FreeToPlay.biz The Business and Design of Free-To-Play Games

23Aug/0713

US Publishers Can’t Buy Asia’s Virtual Goods Lead

Last month my family traveled to London, a city of less than 500,000 in Southwestern Ontario. While there, I watched my 7 and 13 year old cousins, Brad and Kyle, play games on their family computer.

Somewhat surprisingly, Brad and Kyle had just one retail PC game between them (Settlers). Instead, their favorite games were Puzzle Pirates, Habbo Hotel, and Runescape - all free to play, virtual item sales games (with the exception of Runescape, which uses tiered subs rather than virtual items for its revenue).

What does this say about where the North American PC market is headed?

Based on overwhelming anecdotal evidence, it's clear to me that the younger set (under 20) is embracing free to play and virtual goods games because the budget and engagement model is tailored made for for them. And as the younger set is further weened on the same virtual goods business model that's already dominating Asia, retail only pay-to-play PC games will be ignored en masse.

In some respects, North American companies have begun adjusting to the F2P/virtual goods wave. With gifting sites like Facebook and HotorNot.com, microtransaction services like Xbox Live and casual MMOGs like Puzzle Pirates, one might argue that we're at least keeping up with the pack in this emerging space.

But what are traditional North American game publishers (EA, Activision, etc) doing to adjust to this new, non-retail, online-centric business model? Are they seeding their own internal virtual goods projects? Building virtual goods into their existing or upcoming products? Acquiring early movers in the space?

At least right now, the answer appears to be "none of the above".

North American game companies are taking the same "partner and acquire" approach that they've used to achieve growth and purchase innovation for the last two decades. When done correctly, this approach pays off handsomely. Activision partnered with Infinity Ward to produce the first Call of Duty, then opted to purchase the developer for a meager $5M just before Call of Duty 1 shipped. Activision knew that when CoD became a big hit, Infinity Ward's asking price would grow immensely due to their successful IP.

In another bit of foresight, Take Two bought Irrational in 2005 for just $8.2M. Last week, Irrational delivered Bioshock - the highest rated new IP in years. If Irrational were for sale today, their asking price would likely be 5-10x what they sold for.

But studios with already successful IP (or a track record that indicates their next game will be huge as well), command a larger acquisition premium than the aforementioned deals.

For example:

IP Acquisitions

Track Record Acquisitions

But an even larger premium is paid for companies that couple good IP or a good track record with an online-only distribution model.

Online Acquisitions

Why the higher acquisition premium? Because online-only companies such as Club Penguin, Shanda, Netease, etc routinely see annual profit margins of 50% or more.

Look no further than Club Penguin making $35M profit on $65M annual revenue.

By contrast, retail game sector margins have been in decline ever since the last big reduction in costs: the move from carts to CDs in the mid-90s. Development and distribution costs have risen so dramatically in the last two console generations that EA's net income has declined 87% since 2004, Take Two has lost $90M total over the last six years (50M units of GTA sold and still a loss?), and Ubisoft and THQ are considered a profitability leaders at nearly 10% annually. *

So it's no wonder that deals like Disney/Club Penguin and EA/JamDat have much higher valuations than their retail counterparts. They have a far better ROI.

But let's get back to my point: the "partner & acquire" approach Western companies have traditionally used to internalize innovation will likely prove cost prohibitive as it's being applied thus far in the virtual goods space.

Some of the recent virtual goods partnerships made by publishers include:

These are all great relationships, but they are bridging strategies primarily suitable for the short to medium term. The acquisition portion of these partnerships would be cost prohibitive. Which North American game publisher would be able to afford the acquisition cost of a Nexon or Shanda based on the latter companies' very healthy margins and rapid revenue growth?

Let's use Shanda and THQ's most recent Q1 2007 results as an example.

THQ (Q1 2007)

  • Gross Revenue: $139M (down 12% from previous year)
  • Profit: -$10M (net loss)

Shanda (Q1 2007)

  • Gross Revenue: $68.8M (up 61% from previous year)
  • Profit: $58M

Western companies have huge revenues, but even huger development costs owing to their terrestrial products - resulting in little or no profits. Eastern companies have smaller (rapidly growing) revenues, huge profit margins from online only distribution and a big head start on virtual goods. This contrast holds more or less true for most of these Western/Eastern partnerships.

Shanda's market cap today is $2B. It's not far-fetched to assume their purchase price might be close to $3B. The only companies with that kind of cash on hand are EA and Microsoft.

While it could be a partial stock deal, why would Shanda would trade their high growth stock for low growth publisher stock? Any partial stock transaction would ultimately result in a higher overall purchase price.

Netease (NTES) has a market cap of $2.06B. The9's (NCTY) market cap is $1.14B. Nexon is privately held, but with $235M in revenue two years ago, they won't be cheap either. The point is, there aren't many deals left among the virtual goods establishment.

The billion dollar question is: Where will these numbers be next year? Or in 2-3 years?

My gut says that in two years, North American companies will be "priced out" of acquiring a leadership position in the global virtual goods market.

To avoid this fate, big American publishers need internally developed/wholly owned virtual goods projects or partnerships with newer, smaller virtual goods companies whose acquisition costs are far below the big Asian players such as Shanda, Netease, Nexon, The9, NHN, etc.

So...

  • When will we see early stage virtual goods startups acquired by game publishers in massively undervalued deals a la ATVI/Infinity Ward? Are the big publishers even capable of spotting these deals as well as venture capitalists? Companies like Conduit, Three Rings and Areae would be prime targets for early acquisition if VCs like Charles River and others weren't already all over them. Venture capital's eagerness to fund low risk/high margin virtual goods plays (and not high risk/low margin retail game companies) will drive innovation in the sector, ratcheting up acquisition costs for publishers are late to the party.
  • When will we hear of internally developed virtual goods projects underway at major publishers? Perhaps EA and Ubisoft's new casual games focus will bring about the next big Flash MMO or virtual world, but I can't help but think most of their attention is still on on the try-before-you-buy $20 casual games, rather than F2P/virtual goods. Ironically, some of the biggest stateside-initiatives in free-to-play are coming from Asian companies like Sony Online (FreeRealms) and NCsoft (Dungeon Runners).

Until we see big American publishers announcing more than stop gap Asian partnerships, I'm concerned that the next generation of gamers - my cousins Brad and Kyle in London, Ontario - will be playing even fewer games from today's North American publishing giants.

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Notes:

* For more of these numbers, check out the GAAP financials for big publishers using this link to EDGAR, then enter a stock ticker like ERTS to get to a 10-K form like this one for EA. Search for "statements" or "2004" and keep going until you get a table with last five years or so, then check out the net income row.)

Comments (13) Trackbacks (4)
  1. Adrian, extremely insightful post. Will be thinking it through on the train this evening and will be posting a follow up on my blog. Lets get a dialog going here.

  2. Adrian, well said! Most US mainstream publishers don’t even have a coherent, comprehensive online strategy, much less a virtual goods one.

    SOE (don’t forget their online collectible card games), Disney (ditto), … thats about it.

    The Korean game invasion may make the Japanese car invasion look like a picnic… and it is probably going to happen fast.

    It may not wind up being as visible as you or I would like, however. Given that most of these companies are not traded publicly on the US markets and that they don’t buy US market research data (Gartner, IDG, etc. pretty much ignore non-Japan Asia for gaming)… there won’t be much to see except for the steady, slow decline of the US publishing industry.

    Their fate is in the hands of Sony, Microsoft, and Nintendo – which should make the companies, and their shareholders, nervous.

    Of course, the sad part is this should not be hard.

  3. Adrian, well said! Most US mainstream publishers don’t even have a coherent, comprehensive online strategy, much less a virtual goods one.

    SOE (don’t forget their online collectible card games), Disney (ditto), … thats about it.

    The Korean game invasion may make the Japanese car invasion look like a picnic… and it is probably going to happen fast.

    It may not wind up being as visible as you or I would like, however. Given that most of these companies are not traded publicly on the US markets and that they don’t buy US market research data (Gartner, IDG, etc. pretty much ignore non-Japan Asia for gaming)… there won’t be much to see except for the steady, slow decline of the US publishing industry.

    Their fate is in the hands of Sony, Microsoft, and Nintendo – which should make the companies, and their shareholders, nervous.

    Of course, the sad part is this should not be hard.

  4. Adrian, well said! Most US mainstream publishers don’t even have a coherent, comprehensive online strategy, much less a virtual goods one.

    SOE (don’t forget their online collectible card games), Disney (ditto), … thats about it.

    The Korean game invasion may make the Japanese car invasion look like a picnic… and it is probably going to happen fast.

    It may not wind up being as visible as you or I would like, however. Given that most of these companies are not traded publicly on the US markets and that they don’t buy US market research data (Gartner, IDG, etc. pretty much ignore non-Japan Asia for gaming)… there won’t be much to see except for the steady, slow decline of the US publishing industry.

    Their fate is in the hands of Sony, Microsoft, and Nintendo – which should make the companies, and their shareholders, nervous.

    Of course, the sad part is this should not be hard.

  5. Adrian, well said! Most US mainstream publishers don’t even have a coherent, comprehensive online strategy, much less a virtual goods one.

    SOE (don’t forget their online collectible card games), Disney (ditto), … thats about it.

    The Korean game invasion may make the Japanese car invasion look like a picnic… and it is probably going to happen fast.

    It may not wind up being as visible as you or I would like, however. Given that most of these companies are not traded publicly on the US markets and that they don’t buy US market research data (Gartner, IDG, etc. pretty much ignore non-Japan Asia for gaming)… there won’t be much to see except for the steady, slow decline of the US publishing industry.

    Their fate is in the hands of Sony, Microsoft, and Nintendo – which should make the companies, and their shareholders, nervous.

    Of course, the sad part is this should not be hard.

  6. Thanks for your comments, Steven and Darren.

    Great quote about the Korean game invasion, Steven. You’re absolutely right. The pace of innovation in this sector is lightning fast and valuations are increasing daily.

    The irony is that the relatively minimal development dollars it takes to get a pilot virtual goods project going is nothing compared to what’s routinely spent on “Triple A” games.

    But like you said, most game pubs lack on online strategy at all – or any idea how to do P&L on an online-only product (“How will we market it? What will Sales do?”).

    As a result, $2-$5M virtual goods projects with huge potential upside are being neglected for $10-$25M, high risk console games.

  7. And they all have a ton of existing “dead” IP that they could build on – with art assets and perhaps reusable game designs, so they should be able to do this even more cheaply than you are estimating.

    Time to dust off all of those last generation games, whether they were hits or not.

    This is actually the brilliant thing that Shanda did. They were hurting badly with their online games since they were becoming dated. Instead of trying to build new games, the company has switched to the Virtual Asset Purchase model with their existing games… and now they are kicking a**.

    Maybe they’ll listen to some business consultants, since they won’t listen to the troops? :)

  8. And they all have a ton of existing “dead” IP that they could build on – with art assets and perhaps reusable game designs, so they should be able to do this even more cheaply than you are estimating.

    Time to dust off all of those last generation games, whether they were hits or not.

    This is actually the brilliant thing that Shanda did. They were hurting badly with their online games since they were becoming dated. Instead of trying to build new games, the company has switched to the Virtual Asset Purchase model with their existing games… and now they are kicking a**.

    Maybe they’ll listen to some business consultants, since they won’t listen to the troops? :)

  9. And they all have a ton of existing “dead” IP that they could build on – with art assets and perhaps reusable game designs, so they should be able to do this even more cheaply than you are estimating.

    Time to dust off all of those last generation games, whether they were hits or not.

    This is actually the brilliant thing that Shanda did. They were hurting badly with their online games since they were becoming dated. Instead of trying to build new games, the company has switched to the Virtual Asset Purchase model with their existing games… and now they are kicking a**.

    Maybe they’ll listen to some business consultants, since they won’t listen to the troops? :)

  10. And they all have a ton of existing “dead” IP that they could build on – with art assets and perhaps reusable game designs, so they should be able to do this even more cheaply than you are estimating.

    Time to dust off all of those last generation games, whether they were hits or not.

    This is actually the brilliant thing that Shanda did. They were hurting badly with their online games since they were becoming dated. Instead of trying to build new games, the company has switched to the Virtual Asset Purchase model with their existing games… and now they are kicking a**.

    Maybe they’ll listen to some business consultants, since they won’t listen to the troops? :)

  11. Better yet, listen to the players, or lack there of… Seems like the answer lies within the community.

    I do think the cultural differences between the Asian games and those that are achieving a certain amount of success in the West are a little more of a barrier than is being portrayed.

  12. Aye R.B, and another barrier is that the F2P Korean MMOGs are just plain AWFUL. Simplistic, shallow, tedious, boring. Yes they’re very pretty but after a few hours play it becomes obvious that the sole reason they exist is NOT to provide a fun play experience, but rather to make a buck.

    Minimalist hacks cobbled together in months and thrown against the wall to see if they stick is the impression i get.

    Compare that to the depth and quality of WoW, or the upcoming Warhammer Online, Age of Conan, and Tabula Rasa. There’s just no comparison.

    One major market MMOG that is planning free play is The Agency from Sony, still in pre alpha development. http://www.mmorpg.com/gamelist.cfm/setView/news/gameId/292/showArticle/8562

  13. I guess I am one of the Korean invaders. Just a small one. It is true that Korean companies (or Asian companies) are leading the market. But the market is still small compared to the entire gaming market. (No doubt about it’s going to be the next big thing though.)

    What I am afraid is that once US publishers are convinced to pursue thie market, they will get it right with their abundant resource – people, network, brand power and of course money. Not to mention they have more to leverage with.

    It’s a very typical pattern. If there is an emerging market, usually small players gather around. Once the market gets big, only top players survives through M&A or funding then the influx of big fat MNCs.

    I may be wrong on this. But a barrier to entry is still relatively low. Hence a better chance for US publishers to penetrate the market.


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