Blowing Bubbles

Mobile and social gaming are in a huge valuation bubble - but that doesn't have to mean that disaster is coming

By any standards, PopCap is a remarkable company. Of the many new games companies to emerge from the new social and mobile gaming scene, it's one of the only ones which manages to sustain a delicate and difficult balancing act - appealing to an enormous swathe of the mainstream, casual market while still commanding significant respect from core gamers.

In the past decade, the company has proved its ability not only to keenly and intelligently exploit its flagship franchise - Bejeweled - but also to generate new IP that's just as compelling as that original break-out hit, including Peggle, Plants Vs. Zombies and Zuma. Moreover, it seemingly effortlessly straddles the mobile and social gaming sectors, just as comfortable providing apps to iPhone users, coffee-break entertainment to Facebook users and downloadable titles on Steam for more dedicated gamers.

There's absolutely no question that PopCap is a great games company. However, if this week's rumours turn out to be correct, and the company sells for $1 billion, it will be the final confirmation of something that's been whispered for a while now - that social and mobile gaming, along with the "social internet" in general, has become a bubble market.

Finnish firm Rovio took in $42 million in a funding round which even the investors admitted the company didn't actually need.

In the past year, company valuations in this sector have soared, and some truly eye-watering deals have gone through. Last October, Japanese mobile gaming giant DeNA paid out up to $400 million for iOS game developer ngmoco - another great company with fantastic products whose price tag raised plenty of eyebrows. Not to be outdone, DeNA's local rival GREE dropped over $100 million in cash on OpenFeint - creators of a social gaming platform for iPhone and Android.

In the west, EA paid $300 million for PlayFish last year, while Disney paid $760 million for Playdom, and has been aggressively restructuring its entire games business around the social gaming model - with mixed results.

Those are just samples of the deals we know about, because they were made in public. The biggest fish in the pond, Zynga, bears a price tag as high as $10 billion according to some valuations. It's not just in acquisitions that the figures are getting breath-takingly high, either - venture capitalists seem to have caught the fever too. Back in March, Finnish firm Rovio - a developer with only one hit to its name, even if that hit is the seemingly ubiquitous Angry Birds - took in $42 million in a funding round which even the investors admitted the company didn't actually need.

It's not just games, of course. In the wider world of the social internet, analysts mostly seemed to come around to the idea that we had entered a bubble market when Color Labs raised $41 million in first-round funding for an iPhone application which not only hadn't yet been written, but which nobody even seemed to be able to explain without resorting to buzzword-laden drivel. That's even before we start to consider the valuation of a company like Twitter - whose service is wonderful, but whose long-term plan for making money seems almost as confused and optimistic as the worst of the era hopefuls.

Yet even if the wider bubble in the social internet allows us to place the money flying around the social and mobile gaming sector into a logical context, it doesn't do anything to defuse the potential damage of an implosion. What happens when a bubble bursts in a market like this? That's predictable enough - purchasers are left holding an asset that's not worth what they paid for it, and potentially laden with debt which they took on to pay for that asset, while everyone else finds that funding dries up as investors take flight.

So who is exposed to this kind of risk? Electronic Arts, as mentioned, has a $300 million investment in PlayFish. It's no stranger to large acquisitions in this space - it paid out $680 million for mobile publisher JAMDAT back in 2005, although that's not a deal it may particularly want to be reminded of, given that it later had to knock around 50% off its valuation of the asset. Crucially, EA is also linked to the billion-dollar PopCap deal that's said to be on the table, although it's hard to say how credible that is. EA's financial position wouldn't allow it to make an acquisition on that scale easily - it could be done, of course, but it will be an immense risk for the company to swallow.

Disney has committed itself even more heavily to the space than EA, but its Playdom acquisition has been criticised on many fronts for under performing - and although the company has redoubled its commitment to a future in the social games space, it's yet to turn that commitment into any kind of leadership position. However, Disney actually isn't terribly exposed to a social gaming "bubble"; it may have paid above the odds for its investments, but it's an enormous company which can afford to swallow those losses, and the investment bubble shouldn't disguise the fact that social gaming itself is still a market with growing audience and revenues, one which a firm like Disney can ill-afford to ignore.

Whoever ends up buying PopCap will own a social gaming developer whose success is almost unrivalled and whose skills and experience can potentially unlock vast swathes of the marketplace.

Beyond those two firms, others do have significant involvement in mobile gaming - Ubisoft, through GameLoft, being a great example - but have mostly avoided getting caught up in the bubble. Indeed, GameLoft CFO Alexandre de Rochefort was one of the main voices to warn of this emerging situation, earlier this year.

Instead, the investment has come heavily from VCs, and from Asia - and sometimes from both. Asian companies, both Chinese and Japanese, are very keen to invest in this market, and the Japanese firms in particular have been both spurred by the need to keep abreast of the smartphone growth that's displacing the huge "featurephone" market in their native territory, and emboldened by the historic strength of the Yen which allows overseas acquisitions to be made on the cheap, at least relatively speaking.

What happens to those companies when the confidence leaks out of the market and the bubble collapses? It's therein, I think, that the really interesting question about what this bubble actually means to the games industry starts to find some answers.

Nobody - be they a corporation or a private individual - wants to end up holding an asset that's worth far less than they paid for it, but that doesn't tell the entire story. As mentioned above, the ludicrous prices flying around in this sector disguise an underlying story that's arguably much more important - a story of immense growth in both audience and revenue, growth which doesn't justify those prices but which does certainly justify much of the interest being taken in this market.

For companies in Asia seeking to build their presence in the West, or for Western media firms determined to stay on top of developments in their sector, one could argue that social and mobile gaming acquisitions aren't really an "investment" in sense of asset growth. Yes, it would be lovely to buy an asset and watch its value swell on your balance sheet - but what's more important to these firms is to buy into a market, expanding their global or demographic presence and, crucially, denying their rivals an opportunity to do likewise.

Even once the bubble bursts, DeNA - to pick an example - will own a leading mobile developer with fantastic insight and experience in the western market. Whoever ends up buying PopCap will own a social gaming developer whose success is almost unrivalled and whose skills and experience can potentially unlock vast swathes of the marketplace. Their asset values may implode, and the markets aren't likely to like that very much, but the core reasons for the acquisitions will remain.

In other words, if you've got the money to buy, and if your business strategy requires or benefits from this kind of acquisition - then the bubble in the mobile and social markets only matters to you because it'll make it harder to make back the money you spend, but you're in this for the long term and the acquisition may still make sense. Where it matters more is to those companies and investors who are just hopping on the bandwagon because everyone else is doing it, throwing millions at companies with little IP to their name or incredibly risky business plans. Moreover, it definitely matters to companies who really don't have the money for this kind of investment, and will seriously suffer if its value collapses.

A bubble market is by no means a good thing, but equally, it's not a sign that everyone should cower and wait for the sky to fall. It simply means that companies need to be much more wary about their investments, and accept that the gambling stakes are much, much higher than usual. Mobile and social gaming is here to stay - but these valuations are not. If calm heads prevail, we can at least hope that none of the games business' great names get dragged down when the madness eventually ends.

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Latest comments (15)

James Prendergast Research Chemist 6 years ago
I don't think that the risk is only in the money.... by saddling a company with such debt (that has a high chance to be lost) the creative freedom enjoyed by a company not making decisions in an atmosphere of fearing the "must make guaranteed returns" mentality is the other thing that will be lost. The big, entrenched companies have shown time and time again that just buying in the expertise and portfolios does not work because the very act of acquiring the company destroys it in certain ways. This, of course, impacts the ability of the company to get a return on the investment.

It's a bit like the Heisenberg's uncertainty principle in some ways. You can see what you want.... but getting it changes the nature of what it was you wanted.
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Raf Keustermans CEO, co-founder Plumbee 6 years ago
"EA's financial position wouldn't allow it to make an acquisition on that scale easily" - Huh? EA is debt-free and has almost $1.5B in cash. They don't even need to look for financing. There's almost no easier position thinkable... Can you explain what you meant with this statement?
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Antony Johnston Writer & Narrative Designer 6 years ago
James: Very, very few devs have been free of the "must make guaranteed returns" mentality for a long while, now. I agree with what you're saying in principle I've had the same thought myself when considering this bubble but it's not like it's currently all wine and roses, either. Even games which are "only" marginally profitable can threaten a studio's survival, these days.
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James Prendergast Research Chemist 6 years ago
@ Antony,

Point well taken - though i didn't state it specifically, i was trying to make a distinction between "being in debt" and "being in debt and we acquired this asset to do specific 'A'". IMO, those are two separate ideologies. A company as it exists is in business, when it's subsumed it is in business to achieve the specific reason for buying it, not to purely be in business and succeed. I believe that the first one allows more freedom to adapt and change whereas the second can bring expectation and a blinkered view.

Think of a studio that had several successful games (in different genres) which was bought because of their successful FPS franchise or history. Generally, you see them become focused on that one aspect instead of the holistic approach to making successful games.
Sure, i understand it because you don't need to duplicate functionality in different places in the same company.... However, there's a good chance, in a creative industry, that you're losing out on experience or opportunities to make alternative decisions that would perhaps be more successful.

@Raf, I thought EA had been making significant operational losses for the last few quarters. Maybe that's what it was in reference to?

Edited 4 times. Last edit by James Prendergast on 24th June 2011 10:57am

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Graham Simpson Tea boy, Collins Stewart6 years ago
EA has been a turn around success story over the last 18 months. All that now hangs in the balance. While they have got the cash on the balance sheet with interest rates so low (seemingly forever thanks Bernie) it's cheaper to fund the deal with debt. There will be plenty of bankers willing to lend the money trust me. As I said elsewhere a $1bn price tag puts it on a 10x EV/Sales compared to EA 1.2x and ATVI 2.3x.

Of course everyone will try and convince you it's a growth market and the earnings opportunity is exponential. Maybe it is. But PopCap would have to quintruple their sales even to be on ATVIs EV/Sales of 2.3x. That sort of puts into perspective. Do people think that's going to happen? Increase sales five times...really? Yes, it's a growth market but who really is making those exponential sales and profits... it's your behemoths at the top controlling the entire market, your Zyngas etc.

Basically EA numbers don't add up. This acquisition is the act of insanity and represents massive shareholder value destruction... but that never stopped companies in the past right?
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Darren Stewart Videogame investor 6 years ago
Very interesting article.

I actually tend to agree that there's a bubble and that's mainly based on the fact that when VCs, PE funds and the like talk to me about the valuations they do it mainly from a position of hype rather than insight. And these are people controlling huge amounts of money they are trying to place into this area.

Interestingly, I think the "old" video game industry has been in a bubble too over the past years. Can anybody remember Rage software at 70p, Eidos at 62, EA at $60, Ubisoft at 65? All those valuation were impossible to justify.

When these bubbles burst then the primary impact is that lots of investors lose a ton of money and the secondary impact is that those companies who are cash negative and are using their high valuation to raise funds from the market......eventually go bust as their access to cheap money disappears.

So, the healthy will survive and the the unhealthy won't. As it should be.

Personally I'm looking forward to the end of this bubble because the sooner people stop talking about consoles as "legacy system" the happier I'll feel and then the money for the traditional video game industry may come back on stream.

More chat and stuff on my website for people who want to talk about investing in the video game industry

PS EA a turnaround story? may be right in time but the jury is still out on that since they continue to be unable to make a profit.

Edited 2 times. Last edit by Darren Stewart on 24th June 2011 12:12pm

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Michal Doniec R&D Engineer, The Mill6 years ago version 2, start of the story.
Expecting the same end in a year or two.
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Michal Doniec R&D Engineer, The Mill6 years ago version 2, start of the story.
Expecting the same end in a year or two.
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Frankie Kang Producer / Consultant, First Post LLC6 years ago
Wow. $42mm in funding for a game that cost less than $1mm to develop (Angry Birds). Wow.
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Kim Pallister Director of Content, Intel6 years ago
Couple thoughts:
- $1B is a lot of money, but a lot lower multiple of earnings than some of the other examples you listed. NOt to mention Popcap's long track record makes them a lower risk
- $1B doesn't need to all be up front, or all be cash. Some could be based on hitting certain performance targets, some could be EA shares...
- It's not just about them as a studio. Popcap has a moderately successful games portal, portal businesses in Korea, China, and evergreen properties on tons of platforms.

@Frankie: Not $42 in funding for AB. $42 investment in what they believe that studio can do going forward, and on the value of the IP now. (I.e. winning loto tickets tend to be more expensive AFTER the draw)
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Rob Fahey Columnist, GamesIndustry.biz6 years ago
To clarify the EA comment - I think the numbers don't add up for EA because while the company does have about $1.5bn in cash assets at the moment, it's also been posting consistent quarterly losses in recent years. That makes it not impossible, but very risky, to drop the lion's share of that cash pool on an acquisition, especially one with a very high earnings multiple. As Graham observed already, the option of funding the acquisition through debt is of course open to EA - but taking on debt to fund an acquisition in a bubble market is lunacy, in my view, especially when your core business isn't profitable and hasn't been for some time.
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Raf Keustermans CEO, co-founder Plumbee 6 years ago
@Rob - Thx for the comment. However, I think a fair chunk of those losses were 'virtual' - i.e. they didn't really materially impact EA's cash position the last years. Also, a lot of losses were due to GAAP accounting rules, the way they had to account for certain digital revenues etc, I know e.g. that in one quarter last year EA lost hundreds of millions in GAAP and had a positive non-GAAP result, as well as positive cash flow from its operations. Just to say it's not that catastrophic...
Also, I believe a lot of the bad results are coming from EA's legacy business, with big upfront investments, huge studios, low margins due to retail and platform owners taking a cut + expensive licensing agreements. EA probably sees a PopCap acquisition as a way to accelerate their digital growth, and move away (to a certain extent) from it's packaged goods business?

The other interesting question that hasn't been brought up in this story, is: what does this mean for Playfish? And the EA Interactive business unit in general?
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Adam Parker Academic Coordinator, Qantm College6 years ago
Picks and shovels are the best investment in a goldrush economy. So middleware is the play right now... I'm waiting for a Unity IPO instead.
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The bubble was slightly different as the huge investments were being frittered away on paying for things like server infrastructure and website design ;) I think one difference today and maybe a lesson learned is that if you allow the shareholders to take some money off the table then that money stays in the ecosystem. People who just got rich out of founding a tech company don't just buy yachts, they re-invest it and found new companies with it. So although the money being splashed is large, I imagine a lot of it is going into the pockets of the shareholders and can be recycled. We're looking at massive disruptive influences (iPhone & Facebook are just 2) which is causing re-valuation of companies like PopCap who have a longer track record than most, have consistently made hit games, have an existing loyal customer base and have historically high ARPUs. These companies are very SCARCE. If EA could splash $800m on a hardcore games studio like Bioware/Pandemic a few years back, it makes perfect sense in the current market for PopCap to command an equally fantastic price.

Edited 1 times. Last edit by Andrew Eades on 28th June 2011 10:36am

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Graham Simpson Tea boy, Collins Stewart6 years ago
Wasn't Pandemic shutdown?
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