I’m back! If you’ve been wondering why I haven’t been writing, I’ve had quite a bit going on over the last 9 months. I recently took Level 2 of the CFA, and studying for the exam sucked up all my time and left me with no motivation to write. But now that I am done with that (at least for a few months), I am getting back in the saddle with a new series on Video Game monetization models. This will focus on Console and PC games, and largely ignore Mobile as the business model for Mobile is a bit different.
Video Games have drawn a lot of attention from investors and consumers alike since the start of COVID-19 as many who traditionally have not considered themselves “gamers”, bought a console and started playing with their friends as a social outlet. While this type of social engagement is not a new trend, it was massively accelerated by the pandemic. The pandemic also saw the acceleration of “alternate revenue models” for video games, with a large push towards in-game content, subscriptions and the continued momentum of free to play. Players have responded to some of these models, like Free to Play, very positively while others have received huge amounts of backlash from players over their “pay to win” feel. So this begs the question, “Why are publishers changing the way they generate revenue?”
To answer that, lets look at the very basics on video game economics. Developers spend a lot of money up front, building a game, marketing that game, and trying to sell it to as many players as possible on the back end. For the vast majority of video games, this is the primary method of monetization. We can further break this down into two factors, price and volume. Video Games sell for a wide range of prices depending mostly on the size of its developer team and game budget. Here we will be focusing on AAA Titles, which are defined as very large, high budget, high production quality titles built by 100s of developers.
When the Nintendo NES was released in 1983, games had an ASP of $50. This later increased to $70 for N64 games in 1998 before quickly falling back down to $50, coinciding with the release of the PlayStation 2 in 2000 and Xbox in 2001 . It is after this point that the industry started to experience stagnating ASPs. In 2005, Sony and Microsoft released their “next gen consoles”, the PS3 and Xbox 360. These consoles represented dramatic leaps in technology and as a result, video game publishers began ramping up the quality and budgets of their games. Activision, fought hard to raise the ASP of their games to $60 to account for this increase and set the new ASP for others to follow. After this point, the deflationary nature of technology really begins to weigh on game ASPs. ASP grew a mere 1% (-1.3% in real terms) from 2005 to 2021.
What becomes clear from looking at the data is that video games do not have pricing power. This isn’t inherently a problem, until we start to look at the other side of the equation, costs. Per Raph Koster’s piece “The Cost of Games”, AAA development cost (ex. Marketing Expenses) increase roughly 10x every 10 years despite the “cost per byte” getting dramatically cheaper over the same period. This metric gives us a way to “normalize” development costs games of different scales and quality. Larger games with more characters, larger environments and better graphics contain more bytes, and thus cost more to develop. Let’s compare the size of a game like Super Mario Bros., the best selling game for the NES, to one of the highest rated games of all time in Red Dead Redemption 2. Super Mario Bros. had a total file size of 40,000 bytes (40KB) while Red Dead 2 was 150 Billion bytes. That is a 3,750,000x increase over Super Mario Bros. Now, I should note that RD2 is one of the largest games of all time, but it is becoming more common to see games this large. Call of Duty Modern Warefare (2019 version) was 231 GB after all its updates with the average game size being estimated around 50 GB. And while the cost per byte has come down over time (see below), the average cost per byte has come down ~10,000x, much less than the 3.75M fold increase in total game size.
One important thing to note here is that we are looking solely at DEVELOPMENT costs. Marketing budgets have ballooned over this period as well, with Rich Hilleman (EA Exec) stated that marketing budgets for AAA titles are 2-3x a games development cost on marketing [1].
Obviously, there are still video game developers in business and making profits, and that is thanks to volume growth and mix shift. Gaming has grown in popularity (both in terms of players and time spent) and publishers have benefited from the transition from physical game delivery (actual disks) to digital delivery (buying a game from an online store). This not eliminates a lot variable costs, but also reduces PP&E used to create a physical game, thus lifting margins. But these dynamics may have largely run their course; an estimated 40% of the global population are “gamers” and the physical to digital mix shift is basically tapped out. So where does all this leave the industry: Alternate Monetization Models, i.e. the point of this series.
I’ve decided to break this series into four parts. First, we will look at Downloadable Content and other In-Game purchases. Second, we will examine Free to Play games followed by Subscription Services/Bundles like Microsoft’s Game Pass. Finally, we will look at the newest and most unconventional (in a gaming sense), in-game advertising.
I am super excited to share this series as I am a life long gamer and find the businesses involved incredibly interesting. If you enjoyed this intro and want to follow along as I release new parts, consider subscribing. It’s completely free and I have no intention of changing that.
As always, feel free to leave comments, questions or suggestions in the comment section of this post.
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Twitter: @beefycapital
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