Gaming’s Next Level


When I was a kid, games were seriously basic. But I was still hopelessly and utterly addicted to them.

Think Donkey Kong handheld, Tetris on the Gameboy and Frogger on the archaic PC, evolving into the bloody exhilaration of Doom and Duke Nukem 3D, before graduating onto the forbidden fruits of the heavily pixelated Leisure Suit Larry, culminating in the sophistication of Warcraft 3 - played via dial up connection (until mom picked up the phone to call a friend and wrecked six hours of painstaking strategy).

I remember endless school debates about the merits of Super Mario versus Sonic the Hedgehog and whether it was cheating to reboot Championship Manager when you get knocked out of the European Cup on penalties by Italy – 5 times in a row.

Anyone else spend hours of their childhood in front of this screen?  Photo by  Ben Neale  on  Unsplash

Anyone else spend hours of their childhood in front of this screen?

Photo by Ben Neale on Unsplash

Over the past 15 years, A LOT has changed. Whether it’s the strategy of League of Legends, the world of the Witcher, the violence and rush of Grand Theft Auto or the record breaking modern incarnation of today’s millennials in the (initially) free-to-play format of Fortnite, gaming undeniably wears the crown of today’s preeminent form of entertainment and has long since surpassed the film industry in terms of revenues.

However, the industry’s seminal moment arrived many years before. In 2008, when Grand Theft Auto 4 launched, it took the title of the most successful entertainment release in history. In its first 24 hours, GTA 4 generated $310m of revenues, surpassing history's most successful book (Harry Potter & The Deathly Hallows at $220m in 24 hours) and its most successful film (Spider-Man 3 at $117m) [1].

The purpose of this piece is not to regale our investors and readers with the well-covered wonders of the videogame industry. That story by now is clear to everyone, especially the Chinese government. It has become so successful there are logically calls to regulate responsible youngsters’ access to what has been labelled modern day opium. If you wish to learn about the more philosophical side of this discussion, we can recommend reading this excellent piece by David Mattin that discusses some of the merits of liberal democracy versus a nanny surveillance autocracy using videogames, China and Tencent as an example [2].

The gaming ecosystem is rich and varied with multiple sub-segments from developers to hardware to distributors and more recently E-sports. They are all of course linked to each other but each requires deep analysis and discussion. This piece, however will focus on what could lie in store for the developers who have historically been the gladiators of this realm. Their application of blood, sweat, tears, Red Bull, tens of thousands of hours and attention to detail in exchange for ever increasing paydays has coded the DNA of some of today’s most successful entertainment behemoths.

China beat Europe in the League of Legends Worlds 2018 final

China beat Europe in the League of Legends Worlds 2018 final

It’s possible that late last year the industry experienced its most recent inflection point. The release of Red Dead Redemption 2 by Rockstar Games (a subsidiary of US-listed TakeTwo Interactive) set new records as it blew past the previous biggest opening weekend in all forms of entertainment with 17 million copies shipped. As of last week, when TakeTwo reported its 3Q19 results, RD2 was up to 23 million units shipped - a staggering number considering it was only released just 3 months ago!

What’s even more amazing is that TakeTwo’s share price collapsed 14% after the results, despite them being a technical beat. The day before the release, the stock was rated as a high conviction buy from almost every analyst who covered the stock with 21 buys, 5 holds and ZERO sells.

This is not a deep-level analysis of the merits of owning TakeTwo as a stock, but it is important to analyse what has unfolded, as we believe it could be symptomatic of what’s unfolding in the industry today.

So why has the stock collapsed - and languished since it fell post results - given the impressive set of results? A plethora of reasons have been given by analysts and the media including:

  1. It rallied hard into the release of RD2 at the end of October.

  2. The results were not as good as expected.

  3. The guidance was not as good as hoped.

  4. RD2 online has been very disappointing and received negative feedback from the gaming community.

  5. This quarter will prove the biggest for many years until the next big release, so a period of famine is coming.

The above reasons are all valid to varying degrees and symptomatic of post rationalization. We believe they are transient and miss the big picture. What we’ve seen in essence is a steady derating in multiples since the release of RD2. It is possible that some were holding on for a big beat so they could get out at a higher price and that may be why the selloff was more aggressive after results (we are hypothesizing here).  

Make no mistake, we believe TakeTwo is a world class gaming business, which is expertly steered by its much-heralded CEO, Strauss Zelnick. He has repeatedly spoken about his ambition to do inorganic deals, possibly to become a more diversified entertainment company, and it is most likely he can also see that things are not as they were.

Taking a step back, we believe that the game developers are facing an inflection point in their business models. It’s not quite here yet (judging by the massive success of RD2) and there have been hints of what’s to come, but we know things are changing from the events of the last 12 months or so.


Marshmello holds the first ever Fortnite concert live at Pleasant Park.


From the arrival of the unstoppable force of Fortnite, to the looming immovable object of Netflix (or Twitch, or whoever the “Netflix” incarnation of gaming may be, if not Netflix itself) there are challenges ahead and the industry needs to evolve. What we know from many other industries that have been disrupted is that incumbents very rarely lead the innovation and they tend to be reactive.

The power of the aggregated platform is growing. Look at Netflix. With Black Mirror: Bandersnatch they are hinting at a future which merges movies and gaming. If Reed Hastings believes Netflix’s biggest challenger is Fortnite (it has now overtaken sleep as their biggest competitor in his eyes) it should logically follow that Fortnite’s biggest competitor could be Netflix, and for the more traditional developers that means they will have BOTH Fortnite’s Epic creator (with defacto Chinese state support), and Netflix themselves as competitors in a world where time is the only constraint.  

However this unfolds, what is clear to us is that pricing power of the developers is no longer a given.  

Traditionally, developers have enjoyed long investment cycles where they could build IP and generate content and then reap the reward through the sale of their end product. This would typically be through a one time lump sale for PC or console. This has recently morphed to some kind of hybrid, with developers creating online worlds that they can monetize consistently, but the lion’s share of revenues are still through the initial sale. The most recent example of this is Red Dead 2 itself, where Rockstar have struggled to straddle both worlds with a massive hit success in terms of copies shipped but poor feedback from the gaming community regarding its multiplayer format, Red Dead Online.

We know that Rockstar will continue to monetize their tremendous lineup of IP again and again as the years roll by, but the uncertainty now is the question of how? If anything, Steam’s recent concession to allow developers to keep more of the pie (after being threatened by Epic Games’ Unreal Engine which offers 12% take rate to developers, rather than the industry standard for the past decade as dominated by Steam of 30%) should have added to the buy case, but this doesn’t seem to have helped. Is there something else that the market should be worried about?

There are two possible reasons for impending multiple erosion. Firstly, if a super aggregator platform emerges, à la Netflix, that means the revenue model for developers becomes uncertain. Down the line, it’s even possible that a fixed contract for content may emerge, like the one Netflix employs for content producers currently. This would severely limit the optionality inherent in the developer business model as a myriad of developers will compete with a super aggregator where the pricing power will reside. This would be bad news for developers, but it doesn’t mean that they’ll cease to be successful. It simply means the upside operating leverage will subside or disappear completely.  

Secondly, what's also changing is that past success no longer guarantees future success. The predictability of knowing that GTA 4 will be more successful that GTA 3 is dwindling. Fortnite came out of nowhere to have a virtual Marshmellow concert with 10 million concurrent users! 10 million! Just this week, Electronic Arts, a fallen giant with a litany of recent disappointments, seems to have hit the jackpot with a Battle Royale, team-based challenger called Apex Legends and causing Twitch viewership of Fortnite to fall 50% instantly. How can the market apportion a high multiple to something if it has no idea where to look next?  And we haven’t even touched on what augmented or virtual reality brings in terms of uncertainty ahead.

And as far as the past not predicting the future goes, the poster child of mismanagement must be Activision Blizzard. Alongside disappointing launches of long-time franchises like Call of Duty and dwindling growth in former hit shooter game Overwatch, in the past 5 months it has single handedly lost two of the best development studios of the past 2 decades from its stable. Just last month, Bungie (the studio best known for producing the Destiny and Halo series) split ways with Activision, triggering early termination of a ten year agreement and a buyback of distribution rights after long-term disagreements over how to manage and distribute Destiny games culminated in poor sales for Destiny 2.

Similarly, while still commanding half of the company’s name, Blizzard is seeing both gamer and staff goodwill evaporate as we speak, a result of Blizzard fans feeling betrayed by Blizzard’s “sell-out” to mobile-only games and staff looking on in despair as they perceive Blizzard’s independence as increasingly impinged upon by the Activision side of the business. This negative spiral culminated in the firing of Blizzard’s CFO Spencer Neumann in January. His hire by Netflix as their new CFO only 2 days later was ironic, and recent news shows expected layoffs across the entire company as sales falter with few major launches in their pipeline, likely making their most recent quarter the peak of earnings this cycle.

Last week, the Three Body Capital team went to the Victoria and Albert Museum in London to attend their exhibition entitled, “Videogames: Design/Play/Disrupt”, which explores the design and culture of contemporary videogames. It was a fascinating multimedia experience and we learned a heck of a lot. The MOST relevant thing we registered was how much the industry has changed over time. Not only about the obvious continuous technological evolution, but also in terms of the gaming platforms, model of delivery and increasing blockbuster entertainment profile.

The next clue of how the market feels this is all progressing will be CD Projekt’s upcoming blockbuster, Cyberpunk 2077. This game has received extraordinary reviews based on its demos and has been nearly 6 years in the making. It will most likely be recognized as the best game ever made, given its detailed world and attention to graphic beauty, for which its studio became famous with the release of The Witcher 3 some 6 years ago. We expect it to challenge, if not surpass RD2 in terms of hype and possibly copies sold when it’s ultimately released later this year or in early 2020.  

The next big smash? CD Projekt’s, Cyberpunk 2077.

The next big smash? CD Projekt’s, Cyberpunk 2077.

The story is somewhat different, as CD Projekt is listed in Poland and far more undiscovered than TakeTwo Interactive as a listed equity. It has only recently picked up its first multinational sell side coverage when Morgan Stanley initiated in January 2019 with a punchy Buy rating. We expect the stock trajectory from here to be positive too. The question is for how long unless they too adjust their model to what the world will be in the years to come. CD Projekt has a young, fresh founder operated business which enables it to be more experimental and nimble than its larger peers, so it has a shot at navigating this period better than most.

One thing we know about markets is that they always look ahead. From the moment something is crystallized the market moves onto the next variable. This is usually encapsulated in the multiple that is apportioned to any stock.  

The only thing we know for certain is that change is coming to gaming. It’s happening before our eyes. When there is uncertainty, multiples tend to fall. We believe this is what is happening now and that the industry is going to become even more hit driven in the short term as the market will only be willing to reward near-dated success as the fruits are more immediately tangible. The further we look into the future, the more uncertain it becomes.

Our view at Three Body Capital is always that the very best companies morph and prepare for where the puck will be. But the majority of companies are not the very best. We believe that the majority of the industry will not be able to adjust their business models and only a few will emerge victorious.  At Three Body Capital, it is our job to identify who these are and who they are not. We are excited at the current opportunities both on the short side as well as select long ideas in the space.

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