley report said, "put in play the $19 billion that gamers spend on console hardware," as well as the $9 billion in fees that the publishers of video games pay to the console makers.

Just as Netflix and Amazon's Prime Video streaming service have driven a huge demand for television content, the advent of streaming and subscription platforms could be a boon for games developers and publishers.

When Square Enix Holdings unveiled its new title, Marvel's Avengers -- the first in a series based on the popular superhero universe -- at the E3 2019 news conference in June, the Japanese game publisher's trailer showed Google's Stadia alongside PS4, Xbox One and PC as one of the platforms for the game. Square Enix President Yosuke Matsuda predicts that Google's foray will provide a lot of thrust for growth of cloud gaming. The company is working on research to develop so-called "cloud-centric" games, which will require much more computing power than "device-centric" games, Matsuda has said.

Niantic and Nintendo's Pokemon Go pushed the boundaries of hardware-based gaming when it was released in 2016. (Photo by Ken Kobayashi)

At its launch, the Stadia will offer around 30 game titles including "Final Fantasy XV" and "Assassin's Creed Odyssey," both part of long-running and successful franchises. Many game software companies have been asked by Google to provide their games, an industry insider said.

In this new environment, console makers may need to lean less on the quality of their hardware, and more on the appeal of their intellectual property. As Masaru Sugiyama, an analyst at Goldman Sachs, said: "Hardware makers will have to differentiate themselves through their game content, while software makers will also have to leverage their IP [intellectual property]."

For companies such as Nintendo, whose Mario and Pokemon franchises have become enduring cultural phenomena around the world, that could mean promoting its characters through other media, such as TV series and movies, according to the company's president Shuntaro Furukawa.

Microsoft owns the rights to blockbuster hits Halo and Minecraft, while Sony, which has a major movies studio, has access to a considerable library of IP, including the comic book character Spider-Man; an action-adventure game, "Marvel's Spider-Man," was a major hit in 2018.

Sony Interactive Entertainment President Jim Ryan said that content will assume greater importance as the industry goes through this technological shift. The company is considering investing to upgrade the 13 software production studios that it operates around the world, and has not ruled out making acquisitions to boost its capacity.

New frontiers

For publishers, moving to a subscription model could be challenging. The economics of making games is now well understood -- a high ticket price of $60 per game offset the production and marketing costs.

Hideki Yasuda, senior analyst at Ace Research Institute, points out that the high development cost for games will make it difficult for the subscription-based business model to work. "Game development costs are exceptionally higher than that of music. It will take way more time to collect the return on that [through] subscription," he said.

There is also the question of whether customers will be willing to subscribe at all. As Hiroyuki Watanabe, senior analyst at Sumitomo Mitsui DS Asset Management, points out, in many countries, including China, most revenues from mobile games come from "in-game purchases" -- where customers make one-off purchases to access new levels, characters or other assets.

"Even if consumers do subscribe, it will be hard for companies to retain them, because if they find the game uninteresting they can unsubscribe in a second," he said.

"The new generation of gaming is not a box," said Google Vice President and Stadia project lead Phil Harrison, pictured above. "The data center is your platform." © Reuters

There are also substantial technological challenges to overcome. Cloud gaming will require internet service providers, cloud computing businesses, mobile networks, game publishers and hardware manufacturers to work together and to invest heavily.

The prize is likely to be worth it. Analysis company GlobalData predicts that the video games market will double in size to over $300 billion by 2025. Gamers could also benefit, as the disruption to the industry spurs a new wave of competition and creativity.

"New platforms will emerge and there will be huge competition among companies to secure talented creators," said Hirokazu Hamamura, a veteran observer of the industry who heads Famitsu Group, a specialist publisher of video game magazines. "The number and range of content will also grow, giving consumers more choices. The demand for gaming is definitely on the rise. Cloud gaming will lead to the industry's revitalization."

Nikkei staff writers Hisashi Iwato in Tokyo, Natsumi Kawasaki in Osaka, Hiromi Sato in Silicon Valley and Yusuke Hinata in Guangzhou contributed to this report.