January 31, 2018
The Video Game Industry: A Disruptive Force Awakens
It's not game over for the video game industry, which is evolving along with the latest disruptive technological and demographic trends.
Throughout history, technological advancements have led to enormous changes in society. The railroad, the automobile, refrigeration, television and more recently the Internet and mobile devices have all changed how we live. Today, these technology trends are driving a major shift in consumer preferences across all industries and disrupting major profit pools worldwide. At MFS, the Growth Equity team monitors the "creative disruption" theme closely as it has major implications for how we invest. While examples are numerous, we believe the alpha opportunities from creative disruption come in two flavors — identifying potential disruptors and avoiding those that are at risk for disruption.1
Changing consumer preferences has been one common element of disruption across industries. We have been evaluating the $108 billion global video game industry (2017 estimate) through this lens for several years.2 While the industry is mature — one of the earliest video game hits, Pong, was released by Atari in 1972 — it has evolved into a significant disruptive force, primarily for two reasons. First, the Internet has enabled video game makers to establish a direct and more profitable relationship with customers. Second, video games have exploded in popularity as a leisure activity and source of entertainment and have the potential to disrupt the advertising, entertainment and sports industries. In this article, we will focus on the impact of digital disruption.
The evolution of gaming: From Pong to Candy Crush Saga
The video game industry is geographically segmented (in terms of revenues) throughout Asia, North America and other regions, as shown in Exhibit 1. Money started pouring into the industry in the late 1970s after the success of titles like Pong. Advances in console technology have driven a progression of content creation and customer adoption since then.
For most of its history, video gaming was an expensive and risky proposition, with publishers often uncertain as to the lasting power of any particular game title. Each year's content releases felt like a spin of the wheel to determine which titles would be successful, with associated uncertainty related to console development cycles. These characteristics reduced valuations for these models and lessened their visibility within MFS, as video game publishers did not fit into our focus as high-quality, durable franchises due to their volatile, high-risk profiles and sub-par return structures.
A key development in recent years, however, has been the disruptive transition to video game consoles that are connected to the Internet. This has allowed for full games to be downloaded instead of purchased as hard copies and for additional downloadable content to be released after a title has come out. Another key development has been the popularity of free downloadable and mobile games such as Candy Crush Saga, for which consumers can purchase add-ons and other enhancements via micro-transactions that are made within the game. These types of sales are disrupting the manufacturing, marketing and distribution model that existed for decades.
There are still a few bugs in the digital framework, but we believe direct digital downloadable content is a much more profitable way to develop and distribute content directly to consumers so as to deepen the sales relationship and increase engagement and the longevity of the content. A digital dollar produces a much higher gross margin (20 percentage points) than a console dollar because companies are selling direct to the consumer without having to sell a packaged game disc through a retail outlet. Publishers can focus their development efforts around outcomes, which has dramatically changed the financial metrics in these models to more durable cash flow streams with greater visibility.
Investors should always remember that everything is always changing, which inherently leads to fixed views having a high likelihood of error over time. Video games are a great example of that reality, as they are now vastly different than five or 10 years ago. The industry needs to be approached with a fresh perspective. Digital technology is putting into question the historic earnings potential of models across the consumer landscape: from the brick and mortar stores that sell products to the product companies themselves. Companies are also concerned with which media content is being consumed and how. We believe the industry has become more attractive as some companies have demonstrated high-profitability, cash stream–generating models with underlying secular growth and structural support for longer-term durability. The MFS Growth Equity team is always searching for ideas we think will continue to benefit from disruptive changes in digital technology where alpha can be generated and value created over time.
Please check back here soon for the second of our two-part series on creative disruption in the video game industry.
1Alpha is the difference between a security’s expected return (based on its beta, or market return) and its actual return. Beta is the measure of an asset’s risk in relation to the market. A security that moves in line with the market is said to have a beta of 1.
2Newzoo, 2017 estimate of the global video games market. April 2017.
3MFS Investment Management analysis based on reported corporate data.
The views expressed in this commentary are those of the authors and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any other MFS investment product.