Since their birth over 50 years ago, video games have evolved from the arcade to home consoles to mobile devices. Despite these changes, most people continue to acquire one game at a time, either in physical form or via download. Whether single- or multi-player, nearly all games are played using local hardware. This dependence on local hardware and single-game purchases stands in stark contrast to the all-you-can consume, streamed-from-the-cloud model that is taking over noninteractive media like video and music. Platforms like Netflix and Spotify have been widely adopted, but their video game counterparts have yet to gain the same level of popularity.

Despite the apparent lack of demand, we see a number of new and recent entrants attempting to build and sell the next subscription and cloud gaming service models. While these services are coming from deep-pocketed companies like Google, Microsoft, and Apple, we expect that the traditional methods of consumption, as represented by the ninth-generation consoles from Microsoft and Sony, will remain the most important drivers of growth and value for most game publishers. We believe that subscription and cloud gaming services will be additive for most gamers and publishers, instead of taking over, and that the impact of these services could affect how data is shared across the gaming ecosystem at the margin. We expect companies with high-quality franchises and development capabilities will continue to attract large audiences, and further fragmentation of distribution should generally prove positive for the economic moats of the four game publishers we cover: Activision Blizzard (ATVI), Electronic Arts (EA), Take-Two Interactive (TTWO), and Ubisoft (UBI).

Beyond game distribution, a source of worry is the continued regulatory focus on microtransactions, which have become a major component of the expected return for games, even full-priced ones. While larger markets like the United States and United Kingdom had previously viewed random-chance loot boxes and the like as benign, more recent actions in both countries may change how these microtransactions are regulated. While we agree with the market consensus that the industry will self-regulate to mitigate and delay any formal regulation, we are less confident that this approach will work in the long run.

We believe the video game publishers we cover are fairly valued to undervalued despite our neutral view, relative to the market’s positive view, concerning the impact of subscription plans and cloud gaming and our slightly higher concern level about the potential of the regulation of microtransactions. We prefer Activision Blizzard given its more diversified revenue by platform, strong core franchises, and potential upside from its larger exposure to esports.

Are Gamers Ready to Switch How They Consume Video Games? (Probably Not)
While full-game downloads are starting to replace physical video games, the vast majority of video games are still purchased as a single unit owned by the end user. This is in stark contrast to other media forms–video and music–that are increasingly consumed via all-you-can-consume services like Netflix and Spotify. Over the last five years, a number of new subscription services from platform holders and publishers alike offer an all-you-can-consume video game experience. Despite the seemingly good value provided by subscription services, consumer interest has been relatively tepid. We believe a main reason for the underwhelming demand is that users consume video games in a much different manner than filmed noninteractive media, making an all-you-can-consume model less necessary and less desired for many gamers. Over the medium term, we believe a mixed ecosystem of subscription and single-game purchases is more likely than a complete switch to an all-subscription model.

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Most video game subscription services differ from their noninteractive counterparts in their lack of streaming capabilities. Instead, the video game offerings still rely on powerful local hardware to run the downloaded games. Also, consumption patterns for video gamers are very different than the consumption habits for noninteractive media. Consumers may watch over 150 hours of multiple television series or films in one month, while gamers may only play one or two games for 45 hours a month, making the need for an all-you-can-consume service less necessary for gamers.

We view Microsoft’s subscription service, Xbox Game Pass, as an additive to full-game purchases in the game ecosystems on both Xbox and the PC. The company believes that users desire a curated leaner library of rotating titles as opposed to the all-inclusive model offered by video and music services.

EA expects to gain a greater share of the gamer wallet via its Origin Access Premier service despite offering games on the date of launch. We worry that the service and Ubisoft’s recently launched Uplay+ may be attracting hardcore players who would have spent more via single-game purchases.

To overcome the lack of a need for an all-you-can-consume service, we think subscription services will need to feature games from multiple publishers along with access to titles when they are launched. Even with these features, we still expect many gamers to purchase individual games.

If the consumption model switches to all-you-can-play, we project that gamers will continue to gravitate to the best games with emphasis on gameplay and graphics. With their larger financial resources, massive development teams, and investment in research and development, the larger game publishers–like the four companies we cover–should be able create, market, and support major AAA blockbuster titles regardless of the distribution method.

Will Gamers Stream Everything From the Cloud? (Not Quite Yet)
Streaming games from the cloud is a longtime goal for several of the largest video game companies. Despite previous failures, numerous competitors, including Google and Microsoft, appear to be entering that market, following Sony’s lead. However, the supply may be outstripping the demand for cloud gaming, particularly for replacement platforms like Google Stadia. Additionally, the requirement to use a controller may limit the attractiveness of playing console-quality games on a mobile device or tablet. Regardless of the drawbacks, we expect a number of major companies to launch cloud gaming services during the next five-plus years.

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Potential positive aspects of cloud gaming include a lower cost threshold for playing games, gaming on the go, and the elimination of the cost of and need for hardware upgrades. This is balanced by the negative aspects that include additional latency, lack of offline play, broadband data usage, and the loss of games if a service shuts down.

For major publishers, a highly competitive cloud gaming market with multiple deep-pocketed players could be a positive development that helps lower the take rate and expand the overall market. This is balanced by the possibility of another monopoly or oligopoly emerging as seen in consoles, mobile app stores, and PC digital storefronts.

We see three emerging models for cloud gaming: console and/or gaming PC replacement (Google Stadia, Nvidia GeForce Now), console extension (Microsoft Project xCloud, Sony PlayStation Now), and full PC replacement (Shadow). We think the console extension model will be the most successful in attracting users, as it allows gamers to keep their games while also expanding the number of devices games can be played on.

We expect that the demand for cloud gaming, specifically console replacement offerings like Google Stadia, to be weaker than the market expects over the next three to five years. The demand will not materialize until the platforms can either develop or purchase a number of must-have exclusive games.

Next Console Generation Will Preserve Gaming Model
The video game console remains an indispensable platform for both gamers and video game publishers despite the rise of mobile gaming, the resurrection of PC gaming, and the coming onslaught of cloud gaming platforms. The next generation of consoles will launch in the 2020 holiday season with the launch window for the Xbox One successor already announced and the PlayStation 5 projected to match its competitor. While the consoles will feature a number of upgrades, including improved internals, higher resolution, and support for graphics features like ray-tracing, we project that the status quo will continue for consoles (and game publishers) as older features like physical discs will continue to be supported despite the growth in full-game downloads and the advent of cloud gaming.

Video game consoles continue to drive revenue at the four publishers we cover. EA, Take-Two, and Ubisoft all generate over 60% of annual sales on the platform. While Activision Blizzard is less dependent, we project that console revenue will hit almost $2 billion in 2019, a transitional year for the company.

Although we are less than 18 months from the launch window for the ninth console generation, Microsoft and Sony are withholding some key details on the Xbox One successor and PlayStation 5, including price, cloud gaming support, and specifics about the CPU and GPU. We project that the companies will try to match the pricing from the last generation by launching their respective consoles at $399.

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We expect this generation to be focused on refining 4K graphics, increased digital distribution, and improved virtual reality. Both consoles have announced backward combability support for games from the previous generation. By using a similar CPU architecture in the eighth- and ninth-generation consoles, Microsoft could offer “forward combability” similar to the PC gaming space, making the Xbox One X the base platform and its successor the recommended one.

Regulation Could Threaten Growth From Microtransactions
Over the last 15 years, microtransactions have moved from a nice-to-have boost to revenue for AAA games to a major component of the expected return, even for full-priced games. This transition has helped improve the return on AAA games, even as production costs continue to escalate and game prices are at their lowest level on an inflation-adjusted basis. The adoption of microtransactions has not always been smooth; gamers of certain genres and regions have welcomed the practice of adding costs for gamers with more open arms, while others continue to rail against the practice. This backlash has led to more governments examining microtransactions, particularly randomized ones known as loot boxes or loot crates. While Belgium and the Netherlands have investigated and fined or banned games for contravening gambling regulations, larger markets like the U.S. and U.K. had previously viewed loot boxes as being more benign. However, a recent investigation in the U.K. and legislation in the U.S. may change how these microtransactions are regulated. While the industrywide move to disclose drop rates for console games may help alleviate some governmental pressure, it does not remove the Skinner box mechanism built into randomized microtransactions.

The recent recommendation by the Digital, Culture, Media, and Sport Committee of the British House of Commons that loot boxes be treated as gambling despite a lack of real-world trade-in value for prizes could have wide-ranging effects on the regulatory treatment of randomized transactions. We expect that the industry will self-regulate to mitigate and delay any regulations, but an acceptance of this concept would preclude the use of randomized microtransactions in almost every game due to the prevalence of minors in gaming.

While the likelihood of the U.S. government banning or regulating microtransactions is low despite the recent bill introduced into the Senate, we expect the topic to continue to arise as the issue of minors potentially being induced to gamble is a potent draw for publicity-hungry politicians.



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