Weekend Reading #5

Photo by  Annie Spratt  on  Unsplash

This is the fifth edition of our weekly newsletter, Weekend Reading, sent out on Saturday 23rd February 2019. Sign up here and receive a copy each week direct to your inbox.

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Weekend Reading #5

Gaming's next level.

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

Donkey Kong handheld, Tetris on the Gameboy, Frogger on the archaic PC, culminating in Warcraft 3 played via dial up connection – until mom picked up the phone to call a friend and wrecked hours of painstaking strategy.

Over the past 15 years, a lot has changed.

Last week, the Three Body Capital team attended the V&A's exhibition Videogames: Design/Play/Disrupt, showcasing the design and culture of contemporary videogames. It was an immersive multimedia experience and we learned a lot. The most relevant thing we registered was how much the industry has changed over time, in terms of technological evolution, gaming platforms, delivery models and media profile.

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 is undeniably today’s preeminent form of entertainment and has long since surpassed the film industry in terms of revenues.

This week we've been considering what could lie in store for game developers. The future is lined with huge opportunities –  and catastrophic risks. 

The curious case of TakeTwo. 

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. We believe this could be symptomatic of what’s unfolding in the industry today. 

Make no mistake, we believe TakeTwo is a world class gaming business, 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. 

The industry faces an inflection point. 

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 for game developers from the events of the last 12 months or so. 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) 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.  

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.

The only thing we know for certain is that change is coming to gaming. 

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.

For more of our thoughts on where the gaming industry is going, check out the full length blog post here.
Beyond the obvious.
+Fortnite is the future, but probably not for the reasons you think
+China is home to more than half of world’s top AI unicorns as battle for supremacy with US heats up
+The next big blue-collar job is coding
+Why endless TV and music options on Netflix and Spotify are leaving us paralysed by choice
+The ARPUs of the big four tech giants dwarf everybody else