After a short break, Digi-Capital MD Tim Merel returns this month with his regular column looking at investment in the games sector.
This month he takes us through his recently updated Global Video Games Investment Review, looks at the shift towards online and mobile, why China (not America) may dominate games globally, and why 2011 is the year to invest for growth or look for the nearest exit.
Having just published our 2011 Global Video Games Investment Review (available to read here), and spoken at a fascinating GDC in San Francisco, it's a good time to talk about the videogames investment trends which are transforming the industry.
The Acceleration and Fundamental Shift to Online/Mobile Investment
As we anticipated in our 2010 Review, videogames activity accelerated and changed fundamentally during 2010. VC games investment approached 2007 levels in 2010 in terms of funds raised, although the number of investments declined. The top ten investments accounted for around 60 per cent of total games investment in 2010, with a fundamental shift to online/mobile games company investments.
However general VC market weakness and limited knowledge and relationships across complex, fast moving online/mobile games sectors still make generalist VC games investment challenging.
Global Video Games Private Placements
Global Video Games Mergers and Acquisitions
Major console publishers continue to struggle to adapt to online/mobile, with a focus on existing large console games franchises rather than new intellectual property, as the console games market is flat to down, with declining profitability.
The reason for this challenge is that major publishers' core competencies focus on management of $20 million-plus serial, high risk, complex developments, launches and commercialisation. Online/mobile games require rapid, multiple, small scale parallel development platform investments, completely different to major publishers' business cultures, so they are not driving online/mobile games investment.
Similarly, major publishers are wary of large scale online/mobile video games M&A in early stage, fragmented markets where market dominance is not yet clear.
Quality investment demand still exceeds supply, with high quality, high growth (100 per cent annual revenue growth, 20-50 per cent operating margin) online/mobile games companies seeking investment to accelerate growth.
Outside the major investment deals, online/mobile games companies still find it challenging to find high quality investors despite major publisher/media consolidation (Electronic Arts/Playfish $400 million, Disney/Playdom $763 million, DeNa/ngmoco $400 million, Tencent/Riot est $350M-$400 million, Shanda/Mochi Media $80 million).
This isn't to say that good deals aren't being done, but that industry growth and competition could accelerate even faster with more high quality investors in the system.
China, Not America, Could Dominate the Global Games Market
We now believe that China, not America, could dominate the global games market. Online/mobile games should grow total videogames market size to $87 billion and take 50 per cent revenue share at $44 billion (18 per cent compound annual growth rate for fiscal 2009-2014), with the historically strong pure console sector flat to down.
Asia Pacific and Europe should take 90 per cent revenue share for online/mobile games (China 49 per cent, Europe 17 per cent, Japan 14 per cent, South Korea 11 per cent in 2014), although North America remains important.
China's domestic strength has produced high volume (companies like Tencent deliver up to 20 million peak concurrent users – a population the size of Australia at one time), low Average Revenue per User, cost efficient online/mobile games businesses with up to 50 per cent operating margins, enabling significant investment in foreign markets.
Global Video Games Sector Revenue ($ billion)
Regional Online/Mobile Games Revenue ($ billion)
Speaking at the Shanghai World Expo and GDC China last year, and interviewed by CCTV this year, I was struck by the single-minded focus and drive of the Chinese games companies I met. Their approach is analytically driven and commercially balanced, they understand how to make substantial profits while growing revenue at scale, and they are hungry for more.
The high volumes possible in the Chinese domestic market are something which foreign companies can only dream about, and given the relatively high volume/low ARPU nature of online/mobile games, it is an advantage to be respected.
Almost every Chinese games company I know is looking for two types of investment: Foreign companies they can use as a business platform to leverage their domestic strength internationally; and foreign intellectual property and knowledge they can leverage in their domestic market.
At the banquet in honour of China's Vice Premier Li Keqiang (tipped by some to be the next Premier) in London in January, I was fascinated when he voiced sentiments that I heard many times last year. Chinese companies are excellent at execution, but they would like to move further ahead in global terms when it comes to innovation.
Similarly, the 12th five-year plan provides a stronger drive and support for Chinese games companies to increasingly globalise. So we expect to see Chinese companies as major games consolidators in 2011, investing in, acquiring, partnering and licensing from the strongest international online/mobile games companies. The Tencent/Riot Games acquisition announced in February (estimated at $350-400 million) is a portent of more to come.
Online/mobile independents should invest for growth or exit in 2011
In the current market, we believe online/mobile independents should invest for growth or exit in 2011.
Online/mobile games are high growth, but unconsolidated (2009 $19 billion revenue = 32 per cent of global videogames revenue, 2014F $44 billion revenue = 50 per cent of global videogames revenue), with more than 200 million casual online unique users, more than 700 million social online monthly active users, more than 20 million MMO subscribers and more than 10 billion iPhone apps (55 per cent of which are games) downloaded.
Barriers to entry remain low (outside of Facebook social games), with strong competition but limited market dominance by major competitors. Independents are competing successfully with more established competitors, with high revenue growth (100 per cent-plus) and operating margins (50 per cent-plus) being delivered by the strongest independents.
Videogames investment and M&A are accelerating, with fundraising 52 per cent higher in 2010 than 2009, and M&A 60 per cent higher in 2010 than 2009. Online/mobile games valuations for both investment and M&A have been rising, with major deals attracting significant interest.
Major corporate acquirers are increasingly looking to external investments, acquisitions, joint ventures and strategic partnerships for online/mobile games growth and diversification, and as discussed the strong Asian players (from China, Japan and South Korea) are actively seeking foreign opportunities to leverage their capabilities internationally, as well as to source international IP and knowledge for large domestic markets.
But the opportunity will not last forever, as public companies are subject to intense analyst scrutiny of high valuation investments and acquisitions. Not all current online/mobile games investments and M&A are likely to deliver as expected during 2011, with a potentially negative impact on valuations.
So the time to act is now, either raising funds to accelerate growth prior to consolidation, building joint ventures and strategic partnerships to enter major foreign markets (particularly from and to China, Japan and South Korea), or exiting to take advantage of the strong M&A market and valuations.
Consolidation Curve for Videogames
Major Console Publishers Must Evolve to Survive
We don't agree with some who think that the major console publishers are dinosaurs, but we do believe that major console publishers must evolve to survive. We aren't saying that we expect one of them go belly up in the short term, but that the wind is blowing so hard against them that they have no choice but to change.
In that context, some of Satoru Iwata's observations at GDC 2011 were surprising. The challenges major publishers face continue to have well documented knock-on effects on the console independents, although some of the best still thrive.
Console game investment is accelerating, as average game development costs have grown (Xbox 360, PS3: $15-30 million, Wii: $5-7 million). Strong development project management is crucial, and marketing costs can equal development costs or more.
With retail, distribution and hardware royalties significant at 30-40 per cent of retail turnover, console publishers must generally sell 500,000-1,000,000 units just to break even (ex-overheads). I used to work with Ben Feder (retired as CEO of Take-Two in 2010) on the digital side of News Corporation in the US years ago, and when we caught up in New York last year he had just "sucked the oxygen out of the room" with the launch of Red Dead Redemption.
What I understood him to mean was that the console market today is a true blockbuster market, where the marketing scale around major launches leaves space for just one major product at a time. Given the Q4/Christmas sales bias in the console games market, that really restricts commercial opportunity even before you take into account the online/mobile games shift among consumers.
Console Games Are Hit-Driven, With Investment No Guarantee of Success
- A: Red Steel
- B: Crackdown
- C: Lost Planet
- D: Assassin's Creed
- E: Stranglehold
- F: Halo 3
- G: Final Fantasy IX
- H: Call of Duty: Modern Warfare 2
- I: Shenmue
- J: Grand Theft Auto IV
Franchises Selling Tens of Millions of Units Are Lower Risk
y-axis denotes units sales (millions)
However it is worth remembering that videogames rival Hollywood, with a total of $77 billion videogames (hardware $22 billion, software $55 billion) vs $85 billion film global revenue in 2009. So even though the console sector contracted last year, at up to $60 per game sold vs $10-20 per cinema ticket/DVD, it is easy to see that it remains a cash generative business.
We believe console games will remain flat to down this year, with growth hoped for from the next console hardware cycle in 2014-2016 (if it happens). Historically hardware cycles have driven the industry.
Our view is that conglomerates have the best chance to adapt, as major console publisher strategies appear to have converged on fewer franchises, refreshed more often with higher marketing budgets. While adapting to meet fundamental changes in the market with online/mobile organic investment and acquisitions, pureplay console publishers must prove that their repositioning can deliver sustainable profits.
We feel that conglomerates with diversified revenue streams may find it easier to invest in the change to online/mobile games. For example, Disney invested significantly with the Playdom social games and Tapulous smartphone games acquisitions in 2010, as well as indicating an apparent intention to invest less in console games.
It is also impossible to ignore Microsoft's investment in developing and launching Kinect (8 million sold in the first two months), revitalising the sales and market share of Xbox 360 (sales up 42 per cent in 2010 over 2009) and related games software.
The Microsoft/Nokia announcement in February reinforces Microsoft's commitment to high growth markets such as smartphones and therefore mobile games, and they aren't to be underestimated.
There is Significant Opportunity to Invest in 2011
The videogames market is changing across sectors (casual/social online, middleware, smartphone/tablet, browser based MMO, online skill based gaming, pure console, retail MMO, gambling).
Video Games Market Segmentation
As online/mobile games grow and fragment the games market, supported by high growth, high profit business models, we believe there is significant opportunity for online/mobile games growth capital funds to invest in the strongest independent companies.
China's Tencent, Shanda and Giant Interactive have already invested in games funds, and we are exploring the opportunity ourselves around both Chinese games companies with international potential and international companies with Chinese potential.
We also see clear investment, M&A, JV and strategic partnership opportunities for corporate and financial investors, which are covered in depth in the Review.
From our time at GDC, we expect to see more deal activity with the companies we are met there and those already in discussions across Europe, North America and Asia. We're very excited about the prospects for this year.
Digi-Capital is a videogames investment bank focused on high growth companies in Europe, North America and Asia (particularly China, Japan and South Korea), working with major corporates, high growth independent and VC/Private Equity firms. The firm has a particular interest in helping Chinese companies to invest and partner internationally, as well as to find foreign partners to collaborate in China.
Digi-Capital leverages its knowledge, relationships and ideas across investment banking (M&A, investment, fundraising), corporate development (commercial partnerships, JVs, commercial negotiation, new market entry, publishing/licensing) and board advisory work. Digi-Capital works as an inhouse