Investing in video games

Gaming has become a huge part of everyday life. I’ve always been a gamer. I spent way too many hours during my high school days locked up at home playing RPGs on my Sony Playstation. It was only in the recent decade, however, that gaming has stepped out of the shadows of basements into the mainstream.

The appeal of video games for me was the great value proposition they offer. I could spend $20 on a used video game as a kid and get hundreds of hours of entertainment. I simply couldn’t beat that outside of a long fantasy novel and that appeal of the $$ spent/hr of entertainment stuck with me as I got older.

The video game industry has always been good at adapting to the changing nature of tastes and product cycles and the various revenue opportunities that exist and could be harnessed.

The model started with a game you could buy for a $50 to something like an MMO that added a recurring monthly fee and an ever expanding world. All these games started to tap into the addictive nature of progression based gaming as publisher began to realize that they could get more than just the initial sales price and the user base was willing to pay for it to fund additional content.

The turning point was when the old model of selling physical copies morphed into digital copies with additional DLC(downloadable content) that could be purchased.

The proliferation of mobile devices thrust the world of video games into the mainstream and publishers began to realize the benefits of mobile games.

Just like digital, there was an ease of distribution as well as additional ways to monetize the massive user base that mobile games attracted.

Companies realized that a that small portion of users were willing to spend extra money to customize a character or get an advantage in the game. They took advantage of the ability to attract that type of gamer to improve profits.  Micro transactions, first used outside of mobile in limited scope, became a much bigger deal on mobile. These allowed developers and publishers to sell a variety of things like extra lives, power boosts or loot boxes containing items that users could use to customize their characters. The freemium gaming model(free game with in-game purchases) became massive on mobile as publishers wanted to capture as many people as possible in hopes of catching whales(gamers who would spend a ton of money to max out everything possible).

This model soon transitioned back onto PC and console games with an added focus on micro transactions and capturing more and more revenue from the whales that would spend extra money beyond the cost of the initial game to get everything the game had to offer.

Personally, this model doesn’t appeal to me and I never pay extra for a game and will avoid any game where you can buy an advantage but the financials don’t lie.

Video game companies have done very well in recent years and a lot of it is due to the new ways of monetizing their releases.

The truth is that there is always a need for escapism and video games provide one of the most effective ways to achieve that for the end user. The product captures the attention of users due to having a low(often free) cost of entry in relation to amount of entertainment produced leading to a high user base. That means there’s often(not always) a revenue boost for the company when a game first sells. On top of that, game designers have added a very addictive progression based flow to many games with the idea of monetizing a certain percentage of the user base in a big way leading to very high margins and repeating revenue on successful games.

That new foundation of monetizing games after released has meant that the global video game market has exploded in recent years. Almost $110B in revenue has been generated by video games in 2017 and that number is expected to grow at ~6% per year until 2020.

Newzoo_Global_Games_Market_Revenue_Growth_2016-2020_April_2017

One of the most visible trends that has driven this is the growth in Mobile based gaming. The mobile chunk of the pie started at 39% of $101B in 2016 and is projected to be 50% of nearly $130B in 2020.

The data below illustrates what that means from a growth perspective for the various ways to play video games. PC and console are nearly flat in the past year while mobile has grown 20% YoY and that trend is expected to continue going forward.

Newzoo_2017_Global_Games_Market_Per_Segment_April_2017

Based on the Newzoo data above, any investor looking at an investment in gaming should be looking at Mobile gaming. Not only is the gaming market growing but it’s mostly growing in the mobile space.

This makes sense to me as it is by far the easiest distribution method and captures a growing population with growing access to cheap phones. It’s a lot easier for people in emerging markets to get a phone these days that it is for them to get a console or a gaming PCs. Only certain people(people already interested in games) will get a console or a gaming PC while almost everyone will want a phone(and some of those people might become interested in games).

That’s not to discount PC and console gaming as those have higher engagement, higher initial revenue and a stronger ability to develop IP. There are plenty of games on console and PC that generate immense revenue on a yearly basis due to the strength of the IP and the quality of the games. Examples include games like Call of Duty, GTA, Mario and Zelda.

There aren’t many games on mobile that have that type of clout in the gaming world. Mobile games, outside of a few standouts, often have a much shorter shelf life when it comes to retaining players meaning companies have to continually release new games. The one benefit with mobile games is that they’re a lot cheaper to produce than marquee console or PC titles but also have a harder time sticking. That means a mobile company can have 100+ titles with dozens out every year while a company like Take-Two with a few strong IPs(producer of GTA V and NBA 2K titles) can ride the revenue from those for years upon years.

This market shift to mobile is not necessarily driven by the U.S. where consoles and PCs still have a high penetration but countries outside of North America.

In fact, North America has the lowest growth rates in video games and has recently taken a backseat to China which is now the #1 spender when it comes to video games. It’s important to take into account the Asia-Pacific dominance in this market and the impressive growth rate they’ve managed to maintain despite being the #1 spender already. It shows that while video games are popular in the U.S., their growth is outpacing ours by quite a lot in other countries.

Newzoo_2017_Global_Games_Market_Per_Region_April_2017

The most impressive thing in all this data comes from China which not only has become the #1 spender in video games but is expected to maintain sizable growth going into 2020 as evidence below. The 2013-2020 growth rate is projected at an astounding 13.6%. That’s not a bad number from an investment perspective.

The key data point to notice in the data below is the consistent growth in Mobile gaming in China. It has taken 50% of the market this year, a higher penetration that the rest of the world and is expected to take over 60% market share by 2020. The YoY growth from 2016 and 2017 in mobile game revenue was over 30% and while that growth rate is expected to drop off, it’s still a very impressive growth rate projection going into 2020 and beats the overall growth rate of the entire market.

Newzoo_Chinese_Games_Market_Revenues_2013-2020_April_2017

What does all this data tell me? It tells me if I want to invest in gaming, I want to invest in mobile and especially Chinese mobile gaming.

That power of mobile gaming in China is driven by the fact that that market is different than the U.S. and Europe. Those markets are still slanted more towards the console and PC sector. Consoles are only recently entering the Chinese market and maintain a very small market share meaning the majority of that shrinking green piece(other) is PC gaming.

I mentioned earlier the reasons why the growth in the PC and console arena is slowing down in relation to mobile and while there are still great investments in that area, I believe mobile is more likely to attain higher growth rates and compound more effectively going forward.

As mentioned above, if an investor wants to pursue that thesis then there’s no better bet than China.

I’ve been taking a look at video game stocks in the U.S. for a while now but their valuations(ATVI, TTWO, EA) have kept me on the sidelines.

When I wrote my recent asset allocation analysis and saw the lackluster performance of the international index funds, I mentioned I needed to expand my search for good investments outside the U.S.

Based on the thesis, I laid out in this post, I purchased NetEase Inc(NTES) and Tencent(TCEHY) on Wednesday.

Both are Chinese companies that derive a good portion of their revenue and earnings from mobile and PC gaming. The games of these two companies are very popular in China and between the two of them, make up around 80% of the market share in mobile gaming. That means I’m capturing most of that potential growth going forward by owning both assuming they can keep hold of that market share.

There are a few things I liked about these companies beyond the fact that they generated a ton of revenue from games. One of the most important ones is that they used the high margin free cash flow producing business to continue improving their stable of games either via acquisitions(Tencent) or internal R&D(both). The second is that both companies aren’t just resting on their successes in gaming but continue to invest in other areas and grow and diversify their revenue.

I purchased TCEHY after a blowout earnings quarter where they saw revenues rise by 60% due in large part of their gaming division. There’s a lot to say about Tencent as it’s a large conglomerate(~500b market cap) that uses the money from gaming to drive growth in various areas.  They derive about 50% of their revenue from gaming but I believe Tencent is poised for excellent growth based on the various business they operate in and have a great network to which they can sell their various services and products. They have one of the biggest social networks in China(nearly 1 billion users), own a youtube type subscription video service and have a rapidly expanding cloud and payments business. On top of that they have a ton of minority investments in variety of companies and even some moonshots.

On the gaming front, they own league of legends, one of the most popular PC and e-sports games and have some of the highest grossing mobile games in the world(Clash of Clans, Honour of Kings) as well as investments in companies like Epic Games, Activation Blizzard and others.

This is not only a gaming story since their other business are growing at a rapid clip and this is probably one of the best plays overall to take advantage of the growing Chinese middle class. Their integration of their various services within their social network is top class and should generate solid results going forward.

I wouldn’t call Tencent a must buy at this price but companies like this one are so difficult to value. They have done such an amazing job executing that I could see this thing double in the next few years even at this price point if that execution continues and will likely pick up more shares in the future.

The second company NetEase, is a much smaller company that started as a yahoo type internet portal with email, deftly transitioned into PC gaming and then mobile gaming.

I purchased the stock right before earnings and have seen the stock rise 20% since then. Earnings were solid and one of their new games rocketed to the #1 free charts during a beta test while garnering great reviews. There’s no revenue on that game yet but it certainly bodes well for future prospects once they start to monetize it.

I was hoping to pick up a bit more as my asset allocation allowed it but the recent spike has brought it close to my fair value estimate so I may way for a pullback.

Netease has less market share than Tencent and have grown mainly through internal R&D versus acquisitions and investments. They have a stable of over 100 mobile PC games, nearly 30 PC games. Netease also licenses Blizzard and Mojang(Minecraft) titles for Chinese release and is in the early stages of monetizing Minecraft, a very popular game title. They have done an excellent job with their internal R&D and have a stable of popular games as well as upcoming releases that have been received well.

They also have an advertising and e-commerce business that is growing at a high clip. E-commerce is a competitive market in China and will eat into the high gaming margins but it does show that the company is taking steps to diversify the revenue stream down the line. Gaming still makes up 70% of their revenue but that number shrinks each quarter as the fast growing e-commerce business has nearly doubled in the last year.

On top of that the company is also in the pork farming business via a subsidiary that has shown early promise and has the potential to be spun off as an IPO in the next decade.

NetEase is definitely more of a pure play on gaming and carries more risks than the diversified Tencent. However, at the time of purchase($300), I believed it was a better value but I’m not sure I feel the same way now that the price has soared to $367 in two days. The truth is that this is the type of stock that was priced too attractively at $300 for the level of growth it exhibited and it could easily keep soaring if the market is willing to expand it’s P/E closer to some of its competitors. As an example, Tencent’s P/E is almost double that of NetEase even after the 20% gain. For those interested in dividends, NetEase pays out 25% of their quarterly income as a dividend so that’ll vary quarter to quarter.

The thesis for these investments is driven by data above which shows that gaming is a growing industry with potential to outpace the overall market by a good percentage. The growth is most prevalent in China and especially on the mobile side of things which is where both Tencent and NetEase excel. They hold 80% of the market share in China and their excellent cash positions and internal R&D mean they’re able to grow and maintain that strength via new releases or acquisitions. On top of that, both companies understand the need to diversify and use the high margin business to expand into other areas to reduce risk.

There’s certainly major risks involved with investing in these companies driven by the lack of clarity around Chinese accounting practices and the involvement of the government. The latter can be a boon as well as it’s difficult for outside countries to break into the market due to the protectionist nature of the government.

The lack of switching costs in games mean a popular game can fade quickly and that’s a risk for both companies as a good portion of their revenue stems from video games. There’s also the fact that a big portion of that revenue stems from mobile gaming which is often driven by micro-transactions. These not only have a negative stigma around them in the minds of consumers but are often seen as predatory and/or promoting of gambling.

Due to that, there is always potential for government intervention due to the fact that a lot of these games target children and are addictive in nature. One of Tecent’s more popular games, Honor of Kings, recently had a time limit imposed by the company after criticism from a state-run newspaper. That and the recent outrage over EA’s Star Wars Battlefront II micro-transactions also should serve to remind investors who are betting on that revenue as a driver for growth that there will be push back from customers and governmental entities which may limit the upside for some of these companies.

Despite all that, I believe gaming is a solid investment. It’s one of the best forms of entertainment to bet on going forward as the upside is enormous due to the growth potential of not only gaming revenue but also the expansion of e-sports(I also like ATVI on that end)

There’s plenty of investment potential out there to capture that growth but I think these two companies are some of the best values and have the biggest market opportunity ahead of them. Investors in either should prepare for a bumpy ride as both can rise and fall quickly but the long term investment thesis certainly is intriguing.

Thanks for reading and let me know what you think of either company and investing in video games in general.

Disclosure : Long NTES, Long TCEHY, Long ATVI LEAPS

10 thoughts on “Investing in video games

  1. Interesting article thank you! Just this morning I was looking at Activision Blizzard again but their current valuation does not make them really attractive. I’ll also look into these companies, you make a great analysis!

    1. Thanks – ATVI does some expensive but I hold a small long term position via a LEAP. Note that NTES has the Activision Blizzard Chinese distribution rights so you get exposure there too and Tencent owns about 5% of ATVI.

  2. Time –

    Very interesting here! Like you, I used to dump hundreds of hours in playing Final Fantasy, Zelda, you name it – loved RPG games.

    How long have the companies you invested in, been in existence? Curious there! Only reason, with change of technology and customer preference – to see if they’ve already withstood the test of time : )

    -Lanny

    1. They’re both internet age companies so late 90s. NetEase was 97, Tencent was 98 so they’ve been around for as long as most of the surviving big names of the internet.

  3. Still kicking myself for only adding NTDOY to my watch list at 25.64 last year and TCEHY is interesting. Kind of wondering if 1337.HK (Razer) will be available as an ADR once the float increases.

  4. Time, This is not an investment area that I am very familiar with, but I hope you update us on how your holdings in this industry are doing in the future. I’d like to follow and learn based on your experiences. Tom

  5. Great analysis! I was thinking about game industry as well a few months ago – it looks like it keeps growing. I was thinking about Activision Blizzard as I really like their strategy and the loyal database of their users but I can see that you found some companies in much better valuations 🙂 I hope we will see an update from you on how those investments look like in the future.
    -BI

    1. ATVI is a solid company with a loyal userbase for sure. I like them as well and think they have a good future ahead of them especially if their Overwatch league is a success since that’ll open up more avenues for revenue growth.

  6. I love video games! I wish I had bought TTWO at 20. This was way before GTA took off. Games are definitely getting better, but so is competition. Are PC games done? I feel it is a competition between mobile games adn PS/XBOX/Nintendo …

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