Video games power up during pandemic

Video games have been around for over 50 years, and despite its age, the industry continues to not only grow but also evolve. During 2020, the pandemic and associated stay-at-home regulations provided a tailwind to the secular trends underpinning the growth of video games as well as some potential evolutionary shifts. The secular trends include the switch to digital downloads and microtransaction growth, with more evolutionary changes including subscription plans and cloud gaming. The fourth quarter also saw the launch of the ninth console generation with the debuts of the Sony SNE PlayStation 5 and Microsoft MSFT Xbox Series S and X.

We examined these trends and the console launches in a previous article. Given the number of changes since then, we now take a look at those trends in light of pandemic-fueled acceleration and the potential impacts on the four major publishers we cover: Activision Blizzard ATVI, Take-Two TTWO, Electronic Arts EA, and Ubisoft UBI.

Ninth generation off to a rousing start

In November 2020, Sony and Microsoft launched their next-generation consoles to very high demand. Despite the closures of retail outlets in many markets, the new versions of the PS5 and Xbox quickly sold out, and subsequent restocks at every retailer have been snapped up by consumers and scalpers. The secondary market for both consoles provides some indication that the demand remains strong, at least among early adopters. We expect that the supply shortfall will end by the 2021 holiday season as both companies rev up their supply chains to meet the demand and overcome the pandemic-related challenges, thus eroding most of the premiums in the secondary market.

The high demand for both consoles is unsurprising, given the surge of video gaming interest and playing time during 2020. However, the level is surprising when viewed through a more traditional lens under which demand is driven by must-have launch titles, substantial graphical improvements, or unique interfaces. On the Xbox side, the original must-have launch title--Halo Infinite, the sixth entry in the first-person series that arguably made the original Xbox--was delayed into 2021. Most of the other launch titles on the new Xbox consoles are multiplatform games like Ubisoft's Assassin’s Creed Valhalla or Sega's Yakuza: Like a Dragon, which are available not only for the competing PS5 but also on previous-generation consoles. On the PlayStation side, there are a few notable exclusive titles like the pack-in game Astro's Playroom, Sackboy: A Big Adventure, and Demon's Souls, a remake of the classic PS3 title. But the showcase exclusive title, Spider-Man: Miles Morales, is also available on the PS4.

As a result, neither console has demonstrated a massive graphical improvement, particularly versus the midcycle consoles, Xbox One X and PS4 Pro. While we do expect both consoles to outpace their predecessors, that gap has yet to be exhibited in most titles so far. As both consoles largely conform to a similar template as the previous generation, the demand is not being generated by a unique feature or interface like the Nintendo Wii or Switch.

Subscription acceptance accelerates

Due in part to the pandemic, aggressive promotional pricing, and increased investment by Microsoft, Xbox Game Pass has grown much faster than our initial expectations in 2019. (PlayStation now has also exceeded our expectations, but to a much lesser extent.) As of September 2020, Game Pass had surpassed 15 million users, adding 5 million users since April 2020 alone. While we were (and still are) more optimistic about the long-term prospects for the multipublisher subscription model versus a single publisher, we did not expect acceptance to happen so quickly due to certain behavioral patterns among gamers. The pandemic appears to have affected those habits as the amount of time dedicated to gaming has increased.

Xbox booth at the Electronic Entertainment Expo (E3)

That amount of time spent on games appears to have increased because of stay-at-home regulations and the lack of live events at the beginning of the shutdown. According to an NPD survey, 79 per cent of US consumers played a video game during the first six months of the coronavirus outbreak, with total time spent playing up 26 per cent. Of US consumers age 18-24, 66 per cent played more console games in the first month of the COVID-19 lockdowns, well ahead of 28 per cent of all US consumers playing more console games, according to SuperData. Given this rapid increase in time spent on gaming, the rise of the subscription services is not surprising. A gamer fatigued from playing a small number of games would likely find the ability to sample new titles appealing. However, we think that this growth will be stymied or even reversed when pandemic restrictions are fully lifted, as we believe many consumers will return to prepandemic behaviors.

Cloud gaming struggles to gain traction

The end of 2019 saw the launch of the first major cloud gaming service, Stadia. Despite having the heft of Google GOOG/GOOGL behind it, Stadia has strained to gain mind share in the increasingly competitive gaming landscape. The service competes with not only the consoles but also PC and mobile gaming. Some of the reasons for the struggle to gain traction include the need for users to completely buy into cloud gaming/Stadia and a limited game library.

While Google has added a number of titles to the Stadia catalog, particularly over the last six months, the service still lacks exclusive titles and often gets some of largest multiplatform games months after they have launched on consoles and/or PCs. The service has only roughly 130 games, including 11 exclusive games and no must-have titles, and over 45 per cent of the games were released in 2018 or before. However, the strength of the Stadia platform did shine during the launch of CD Projekt's Cyberpunk 2077, which encountered a number of game-breaking issues on the base consoles from the eighth generation. Due in part to its more scalable architecture, the Stadia version of the highly anticipated title ran on par with or better than the newest consoles and higher-end PCs. But we still see an uphill climb for the service, given the need to buy into the Stadia ecosystem to use the service at its full potential.

As we expected, Amazon AMZN has joined the cloud gaming rush with Luna, currently in closed beta testing. Unlike Stadia, which is focused on single-game purchases, Luna is based on subscriptions to channels, with two channels currently announced and available: Luna+ at $6 per month and Ubisoft+ at $15 per month.

Unlike its competitors, Microsoft has a deep history and investment in traditional video game infrastructure. As a result, it is looking to use cloud gaming not to replace console or PC gaming, but to extend it. Microsoft launched its cloud gaming service, xCloud, in 2020 and added it to the Xbox Game Pass Ultimate tier for no additional charge.

Given the struggles of Stadia and the slightly overpriced cost of Luna's channels, we still believe that demand for cloud gaming will be weaker than the suppliers and the market expect, at least over the next three years. We expect that some users will embrace cloud gaming as an extension of the Xbox or PlayStation platform, enabling game play in remote locations, especially if the cost is free (or even nominally priced) for Xbox Game Pass Ultimate or PS Now subscribers. However, we believe demand will remain weak for stand-alone cloud platforms until these services develop or purchase exclusive video games to entice gamers to join. As in most of the media world, content is king here.

Strong demand and console features augur well for publishers

We've long held that consoles will remain an important segment for the four publishers we cover, a view that the early success of the PS5 and Xbox Series S/X has validated. Take-Two still generates well over 70 per cent of revenue from consoles despite branching out into PC and mobile. Console games still produce over 55 per cent of revenue for Ubisoft and 65 per cent for EA, even though both companies have increased their output of mobile and PC games. Activision Blizzard is the only company with less than 55 per cent of its 2020 revenue derived from console games due to the importance of Blizzard on the PC side and the acquisition of mobile gaming publisher King Digital (Candy Crush) in 2016. However, we still project that console revenue for the company will hit $2.3 billion in 2020 as Activision Blizzard rebounds from a transitional 2019. We expect that the ninth-generation console launch will continue to significantly affect these companies over the next five years.

Gross margins benefit from full game download trend

One unique feature for both ninth-generation console launches is a version without a disc drive. The two consoles are riding on the secular trend of full game downloads that had been gaining traction before the pandemic. The retail shutdown and stay-at-home orders in many countries during 2020 helped to accelerate the acceptance of full game downloads for companies like EA. A more minor factor in driving the uptake of full game downloads for Xbox Series X/S console owners is the introduction of Quick Resume, a feature that lets gamers switch among up to eight downloaded games without closing and restarting the games. We expect that the disc drive-less consoles will only help to accelerate this trend, particularly in markets with strong broadband infrastructure and no or very high broadband caps.

Despite the gains made by full game downloads, we believe that physical sales will still contribute significantly to publishers' revenue over the next five years, albeit declining as a percentage of the total. While there are a number of advantages to full game downloads like Quick Resume, we think some consumers will continue to prefer physical media for a number of reasons, including potential resale value, archival purposes, and lower stress on their broadband caps. Additionally, physical media are generally preferred by older shoppers when gift giving, which does make up a sizable portion of sales, especially for annualized franchises like Madden, FIFA, NBA 2K, and Call of Duty.

The ongoing shift from physical to digital for full games could be a driver of some revenue growth for publishers because of the ease of acquisition. However, we think this growth has and will continue to offset the ongoing trend among many consumers to purchase fewer games. As players have migrated to multiplayer and persistent world games like Call of Duty and Grand Theft Auto Online, the time spent per game has increased for many users, thus negating the need to purchase additional games. As a result, we believe that most hardcore gamers are probably buying fewer games than their counterparts were 15-20 years ago, even though they may be spending as much or even more time playing video games. Publishers have instead benefited from an expansion in the number of players in terms of volume of games sold.

A shopper stands in front of Nintendo's official store the Shibuya shopping district in Tokyo.

The real financial advantage for video game publishers appears at the gross margin level. Digital sales on Sony's or Microsoft's digital storefronts are charged the standard take rate of roughly 30 per cent of revenue. This is in line with the ones charged by Apple and Google on the mobile side and Valve's Steam for PC games. While the value and cost of the services provided by a digital storefront may in some cases not actually approach 30 per cent of a title's revenue, publishers are benefiting as the gross margin on physical games is generally around 50 per cent. The 70 per cent gross margins have been one of the tailwinds behind the gross margin improvements at EA and other publishers along with the rise in microtransactions or recurrent revenue.

More playing time, subscriptions spark microtransactions growth

Microtransaction/recurrent revenue also gained a boost from the additional time spent playing video games during the COVID-19 lockdowns. While this growth is likely to taper off as many consumers return to prepandemic behavior, it does show that there may still be more opportunity in microtransactions as consumers, particularly younger ones, have become increasingly used to making additional purchases after paying for a game. As these younger gamers grow older and start making purchasing decisions, the uptake rate on microtransactions could increase.

The growth in subscription services, specifically multipublisher ones, should also help to further increase recurrent revenue as the barrier to start or try a new game on the service is considerably lower. We have already seen a few multiplayer-oriented titles like Destiny 2 jump on to Xbox Game Pass to reinvigorate their player base along with recurrent revenue. While Bungie made the base Destiny 2 game a free-to-play title in October 2019, players still need to purchase the two expansions to fully experience the game, which did stop some from starting or returning to the game.

To expand the player base, Bungie made Destiny 2 and its first two expansions free to Xbox Game Pass subscribers in September 2020, forgoing $50 in revenue, though Microsoft did pay an undisclosed amount to add the game to the service. Additionally, Bungie and Microsoft put the newest expansion, Beyond Light, on Game Pass the day it was released, despite its $40 retail price. While the revenue from Microsoft is probably lower on a per-player basis, Bungie can recoup some of the revenue by selling emotes and other cosmetics as well as season passes for $10 that offer unique content and drops. Also, the influx of players is important to a multiplayer-focused game like Destiny 2 as a deeper player base helps with matchmaking for both cooperative-player and player-versus-player modes.

Game prices could finally rise

The price of console video games has failed to keep up with inflation in the United States over the past 35-plus years. The standard retail price of console games has been stuck around $60 since 2006. However, the complexity of the games has skyrocketed, progressing from the basic pixel graphics of the Atari 2600 to the 4K graphics of the Xbox Series X and PlayStation 5.

Spectators at the Fortnite World Cup in New Year, July 2019 

With the advent of the ninth-generation consoles, the $60 price ceiling is starting show some cracks as publishers are cautiously increasing prices for major franchises. Take-Two was the first publisher to break the barrier, announcing a $70 price point for the next-generation releases of NBA 2K21 while keeping previous versions at $60. Sony followed suit with the announcement that Demon's Souls and Destruction AllStars would launch at $70. However, the price increase was not uniform for Sony as other launch titles like Spider-Man: Miles Morales and Sackboy: A Big Adventure remained at or below the $60 ceiling. Other publishers have taken a similar tack as Sony, with some games at eight-generation prices and others raised to $70.

We think publishers will monitor the sales of higher-priced games and attempt to judge whether the additional $10 is simply reallocated from gamers' recurrent spending or is new money flowing into the system. With the rise of free-to-play games with massive audiences, like Fortnite, and the lifting of COVID-19 restrictions, the $70 price may be a hard sell for all but the most-wanted and must-have titles. As a result, we expect that the price points will remain mixed for the next few years as the ninth-generation install bases grow and publishers gain a better understanding of gamers' price sensitivity.

Valuations appear fair despite our positive outlook

Given the number of positive factors that have hit the industry, including the ninth-generation console launches, the increased time spent playing, and the lockdown-related boosts to recurrent revenue and full game downloads, we recently re-examined our projections for the four major publishers we cover--Activision Blizzard, Take-Two, Electronic Arts, and Ubisoft--and increased our fair value estimates for all of them. However, even with these increases, we believe the video game publishers are fairly valued despite our positive views on the impact of subscription plans and the console launches.