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US equities Everything you wanted to know about video games but were afraid to ask

Chief Investment Office GWM | 23 April 2019 7:24 pm BST Robert Samuels, Consumer Discretionary and Media Analyst Americas, robert.samuels@.com; Reid Gilligan, Equity Associate Analyst Americas, [email protected]

• Although growth is slowing, the market continues to expand driven by macro tailwinds, new titles and in-game expenditures. • Mobile devices eclipse consoles and PCs as the primary tool for gaming. • Revenue model is in flux with the rise in popularity of free- to-play games like Fortnite. • Subscription gaming services and cloud gaming are likely to Fig. 1: 2018 video game revenue by region disrupt the over the next several years. Latin America Europe, 4% Middle East & Africa The has seen growth over the past 22% few years driven by favorable demographics, a growing addressable market, improving product quality, and faster speeds. Asia-Pacific We expect these trends to continue although competition within 49% the space, and for share of the consumer's wallet and time, is likely to make share gains for individual game publishers more challenging. Furthermore, the popularity of free-to-play games such as Fortnite has altered the industry's revenue model, which creates North America both opportunity and risk for game makers. 25% Before jumping into some of the most frequently asked questions Source: Newzoo, UBS around gaming, there are several macro trends to understand that help expand the landscape. The success of current video games relies on fast and dependable network speeds as more consumers are playing online. Today, the majority of video game players live in China, the US, , and Europe—areas of the world where access to high broadband speeds is prevalent. As access to reliable broadband becomes more widespread, the number of potential gamers increases correspondingly. This also applies to the global smartphone market, which is expanding the potential number of consumers given the growth of mobile gaming.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 8. UBS does and seeks to do with companies covered in its research reports. As a result, should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. US equities

1. How big is the video game market? Fig. 2: Global video games market Consumer spending on is rising and the gaming sub- (USD billions) $174.0 segment is expected to experience the fastest growth. According $160.5 $148.1 to market intelligence firm Newzoo, global video game revenues $134.9 $121.7 reached roughly USD 135 billion in 2018, an 11% increase over the prior year. While the gaming market is likely to grow at a slower pace than it has over the past several years, revenues are forecast to grow 8.4% annually from 2019 to 2021. We see a number of secular tailwinds that will help support growth over the next several 2017 2018 2019E 2020E 2021E years, including a growing installed base, increased engagement, Source: Newzoo and in-game expenditures. In terms of users, Newzoo estimates that there were almost 2.5 billion gamers worldwide in 2018, mainly located in China and the . 2. I've seen my kids playing games on their phones and Fig. 3: 2018 Global gaming market device tablets. How big is the market for mobile gaming? breakdown The installed base mentioned above consists of consoles (Xbox, Console 28% PC Playstation, etc.), PCs, and mobile. While the console installed 25% base has certainly increased, the mobile gaming audience has Boxed/Downladed PC grown exponentially thanks to the prevalence of smartphones, Browser PC USD 134.9 bn Tablet increased quality, and free or very inexpensive games. In fact, Tablet mobile gaming revenue surpassed USD 60 billion last year. Looking 10% Smartphone Console Smartphone forward, Newzoo estimates that mobile will grow at a 12.6% 37% annually compounded growth rate from 2019 to 2021 to USD 91.2 Mobile billion and be over 50% of global video-game revenues. 47% Source: Newzoo The growth of mobile gaming is vital to the overall health of the industry given the global installed base of smartphones compared to consoles and PCs. With already fast internet speeds and the coming of 5G, mobile users have access to games with astounding Fig. 4: Percentage of revenue by device over graphics, almost on par with Xbox or PC. In fact, Activision Blizzard time announced that the newest version of its popular Diablo game will 23% 22% 21% 20% 19% 2% 2% 1% be released on mobile and not PC. Apple is also diving deeper into 4% 3% 27% the mobile gaming market with the launch of Apple Arcade later 28% 27% 27% 28% Boxed/Downloaded PC this year. Thousands of games are available on both the iOS and 9% Browser PC 10% 10% 10% 10% Android app stores, with a majority of them being free. Free games Console Tablet 43% make money by selling advertisements within the game or incorpo- 36% 37% 39% 41% Smartphone rating in-game purchases. The vast number of free games is a sign of the low barriers to entry in the mobile space. 2017 2018 2019E 2020E 2021E Source: Newzoo 3. I've owned a Playstation 4 and for several years already. When can I expect to see a new console? We are currently in the eighth generation of video game con- soles, which encompasses all consoles released since 2012. This includes Microsoft's xBox One, 's PlayStation 4, and Nintendo's Switch. While the original consoles were released in 2012 and 2013, upgraded consoles such as the PlayStation 4 Pro and the Xbox One X have been developed and released in recent years, which is still considered part of the 8th generation. Console cycles have histor- ically lasted five to eight years but with continued additions and upgrades we expect this cycle to last slightly longer than those in years past. The 8th generation console installed base ended 2018 at roughly 125 million units, up from 89 million in 2016, which lends credence that there are a growing number of consumers to spend money on games.

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The market generally believes this generation of consoles will be Fig. 5: Facebook's Occulus coming to an end in the next year or two, with expected announce- ments of the 9th generation to occur in 2019 and a release date in 2020. We expect the 9th generation to hold more competitors than simply the popular Xbox, Playstation, and Switch. Virtual reality and cloud streaming will also play a role. As the hardware continues to improve and the price points come down, we expect to see a rise in VR headset popularity. PlayStation VR and Gear VR have so far been a success for Sony and , respectively. Facebook's Oculus is also gaining traction especially with the Oculus One, which does not need to be hooked up to a computer as in previous iterations. Source: Facebook 4. Who are the biggest players in the video game industry? Given economies of scale and M&A over the past decade, the video game market is dominated by a small number of companies. In fact, the ten largest companies comprise greater than 50% of the overall Fig. 6: Top public companies by gaming revenue global market. There are currently three publicly traded video game 25 publishers in the US: Activision Blizzard, Electronic Arts and Take- 20 )

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Historically, companies sold games for an upfront price in the USD U 30-60 range. However, over the past few years, the industry has 5 trended towards a more recurring and diversified revenue stream. 0 This transition occurred as (1) games became much more social and (2) the focus shifted towards digital downloads (rather than purchasing a physical disc), in-game purchases of downloadable 2017 2018 content (DLC), and microtransactions (see Fig. 7). According to Source: Newzoo SuperData, global in-game purchases totaled USD 87 billion last year, up more than 11% from 2017. Finally, digital revenue made up 73% of total revenue for the major US video game makers com- Fig. 7: Revenue tree pared to 37% in 2009. The ability to offer new maps, characters, achievements, and more Video helps extend the lifespan of a game because it offers new and Game Publisher exciting opportunities for the fan base over a longer period. Digital Revenue purchases and transactions also enhance game profitability. The margin on a digital download and DLC is approximately in the mid-60% range while microtransactions are even higher at approx- imately mid-80%. While mobile is 100% digital downloads and PC is greater than 90%, console digital downloads are still in the 50% range, meaning there is still room for growth in the digital download Digital Physical space. A large reason for the lower console percentage is due to · Digital download · Disc the fact that physical discs are a popular gift giving item and the memory limitations. 6. Why do I hear my kids talking to other people while they play video games? I thought they were playing by them- selves? DLC (downloadable content) Microtransactions Looking back at popular games of the past, including Super · Season pass · Characters / costumes · Expansion pack · Loot Boxes Mario Brothers, Legend of Zelda, and Doom, gamers predomi- · Maps · Emotes / Dance moves nantly played by themselves. Today, gaming has become much more Source: UBS social given the live services enhancement to gameplay that enables players to compete with friends and strangers in real time. Increased user engagement with more social aspects increases widespread popularity and extends the lifespan of a game. In addition to playing with people, gamers can also watch others play on a live stream, most commonly on Amazon's Twitch platform and Alphabet's Youtube. As a quick explanation, people can stream their game-

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play on Twitch for anyone to watch for free, while making money from advertisements, paid subscriptions, and donations. According to Newzoo, people spent 8.9 billion hours watching live Twitch content in 2018, up from 6.3 billion in 2017.

7. My child wants to become a professional video game player, is this a good idea? In short, no. There are thousands of people attempting to make money by live streaming themselves playing video games or by playing in competitions, meaning it is exceedingly difficult to stand out from the crowd. However, that does not mean it is impos- sible. As an extreme example, the most popular Fortnite player, Tyler "Ninja" Blevins, earns over USD 500,000 per month. While this level of celebrity is not easily earned, it speaks to the huge amount of money people are willing to spend not just to play a game, but simply watch someone else play it. eSports is another way to make a career out of gaming. We believe Fig. 8: eSports sources of revenue the eSports phenomenon continues to offer a significant oppor- 500 450 +34.3% tunity for video games. eSports, or competitive video gaming, has ) 400 s YoY n 350 o i taken the world by storm and is now the fastest growing spectator l 300 l i 250 m sport in the world. Given the demographics that eSports cater to ( 200 +41.8% D

S 150 YoY +14.8% — millennials and gen Z — and the global reach of gaming, we are U 100 YoY +22.4% -3.0% 50 likely still in the very early innings of growth. According to research YoY YoY 0 firm Newzoo, the eSports industry is projected to generate more Sponsorship Media Rights Advertising Merchandise Game than USD 1 billion in revenue this year and grow to the size of & Tickets Publisher Fees approximately USD 1.65 billion in 2021. Compared to the USD 138 Source: Newzoo billion video game , it is relatively small but has a big impact by driving expanded popularity and attachment. Activate estimates that there were 270 million global fans of eSports in 2016 and projects that number to Fig. 9: 2018 largest eSports games by total com- grow to 495 million in 2020. Already, eSports has a larger audience bined prize pool 45 than two of the major sports leagues in the United States (MLB 40 35

and NHL) because of the global audience. So what are the most ) s

n 30 o i l popular eSports games? Dota 2 (PC) is by far the most popular l

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eSports game with a whopping combined USD 41.26 million prize D S 15 U pool in 2018. Others include Fortnite, Overwatch, Call of Duty, and 10 Counter-strike. While there are individual competitions throughout 5 the year, there is a growing number of leagues. Blizzard's Overwatch 0 League (owned by Activision) is near the top of the list with 12 teams competing for a total prize pool of USD 3.5 million. Players have to be at least 18 years old and salaries range from USD 50,000 to USD 150,000 — not too shabby for playing video games for a Source: esportsobserver.com living. Interestingly, these teams are branded and localized to a geo- graphic area with team ranging from Bob Kraft (owner of the New England Patriots) to Kroenke Sports and Entertainment (owners of the Los Angeles Rams, Denver Nuggets and Arsenal FC). Fig. 10: Global eSports audience growth Just recently eSports Gen.G, which fields eight profes- 700 sional eSports leagues, announced that it has raised USD 46 million 600 ) s

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from investors including actor Will Smith and Los Angeles Clippers l l i 400 m minority owner Dennis Wong. ( e

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e 200 8. It sounds like eSports could make a good investment. How P can I invest? 100 0 We have received questions on how to invest in eSports. As a 2017 2018 2019E 2022E short answer, it is very difficult to invest in a pure play eSports eSports Enthusiasts Occasional Viewers company. Game publishers only have a small portion of their Source: Newzoo revenue coming from eSports leagues. The platforms used to watch

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eSports such as Twitch, Youtube, Ustream, and Livestream are all owned by Amazon, Alphabet, IBM, and Vimeo, respectively. Amazon, Alphabet, and IBM are not eSports investments and Vimeo was purchased by IAC. If investors are looking for a eSports focused investment, they likely have to look in the private markets for the time being. 9. What makes a good video game? The importance of strong intellectual property in the video game industry is paramount to success because of the highly compet- itive landscape. Titles with a strong following like EA's FIFA and Activision's Call of Duty franchise offer a more secure revenue base. Another opportunity we see are companies with strong IP re-making popular games of the past with live services in order to capture the nostalgia of millennials and baby boomers. Games that target older generations can also capture consumers with higher disposable income. 10. What are some trends that are likely to disrupt the video game industry over the next several years? Subscription services and cloud-streaming of games are two trends that we are keeping an eye on.Think of how Netflix turned tra- ditional media on its head. Subscription services entail paying a recurring fee for access to a number of games. For example, EA's subscription 'EA Access', costing either USD 5/month or USD 30/year, offers subscribers the ability to purchase new titles at a dis- count and the ability to download over 50 additional games. With continued advances in technology, the video game industry Fig. 11: Google's Stadia controller is on the cusp of turning into a streaming model rather than the downloading or purchasing of disc-games. In fact, Google recently unveiled a new cloud gaming service named Stadia that is expected to launch this year. While we don't know how much it will cost or what games will be available at launch, consumers will have instant access to play games on laptops, desktops, TVs, tablets, and phones without having to purchase a console or download the game. Google is using its data centers across the globe to facilitate high resolution streaming, something that has been a major sticking point when attempting to stream games in the past. Also, Stadia will be directly tied to YouTube, meaning a consumer can share Source: Google's website their own gameplay to YouTube, watch others play and facilitate playing alongside professionals. By creating the service with "pro- fessional streamers" in mind, YouTube is taking steps to compete with Amazon's Twitch on a larger scale. Google is launching its own game development studio and will allow others to build their own titles and offer it on the platform. As for the user experience, Stadia enables cross-platform gameplay. The only physical piece of this new platform is a custom controller (see Fig 11), the company built but isn’t required as it will support other game pads as well. While Google launched their own game development studio, it takes a lot of time and money to develop high quality games. In the near term, we expect Google to form with current developers such as Activision Blizzard, EA, and Take Two Interactive to entice consumers to join Stadia because of the loyal fan-base certain games have. Google was the first to announce their cloud- gaming platform, and may be the first to launch, but there is also that other firms may be their own cloud streaming service.

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Amazon already has the largest footprint in the video-game streaming world with Twitch, and may want to build upon it while also using their expertise in cloud-computing. Although Microsoft doesn't have a streaming service, the firm is best positioned to combine their Azure cloud prowess with original software content creation. In the near term, strong IP remains essential to draw a large enough fan-base to drive revenues, which bodes well for major game devel- opers. The total addressable market (TAM) may increase as well with the decreasing consumer barriers to entry such as expensive con- soles and PCs. Over the long term, investors should be wary of the increased competition between game studios for the consumer's time and money. 11. What are Apple's plans in the video game space? Fig. 12: Apple Arcade Apple recently announced Apple Arcade, a subscription gaming service that it plans to launch later this year, offering subscribers access to over 100 exclusive games. The company has yet to announce the cost of this new service. The collection of games available will be updated monthly and will include original releases from renowned creators such as Ken Wong, Will Wright and Hironobu Sakaguchi. Some reports suggest that Apple is set to spend over USD 500 million on the new service. Currently, Apple's App store revenues are dominated by free-to-play games that make money from advertisements and microtransactions. Apple Arcade's focus on premium games without the pay-to-play mechanics may provide a welcome path for gamers as the mobile segment con- Source: Apple Website tinues to grow. 12. My kids are obsessed with Fortnite. What do I need to know about this game and its popularity? Fortnite, which is produced by , revolves around a simple 'Battle Royale' format where gamers search for weapons and armor to fight one another and build structures for protection all while the world they are playing in becomes smaller and smaller until there is only one player left standing. The game is free to download, simple to play and its cartoonish-style has made it a cultural phenomenon, with almost 250 million registered users to date since launching in 2017.

While the game is free to play, Fornite makes money by selling V-bucks, which cost USD 9.99 per 1,000, and can be spent on customization items such as emotes, or dance moves, and skins, which are outfits and accessories. Gamers can also purchase battle passes, which unlock various challenges and rewards for the 10- week season. According to Nielsen's SuperData tracking arm, the game made nearly USD 2.5 billion in sales last year. Quite an accom- plishment given the fact that this game is free to play. Finally, the game's popularity has actually expanded the number of gamers, with a notable increase in female gamers.

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13. So what are going to be some of the must-have games this year? In 2019, there are numerous popular titles that have been announced to the public. More games are in development and could be announced later, especially with the launch of Stadia and Apple Arcade, but some titles we know are coming is as follows:

2019 Video Game Releases Game Title Publisher Anthem EA Apex Legends EA Borderlands 3 Take Two Civilization VI: Gathering Storm Take Two Crackdown 3 Microsoft Crash Team Racing: Nitro-Fueled Activision Blizzard Days Gone Sony Far Cry New Dawn Ubisoft Gears of War 5 Microsoft Halo Infinite Microsoft Madden NFL 2020 EA Mortal Kombat 11 Warner Brother Games Pokemon Sword and Shield Nintendo Resident Evil 2 Capcom Sekiro: Shadows Die Twice Activision Blizzard Star Wars: Jedi Fallen Order EA Super Mario Maker 2 Nintendo The Legend of Zelda: Link's Awakening Nintendo

Source: Company data

We certainly expect to see developers launch games around the 2019 holiday season, similar to last year with big-name releases such as Red Dead Redemption II, Call of Duty: Black Ops 4, and Battlefield V.

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Appendix

Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. Statement of Risk Statement of Risk Equities - market returns are difficult to forecast because of fluctuations in the economy, psychology, geopolitical conditions and other important variables.

Required Disclosures For a complete set of required disclosures relating to the companies that are the subject of this report, please a request to UBS CIO Global Wealth Business Management, 1285 Avenue of the Americas, 20th Floor, Avenue of the Americas, New York, NY 10019.

UBS CIO WM equity selection system (for US sector Equity Preferences) US equity sector provide two equity selections: Most Preferred (MP) and Least Preferred (LP). Most Preferred* We expect the stock to outperform the benchmark in the next 12 months. Least Preferred* We expect the stock to underperform the benchmark in the next 12 months. *A stock cannot be selected as Most Preferred if UBS Research rates it a Sell, while a UBS Research Buy rated stock cannot be selected as Least Preferred. Restricted: Issuing of research on a company by CIO GWM can be restricted due to legal, regulatory, contractual or best business practice obligations which are normally caused by UBS Investment ’s involvement in an transaction in regard to the concerned company. Equity selection: An assessment relative to a benchmark Equity selections in Equity Preferences lists (EPLs) are relative assessments versus a sector/industry, country/regional or thematic benchmark. The chosen benchmark is disclosed on the front page of each EPL. can be selected for several EPLs. To keep consistency, a stock can only be selected as either Most Preferred or Least Preferred, but not both simultaneously. As benchmarks differ between lists, stocks need not be included on every list to which they could theoretically be added. The country EPL is a list of Most Preferred recommended stocks that our US Equity Sector Strategy team feels are best positioned within their respective sector coverage to outperform their respective sector benchmark over a 12-month investment horizon. These selections should not be viewed as a portfolio as they represent a current snapshot of our views. In the event that a recommended stock is no longer Most Preferred, the list will be updated in the next monthly publication. As such, these recommendations are only valid as of the date of the report and performance for this list will not be calculated. For updates to the views on these names, please consult the most recent Equity Preferences List (EPL) for the relevant sector, which may be obtained from your client advisor.

Required Disclosures For a complete set of required disclosures relating to the companies that are the subject of this report, please mail a request to UBS CIO Global Business Management, 1285 Avenue of the Americas, 20th Floor, Avenue of the Americas, New York, NY 10019. Disclosures (23 April 2019) Within the past 12 months UBS AG, its affiliates or subsidiaries may have received or provided investment services and activities or ancillary services as per MiFID II which may have given rise to a payment or promise of a payment in relation to these services from or to each company mentioned in the publication. Activision Blizzard Inc. 2, Alphabet Inc 1, 2, 3, 7, 9, Alphabet Inc. Class A 1, 2, 3, 7, 9, Amazon.com 1, 2, 3, 4, 5, 6, 7, Apple Inc. 1, 2, 3, 4, 5, Electronic Arts Inc. 2, Facebook 2, 3, 8, Microsoft Corp. 1, 2, 3, 4, 5, 6, 7, 10, 11, 12; Take-Two Interactive Software Inc 2,

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Appendix

1. Within the past 12 months, UBS Securities LLC and/or its affiliates have received compensation for products and services other than investment banking services from this company/entity. 2. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 3. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month's end (or the prior month's end if this report is dated less than 10 working days after the most recent month's end). 4. This company/entity is, or within the past 12 months has been, a client of UBS Financial Services Inc, and non- investment banking securities-related services are being, or have been, provided. 5. Within the past 12 months, UBS Financial Services Inc has received compensation for products and services other than investment banking services from this company. 6. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. 7. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided. 8. The equity analyst covering this company, a member of his or her team, or one of their household members has a long common stock position in this company. 9. UBS AG, its affiliates or subsidiaries owns a net long position exceeding 0.5% of the total issued share capital of this company. 10. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity or one of its affiliates. 11. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided. 12. The UBS Wealth Management , a member of his or her team, or one of their household members has a long common stock position in this company.

Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition A actual i.e. 2010A COM Common shares E expected i.e. 2011E MP Marketperform: The stocks expected performance is in line with the sector benchmark NAV Net asset value Shares o/s Shares outstanding UP Underperform: The stock is expected to CIO UBS WM Chief Investment Office underperform the sector benchmark x multiple / multiplicator

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Appendix

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