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The future is digital -- right?

The physical format faces headwinds, but will its demise be slower than we expect?

Did you get a physical game in a box for Christmas? Or better still, a new console? When it came to the new consoles you had two choices with either system: do you opt for the cheaper disc-less version, or the more expensive one that comes with an optical drive?

For years we have heard that the future is an all-digital world where physical media is dying. With that in mind, you would think the obvious choice is opt for the cheaper console -- after all, why spend more money unnecessarily? That message has not filtered through to most UK gamers, who tended to buy the more expensive disc-based console. According to ISFE's retail tracking Games Sales Data (GSD), over 75% of PlayStation 5 and Xbox Series X/S combined sales were for the disc-based console.

What happened to the all-digital future we keep on reading about? This essay will explore why, in the video game industry, consumer behaviour has clouded the direction of choice.

With the growing popularity of digital games, DLC and microtransactions, it feels as if the physical video game does not quite belong in this new digital world. Data from GSD reveals some ominous signs: FIFA 21 launched in early October in the UK, and by the end of its first week 69% of the games were downloaded when measured by sales value. If this is a secular trend it is hardly surprising when Goldman Sachs, an investment bank, concluded that the PlayStation 5 digital version will help accelerate digital-only games to account for 80% share of global game sales, compared to just 20% for physical games in 2025.

With the growing popularity of digital games, DLC and microtransactions, it feels as if the physical video game does not quite belong in this new world

Then there is subscriptions and streaming. In the last several years subscription has taken off with services like Xbox Game Pass, which has a membership heading towards the 20 million mark, if it hasn't already passed that threshold. With Stadia and Luna, Google and Amazon have both jumped on to the streaming bandwagon. Research firm Omdia has predicted cloud gaming revenues are poised to rise by 188% to $4 billion in 2021, before reaching $12 billion by 2025.

Faster internet speeds are another benefit. According to Limelight Networks, a content delivery network service, 87% of gamers globally find the process of downloading video games frustrating, with download times being the top bugbear. However, this will change in time as faster speeds neutralize download frustrations.

In sum, those who prefer physical games may feel increasingly squeezed by both digital and streaming gamers.

Let's get physical

The second quarter of 2020 is instructive of how the shift from physical to digital games globally coincided with the high street shutting down due to government rules to manage the spread of the COVID-19 pandemic. According to Sony, only 41% of Sony's PlayStation games in the second quarter were sold in the physical format, down from 55% in the same quarter in 2019. This only helped to consolidate PlayStation's revenue from digital sources -- including downloaded software, add-ons, and networking services -- which reached 77% of all global game revenue. GSD data for the UK shows a similar trend. Across the first three quarters of this year, physical game sales only accounted for 25% of sold units and 32% of sales value (among the 18 major publishers who share digital data with ISFE).

Sam_Naji

Sam Naji

All of this looks ominous for physical games, but this is not the complete picture. A lot of downloaded games are back-catalogue titles, and when it comes to looking at data for new games, especially for the first two weeks of sales, the story changes -- physical game sales accounted for 41% of sold units and 41% of sales value.

The holiday quarter of Q4 is even more productive for physical games. Last year, physical game sales in Q4 2019 accounted for 57% of sold units and 60% of sales value. Given the surge in digital downloads over the last several years it could be argued that the physical format is holding up well, and it appears that some gamers are determined to buy their favourite games in the physical format. The fact that so many console purchases were for the disc-based system is evidence that gamers want to have the option to buy physical format games, even if more gamers are gravitating to digital downloads.

An optical illusion?

The much-vaunted solid-state drive (SSD) is said to transform how games will be delivered on the new consoles from Microsoft and Sony: faster load times when booting up from standby; bigger open worlds in light of more effective system memory; more bandwidth to reduce texture pop-in; and an ability to just install a game's multiplayer mode or immediately enter into a specific part of a game. Sony claims that its new consoles will "revolutionize the game experience for users" -- but users first need to access the game experience in the first place, and therein lies a problem.

When Sony CFO Hiro Totoki noted that Sony's new console will have a negative impact on earnings, it seemed to be an admission that each unit will sell at a loss. It may take Sony three years to break even on the hardware, losing as much as $170 per unit, according to the Financial Times newspaper. When the two console giants decided how to compete on price, they both worked out what compromises had to be made. Hard-drive capacity appears to be a sacrificial lamb in helping to keep hardware costs down.

The new consoles have usable hard drives of less than one terabyte: the PlayStation 5 has 667 gigabytes of usable space, and the Xbox Series S has 364 gigabytes. Call of Duty: Modern Warfare, with all its patches, comes in over 200 gigabytes, and even smaller games like Red Dead Redemption 2 and The Last of Us Part 2 require 100 gigabytes in space. With a handful of AAA games on their consoles, gamers will have to start seeking out external hard drive solutions, such as the Xbox Series X drive card for $220 -- a pricey addition.

A lot of downloaded games are back-catalogue titles, and when it comes to looking at data for new games the story changes

Large games thus pose an issue of inconvenience. Those who do not opt for an external hard-drive solution, either out of choice or expense, will have to manage their library of games in the most efficient way. The fact is no matter how fast internet speeds get, they cannot beat the time it takes to pop in a disc and install a game from physical media.

There is also the advantage that these consoles are multimedia devices. As prices continue to fall for 4K televisions, gamers will be encouraged to upgrade -- not only to play games in 4K, but to have the flexibility of owning a multimedia console device, enabling the playback of UHD 4K Blu-ray discs, which in turn encourages investing in film libraries.

Last but not least, there are choices and perceptions of what a physical game means and how to use it, such as borrowing, selling, gifting, building a library that you can physically see, and having some control over ownership. That argument was well and truly won back in 2013 when Microsoft completely misread the consumer market with the unveiling of the Xbox One, and its online requirements. Gamers did not want that then and they most likely do not want that today, even if reality is cajoling them to have some sort of digital presence for almost all games.

Creature comforts

When the portable and digital-only PSP Go launched in 2009 Sony considered a program where gamers could trade in their Universal Media Discs from the original PSP. Unfortunately the Go flopped, partly due to a lack of features, and was replaced by the more successful PlayStation Vita.

Nevertheless, this laid the foundation for how someone with older games could be persuaded to upgrade their console, and Microsoft seems ready to take up the gauntlet. Its Smart Delivery service offers free upgrades to first-party games and any third-parties that opt-in going back to the original Xbox -- whether physical or digital games, and even on a PC.

This still won't be enough for some physical format aficionados. There are real concerns regarding game conservation, because if a digital-only game is delisted from an online store, for all intents and purposes that game is gone forever.

Damian

Damian Abrahams

Digital game distributer Fanatical found in a survey in early 2020 that collectors owned an average of 931 games. These people are dedicated, and one lucrative area for collectors, according to The New York Times newspaper, is factory-sealed video games for the Nintendo Entertainment System -- such as Nintendo's "black box" series, which features almost a dozen variations of the standard black packaging for Super Mario Bros. Nintendo has shown us that limited editions can even come in the digital format with the release of Super Mario 3D All-Stars, but this concept has its shortcomings -- there is no resale value, and it cannot be enjoyed with others. The question then arises: how important is sharing in this all-digital world we are marching into?

One way to look at the social aspect of video games is through the growing "sharing economy." According to PYMNTS, a payment news platform, the number of US adults participating in the sharing economy may reach 86.5 million in 2021, hitting $335 billion in revenue by 2025. The purpose of the sharing economy, or the "rental economy" with a more business-to-consumer slant, is to provide goods or services to users globally -- a company like Airbnb, for example.

Millennials encapsulate this move to more socially conscious decisions, with their penchant for travelling light and consuming less, despite having adequate spending power. For example, they will typically reduce their long-term financial commitments, such as using Uber instead of owning a car. This social trend seems to be a perfect reason to subscribe to Xbox Game Pass or another game subscription service, and shun buying a physical game. That is what Microsoft could be banking on with the cheaper format of the Xbox Series S.

Pricing power

One element where physical can still be relevant is in the resale market. Although the pool of pre-owned games will continue to fall as gamers buy greater amounts of digital content, the expense of buying new games could take its toll for many, especially during these uncertain economic times. Take-Two Interactive announced NBA 2K21 for PS5 and XboX Series X|S will have a price tag of $69.99, up by $10 on the previous generation of consoles. A few months later, during its PlayStation 5 showcase, Sony announced Demon's Souls and Destruction All Stars will also be sold for $69.99.

For some gamers, that $70 price tag could only be viable if a new game can retain its value after purchase and be resold

The industry defended these rising prices, particularly for AAA games. IDG president and CEO Yoshio Osaki referred to game pricing remaining flat for the last 15 years, whereas TV and movie prices have increased sharply, while production costs have gone up by 300% in some cases and development cycles can last up to six years. Take-Two boss Strauss Zelnick concurred, adding: "We deliver a much, much bigger game for $60 or $70 than we delivered for $60 ten years ago. It's a complete, incredibly robust experience even if you never spend another penny after your initial purchase."

Meanwhile, the contrasting strategies of Microsoft and Sony are striking. PlayStation boss Jim Ryan doubts the sustainability of a cheap-as-chips subscription-heavy model that Microsoft has gone for with its deflationary Game Pass. Microsoft contends it does not focus on console sale units but, instead, is betting on capturing an increasing number of players into its ecosystem, allowing it the opportunity to promote other parts of its business.

Sony, with its strong offering of first-party games, is indicative of an industry at the top of its game and brimming with confidence, so much so it can introduce higher prices in the middle of a pandemic. For some gamers, however, that $70 price tag could only be viable if a new game can retain its value after purchase and be resold -- something that is not possible if bought digitally.

Winds of change

It is a curious that some games cost more digitally are than their physical counterparts. A clue as to why might be traditional retailers competing fiercely for business with the likes of Amazon, which is able to sell physical games at a loss if it means recruiting new people to its Prime program to sell them other, profitable products. In contrast, buying a console means having access to only the PlayStation Network (PSN), Xbox Live or the Nintendo eShop platform -- akin to Apple's lucrative App Store walled garden. Discount-hungry digital gamers must wait until publishers decide to run a sales campaign and then pray their wished-for game is on discount.

Even PC gamers have a better deal, with a plethora of digital stores selling digital keys. Discounts can be generous as well. For example, Steam runs seasonal sales offering discounts of up to 90%, and this is largely because other digital stores for the PC are offering deals as well. For the console market, this structural anomaly will continue to be a modest tailwind for physical games.

Delays in game production is a headwind for the industry, though. Xbox's flagship Halo Infinite has been delayed until later this year, and it was not an isolated example. Cyberpunk 2077's release was postponed multiple times -- in hindsight, maybe more delays were needed -- and if game-fixing patches are getting bigger and bigger it almost makes the need for a physical disc a bit of a joke. Although the market is not there yet, we could see a possible future of digital-only releases (similar to how free-to-pay games are distributed) if publishers do not want to delay getting their games to market longer than necessary. If the decline in physical sales continues, outside the holiday season of Q4, there could come a time when publishers will eye that strategy if the demand is there.

There is another countervailing force which will make the convenience of digital downloading more appealing in the current environment. Changing consumer behaviour during lockdown is putting intense pressure on the retail industry. Even though consumers are avoiding stores and choosing to shop online instead, it does not mean they will get their products as quickly as expected. The pre-order disruption with the new consoles is a case in point -- even if Ampere Analysis, an analytics firm, still thinks nine million of these new consoles will be sold globally by the end of 2020. According to Retail Economics, a consultancy, most UK retailers are not equipped for a 50% share of online sales, nor for the possible 15% spike in sales over the festive period. One of the issues is that supply chains are operating in slower, socially distanced warehouses. Another is delivery constraints, so much so that some delivery companies have imposed parcel limits on retailers.

The pandemic will pass, and high street shops will reopen, but its legacy will reverberate for years to come. In times of uncertainty, familiar brands often do well as people seek comfort in what they know. The Q4 period is the cash cow for the physical games market, making up over 40% of physical sales for the year. Given the pandemic and the surge in downloaded content during 2020, that trend will have been tested.

Sam escaped an early career in finance and now combines his passion for video games and analytical experience to provide consultancy services. Damian is a market analyst with over 15 years experience, including 12 years at Microsoft Corp. He joined Sam as a consultant in 2020 to provide insights on how the macro environment is impacting the video game industry.

If you are interested in getting to know more about GSD and B2Boost and how they can help you with video game analytics, please send an email to sebastien.vanvyve@b2boost.com.

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