Online, Social, and Mobile: The future of the video games industry

January 2011

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In this sector briefing we cover the video games industry which is arguably one of the hottest segments in the entertainment and digital media sector. We focus exclusively on relatively new segments and business models that are shaping the future of the industry. Virtual goods based monetization is gaining traction across the board. Social gaming, referring to games leveraging social relationships of players, is dominating headlines and has emerged to become a multi-billion dollar industry in just a few years. Boosted by the sheer number of devices out there, mobile games have experienced a meteoric rise. Even businesses with a somewhat longer history such as browser-based massively multiplayer online games (MMOGs) and virtual worlds are currently in a dynamic phase. Finally ‘recommerce’ (trade of used / pre-owned physical games) is capturing value by weeding out inefficiencies in the secondary market for video games. We look at key trends and drivers in all these highly dynamic markets. For this purpose, we draw heavily from expert interviews as well as first-hand corporate finance execution experience in the sector. We are bullish on the M&A and venture capital financing prospects of the sector.

Introduction: A fundamental shift

Figure 1 shows the remarkable transformation that the industry has gone through in the last 10 to 15 years. The advent of online, social and mobile gaming has opened up the gaming industry to a much wider audience beyond the traditional target group of ‘hardcore’ gamers. Traditional video games continue to thrive (note that in November 2010, Activision’s Call of Duty Black Ops grossed an impressive USD 650 million within the first 5 days of launch and Microsoft's next generation controller, Kinect, sold 25 million units within 25 days); only that they now represent a part of a larger ecosystem. We live in a world where nearly everybody plays games. We argue that it is this central shift that is leading to a radically larger pie.

Traditionally, box sales (along with one-off console / PC sales) essentially drove the market. New business models such as subscription, pay-per-download and freemium (based on virtual goods sales) are disruptive and have taken value from publishers and retailers. The freemium model is perhaps the most influential of these: gamers can play for free but can customize or improve game play by purchasing ‘virtual goods’. The emphasis here is on the continuing average revenue per user (ARPU) and life time value of the customer (LTV) rather than the one-off retail price. Most social and browser-based games as well as virtual worlds rely on this model for monetization. Mobile games are primarily deploying the pay-per-download model as users lap up applications from one the many popular app stores.

Diversified (micro) payment channels available have been key enablers of the aforementioned freemium and pay-per-download models. Additionally, advertising as a means of monetization of games is expected to grow rapidly, albeit from a smaller base. Even with traditional box sales, recommerce has changed the world order forcing publishers to come up with new strategies.

Further, games are not only being played on consoles and PCs but also in browsers, on social networks, mobile phones, connected TVs and other portable devices. Increasingly, the user is looking to place-shift his games, i.e. he expects to access his games from any device of his liking.

Online gaming has potentially been the single biggest change in the industry for decades. Rich interaction with other players across the world has given gaming a whole new dimension. In December 2010, World of Warcraft, a client-based online game, sold 3.3 million copies of its new edition within 24 hours creating a new record. Social games go a step further by allowing ‘friends’ to play with each other. While they may be less sophisticated in terms of graphics and artificial intelligence compared to their console / PC cousins, they rely on intelligent social and behavioral paradigms to effectively engage gamers and monetize them. The latest success story is Zynga's CityVille which attracted more than 70 million active users within one month from launch and is the first game to have cracked the 100 million monthly active users ("MAU") mark.

One of the fastest growing markets

All these radical changes are expected to continue contributing to the growth of the industry at large. According to PricewaterhouseCoopers (PwC), video games will be the second-fastest growing market in the entire media sector, trailing only Internet Advertising. While console games are expected to show slower growth (5.9% CAGR), PC games are even expected to decline slightly. Worldwide online gaming market revenue is forecast to reach USD 13.7 billion in 2013 growing at a CAGR of 10.6%.

Driven by better connectivity, increasing smartphones usage with superior user experience, the mobile gaming market is expected to hit USD 13.4 billion by 2013. Most radically of all, the social gaming industry has stormed into public consciousness growing to a USD 720 million market in 2009. It is expected to grow to USD 2 billion by 2012 (Source: ThinkEquity, 2009).

Trends and development of key segments

Virtual goods based monetization catches on in the Western world	Freemium models allow the user to choose whether or not he purchases certain additional features within a game. As there are no initial costs involved, a larger number of players can be attracted to the game through this model. It is estimated that virtual goods worth USD 6 billion will be sold in 2013. The share of the largest Western market, the USA, is projected to rise from 28% to 41% of the total global market. The successful MMOGs Lord of the Rings and Dungeons & Dragons recently switched from a subscription-based model to the freemium model with the latter game experiencing revenue growth of 500%. Most online and social games (including the immensely successful Farmville) as well as virtual worlds (with the notable example of subscription driven World of Warcraft) are now powered by the virtual goods model. Know-how of appropriate placement of virtual goods within games is now critical for success of most gaming firms.
Micropayments and social monetization tools	The growing penetration of micropayments has been very important for the success of freemium model. Now that virtual goods sales have taken off, we expect online and mobile payment firms to reap the rewards. Credit card-based sales remain dominant in the USA but mobile and online payments are catching up. Europe and Asia already have well developed mobile payment channels. Innovative non-cash payment mechanisms are also emerging. There is a consensus in the industry that making the users pay for the first time constitutes something of a holy grail. New indirect methods facilitate conversion of non paying users to paying users. dealunited and others allow players to pay for virtual goods by purchasing or trying out another (unrelated) item from one of their partners’ stores. Leading players in the online gaming world such as BigPoint, Gameforge, gPotato, 6waves and Perfect World are using such indirect monetization techniques. Other approaches such as those from FreeCent dole out virtual goods when users watch advertisements.
Social gaming market matures	The massive growth in social gaming within a span of only 3 years has seen the industry go through various transformations in fast-forward mode. (See Figure 5) In what is referred to as the ‘gold rush / wild west’ by industry experts, the first phase of growth was marked by high virality (bordering on spam), negligible acquisitions costs, low quality games and poor monetization. When Facebook decided to restrict notifications / publishing of applications-related news feeds around mid-2008, developers were forced to at least partly rely on paid user acquisition. With higher budgets required for user acquisition, scale started becoming important and a handful of larger players began emerging. The larger players have now developed a portfolio of higher quality games and attempt to effectively cross-promote them. The idea is to send a particular user to the exact game where he is likely to spend the most money. Higher quality games require higher budgets and longer development cycles. Social gaming is now in the big business phase. Watch out for: Disruption: Despite the benefits of scale, we expect smaller players to continuously challenge the ‘incumbents’. In 2010, the runaway success of Digital Chocolate’s Millionaire City has proven that a smaller firm with a good game and good market timing can make it big. Branded content / media IP: Media firms could potentially deploy their content IP to create social games. We could also see moves from IP owners such as Hasbro (cooperated with EA) and Mattel (cooperated with RealNetworks) enter the market directly or through licensing agreements. Non-Facebook activity: As opposed to common perception, social games are not only enjoying traction on Facebook (Facebook with its 500 million is the most important platform for social gaming). In countries such as Russia, where Facebook does not have a dominant position, local social networks such as VKontakte are very important. Vostu and Mentez, both social games developers, are focusing on Brazil where the most popular social network is Google owned Orkut. Hi5 is now positioning itself as a site for social games and no longer as a generic social network.
Browser Games, hidden champions	While social games have enjoyed the most attention over the past 2 years, browser games (played directly on a dedicated or publishers’ website) continue to monetize their loyal audiences very well. In particular, highly interactive MMOGs are doing well. Significantly, European players are increasingly prominent in what used to be a largely Asian show. While they don’t yet resemble their Far Eastern cousins (Ncsoft, NHN, Shanda and Co.) in terms of size or breadth of offering, they are growing rapidly. Hamburg (DE)-based publisher and developer BigPoint had an excellent year reportedly doubling its top line. Other successful MMOG developers in Europe include Jagex (UK), Ankama (FR) and Travian (DE). A new breed of emerging players in this segment includes Owlient (FR), upjers (DE) and Innogames (DE) and eRepublik (ES). Publishing upstarts such as worldwide games (DE) could gain traction in the coming years while smaller developers may also try their hand at publishing to reduce dependence on own hits. Key trends in this segment: Increasing competition in the West: We will see Asians coming to the Western markets through organic or inorganic initiatives. Social gaming and browser games are expected to continue stepping onto each other’s turf. Synchronous games: Browsers games and game related communities may be better suited to capture the synchronous games opportunity (multiple players need to play at the same time) compared to social networks. On social networks, only a limited number of ‘friends’ are online at the same time. Browser game portals are more likely to succeed in this genre of games. 3D games: 3D support within the browser should catch on with enablers such as Unity 3D making rapid advances. Unity’s development platform allows various stakeholders to develop 3D games at an economical price point. On the stereoscopic 3D front, BigPoint recently announced that it will launch free-to-play games where users can experience 3D within the browser.
Virtual worlds, targeted entertainment	Virtual worlds, having been the darling of the industry in 2006/07, quickly dropped off the radar as other segments captured mindshare. The dust on the hype has long settled; the industry has since received a reality check and quality offerings have survived and are thriving. Encouragingly, IMVU, a 3D virtual world with a focus on flirting, had a revenue run-rate of USD 40 million in April 2010 with 50 million registered users (4 million active users). Berlin continues to be a hotbed of virtual world companies such as Panfu (learning for kids), Metaversum (real cities) and sMeet (flirting). ClubCoee, another Germany-based virtual world with 3D chat avatars, is giving IMVU a run for its money in the young audience/flirting segment. DeNA from Japan generates significant revenue from its avatar-based mobile social network. Key issues: Younger audiences as key segment: Younger audiences are clearly more comfortable with avatars and virtual worlds. The closing of three virtual worlds targeting an older audience this year indicates that this will be a tougher demographic for virtual worlds. Needless to say, analyst reports from 2005 suggesting 8 of 10 people would have an avatar by 2010 have turned out to be unsubstantiated. Yet, a younger generation that has grown with avatars are likely to ‘age well’ for the industry. Habbo Hotel, Stardoll, Club Penguin and Panfu are all still performing well with most showing growth. Clearer positioning: Niches have emerged in terms of offerings. The central proposition is often one of the following: learning, flirting, gaming, or appeal to a certain demographic. The common thread for all virtual worlds is interaction with others, but interaction for interaction’s sake is not effective. We are positive on virtual worlds with a high gaming component. Browser vs. client-based virtual worlds: Both schools of thought have their virtues (no downloads vs. richer 3D interactions). Going forward, we expect browser-based 3D models to combine the best of both worlds.
The mobile gaming revolution	Apple’s App Store is reaching a remarkable milestone in January 2011 when the 10 billionth app will be downloaded. Interestingly, a major chunk of the applications downloaded were games. This has inspired other handset makers such as Samsung as well as operators to launch own app stores. The proliferation of new devices such as the iPad and Samsung Galaxy is making the mobile gaming pie even bigger. The most successful mobile game of 2010, Angry Birds developed by Rovio from Finland, sold over 12 million copies of the game to go with roughly 30 million downloads of the free app. Besides stand alone games, mobile versions of online or social games are being launched to ‘follow the gamer’. Key trends are: Evolving business models: We expect the pay-per-download model to remain a powerful way to monetize games, yet virtual goods-based freemium models will become more dominant in the coming years. In particular, rich multi-player games played over longer periods of time are more suited to the virtual goods model. Pay-per-download model is suited to casual (often) single player games. Android: The fastest growing mobile platform will eventually overcome its fragmentation issues (Angry Birds was nothing short of a disaster on the Android platform with a massive number of users not being able to get the application to launch). The openness of Android should help sustain its ongoing popularity with developers. Richer games: As hardware continues to evolve, mobile gaming will provide a very rich user experience. 3D technology, motion detection and smart gesture recognition / UI are increasingly becoming commonplace allowing developers to harness the potential of 24/7 gaming. Attention to mass market devices: With pervasive talk of smartphones, it is easy to forget that feature or Java-based phones represent the overwhelming majority of the device pool. We expect to see mobile gaming and social network services such as qeep doing well not only in the developing world but also in broad areas of the developed world. Social mobile gaming networks: As multi-player mobile gaming catches on, social mobile gaming networks are becoming important. Platforms such as Scoreloop and OpenFeint allow developers to add social features to their games. Players can then challenge others, compare rankings on leader boards, recommend apps to friends among others. Recognizing the potential of the opportunity, Apple launched its own initiative in 2010, the Game Center. Scoreloop and OpenFeint support multiple platforms (iOS, Android and others) while Apple covers its own platform only.
ReCommerce - a new way of making money	Another major market that has come into the spotlight is recommerce. Second hand or pre-owned product sales represent a massive market for media products, in particular for video games. High price points of new video games make the secondary market particularly attractive. Publisher Activision estimates a USD 3 billion market for used games. The market for used video games has traditionally been dominated by small retailers and more recently by online market places such as eBay and Amazon. Newer C2B (Consumer to Business) models are capturing value by offering unforeseen convenience to consumers and higher margins for retailers. Consumers can exchange their old games for store credits or cash without the hassle of using an auction platform. The retailers then resell the used game with a markup that is higher that that for new games. Following the trend-setter GameStop, major retailers such as Wal-Mart, ASDA, Tesco, ToysRUs, Best Buy, Media Markt etc. have launched pre-owned games/media initiatives. GameStop's pre-owned games business grew 32% in 2009 compared to 1% growth for new games. Internet firms (e.g. Gazelle, ReBuy, momox and spun.com), with their lower costs, are entering the market in a big way. A number of these players are cooperating with bricks and mortar retailers to optimize the process.

Sector valuations

Public company valuations reinforce the rise of online and mobile gaming. Figure 6 presents Enterprise Value/Last Financial Year (LFY) Sales for a selection of gaming firms. While there are few listed social/mobile gaming forms, it is interesting to see how the market values traditional publishers (in gray) compared to online gaming firms. Walt Disney and Electronic Arts, who have actively entered new gaming markets through acquisitions and own initiatives, are valued higher than others with a traditional publisher background. Of course, company specific factors as well as geography must be considered, but the figure reveals an important general trend.

M&A environment

2010 has been the year of the social and online gaming transactions.

The giants of social gaming, Zynga (8 announced acquisitions) and Playdom have been active consolidators in the market swooping in on smaller social / mobile gaming outfits. The headline transaction this year was the acquisition of Playdom by The Walt Disney Company in July 2010 for a consideration of up to USD 763 million. MTV (owned by Viacom) and NewsCorp also made forays into this space by acquiring Social Express and Irata Labs respectively.

Online games also had a busy year with several key transactions taking place. The dominant players in online games and MMOGs from the Far East including Nexon, NHN, NCsoft, The9 and Shanda also made acquisitions at home and abroad. Warner Brothers picked up Turbine, an online game developer, for its popular Lord of the Rings MMOG in April 2010. Virtual worlds came back into the limelight with Microsoft’s acquisition of Vivaty in October 2010. Reports indicate that Microsoft will leverage Vivaty’s technology to make its forays into the space.

The Walt Disney Company (Tapulous in July 2010) and Zynga both made acquisitions in mobile gaming, but major transactions are still to come. DeNa from Japan acquired of ngmoco for a consideration of USD 400 million which sets the tone for M&A activity in 2011. Electronic Arts acquired Chillingo, best known as the publisher of Angry Birds in October 2010. Chillingo’s publishing abilities across mobile platforms make it an interesting acquisition.

We expect an intensification of M&A activity in social gaming: Until now, only a few diversified media and traditional video game publishers have bought into the social gaming space. As certain large traditional publishers are realizing, social gaming is an entirely different ball game. Weekly releases and constant improvement in social gaming is a very different from doing large releases of console / PC games. At the moment, we are seeing the buy argument winning the ‘make or buy’ dilemma. Even browser gaming specialists are buying into the social gaming space in acknowledgement of a different required skill sets required in these areas. Larger social gaming players are expected to continue acquiring smaller outfits.

Browser games with increased M&A activity: Buyers from the Far East, who are the biggest players in the online gaming space, have now started to make acquisitions in the Western world. Homegrown Western online gaming companies such as BigPoint and Gameforge from Germany are now big enough to make acquisitions to get to the next level and could be active consolidators in the market. Social gaming players may acquire MMOG developers on a selected basis to leverage their IP. Media firms / traditional gaming companies could make acquisitions to participate in a high growth market as well as to leverage their IP in this high growth space.

We also expect a higher number of mobile gaming acquisitions in 2011: Given the attractiveness of the segment and increasing hype around it, we expect buyers from all categories to be bullish on this segment.

Limited but sustained M&A activity for virtual worlds: We do not expect M&A and fundraisings to be frantic like in other segments covered in this report. Given the sheer number of players in the industry, particularly in the teens and ‘tweens’ segments, we expect some consolidation in the coming years. Due to the highly targeted nature of certain virtual worlds, buyers from the offline world with the same target demographic could enter the space through acquisitions. Finally, we expect a few more technology deals on the lines Microsoft / Vivaty deal in the space.

ReCommerce should also see the beginning of a consolidation phase where retailers pick-up strong growing start-ups.

Potential acquirers

Media companies: With the impressive growth expected in the online and mobile gaming industries, it seems straightforward that international media powerhouses and local media entities will have to make their moves into the space in the near future. The largest global media houses such as The Walt Disney Company, Viacom, Vivendi, Naspers, Bertelsmann and Time Warner are already well-represented in the gaming industry and might reinforce their presence through acquisitions. We expect others to follow in the coming years.

Traditional games publishers: Most top executives from leading publishers with whom we have spoken to over the past 12 months have pointed to long term initiatives that would make online and mobile gaming a key part of their strategy.

Online and social gaming firms: Asian online gaming players such as NHN, Shanda, Nexon, etc as well as Western players such as BigPoint, Gameforge and Travian might be active consolidators in the market. Independent social gaming firms such as Zynga and Crowdstar may continue to acquire to broaden their portfolios.

Internet firms: Internet services and portals such as AOL, Google, Yahoo! and Mail.ru already have significant presence in gaming. Given their large cash reserves, they may be potential buyers in the sector.

Others: We expect the entry of at least one major unrelated company into the space. Particularly, companies serving certain demographics could acquire relevant online/mobile gaming companies.

Fundraising Environment

2010 has been a good year for fundraising in the gaming sector. As expected, we saw major investments in social and mobile gaming. Most prominently, social gaming leader Zynga raised USD 150 million from Softbank Capital which was followed by an investment of hundreds of million dollars by Google. Other top social gaming players to raise additional capital included Playdom (before being acquired by Disney), RockYou, 6waves and Digital Chocolate. On the mobile gaming front, ngmoco raised money twice in 2010 before being acquired by DeNA. Aurora Feint, which runs a successful mobile gaming network, raised money from Intel Capital as well as The9, a Chinese online gaming firm. The company had raised an earlier round in July 2010 to add Android to its previously iPhone only network. Papaya Mobile announced that it would utilize the proceeds of a USD 4 million round to build a mobile social gaming platform for Android.

Conclusion

The video games industry has undergone a landmark shift in the past decade. Online, social and mobile games have emerged as massive markets showing explosive growth. The highly dynamic nature of these segments suggests that disruptive innovations will continue to take place. This innovation combined with the sheer size of the opportunity will drive investments and M&A activity in the coming years. In short, the games have only just begun.

Cartagena Capital has succesfully advised on several M&A and fundraising transactions in the gaming sector, most recently on Qeep's multi-million Euro fundraising round. Metaversum/Twinity also is a former client of Cartagena Capital.

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