May 4, 2009 Industry Report
Think Entertainment: Gaming Reason for Report: The Emergence Of Games As A Service Industry Update Atul Bagga THINK SUMMARY: 415-249-6362, [email protected] Over the long term, we believe that gaming will emerge as a true multi-channel Games As A Service, where players will be able to play games on multiple channels with the game experience optimized for each of the channels and profile information seamlessly carried across the platforms. In the meantime, we expect strong growth in online gaming, social gaming, mobile gaming, and alternative business models. A large population of Internet users and the efficiencies of the digital channel will drive growth in online gaming, in our opinion. We think that social gaming will be another growth area, driven by the large reach and viral nature of the social networks. Similarly, we believe that the ubiquity of mobile devices and the emerging devices and platforms will put mobile gaming on a strong growth trajectory. With strong growth in the number of gamers, gaming is fast becoming an attractive alternative media for advertisers, in our view. We are also optimistic about the virtual goods model, which we believe could get a boost from the Generation Y's comfort level with Internet and virtual worlds. KEY POINTS: • Long term, we believe that gaming will emerge as a true multi-channel Games As A Service, where players will be able to play games on multiple channels (PC, gaming consoles, and mobile), with the game experience optimized for each of the channels and profile information seamlessly carried across the platforms. • Given the advancement in technologies, today's PCs are robust gaming machines, comparable to the dedicated gaming consoles. Also, we believe the large population of Internet users (15-20x that of the gaming console base) plus inherent advantages of online distribution make the Internet an attractive gaming platform. • We believe that the social networking sites not only create a platform for viral distribution of games, but even more importantly, fundamentally transform the gaming experience into more of a social experience for players to spend time with their real-life friends, which we believe broadens the scope of gaming to include non-gamers and presents an attractive billion-dollar-plus market opportunity. • Similarly, we are optimistic about the mobile gaming space. We believe that the large penetration (2-3x that of Internet users and 30-40x the console installed base) and the ubiquity of mobile devices positions mobile phones as attractive gaming devices. We think that recent advancements in technology (iPhone and Google Android) and emerging platforms for mobile applications (AppStore) should overcome historical constraints and be catalysts for mobile gaming. • We believe that a broadening demography of games, coupled with a strong growth in the usage level of games, positions gaming as an attractive alternative media for advertisers that are grappling with the reducing effectiveness of traditional media. We think that advertising could emerge as a multi-billion dollar opportunity for gaming. • We believe that Generation Y's comfort level with Internet and virtual worlds could drive spending on virtual goods. • We think the key success factors in the new world of gaming will be: a) a focus on understanding consumer behavior (versus on AAA titles in the older model), b) building communities (versus building IPs), c) managing virality (versus large marketing campaigns), and d) monetization through alternative models (versus price discounting).
Please see analyst certification (Reg. AC) and other important disclosures on pages 210-211 of this report. May 4, 2009 Industry Report
Table Of Contents
Section 1: The Emergence Of Games As A Service Emergence Of Games As A Service ...... 5 The Digital Revolution ...... 7 Competitive Landscape Of Games As A Service ...... 10 Take A Break: Time To Play Crossword Challenge ...... 12 Online Games ...... 13 Demand Drivers For Online Games ...... 14 Emergence Of Social Gaming: Convergence Between Gaming And Social Media ...... 18 Drivers For Social Gaming ...... 19 Market Size Estimation For Social Gaming ...... 21 Mobile Games Coming Of Age ...... 23 Drivers For Mobile Gaming ...... 24 Potential Market Size—Mobile Gaming ...... 27 Weapons Of Price Discrimination: Free-To-Play, Pay-For-Items Model ...... 28 Drivers For Free-To-Play Model ...... 30 Market Size Estimation Of Virtual Goods In Games ...... 34 In-Game Advertising ...... 35 Demand Drivers For In-Game Advertising ...... 39 Market Size Estimation Of In-Game Advertising ...... 41 Who Will Succeed: Characteristics Of Winners In Games As A Service ...... 43 Take A Break: Time To Play Scramble...... 45 Take A Break: Time To Play Word Search ...... 46
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Section 2: Interviews With The Leading Private Gaming Companies
Online Gaming: An Interview With The Founder And CEO Of Acclaim ...... 48 Online Gaming: An Interview With The CEO Of Bigpoint ...... 52 Mobile Gaming: An Interview With The CEO Of Digital Chocolate ...... 56 In-Game Advertising: An Interview With The CEO Of Double Fusion ...... 59 China Online Gaming: An Interview With The COO Of Ferry Game ...... 63 Online Gaming: An Interview With The CEO Of Gaia Online ...... 67 Online Gaming: An Interview With The CEO Of K2 Network ...... 71 Online Gaming: An Interview With The CEO Of Kongregate ...... 75 Online Gaming: An Interview With The Co-Founder Of Metaboli ...... 80 Online Gaming: An Interview With The Founder And CEO Of Miniclip.com ...... 84 In-Game Advertising: An Interview With The CEO Of Mochi Media ...... 89 Virtual Currency: An Interview With The Founder And CEO Of Offerpal ...... 94 Social Gaming: An Interview With The CEO Of Playfish ...... 98 Online Gaming: An Interview With The CEO Of Turbine...... 102 Gaming Suppliers: Interview With The CEO Of Vivox ...... 106 Social Gaming: Interview With The CEO Of Zynga ...... 110
Section 3: Private Company Profiles
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Emergence Of Games As A Service “In the last five years, an Omni Media market has emerged in which everyone has become a gamer to some degree. They are playing simple, convenient, and social games on a wide variety of new platforms including mobile phones, the Web, smartphones, social networks, and online console networks like Xbox LIVE.” Trip Hawkins, Founder & CEO, Digital Chocolate
Recently someone posted a question on LinkedIn—“How did you do job search pre-Internet days?” It should have been a simple question to answer for most people of my generation who were born in the late ‘60s and early ‘70s, who, unlike today’s generation, didn’t grow up on the Internet and who started careers before the world was connected like it is today. But for some reason, I had difficulty even remembering how we searched for jobs without emails, job boards, alumni Websites, LinkedIn, and Twitter. Then it dawned upon me how much we take the Internet for granted and truly how much it has transformed our lives. It is difficult to even imagine life without Internet. How would people communicate in a world without emails? How would a research analyst like myself perform due diligence in a world without Google? How would we have any chance to find our old school friends in a world without Facebook?
The Internet has changed our lives by revolutionizing many industries, including music, video, software, telecommunication, newspaper and publishing, project management and entertainment. Until about five years ago, CDs were the dominant format for music delivery—almost 100% of music was delivered in CDs. Fast forward five years, to the iTunes, Amazon Music, Wal-Mart world. CDs, as a delivery format for music, has shrunk to 30%, and digital music has become the dominant medium of delivery (see Exhibit 1).
Exhibit 1: Evolution Of The Music Industry
100% 90% 80% 70% 60% Mobile 50% Digital 40% CDs 30% Cassettes 20% 10% 0% 1997 1999 2001 2003 2005 2007
Source: Recording Industry Association of America
Similarly, the Internet has changed the way we watch videos—from DVDs to iTunes, to YouTube; from TV to Hulu, Joost, and TV.com.
But it has not always been a revolution. For some industries, it has been a process of slow evolution. For such transformation to materialize, there has to be some real tangible benefits for consumers, for vendors, or for the other stakeholders. We believe these tangible benefits are the mandatory, but not the sufficient condition to make this change happen. And that’s why in some cases, we have often seen a long process of evolution that involved multiple iterations of business models and innovation in technologies. Take software for example. Software as a Service (SaaS) had to undergo many iterations (client-server model, ASP model, hosted model) before it came into being as multi-tenant, browser-based Software as a Service, as we know it today.
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Even if we have the right business model and the technology, it may take time and a catalyst to create sufficient momentum that would spur wide adoption. Again, take the example of software. Even though the SaaS model has been in existence for almost 10 years, until approximately five years ago, it was considered a fad; until a couple of years ago, it was considered acceptable only for small businesses; and now it is well accepted by small, medium, and large businesses alike and we expect it to grow more than twice as fast as the overall software industry and to become a significant portion of enterprise software by 2012.
Exhibit 2: SaaS Versus Packaged Software Growth
3000 SaaS 2500 On-premise 2000
1500
1000 Revenue Index 500
0 2002 2003 2004 2005 2006 2007 2008
Source: FactSet and ThinkEquity LLC
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The Digital Revolution From To Music has Changed
Home Video is Changing
TV has Changed
News Media has Changed
Phone has Changed
Communication , has Changed
Software is Changing
Source: Company Websites
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The Internet changed all of these industries because of a few common themes: reduced cost of ownership, increased convenience, and freedom from proprietary technologies. Consumers benefited by the ease of use, the ease of the buying process, a lower upfront investment, the ability to buy in small sizes, and the ability to buy without making a long-term commitment. Vendors benefited by streamlined supply chain, low friction sales model, satisfied users who become evangelist of products, viral marketing, reduced costs for development and support. We believe that the same reasons will transform the gaming industry from packaged software to Games as a Service business. We are at the dawn of multi- channel-game-as-a-service.
What Is Multi-Channel Games As A Service? We believe that today’s Internet generation is looking to stay connected with their friends at all times. With increasingly capabilities and functionalities of the smartphones, users are connecting with their friends on their mobile devices while on the move (think Twitter, Facebook Mobile, Google Latitude) and via computer while at work, school, or home. According to Research In Motion (the maker of the BlackBerry), the MySpace BlackBerry application had 400,000 downloads within one week of launch in October 2008 and Facebook BlackBerry application downloads surpassed the one million mark within five months of launch in April 2008.
Gaming will be no different, in our opinion. We believe just like people want to stay connected with their friends on social networks, players want to stay connected with their friends on virtual worlds/game environments too. With the next- generation of gaming phones, we expect to see convergence between social gaming, mobile gaming, and online gaming. We believe this convergence makes sense not only for core gamers who may want to track their guild activities, but even for the casual gamers who may want to use the same avatar (a representation of the gamer in the game environment) on all platforms to make progress within game levels and to share achievements irrespective of the platform.
The next-gen multi-channel games will let players enjoy the game at any channel of his or her choice and give the player the ability to change the channel, but still pick up the game from where he or she left off. For example, “Jane” can play a game on her console at home, and when she leaves for work, she can continue to play the same game on her mobile device. While at work, she can check the stats, send a message to one of her guild friends, or even play the game on her work computer without the need for a separate download and while using the same avatar that she used in her console or mobile device. Not only will she be able to play the game on all channels, but the game play will be modified in all three instances to make the best of available hardware and to maximize the gaming experience based on the players’ device preference at that time.
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Exhibit 3: Emergence Of Games As A Service
Console PC Gaming Gaming
Multi-Channel Games As A Service
Online Mobile Social Gaming Gaming Gaming
Pay to Play: Upfront Purchase; Subscription
Others – App Premium Virtual Install, Ads Content Goods Incentive Subscription Free-to-Play Marketing
Source: ThinkEquity LLC
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Take A Break: Time To Play Crossword Challenge
Source: ThinkEquity LLC (For solution, please email [email protected]).
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Online Games Online games have been in existence almost since the beginning of the Internet. Historically, online games could only be played on PCs, but that changed with the launch of PS2 and Xbox, which allowed online play. And now, the next- generation consoles come with enhanced online capabilities that allow players to find and connect with their friends online such as Xbox Arcade, PlayStation Network, and Wii Virtual.
Online games include a gambit of genres and categories, from causal games to hardcore Massive Multiplayer Online (MMO) and everything in between.
Casual games are games that are easy to play, require less commitment, and last smaller sessions like puzzle games, time management games, racing games, arcade games, casual action games, card games, and word games. The biggest driver for casual games has been the increased number of connected devices. While core games largely remained confined to the bedrooms of core gamers who owned one or another console, casual games broadened the scope to include just about everyone. Although a large percentage of the PC users and mobile phone users may not identify themselves as gamers, various studies suggest that most of these users often indulge in some form of game play on their PCs and/or phone (mostly casual games). Casual games open up the target market to about one billion Internet users, and about four billion mobile subscribers—numbers that dwarf the target market for core games, limited to about 100 million console owners.
Massively Multi-player Online games are played between thousands of players and are generally targeted toward core gamers. MMOs can range from role-playing-games (MMORPG), first-person-shooter games (MMOFPS), real-time strategy games (MMORTS), sports games, and racing games. MMOs became immensely popular amongst the Asian gamers because of the affordability, and in some cases, government regulations on availability of consoles. Another big catalyst for the MMO games happened in early 2000, when some of the Asian companies started to experiment with the free-to-play model to revive interest in some of the old catalog games. The idea of free-to-play games is that players can play the game for free and pay smaller amounts to customize their avatar or to buy virtual weapons, maps, more levels, or new cars that enhance their game play. The free-to-play model gave a new lease to some of the old and dying games, and has now emerged as the dominant model for MMO in Asia, in our opinion.
Exhibit 4: Broad Categories And Target Audience Of Online Games
CORE GAMES ADVANCED CASUAL CASUAL GAMES GAMES
Fantasy/ Board Adventure Card Action Time Action Shooting Mgmt Racing
Martial Simulation Arcade MMORPG Sports Puzzle Arts Word Strategy Music
Teens/Young Male Kids/Tween Females
Source: ThinkEquity LLC
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Demand Drivers For Online Games
Online Gaming Opens Up Much Broader Market: Ubiquity Of PCs And Internet Personal Computers are everywhere—home, work, during the commute on public transit, on vacations, on business trips, on airplanes, and at airports. In contrast, consoles are mostly available at homes. The total population of PCs has already surpassed the one billion mark and is expected to reach two billion by 2014, according to Gartner. The Internet has even deeper penetration with more than 1.5 billion users worldwide and is expected grow at 15-18% over the next three years (according to Internet World Stats). On the other hand, the worldwide console population is estimated at about 100 million (260 million for the current and previous generations combined). Even within the U.S., the number of Internet users (at about 250 million) far exceeds the number of the gaming consoles installed base of 48 million. PC gaming not only opens up a bigger market, but it also expands the usage beyond the home. Players are not limited to playing the games only within their living rooms, but now, the players can have the same gaming experience during breaks at work or in a hotel room while traveling.
Exhibit 5: Internet Users Far Outnumber The Gaming Console Users
1,600 Consoles Installed Base (Two Most Recent Generations) 1,400 Internet Users 1,200
1,000
800 million 600
400
200
- 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: NPD, www.Internetworldstats.com
With recent advancements, we believe technology is not a barrier anymore. Not only are PCs everywhere, but today’s PCs are powerful gaming machines. Historically, there has been a large gap between PC hardware and console hardware and, therefore, for a high-quality, 3D gaming experience, someone has to have a dedicated gaming console system. The line between the PCs and the gaming consoles have blurred with the recent advancements and democratization of specialty hardware, in our opinion. Today’s PCs are powerful machines capable of playing high-definition 3D rendering, removing the need for a dedicated game console. In addition, increased adoption of online gaming and falling hardware prices have helped accelerate the pace of innovation in PC gaming peripheral technology—like a motion sensor controller (similar to that of a Wii remote), which makes the digital experience more real and interactive.
Exhibit 6: Development In PC Peripheral Bringing PC Gaming Closer To Console Gaming: CyWee Z Controller for PC Games—in the straight position (for tennis, golf games), in the gun position (for shooter game), and in the wheel position (for racing or aviation games)
Source: CyWee
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In addition, the increasing speed and ubiquity of broadband makes it easy to transfer high-resolution graphics over pipes, enabling gamers to have an immersive 3D experience without noticeable lags. The new technology is now enabling gamers to have immersive 3D experience even within browsers, i.e., without the need for a client download, which should further reduce friction for online games.
Exhibit 7: Sample Of The Immersive 3D Experience With Online Gaming
Source: Company Websites (clockwise from top left): World of Warcraft by Blizzard, Warhammer Online: Age of Reckoning by Electronic Arts, Gaia Online, and Vivaty Scenes for Facebook by Vivaty
Reduced Cost Of Ownership For Consumers If you are like most gamers, you will want to play at least 20-30 different games per year, you will want to own all the major consoles, and you will need to buy a new generation console every three to four years to play these games in their full glories. That works out to an annual spend of about $2,000-2,500 per user on gaming, which might be out of budget for many gamers. Even more importantly, although the marginal entertainment value of every next game for a user is arguably lower than that of the previous game that he/she owned, the marginal cost remains the same. And, as a result, most gamers end up buying about four to five titles (about $250-300) per year. Since Game as Service enables players to pay as they go, a player doesn’t have to buy all 30 games (that she wants to play) at $60 a piece. Rather, the user can play all the games only as much as he/she wants to play and pays only for as much as he/she plays. Game companies should benefit as many players, for who a marginal $60 investment for the 10th game didn’t make sense, will now be willing to open their wallets for not only the 10th best game but also for 11th, 12th, and all the games that they would not have bought.
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Avoid Buyer’s Remorse “For the premium [subscription] offer, they [subscribers] play ten different games a month; for the basic offer, they try or play four to five games a month. … They try them, and concentrate on those they really like, which is the interest of this service. Our customers don't have the stress to choose one game among the others in the shelves, which is a bet, because every gamer has made several times the wrong choice. A game is very personal; the packaging does not tell you what is really inside the box, and the game reviews, and friends' recommendations, only limit the risk to make the wrong choice.” Thibaut de Robien, Cofounder of Metaboli
And then there is always the case of buyer’s remorse, players getting stuck after buying a game because the game was not really their type. The problem is exacerbated for kids games, as these players arguably have a lower attention span.
Exhibit 8: Buyer’s Remorse: “Those WERE the droids I was looking for…”
Source: www.pbase.com/joony/image; www.flickr.com/photos/24973901@N04/2762458387/
With Games as a Service, players are paying only for their playtime and, therefore, avoid buyer’s remorse. Not only that, Games as a Service enables the vendors to offer “Try and Buy”—the idea is to offer a free trial for a limited time, and if the player likes the game, she can either buy unlimited play or enroll in some other form of game subscription. By offering a free trial, the vendor can cast a wider net and players who otherwise may not have bought the game, may now try the game and eventually convert to become paying customers. Furthermore, since the players have already tried the game before making a monetary commitment, the buyers’ remorse is limited, resulting in fewer returns and fewer customer service calls.
Improved Efficiency With Digital Distribution “There's a shift and a disruption going on in the games industry that had for so long relied on producing very expensive, high budget games, and when these big budget games fail, developers go out of business. The times are changing. Now solo game developer and hobbyists can develop a game in their spare time and find an audience through sites like Miniclip and they don't have to get involved in this very complex, hierarchy of distributors and publishers.” Robert Small, Founder & CEO, Miniclip.com
In the traditional packaged game distribution channel, since the shelf space is limited, the retailers are willing to assign the premium shelf space only to the super-hyped, highly anticipated, AAA games. As a result, most of the smaller or second tier titles are either left out for non-premium shelf space where they have limited visibility from walk-in customers, or even worse, these titles may not get any distribution deals. This creates a Catch-22 situation for smaller titles—since they don’t have the fire power of an AAA title, they cannot get the premium shelf to get players attention, and since they don’t have the players’ attention, they have even less chance to succeed. Not only that, larger gaming companies mostly focus on AAA titles that may appeal to broader mass markets, ignoring the needs for smaller niche markets, which creates inefficiency in the market.
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Digital distribution by definition breaks the barrier of limited shelf space, which makes the distribution to the niche markets financially viable. With digital distribution, vendors can publish titles focused on the smallest of the niche; and use guerrilla marketing or viral marketing to reach the desired segment efficiently. Digital distribution may also help expand margin for vendors—as vendors save on the cost of medium, packaging, and slotting expenses.
Exhibit 9: Digital Distribution Enables Reaching Out Long Tail
! ! ! Rhapsody "#$%&&&!'()*+! ! Wal-Mart #5%&&&!'()*+! ! ! ! ! ! ! Amazon.com ! ! ,-#!./0!1((2+! ! Barnes & Noble 6#&%&&&!1((2+! ! ! ! ! ! ! Netflix ! ,$%&&&!343+! ! Blockbuster ! #&&&!343+! ! ! Source: “The Long Tail” by Chris Anderson
Viral Growth “We don't really spend any money on marketing….Our growth is from friends recommending games, friends challenging each other to games, so it's word of mouth and virality.” Jim Greer, Founder & CEO, Kongregate
“We acquire all our customers through word of mouth. We’ve never done any marketing in the history of the company. Even within our game, there are very few places that you will see us advertising membership. …In many respects, it is one of the world’s best kept secrets.” Mark Gerhard, CEO, Jagex
Viral marketing refers to users promoting an application to other users without getting directly paid for the same. Online gaming vendors utilize viral marketing to expand reach and create buzz. With online games, players challenge their friends by emailing links or by embedding links on their profile pages, and help vendors reach new audiences without spending any money on customer acquisition. A number of online gaming vendors like miniclip.com, Jagex, Big Point, and Kongregate have been able to build significant audience without reportedly spending any money on digital marketing.
Ability To Respond To Changing Consumer Demands “It [online gaming] is more similar to a Web 2.0 business model than a pure video gaming business. The traditional video gaming business companies are in a retail business where you ship games and then it's a one-off sale until there is a next expansion or sequel. … We have a large number of experienced, dedicated, full-time employees whose job is to interact with our gamers and generate revenues. We get gamers' feedback, their needs and wants and desires, and we funnel that information directly toward our developer and then we update the game on a regular basis.” Joshua Hong, CEO, K2 Networks
Gaming is largely a hit-driven business, and predicting a hit or miss before a game launch is not an accurate science—it is more of a guessing game. In the traditional video gaming business model, after a game is launched, there is a little that the gaming vendors can do to fix issues with the game or make changes based on the users’ response. The traditional gaming vendors rely a lot on focus group studies and consumer behavior studies conducted during the product development stages and before the game launch.
Unlike traditional gaming vendors, online gaming vendors have the ability to make regular updates to their games based on the players’ behavior/demands. Sophisticated gaming companies spend considerable resources in gathering and analyzing implicit and explicit consumer feedback to update their games, which reduces the risk profile of the business.
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Emergence Of Social Gaming: Convergence Between Gaming And Social Media “What makes social gaming particularly interesting…not only the viral distribution of games, but also the ability to create game play where the game knows who your real world friends are and let you play with them…the emotional drive to play is not to kill time or escape but rather to socialize, communicate and express, much like why we play board games, ball games or card games in real life.” Kristian Segerstråle, CEO, Playfish
“For the first time ever, we're letting them [users] engage in games with their real friends in their real social networks. Gaming is a fundamentally social experience, not a single-player experience, and not a technology experience. We are bringing gaming back to its roots.” Mark Pincus, CEO, Zynga
We define social gaming as games that are played on a social network or virtual worlds between friends. Social networks could be existing networks (e.g., Facebook, MySpace) or networks designed especially for gamers (e.g., Arcadia). Social games bring a fundamental shift in the video games—away from a single player shooting aliens or killing monsters to a fun activity where one is playing with one’s real life friends in a virtual environment. Social gaming enables players to play against their real life friends and provides a place to hang out in a gaming environment thus taking the games back to its roots of fun activity.
We believe social networks have been the hottest trend in 21st century, exhibiting the fastest growth of any media. According to industry sources, more than two-thirds of online users have participated in a social network over the past year, and this number is expected to rise. The trend is not limited to the young users anymore, and people ages 35-54 years have shown the highest growth of any demographics.
Exhibit 10: Time To Reach 150 Million Users/Units Time to Reach 150 Million Users/Units 90 89 80 70 60 50 38
Years 40 30 20 14 10 7 5 0 Telephone Television Cellphone iPod Facebook
Source: Portio Research, CNN Money
Games are one of the most widely used and fastest-growing categories of applications on social networks. Most of the social games are based on a free-to-play model and monetize users through premium subscription, in-game ads, virtual item sale, incentive marketing, and application installations. We do not expect the vast majority of the users to directly pay for the games, and believe gaming companies will be monetized through in-game ads, while a small percentage of the players (10-15%) will convert to paying users either through subscribing to premium content or regular buyers of virtual goods.
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Drivers For Social Gaming
Large Underpenetrated Market Today’s generation is connected on social networks. According to comScore, more than two-thirds of Internet users are also on social networks, and the number is still growing. The popularity of the social networking sites is not just limited to the Y generation, more and more people 35 years of age and older are also joining these social networks. The latest statistics regarding Facebook users show that the number of users in the 35-54 years of age population has increased 10x versus 88% growth for the 18-34 years of age group since October 2007. Not only are more people joining these social networks, but they are also spending more time on these social networks. According to Hitwise, the average user is now spending approximately 27 minutes/day, up 71% Y/Y.
We believe the reach and the demographic of the users on these sites make the social networks fertile ground for the game vendors to acquire users, build awareness, and create buzz through viral marketing. We believe that the penetration of games on social networks remains less than 10% and suggests significant room to grow.
Exhibit 11: Comparison Of Internet And Social Networking Growth
900,000 800,000 Internet Users 700,000 600,000 500,000 Social 400,000 Netowrking 300,000 Users 200,000 Consoles Installed Base 100,000 0 2007 2008
Source: NPD, Internetworldstats.com
Viral Marketing “Over 95% of our growth is viral. In fact, when we launched our first title a year ago, we started by inviting 100 of our own friends and we've grown from there to over 60 million registered players across our games organically.” Kristian Segerstrale, CEO, Playfish
The other day, I got a message on Facebook, “Pamela (real name substituted with a similar sounding name) thinks that you would cheat on your wife. See what else Pamela is saying about you.” I knew very well that it was a bait to lure me to add another time waster application, but it was coming from Pamela, my old school friend, and I just couldn’t resist finding out what she was saying about me (and seriously, I had no idea that Pamela could have said such things about me for the promise of some measly virtual goods). Funny part was that the application was fun and I ended up saying some nasty things about my other friends, and I am sure that, just like me, my friends must have received the notification (such as Atul thinks you are a liar. See what else Atul is saying about you); and probably they must be checking out this application and saying nasty things for their friends and so on. All of these people checking out the application and evangelizing the application without a single penny out of the company’s pocket, now that is the power of viral marketing.
A person can see viral marketing in action if he/she plays Playfish’s Who has the Biggest Brain on Facebook. After the player completes the game, it will ask the player to send his/her brain-weight score to friends who have never played Who has the Biggest Brain, inviting them to play and compare their brain-weights with that of the player (user acquisition) and send a tout to friends who have already played this game (repeat players); and, of course, as one can imagine, the friends the player touts will most likely beat the player’s score and tout the player and others back.
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Viral marketing refers to users promoting an application to other users without getting directly paid for their efforts. For online gaming vendors, social networks offer an inexpensive way of marketing their games to new users and improve stickiness through viral distribution. We believe that social networking sites level the playing field for small developers to compete with large companies like Electronic Arts (recall the success of Scrabulous, developed by two brothers in remote corners in India, which became a rage on Facebook through viral marketing).
Exhibit 12: Example Of Viral Distribution
Source: Playfish’s Who has the Biggest Brain on Facebook; Playfish’s Who has the Biggest Brain invites you to send a tout (Who is your Daddy Now!) to your friends on Facebook, whose score you have beaten.
For social networking sites, games provide an easier way to monetize their users, in our view. Despite significant size, strong community, and solid ecommerce platforms, most social networks have struggled with monetizing their users. With ARPU hovering in the range of $0.10-0.25/month for most of the social networks versus as high as $150/month for some of the online games, social networks do look under-monetized. Most social networks rely largely on banner and text ads for user monetization, but, given low conversion rates (less than one-tenth of a percent), display ad rates for most social networks hover at about $0.10-0.25 cost per thousand (CPM) versus as high as $35 for video ads and $8 for display ads for in-game advertising. We believe online games provide a natural way for the social networks to monetize users through in-game advertising and more importantly through virtual goods sales.
Games can also help social networking sites strengthen community bonding among their users. We believe that not only will games help social networking sites monetize their users, but they will also help to increase the stickiness of these social networking sites. Games are known to bring communities closer, to encourage user interaction and active participation (e.g., more than two million user-generated content on Spore, and more user- generated content on Halo than YouTube videos produced in a month), which is the lifeblood for social networking sites.
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Market Size Estimation For Social Gaming
Exhibit 13: Addressable Market Size Estimation For Social Networking
2011E
2008 Best Worst Base
Population (million) 337 368 368 368
Internet Penetration 74% 80% 74% 77%
Internet Users (million) 248 295 273 284
Social Network Penetration 53% 80% 60% 70%
Social Network Users (million) 131 236 164 198
Gamers on Social Network 25% 50% 25% 40%
Gamers on Social Network (million) 33 118 41 79 Paid Users (Virtual Goods, Premium Subs) 2% 10% 2% 5%
Paid Users (million) 1 12 1 4
ARPU - Paid Users ($/month) $2 $10 $2 $5 Market Opportunity - Paid Users ($ million) $16 $1,414 $20 $238
Ad Supported Users 98% 90% 98% 95%
Ad Supported Users (million) 32 106 40 75
Hours Game Play/Week 5 5 5 5
Ads Served/Hour Game Play 20 20 20 20
Total Ads Served (billion) 167 551 208 392
CPM $0.30 $5.00 $0.50 $2.00 Ad Revenue Opportunity ($ million) $51 $2,757 $104 $784
Effective ARPU ($/month) $0.17 $2.95 $0.25 $1.07 Addressable Market Opportunity ($ million) $66 $4,172 $124 $1,023 Source: ThinkEquity LLC estimates
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16 Of The Top 50 Applications On Facebook Are Games Rank Game Developer Monthly Reviews Active Users (in thousands) Texas Hold’Em Poker 7 Play Texas Hold'Em with your fb friends. Get free chips every day that you Zynga 12,330 5,047 play.
Pet Society 8 In the world of Pet Society you and your pet can have a great time! You can Playfish 10,567 70,431 play games, decorate your house, and even bring gifts for your friends when you visit them. Play now and share the fun with everyone!
Mafia Wars 9 Start a Mafia Family with your friends, do Crime Jobs for cash, buy Zynga 9,494 9,394 Powerful Weapons, and Fight!!!
YoVille 18 YoVille is a world where you can buy new clothes for your player, purchase Zynga 5,347 3,496 items for your apartment, go to work, and meet new friends. Join YoVille today for free! Geo Challenge 25 Geo Challenge takes you on a tour around the world as you put your Playfish 4,051 494 geography knowledge to the test!
Word Challenge 28 Word Challenge is the addictive new word game featuring vivid animations, Playfish 3,531 1,846 40,000+ words, 20 vocabulary types, a bonus game mode and weekly, monthly, and all-time top scores.
Who Has The Biggest Brain? 29 Think you are smart? Play this highly addictive brain training game to prove Playfish 3,517 2,300 it! Ever wondered Who Has The Biggest Brain amongst your friends? Play and invite your friends to find out!
MindJolt Games 31 Play over 500 games. At MindJolt Games you can play any of the Arcade, MindJolt 3,220 388 Puzzle, Strategy, and Sports games we offer for free.
Bowling Buddies 33 Go bowling with your friends! Featuring stylish 3D graphics, easy controls, Playfish 3,685 2,125 tons of achievements, customized characters and challenges against your friends. Street Racing 36 Pimp your rides, start a crew with your friends, and race! "It don't matter if Zynga 2,690 5,300 you win by an inch or a mile. Winning's winning." - The Fast & The Furious
Vampire Wars 39 Drink the blood of the innocent and tear your enemies limb from limb in Zynga 2,641 7,054 Vampires!
Kidnap! is an international game of Nap or be Nap’d! Pick your favorite city 42 in the world and cram all your Friends inside! Time is running out. With Context 2,494 598 Nappers popping up across the globe, it’s literally you against the world! Optional
Friends For Sale! 44 Buy and sell your friends as pets! You can make your pets poke, send gifts, Serious 2,151 2,801 or just show off for you. Make money as a shrewd pets investor or as a hot Business commodity! Mob Wars 45 Join the Mafia, and start your own mob. Band together with your friends to Mob Wars 2087 18,174 become the most powerful force in the elite criminal underworld of Facebook. Poker Palace 46 Play for FREE in the best poker game on Facebook! Fun & Easy! Trevor 1,917 362 Smith
Minigolf Party 48 Get your golf on and join the fun with Minigolf Party! This crazy collection of Playfish 1,866 553 courses takes you on the minigolf ride of your life.
Source: Facebook as on 04/21/09
Page 22 May 4, 2009 Industry Report
Mobile Games Coming Of Age We define mobile games as the games played on mobile phones, and smart phones (not including games played on the handheld consoles like the PSP or the Nintendo DS). Games started making their appearance on the cell phone almost from the time commercial cell phones were launched. The first mobile game was Snake (launched in 1999) that came pre- installed in Nokia phones and has been reportedly played more than a billion times.
Exhibit 14: Evolution In Mobile Phones
Source: Company Websites (from left to right): Motorola DynaTac launched in 1983; Screenshot of “Snake,” the first mobile game launched in 1999; iPhone (launched in 2007); and Electronic Arts games on T-Mobile G1 aka gPhone launched in 2008
With improving hardware, increasing ubiquity of broadband on mobile devices, and increasing affordability, we believe mobile gaming is quickly coming to the mainstream in the United States. The audience for mobile games is not just limited to core gamers, but has expanded to include professionals looking for easy stress busters between meetings or while traveling, and teenagers who are now increasingly mobile. Mobile games (such as Snake) can come pre-installed with phones, or can be bought through mobile operators’ e-stores or, more commonly, now from third-party stores (e.g., Apple AppStore). Players can play these games by themselves or they can play against their friends.
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Drivers For Mobile Gaming
Ubiquity Of Cell Phones Cell phones can be found almost everywhere, in our opinion. The number of cell phone subscribers in the United States has grown almost 10x to 262 million in 2008 from 28 million in 1995. Worldwide, the number of mobile subscribers has more than quadrupled over the last seven years to 4.1 billion in 2008 and is expected to reach 5.2 billion by 2011, according to Infonetics Research. The number of mobile users far exceeds the number of gaming consoles (about 100 million for the current-generation consoles, 260 million for the current- and previous-generation consoles combined) and the PC population (about 1 billion) or Internet users (about 1.5 billion) combined.
Exhibit 15: The Number Of Mobile Subscribers Has More Than Quadrupled In The Last Seven Years
4,500.0
4,000.0
3,500.0
3,000.0
2,500.0
2,000.0
1,500.0
1,000.0 Mobile Subscribers (million) 500.0
- 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: International Telecommunication Union
Not only do mobile subscribers outnumber the PC users and gaming console users, we believe mobile phones are almost everywhere. While someone cannot carry a console or a PC all the time, a person is almost always carrying a cell phone. Therefore, when boredom strikes, people are more likely to reach out to their cell phone for a quick game, which we believe makes the cell phone an attractive candidate as a game console.
Hardware Reaching To Age “The iPhone is the archetype and the inflection point, but Apple alone cannot supply all the demand. Hence, we now have a clone industry making things like the Google Android and many manufacturers and all carriers and channels will get in on the act. It will take a few years to build industry capacity, but we are now officially in the go-go growth phase.” Trip Hawkins, CEO Digital Chocolate
Not only are phones becoming ubiquitous, phones are also increasingly becoming more sophisticated. Some of the next- generation phones promise to deliver a gaming experience comparable to that of a gaming handheld device (like a Nintendo DS or a PSP) or even that of a gaming console.
Exhibit 16: Potential Upcoming Mobile Phones
Source: Company Websites (from left to Right): Nokia Concept Phone, Nokia n81, Anycall 5200, and Samsung SPH- B5200
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We believe that the inflection point in mobile gaming truly came with the launch of the iPhone. With its 3.5” color screen, multi-touch capability, robust processor, 3-D graphics capabilities, and accelerometer, the iPhone was the first mobile device capable of playing full-fledged games, such as Sim City 3 and Spores. And people have taken note of it, they are using iPhone as a gaming device and they have even ditched their gaming handheld device in favor of the iPhone. According to ComScore, 32.4% of iPhone users have downloaded a game, compared with a market average of 3.8%.
The success of the iPhone has attracted a number of iPhone clones, and also some serious players that are positioning mobile devices as video game players.
Increasing Affordability We believe that falling hardware prices plus an alternative revenue model for games make mobile gaming within reach of the masses. Especially in the emerging markets where the PC or console penetration is low, mobile devices offer a good gaming platform and with affordable revenue models (combination of premium subscription, ad supported, virtual goods), mobile gaming could be one of the cheapest sources of entertainment for a big population. The Asia/Pacific region is already the largest mobile gaming market, estimated at $2.3 billion and expected to reach $3.4 billion by 2011, according to Gartner.
Increasing Broadband Speed On Mobile Devices With increasing wireless data speed on mobile devices, players can easily find and play against their online friends. Increasing broadband speed allows players to play online games with no lags within an immersive 3D environment.
Exhibit 17: Broadband Speedometer
Broadband Speedometer – Maximum Download Speeds 30 Mbps 30 Mbps 15 Mbps 3.6 Mbps 20 Mbps 3 Mbps 3 Mbps 5 Mbps 2 Mbps 2 Mbps 1.5 Mbps Not toScale 384 kbps 768 kbps 144 kbps 144 kbps 56 kbps 56
Dial-Up EVDOEVDO HSDPA UMTS / WiMAX Cable FiOS FiOS FiOS
ADSL ADSL ADSL Rev. A WCDMA Modem EDGE GPRS IX RTT
Wireline 2.5 G Wireless 3G Wireless 4G Wireless
Source: CTIA Website
Lucrative Business Model For Wireless Operators And Platform Vendors In our view, gaming provides an attractive revenue stream for mobile operators in the form of accompanying sale of data plans and also revenue share with game developers. Although the revenue from gaming remains pretty small compared to the overall mobile business, it could start to look as an attractive way to grow a company’s ARPU as it struggles with falling prices and slowing growth. Not only is the opportunity lucrative for carriers, we believe that it makes a lot of sense for gaming vendors, as the incremental cost of porting existing games on a new platform is minimal and, therefore,
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incremental profit margins substantial. According to an article in The Wall Street Journal, Simon Jeffery, the U.S. president of Sega said he believes that [despite 30% revenue share with Apple] "games sold via the AppStore are the most profitable in terms of any of the formats.”
Emerging Standardized Platforms For Gaming Historically, non-standardized phones, varied carriers specifications, and multiple operating systems meant that the mobile gaming companies had to port their games on a number of platforms and support hundreds, if not thousands, of SKUs, which involved significant upfront costs and maintenance costs and stifled innovation. With the emergence of the iPhone (although a proprietary platform, given the high reach of iPhone, it eliminates the need to support multiple platforms to achieve similar penetration), Google Android, and Nokia Ngage, the mobile gaming market, in our opinion, will concentrate to a few standardized platforms, which should make the job of maintaining and supporting versions of mobile games easier for the developers and encourage innovation.
Easy To Use And Consumer-Friendly eStores For Games We believe that improving user experience for buying and installing of mobile games will drive adoption of mobile gaming. Historically, most people played only those games that came pre-installed with the mobile phone, given that the process of installing games on the phone has been pretty complex. Apple changed that with the launch of AppStore, which made the process of browsing, searching, downloading, and installing games very easy and user-friendly. The popularity of AppStore can be gauged by the fact that since it opened in July 2008, and there have already been over 500 million applications downloaded on 17 million iPhones, i.e., about 72 apps/year/iPhone versus 2.5 apps/non-iPhone smartphone owner (Source: MMteric 1/31/08 Survey of U.S. Mobile Owners).
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Potential Market Size—Mobile Gaming Mobiles games have come a long way since their humble beginning as a “Snake” in 1999. Gartner estimated the worldwide mobile games market at $4.3 billion in 2007, and expected it to grow at 22% over the next five years. In the U.S., mobile gaming was estimated at $717 million, with an estimated growth of 24%. The Asia/Pacific region is the largest mobile gaming market, with revenues estimated at $2.3 billion in 2008.
We believe that the potential opportunity for mobile games could be more than $2 billion in the United States alone.
Exhibit 18: Market Size Estimate For Mobile Gaming Number of Mobile Subscribers (million) 225 Penetration of Games 25% Potential Market (million Subscribers) 56.25 Average Spend/Day $0.10 Potential Market Size ($ million) $2,053.13 Source: ThinkEquity LLC estimates
Our assumption of $0.10/day for mobile games is based on the average pay for other mobile services commonly available.
Exhibit 19: Average Cost Of Mobile Value Add Services ($/day)
Games Service (Our Assumption)
Weather Channel
MobiRadio
Wikimobile
SMS (200/month)
$0.00 $0.05 $0.10 $0.15 $0.20 $0.25 $0.30 $0.35
Source: ATT Wireless
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Weapons Of Price Discrimination: Free-To-Play, Pay-For-Items Model
Imagine yourself as a game publisher working on the latest and the greatest game. As a game marketer, you know that your audience is composed of roughly three core segments: ! Core Gamers: These players will play your game five hours a day, seven days a week. They will be waiting in the line from early morning on the day of release to get their hands on the first copy of the game. ! Ex-Core Gamers: These used to be core gamers, but now because of the work/family pressure, they don’t have the same time commitment for the games as they had before. Nonetheless, their love for the latest games is not lost, and they are willing to make-up their lack of time by spending extra on the games. ! Price-Cautious Gamers/Students: These love to play games as much as core gamers, but don’t have enough money to buy all of the latest games. They will probably wait for someone to sell a used game or worse they will be downloading a “crack” copy of the games.
In a traditional business model, a company can price its game at about $40-60 and capture a part of the first two segments, and if the game is successful, the company will come up with a sequel, charge full price, and offer the previous release at a deep discount in hopes of capturing the last segment. However, by charging a fixed price, it may be leaving money on the table as its top customers in the first and the second segment might be willing to pay much more than the list price of the game (and in many instances they are already paying to black marketers for the first copy of the game or to gold farmers to advance them in the game). What if there was a way to capture more value from the top two segments and also capture some value from the third segment, without antagonizing your core customers?
In contrast to the traditional model where companies charge a fixed price to all of the prospects, the “free-to-play” (FTP) model allows customers to self select the segment they belong to and pay accordingly. In addition to offering price discrimination, the FTP model also enhances the community around the game (lure of free to play), increases longevity of the game, and helps increase the game’s stickiness. FTP games can be monetized either through ads (more on this in the next section) or through the sale of virtual goods.
Virtual goods are digital goods that people will buy using real money in order to get additional functionality (e.g., virtual currency), more power to their avatars (e.g., better swords, more powerful weapons), to customize and improve their avatar’s look (e.g., cool sunglasses, designer jeans), or as a token of appreciation to other players (e.g., virtual flowers, birthday cake). The virtual goods model has been very successful and is the most-dominant model in Asia. We believe that with the increasing popularity of online gaming and with the Y Generation’s comfort level in expressing itself via the Internet, the virtual goods model is likely to take off in the U.S. and other Western countries too. Taking a cue from the success of the virtual model with companies like Sulake, Second Life, Facebook, Gaia Online, K2 Network, Nexon, Acclaim, and Aria, we believe that more online gaming companies will experiment with the virtual goods model in the West.
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Exhibit 20: Examples Of Virtual Goods
Source: Games Screenshots (clockwise from top left): Webkinz, Disney’s Club Penguin, Sulake’s Habbo, Puzzle Pirates, Zwinky, and Nexon’s Maple Story
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Drivers For Free-To-Play Model “…some of the old players will continue to play subscription-based MMO, or console games, but the younger audience is different, they start right from the free-to-play experience and once you get the taste of it, then there's no going back. Why would you want to pay $50, get a game that you don't even know whether you're going to like it?” Joshua Hong, CEO, K2 Networks
Effective Way To Control Piracy And Build Community Although the lure of converting pirated copies into legal copies by effective anti-piracy measures may seem lucrative, a couple real-life examples suggest that the conversion rates remain insignificant (as low as 0.02%) with anti-piracy measures. On the other hand, anti-piracy measures generally cause inconvenience and, thus, user dissatisfaction for legitimate buyers, which risks the popularity of the games. For example, Electronics Arts’ “Spore” was one of the top ranked games, but was also a highly pirated game. As Electronic Arts put stringent anti-piracy controls into place, the number of illegal downloads was reduced, but so was the ranking. However, the free-to-play model enables vendors to build community and momentum without worrying about piracy. We believe the question that game vendors will have to answer is, are they willing to sacrifice community around the game and potentially jeopardize the popularity of the game to be able to sell an insignificant number of titles or can they find alternative ways to monetize users who wouldn’t want to pay hard cash for the game? We believe that vendors (especially the newcomers, without the legacy of owned IPs) will be willing to eschew the loss of upfront sale and embrace the alternative monetization models such as virtual goods.
Virtual Goods Model Enables Price Discrimination Unlike fixed fee-based models (such as subscription or outright purchase), the virtual goods model allows the vendors to price discriminate the customers by letting players choose the value they assign to the game. By making the games free- to-play, vendors are able to attract a larger audience. Players with free time on their hands (like students, cost-cautious players) will spend time/effort to advance levels in the games, while players who need instant gratification of moving up the ladder (like ex-core gamers and core gamers) would rely on virtual goods. While we acknowledge that some of the players who would’ve spent $60 for the game may not spend the equivalent amount in the free-to-play model, we argue that the free-to-play model will encourage some otherwise non-paying players to spend on the game and some hardcore players to spend much more than what they would’ve spent with the fixed fee model.
Exhibit 21: ARPU Distribution Curve Of ZT Online, A Free-To-Play Game By Giant Interactive
160
140
120
100
80
60
ARPu ($/Month) 40
20
- -5001,0001,5002,000 (20) Users ('000)
Source: Company Reports and ThinkEquity LLC
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Perfect Price Discrimination: “Holy Grail” Of Producer’s Pricing
Shown on the left is a typical supply-demand curve in a normal functioning market. The demand curve is represented with the red line and the supply curve is represented with the blue line. Equilibrium occurs at a price point where marginal cost equals marginal revenue, i.e., where the demand and supply curve intersect. However, at the equilibrium price point, a number of customers benefit as they only have to pay the market clearing price, which is lower than their perceived value of the goods. The amount that these consumers (with low price elasticity) end up saving is called consumer surplus (represented by the red shaded region).
Producers use a variety of price discrimination techniques to
P1 minimize consumer surplus and maximize producer surplus. Simply speaking, price discrimination suggests that producers
can offer the identical goods or services at different prices. The simplest form of price discrimination is used by retailers
in the form of discount coupons. With the simplest form of P2 price discrimination, a demand curve is divided into two parts and a higher price (P1) is charged to the consumers with low price elasticity while a lower price (P2) is charged to consumers with high price elasticity.
P1 P2 The “Holy Grail” for the producer is to achieve perfect price discrimination, i.e., charging every consumer the price that he P3 or she is willing to pay, thus fully eliminating consumer P4 surplus. P5 P6
Source: ThinkEquity LLC
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Increase Longevity And Improve Games’ Stickiness Unlike a fixed fee game, where players are only putting in efforts to advance levels, in the virtual goods model-based games, players advance levels though efforts as well as through spending hard cash on virtual goods. And so, with every virtual goods purchase, players are increasing their investment in the game and thus increasing switching costs for themselves, increasing the longevity of the games. In addition, the free-to-play model attracts more users (lure of free) and the larger community itself becomes a draw for new players.
This was evident in the example of Shanda, a Chinese gaming vendor that was able to grow revenue and increase useful life of its games by converting the business model from a subscription model to free-to-play model.
Exhibit 22: Annual Revenue Contribution From Shanda’s Legend Of Mir 2
$300
$250
$200
$150
$100 %"&"'(")*+),-..-/'0
$50
$0 2004 2005 2006 2007 2008 !"#$
Source: Company Reports (Shaded area represents the game was converted to free-to-play model)
Emergence Of New Payment Channel Players under 18 years of age account for 25% of video games sales and likely account for a much-higher percentage of the online gamer population. Being underage, these players usually do not have access to the popular payment methods like credit cards or PayPal. In the past, gaming vendors struggled with the issue of accepting payment from the younger players. Gaia Online, which has a large percentage of users in this demographic, has full-time personnel who open envelopes to collect cash mailed by their players to purchase virtual goods.
Nexon changed that with its Maple Story pre-paid cards. Pre-paid cards are popular in Asian countries. The idea of a pre- paid card is that the users pay in advance to buy prepaid cards and enter the code to their online account to get credit for the value of the pre-paid cards. Since the pre-paid cards are available at retail locations, younger players can use their allowance to easily buy the cards from the retailer and use the credit to play games. Increasing acceptance and popularity of the pre-paid cards could cause more vendors to experiment with the virtual goods model.
Generation Y’s comfort level with virtual worlds will likely translate into increased popularity of the virtual goods model, in our opinion. “A lot of old gamers, who grew up playing console games, may not be comfortable with this model, but the younger generation is very comfortable with it. We have already seen the changing consumer preferences transform businesses like Facebook and Twitter.” Howard Marks, Founder & CEO, Acclaim
While some may snicker at virtual goods, others, especially those from generation Y, who are comfortable at expressing themselves via social Internet sites such as Facebook and Twitter, seem to also like virtual goods (e-greetings, e-flower, e-pet) as a way to express themselves in a similar way others find it natural expressing themselves by wearing a certain brand of clothes or jewelry. Having grown accustomed to the connected experience of the social networking and virtual goods in social sites, these users find themselves at ease with virtual goods in games that can help them advance levels.
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We also have the precedence from the example of the Chinese and Korean gaming industries where a number of users (mostly first-time gamers who didn’t have any preconceived notion about a virtual goods model) readily embraced the virtual goods model, making it the most-dominant business model in those countries. We believe that the generation shift will accelerate popularity of the virtual goods model in the Western countries as well.
Ability To Grow ARPU The virtual goods model, by definition, delimits ARPU. Unlike the subscription model or outright purchase model where users pay a fixed fee for one-time purchase or monthly (or hourly) subscription, users in virtual goods pay based on their engagement level with the game—the more they are engaged, the more they value the game, the higher their spending is likely to be. The virtual goods model gives vendors the ability to link customers’ perceived value with the price of the game. It’s no surprise then that smart companies can do a perfect segmentation of the market and optimize the price- demand curve of their product.
Exhibit 23: Game Spend As A Percentage Of Per-Capita Income
Games Spend as % of Per-Capita Income 0.16%
China 0.14% U.S.
0.12% South Korea
0.10%
0.08%
0.06%
0.04%
0.02%
0.00% 2003 2004 2005 2006 2007
Source: ThinkEquity LLC
Virtual Goods Model = Unpredictable Cash Flow? We don’t think so. A common misconception around the virtual goods model is that the revenue stream under the virtual goods model is unpredictable since the virtual goods purchases are largely driven by the whims of the players. Although we acknowledge that the rules of the game in this model change and the vendors have to be more proactive with updates and other reasons to encourage players to spend, we believe that gamers who are engaged with the game will continue to pay for the game as long as they see the right reason and value in spending. In fact, most of the Chinese gaming companies that work on the virtual goods model have seen their ARPU at a very consistent level after rising in the early stages.
Exhibit 24: ARPU Of Chinese Gaming Companies (US$/Month)
18.0 SNDA - Casual 16.0 SNDA - MMO 14.0 PWRD 12.0 GA GIGM 10.0
8.0
6.0
4.0
2.0
- 1Q06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08Jun-08Sep-08
Source: Company Reports
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Market Size Estimation Of Virtual Goods In Games “Micro-transaction is essentially a form of pricing model and will have a meaningful share of the market in the U.S. because it provides more options to players.” Joshua Hong, CEO, K2 Network
“The market [free-to-play, virtual goods based] is already a few hundred million dollars revenue per year...could easily be a billion dollar market.” Heiko Hubertz, CEO, Big Point
“Virtual goods have only recently gone mainstream, and for every publisher that currently sells virtual goods, there are probably another five or six that are planning to do so soon. As consumers become more accustomed to virtual goods, and as the payment systems for acquiring those goods become more ubiquitous, the size of the market will expand exponentially.” Anu Shukla, Founder and CEO, Offerpal
We estimate the total addressable opportunity for virtual goods model games to be in the $2 billion range in the U.S. Our estimate is based on the assumption of $14 ARPU per month per paying player, which we believe is reasonable considering most of the virtual-goods-model-based online gaming companies that we talked to reported ARPU of $10- 25/month/paying user. For our market size estimate, we are assuming 10% penetration (active paying users to the addressable gamers i.e., 15-45 years of age and an Internet User), which we believe seems reasonable compared to the 22% average for the Chinese gaming industry.
Exhibit 25: Addressable Market Size Estimate For Games Based On The Virtual Goods Model China U.S.
Total Population (million) 1330 337
Internet Users (%) 22% 73%
Internet Users (million) 298 247
Population 15-45 Years Of Age (% of total) 41% 44% Addressable Population (Internet Users And 15-45 Years Of Age (million) 122.2 108.7
Paying Online Gamers (million) 27.1 10.9
Paying Online Gamers (%) 22% 10%
ARPU/Month/Active Paying User $5 $14
Per Capita GDP $6,000 $47,000
ARPU/Per Capita GDP (basis points) 7.9 3.0
Market Potential for Virtual Goods ($ million) $1,540 $1,839 Source: IDC, InternetWorldStats, ThinkEquity LLC
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In-Game Advertising In-game advertising refers to advertisements that are made either within a game or used as a wrapper around games. We believe that with broadening scope and increasing ubiquity, games are emerging as a new media just like newspaper, TV, and Internet. While the effectiveness or the reach of the traditional media is declining—the conversion rates on Internet remain at very low levels, newspaper readership, and TV viewership continue to dwindle and TiVo complicating the ad delivery on TV-game play time has continued to increase. We believe the amount of time and energy that consumers spend playing games are too big to ignore from a marketer’s perspective. In-game advertising was traditionally limited because of non-availability of technology. Our view is that with the recent advancement in in-game advertising technology (ability to insert ads at any stage of game’s life-cycle, ability to serve ads dynamically) and ability to verify and measure effectiveness of in-game ads, the marketers will be more amenable to embrace the idea of in-game ads. Like Internet advertising, in-game advertising is measurable and accountable (unlike the effectiveness of advertising in traditional media, which is difficult to measure). We believe that sophisticated marketers are already taking notice of games as a media (see Exhibit 26 on President Obama’s presidential campaign ads in-games). Games give marketers a captive, targeted audience who most of the time is willing to watch ads in return of the value provided for free.
Exhibit 26: President Obama’s Presidential Campaign Ads In Games
Source: Screenshots from Electronic Arts’ Burnout Paradise and NBA Live
In-Game Advertising For Consoles Games Consoles are emerging as media devices capable of playing not just games but also watching movies, downloading music, and surfing the Internet. Similarly, publishers are increasingly looking to monetize their games with ancillary revenue streams such as licensing for movies, character dolls, and increasingly in-game advertisements. Given measurability, accountability of in-game ads (as compared to TV), and a more highly targeted audience, and high brand recall (30% ad recall after six months for in-game ads versus typical 10% ad recall for traditional ad campaign per a study by Nielson), in-game ads for console games offer compelling value proposition to marketers, in our opinion.
In-game advertising for the console game was popularized by Massive Incorporated (now part of Microsoft). The competitive landscape for in-game advertising is mostly limited to Massive, IGA Worldwide, and Double Fusion. While Massive is mostly focused on ads on the Xbox platform, IGA Worldwide and Double Fusion work with Sony Play Station Console games.
! Static In-Game Advertising: The first generation of in-game ads, static in-game advertisements refer to advertisements that are hard-coded in the game environment. These ads can be in the form of product placement (e.g., Coca Cola vending machine in Splinter Cell), billboards (Sprite bill board in Splinter cell), or even as the part of the game play (Ax Deo Glowing Wall as an obstacle that players need to overcome in Splinter Cell). However, since static ads are hardcoded, they cannot be removed, altered, or tailored according to gamers
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demographics/preferences. Furthermore, these ads should be available even before the game is published (which makes it a difficult proposition—success of the game unknown). We believe most ads are now moving to second- generation dynamic in-game advertising.
Exhibit 27: Example Of Static In-Game Advertising—Sprite In Ubisoft’s Splinter Cell
Source: egamemarketing.com
! Dynamic In-Game Advertising: Unlike static ads, dynamics ads can be delivered based on the players preference/demographics, and ads can be changed over time too. Game developers build “hooks” in the game environment (receptor of in-game ads) and no advertisement is hardcoded. Ads are delivered on these hooks via the Internet when the gaming device is connected to the Web. Dynamic ads also allow the publisher and marketers to track the ad performance metrics and make tweaks accordingly.
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Exhibit 28: Examples Of Dynamic In-Game Advertisements
Source: Screen Shots from (clockwise from top left): Electronic Arts’ Madden NFL, NBA Live, Battlefield 2142, and Need for Speed
Advertisers clinch deals with console manufacturers to publish ads on their platforms, clinch deals with game publishers to place ads in their upcoming titles by offering either upfront fixed fee or revenue share (with some minimum revenue guarantees), and sells the inventory to its clients (brand managers). In effect, ad networks have to manage the risk of game success. The typical CPM range is approximately $25 to $35, which likely will come down as more inventory becomes available.
Since most of the console games are targeted toward core gamers, mostly males within the 18-34 years of age group, the scope of in-game advertising is primarily limited to brands that cater to this demographic. The scope of in-game advertisement on consoles is further limited because a number of games may not be appropriate for advertisement, i.e., marketers may not want to associate their brands with violent games, and, many times, ads may not make sense given the gaming environment such as a fantasy realm.
In-Game Advertising For Online Games Online games are probably the easiest target for in-game advertising since these games, by definition, are all always online. Ads can be delivered within the game environment or as pre-rolls. In-game advertising for casual games is more akin to other advertising on other Internet properties rather than in-game advertising on consoles games. In-game ad networks typically work with game developers, ad enable their games, maintain inventory on a large number of ad- supported games, publish these games on third-party publishers (such as Yahoo! Games, Real Arcade, etc.), and serve
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ads on these games. Most ad networks are focused on causal games, given the extremely large number of small game developers in that space and strong demand from gamers for these games.
Exhibit 29: Examples Of In-Game Advertisements In Online Games
Source: Screenshots from (clockwise from top left): Miniclip.com, Kongregate, Second Life, and Gaia Online
We believe that online games could be the bigger segment in in-game advertisement for the following reasons: - Much Bigger Player Base: Unlike console games that are sold for a fixed price, many online games are launched in a free-to-play model (supported by virtual goods, premium subscription, incentive marketing, and/or ads), which broadens the player base. - Casual gamers also come from broader demographics. In contrast with core gamers who tend to be largely 18-34 year old males, casual gamers encompass a wider demography that includes women, elderly, and younger players. - Captive And Engaged Audience That Values Free Content And Is Willing To Listen To The Message: Furthermore, casual gamers may be more receptive to watch ads as compared to core gamers. Core gamers who spend hundreds of dollars on consoles and another $50-60 on games may view an advertisement as an intrusion into their gaming environment versus casual gamers who may be more willing to watch ads. By nature, casual gamers are interactive and a playful audience that can be lured into game-advertisement and interesting ads (people watching Super Bowl ads after the game).
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Demand Drivers For In-Game Advertising
Gaming Emerging As A New Media “Gaming is now becoming a major medium. Research by Nielsen has shown that there has been a 12 percent decrease in prime television viewership in the demographic of males aged 18 to 34 years vs. a 20 percent increase in the times spent playing video games for the same group. So the advertisers and their dollars have to follow where the consumers are going.” Justin Townsend, CEO IGA Worldwide
Just like the Internet, television, and newspaper, gaming is emerging as a new medium. As the older media are increasingly becoming less effective (reduced readership of newspaper, reduced viewership of television complicated by the TiVo effect), advertisers are looking for new ways to reach their target audiences. With the increasing popularity of online gaming, gaming seems to be promising new media for advertisers to reach young users. The popularity of casual games has broadened the scope of gaming beyond just the young males to include females and older males and made games more ubiquitous. As ad buyers are becoming more familiar with the notion of gaming becoming a mainstream media, we believe in-game advertising growth will continue to accelerate.
Technology Coming To An Age “To a large part, it's the availability of technology for dynamic in-game advertising which hasn't been available until now— this technology opened up the possibility for advertisers to once again reach the gaming audience effectively through standard media buys.” Jonathan Epstein, CEO, Double Fusion
Strong ROI “We have a number of case studies that have shown positive results for the programs that our advertisers have done.” Jonathan Epstein, CEO, Double Fusion
“The research proved that brand recall for ads in games eclipses that for traditional media, as high as 30 percent after six months vs. less than 10 percent for traditional ad campaigns.” Justin Townsend, CEO, IGA Worldwide
“Our click rates are …much higher than what you would typically get in any kind of an Internet ad. And to some extent that's a function of the medium because if somebody's playing a game—they're more engaged, they're focusing on the window that the game is playing in, and they're more attentive. Whereas, if you're looking at content on a Web page, you've got ads around the top, bottom, and sides of the page but you're really focusing on the content in the middle.” George Garrick, CEO, Mochi Media
“Our advertisers have had a lot of success on our site and a lot of those advertisers keep coming back and re-buying. We leverage our gaming community and the fact that our users are addicted to achievement.” Jim Greer, Founder & CEO, Kongregate
Unlike traditional media, new media (such as Internet and games) lets the advertisers reach the target segment more effectively. Using behavior targeting, advertisers can personalize the message for each segments. Using A/B testing and multi-variate testing, advertisers can see the impact of the message on the fly and tweak and optimize the message. We believe that in-game advertising offers all the advantages of the online media plus offers more engaged users. While strong increase of online advertisement has led to “banner blindness” reducing the user engagement and therefore effectiveness of the banner ads; games offer engaged users. Unlike Internet users, gamers are pretty engaged since they want to advance to the next level, since they want to win and since they want to share their achievements with their friends.
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Measurability Of In-Game Ads “Other forms of display advertising, such as TV, print, and radio may have high reach but lower accountability and one cannot really determine the ROI on advertising in these means…[our advertising] is also very accountable because our software sits inside the games and we can measure and report back the effectiveness of the campaign to our advertising clients.” Justin Townsend, CEO, IGA Worldwide
Not only are the ads on the games more effective but also measurable, unlike traditional media ads, which improves the value proposition of in-game ads to today’s sophisticated ad buyers who are looking to see a measurable ROI on their ad- spend.
Improving Advertisers’ Sophistication Level With In-Game Advertising “I think for most advertisers, it's still considered a new media at this point. They're spending real budgets, but they probably are still looking at it as the new medium that they haven't fully figured out yet.” There's a lot of things that advertisers don't know yet, just because there hasn't been enough time to observe in enough different situations. So we're getting significant ad buys but we haven't had any million dollar ad buys yet.” George Garroick, CEO, Mochi Media
“This industry has evolved at a rapid pace…As for the advertisers, we have come a long way in the past two years and I think the next three to five years, it's going to be a steep upward trend. In the early years, in-game advertising budgets were mainly from experimental budgets. Now it's coming from the digital budget itself, and in many cases we're seeing reallocation of budgets from outdoor advertising, print advertising, TV, and other traditional media that opens a big opportunity for us.” Justin Townsend, CEO, IGA Worldwide
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Market Size Estimation Of In-Game Advertising “Look at the size of the videogame market and then look at the size of the TV market. What's interesting with online games is that we cover both. We're more of an online media company. To understand our potential, look at the value of Google! Now, where do people spend most of the time online? Is it on searching for things or is it entertaining themselves? If it's entertaining, then our industry is worth more than what Google is worth.” Howard Marks, Founder & CEO, Acclaim
We estimate the total addressable opportunity for console games advertisements to be in the $1 billion range. This estimate is based on our assumption that 40% of the consoles are connected to the Internet and that CPM will stabilize at about $10.
We believe that the opportunity for ads on online games could be bigger than that for ads on console games. We have assumed a CPM rate of $2 for ads served on online games.
Exhibit 30: Addressable Market Size Estimate For In-Game Advertising In Console Games
2011E
2008 Best Worst Base
Three-Year CAGR in Console Gamers 10% -2% 5%
Console Gamers (million) 73 97 69 85
Hours Game Play/Week/Player 8.2 9.0 7.0 8.2
Hours Game Play Year (million hours) 31,161 45,522 25,037 36,073
Percent Of Ad-Friendly Titles* 38% 38% 38% 38%
Ad-Friendly Game Play (million hours) 11,763 17,185 9,451 13,618
Consoles connected (%) 20% 50% 30% 40% Ad-Friendly Game Play on Connected Consoles (million hours) 2,353 8,592 2,835 5,447
Ads Served Per Hour of Game Play 20 20 20 20
Total Ads Served 47,054 171,846 56,708 108,941
CPM $10 $15 $5 $10 Market Potential for In-game Advertising ($ million) $471 $2,578 $284 $1,089 Source: NPD, ESA, and ThinkEquity LLC estimates
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* Ad Friendly Video Games By Units (%) Genre Units % Ad Friendly Ad Friendly Action 22.3% Family Entertainment 17.6% 50% 8.8% Sports Games 14.1% 100% 14.1% Shooter 12.1% 50% 6.1% Racing 8.3% 100% 8.3% Role Playing 7.6% Strategy 4.7% Fighting 4.5% Adventure 4.3% Children's Entertainment 1.0% Flight 0.7% Arcade 0.5% 100% 0.5% Others 2.3% Total 100.0% 37.8% Source: ESA, ThinkEquity LLC
Exhibit 31: Addressable Market Size Estimation Of In-Game Advertising For Online Games
2011E
2008 Best Worst Base
Three-Year CAGR in Online Gamers 10% 0% 5%
Online Gamers (million) 67 90 67 78
Internet Users (million) 248 295 273 284
Online Gamers (% of Internet Users) 27% 30% 25% 27%
Hours game play/week/player 7.0 8.0 6.0 7.0
Hours game play year (million hours) 24,504 37,273 21,003 28,366
Percent Of Ad-Friendly Titles 100% 100% 100% 100%
Ad-Friendly Game Play (million hours) 24,504 37,273 21,003 28,366
Ads Served Per Hour of Game Play 20 20 20 20
Total Ads Served 490,072 745,470 420,062 567,320
CPM $1 $5 $1 $2 Market Potential for in-game Advertising ($ million) $490 $3,727 $420 $1,135 Source: ThinkEquity LLC estimates
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Who Will Succeed: Characteristics Of Winners In Games As A Service
“In a traditional gaming business, once the disc is pressed and shipped to the retail, more or less the show is over. In the free-to-play model, once we launch a game the show starts.” Heiko Hubertz, CEO, Big Point
“This is a new kind of gaming business, and it's not build and publish; it's build and serve and then have recursive loops around tweaking and serving. It's an always-on business…where you have to have people watching your leading indicating metrics all the time…you're constantly turning dials.” Mark Pincus, Founder & CEO Zynga
“When selling games in a retail environment, prominent placement and recognizable brands are important sales drivers. On social networks, things are different. On social networks, you almost never look for games in a retail or catalogue like environment; you stumble on them because your friends play them. In fact, there's today not a single game franchise in the Facebook games top-10.” Kristian Segerstråle, Founder & CEO, Playfish
“The skills that it takes to make a successful, console game…are very different from the skills that it takes to make a successful online game. EA excels in having big teams, big marketing budgets, big brands and not necessarily adapting quickly to changing market conditions, to building a platform, which are what you're going to do online.” Jim Greer, Founder & CEO Kongregate
Focus On Understating Consumer Behavior Similar to the differences between the SaaS model and the traditional on-premise Software model (the on-premise model centers around closing the deals, while the SaaS model is about maintaining the customer base by proving the value of software every day), the online gaming model is about retaining the user base by delivering a continuously pleasant and engaging game-play experience. Similar to Web 2.0 businesses, online gaming companies have to continuously collect customer feedback (implicit and explicit—through various analytical software as well as through In-game non-player characters), understand and analyze customer behavior, and regularly update the game based on this understanding of consumer behavior.
Managing Piracy Versus Managing Communities; Aggressive Marketing Campaigns Versus Viral Marketing Managing online games is about successfully managing communities, in our view. Vendors, who offer the platform for developing and fostering community bonds can have strong community that is self sustaining, one that can invite their friends and spread word of mouth. While in the traditional packaged game business, the vendors have to worry about curbing piracy to grow, the online business is more about nurturing communities. While in the traditional packaged game business, vendors have to create aggressive marketing campaigns to create buzz around their games, online games are more about spreading messages by more-sustainable (and practically free) word-of-mouth marketing. Not only do we believe that the successful companies will use these customer evangelists to spread the word, but they will also use them for supporting players and handholding new players.
Distribution Is About Viral Nature Success of the online game is usually proportional to the virality of the games, with the elements of the social interaction in the game. As we mentioned before, for online gaming, virality drives adoption as opposed to the large distribution networks. In this marketplace, IPs become less important—success of a game may not necessarily translate into success of a series of games; players are far less forgiving and expectations are always moving up, people’s recommendations/number of people playing become more important than the title of legacy of the IP.
Monetization Through Alternative Models A successful company will typically use all the ammunition on hand to monetize its games. A vast majority of the players will most likely not pay for the game directly, but these players are equally important as the paying users. We believe that successful companies want to keep their communities healthy (even those that are not paying users) and will use
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advertising to monetize this population. Only a small percentage (5-15%) of the players will be willing to pay for subscription fees/virtual goods. We believe successful companies will adopt advertising combined with other forms of monetization to optimize value creation by each player.
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