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Entertainment:

February 11, 2014

Michael Pachter Nick McKay Nick Citrin (213) 688-4474 (213) 688-4343 (213) 688-4495 [email protected] [email protected] [email protected]

Post Hoc Ergo Propter Hoc; Why the Next Generation Will Be as Big as Ever

Wedbush Securities does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors :Software should consider this report as only a single factor in making their investment decision. Please see page 172 of this report for analyst certification and important disclosure information .

ACKNOWLEDGEMENT

We thank our good friend, Junkwaffle, for the fabulous cover art and for demonstrating that there are many misperceptions about the past and the likelihood the past will repeat itself.

We also thank the many viewers of Pach-Attack! at GameTrailers.com and our many followers for giving us many of the ideas discussed in this report.

It is important to acknowledge the contribution from media sites Edge-Online, The Verge, .com, , VentureBeat.com, gamesindustry.biz, .net and gamasutra.com for keeping us on our toes and always asking us to think about the industry in real time.

Finally, we feel we must give a shout out to NeoGAF.com and its members, for challenging virtually everything we say as being wrong, and for making us re-think many positions over the years.

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TABLE OF CONTENTS

ACKNOWLEDGEMENT...... 1 TABLE OF CONTENTS ...... 2 LIST OF FIGURES...... 5 OVERVIEW ...... 6 EXECUTIVE SUMMARY...... 8 INDUSTRY FORECAST...... 11 Hardware Forecast ...... 11 Software Forecast...... 12 Investing in Software Publishers...... 13 SECTION 1: INDUSTRY OVERVIEW AND FORECAST...... 15 DEFINING THE INDUSTRY...... 16 Distributors...... 17 Retailers...... 18 INDUSTRY SIZE: THE ADDRESSABLE MARKET OPPORTUNITY...... 20 Geographic Markets...... 20 Hardware and Software Sales Split ...... 22 Software Versus Other Entertainment Sectors ...... 22 WHAT CAUSED THE DECLINE FROM PEAK 2008 LEVELS?...... 24 The Rise of Mobile and Tablet Games...... 24 The Rise of Free-to-Play PC Games ...... 25 The Dramatic Growth of Online Multiplayer ...... 26 Console Fatigue and Fads...... 28 The Economy...... 29 Conclusion...... 29 DEMOGRAPHIC ...... 30 Widening Age Demographic ...... 30 Rapid Teen Growth...... 31 Female Market...... 31 Increasing Youth Income ...... 32 HARDWARE PLATFORMS...... 33 Home Consoles ...... 34 Console Cycles...... 35 Prior Console Transition ...... 40 128-Bit Consoles ...... 40 PlayStation 2 ...... 43 GameCube ...... 44 ...... 45 ...... 46 PS3...... 47 ...... 50 ...... 51 PS4...... 52 ...... 52 Handheld, Portable and Mobile Consoles...... 52 Advance...... 52 DS...... 54 Sony PSP ...... 54 Nintendo 3DS ...... 55 PlayStation Vita (PS Vita) ...... 55 Mobile Gaming...... 56 WHY THIS COULD BE THE LAST CONSOLE CYCLE ...... 58 POST HOC ERGO PROPTER HOC...... 60 Introduction...... 60 PlayStation Now Is Unlikely to Change the Landscape ...... 64 Once Again, There May Not Be Another Console Cycle (But Lots and Lots of Console SKUs) ...... 65 Digital Downloads Are Here and Now...... 67 The Wii U Appears to Be a Bust: We Believe Nintendo Must Rethink Its Strategy...... 67 The Handheld Market Is Likely to Continue to Shrink ...... 68 Is the Past of Online Gaming ...... 69 Digital Downloads Will Likely Limit GameStop’s Growth...... 70 Free-to-Play Games Are the Mass Market Present and Future ...... 73

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Mobile Phone Games Should Drive Overall Growth ...... 74 POST SCRIPT—LESSONS LEARNED FROM THE LAST CONSOLE CYCLE ...... 76 Conclusion...... 77 INDUSTRY CONSOLIDATION ...... 78 M&A Doesn’t Make Sense...... 78 We Believe Competition from Media Companies Doesn’t Make Sense...... 79 ...... 79 Blizzard...... 80 Take-Two Interactive ...... 80 Majesco ...... 81 ...... 81 HARDWARE FORECAST ...... 82 PERSONAL VIDEO GAMES ...... 88 SOFTWARE ECONOMICS ...... 90 Retail Pricing Trends...... 90 Production Costs ...... 93 Game Platform...... 94 Content Source...... 94 Development Costs ...... 95 Other Costs...... 96 SOFTWARE GENRES...... 98 Strategy/RPG...... 98 Sports ...... 100 Extreme Sports ...... 100 Action/Adventure ...... 101 Shooter ...... 101 Racing...... 102 Fighting...... 103 Simulation...... 103 Family Entertainment/Children...... 104 Other...... 104 CONTENT OVERVIEW...... 105 Brand ...... 105 Game Play...... 106 Genre...... 107 Kiddie Content ...... 108 Sports ...... 108 Extreme Sports ...... 108 Edgy Content...... 109 All Other...... 109 Target Demographic ...... 109 “Buzz” ...... 111 Conclusion...... 111 SOFTWARE GROWTH FORECAST ...... 113 SECTION 2: INVESTING IN SOFTWARE PUBLISHERS...... 119 INVESTING IN SOFTWARE PUBLISHERS...... 120 Industry Price Performance ...... 120 Historical Industry Returns...... 121 Revenue Size and Growth...... 121 COMPANY STRATEGIES...... 123 Platform Focus...... 123 Development Assets...... 125 Development Synergies...... 126 Third-Party Distribution ...... 127 Geographic Dispersion of Revenues ...... 128 Online Strategies ...... 128 Strategies ...... 129 ...... 130 Electronic Arts...... 130 ...... 130 Nintendo ...... 131 Take-Two Interactive ...... 131 Ubisoft...... 131

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Mobile Strategies ...... 132 CONTENT COMPARISON...... 133 Brand Building ...... 133 Top Brands of 2013 ...... 134 Top Brands by Publisher...... 135 ACCOUNTING ISSUES ...... 137 Capitalized Software Development and Prepaid Royalties...... 137 Reserves...... 138 UPSTARTS AND STARTUPS...... 140 ...... 140 Oculus VR...... 140 ...... 140 SECTION 3: COMPANY PROFILES...... 141 PROFILES – COVERED PUBLICLY TRADED COMPANIES...... 142 PROFILES – NON-COVERED PUBLICLY TRADED COMPANIES ...... 150 PROFILES – PRIVATE COMPANIES...... 162

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LIST OF FIGURES

Figure 1: Top 20 Entertainment Software Publishers as a Percentage of Total Sales, 2012 and 2013 ...... 17 Figure 2: U.S. Retailer Console and PC Software Market Share ...... 19 Figure 3: Worldwide Interactive Entertainment Sales 2004 – 2016E ($ millions) ...... 21 Figure 4: Addressable Market for U.S. Software Publishers 2004 – 2016E ($ millions)...... 22 Figure 5: Primary Video Gamer by Age and Gender...... 32 Figure 6: 2013 Video Game Software Sales Market Share by Platform Type...... 33 Figure 7: U.S. Console Cycles and Hardware Launches ...... 36 Figure 8: U.S. Cumulative Hardware Unit Sales...... 37 Figure 9: U.S. Annual Hardware Unit Sales ...... 39 Figure 10: U.S. Software Sales by Platform ...... 40 Figure 11: Console Installed Base (U.S. and Europe)...... 42 Figure 12: Console Installed Base (Worldwide)...... 43 Figure 13: Sony PlayStation 2 Unit Sales (2000 – 2015E) ...... 44 Figure 14: Nintendo GameCube Unit Sales (2001 – 2008) ...... 45 Figure 15: Microsoft Xbox Unit Sales (2001 – 2007) ...... 46 Figure 16: Microsoft Xbox 360 Unit Sales (2005 – 2016E)...... 47 Figure 17: Sony PS3 Unit Sales (2006 – 2016E) ...... 49 Figure 18: Nintendo Wii Unit Sales (2006 – 2016E)...... 51 Figure 19: Nintendo Unit Sales (2001 – 2008)...... 53 Figure 20: Sony PSP Unit Sales (2004 – 2015E)...... 55 Figure 21: U.S. Console Price History...... 57 Figure 22: Average U.S. Console Ownership by Household...... 82 Figure 23: Console Unit Sales U.S. and Europe (2003 – 2016E)...... 84 Figure 24: Console Unit Sales Japan and Worldwide (2003 – 2016E)...... 85 Figure 25: Console Dollar Sales U.S. and Europe (2003 – 2016E)...... 86 Figure 26: Console Dollar Sales Japan and Worldwide (2003 – 2016E)...... 87 Figure 27: PC Entertainment Software Sales (2004 – 2016E) ...... 88 Figure 28: Average U.S. Retail Software Price by Platform...... 90 Figure 29: Sample Gross Margin Calculation...... 97 Figure 30: U.S. Video Game Software Market by Genre, 2001 – 2013...... 98 Figure 31: U.S. Top Video Game Software – Strategy and Role Playing Games ...... 99 Figure 32: U.S. Top Video Game Software – Sports...... 100 Figure 33: U.S. Top Video Game Software – Action / Shooter...... 102 Figure 34: U.S. Top Video Game Software – Racing ...... 103 Figure 35: U.S. Top Video Game Software – Fighting ...... 103 Figure 36: U.S. Top Video Game Software – Family / Children ...... 104 Figure 37: Percentage of U.S. Publishing Sales by Genre, 2013...... 107 Figure 38: Percentage of U.S. Software Genre Sales by ESRB Rating, 2013 ...... 110 Figure 39: Percentage of U.S. Software Publisher Sales by Ratings, 2013 ...... 110 Figure 40: Percentage of Total U.S. Console Software Sales by Rating, 2001 – 2013...... 111 Figure 41: Worldwide Interactive Entertainment Software Sales (2004 – 2016E) ...... 113 Figure 42: Software Unit Sales U.S. and Europe (2003 – 2016E)...... 115 Figure 43: Software Unit Sales Japan and Worldwide (2003 – 2016E)...... 116 Figure 44: Software Dollar Sales U.S. and Europe (2003 – 2016E)...... 117 Figure 45: Software Dollar Sales Japan and Worldwide (2003 – 2016E)...... 118 Figure 46: Key U.S. Publicly-Traded Interactive Entertainment Software Publishers...... 120 Figure 47: Industry Stock Performance (1999 – 2013)...... 121 Figure 48: Covered Companies Publisher Sales Mix by Platform, 2010 and 2013 ...... 125 Figure 49: Top Interactive Entertainment Software Brands (U.S. % Sales 2011 – 2013)...... 134 Figure 50: Publisher Top Brands (U.S. % of Sales 2013) ...... 135

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OVERVIEW

Over the last five years, the has seen a massive shift. Software sales for dedicated handheld and console hardware declined by 45% between 2008 – 2013, and at the same time, annual revenues from mobile games grew astronomically, to an estimated $6 billion in the West.

Many industry observers correlated the two trends, concluding that the rise in mobile and tablet game revenues must have caused the decline in dedicated handheld and console software sales. The title of this report, Post Hoc Ergo Propter Hoc , stands for the proposition that because event B followed event A, then A must have caused B. We believe that conventional wisdom dictates that as mobile and tablet game revenues continue their inexorable rise, then console and handheld software sales will continue to decline. We reject this conclusion.

We believe that the rapid ramp of next-generation consoles sales (the Wii U, Xbox One and PlayStation 4 are all next generation consoles) will trigger an equally rapid ramp in software sales for the consoles. We acknowledge that mobile and tablet game revenues will continue to grow at a rapid pace, but believe that their impact will be primarily felt on the handheld side of the business. As such, those publishers with little exposure to handheld software sales should see their revenues grow at or above the pace of overall industry software sales growth.

We forecast industry growth in the U.S. and Europe (the addressable market for the companies we cover) of 18% in 2014, 14% in 2015 and 11% in 2016, for a three-year compound annual growth rate of 14.5%. This growth is the product of continuing current generation software sales declines of 30% annually, more than offset by robust contribution from software sales for next-generation consoles. We forecast that current generation handheld and console software will decline from $8.3 billion in 2013 to $5.9 billion in 2014, $4.1 billion in 2015 and $2.8 billion in 2016. At the same time, we expect next- generation software sales to grow from $1.5 billion in 2013 to $6.1 billion in 2014, then to $10.1 billion in 2015 and to $13.2 billion in 2016.

We base our estimates on our observation that the ramp of current generation software sales was closely correlated to the ramp of sales for current generation consoles (the PS3, Xbox 360 and Wii). In the current generation, combined U.S. and European sales of PS3, Xbox 360 and Wii hardware reached a cumulative 32.8 million consoles in 2007; that year, software sales for those three consoles totaled $7.6 billion. In the next generation, we forecast that combined hardware sales for the three consoles will total 33.6 million at the end of 2014, suggesting that this year should be comparable to 2007 in forecasting contribution from software sales for the three consoles. Our forecast of $6.1 billion is 20% below the achieved in 2007, leaving some room for lower tie ratios as a result of competition from mobile and tablet games.

It is entirely possible that current generation software sales will continue their decline more rapidly than we have forecast. However, sales of software for the three current generation consoles peaked at $16 billion in 2008, and have declined by 48% since, leaving us at a very low starting point. While we acknowledge that current generation software sales could decline at a faster rate than the 30% we have modeled, we hasten to point out that even if the rate of decline is 50%, overall console and handheld software sales would grow by 5% in 2014.

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The following are the main points in this report:

• In Section 1 of the report, we discuss the industry in general, providing an overview and forecasting rates of growth.

• The industry is defined in terms of participants in the value chain.

• The size of the addressable market is discussed, including areas of opportunity, and a comparison of video game software to other entertainment options.

• The 45% decline from the software sales peak (console and handheld combined) is explained, and a basis is provided as to why these declines will likely moderate going forward.

• Market demographics are discussed, including growth due to an aging gaming population, greater disposable income for teens and an increase in the number of women playing games.

• The history of home consoles is discussed to make the point that the past is prologue, and each succeeding console cycle has been larger than the preceding cycle. We expect this cycle to approach the size of the last, albeit with some cannibalization from a shift of spending to mobile and free-to-play PC games.

• The key to this report is our discussion of why the software sales declines of the past five years are likely to reverse. We discuss why people enjoy purchasing packaged game software, why digital downloads will be an increasing part of the , why this is likely to be a two-console race, why the handheld market will continue to shrink, and why online business models are likely to continue their evolution.

• The balance of Section 1 discusses the economics of the industry, the various genres of games, and an overview of content. Section 1 concludes with our software growth forecast.

• Section 2 discusses investment in the publishers, providing historical performance and setting forth the various strategies employed by the companies we cover. We also compare original and licensed brands produced by each of the game publishers.

• Section 3 contains profiles of the companies we cover, and profiles of public and private companies that compete with our covered companies.

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EXECUTIVE SUMMARY

Video game software sales have had ups and downs, but none so pronounced as in the current generation console cycle. Since the launch of the Xbox 360 in late 2005, interactive entertainment software sales have ebbed and flowed, with sales in the U.S. and Europe growing by 70% from 2005- 2008, and declining by 45% since then. Sales of software grew from around $14 billion in 2005 to over $24 billion by 2008, and in the past five years, sales have declined to the point where they are actually below 2005 levels.

We believe there are many explanations for the decline: first, the explosive growth in software sales was largely attributable to rapid sell-through of the Wii, which sold over 100 million hardware units worldwide. The Wii brought in a large number (we estimate 50 million) of non-traditional consumers who had never owned a console in the past, and who, we believe, will not buy another one in the future. As these consumers moved on from purchasing Wii software, recurring sales of software overall were negatively impacted. A second explanation is the increasing popularity of multiplayer games, which had an estimated 3 million combined players in 2007 and grew to an estimated 30 million in 2013. As an increasing number of games added multiplayer functions, consumers played those games longer, and bought fewer new titles as a result. A third explanation is the evolution of and tablet games, which provide a first-rate experience, often for free. We believe these games cut into the addressable market for dedicated console and handheld games at the low end, and cannibalized sales overall. Finally, the publishers contributed to the overall decline, by making fewer games as a way to control research and development spending; with fewer choices overall, consumers bought fewer games.

We define “current generation” as software for the Nintendo DS, 3DS and Wii, for the Sony PSP, PS Vita and PS3, and for the Microsoft Xbox 360, and will refer to this as “current generation” throughout this report. We define “next generation” as software for the PS4, Xbox One and Wii U. Because current generation console prices remain relatively high, we expect the current generation to generate sales for several more years, with declines in software sales of roughly 30% annually going forward. Beginning in 2011, revenues from non-traditional sources (online games, casual games, games, , and in-game ) began to contribute meaningfully to results for most publishers, offsetting slowing growth of packaged goods software sales.

The current generation began without fanfare in 2004. That year, Nintendo reinvented its handheld Game Boy Advance as a dual-screen device, with a touch screen allowing the consumer to interact with video game content in a different way. We believe few observers appreciated that the Nintendo DS signaled a change in game play that previewed the company’s plans for its console (the Wii) introduced in 2006. In early 2005 (December 2004 in Japan), Sony launched the PlayStation Portable (PSP), intending to capture share in the handheld market from Nintendo. Later that same year, Microsoft launched the Xbox 360, offering true high-definition gaming. In late 2006, Sony and Nintendo launched the PS3 and the Wii, respectively, and the current generation was in full gear. Although the last of these launches completed the beginning of the current generation cycle, they by no means marked the end of the current cycle. All major software publishers made a distinct effort to extend the value of the “legacy” system in 2007 and 2008 by continuing to develop games for the PS2. Perhaps the most successful of these new games were the music-themed rhythm games, and .

The preceding video game software cycle began with a dip. Annual industry software sales, reflecting combined sales of console, handheld and PC games in the U.S. and Europe, declined by 9% in 2000, followed by growth of 4%, 15%, 12%, and 11% in 2000-2004, respectively. The current console cycle began with a similar dip, as sales declined by 2% overall, with a rebound to 4% growth in 2006. After a relatively modest beginning, the current cycle became a , with 35% sales growth in 2007 and 41% growth in 2008. The 2008 figures were dramatically impacted by foreign currency translation (all of our sales figures are stated in U.S. dollar terms). Two factors contributed to the robust results in 2007 – 2008: first, while consumers were slow to adopt current generation technology due to supply constraints, they chose to continue purchasing legacy generation software while waiting to replace their

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old consoles. While last generation software sales declined by 71% between 2005 and 2008, the category still contributed almost $2.5 billion in overall sales (11% of the total) in 2008, compared to only $550 million (4.2% of sales) for legacy software at a similar point in the last cycle. The second reason for robust sales growth is the rate of adoption of the Wii, with non-traditional households buying and Wii software in historically high numbers. At the same time, sales of the relatively high-priced PS3 have been unimpressive, with the more moderately priced Xbox 360 performing about as expected.

In the console cycle that began in 2000, the installed base of legacy generation hardware (PS2, GameCube and Xbox) peaked at around 115 million units in the U.S. and Europe. Total console and handheld software sales grew from $6.6 billion in the U.S. and Europe in 2000 to $11.2 billion in 2005, representing a compound annual growth rate of 11%. This growth rate accelerated between 2005 and 2008 to over 25%, and sales thereafter precipitously declined. Sales were down by 14% in 2009, 7% in 2010, 11% in 2011, 18% in 2012 and 13% in 2013, for a compound annual decline rate of over 12%. As sales grew in the middle part of the decade, publisher stocks soared; as sales decline over the last five years, publisher stocks stagnated.

We expect the next generation of consoles to usher in another growth cycle for software sales. The potential for a rebound to phenomenal sales growth and the relative underperformance of stocks has triggered heightened investor interest in the dynamics of the video game “console cycle”, which began with the launch of the Wii U in November 2012 and continued with the launches of the PS4 and Xbox One in November 2013. In this report, we explore industry fundamentals, forecast industry sales growth by segment and geographic area, and compare several publicly traded publishers to uncover the industry’s likely top performers over the next several years. As packaged good sales growth inevitably slows, we expect significant contribution from four non-traditional sources of revenue: online subscription games (MMOs), free-to-play PC games, mobile phone and tablet games and extra content sold via digital downloads. Later in this report, we forecast the overall market size for each of these non-traditional sources, and attempt to quantify their impact on publisher earnings over the next decade.

Ultimately, we expect console hardware sales to be closely correlated to the quality and quantity of the underlying available content. There are two key differences between the current and next generation console cycles: first, the Wii was the industry leader, while the Wii U is almost irrelevant; and second, the sell-through and production plans for the Xbox One and PS4 suggest that both will sell at a more rapid pace than their predecessors. We believe that Sony regrets its decision to allow Microsoft to gain a first-mover advantage with the 2005 introduction of the Xbox 360, as it chose to forego potential PS3 sales that year in order to dominate the high-definition DVD market. However, by focusing on winning the Blu-ray / HD-DVD battle, Sony lost the last console war. In the next generation, Nintendo launched the Wii U first, to tepid consumer response, and Microsoft and Sony appear intent upon battling it out with their respective consoles.

The modestly priced Wii U was offered in late 2012 at an initial price of $349 in the U.S., and came bundled with a game. Nintendo sold well below its plan, and cut the price to $299 for its bundle in mid- 2013. However, the price cut didn’t help, and the company forecasted sales of only 2.8 million consoles in its second full year. It appears that Nintendo was convinced that once again, its innovative control mechanism would sell consoles, but the company missed the mark with its Game Pad controller, which is not intuitive for more casual gamers. The company is not especially profitable on Wii U hardware, as the Game Pad controller is expensive to produce.

The Xbox One and PS4 are differentiated from the Wii U insofar as they have significantly faster and controllers. Additionally, both Sony and Microsoft have invested heavily in building out online networks and in driving subscriptions to these networks, with Microsoft having an estimated 22 million Xbox Live Gold members and with Sony having an estimated 15 million active paying PSN Plus subscribers. Nintendo benefited in the current generation from the large number of standard definition TVs in global households at the time of the Wii’s launch, but we believe the Wii was

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often relegated to the storage closet when those households upgraded to HDTV. In the next generation, we expect Sony and Microsoft to dominate sales with their respective consoles, and we forecast sales of 100 – 115 million of each console over the next seven years, with Wii U sales likely lagging far behind, at 20 million or so. This means that the next generation installed base will be smaller than the current generation base, but that the two “hard core” consoles will capture greater share, with combined sales of 220 million surpassing the combined 160 million unit installed base of their predecessors.

There have only been three “real” console cycles before the current one—the PlayStation cycle that began in 1995, the PS2 cycle that began in 2000 and the Xbox 360/PS3 cycle that began in 2005/06. In each of these cycles, advances in the quality of content drove robust sales growth, as advances in processing power allowed content to be richer and more complex. In the current cycle, quality for current generation games was noticeably better from the outset, leading to solid attach rates, notwithstanding light hardware sales for the PS3 and the Xbox 360. Software attach rates for the Wii, which were initially very strong, ended up below the other consoles in large part due to the lack of high- definition graphics. For the first three years of the current cycle, we believe high prices for current generation consoles and more prudent planning from the publishers kept demand for last generation PS2 games from falling off a cliff. PS2 software sales declined only 11% in 2006, 27% in 2007, and 31% in 2008, compared to a 37% decline in PS1 software sales in 2001 (the year after the launch of the PS2). We expect a similar pattern for declines in PS3/Xbox 360 software sales, and expect the slow rate of decline for current generation software to result in an overall sales gain of 18% in 2014, 14% for 2015, and 11% for 2016 in the U.S. and Europe combined. Relatively stable development costs allowed publishers to increase the quantity of software developed for the Xbox One and PS4, and we expect market penetration for these new platforms to vastly exceed the rate of penetration by their predecessors. At the same time, the Wii software has declined more rapidly than expected, and the Wii U has not made up much of the shortfall. We expect Xbox One and PS3 to capture share from Wii U in the next generation, and think that the poor performance of the Wii U may cause many Wii owners to purchase a PS3 or Xbox 360 over the next few years, softening the natural decline of current generation software sales. We believe that as a greater number of games are developed for each console, next generation software sales will accelerate.

We believe that the Xbox One and the PS4 are similar to one another, much as their predecessors were, and think that the economics of game development will limit the amount of third-party exclusive content for either console. In a perverse way, the similarity between the two platforms will likely serve to lower the costs of software from one platform to the other, and we anticipate that virtually every third- party title produced for one will be produced for the other. The lack of differentiation between the PS4 and the Xbox One means that consumers will initially make their purchase decision based on brand loyalty or price, with the former favoring Microsoft and the latter favoring Sony. We expect the Wii U to remain an afterthought for most consumers, and do not expect significant third-party support after 2014.

We believe that digital content offers the potential for tremendous growth, and expect a significant revenue contribution from sales of digital content over the next several years. Digital content takes four forms: free-to-play PC games, full-game downloads, mobile games and downloadable console content. Each of these has a different growth trajectory, with free-to-play PC games and mobile games expected to generate 20 – 25% annual growth for the next several years, and with full-game downloads and downloadable console content to grow at a rate more closely mirroring overall demand growth for console games. We did not include online subscriptions in our description of digital content, as we believe that the subscription model is outdated and destined to see declining revenue; Activision Blizzard is the exception to the rule above, with approximately 20% of its revenues and 33% of its profits derived from its .

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INDUSTRY FORECAST

• We estimate that the interactive entertainment industry generated worldwide sales of $27 billion in 2012 from consoles, handhelds, and their associated software, and $26 billion in 2013. We estimate that the addressable market opportunity for U.S. software publishers is $14.8 billion in 2014 (packaged software only) and we expect sales to grow at a double-digit pace for the next three years. We note that the Japanese market remains virtually closed to U.S. and European publishers, with only minor inroads made by Electronic Arts and Take-Two, and do not anticipate significant contribution for the U.S. and European publishers in the near future. • We forecast the combined U.S. and European software markets to grow at a 9% CAGR over the 2014 – 2016 period. Our forecast assumes console software sales (i.e., legacy sales and sales on Xbox One, PS4 and Wii U) of $12 billion in 2014, growing to $14 billion in 2015 and to $15 billion in 2016. We expect handheld software sales (i.e., DS, 3DS and PS Vita) to remain flat at approximately $1.6 billion per year over the three-year period. We believe that the top-performing software publishers will capture a disproportionate share of top-line growth, will deliver operating leverage, and will grow EPS at a higher rate during this period. • We expect growth to be driven by similar console penetration rates (lower for the handheld platforms), with higher “tie ratios” than we saw last cycle (a tie ratio is the number of software units sold per hardware console) and with higher overall game pricing. • In 2014, we forecast that U.S. interactive entertainment software sales (at $7.3 billion) will still be only a fraction of the level of movie box office, rentals and sales (approximately $27 billion in the U.S. in 2013), indicating that there is significant potential for further growth. • Several demographic trends and market drivers should fuel rapid growth of interactive entertainment software sales. We believe the most compelling of these trends is the expanding age demographic of the interactive game consumer, accompanied by an increasing level of disposable income and the propensity to spend that income on entertainment.

Hardware Forecast • Total last generation (PS2, Xbox and GameCube) hardware shipments through the end of 2008 reached 125 million units in the U.S. and Europe (the addressable market for U.S. and European publishers). By comparison, 32-/64-bit (PS1, N64 and Saturn) shipments in the U.S. and Europe totaled only 93 million units during the analogous 1995 – 2003 period. Current generation hardware shipments through the end of 2013 reached 202 million units in the U.S. and Europe, up 61% over the last cycle. • The installed base of handheld hardware is also quite large, although sales have slowed in the past few years. Cumulative DS and PSP sales in the U.S. and Europe totaled 146 million units by year- end 2013, compared to GBA sell through of only 60 million units in the analogous 2000 – 2008 period. Nintendo’s 3DS, while off to a solid start, is tracking at around half the rate of its predecessor, and Sony’s PS Vita is unlikely to sell more than 10 million units. By the end of 2016, we forecast that total next generation handheld hardware in the U.S. and Europe will total only 59 million units. • By the end of the next generation cycle, we expect console penetration rates to be relatively stable in the U.S. and Europe, but expect an increase in other jurisdictions. However, we expect the Sony and Microsoft consoles to gain share in every major geographic segment due to strong demographics, additional functionality, increased market segmentation, and much higher marketing spending. We expect Nintendo to lose as much as 80% of its sales, with a large portion of Wii owners shifting allegiance to consoles from Sony or Microsoft. • Current generation consoles saw the introduction of increased multimedia functionality, with high- definition DVD playback on the PS3 and Xbox 360, high definition display for both, online gaming capability for all three consoles, and access to content downloads for all three. The current generation of game machines appealed to a much wider than in any prior cycle, driving the percentage of households that own at least one console from 52% during the 128-bit cycle to 65% during the current cycle. From 2006 – 2013, for example, 115 million U.S. households purchased a

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total of 130 million consoles; that suggests that over 75 million households purchased an average of close to 1.8 consoles each. • with peripherals such as Rock Band , Guitar Hero and converted new households into video game households, though the trend appears to have been a fad. We estimate that as many as half of Wii households purchased their first and last console when they bought a Wii, and we believe that many of these households have moved on to PC-based free-to-play games, mobile and tablet games, or no games at all. • Our growth forecast assumes that the number of consoles owned by each household will decrease slightly from 1.80 to 1.65 during the next cycle. In contrast with the last cycle, when the second console of choice in most households was the Nintendo Wii, we expect an increasing number of households to buy more than one next generation console. We think that the increased multimedia functionality for the next generation consoles will cause many households to purchase multiple units for different rooms in the home, although it is possible that innovations similar to will permit households to access console functionality in more than one room at a time. We do not expect as many households to purchase both a PS4 and Xbox One as purchased the PS3/Xbox 360 combination last cycle, given the similarities between the consoles. • We expect the dominant console at the end of the this cycle to be the PS4, although we think that Sony’s edge over Microsoft will be far more narrow than the gap between the Wii and its competitors in the last cycle. We believe the Wii’s low price point, innovative control mechanism, and compatibility with standard definition televisions gave it a competitive advantage at the outset of the last cycle, and Nintendo’s next generation entry, the Wii U, is simply not as interesting to most consumers as its predecessor was. We think Nintendo waited too long to introduce the Wii U, and has thus far failed to convert its large installed base into true “next generation” households, providing an opportunity for Microsoft and Sony to catch up with lower priced current generation consoles, then to exploit their growing installed base with the introduction of more powerful and far more compelling hardware last year. • Our choice of the PS4 to win the next generation console race is purely a function of its price; at $399, we believe the PS4 presents a more compelling value proposition than the $499 Xbox One. Microsoft’s console offers many features not available on the PS4, with its peripheral allowing users to control their consoles via voice commands, and allowing access to many camera-oriented features such as . Microsoft will argue that the value proposition afforded by the bundling of Kinect with the Xbox One justifies the higher price point, but we are not convinced that the company has adequately communicated the value proposition to consumers, and we expect most to ultimately make their purchase decision based upon brand loyalty or price.

Software Forecast • One of the primary drivers of Sony’s during the PS1 and PS2 cycles was its ability to provide a greater quantity of high-quality titles than its competitors. In addition to a large first-party library ( , SOCOM Navy Seals , The Getaway , , and Ratchet and Clank and Jak ), the company was successful in securing enormous third-party software development support for the PS2. The three most successful single platform titles as of 2004, Take-Two’s III , Grand Theft Auto: Vice City , and Grand Theft Auto: San Andreas , debuted exclusively on PS2 and sold over 60 million units on the PS2 alone, each selling approximately twice as many units as -selling Xbox and GameCube games, according to our research. Sony did not secure significant third-party exclusivity for PS3 titles, instead focusing on its internal development efforts for blockbuster games. As a result, we believe its advantage over the competition eroded in the current generation cycle, and the PS3 was largely perceived by most consumers to be roughly equivalent to the Xbox 360. Consumers made their console selection increasingly based upon multiplayer functionality, rather than on exclusive software titles. • In the next generation, we do not expect a significant number of third-party commitments for software designed exclusively for a single platform. EA’s is an early third-party exclusive for the Xbox One, but to date, few other third-party exclusives for any of the three consoles have been announced. We expect the ultimate outcome of the console to be decided by pricing, as we view the likely software offerings for each of Sony and Microsoft’s next generation consoles to be

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roughly equal. We believe Nintendo has significantly more (and better) first-party content than its competitors, but has significantly worse hardware, with limited multimedia functionality, limited storage, and an underdeveloped online multiplayer network. • Developing video games has become an increasingly complex endeavor. Most video games created for the legacy consoles (the PlayStation and N64) could be built in less than one year (we estimate that the average development time was six to nine months) and cost less than $1 million to produce. In the PS2/Xbox generation, the average required 18 to 36 months to finish, and cost an average of $4 million. Thus far in the cycle, current generation console games require between 24 and 36 months to develop, and average development costs rose to between $20 – 30 million, with some economies obtained if games are developed for both the Xbox 360 and the PS3 simultaneously. We believe that the first efforts for most next generation games are likely to cost more than $30 million (with some games costing as much as $50 million), but we expect most publishers to quickly advance along the learning curve, and we anticipate that average costs will decline to $25 – 30 million over the next two years. • We expect software sales to grow by 18% in the U.S. and Europe in 2014, by 14% in 2015, and by 11% in 2016. The U.S. and Europe largely comprise the addressable market for the publishers we cover, suggesting that software sales for the publishers will see aggregate growth close to this figure. Our estimates reflect a relatively large 29% annual decline for current generation software sales, more than offset by dramatic growth for next generation software sales. We expect next generation software to contribute $6 billion in retail sales in 2014, similar to the $6.2 billion contribution from 128-bit console software sales in 2002 and the $7.5 billion contribution from current generation console software sales in 2007. Each of those years was the third full year in their respective console generations, but we believe that the simultaneous launch of next generation consoles and the rapid initial sell-through of hardware will cause an acceleration of software sales into 2014.

Investing in Software Publishers • With the economic downturn, the gains in share prices from the prior years for the major publishers were all but wiped out. The average forward multiple for a video game publisher has historically been 25 – 50% higher than the overall market multiple, reflecting, we believe, the superior growth prospects for the industry and the tremendous earnings leverage generated by massive early investments in R&D. However, as of this writing, the public video game publishers trade at or below the market multiple, reflecting, we believe, investor concern about the health of the industry. • We believe that the interactive entertainment industry offers secular dynamics that will provide extended and sustainable growth. We believe several publishers stand poised to capitalize on this growth, providing investors with an opportunity to participate. In this section, we analyze historical returns for the industry, and compare and contrast the publishers in order to provide our insights into how their different strategies and assets produce different risk and return profiles. • The universe of publicly traded entertainment software publishers includes companies with market capitalizations ranging from under $50 million to over $15 billion. The industry offers two large-cap companies (Nintendo and Activision Blizzard), one mid-cap company (Electronic Arts), two small-cap companies (Take-Two and Ubisoft), and one micro-cap company (Majesco) to consider as investment opportunities. Over the last ten years, seven micro-cap companies under our coverage (Acclaim, , Bam!, Interplay, Midway, THQ and 3DO) declared bankruptcy or ceased operations. • Each of the large-cap, mid-cap and small-cap publishers we cover has achieved great success in creating and nurturing high-quality branded entertainment software. Nintendo is unquestionably the most successful creator of entertainment software over the past 30 years, capturing the number one position in U.S. sales among software publishers each year until 2001. Many of the brands that Nintendo introduced in the and early for the NES and SNES consoles are still dominant brands today such as , Zelda , and . Similarly, Electronic Arts has built a portfolio of recurring revenue streams by growing its library of established brands. Electronic Arts now dominates the sports genre and its hit football, soccer and golf games are best sellers year after year. Electronic Arts also has expanded beyond the sports game genre and built successful brands

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in many other genres, including real-time-strategy ( Command & Conquer ), first person shooter (Battlefield ), strategy/RPG ( ), extreme sports ( Skate ), kiddie ( ) and driving ( and ). Activision’s results are far more concentrated, with its top two brands ( and Skylanders ) responsible for over 75% of its domestic sales. According to NPD, in 2013, Activision captured the highest market share for entertainment software sales in the U.S., with its 18% market share slightly ahead of second place EA’s 17% share, and with Take-Two in third place also with 17% market share. • We believe that brand depth is one the most important indicators of a publisher’s future prospects. Strong software brands provide a publisher with sequel titles for several years and a deep library of brands provides a steady base of recurring revenues. We note that all but two of the top 30 brands of 2013 were established brands with a history of producing successful titles prior to 2012. These mega-hit brands are the result of growing and developing successful brands over several years. Possessing a deep library of solid brands is the first step to producing one of these mega-hit brands in the future. • Nintendo, Electronic Arts, Activision, Take-Two and Ubisoft each had more than one brand that generated over $100 million in U.S. retail sales during 2013. We chose a $100 million threshold because we believe that this figure reflects potential global lifetime sales of more than five million units, indicating a bona fide “home run”. Eight of Electronic Arts’ top-10 brands generated more than $50 million in 2013, demonstrating the depth of the company’s offering. Nintendo had three brands generate more than $50 million apiece, Ubisoft had five, Take-Two had three and Activision two. The $50 million level of U.S. retail sales, in our view, is a good proxy for a worldwide three million unit seller, reflecting a profitable franchise. • We have a positive outlook for sales growth over the next several years, and expect the remaining publicly traded publishers to maintain or gain market share throughout the next generation cycle. The larger companies (Activision Blizzard, Electronic Arts, Take-Two and Ubisoft) are poised to deliver operating leverage, particularly as the installed base of next generation consoles grows sufficiently to drive unit volumes higher for new software. We believe Nintendo is likely to become the biggest loser in the next generation, as its handheld business struggles to market share losses to mobile phone and tablet game sales, and as its console struggles to find an audience. We expect those publishers (named above) focused on Sony’s and Microsoft’s consoles to gain overall market share as Nintendo is likely to be a much smaller portion of industry sales going forward compared to the current generation cycle. • We expect shares of the interactive entertainment publishers to trade higher later in 2014, as investors gain greater comfort about the prospects for industry growth. Our industry growth model projects combined U.S. and European compound annual sales growth of 14.5% over the next three years, with an 18% increase in 2014. We believe that earnings of the publicly traded publishers can grow at a much higher rate, as the larger publishers have made a significant investment in current generation technology, and are poised to deliver operating leverage as their revenues grow. • We note that publicly traded publisher stocks have traded at or below the market multiple since 2008, when software sales began a string of annual declines. Historically, these stocks trade at a premium to the market, as the rate of top-line growth has consistently exceeded overall GDP growth, and the companies have typically been able to deliver operating leverage. As a result of the recession and several other factors, investors appear to be concerned that top-line growth and operating leverage going forward will lag the overall market, creating an investment opportunity for those who see the industry growing as we forecast. • We recommend that investors accumulate shares in publishers Activision Blizzard, Electronic Arts and Ubisoft at current levels.

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SECTION 1: INDUSTRY OVERVIEW AND FORECAST

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DEFINING THE INDUSTRY

The players. The interactive entertainment industry consists of several constituencies: 1) the manufacturers of dedicated video game consoles and portable devices; 2) the publishers of packaged software products that can be played on consoles, handhelds and PCs; 3) the developers of packaged software; the producers of games that can be accessed digitally, whether through a mobile, Internet or direct download; 4) social game portals; 5) game download services; 6) mobile gaming publishers; and 7) multipurpose device manufacturers and developers of apps for those platforms. This report primarily focuses on publishers of products for dedicated consoles, subscription game services, and Internet gaming (including mobile, social, casual and player-vs.-player games). Total hardware and packaged product sales in the U.S., Europe (comprising Europe, Middle East and Africa) and Japan totaled an estimated $45.5 billion in 2008, with hardware sales comprising $18.8 billion and software sales $26.7 billion of the total. U.S. sales represented about 47% of the total, Europe about 42%, Japan about 11%. A combination of the global recession, increasing adoption of free online multiplayer gaming, migration of casual games to Internet downloads, and a very long console cycle drove overall hardware sales down to $10.5 billion by 2012 (down 44%) and overall software sales to $16.2 billion (down 39%). Software sales continued to decline in 2013, but hardware sales rebounded slightly with the launch of next generation consoles from Sony and Microsoft.

Sales in Japan have trended down in the last decade because of relatively slow console adoption rates and declining tie ratios. Our report speaks in general terms about only those sales generated from the three primary markets for video games, the U.S., Europe, and Japan, which have historically combined for over 90% of global hardware and software sales. On its face, our analysis disregards sales from the rest of the world; however, we believe that the totals reflected in our estimates represent a good proxy for worldwide sales. While rest of world sales have accounted for only a very small portion of total worldwide sales in the past, we expect rest of world to account for as much as 20% of global sales by 2018. The markets with the greatest current demand for video game products (outside of the U.S., Europe and Japan) are and Canada, with combined demand comprising approximately 5% of the global total. We estimate that rest of world sales (including Australia and Canada) totaled $4 billion in 2008, or about 9% of the total sales generated in the U.S., Europe and Japan, split roughly 60% software and 40% hardware. Further, we believe that around 35% of the estimated $2.4 billion in software sales consisted of catalog sales with relatively high distribution costs, and correspondingly low profits. Since 2008, we believe that rest of world percentage climbed by 100 basis points per year to its current 11 – 12% of the total, and we expect it to climb by approximately 100 basis points for the next several years, with increasing penetration in non-traditional markets such as South America, Eastern Europe, and Scandinavia. As these sales grow, they will likely generate higher profits for the U.S. and European publishers. Accordingly, we expect to incorporate rest of world into our estimates in future industry forecasts, beginning next year.

Video game hardware includes dedicated game consoles for both home and handheld use, as well as various accessories ( e.g. , controllers, peripherals and memory cards) for these consoles. In the last year, we have seen new “consoles” enter the market from Ouya and PlayJam (the Ouya console and the GameStick, respectively), and we expect other entries from various manufacturers over the next few years. Game consoles are the machines or platforms that play dedicated video game software. We include sales of game software for personal (PCs) within our definition of video game software, but do not include sales of PC hardware within our industry definition. Several “games” include a peripheral as part of a bundle (notably Wii Fit and Guitar Hero in past years and Skylanders and Disney’s Disney Infinity in recent years). Initial “starter kits” for these games are considered software, and are included in the software data published by the NPD Group, but add-on hardware (extra guitars, figurines for Skylanders and Infinity ) are not included within software sales or our projections. In addition, although the of video game consoles is rooted in location-based entertainment ( e.g. , arcade games and machines), we consider this a separate industry and do not consider these devices in our analysis. Mobile games played on phones and tablets have seen explosive growth over the last several years, according to SuperData Research.

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We do not include these sales in our forecasts, as they do not generate significant revenues for any of the U.S. and European publishers we cover (except for Electronic Arts). Later in this report, we discuss opportunities for sales.

Our report and research coverage focuses on interactive entertainment software publishers, Internet portals and retailers that derive a significant portion of sales from interactive entertainment. The following is a more thorough description of the key players in the hardware and software sectors and the various roles they play within the industry.

Figure 1: Top 20 Entertainment Software Publishers as a Percentage of Total Sales, 2012 and 2013

Publisher 2012 Publisher 2013 1 Activision Blizzard (Corp) 21% 1 Activision Blizzard (Corp) 18% 2 Electronic Arts 16% 2 Take 2 Interactive (Corp) 17% 3 Ubisoft 10% 3 Electronic Arts 17% 4 Nintendo 10% 4 Nintendo 10% 5 Take 2 Interactive (Corp) 8% 5 Ubisoft 8% 6 Microsoft (Corp) 6% 6 Warner Bros. Interactive 6% 7 Warner Bros. Interactive 4% 7 Sony (Corp) 5% 8 Sony (Corp) 3% 8 Microsoft (Corp) 4% 9 USA 3% 9 Studios 3% 10 Disney Interactive Studios 3% 10 Inc (Corp) 2% 11 THQ (Corp) 2% 11 Games (Corp) 1% 12 2% 12 1% 13 Square Enix Inc (Corp) 2% 13 Capcom USA 1% 14 Namco Bandai Games (Corp) 2% 14 Bethesda Softworks 1% 15 Majesco 1% 15 1% 16 Sega 1% 16 Majesco 1% 17 Deep Silver 1% 17 Digital Ent. 1% 18 Konami Digital Ent. 1% 18 THQ (Corp) 1% 19 Nordic Games 1% 19 D3Publisher 0% 20 D3Publisher 0% 20 0% Subtotal for Top 20 96% Subtotal for Top 20 97% Industry Total 100% Industry Total 100%

Note: Includes PC. Source(s): The NPD Group and Wedbush Securities estimates.

Distributors Distribution refers to the warehousing, handling, and transporting of games from a publisher to a retailer’s shelves. Each major publisher distributes its own games to the largest retailers, and many distribute their own games to all retailers. Some publishers also use their own distribution assets to distribute games for other smaller publishers–referred to as “third-party” distribution. The major hardware companies also distribute the bulk of their software directly to retailers. National distributors, such as Ingram Micro, Handelman and Speed Commerce, provide third-party distribution services to the smaller publishers and also provide the larger publishers with access to small “mom & pop” retail outlets. The industry trend over the last decade has moved away from third-party distribution as publishers seek to capture a greater portion of the software value chain. We estimate that third-party distribution declined from approximately 50% of the retail market to less than 5% of the retail market over the last 10 years. We estimate that distribution accounts for approximately 5% of the retail price of a video game, whether captured internally by a publisher or paid to a third-party distributor.

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It is important to distinguish “distribution” from “co-publishing”. In the former case, the distributor arranges for the placement of a publisher’s product in a particular territory; in the latter, the “co- publisher” places its name on the packaging as if the game were created by it, and is responsible not only for distributing the game, but for all associated marketing expenses. Co-publishers typically receive close to 30% of revenues from a game, and operating margins are typically 10 – 15% after factoring in marketing expense. Examples of co-published games are Electronic Arts’ Titanfall , Activision’s and Take-Two’s Elder Scrolls Oblivion .

Retailers Video games are sold primarily through mass-market retailers such as Wal-Mart, Best Buy and Target (over 50% of total U.S. sales) and through specialty retailer GameStop, which has around 30% U.S. market share. The balance of game sales take place at other toy and electronics retailers, as well as at other retail outlets and online (Amazon has around 5% of the market). The next figure illustrates our estimates for retailer market share of U.S. sales in 2012 and 2013, reflecting sales of console, handheld and PC games. Console and handheld games comprised approximately 94.9% of the U.S. software market in 2013, while PC games totaled approximately 5.1%. We expect console and handheld games to capture 94.3% of the software market in 2014.

The retail environment for entertainment software has trended toward mass-market retailers over the last several years. It is now common to see a sizeable video game department within every destination retailer. Retail margins for new games are typically 20% (not including vendor allowances), with higher margins on lower priced “budget” or “value” titles. In the past, retail margins were as high as 30% on all games, but since the introduction of the PS2 in 2000, software margins have compressed.

Overall retail margins for the video game category (reflecting the mix of hardware, software, and accessories) can range from 15 – 25%, trending toward the low end of the margin range early in the console cycle (shortly after the introduction of new hardware), with margins expanding as the installed base grows. This is attributable to a shift of product mix from a high percentage of hardware at high prices and low margins (around 6 – 10%, including warranty revenue) early in the cycle to a lower percentage as hardware prices decline and console sales flatten. In addition, over the of the console cycle, the amount of older “value” titles and used software available allows retailers to capture incremental margins as high as 50%, driving up average selling margins.

We believe specialty retailers have developed a competitive advantage over the mass merchants due to their ability to offer a large number of used games to consumers. We estimate that the market for used video games was approximately $2 billion in the U.S. and around $500 million in Europe in 2013, with retailer GameStop capturing over 90% market share in the U.S. (GameStop also sells used hardware, accounting for the difference in its overall sales of used “products”). Margins on used games have averaged between 45 – 50%, with some moderation toward the midpoint as GameStop has attempted to turn its inventory faster. We believe that the total global market opportunity will approach $3.5 billion annually in the combined U.S. and European markets by 2016, and expect GameStop to capture at least 80% share, with some competition from Amazon, Best Buy, and several European retailers. We don’t consider any of GameStop’s competitors to be a real threat to the company’s established market share leadership, but think that the existence of competition, particularly from Amazon, could cause some downward pressure on margins.

Retail margins in Europe tend to be somewhat higher than in the U.S., with UK margins historically close to 30% in the early part of the last decade, and continental European margins in the low 20% range. There has been some margin pressure in the UK as mass merchants have endeavored to gain market share through promotional activity, and UK margins on new software have trended closer to 20% over the last five years.

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Figure 2: U.S. Retailer Console and PC Software Market Share

2007 2013 Rank Video Game Retailer Share Rank Video Game Retailer Share 1 GameStop 25% 1 GameStop 30% 2 Wal-Mart 24% 2 Wal-Mart 25% 3 Best Buy 14% 3 Target 15% 4 Target 14% 4 Best Buy 12% 5 Toys R Us 4% 5 Amazon 6% 6 Circuit City 3% 6 Toys R Us 1% 7 Amazon 1% 7 Kmart / Sears 1% 8 Kmart / Sears 1% 9 Movie Gallery 1% 10 Blockbuster 1% All Other 12% All Other 10% Total 100% Total 100%

Source(s): Wedbush Securities estimates.

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INDUSTRY SIZE: THE ADDRESSABLE MARKET OPPORTUNITY

The video game market is quite large, and sales declines over the last five years create an opportunity for a dramatic rebound this year. We estimate that interactive entertainment sales totaled $45.5 billion worldwide in 2008, consisting of $26.7 billion in software sales and $18.8 billion in hardware sales, and declined to $26.2 billion by 2013. The nearly $2.2 billion Japanese software market remains challenging for non-Japanese publishers, primarily due to cultural differences, and we expect the U.S. and European publishers to continue focusing primarily on the U.S. and European markets for the foreseeable future. We estimate that the addressable market opportunity for U.S. and European packaged software publishers in 2013 was $13.2 billion, growing to over $16.6 billion by 2016. However, these figures understate the growth in demand for software made for Sony and Microsoft consoles, which we expect to grow from a combined $9.1 billion in 2013 to a combined $13.6 billion in 2016, reflecting a compound annual growth rate of 14% annually over the next three years. In addition, we estimate that the addressable market for subscription services and game-related downloads (both full-game downloads and downloadable extra content for console games) is well over $3 billion, with U.S. and European publishers competing for as much as 70% share. We expect the subscription market to remain relatively stable, as “new” models (such as Xbox Live and PlayStation Network subscriptions) are established in non-traditional gaming channels while historical models (such as online MMOs) see a continued migration toward free-to-play. Console, handheld and PC video games comprise a significant portion of overall entertainment industry sales, we believe comparing favorably with other mainstream entertainment products such as movies, books, and music. With comparable size and growth at a faster rate than these competing forms of entertainment, we expect the interactive entertainment software sector to present a compelling investment opportunity over the next three to five years.

Geographic Markets According to our research, the interactive entertainment industry encompasses three primary geographic markets: North America, Europe/Middle East/Africa, and Japan. The North American and European markets were close to the same size in 2013 ($11.4 billion and $10.9 billion in combined hardware and software sales, respectively), followed by the smaller Japanese market ($3.75 billion). Several other large potential geographic markets exist, notably Australia, the Middle East, Eastern Europe and South America; however, we estimate that total sales for all these markets combined amounts to less than 8% of overall interactive industry sales. The software publishers that we cover generally sell less than 10% of their products directly into these markets, and retail presence for U.S. and European based companies is minor. Interactive software sales in other regions comprise approximately 4% of global software sales, with an additional contribution of over $10 billion in sales of mobile game downloads and virtual content worldwide. The figure below illustrates historical and forecasted interactive entertainment dollar sales by region for the three primary markets.

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Figure 3: Worldwide Interactive Entertainment Sales 2004 – 2016E ($ millions)

$50,000 $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13E '14E '15E '16E

North America Europe Japan

Source(s): Wedbush Securities estimates.

On average, the U.S. software publishers generate approximately 50% of their sales from the North American market and 45% from the European market, with European publisher Ubisoft generating approximately 45% of sales from the U.S. market and 50% from Europe. The publishers’ other sales come from rest of world. Japanese publisher Nintendo (the only Japanese company we cover) derives approximately 40% of its software sales from the U.S. and 40% from Europe, with the balance from Japan. European sales comprise approximately 12% PC games, 88% console and handheld games, down from a 25%/75% split just eight years ago; we expect the PC game component of European sales to stabilize over the next three years, with PC sales ultimately comprising approximately 12% of overall packaged software sales for the foreseeable future. It is for a U.S. or European publisher to realize more than 5% of revenues from Japan; that market has generally been closed to gai-jin content. In 2006, we estimate that industry leader Electronic Arts derived approximately 5% of total sales from Japan, with strong sales of FIFA World Cup Soccer , and we think that performance was a high-water mark for the company. We think that overall Japanese sales for U.S. and European publishers declined to less than 3% of overall sales in 2007 and to around 2% in 2008 and thereafter.

Japan has been critical to the overall growth and success of the interactive entertainment industry because it is the source of the majority of console hardware and some of the industry’s best development talent. Notwithstanding Japan’s overall importance to the market, we do not expect U.S. or European software publishers to achieve significant market penetration in Japan over the next several years, at least not until a foreign publisher acquires a going concern in Japan. We believe structural and cultural barriers in the Japanese market will preclude any U.S. or European publisher from generating significant sales in that market in the near term. We believe that the addressable market for U.S. and European publishers for the next several years will be limited to the U.S. and European markets, with growth coming from developing markets in Latin America and Eastern Europe.

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Figure 4: Addressable Market for U.S. Software Publishers 2004 – 2016E ($ millions)

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13E '14E '15E '16E

Europe Console Software Europe Handheld Software Europe PC Software U.S. Console Software U.S. Handheld Software U.S. PC Software

Source(s): The NPD Group and Wedbush Securities estimates.

Hardware and Software Sales Split Of the $26.2 billion in interactive entertainment sales in the three primary geographic markets last year, we estimate that 41% of this amount, or $10.8 billion, was attributable to sales of dedicated game console hardware. The remaining 59% consisted of sales of console, handheld and PC entertainment software. Software for dedicated home consoles comprised 43% of overall worldwide industry sales, 11% for handhelds, and 5% for PCs. It should be noted that we count the PC software sales market at only $1.3 billion in packaged product sales, and we believe that full game downloads of PC software comprised close to 2/3 of the market, bringing total PC software sales to over $3 billion. Of the over $17 billion in worldwide entertainment software sales in 2013, we believe that the $15 billion from the North American and European markets defined the immediate addressable market opportunity for U.S. and European software publishers. The previous figure illustrates our forecast of the addressable market opportunity for U.S. software publishers through 2016.

Software Versus Other Entertainment Sectors We estimate that U.S. retail sales of interactive entertainment hardware and software totaled $19.5 billion in 2008, with software sales comprising 60% of the total. The 8.5% compound annual sales growth for software from 1998 – 2008 resulted in the interactive entertainment segment’s being among the largest sectors within the entertainment industry. In 2008, the U.S. market for interactive entertainment was larger than both the U.S. movie industry (box-office receipts) and the U.S. music recording industry. Since 2008, U.S. retail sales of interactive hardware and software declined to $11.4 billion, plus an estimated $800 million of PC game downloads, placing industry sales on par with U.S. box office, leisure book and record industry sales. We note that total film industry revenues are much larger when VOD, streaming, DVD rentals and sales are included (we estimate that these revenues added over $16 billion to the total in 2013); the market for video game rentals is much smaller in comparison, at approximately $500 million in 2013. We estimate that the total sales of books intended for leisure or entertainment amounted to over $8 billion in 2013.

We expect interactive entertainment to grow faster than other U.S. entertainment sectors over the next five years. We expect U.S. interactive entertainment software sales to grow by approximately 4% per year over the next three years, and expect hardware sales to decline by under 1% annually, as

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hardware prices are expected to decline and unit sales are expected to grow only modestly. We project that all other entertainment products sales (other than video game software, mobile game software, MMOs and digital downloads) will grow in the 0 – 2% range over the same time period. Using our projected growth rates, we forecast that the U.S. interactive entertainment industry in 2016 will continue to be larger than books, box office and music, becoming the second largest major entertainment sector in the U.S.

We note that the U.S. retail market for movie rentals and sales for home use was approximately $16 billion in 2013, according to Digital Entertainment Group. We estimate that $10 billion of this amount represented sales of movie and television DVDs to an installed base of approximately 95 million DVD console owners. This translated to approximately $100 in DVD software purchases for each DVD console owner, below our estimate of around $150 in game sales per U.S. current generation console, but almost three times higher than our forecast for sales of video game software for each console and handheld owner in 2013 (when last generation consoles are included). Of course, our forecast does not account for “retired” game consoles, so the figure is more likely closer to twice as high. Nonetheless, the size of the home DVD market suggests that the video game market could continue to grow at a single-digit rate for several more years. We believe that the entertainment value of interactive entertainment software makes the purchase of video games a compelling value proposition for consumers, and expect sales growth to increase dramatically as household console penetration increases.

We also think it is important to consider video game software purchases in the context of all entertainment spending. When books, music, movies and video games are added together, total U.S. spending on entertainment content totaled over $65 billion in 2013. The portion spent on video game software, at around 11% of the total, has the potential to grow at a faster rate than any of the other entertainment categories for many years to come.

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WHAT CAUSED THE DECLINE FROM PEAK 2008 LEVELS?

Video game software sales declined for five consecutive years beginning in 2008, coincident with the rise in smartphone and tablet sales. According to NPD and Gfk-Chart Track data, the video game industry experienced software sales declines for five consecutive years from 2008 – 2013, with overall software sales dropping almost 42% over that period. There were clearly many reasons for the decline, and many attribute the decline in overall software sales primarily to the explosive growth of mobile and tablet games, which are enjoyed by a large number of people and which generate minimal revenues per user. We think that the explanation is far from simple, and in the following pages, have endeavored to explain our reasoning behind the decline.

In summary, we think it is important to point out that in the last console generation, there were 260 million home consoles sold (according to the manufacturers; our model lists around 225 million, and clearly doesn’t consider sales outside of the U.S., Europe and Japan) and approximately 200 million dedicated handheld gaming devices sold. The installed base of 460 million devices compares to an installed base approaching 1.5 billion (according to Gartner Group) and a base of over 2.4 billion Internet users. Console users, at approximately 17% of smartphone users and approximately 10% of Internet users, are a very small niche. We believe that ultimately, penetration of games among smartphone users and Internet users will be a good thing for the console gaming business, as it creates opportunity to upsell more casual users to the more hard core niche market.

However, we do believe that there has been some impact from the topics discussed below on the handheld market, and we believe that has begun to show up in the figures for sales of dedicated handheld gaming devices. The market for sales of dedicated handheld gaming hardware grew every year from 2002 – 2007, peaking at just under 41 million units sold in 2007, according to our research. That figure has declined every year since, to an estimated 21 million in 2013, and we expect handheld hardware sales to decline annually for the foreseeable future.

The Rise of Mobile and Tablet Games Over the last five years, smartphones and tablets have proliferated, with sales of smart handheld devices approaching 1.5 billion units in 2013 according to Gartner Group. These figures are projected to rise by mid-single-digit percentages in each of the next three years, according to Gartner.

Many industry observers correlated the rapid rise of smartphone and tablet sales with the decline of dedicated console and handheld software sales. The title of this report, Post Hoc Ergo Propter Hoc , refers to a common fallacy that argues that because event B occurred after event A, event B must have been caused by event A. The conventional wisdom here reasoned that since the rapid growth of smartphone and tablet sales was in part due to the wide variety of apps available, and these apps were primarily gaming related, then the decline in console and handheld software sales must have been caused by the rapid growth of smartphone and tablet sales. We disagree, in part.

In our view, mobile and tablet games compete directly with casual and puzzle games, but not as well with more complex core games. There are essentially three types of games—social games, player vs. player games, and player vs. environment games. Social games are games where no player “loses”, where players collaborate in order to help one another succeed. Player vs. player games are those where players compete against one another, and are generally “ sum”, meaning that players benefit only if they take resources from other players. Player vs. environment games are those where players compete against the game itself (and not against other players), so the player can win if the game is defeated. Social games are probably the most casual of the three, and appeal to a very wide audience, but are most often found on PC and are Internet-based, because of the large data sets required to connect players to one another. Similarly, player vs. player games require a lot of data and are typically played on PCs or on a closed network (like PlayStation Network or Xbox Live), and are seldom found on mobile phones. The third category, player vs. environment, captures all games where the player is

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pitted against the artificial intelligence of the device. This category lends itself well to the mobile format, and the vast majority of mobile games are player vs. environment.

It is true that many console games are also player vs. environment, but the richer textures offered by high-powered consoles and the ability to download incremental levels or challenges in some part serves to insulate the console publisher from attack on the mobile front. Also, mobile games are most often offered as “free-to-play” with virtual items for sale or with advertising furnishing the business model. Because there is typically no price paid by the consumer for the mobile experience, the games themselves are usually created with lower development budgets, meaning that there are several thousand mobile games developed every year compared to only 150 – 200 console games. Because of the high degree of competition and low likelihood of success, most mobile developers are reticent to spend too much time and money with such a high risk of failure.

Instead, we typically see mobile games offered that are far more casual than those offered on consoles, and that are far less data- or graphics-intensive. We believe that many mobile games are on par with simple games, such as (the mobile version and the dedicated handheld versions are essentially identical), but we believe that few mobile games compete head-to-head with complex console games, particularly in the multiplayer area.

We believe that mobile and tablet games have cut into handheld device and software sales at the more casual end of the spectrum, and believe that they will continue to impact sales going forward. By “more casual end”, we mean dedicated handheld purchasers who in the past did not consider themselves core gamers, but instead obtained a handheld device either as a gift or to pass the time playing puzzle and other player vs. environment games. We believe the decline in dedicated handheld device sales (from 40.5 million units globally in 2007 to 20.9 million in 2013) reflects cannibalization of this audience by mobile and tablet games.

In contrast, home console sales have not declined as precipitously, and if the Wii console is excluded from sales figures, home console sales have actually grown over the same period. Excluding the Wii, global console sales were a stable 23 million units per year from 2006 – 2009, and then actually grew each year since. In part, this explains why GameStop was able to grow its market share over the past four years in spite of annual overall software sales declines; the market was declining on the handheld side and Wii hardware and software sales were falling off a cliff, but GameStop’s core customer continued to purchase an increasing number of harder core consoles and software.

We think that the data suggests that mobile and tablet growth has eroded the casual end of the gaming market, but has left the hardcore portion of the market largely unaffected. It is important to note that as of the time of this writing, the installed base of smartphones and tablets capable of playing mobile and tablet games exceeded 1.5 billion; this is at least six times the addressable market for the dedicated handheld and console market, suggesting that the overall impact of mobile and tablet games has been to expand the market rather than to cannibalize only.

The Rise of Free-to-Play PC Games Much as mobile and tablet games distracted many consumers and caused a decline in dedicated handheld and console software sales, the dramatic growth of free-to-play (“FTP”) PC games also sucked up available leisure time. These games appeared in many forms, with social games like FarmVille experiencing wild popularity over the first four years of dedicated handheld and console software sales declines.

Zynga was behind much of the explosive growth of social games, which have declined in popularity over the last two years, taking shares lower with them. Social games tended to focus at the more casual end of the FTP spectrum, with very simple games allowing virtually anyone to play without a tutorial or much of a time investment. They were geared to drive revenues from sales of virtual items, with most items available to be earned by playing the game, providing an incentive for players with more

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money than time to buy them rather than by going through the tedious process of earning them, or of asking friends for the item. We believe Zynga games declined in popularity largely because the company oversaturated the market with only a handful of successful games; their simple game design proved insufficiently challenging to keep a large number of paying players engaged, and their pipeline was thinly supplied with new games.

There are several other popular games that cut into dedicated handheld and console software sales. Among these are games like Riot Games’ , a battle arena game that has routinely attracted over 40 million monthly active users. Barriers to entry in player-vs.-player games like League of Legends are low, but the game is sufficiently challenging that it is still going strong after over four years on the market. Anecdotal evidence suggests that League of Legends generates over $600 million in annual revenue, generated from a substantial minority of its users (we estimate 25 – 30% spend money in the game). We think that these types of games caused some cannibalization of the harder core end of the console gaming spectrum, and when combined with the cannibalization from the far more casual social games published by Zynga, the dedicated handheld and console market was under assault from both ends of its total addressable market spectrum.

The final FTP threat to dedicated handheld and console software sales was the dramatic increase of player-vs.-environment games, perhaps best exemplified by King.com’s . This game is a simple puzzle game that is quite easy to start playing, but that grows progressively more complicated and difficult as the player advances beyond the first 20 – 30 levels. The game progresses through 515 levels (as of the time of this writing), with virtual items offered throughout the experience that will aid the player in completing a particular level. Candy Crush Saga has been speculated to generate as much as $80 million per month in revenue as of this writing; several industry observers have suggested that King.com is considering an initial public offering, so details into the game’s performance may become available sometime in the future.

The important takeaway from the cannibalization of dedicated handheld and console software by FTP games is that the FTP phenomenon is growing, while the dedicated software market is not. FTP PC games can be enjoyed by virtually anyone with a PC and an Internet connection, so the ultimate addressable market is 2.4 billion people worldwide and growing. Console and handheld games can be enjoyed only if the player purchases a dedicated hardware unit, limiting the market to the approximately 400 million hardware unit installed base (with a significant percentage of cross ownership of consoles and handhelds); we estimate the number of households in the installed base is around 200 million, or less than 10% of the addressable market for FTP PC games. As we have discussed above, few FTP games offer as immersive or rich an experience as the large majority of dedicated handheld and console games, but the FTP experience is enjoyable enough to attract a very large number of players, and to limit the potential number of hours that would have otherwise attracted dedicated handheld and console players to the market.

As we said above, the threats to dedicated handheld and console software sales have largely come in areas that were much bigger opportunities than the relatively small home dedicated market. We believe that FTP PC games have been a net positive for future dedicated handheld and console sales, as they have served to expand the market by bringing in a large number of people who had previously not played games. While we believe few of these new entrants is likely to purchase a dedicated handheld or home console in the future, all of them are likely more tolerant of gaming than they were before they played FTP, and many will consider either a purchase for a friend or relative, or will consider allowing their children to play dedicated handheld and console games in the future.

The Dramatic Growth of Online Multiplayer We believe that the console online multiplayer phenomenon was one of the biggest drivers of the decline in overall dedicated handheld and console software sales over the last five years. Online multiplayer is a feature built into many first person shooter and sports games that allows players to play against one another through either the PlayStation Network (“PSN”) or Xbox Live (“XBL”). This feature began on

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PC, with shooter games like Half-Life modified in the late 1990s by dedicated players so that they could play against one another. The early modification was renamed Counterstrike , and gamers were able to network their PCs either directly together in a single location, or through the rapidly growing Internet. Microsoft built this functionality into its first console, the Xbox, launching in 2001 with a vision of gamers playing online multiplayer through its proprietary XBL network.

The first successful online multiplayer console game was Microsoft’s , a launch title created by then- internal studio . The multiplayer functions were introduced shortly after launch, in early 2002, and Halo was the selling point for Microsoft’s fledgling XBL Gold subscription service, then priced at $50 per year. The company attracted approximately 1 million paying customers by the end of 2002, and the figure grew to over 3 million paying customers by 2004 with the launch of .

Electronic Arts made some efforts to develop online multiplayer for its sports games in 2003 – 2004, but at the time, the company believed it should be compensated directly by Microsoft for access to the multiplayer features of its games. EA reasoned that if Microsoft was collecting $50 per year, and if gamers were willing to pay that amount for access to multiplayer content, then Microsoft should be willing to share a portion of its subscription fees with content providers. The dispute lasted a year, and was quietly settled in 2004. Only then did EA make a concerted effort to build out the multiplayer functionality in its games.

Activision, on the other hand, saw the solid success of Microsoft’s Halo and Halo 2 (which sold an estimated 6.5 million and 8.5 million, respectively, into an Xbox installed base that peaked at 24 million), and decided to develop multiplayer functionality for its fledgling Call of Duty first person shooter series. The addition of multiplayer functionality drove overall unit sales of the game, with dramatic growth between (estimated sales of 9 million units) and Call of Duty 4 (the first entry in the Modern Warfare series, with estimated sales of 17 million units). Activision exploited the online multiplayer phenomenon with its succeeding installments in the Call of Duty series and, according to the company, the game has generated annual sales in excess of 20 million units each year since 2009.

EA generated more modest success with online multiplayer in its sports games, with its FIFA series generating sales of 7 million units annually prior to the introduction of online multiplayer functionality, and routinely generating sales in excess of 10 million units after the online multiplayer functions were added.

We estimate that in 2008, when global dedicated handheld and console software sales peaked at $24.5 billion, there were approximately 7 million monthly active users (“MAU”) of multiplayer functionality in console games. By 2011, that figure had grown to an estimated 30 million MAUs. Microsoft told us in 2011 that the average player who accessed online multiplayer functions through Xbox Live spent an average of 10 hours per week playing against others on its network. If we extrapolate these estimates, this means that 30 million people on PSN and XBL spent an average of 500 hours per year, or a cumulative 15 billion hours annually, playing against one another online.

These figures are remarkable, especially when compared against global software sales. The $24.5 billion peak sales figure represents sales of approximately 580 million units of software. If the average single player game takes 30 hours to complete (a reasonable estimate that is probably at the high end of the range, reflecting replayability), cumulative hours spent by all gamers playing the single player track for all games purchased in 2008 totaled around 17.5 billion hours. Thus, the cumulative time spent playing multiplayer in 2011 was approximately equal to the cumulative hours spent playing single player in 2008. It appears to us that the time sink of online multiplayer was the biggest contributor to the slide in dedicated handheld and console software sales that began in 2009.

With that said, it appears that console online multiplayer is approaching a peak. Sony converted its free PSN into a pay service with the launch of its PS4 late last year, and while we think that the number of people who intend to play online multiplayer will continue to grow, we think that the imposition of a $60 annual fee will serve to limit overall growth. Microsoft raised prices for its XBL service in 2010, and it,

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too, charges $60 per year. We think that online multiplayer will continue to grow, but far more modestly than in the past. Accordingly, we think that much of the damage done to software sales has been done, and we expect little further downward pressure on dedicated handheld and console software sales in the next several years.

Console Fatigue and Fads The current generation console cycle began in 2005, when Microsoft launched the Xbox 360. The following year, Sony launched its PS3 and Nintendo launched the Wii. Each of the console manufacturers spoke of plans to extend the console cycle from the five-year cycles in the past to something a bit longer, and each followed through on those plans.

Somewhat surprisingly, overall demand for the current generation consoles surpassed demand for the prior cycle, with the installed base growing from approximately 200 million consoles in the PS2/Xbox/GameCube cycle to over 260 million in the PS3/Xbox 360/Wii cycle. The relative position of the three players shifted, with Nintendo’s Wii sales leading the way at 100 million units (compared to around 20 million ), followed by Microsoft’s Xbox 360 at 80 million (compared to 24 million Xboxes) and Sony’s PS3 also at 80 million (compared to 155 million PS2s). Even more surprisingly, demand for the PS3 and the Xbox 360 remained strong after five years on the market, although neither console saw its price drop to the historically attractive $199 price point.

We think that the bigger console cycle is attributable to three things: first, Nintendo captured consumers’ imagination with its Wii control mechanism, bringing in a large number of new gamers (those who had never played games on a console before); second, the cycle lasted a lot longer than the typical five-year prior cycles, with the Xbox 360 on the market for eight years before a replacement was launched, the PS3 on the market for seven, and the Wii on the market for six; and finally, the addition of non-gaming functions (such as Netflix and Blu-ray) made the console purchase decision more likely for non-gaming households than in prior cycles.

The three drivers of cycle-over-cycle growth for hardware had the undesired effect of lower software attach rates than in the past. Console purchasers who had never played games before were more satisfied with a handful of games than consumers had been in prior generations. Similarly, people who purchased a console to play a specific game (like Guitar Hero or Rock Band ) or to use non-gaming services were far less likely to buy the historical 12 – 13 units of software over the console’s lifetime. Finally, the specter of console fatigue surfaced, with the consoles growing old and their owners getting tired of them. We think that this final factor is analogous to owning a car past the typical seven-year life; the older the car gets, the more likely that its owner will consider a replacement, and begin to defer maintenance on the older car. We think that many console owners grew bored of their old consoles, and bought fewer software titles as the cycle dragged on past the historical five-year time frame.

We believe the game publishers were complicit in driving console fatigue. Several games were released (particularly for the Wii) that tried to exploit the non-gamer orientation of the larger addressable market. Many of these games were faddish in nature (such as the aforementioned Guitar Hero and Rock Band ), and when their popularity faded, they were discontinued. Because the current generation games cost significantly more to develop than games cost to develop in the prior cycle, publishers were forced to make fewer bets on content, resulting, in turn, in fewer choices for consumers. At the same time, many publishers found themselves losing money due to their inability to create a sufficient number of compelling titles each year, and several (, Atari and THQ among them) closed their doors. EA famously lowered the number of games released each year by 2/3, going from over 50 titles in the year of the to under 20 each of the past three years. With fewer choices, consumers bought fewer games overall for their consoles, in our view.

In addition to the impact of console fatigue, we believe many games were introduced that had a large impact on game sales at the peak of the cycle, but these games turned out to be fads. The most notable were Guitar Hero and Rock Band , which combined to generate over $2 billion in sales worldwide in

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2008, but which faded in popularity so that sales were virtually zero by 2011. Other examples were Wii Fit , , and to a lesser extent, Just Dance , each of which peaked late in the last decade and saw fading sales in the early part of this decade. We estimate that the drop-off in sales of these games contributed more than 10% to the 45% decline in overall dedicated handheld and console software sales we saw between the peak year in 2008 and the end of 2013.

The Economy It is clear that declines in employment levels and flattish GDP contributed to lower sales of video games. Entertainment has long been relatively immune to recessions, but the high price of games and the stubborn price points for current generation consoles set barriers that were too high for many middle and lower income people to cross. Historically, game console prices declined by 50% within the first three years; in the current generation cycle, the core Xbox 360 model is still priced at 75% of its launch price after eight years on the market (as of this writing). Game prices have also remained stubbornly high, with new releases still routinely priced at $60, while prior generations saw new release prices drop to $40 after four years. Consumers were faced with lower overall household incomes and higher relative entry costs, and we believe that this was a contributor to persistent software sales declines.

Conclusion Each of the factors that led to the decline in dedicated handheld and console software sales has either reversed or stabilized in the past year. Mobile and tablet games continue to see solid growth, and we think that the impact on sales of dedicated handheld hardware and software will continue to be felt. However, few of the publishers are focused on handhelds, with the notable exception of Nintendo, and we think that continued declines in dedicated handheld software sales will have almost no impact on the other publishers. Similarly, free-to-play PC games should see unabated solid growth, but we think that once again, the hard core gaming audience is largely immune to further expansion of the free-to-play genres. We think that one of the reasons for the Wii U’s rocky start is the defection of so many Wii owners in favor of FTP PC games, but don’t expect the same to happen with PS3 and Xbox 360 owners.

Online console multiplayer appears to us to be reaching a saturation point. We estimate that there are 30 million monthly active unique players of online console multiplayer games, or around 20% of the combined installed base for the PS3 and Xbox 360. While we think that it is likely that the number of online console multiplayer users will grow, we think that overall use will peak at around 25% of players, as we believe that most people will play only one or two multiplayer games per year, and most won’t play all year. Our 25% estimate means that we believe that around 50% of all gamers will play online console multiplayer games, but will do so only around half of the time. Accordingly, the impact of online console multiplayer on software purchases is likely to peak in the near term, and we should see software sales begin to overcome the negative impact of time sink.

We believe console fatigue has been addressed with the launch of the next generation consoles from Microsoft and Sony, and the sales declines caused by the fad phenomenon are over. The economy is expected to continue to improve, and the console manufacturers are focused on a wider geographic area than in the last cycle. We think that when taken together, the factors that caused a decline in dedicated handheld and console software sales have largely been overcome, and do not present a significant obstacle to renewed growth over the next several years.

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DEMOGRAPHIC TRENDS

The games industry is poised for a sales rebound, in part due to an aging demographic, more teen disposable income, and the broader appeal of games beyond the traditional teen male focus. In addition to fundamental market drivers like an improving economy and geographic expansion, we expect a broadening demographic is the most important factor that will determine the size of the interactive entertainment software market. This broadening demographic includes the aging of the pre- existing video game customer, rapid growth of the teen and twenty-something population, growth of the female gamer market, penetration of the Wii among people over 40, and the increasing disposable incomes of teens and pre-teens. While we think that the broadening demographic in the last cycle created a casual bubble that burst from 2008 – 2013, we believe that the exposure of older people to the Wii created increased acceptance of gaming in general. We expect an aging of the demographic overall to drive sales growth in both the hardware and software sectors of the industry for the next five years.

Widening Age Demographic The primary demographic behind the industry’s growth is the dramatic expansion in the age profile of the interactive game consumer. Video game consumers typically enter the market as children as young as six years old. In the 1970s through the early 1980s, most consumers were introduced to interactive entertainment in arcades. In the early 1980s, home consoles began to proliferate, and a group of “Atari kids” grew up playing video games at home. In the late 1980s and early 1990s, Nintendo emerged as the console manufacturer of choice, and a new generation of gamers was born. Since 1995, PCs have become prevalent in U.S. households, and an increasing number of consumers were first exposed to graphically complex video games through the PC. Internet connectivity has created yet another group of gamers who are aficionados of online games. Widespread Internet use led to broader distribution of “casual” games, with very small available for download (often for free), and increasing penetration of flash-based casual video games. The availability of wireless downloads has created yet another market for casual games played on cell phones. Finally, the introduction of the Wii, with its innovative control mechanism, appears to have expanded the market to older consumers who have never played video games before. Once they have entered the market, video game customers typically remain market participants long after their adolescence ends, and the increasing slate of product offerings (casual games, cell phone games, Wii games, etc.) should expand the age demographic further.

The first mass-market generation of interactive consumers (and now the oldest) started playing video games with the release of the Atari home console during the late 1970s. We estimate that the age range of video game consumers in the late 1970s was approximately 8 – 20, with a mean age of 11 (or an average year of birth of 1967). Since the 1970s, succeeding generations of video game consumers have embraced more advanced game systems and complex technology. Some older consumers dropped out of the market each year, replaced by a larger number of children receiving their first DS or PlayStation consoles. The mean member of the original generation of “Atari kids” is now over 40 (with an emerging group of “Nintendads” approaching their mid-30s), and many still play games on PCs or on home consoles. We believe that the age demographic of 90% of gamers now ranges from 6 – 40, dramatically broader than the demographic of the late 1970s.

It is difficult to assess the “average” video game customer’s age. We have seen forecasts placing the average age of video gamers as high as 29, although we believe that these figures include casual gamers who play games like solitaire and backgammon on their PCs. Our best guess is that the average age of console gamers is between 23 – 25 years old, but we think that the bell curve for game play is flattening, and that 80% of active gamers are between 8 and 35 years old. We also think that greater penetration of casual and arcade-style games on the consoles will attract a greater number of older and younger gamers.

As the high end of the gamer age range increases, the number of overall video game consumers continues to increase. More important, in a “normal” economy, people over 22 tend to be employed, and

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those who are employed generally have a significant amount of disposable income. People in their 20s are also generally quite self-indulgent, and we believe that they are willing to spend a large portion of their disposable income on entertainment. As the average age of video gamers expands beyond 22, we expect to see acceleration in spending per user. This phenomenon differentiates the present console cycle from past cycles.

We see continuing expansion of the age demographic for at least another 20 years, as the oldest gamers stay interested in games well into their 60s and children continue to embrace games. Over the next ten years, we envision a generation of “Nintendads” who grew up in the 1980s playing on the Nintendo Entertainment System and who will have kids of their own playing games in the next decade. We think that these fathers will enjoy playing video games with their own children, and expect this phenomenon to further expand the average age of video game consumers when it occurs.

One of the drivers for the “stickiness” of video gaming has been the convergence of multimedia in games, with surround sound, music soundtracks, and movie footage interspersed throughout the game. We envision incremental demographic expansion as the current-gen and next-gen consoles from Microsoft and Sony have embraced high definition as the graphics standard. Of particular importance is the cost of high-definition monitors: for early adopters, the expense of the monitor has tended to accelerate the adoption of any technology that provides HD content. As prices for HD monitors decline over time, we expect household penetration to increase and HD content, including video games, to proliferate. We believe that HD, music, movie footage, and similar features appeal equally to gamers young and old, and anticipate that the market will continue to expand until the upper end of the age range is no longer able to manipulate the .

Over the past few years, online console gaming has proliferated, further enhancing the social experience of game play. Player-vs.-player gaming through services like Xbox Live and PlayStation Network has made games far stickier than in the past. The introduction of casual, arcade, and mobile phone games has made video gaming ubiquitous, with gamers in airports, offices, bus stops, and everywhere else.

Rapid Teen Growth The core video game consumer is an early teen to mid-20s-age male. Historically, this demographic (known as “hard core” gamers) has purchased a disproportionate number of games and formed the target audience for many of the industry’s best-selling titles, driving a proliferation of testosterone- charged games. We expect this group to continue to grow at least through the middle of the next decade. According to the National Center for Health Statistics, more than four million children were born in the U.S. every year from 1989 to 1993. This is the highest number of births over a five-year period since the baby boomer years of the 1960’s. The oldest members of this group are 20 this year, and the youngest are 16, and we expect them to drive sales of the current generation consoles in 2009 and beyond.

Female Market Notwithstanding the historical strength of the male demographic in the interactive entertainment industry, the largest area of growth last cycle was the female market. Over the last five years, the “casual” phase of the current video game cycle hit its stride, with a proliferation of games that targeted female audiences. Some of the most popular games of the past five years were music-themed games Guitar Hero and Rock Band , and we note that there were several sleeper hits developed for the Wii, such as Carnival Games , Jillian Michaels’ Fitness Ultimatum and . Because of the widespread popularity of the Wii and the performance of such non-violent games, many publishers chased the genre, but few had lasting success. Mass-market games have long been the focus of many publishers, as evidenced by the success of popular titles such as: Pokémon , The Sims , and Mario Brothers . In addition, in the last two console cycles, many publishers focused on licensed content from mass-market sources, such as Harry Potter , SpongeBob SquarePants , Simpsons , Shrek , Spider-Man , etc. As more games targeted the mass-market, we saw a greater number of female gamers participate. We estimate that at the peak of the Wii’s popularity, over 30% of all primary gamers in households were female, up

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from the low teens early last decade. The Entertainment Software Association (ESA) estimates that female users (either primary or secondary) make up only 35% of the console market and 43% of the PC market. An increase of 5% penetration in these platform compositions by female gamers could translate into as much as $1 billion of incremental annual revenues to the industry each year. Unfortunately, as the Wii faded in popularity, female gamers appear to have migrated to other forms of interactive entertainment. In particular, the casual end of the console gaming spectrum migrated to smartphone, tablet and social games, contributing to declines in dedicated handheld and console software sales for the last five years.

Increasing Youth Income Another positive demographic trend for the industry is increasing disposable income for children ages 8 to 14, frequently referred to as “tweens”. Tweens make up one of the largest segments of the interactive entertainment market. An indication of how pervasive interactive gaming is in the tween consciousness can be gleaned from their reading habits – the top two periodicals read by males in this age group are gaming magazines ( and ). According to magazine publisher information, Game Informer is the 3rd highest circulation magazine in the U.S., with over 7.8 million monthly subscribers (over double People’s 3.7 million). Increasing incomes of this group and their rising influence on household spending means more money spent on interactive entertainment. We believe that spending for this age group has increased 300% in the last decade (a 12% CAGR) and estimate that the 27 million tweens in the U.S directly influence more than $120 billion of family spending.

Figure 5: Primary Video Gamer by Age and Gender

(in years) Age Range %

Under 18 32% Female 18 or older 68% 45% Total 100% Male 55%

Average age 30

Source(s): Entertainment Software Association.

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HARDWARE PLATFORMS

Games can be played on consoles, handheld devices, PCs, smartphones or tablets. Video games are played primarily on three major hardware platforms: home consoles, handheld gaming devices, and PCs, with hybrid devices such as smartphones and tablets driving significant revenue and growing the overall market beyond the traditional focus of dedicated software publishers. Home consoles capture the greatest share of the global interactive entertainment dollars, but free-to-play games on PC and smartphones/tablets dominate total time spent gaming, and are expected to generate higher revenues this year. In 2013, we estimate that approximately 65% of all packaged video games on a unit basis were console games. We estimate that video games sold for the handheld and PC platforms accounted for roughly 23% and 12% of the market, respectively. Over the last five years, the console market has grown only slightly from a 56% share, and the handheld market has declined from a 30% share, while PC games have held relatively steady. Over the next five years, we expect console games to capture roughly 70% of all software sales, with handhelds capturing around 20% and PCs capturing 10%.

Figure 6: 2013 Video Game Software Sales Market Share by Platform Type

Console Handheld PC Total 82% 12% 5% 100% Europe 75% 12% 13% 100% Japan 37% 56% 7% 100% Worldwide 73% 19% 9% 100%

Source(s): Wedbush Securities estimates.

As the previous figure illustrates, dollar sales by platform vary widely across the three primary geographic markets. The home console is the largest platform in two of the three primary markets, with the handheld platform leading software sales in Japan. In Europe, while home console software sales are strong, the market for PC software remains relatively robust, due to a combination of slow console adoption in Eastern Europe and Scandinavia, with Western European adoption rates similar to those in the U.S. Meanwhile in Japan, home console software has lost market share, while sales of handheld software have grown dramatically. PC software barely registers in Japan, at 7% of total sales, and the U.S. has followed Japan’s lead with a precipitous decline in PC game software sales over the last several years as a percentage of packaged goods sales. The decline in PC software sales in the U.S. is more likely attributable to the popularity of PC download services such as Valve’s service. We think that PC software sales remain robust in the U.S., but think that as much of 70% of PC game software is sold via download rather than in packages. We think that Japan is the last refuge for handheld software, likely due to widespread use of mass transit and long commutes, but we expect handheld sales to decline in that country going forward as smart phone and tablet games begin to inevitably encroach on dedicated handheld software sales. We expect European adoption rates for console software to increase in the next cycle.

Market share trends in Europe have mirrored U.S. trends in recent years, with each region generating approximately around 70% market share from console software sales. We expect to see free-to-play PC software sales and smart phone and tablet game revenues grow at a very high rate over the next several years, as smart phones and tablets become more prevalent. We note that the quality of games created for smart phones and tablets is becoming competitive with console game quality, although the games for those platforms tend to be more “bite sized”.

The prevalence of online games has increased with several popular free-to-play games attracting tens of millions of users and generating hundreds of millions of dollars in revenue. We estimate that Riot

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Games’ League of Legends has 60 million active players and generated approximately $650 million in 2013, while ’s has 100 million players who generated approximately $350 million last year. Neither company sells packaged software, reflecting how much the PC market share is understated when considering only packaged goods sales.

The adoption of handheld consoles in Japan is a trend worth noting. The devices have always performed well in the region, but the increase in market share for handheld games was dramatic in 2004 through 2013, almost tripling from 21% to 58% in just nine years, according to Media Create. The U.S. and European markets appear to be leading the Japanese market in the move away from dedicated handhelds, as smartphones and tablets are prevalent and a greater number of casual gamers are satisfied with those experiences. We think that U.S. and European market share for handheld games will continue to decline from current levels, particularly as console software sales grow. While we don’t expect any potential for an increase in market share for handheld games, we see the category contributing significantly to overall software sales for the next several years.

The following are our views and analyses of these competing platforms. We include forecasts for each platform within the specific platform descriptions and present a summary hardware forecast for the home and handheld consoles at the end of this section.

Home Consoles Over the last 30 years, we estimate that more than 100 dedicated gaming consoles were introduced to the video game market. Of these various console platforms, only a handful proved economically successful. The business model of choice is a “razor-and-blade” economic model. Under this model, consoles (the razors) are sold at very low or negative gross margins with the expectation that the console manufacturers will recoup their investment by charging royalties to publishers on software produced or from online services and downloads (the blades). Because the stakes of console introduction are quite high, this model dictates that only a few consoles capture enough market share to succeed, with those that do dominating the market. The winners have historically been those manufacturers that penetrate the market most deeply while keeping manufacturing costs low. Over the last 30 years, the clear leader was Sony, with more than 130 million PS2s sold. We estimate that PS2 production costs averaged well below $100 per unit, compared to the PS3’s average cost of $250 per unit. In the legacy cycle, Sony’s PS2 had a cost advantage over Microsoft’s Xbox (estimated to be more than $50 per hardware unit) that allowed Sony the luxury of competing on price.

The have turned in the current cycle. In late 2005, Microsoft introduced the Xbox 360 at a $299/399 price point. Sony and Nintendo launched current generation consoles in late 2006, with the PS3 priced at $499/599 and the Wii priced at $249. Microsoft wasted little time in exploiting its cost advantage, cutting the price of its Xbox 360 Pro in 2007 to $349 and again in 2008 to $299, and introducing an “Arcade” version (sans hard drive) at a $199 price point. Curiously, Microsoft has as yet to cut the price of the Xbox 360 almost five years later. We estimate that Microsoft’s current cost of production for the Xbox 360 core model (with a 250 GB hard drive) is around $200, and estimate that the company breaks even on its Arcade model. Sony matched Microsoft on pricing by 2009, and cut the price of the PS3 to $249 in 2011. We think that Sony has a similar cost for its core PS3 model, but makes a lower profit on each console than Microsoft because the PS3 is sold for $50 less. Notwithstanding their respective cost structures, we think that both companies will cut price to $199 at some time in 2014, as each firmly believes that buyers of their current generation consoles are most likely to be buyers of their next generation consoles at some point in the future.

Nintendo dominated the current cycle, with its $249 Wii (which included its game) allowing it to undercut pricing for the core models offered by its competitors at launch. Nintendo cut the price of the Wii to $199 in 2009 and to $149 in 2011. We expect a further cut to $99 this year. We estimate that the Wii cost under $150 to produce at launch, and likely costs below $100 now, so Nintendo earned a solid profit on each unit sold.

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The Xbox One debuted in 2013 for $499, and likely costs Microsoft under $400 to produce. In contrast, the PS4, which also launched in 2013, carries a price point of $399, and likely costs Sony $350 to produce. Microsoft appears intent on profiting from each Xbox One sold, and we believe that the company is conceding a huge price advantage to Sony, whose console is likely to appeal to price- conscious consumers.

The Wii U debuted a year before the next generation consoles from Microsoft and Sony at a $349 price point. While the components within the console itself likely cost around $200 to produce (similar to the cost of the Xbox 360 and PS3), the Wii U’s “Game Pad” controller is very expensive to produce, likely costing around $70. Thus, the Wii U, priced at $299 currently, is unlikely to make a profit for Nintendo; this represents a departure from the company’s past practice of being profitable on every hardware unit sold. Because its sales are so poor, Nintendo finds itself in a quandary. The company must either resign itself to poor sales and sacrifice future profits from its software business due to a small console installed base, or it must take a loss on each console sold in order to drive the installed base higher.

Console Cycles 2012 marked the beginning of the sixth generation of home consoles. Since 1985, console manufacturers have introduced new hardware technology approximately every five years. That practice ended with the current cycle. In the past, new hardware was referenced by the prevailing CPU technology of that era (i.e., 8-bit, 16-bit, 32-/64-bit or 128-bit console cycles). This convention is no longer used to describe the current consoles, as the architecture of the three new consoles differs markedly from prior consoles. The five-year time period that has defined each of the prior three console cycles is not coincidental: the lag in time was both a function of the time necessary to create new hardware (typically based upon manufacturers waiting for the commoditization of components) and the time necessary for hardware manufacturers to recoup their investment via software sales. Although it is likely that the leaders in each cycle (Nintendo in 1990 – 95, Sony in 1995 – 2000 and 2000 – 05) would have preferred a longer tail on the cycles, competition from upstarts (Sony in 1995, Microsoft in 2001 and 2005) triggered a to introduce a new console sooner than consumer demand may have justified. Apparently, consumers didn’t crave new consoles in late 2005, given the relatively slow ramp of the Xbox 360 and continued strong demand for the PS2. In fact, the PS2 outsold the Xbox 360 or held relatively even in the U.S. until early 2008, when the Xbox 360 moved ahead for good. We think that pricing had a lot to do with the relatively slow start of the Xbox 360, given that no successful console had been priced above $300 in the past. We believe that in the past, the pace of technological advancement drove in the functionality of consoles, leading manufacturers to build “better mousetraps” as soon as they were able. While consumer appetite for something new has provided support for new hardware introductions every five years, the console manufacturers deviated from past practice and held off introducing new hardware until 2012 (the Wii U) and 2013 (the PS4 and the Xbox One).

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Figure 7: U.S. Console Cycles and Hardware Launches

U.S. Life U.S. Launch Cycle Units Date CPU Manufacturer Console Sold (mil) % Growth

Oct-85 8-bit Nintendo NES 36.3 Actual Total 36.3

Jan-89 16-bit 18.5 Actual Aug-91 16-bit Nintendo SNES 20.0 Actual Total 38.4 +6%

May-95 32-bit 1.4 Actual Sep-95 32-bit Sony PlayStation 30.4 Actual Oct-96 64-bit Nintendo N64 18.0 Actual Total 49.7 +29%

Sep-99 128-bit Sega 4.1 Actual Oct-00 128-bit Sony PlayStation 2 46.4 Actual Nov-01 128-bit Microsoft Xbox 14.5 Actual Nov-01 128-bit Nintendo GameCube 11.8 Actual Total 76.8 +54%

Nov-05 Current-gen Microsoft Xbox 360 41.1 Projected Nov-06 Current-gen Nintendo Wii 41.6 Projected Nov-06 Current-gen Sony PS3 25.6 Projected Total 108.3 +41%

Nov-12 Current-gen Nintendo Wii U 2.1 Projected Nov-13 Current-gen Sony PS4 2.0 Projected Nov-13 Current-gen Microsoft Xbox One 1.8 Projected Total 5.9

Note: As of December 2013. Source(s): The NPD Group and Wedbush Securities estimates.

The figure above illustrates the most recent console cycles and the dominant consoles within those cycles (note that the “Units Sold” includes U.S. sales over each console’s life cycle, not just the initial five-year period).

Each prior console cycle in the U.S. resulted in increasing sales and a larger installed base. As discussed later in this report, we think that the term “console cycle” is a misnomer, insofar as it implies that this is a cyclical business. Console software sales (excluding handheld software) in the U.S. and Europe combined rose from approximately $1.3 billion in 1990 to over $18 billion in 2008; this resulted in a compound annual growth rate of almost 16%. Since 2008, console software sales have declined every year, as the console manufacturers and publishers misjudged the staying power of current generation consoles. Console software sales in 2013 were only $9.8 billion, at the same level as they were in 2004, before the current console cycle began. We believe that this low level of sales positions the industry for a dramatic rebound, and makes our double-digit growth forecast even more believable.

In the 1995 and 2000 console cycles, demand and price points for both hardware and software were relatively high, with hardware prices dropping in the second full year of each cycle. In the current cycle (which began in 2005), price points started at unprecedented levels, with the Xbox 360 priced 33% higher than the Xbox and the PS3 priced at 200% of the PS2’s introductory price. In contrast to earlier cycles, hardware pricing held for quite a while, with the Xbox 360 remaining at $399 until mid-2007, then cut by only $50, or 12% (in contrast to a 33% price cut six months after the Xbox launched). Microsoft cut price another $50 in mid-2008, and has not cut pricing since. The PS3 price was cut to $399 in mid- 2007 as well, then saw another cut to $299 in 2009, and saw its last cut (to $249) in 2011. In contrast to

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other cycles, Sony and Microsoft have offered several different SKUs for each console (ten models for the PS3 and eight for the Xbox 360); our reference to price cuts is for the most popular models. At today’s prices of $249 and $299, the PS3 and Xbox 360 are more than double the price of their predecessor console ancestors five years beyond the lowest price point in the past cycle (the middle of the fourth full year of the cycle).

Price elasticity of demand dictates that lower price points will spur sales growth, as the target audience shifts toward a lower socioeconomic demographic (typically defined as “mass-market” or more casual gamers). In past cycles, console hardware sales typically peaked three years after each console’s introduction, and software sales tended to peak in the fourth year. The end of the fifth year historically marked the introduction of new console hardware, with a dramatic decline in both hardware and software sales for the older systems, as consumers tended to defer purchase decisions until they were able to acquire the current generation technology.

The current cycle has been different. Hardware sales for the PS3 and Xbox 360 peaked in 2011 (six years after the cycle started), while software sales peaked in 2008 for the Xbox 360 and in 2011 for the PS3. Due to the long delay between launch of the current generation in 2005 and the introduction of new consoles in 2012, we believe consumers grew tired of the same old software; this fatigue was supported by fewer choices, with many publishers going out of business, and with the remaining publishers sharply curtailing the number of titles offered.

The console manufacturers ended up benefiting from a long cycle by saving on development and marketing costs for their next generation consoles, but most of the publishers saw profits dwindle in correlation with software sales declines. We think that console pricing above historical levels seven and eight years into the current cycle is unsustainable, and we expect hardware prices for current generation consoles to drop this year, with consoles likely priced at $149 in 2016.

Figure 8: U.S. Cumulative Hardware Unit Sales

140

120

100

80

60

40

20

0

8-Bit 16-Bit 32/64 Bit 128 Bit Current Gen Next Gen

Source(s): The NPD Group and Wedbush Securities estimates.

The one- to two-year period of overlapping hardware cycles is called the “console transition” period. The previous figure shows console unit sales during the last four console cycles and illustrates the timing of past console transitions, with a flat “tail” to the end of each cycle followed by a rapid ramp in sales for the succeeding console. We think that it is noteworthy that the ramp up of both the 32/64-bit cycle and the

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128-bit cycle was steeper and more sustained than either of the prior two cycles. This suggests to us that the technological improvement of each console compared to its predecessors was more dramatic than in past cycles, drawing an ever-increasing number of consumers to the console. The five-year trend ended with the current generation, and we do not expect it to continue going forward, as we believe that the “law of diminishing returns” has resulted in smaller incremental gains in game play and graphics resolution with each generation. As the software development time and effort required to fully exploit faster microprocessors and faster graphics cards drove up the cost of game development, game developers and publishers became more selective about games produced, with a decreasing number of titles available for this generation’s consoles.

The current console cycle lasted an unprecedented eight years, as the console manufacturers needed more time to recoup their initial investments, and technology did not advance as dramatically as in past cycles. As shown from the significantly higher slope of the curve for the current cycle, it is clear why this cycle lasted three years longer than past cycles. We believe that significant advances in speeds and the amount of data that processed per cycle have advanced the art of video game publishing and substantially increased the entertainment value of the medium, but the ability to advance graphics further diminished sharply with the current generation. In our view, the steep increase in demand for 128-bit machines was a function of better games, pure and simple. We discussed this phenomenon in our industry report entitled “Content is King,” published in 2002, and elaborated upon it in our industry report entitled “The Great Console Cycle Myth,” published in 2003. In our 2004 report, “The Definition of Insanity”, we questioned the wisdom of a premature truncation of the 128-bit cycle in order to gain first-mover advantage, and elaborated on this question in our 2005 report entitled “Field of Dreams”. Notwithstanding our concerns, Microsoft chose to introduce its current generation console, the Xbox 360, in late 2005, and sales of Xbox software declined precipitously in 2006 as a result.

We believe our views over the last 13 years have been borne out over the last few years of the current cycle. Hardware prices held up significantly longer for the current generation consoles than for any predecessor console. The first price cuts for the PS2 came almost 19 months after the console was introduced (from $299.99 to $199.99), and the second price cut came 12 months later (to $179.99). The price point dropped to $149.99 a staggering 43 months after the console’s debut, and was maintained for an additional 23 months. Sony cut the price of the PS2 to $129.99 in April 2006, six months prior to the launch of the PS3, in order to maintain demand for the legacy console, and cut price to $99.99 in April 2009, a full 30 months after the PS3 launched. In contrast, the original PlayStation’s (a 32-bit machine) price was cut to $149.99 barely 24 months after introduction, and was further discounted at retail 48 months after launch. We calculate the average selling price for PS2s sold to be approximately $180/unit in the U.S. over the first eight plus years since launch, compared to an average price of $134 for the original PlayStation over a similar period. Even at these higher prices, we expect that by year- end, Sony will have sold 31% more PS2s worldwide than at a similar point in the latter console’s life cycle. In contrast, the average selling prices for the PS3 and Xbox 360 is well over $300.

We believe that Sony was forced to keep the price point of the PS3 higher longer than in prior generations because it was losing money on its hardware sales. This was attributable to the company’s decision to incorporate its cell processor in each PS3, and to include a Blu-ray drive with each unit in order to allow it to win the DVD format war with Toshiba. If our estimates are close, Sony generated over $500 million in gross profit from PS2 hardware sales in 2006, and lost money each of the first four years that it produced the PS3. We think that the PS3 is solidly profitable at present, but expect price cuts in 2014 to cut margins on the hardware to close to zero.

In contrast, we estimate that Microsoft has managed to produce the Xbox 360 at a profit since 2007, and its current production costs, roughly the same as Sony’s, have allowed it to generate higher profits due to the Xbox 360’s higher price point. We expect the Xbox 360 to see a price cut to below $200 later this year. Microsoft lost money on each original Xbox unit produced from 2001 – 2005, and we think that the company’s pricing on the Xbox One is the result of learning that hard lesson. While we expect the Xbox

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One to perform very well, we think that its $499 price point may be prohibitive to many consumers, and we expect the PS4 to outsell the Xbox One so long as it is priced $100 cheaper.

Figure 9: U.S. Annual Hardware Unit Sales

25

20

15

10

5

0

8-Bit 16-Bit 32/64 Bit 128 Bit Current Gen Next Gen

Source(s): The NPD Group and Wedbush Securities estimates.

Console transitions have never been easy, and the current transition is one of the most difficult. Historically, console transitions have been difficult for software publishers because consumers have tended to slow their purchases of existing hardware and software while waiting for the new consoles to launch. This was particularly evident and painful for software publishers in the transition from 16-bit systems to 32-/64-bit systems in 1995. That year, console and handheld software sales in the U.S. and Europe declined 35% to $2.3 billion from $3.6 billion the prior year. We believe that a key contributing factor to this decline in software sales was the level of support given to the PlayStation launch, with most U.S. and European publishers developing an inordinate number of titles for the new platform. The U.S. and European publishers learned very little from their experience in 1995, and again rushed to support the 128-bit hardware launch in 2000. Again, software sales in the U.S. and Europe declined significantly from the prior year. Sales of console and handheld software dropped from $7.2 billion in 1999 to just under $6.6 billion in 2000, a decline of 9%. Importantly, the year 2000 marked the slowing of a phenomenon experienced in 1995, where current generation (i.e., 16-bit) software sales declined by almost 50% (from over $2.5 billion to under $1.3 billion). In 2000, then current generation (i.e., 32/64-bit) software sales decreased 21%, from $6.0 billion to $4.8 billion. It appears that this trend began to reverse in 2005, with current generation software sales down only 3%, and the modest decline continued in 2006 with only a 13% decline. The modest declines are attributable to rapidly growing contribution from the handhelds, which are somewhere in between “current” and “next” generation. Increasing sales of current generation software offset declines in software sales for legacy systems in 2006, leading to overall software sales growth that year. In 2007, current generation console sales declined by only 38%, with over 45% growth in handheld and current generation software sales. This rapid shift from legacy to current generation software drove overall sales growth of 25% for the year.

In contrast, current generation software sales declined every year since 2008, notwithstanding that there was no new console announced until 2011. Overall software sales declined by 45% from 2009 to 2013, setting the bar very low for a rebound in software sales growth this year. The current level of console

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software sales is at its lowest point since 2004, suggesting that there is significant room for growth without the need to achieve prior record levels.

The previous figure illustrates the annual sales of hardware systems in the U.S. for the past three console cycles and our estimate for the coming cycle. Note the severe drop-off in sales during the last two console transitions (1995 – 1996 and 2000 – 2001). The drop-off in the last transition (2005 – 2006) was not as steep, as Sony continued to promote the PS2 and publishers continued to create software for the legacy platform. This cycle, we expect price cuts on current generation hardware to mitigate declines in current generation software sales, and we expect a rapid ramp in next generation console hardware to drive outsized software sales growth, beginning this year.

Prior Console Transition Prior to the Xbox 360 cycle, the industry last completed a console transition between 2000 and 2002, when the generation of 32-/64-bit hardware was phased out and replaced with 128-bit technology. The following figure illustrates U.S. software sales by platform technology over the last several years (and our forecast of the next three years), highlighting the shift in the U.S. console market from 32-/64-bit systems to the 128-bit machines.

In 2005, 128-bit software comprised 96% of total U.S. console software sales, up from 57% in 2001. 128-bit software sales dropped to 71% of total U.S. console software sales in 2006 and declined to 31% in 2007 and 14% in 2008, as publishers chased market share on current generation consoles. This contrasts with 32-/64-bit software market share of 84% in 2000 (the year of the PS2 launch), 43% in 2001, 14% in 2002 and 5.6% in 2003. The staying power of the last generation software and corresponding slower ramp in sales of current generation console software supported higher average software selling prices for both sets of software, slightly lengthening the transition between console cycles, according to our research.

Figure 10: U.S. Software Sales by Platform

$12,000

$10,000

$8,000

$6,000

$4,000

$2,000

$0

16-Bit 32/64 Bit 128 Bit Current Gen Next Gen

Source(s): The NPD Group and Wedbush Securities estimates.

128-Bit Consoles As in prior console cycles, the 128-bit cycle did not generate sufficient software sales to support three successful consoles, with Sony’s PS2, Nintendo’s GameCube, and Microsoft’s Xbox all clamoring for

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market share. While most industry observers have generally declared Sony’s and Microsoft’s efforts successful, declaring Nintendo’s a failure, we disagree. In our view, success should be measured by profitability, and based upon that metric, only Sony was wildly successful. It is important to note that Microsoft lost billions of dollars garnering its 18% hardware market share (and 20% software market share) during the 128-bit cycle, while Nintendo was generally profitable throughout with only 17% market share. The dominant console of the 128-bit cycle was the PS2, garnering approximately 65% of worldwide 128-bit hardware unit sales through 2006 and over 67% software market share. Xbox and GameCube production ceased in 2006, giving Sony an opportunity to gain share in a declining market for current generation software sales.

Although PS2 sales in the U.S. started slowly in 2000, the sheer volume of titles available for the PS2 (which was backward-compatible and allowed the playing of a large number of PlayStation One games) gave the console a huge first-mover advantage and made it the most popular choice among 128-bit machines. We believe that Nintendo’s software offering allowed it to capture a dominant market share among young gamers, keeping the company close to Microsoft in the worldwide hardware rankings. Although much was written about Nintendo’s third place position in the last console cycle, pundits frequently overlook the company’s dominance in the handheld arena, with over 73 million Game Boy Advance hardware units sold worldwide and 27 million Nintendo DS hardware units sold at the end of 2006 (when the GameCube was discontinued). The strength from its handheld offering allowed Nintendo to remain profitable throughout the last console cycle. Nintendo-produced first-party software captured the dominant share of software sales for these devices, driving its profitability. We believe Microsoft’s challenge to gain share in the 128-bit console cycle was due in large part to a lack of support from Japanese software developers, compounded by the company’s late entry and its relatively light line-up of first-party software. Microsoft has clearly established itself as a long-term player in this market, and learned much from its mistakes in the last cycle. The company was better prepared for its launch of the Xbox 360 (discussed below), and has gained significant share in the current generation.

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Figure 11: Console Installed Base (U.S. and Europe) 120

PlayStation 100 GB Advance/SP DS/DSi 80 3DS PSP

PS Vita

60 PlayStation2/PS2

Xbox 40 GameCube PS3

Xbox 360

20 Wii

Wii U 0 PS4 Xbox One 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E (million units) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 52 57 61 62 64 64 64 64 64 64 64 64 64 64 64 64 64

GB Advance/SP 8 17 30 43 51 57 59 59 59 59 59 59 59 59 59 59 DS/DSi 1 6 17 36 58 78 93 100 102 103 103 103 103 3DS 8 15 25 34 43 50 PSP 6 12 20 27 32 36 40 42 43 44 44 44 PS Vita 3 4 5 7 8 Handheld Subtotal 8 17 30 44 62 85 115 145 170 189 207 221 234 246 256 265

PlayStation2/PS2 2 12 27 41 51 63 72 80 85 88 90 90 90 90 90 90 90 Xbox 1 6 11 18 22 22 22 22 22 22 22 22 22 22 22 22 GameCube 1 5 9 13 16 17 18 18 18 18 18 18 18 18 18 18 128 Bit 2 15 37 61 82 101 112 120 125 128 130 130 130 130 130 130 130

PS3 1 7 14 23 33 44 53 59 63 67 70 Xbox 360 1 7 13 21 30 41 53 62 68 73 76 79 Wii 2 13 32 47 60 69 73 75 76 76 76 Current-Gen 1 9 33 67 100 135 166 189 202 212 219 224

Wii U 1 3 6 8 10 PS4 4 16 28 40 Xbox One 3 12 22 32 Next-Gen 1 11 34 57 82 Source(s): The NPD Group and Wedbush Securities estimates.

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Figure 12: Console Installed Base (Worldwide) 160

140 PlayStation GB Advance/SP 120 DS/DSi 3DS

100 PSP

PS Vita

80 PlayStation2/PS2

Xbox

60 GameCube

PS3

40 Xbox 360

Wii 20 Wii U 0 PS4 Xbox One 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E (million units) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 72 78 82 83 85 85 86 86 86 86 86 86 86 86 86 86 86

GB Advance/SP 8 20 37 53 62 68 70 71 71 71 71 71 71 71 71 71 DS/DSi 2 11 30 57 83 107 124 132 134 135 135 135 135 3DS 12 25 40 55 70 84 PSP 2 9 17 28 39 46 53 59 62 64 65 65 65 PS Vita 0 4 6 9 11 14 Handheld Subtotal 8 20 37 56 81 115 155 192 224 248 274 296 316 335 352 369

PlayStation2/PS2 6 20 38 55 68 82 93 102 107 111 112 112 112 112 112 112 112 Xbox 1 6 12 19 22 23 23 23 23 23 23 23 23 23 23 23 GameCube 2 6 12 17 20 21 21 21 21 21 21 21 21 21 21 21 128 Bit 6 23 50 78 103 125 137 146 152 155 156 157 157 157 157 157 157

PS3 1 8 17 28 39 51 62 69 73 77 80 Xbox 360 1 7 13 22 31 42 54 64 70 74 78 81 Wii 3 18 39 57 72 81 86 88 89 89 89 Current-Gen 1 10 39 78 115 153 187 211 226 236 244 250

Wii U 2 5 8 11 14 PS4 4 17 31 45 Xbox One 3 12 22 33 Next-Gen 2 12 37 64 92 Source(s): Source: Wedbush Securities estimates.

Sony PlayStation 2 Sony’s PlayStation 2 (PS2) hit store shelves in Japan in March 2000. Retailing for approximately $370, Sony sold nearly one million units at the Japanese launch. Sony followed with a U.S. launch of 500,000 units, retailing for $299 each, in October 2000. The company had originally anticipated shipping one million units for the U.S. launch, but due to microprocessor production problems, it scaled back initial shipments into the U.S. The company launched the PS2 in Europe in November 2000, also with a reduced initial shipment. Sony’s lowered shipments angered customers, publishers, and retailers in the U.S. and Europe, who were counting on much higher volumes for the holiday season. In particular, the U.S. and European publishers were hard hit by the low initial shipment, as many devoted an extraordinarily large portion of their development budgets to launch titles. The PS2 represented a significant technological advance over its predecessor, the PS1, as it was capable of several multimedia functions, including DVD playback, CD audio, as well as the potential for Internet connectivity. The company also chose to make the PS2 fully backward-compatible, allowing new PS2 owners to enjoy game play from their cumulative library of PS1 games. Notwithstanding the relatively light launch, the company ramped its manufacturing capacity dramatically, selling over 14 million PS2s worldwide in 2001.

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Sony enjoyed a large first-mover advantage, and the PS2 was the dominant console of the 128-bit cycle by a large measure. Sony received tremendous third-party software development support for the PS2, and we believe that this was the deciding factor in the console war that cycle. Many titles released only (or initially) for the PS2 performed quite well, such as Sony’s Gran Turismo 3: A-Spec , , SOCOM Navy Seals I and II , and God of War 1 and 2; Square Enix’s and I and II ; and Take-Two’s Grand Theft Auto 3 , Grand Theft Auto: Vice City , and Grand Theft Auto: San Andreas . The following figure illustrates unit sales of PS2 hardware by geographic area.

Figure 13: Sony PlayStation 2 Unit Sales (2000 – 2015E)

20 18 16 14 12 10 8 6 4 2 0

U.S. Europe Japan

Source(s): The NPD Group and Wedbush Securities estimates.

Until late in 2004, Sony’s strategy for competing in the console business was to generate profits from software royalties (approximately $8 per unit on average for the PS2, higher now for the PS3). Consoles were sold at a small profit, allowing Sony to gain market share and receive more software royalties once the installed base of console owners continued to purchase software. In late 2004, the company was able to redesign the PS2 and cut its manufacturing costs dramatically, while maintaining the price of the device at $149. We estimate that for the first time, Sony was able to generate substantial profits from hardware sales, with $600 – 700 million in gross profits in 2005. When the company cut the price of the console to $129 in 2006, its gross profits from hardware likely declined to around $500 million. This compares to our estimate of $1.5 – 1.6 billion in gross profit from software royalties.

We think that Sony learned a difficult lesson from its experience with the Betamax video recorder in the early 1980s—Sony’s product was technologically superior to rival ’s VHS format, but VHS won market share by sacrificing margin and forsaking software royalties in order to drive unit sales. With the PS2, Sony embarked upon a strategy of securing wide support for its format, despite claims of technological superiority by its competitors, Nintendo and Microsoft. The company tried to do the same with the PS3 (discussed below).

Nintendo GameCube Nintendo launched the GameCube in November 2001. At the time of launch, Nintendo chose a small form factor (a cube) and chose to compete on price, with its console debuting at $199 compared to its competitors’ launch pricing of $299. In support of the GameCube, Nintendo capitalized on its internal development strength and targeted its loyal fan base, composed of players in their twenties who grew up playing Nintendo games and younger players who favored more family-friendly games. Notwithstanding

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its oft-stated desire to appeal to hardcore gamers, Nintendo’s product offering tilted towards E-rated games. The GameCube’s appeal as a kiddie device was made more apparent given the fact that the device did not include DVD playback functionality, a more adult feature included in its competitors’ 128- bit consoles.

We believe that Nintendo made several strategic errors at launch. First, it launched its console prior to the release of its most popular content, striving to “keep up” with competitor Microsoft. Second, it failed to include DVD functionality, leading to a lower price point than its competitors, and created the perception that the GameCube was an inferior device. Third, it depended too heavily on internally developed content that was high quality, but skewed too far toward a younger audience. Fourth, it made its device too “cute”, giving it the appearance of a toy and appealing to younger consumers as a result. Fifth (and finally), it chose to change the format of its medium from cartridge-based to disc-based, eliminating the potential for backward compatibility. Accordingly, we believe that the GameCube’s failure to capture share close to Sony’s, and failure to surpass Xbox sales is explainable. Nintendo adroitly managed to avoid these mistakes with the launch of the Wii (see our discussion below). With a strong lineup of games featuring the ever-popular Pokémon , Zelda , , Donkey Kong and Bros. franchises, GameCube sales were solid, if not spectacular, but insufficient to allow it to rise above the number three console position worldwide, well behind the PS2 and only slightly behind the Xbox.

Figure 14: Nintendo GameCube Unit Sales (2001 – 2008) 6.0

5.0

4.0

3.0

2.0

1.0

0.0 2001 2002 2003 2004 2005 2006 2007 2008

U.S. Europe Japan

Source(s): The NPD Group and Wedbush Securities estimates.

In essence, Nintendo “invented” the razor-and-blade business model, having competed in the video game arena since 1985 with its NES, SNES, and N64 systems and with the various iterations of Game Boy prior to entering the 128-bit console wars. In addition, the company has significant development strength, enabling it to provide exclusive content for its consoles. Also, Nintendo was able to secure modest support from Japanese third-party developers for the GameCube, notably with the series of games from Capcom. The previous figure illustrates unit sales of GameCube hardware by geographic area.

Microsoft Xbox Microsoft launched the Xbox in November 2001 for a retail price of $299. With a $500 million marketing budget and agreements with more than 150 video game developers, Microsoft immediately became a major player at the outset of the last console cycle. Though the Xbox was technically superior to the PS2

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and GameCube, with a significantly faster microprocessor, Microsoft had trouble capturing market share from Sony and struggled in its efforts to overcome Nintendo for second place in the console wars. Although its year-late start hampered its prospects for success, we believe that a bigger problem for Microsoft was the lack of Japanese developer support for the Xbox, with very few major Japanese developers developing titles exclusively for the Xbox. We note that one of the big keys to Sony’s success during its first console cycle was the company’s ability to convince influential game companies Square and Enix (since merged) to publish their blockbuster games on the PlayStation and not on the . Despite significant obstacles, Microsoft was able to capture 20% of the 128-bit console market through 2006 (a level that we consider a success for a first effort). From a standing start, Xbox hardware sales peaked at approximately 7 million units in 2004. The company matched Sony’s pricing, and cut the price of the hardware to $199 in 2002 and to $149 in 2003. Sony cut the PS2 price to $129 in April 2006, and Microsoft chose instead to discontinue the Xbox in favor of the Xbox 360.

Microsoft pioneered a strategy that differed from its predecessors—rather than being focused on the razor-and-blade business model, the company focused on driving the home Internet connection from behind the PC in the home office to behind the television in the living room or den. This strategy was apparent from Microsoft’s laser focus on Xbox Live, its subscription service for online gaming. The company’s consistent mantra was that gaming is a social experience, and that an ever-increasing number of consumers will choose to play online against one another rather than play alone. We were skeptical at the outset, but consistent inroads made with and Xbox Live Marketplace suggested that the online business is much larger than we originally thought, so we changed our view.

Once the Xbox was discontinued in 2006, the number of Xbox SKUs dropped by around 75% in 2007, and new Xbox games disappeared altogether in 2008. Worldwide Xbox software sales were only $226 million in 2007 (down 77% year-over-year), and only $36 million in 2008. The following figure illustrates historical worldwide Xbox hardware sales by region.

Figure 15: Microsoft Xbox Unit Sales (2001 – 2007) 8.0

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Source(s): The NPD Group and Wedbush Securities estimates.

Xbox 360 Microsoft released the Xbox 360 in November 2005 with a simultaneous worldwide launch. The console’s technical specifications were a huge advance in graphics capability: it has three symmetrical core CPUs running at 3.2 GHz each (each over 4x faster than the Xbox CPU); a custom ATI graphics processor that allows 500 million polygons per second (faster than the then state-of-the-art PC graphics

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process that allowed 380 million polygons, and 4x greater than the original Xbox); 512 Mb of RAM (8x the original Xbox); and some backward compatibility. The device utilizes a DVD-ROM drive, with the now defunct HD-DVD drive as a separate accessory. The Xbox 360 was released with a deep slate of “launch” titles (available at or near the launch date), with a handful of exclusive titles developed by Microsoft Game Studios and a few third party publishers.

The Xbox 360 sold out from the day of launch through early April 2006. In part, the sellout was attributable to incredible demand for the console, and in part attributable to lack of supply. According to company reports, Microsoft shipped 1.5 million Xbox 360 units in 2005, although according to the NPD, only 610,000 found their way into U.S. living rooms. The company stated that it sold 10 million consoles as of the end of 2007, although again, NPD figures showing U.S. sales of 4.5 million units suggest that the overall sell-through figure was likely closer to 9 million.

The initial price of the “Pro” model of the console (fully equipped with a 20 GB hard drive) was $399.99, with an “Arcade” version (no hard drive) available for $299.99. In 2007, Microsoft introduced an “Elite” version of the console, with HDMI output, a high definition video cable, and a 120 GB hard drive for $479.99. The company cut prices for all three versions in 2008, with the Pro version cut to $299.99, the Arcade model at $199.99, and the Elite model at $399.99.

Microsoft achieved an installed base of over 70 million Xbox 360s, or over three times the installed base of the original Xbox. We do not count replacement units in our calculation, so our estimate reflects the installed base, not units sold. We think that further price cuts for the Xbox 360 should drive sales of 3 – 5 million units annually for the next three years, and we expect Microsoft’s ultimate installed base for the Xbox 360 to reach over 80 million units.

Figure 16: Microsoft Xbox 360 Unit Sales (2005 – 2016E) 14.0

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PS3 Sony released its current generation console, the PlayStation 3 (PS3), in November 2006, with a simultaneous worldwide launch. The company surprised many with a launch price of $599.99 for the 60 GB SKU, with a 20 GB model (since discontinued) offered for $499.99. Like the Xbox 360, the technical specifications of the PS3 were mind-numbing. The device has a 3.2 GHz “cell” microprocessor running simultaneously over seven cores, with 512 Mb of RAM and a 550 MHz graphics processor. The improvement over the PS2 was staggering, given that the former device ran at only 295 MHz, with 32 MB of RAM and a 150 MHz graphics processor. Sony’s console features a Blu-ray High-Definition DVD-

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ROM drive, allowing it to play CDs, DVDs, or high definition DVDs (not to be confused with Toshiba’s now defunct HD-DVD format).

There has been some debate about whether the PS3 is more powerful than the Xbox 360. Sony has claimed technological superiority, but Microsoft has countered that since the PS3’s memory must be allocated across seven cores compared to the Xbox 360’s three cores, the Xbox 360 will actually outperform its counterpart. Our lay view of the two devices is that both provide significantly more power than is required to run the games designed for them to date, and that the two are comparable to one another.

The more important differentiating factor, in our view, was the inclusion of the Blu-ray drive. Sony made a that Blu-ray would be the technology of choice for movie studios when films complete the migration from standard DVD format to HD format. Blu-ray is a partnership between Sony and Matsushita (and several others), and competed directly with the HD standard sponsored by Japanese rival Toshiba. The Blu-ray format became the de facto standard early in 2008, when Toshiba announced that it intended to discontinue its HD-DVD format. The Blu-ray format (54 Gb discs) is more than sufficient to host the most complex video game (typical files are between 1 – 4 Gb, and most file sizes are under 9 Gb—we note that the DVD format supported by the Xbox 360 will hold up to 9 Gb files). However, most films recorded in DVD format require approximately 1 GB of storage per hour of content, while most HD recordings require 6 – 7 GB of storage per hour. Thus, as film migrates to the Blu-ray format, the disc drive included in the Xbox 360 is unable to play an increasing number of HD movies (those in the Blu- ray format). Sony’s plan was that when it prevailed in its bid to establish Blu-ray as the uniform standard for HD movies, the inclusion of a Blu-ray drive in its PS3 would potentially drive sales of the console to consumers interested in both games and HD movies. The ability to play DVDs was a factor in the early advantage enjoyed by the PS2 over the GameCube (which could not play DVDs), and helped Sony with its first-mover advantage over Microsoft in the current generation.

Unfortunately for Sony, its victory in the Blu-ray/HD-DVD format wars did little to help it establish the PS3 as the dominant console early this cycle. The inclusion of a Blu-ray drive drove Sony’s cost of production at least $100 higher than Microsoft’s, and the inclusion of a Cell processor drove costs even higher. Sony is now profitable on the PS3 (currently priced at $249), and we expect another price cut later this year.

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Figure 17: Sony PS3 Unit Sales (2006 – 2016E) 14.0

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Wii Nintendo launched its current generation console, the Wii, in November 2006. Although observers were initially skeptical, consumers embraced the device in record numbers, and enthusiasm continued to build for many years. The Wii uses a DVD-ROM drive, is backward-compatible with all content originally released for the N64, the Super NES, and the original Nintendo Entertainment system (through software downloads), plays all GameCube games, and is significantly more powerful than the GameCube, but not as powerful or feature-packed as the PS3 or Xbox 360. The Wii launched at a lower price than its competitors, at $249.99 (including a game), and pricing held for years after launch.

Nintendo chose to compete with the others through innovations in game play, devising a motion- sensitive controller (the “Wii-mote”) that allows the player to interact directly with characters and items on the screen (much like a mouse). We believe the company has a competitive advantage based upon its considerable library of high-quality content, and the early success of the Wii encouraged third-party development. In our opinion, the Wii was successful due to two factors: first, it was priced significantly lower than its competitors’ products; and second, the company’s redesign of the console’s controller, a cordless remote-control-like device designed to be used with only one hand, allowed for a unique style of game play that was not available from the competition. A small sensor placed near the monitor, along with an accelerometer chip and infrared pointer inside the controller, allowed tracking of its position and orientation. This allowed the player to manipulate the action on-screen by physically moving the controller itself.

Nintendo’s strategy proved successful. The company capitalized upon its software development strength, and acknowledged an unwillingness to compete in the console wars “at any price”. Nintendo established the Wii as the second best-selling console of all time (the record holder is the PS2 with over 136 million cumulative consoles sold since its October 2000 launch). Microsoft paid a significant financial price to compete with Sony in the 128-bit cycle, and spent even more to compete in the current generation cycle (although with much better financial results). At the same time, Sony saw its market dominance erode, generating losses in 2006 from its computer entertainment division for the first time in over 12 years. Nintendo, on the other hand, leveraged its dependable revenue stream from its first-party software sales and from its market dominance in the handheld arena, and endeavored to be a major player in the console wars, without feeling compelled to finish in first place. As a practical matter, the Wii’s low price point and novel game play drove Nintendo into first place in 2008, although it later lost its leadership position.

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Figure 18: Nintendo Wii Unit Sales (2006 – 2016E)

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Nintendo capitalized on a demographic, “Nintendads”, who grew up playing Nintendo games 20 years ago, and who were just beginning to have children of their own. We think that Nintendo’s decision to make the Wii compatible with older Nintendo titles encouraged these Nintendads to play older Nintendo games and updated versions of Nintendo classics with their own children.

Nintendo devoted the resources necessary to finish in first place in the current generation, but saw its sales decline each of the last several years as console fatigue (and to some extent, the non-core nature of a large percentage of its audience) set in. We think that to some extent, Nintendo benefited from dual ownership of consoles, as many consumers purchased a Wii because of its innovative design, and later purchased one of the other consoles for high definition graphics. In the prior cycle, many consumers purchased both a PS2 and an Xbox, largely due to the high-quality exclusive content offered on the PS2 and the better graphics and online functionality of the Xbox. In the current cycle, there have been only a few exclusive titles, and we believe that the graphics of the PS3 and Xbox 360 are sufficiently similar as to largely eliminate the need to own both. Xbox Live is still a differentiator, but Sony’s PlayStation Network had an impressive re-launch in 2008, and gained ground fast. Ultimately, we think that most traditional video game households decided to own either a PS3 or an Xbox 360, and we believe that most consumers who opted to purchase a second console chose the Wii. The lower price point and innovative control scheme for the Wii flipped the order of the “second console” choice, with most households who ultimately chose to own two consoles choosing the Wii first.

Wii U Nintendo launched its Wii U in late 2012, with little consumer response. The Wii U debuted at $349 (including the game), and in just over a year, sold only 4.9 million consoles. The Wii U is more powerful than the Wii by a large measure, and is slightly more powerful than the current generation PS3 and Xbox 360, with games for the Wii U in full HD and capable of running at 60 frames per second. In launching the Wii U, Nintendo attempted to innovate once again by introducing a console with a tablet-like controller called the Game Pad. In essence, the Game Pad works much like the lower screen of a Nintendo DS, with the home television taking the place of the DS’s upper screen. Consumers were not enthusiastic about the Wii U’s launch, particularly in light of the relatively thin software lineup. Over a year after launch, Nintendo still has not released many of its most popular titles, and the console has failed to capture the market share that it expected. Nintendo has built an online multiplayer network, but

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its efforts came over 10 years after Microsoft launched Xbox Live, and over 4 years after Sony re- launched PlayStation Network. We think that Nintendo’s slow progress in embracing online multiplayer may prove fatal to its chances of attracting significant third-party support for the Wii U. We expect the Wii U to languish in a distant third place in the console race, and expect Nintendo to sell 3 million units this year.

PS4 Sony launched the PS4 in late 2013 at a $399 price point, and the console was a phenomenal success right out of the gate. After just 6 weeks on the market, the PS4 sold through an amazing 4.2 million units, and we expect the console to sell another 12 million in 2014. The PS4 is significantly more powerful than the PS3, but its power is unlikely to be fully harnessed by game developers, as the PS3 was already capable of HD output at 60 frames per second. Instead, we think that the increased power is likely to be more advantageous for handling the many multimedia capabilities of the console, and we expect to see Sony launch its game streaming service, PlayStation Now, later this year.

Xbox One Microsoft launched the Xbox One a week after Sony launched the PS4, and also achieved great success, selling over 3 million units in just five weeks (approximately three times the sales level for the Xbox 360). The Xbox One comes bundled with a new and improved Kinect peripheral, which offers a high-definition camera and a sophisticated audio array. The console carries a retail price of $499, which we think may put some consumers off. Kinect allows users to control the Xbox One with voice commands, and makes it easy for users to integrate Skype into the console experience in the living room. Due to its relatively high price point, we expect the Xbox One to sell 9 million units this year.

Handheld, Portable and Mobile Consoles There is some confusion about the size of the market for handheld games. Many industry observers refer to “handheld”, “portable” and “mobile” games interchangeably, intending to describe games played on a device that can be carried. We believe that the “handheld” market consists of three distinct subsets: handheld, describing devices that offer a gaming experience designed for dedicated devices; portable, describing devices that offer a gaming experience similar to home console gaming; and mobile, describing hybrid devices that function as cell phones in addition to allowing downloads of ever more complex games.

Over the past 20 years, Nintendo’s Game Boy, Game Boy Advance, DS and 3DS consoles have dominated the market for handheld or portable games (around 80% of hardware units and over 82% of software sales), generating over $2.7 billion in retail software sales last year. We expect worldwide sales of 3DS software alone to grow to over $2.4 billion in 2014 and to grow by $300 million in the following two years. Since the introduction of the Game Boy in 1988, several companies have attempted to launch and support handheld consoles with little or no success. Sales of Sony’s PSP slowed after a very strong start, and the replacement device, the PlayStation Vita, has failed to sell well at all. Sony positioned the PSP as a portable device, with many games appearing on both consoles and the PSP. PSP software sales worldwide peaked at $1.2 billion in 2007; combined PSP and PS Vita software sales in 2013 were under $500 million, and are expected to decline to $350 million by 2016.

We believe mobile game downloads present a solid opportunity, with sales (primarily of virtual goods in free-to-play games) of approximately $10 billion worldwide. Sales of mobile games have grown in correlation with the penetration of smart phones and tablets, with the devices having sufficient processing power to allow games to be more complex, approaching the game play found on the DS just 10 years ago.

Game Boy Advance Nintendo launched the first widely successful handheld, the Game Boy, in 1989. After selling over 50 million of the devices and over $200 million per year in software, the company introduced the in 1998. The latter device sold almost 50 million units in only three years, and software sales

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increased to over $1.6 billion in 2000 alone. Nintendo further improved upon its Game Boy technology with the introduction of the Game Boy Advance (GBA) in Japan in March 2001 and in the U.S. and Europe a few months later. The GBA was a giant technological step up from the older Game Boy/Game Boy Color technology, with a 32-bit processor compared to the 8-bit unit found in the Game Boy Color (GBC). The processor speed and memory in the GBA were comparable to the system specs for the Sony PlayStation. The GBA sold over 25 million units in its first two years, and generated worldwide software sales of over $1.7 billion in 2002.

In late March 2003, the company launched an improved version of the GBA, named the GBA SP (for “special”). With the GBA SP, Nintendo further improved the device design by placing a hinge in the middle of the console (a “clamshell” design allowing proper positioning of the screen and a protective cover for the screen when the device is not being used). Perhaps the most significant improvement in the GBA SP was a front-lit screen (the poorly lit GBA screen was among its biggest drawbacks). Another benefit was its rechargeable batteries, which eliminated the need to constantly replace its predecessor’s two AA batteries. The GBA SP was compatible with all GBA and GBC software, and launched at an MSRP of $99.99, with a price cut to $79.99 in 2004. The GBA SP sold over 40 million units, and software sales peaked at just under $2.4 billion in 2004.

Nintendo constantly tinkers with its product design, and introduced a new, smaller GBA SP called the GBA Micro in 2005, with a 2¼” screen compared to the 3” screen on the GBA SP. The Micro was priced higher than the GBA SP at $99.99, and the device was intended to be “pocket” sized. The device did not have a significant impact in the marketplace.

We classify the GBA line of products as handheld devices, as opposed to portable devices. Few, if any of the games created for the GBA or for the DS (discussed below) are created in the same form for consoles, with the same level of game play. As we believe that Sony’s PSP (discussed below) has targeted a different market niche, we never expected any serious competition for the GBA/GBA SP/DS. The primary market for handheld consoles is the 8-to-12-year-old gamer and Nintendo’s software dominates this market segment. As is more fully discussed in the next section, Nintendo expanded this demographic with the DS. The company produced approximately 1/3 of all GBA software units sold, and received tremendous third-party support for the handheld platform, most significantly from THQ, which captured approximately 30% of U.S. GBA software sales. The following figure illustrates historical Game Boy Advance hardware sales by region.

Figure 19: Nintendo Game Boy Advance Unit Sales (2001 – 2008) 30.0

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DS Nintendo released the Nintendo DS (for dual-screen) in November 2004, and the device sold through extremely well. The DS was a departure from the GBA SP, offering two 3” front-lit screens in a clamshell design, with the lower screen activated by touch. The DS permitted developers to expand the game play experience for handheld devices, as consumers are able to control characters with a combination of buttons, fingers, and motions of a stylus. The DS debuted at a price of $149.99, and the price dropped to $129.99 in 2005. In mid-2006, Nintendo tinkered with the DS design and introduced a “Lite” version of the product, with a brighter screen and a streamlined form factor. The DS Lite was a phenomenal success from the start, with sell through volumes double the level of its predecessor in the first ten months following launch. DS games were typically priced between $30 – 40, compared to pricing on GBA games of between $20 – 30. The DS offered full backward-compatibility, allowing consumers to play over 1,200 GBA and GBC software titles. We believe that backward compatibility served to drive an inordinate number of “replacement” sales, with consumers who previously owned the GBA or GBA SP trading up to the DS. Accordingly, “tie ratios” for the device (the number of software units sold for each hardware unit) trended slightly lower for the DS than for the GBA SP in the early months following introduction.

Sony PSP Sony launched its first portable gaming device, the PlayStation Portable (PSP) in late 2004 in Japan, followed by a March 2005 launch in the U.S., and a European launch in September 2005. The PSP is a 170 x 69mm device (approximately 6.7” x 2.7”) with a 4.3” diagonal LCD screen. The medium for game play is a UMD (universal media disc). The name UMD reflected Sony’s intentions to create a device that would play more than just video games. We also think it is important to note that the UMD is a 1.8 gigabyte capacity, 60mm disc, remarkably similar in size to the Sony MiniDisc, the company’s failed attempt to capture share of the music market. Over its lifetime, there were over 450 video game titles available and hundreds of movies available on UMD format. In addition, there were thousands of movies available for download to the PSP, stored on a Sony memory . Early consumer response to movie content on UMD was underwhelming, and the number of movies offered in that format declined after 2009. However, the offering of movies available (each film is around 400 MB) continued to expand through downloads.

The PSP debuted for $249.99, including a bundled copy of the Spider-Man 2 movie, and this price point held for its first year. In March 2006, Sony lowered the price to $199.99, and this price point held for another year. The device saw another price cut to $169.99 in 2009, and another to $129 before the launch of the PS Vita in 2012. Software for the PSP typically retailed for $40, or $10 on average higher than Nintendo DS software and $15 on average higher than GBA software. We believe that royalty rates for PSP games were competitive with other formats (around $7, including manufacturing, for a full- priced game, compared to an estimated $5 for GBA games and $6 for DS games), and that development costs were low (approximately $1 million per title). This means that a modest seller generated large margins for publishers. However, modest sales for the hardware limited the offering of software, and the PSP never really achieved the critical mass many expected.

Sony’s original strategy for the PSP was its third try (following its failed attempts with both the Betamax and with the Sony MiniDisc player) to induce music publishers and movie studios to pay royalties for the privilege of placing content in a format playable only on Sony devices. The Betamax failed due to competition from the technologically inferior Panasonic VHS format, which allowed movie studios to publish royalty-free. The MiniDisc player failed for similar reasons, as music publishers did not feel particularly compelled to pay Sony for the production of discs when the CD format was universally accessible at extremely low fabrication costs. This time around, Sony failed to capture strong third-party video game software support, and although it sold a relatively large number of PSPs to the video gaming community, the device never captured a large tie ratio for software, averaging only around 1.2 units per PSP in 2007, at the peak of its software sales.

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Of course, Sony faced an uphill struggle, given the incredible popularity of Apple’s iPod Touch and iPhone, each of which offered downloads of both music and filmed content. As smartphones and tablets became more prevalent, the PSP appeared to be just another smart device, albeit without phone capability.

Figure 20: Sony PSP Unit Sales (2004 – 2015E)

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Nintendo 3DS Nintendo launched a 3D version of its popular DS handheld in early 2011 at a price point of $249. The price appears to have been too high for many consumers, and a lack of compelling software in the launch year resulted in sales that were below the company’s expectations. After just a few months on the market, Nintendo cut the 3DS price to $169, where it has remained, and sales picked up immediately.

The 3DS has sold 40 million units in just under 3 years, placing it on par with early sales of its predecessor, the DS (which sold fewer units). However, the DS saw sales of over 25 million units annually in its fourth, fifth and sixth years, and recent sales of the 3DS suggest that the device is likely to sell closer to 15 million units annually going forward. We think that Nintendo has created a compelling game play experience with the 3DS, and the company has most definitely supported its hardware with outstanding software, but we believe that strong sales of smartphones and tablets have cannibalized the more casual end of Nintendo’s addressable market.

PlayStation Vita (PS Vita) Sony redesigned the PSP as a much sleeker and more sophisticated handheld device, launching the PS Vita in 2012 at a $249 price point (with a 3G enabled device for $50 more). The PS Vita had a much larger screen than the PSP, with a touch interface on both the screen and the back of the device. The PS Vita has a 5 inch multi-touch screen, front and rear cameras, built in stereo speakers and microphone, a six-axis motion sensing system, built-in GPS and Wi-Fi built in (with mobile connectivity on the 3G device). We believe it is an elegant device, but at the $249 price point, failed to sell well at the outset.

Sony cut the price of the PS Vita to $199 in mid-2013, but the price cut failed to spur sales. The PS Vita sold only 2.7 million units worldwide in 2013, and only 6.4 million since launch, or under 20% as many units as the 3DS has sold.

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Mobile Gaming introduced its hybrid cell phone/video game device in late 2003, and the device failed miserably. Tiger Telematics launched its hybrid GPS/video game device, the Gizmondo, late in 2005 with similar results. These devices offered hybrid functions, and attempted to compete with cell phones, which had superior download capability and a deep slate of content available through cell service providers and dedicated mobile gaming portals.

For much of the last decade, we were skeptical about the potential for mobile downloads. Initially (back in 2002), mobile devices were constrained by bandwidth, storage and battery life. As bandwidth has improved with 3G networks and came down in price, mobile downloads began to show some potential. With the introduction of smartphones, mobile gaming took off, and we estimate that the U.S. market for mobile downloads grew from $1 billion in 2006, including downloads of tones, wallpaper, greeting cards and games (but not including music) to over $3 billion in 2013. Smartphones allow wireless access, built-in Internet browsers and relatively large storage capacity of 4 GB or more, so the potential for mobile downloads increased exponentially and revenues scaled in correlation to smart phone penetration. We estimate that the global market for downloads exceeded $10 billion in 2013, and we expect it to grow by 25% per year for the next several years.

Game downloads represent over 90% of the mobile download market. We note that industry leader EA Mobile generated estimated revenues of $465 million in 2013, largely due to strong sales of “paid download” mobile games offered on smart phones and tablets. The company began to offer free-to-play games with the introduction of tablets, and that strategy has paid off, as it has seen its mobile revenues grow at above a 25% rate for each of the last three years. We estimate that the average smart phone owner downloads 2 – 3 games per year, meaning that over 3 billion games are downloaded annually.

We were skeptical about sustainable growth of this segment in the past for several reasons, each of which has been addressed with each succeeding model of smartphone or tablet introduced. Cell phones are carried primarily as communications devices, so battery life is important to most users. Few consumers would risk being “out of reach” by draining the battery on their cell phones in order to complete another level of . However, each succeeding model of smartphone has seen an increase in battery life, with the standard now allowing 10 hours of use before requiring a re-charge. Smart phones have also addressed memory constraints, and as memory prices declined, flash memory in phones increased, so the standard smartphone has 8GB or more of memory. With the introduction of 3G, bandwidth became less of a constraint. Further, the touch screens offered by most smartphones provided a user-friendly interface, making gaming more accessible. We think that this was one reason that the Blackberry faded into obscurity, as its keyboard initially limited the size of its touch screen.

Further adding to our skepticism was the business model used by most mobile carriers, who often charged as much as 70% of revenue to allow a game to be published on their store front. Apple solved this problem by insisting upon control of its App Store in exchange for providing AT&T an exclusive on the first iPhone, and applied the iTunes model (30% revenue share) to game downloads. Other companies who chose to compete with the iPhone were forced to adopt the Apple model, and 30% royalties has become standard practice in the industry, allowing game publishers to make a profit. The relatively modest revenue share also encouraged the introduction of “freemium” games – games that a user can download for free, but which generate revenues from virtual item sales.

Mobile and tablet games definitely cut into the addressable market for dedicated handheld consoles and the software created for them by capturing a large share of the market for more casual games. As a result, dedicated handheld hardware and software sales are tracking at about half of peak levels, and we do not expect them to grow materially in the next several years.

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Figure 21: U.S. Console Price History

Microsoft Xbox 360 Nov-05 Launched at $299 (Core)/399 (Pro 20Gb) May-07 New Xbox 360 Elite (120Gb) at $479 Aug-07 Cut to $279 Core, $349 Premium, $449 Elite Oct-07 Launched Arcade at $279 Jul-08 Cut to $299 Pro, to launch new Pro w/ 60Gb at $349 Sep-08 Cut to $299 Pro w/ 60Gb from $349, Arcade to $199 from $279, and Elite to $399 from $449 Aug-09 Cut to $249 Pro w/ 60Gb (until sold/phased out) from $299, Arcade stay $199, and Elite to $299 from $399 Nov-09 New 250Gb game bundle at $399 Jun-10 Launch 360 Slim (250Gb) at $299, Cut existing Arcade to $149 and Elite to $249 (until sold/phased out) Aug-10 Launch 4GB Xbox 360 S Arcade $199 May-12 Xbox 360 4GB w/ Kinect for $99; requires 2-year subs to Xbox Live Gold at $14.99/month; at Microsoft stores only Jun-12 Subsidized Xbox available at Best Buy and GameStop Aug-12 Kinect price dropped to $109 from $149 in US only (bundle prices unchanged, int.'l prices unchanged) Sep-12 Kinect 4Gb bundle for $249 at certain retailers (was $299); Kinect 250Gb bundle for $349 at certain retailers (was $399)

Sony PS3 Nov-06 Launched at $499 (20Gb)/599 (60Gb) Jul-07 Cut to $499 for 60Gb, introduce 80Gb at $599 Oct-07 Cut to $499 for 80Gb, introduce 40Gb at $399 Aug-08 Cut to $399 for 80Gb, introduce 160Gb at $499 Aug-09 Cut to $299 for 80Gb, to $399 for 160Gb, introduce 120Gb PS3 Slim at $299 Nov-09 New 250Gb at $349 Aug-10 PS3 Slim is now 160Gb, still $299 Nov-10 New 320Gb at $349 Aug-11 160 Gb cut to $249, and 320Gb cut to $299 Sep-12 $299 for Move bundle at Wal-Mart (down from $349) Sep-12 US intro of new 250GB model; black; $269 for bundle with Unch. 3: Drake's Decept. GOTY / $30 voucher Oct-12 US intro of new 500GB model; black; $299 for bundle with Assassin's Creed 3 Aug-13 US intro of 12GB model for $199

Nintendo Wii Nov-06 Launched at $249 Sep-09 Cut to $199 May-10 Wii now include , still $199 May-11 Cut to $149, now include , no more Wii Sports/Resort Oct-12 Cut to $129, all black, now includes Plus, Nunchuk controller, Wii Sports and Wii Sports Resort Dec-12 Wii Mini introduced in Canada for $99, includes Wii Remote Plus and Nunchuk controller, but no pack-in game Nov-13 Wii Mini introduced in the US for $99, includes Wii Remote Plus, Nunchuk controller, and game

Nintendo 3DS Mar-11 Launched at $249 Aug-11 Cut to $169 Aug-12 US release of Nintendo 3DS XL (90% larger screen) in red or blue for $199

Sony PlayStation Vita Feb-12 Launched at $249 for WiFi, $299 for 3G / WiFi, $349 for First Edition Bundle (4GB memory card, game, case) Aug-13 Cut to $199

Nintendo Wii U Nov-12 Wii U release: white Basic Set, $299 for 8 GB mem., 1 GamePad; black Deluxe Set, $349 for 32 GB mem., 1 GamePad, Nintendo Land, Deluxe Digital Promotion (eShop points for digital purchases, through 2014) 9/20/2013 Deluxe Set to be cut to $299

Nintendo 2DS 10/12/2013 Launched at $129

Sony PlayStation 4 11/15/2013 Launched at $399

Microsoft Xbox One 11/22/2013 Launched at $499

Source(s): Wedbush Securities.

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WHY THIS COULD BE THE LAST CONSOLE CYCLE

We do not expect console microprocessors to dramatically outpace display technology; accordingly, it is possible that the next generation is the last console cycle. We believe there is a commonly held misperception that consoles can only support software sales growth for a five-year period, and the drop-off in current generation console software sales after 2008 supported that misperception. As is fully explained in a previous industry report, The Great Console Cycle Myth , we disagree with this belief. We think that the basis for this misperception is historical, as each prior generation console was replaced after five years. However, it is important to note that this pattern has occurred only four times (in 1990, 1995, 2000 and 2005). While four data points is certainly a meaningful sample, we do not think that it is statistically significant. Rather, it is clear to us that Sony learned from its past experience, and chose to defer the launch of its current generation console until 2006, notwithstanding that it ceded the first-mover advantage to Microsoft. Sony’s patience allowed it to sustain a high level of PS2 game sales, with PS2 software sales down only 30% in 2007. This compares to a 50% decline in PS1 software sales at the outset of the last cycle. Notwithstanding Sony’s strategy to use PS2 software profits to fund a slow transition to the PS3, the company stumbled with the PS3 launch, and struggled to catch up with its competitors.

We believe the past four transitions occurred for different reasons. The first transition occurred in 1990, when Nintendo chose to replace its 8-bit Nintendo Entertainment System (NES) with its own 16-bit Super NES. At the time, Nintendo’s first-party software dominated the available software for both platforms, and the company was in a good position to truncate the NES cycle, as consumers had few alternatives. The next transition occurred in 1995, when Sony decided to compete with Nintendo head- to-head through the introduction of its 32-bit console, the PlayStation One. Nintendo had previously announced its intention to skip development of a 32-bit console in favor of developing a 64-bit console (the N64). Sony, in an attempt to preempt Nintendo’s technological advantage, chose to introduce its 32-bit console two years before the launch of the N64 in order to gain a first-mover advantage. In order to gain this advantage, Sony acquired first-party development capability and enlisted the support of third- party publishers (notably, Electronic Arts). These steps allowed the PlayStation to launch with a significant number of titles available, and the console attracted a large number of purchasers (over 27 million) in the two years before launch of the N64. Concern over competition led to the third console transition, in 2000, when Sony launched the 128-bit PS2, again in order to gain a first-mover advantage over Nintendo and Microsoft. Both Nintendo and Microsoft launched consoles in 2001, and although both were technologically superior to the PS2, neither console was backward compatible. Also, Sony’s pre-emptive launch ensured that it would have a leadership position in terms of the number of software titles available for the PS2 when the Xbox and GameCube were launched a year later (an advantage of over 3 to 1). We believe that Sony’s decision to include backward compatibility as a PS2 feature was one of the key reasons for the console’s dominance in the last cycle. The fourth console cycle began in 2005, with Microsoft launching its Xbox 360 late in the year in order to obtain a first-mover advantage over Sony. Microsoft’s console was a technological wonder, and its games were visually stunning, but the company’s zeal to launch a year ahead of the competition led to undersupply at retail, with an installed base of approximately 2 million four months after the worldwide launch. At the same time, Microsoft discontinued production of the first Xbox, limiting its potential for profitability from software royalties and ceding the mass-market opportunity to Sony.

Sony has adopted a razor-and-razor blade model, whereby it sells consoles at close to its cost (the “razors”), and makes a profit on each unit of software sold for those consoles (the “razor blades”) by controlling the manufacture of the software. At the outset of the current cycle, Sony was indifferent as to whether it sold Trac-2 razor blades (PS2 software) or Mach 3 razor blades (PS3 software), so long as it maximized the total number of razor blades it sold. By extending the life of the last cycle, Sony expected to be in a position to generate maximum annual royalties. Neither Microsoft nor Nintendo exploited their respective installed bases in the same way as Sony, placing each at a competitive disadvantage. Sony continued to sell a large number of PS2s, allowing it to generate significant profits from the sale of hardware, and giving it an opportunity to slow the rate of sales decline for its legacy software while the

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current generation cycle is well under way. Of course, the ramp in sales of the PS3 sorely lagged the ramp of the PS2 six years earlier, eroding the competitive advantage Sony sought to gain by extending the PS2 cycle for another few years.

When the Sony PlayStation was introduced in 1995, it represented a paradigm shift in console technology. The PS1 offered an amazing 48-fold increase in information processing capability over its 16-bit predecessors, and advances in game play and graphics triggered a significant increase in the number of units sold. Worldwide, the PS1 sold over 100 million units, dwarfing the penetration of its predecessors, the Nintendo Entertainment System (NES) at 60 million units, the Super NES at 46 million units, the N64 at 30 million units, or the Sega Genesis at 26 million units.

The PS2 had even more impressive results. We expect that the number of households that intend to purchase a console in the current cycle will increase by approximately 25% over the 10-year period following the last cycle’s midpoint due to a combination of increasing household affluence, aging of the target demographic, and demographic expansion by the Wii. We also expect the number of consoles per household to increase slightly over the next four years, due to the price point and differential game play offered by Nintendo’s Wii.

Most consumers do not readily “abandon” their last generation consoles until a new console is purchased. Rather, these devices typically remain connected to the living room TV until replaced, albeit with decreasing annual software sales per household. We believe that the appropriate analogy is to the PC market, where individual consumers aren’t buying 3.2GHz machines for $349 at the same rate as they replaced PCs in the past (at much higher prices) because they don’t need them. We believe until an application exists that will compel consumers to replace their existing PCs, they won’t. We believe this analogy holds for the current generation video game consoles; until an application (game software) exists that will compel consumers to replace their existing consoles, they won’t. The next generation consoles are not backward-compatible, so software developed for them will be exclusively next generation, and may compel many consumers to abandon current generation technology and upgrade. Also, the length of time between console launches was an unprecedented seven years, suggesting that many consumers are fatigued with their old consoles and are ready to buy something new.

In the preceding paragraphs, we pointed out that the U.S. and European publishers chose to abandon the PS1 audience prematurely, instead devoting resources to the development of compelling content for the PS2. Because of a relatively thin lineup of games in 2000 and beyond for the PS1, according to our research, U.S. software sales for that platform declined from $2 billion in 1999 to $1.7 billion in 2000, $1.06 billion in 2001, and under $600 million in 2002. The drop-off in European sales was more dramatic, declining from almost $2.3 billion the prior year to $1.5 billion in 2000, $600 million in 2001, and $440 million in 2002. The U.S. and European publishers collectively captured over 65% of the PS1 software market at the time, meaning that the decision to abandon the PS1 and support the PS2 caused a decline in collective annual revenues of over $2.2 billion between 1999 and 2002. Full support of the PS2 in 2006 mitigated the decline in software sales, with combined U.S. and European sales for the platform declining only 11%, from $5.4 billion to $4.8 billion. We expect a similar long tail for the current cycle, with solid sales for several years. Because of annual declines in software sales from 2009 – 2013, the base level of sales for current generation software is at a historical low; we therefore expect only modest declines in current generation software sales now that the next generation consoles have launched.

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POST HOC ERGO PROPTER HOC

Introduction The past is not always a predictor of the future (or maybe it is . . . ). Five years ago, we based our industry report, Money for Nothing , on our thesis that the growth of digital revenues would impact the trajectory of software sales for the current generation consoles. While we expected an impact, it was inconceivable to us at the time that the migration of game play to digitally downloaded content, while expected to be large, could actually impact sales of dedicated handheld and console software to the extent that it actually did (down 45% over five years). This year, with the launches of next generation consoles behind us, our theme has shifted focus to the likelihood of a rebound in console software sales.

In our view, during 2007 and 2008, there was some measure of among investors, who apparently believed that all of the risk is behind the video game publishers. It became apparent in late 2008 and early 2009 that while a great deal of risk had been eliminated, the “good news” many expected (rapid industry growth, industry consolidation and digital downloads growth that exceeded physical media sales) was not so good. As the industry saw its overall sales shrink and market share shift from the traditional software publishers to a large number of startups and upstarts, investors abandoned the video game publishers and retailers, and they took their investing dollars elsewhere. We believe investors were overly optimistic about the ramp of current generation consoles, tie ratios, alternative revenue streams from sources such as online games, the advent of in-game advertising, and the ease of delivering downloadable content.

We waited five years to issue this report, as we were both unsure of the sustainability of growth for digital revenue streams and uncertain whether the traditional publishing model was sufficiently robust to allow for a return to revenue and profit growth. Since our last report, Activision grew into the largest independent publisher and bought back its shares from majority shareholder Vivendi; Electronic Arts saw modest revenue growth, a change of CEO, and a markedly lower share price; Take-Two returned to solid profitability; Ubisoft saw a series of missteps drive its share price lower; and THQ declared bankruptcy. Each year from 2010 – 2013, we thought there was potential for dedicated handheld and console video game software sales to rebound, and each time we were disappointed.

The digital download landscape changed in ways far different than we anticipated five years ago. The rapid penetration of smartphones and tablets shifted a large proportion of casual gaming to those devices, and the introduction of social games and free-to-play online PC games began to both expand the market and cannibalize traditional publisher revenue streams. Each of the current generation and next generation home consoles had Wi-Fi built in, allowing consumers to download either independently produced games (“indie games”), arcade style games, or classic games created in past generations. Each of these phenomena served to cannibalize a portion of traditional revenue streams. The result of migration to of games was a marked decline in packaged software sales, with virtually every participant in the dedicated handheld and console delivery chain suffering. Investors shunned shares of the console publishers and of GameStop, and each of the companies’ respective shares performed worse than the market as a whole.

We have reconsidered our views on digital delivery of games. The Internet made game play accessible to 2.4 billion people globally, and the proliferation of Internet-ready portable devices made a large number of mobile games accessible to the 1.5 billion people who purchased them over the last five years. While the quality of games delivered digitally is often well below the quality of dedicated handheld and console video game software, the price (free) is generally right. Since our last industry report in 2009, the global market for mobile, tablet and free-to-play PC games has grown from an estimated $5 billion (including China) to an estimated $15 billion in 2013, and we expect to see 20% compound annual growth over the next five years. 2013 revenues from digitally distributed games exceeded global revenues from physical game sales for the first time, and although we expect packaged goods sales to grow as a result of the launch of next generation consoles, we do not expect physical delivery ever to generate greater revenues than digital delivery. Perhaps most strikingly, the participants

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in the digital value chain are not the historical creators of packaged goods, but the fragmented digital market is dominated by several start-ups and upstarts who didn’t exist five years ago.

The name of this report, Post Hoc Ergo Propter Hoc , is intended to suggest that the prevailing view is based on a fallacy or common error in logic. The title is a Latin phrase that means because event Y followed event X in the past, then X must have caused Y. We believe many people (and most investors) believe that several patterns from the past will repeat themselves in the future Among these is the widely held belief that because every console cycle in the past saw new consoles launch that were significantly more powerful than those from the prior cycle, each past cycle saw an increase in sales. This logic has led many to expect the next generation of consoles to be a bust (albeit one that is off to a phenomenal start), as the next generation of consoles are only 4 – 8x more powerful than their predecessors, compared to launches that routinely reflected a 40-fold increase in graphics capability in the past. Stated simply, we think that the logic that something will happen again because it happened before is flawed.

We believe that the next generation will succeed due to a different observation than that Y was caused by X. Past cycles launched every five years (in 1985, 1990, 1995, 2000 and 2005), suggesting to us that after five years, consumers were ready for something new. Every five years, the console manufacturers satisfied consumer desire for something new, each time with a remarkable increase in power. The next generation did not launch after five years, primarily because the console manufacturers believed that they could extend the life of a cycle and profit. We believe, however, the gaming ecosystem suffered, as console fatigue caused many consumers to look elsewhere for interactive entertainment, and the launch of the first next generation console (the Wii U in late 2012) did not capture consumers’ imagination. Finally, in late 2013 (eight years into the current generation), Sony and Microsoft delivered consoles that represented enough of an improvement over their predecessors to create significant enthusiasm among consumers, and the next generation was off to a record start. Sell- through of next generation consoles in the first six weeks exceeded 7.2 million units globally, well in excess of the 2.1 million unit mark from the current generation. Consumers appear to be voting with their wallets, and we think that the remarkable launch of next generation consoles will be sustainable for at least three to four years.

The other fallacy in the “X caused Y” logic is that because digital delivery overtook physical goods sales, dedicated handheld and console video game software sales can never grow again. We document throughout this report our forecast for overall dedicated handheld and console video game software sales over the next three years. We expect compound annual sales to grow by over 16% annually, as the large drop in current generation software sales has already occurred, and the rapid ramp of next generation software sales is likely to grow at a much faster pace than the further decline in current generation software sales. As we explain in the section of this report entitled “What Caused the Decline from Peak 2008 Levels,” we believe that most of the factors that contributed to the decline have largely played out, creating the opportunity for next generation software sales to ramp faster than they have done in the past.

This does not mean that we expect digitally delivered game sales to subside. Digitally delivered games are available on virtually every computer, on every smartphone and tablet, and on all current and next generation consoles. In all, over 2.4 billion people globally have the opportunity to access digitally delivered games on computers, with a subset of 1.5 billion able to access via smartphone and tablet, and a further subset of 260 million able to access on a current generation console. We expect the market for digitally delivered games to grow at a faster rate than the pace of Internet access expands, as we think that digital sales will be more closely correlated to the expansion of smartphone and tablet sales.

Bandwidth is seldom a constraint for the digital delivery of games. Approximately 86 million U.S. households have broadband, according to IHS, representing over 90% of households with a computer. We expect a similar number of European households to adopt broadband Internet over the next several

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years, meaning download times for large game files will be reduced. Most free-to-play games are in very small files, with many delivered as browser-based games. Mobile and tablet games are seldom large files, and only full PC games and full console games take up significant storage. Because of this, most home PCs have large storage capacity, and the next generation consoles from Sony and Microsoft have 500GB hard drives.

We do not expect the pace of migration to digital copies for dedicated handheld and console video games to mirror the pace for mobile, tablet or free-to-play PC games, largely due to the fact that digital files have no resale value. Many consumers value the option to trade-in games (we estimate that approximately 30% of console games in the U.S. are ultimately traded-in), suggesting that many consumers will resist paying the same for a digital copy of a game instead of a physical copy. So long as the publishers value point-of-sale promotion at retail, we expect digital delivery to be limited to an “opt-in” service, where the purchaser will have the choice of a physical disc or digital delivery. As such, we believe that the penetration of digital delivery will be slow over the next several years, with a likely maximum of 50% of all purchases digitally delivered in the latter half of the decade.

Perhaps more importantly, there is no clear cut aggregator for digital downloads. Music downloads have services such as iTunes to provide a wide variety of content. In order to download console games, consumers are required to visit the , PlayStation Network or Xbox Live Marketplace to find games. The console manufacturers tightly control access to their consoles, as each hopes to collect 30% of digital download revenues from downloads through their networks.

We expect the emergence of free-to-play games with virtual goods sales on the three manufacturer networks over the next several years as well. These services have expanded significantly over the last five years, and it is likely that most games released in physical form will ultimately be available for download on each console manufacturer’s respective network. The launch of the current generation consoles saw an increase in availability of full-game downloads, with PlayStation Network offering full game downloads on the PS4 on the same day the games were released in physical form. To date, Microsoft has not followed suit, but we expect the Xbox One to offer full game downloads day-and-date with physical release over the next one or two years. For PC games, services like privately held Valve’s Steam service serve as aggregators.

We believe that being the “winner” of the current console cycle has no relevance to relative sales in the next generation. Nintendo’s Wii dominated the current generation console cycle, with over 100 million units sold, and yet Wii software sales led the decline in current generation software sales over the last year, declining from a peak of $7.5 billion in 2008 to under $1 billion in 2013. Nintendo made inordinately large profits from the Wii, and managed to retain most of these profits, but the success of the Wii did not guarantee that the company’s next console launch would succeed. We believe the Wii U is off to a very weak start, as the innovative controls of the Wii captured the imaginations of a broad demographic, while the Wii U’s Game Pad appears too complex for most consumers.

Instead we think that the “winners” of the next generation console cycle will be those manufacturers who achieve overall profitability and sustain that profitability. Sony’s Blu-ray DVD strategy was a drain on its early profits in the current generation, adding significantly to its manufacturing cost and limiting early hardware sales. We think the company miscalculated in building in many features that are nice to have, but which apparently were not sufficiently valued by consumers. As a result of offering a feature-rich console, Sony’s cost of production was higher than its competitors by a large measure, and it was forced to pass along the bulk of its higher costs in the form of a higher selling price. Due to its high price point, early traction for PS3 sales failed to materialize. Sony did not repeat this mistake with the launch of the PS4, and its launch price of $399 is far more competitive than the $599 launch price of the PS3. As a result, it appears that Sony will capture higher market share in the next generation and will increase its overall profitability.

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Microsoft appears to have made the same mistake in the next generation that Sony did in the current generation. The company is committed to bundling its Kinect audio and video hardware with every Xbox One, and the manufacturing cost of Kinect in turn caused Microsoft to launch the Xbox One at a $499 price point, or $100 higher than the price of the PS4. Microsoft has advised us that the price of the Xbox One “has nothing to do” with the inclusion of Kinect, and the company maintains that it priced the Xbox One at $499 because management firmly believes that the value proposition of its next generation console justifies the retail price. Notwithstanding its protestations to the contrary, we continue to believe that without Kinect, the Xbox One would be priced the same as the PS4.

We understand Microsoft’s desire to bundle Kinect, especially given the company’s $8.5 billion purchase of Skype in 2011. We believe Skype is a killer app for the Xbox One, but we don’t think that many hard core gamers appreciate this point. Skype is widely available on PCs, tablets and smart phones, and Microsoft’s own “smart glass” initiative means that many smartphones and tablets can be used to access several features on the Xbox One. We think that the other features available only with Kinect have only minimal value to these early adopters (such as voice commands, which can be accomplished with any controller or smart glass), and we are skeptical that Microsoft will deliver many hit games that require Kinect to operate. In our view, most consumers view Kinect as “nice to have”, but as non-essential. As such, we believe that most consumers view the Xbox One and PS4 as comparable consoles, with one priced $100 cheaper than the other. Our sales forecasts reflect our belief that the relative price will ultimately determine the sales of each console, and we have forecast an installed base of 45.2 million PS4s and 32.6 million Xbox Ones by the end of 2016. Should Microsoft unbundle Kinect or choose to otherwise reduce the price of the Xbox One to place it on parity with the PS4 before 2016, we will most likely revise our market share forecasts for the two consoles.

On the other hand, the relatively underpowered Wii U, offered at only a slight discount to the PS4, has thus far failed to capture much consumer interest. We estimate that production costs for the Wii U relative to its wholesale price point are significantly higher than the costs for the Wii, meaning that Nintendo is likely generating only a slight profit for each Wii U sold. Given its very slow console sales, Nintendo appears destined to see its console software sales and royalty stream markedly lower than in the last cycle, and we are skeptical that it will make a profit from its console business during the next generation.

At our projected sell-through rate, we expect both Sony and Microsoft to be very profitable in the next generation. Notwithstanding their relative projected market shares, we expect both companies’ console penetration to substantially exceed their penetration in the current generation console cycle, primarily due to market share gains from Nintendo. We think that console fatigue in the current generation is responsible for the rapid sell-through of Microsoft’s and Sony’s consoles at launch, and we do not expect this rapid sell-through rate to subside significantly.

Microsoft’s Xbox Live service has been quite profitable over the last few years, with an estimated 22 million Xbox Live Gold members paying an average of over $50 per year for access to the network. Sony launched the PlayStation Network as a free service in the current generation, and we believe that PSN has over 35 million active members, with as many as 15 million monthly active users. Sony decided to emulate Microsoft in the next generation, imposing an annual $50 fee for access to PSN, and we expect as many as 35% of its ultimate PS4 market to pay for online multiplayer. We are biased that this figure could be substantially higher if the company provides sufficient value added services to drive membership (such as free game downloads). Both Sony and Microsoft appear intent on building out their multiplayer networks as profit centers, and we think that a combined 80 million paying customers is likely, with upside to as many as 100 million paying customers. Thus, the access fees for the two companies’ combined networks could exceed $5 billion in annual fees, all but ensuring that both console manufacturers will be wildly profitable.

If our estimates are close to the mark, both Sony and Microsoft will likely be profitable on each console sold, and their respective games divisions will at worst break even. More importantly, Sony and

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Microsoft earn royalties on every game sold for their respective consoles; our forecast calls for 294 million cumulative PS4 software units and 227 million cumulative Xbox One software units sold by the end of 2016, with an average of $8 – 10 in profit for each unit booked by each company. Both their multiplayer networks and their royalty businesses will provide a recurring revenue stream at a very high dollar margin (the respective networks require a high level of capital and support spending, while the royalty businesses bear little cost), meaning that both Sony and Microsoft should deliver substantial profits from their gaming businesses over the next several years.

The current generation should also fuel profits for both companies. By the end of 2016, we expect a significant number of gamers to shift their loyalties to next generation consoles, but we believe that Sony and Microsoft are positioned to capture revenues throughout the shift by cutting the prices for their current generation consoles and attracting new customers for years to come. We forecast combined hardware sales for PS3 and Xbox 360 of 42 million units, and combined software sales of 316 million units, albeit at slightly lower profit margins than those for the next generation consoles.

We believe that it is a mistake to expect the next console cycle to develop in the same way as the most recent cycle. Although we expect digital distribution of content to affect the outcome of the next generation console cycle, we think that much of the impact has already been felt. Our predictions are intended to provoke discussion, and are our best guesses as to what will happen. We have structured our discussion in terms of events that we believe may occur far in the future, and in some cases much later than commonly held perceptions. The ultimate outcome of the console wars will be impacted by a variety of factors. In addition to the continued growth of digital distribution models, these include pricing, timing, competition, and most importantly, third-party support.

PlayStation Now Is Unlikely to Change the Landscape Without compelling content, we don’t expect PlayStation Now to gain traction. Sony recently announced the PlayStation Now game streaming service, using the company’s proprietary technology. Sony purchased Gaikai in 2012 for an estimated $380 million. The Gaikai technology allows users to stream games from a central server, allowing access to hundreds of games without requiring purchase of physical media or the downloading of large files. Sony envisions launching PlayStation Now as a subscription service sometime this year, and anticipates allowing users to also pay for game sessions on a rental basis. The company did not specify its intended pricing structure for the service, nor did it delineate the scope of its game offering, other than to promise “some of PlayStation’s most popular full games”.

Server-based gaming services were “the next big thing” in the last decade, but failed to resonate with consumers. The OnLive service launched in 2010, consisting of a server-based gaming platform and a simple device that compresses and decompresses the game file to allow a low latency transmission of the game from server to user’s television or PC. The OnLive game files reside on central servers, and users access the game by logging into their OnLive accounts and playing either single-player or multi- player games. While the service was impressive, OnLive never resonated with enough consumers to gain critical mass, and more importantly, to deliver profits. PlayStation Now is similar to OnLive insofar as it offers a cloud based gaming service, but PlayStation Now appears to be intended to work on both PS3s and PS4s without the purchase of additional hardware.

While we think there is a future for server-based gaming, we think that the appeal will be magnified or limited by the availability of compelling content. We believe OnLive ultimately failed because the company had difficulty attracting publishers to provide compelling content for its service. Few games available on the service were less than two years old (except for a handful of THQ games as THQ careened towards its own bankruptcy), and the lack of compelling content meant that the service didn’t resonate with gamers. We think that it is unlikely that PlayStation Now will attract many third-party games less than two years old, although we believe that Sony is in a position to make any of its first- party titles available on the service whenever it chooses to do so.

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The problem of attracting compelling content is rooted in the conventional publishing business model. Publishers endeavor to come up with game franchises that sequels, and in most cases, release sequels every two to three years. Thus, the natural lifecycle of a new game is typically two years. As a practical matter, this means that a paid subscription service like PlayStation Now can only attract games after their retail lifecycle has ended; should the service hope to gain access to games earlier than that time frame, it would be required to compensate the publisher of the game for lost catalog sales over the remainder of the two-year sell-through lifecycle.

Because of this, PlayStation Now is unlikely to attract many games that are two years old or newer unless it can find gamers who are willing to pay a significant premium for to content less than two years old. We believe gamers will weigh the cost of a monthly subscription or a pay-as-you-go rental scheme against the value of the underlying content; therein lies the rub. Two-year old games are typically widely available for $20 or less—as an example, EA’s , released in late 2011, is offered at GameStop for $20 new and for $10 used—meaning that gamers will pay only a small amount for access to a two-year old title. We believe that publishers will seek 70% of PlayStation Now revenues, similar to the iTunes pricing model, and we think that publishers will have little interest in “renting” a $20 game for anything less than $8 – 10. Thus, we think that the pricing of pay-as-you-go rental will be prohibitive, or in the alternative, the quality of the content available on a pay-as-you-go basis will be poor.

While we think PlayStation Now has little merit as a standalone service, we think that it is destined to end up part of an expanded service offering. Sony’s purchase of Gaikai suggests to us that the company intends to integrate streaming games into its other entertainment service offerings, such as music subscriptions and pay-as-you-go movie video on demand. We think that Sony may succeed in bundling PlayStation Now with these other entertainment offerings in the future, but we remain pessimistic that the service can succeed as a standalone game service.

Once Again, There May Not Be Another Console Cycle (But Lots and Lots of Console SKUs) Conventional wisdom has always dictated that after a brief transition period, consumers would wildly embrace next generation console technology, and rapidly accelerating software sales growth will follow. We believe there is a certain Field of Dreams mentality among the console manufacturers—if we build it, they (the consumers) will come. Conventional wisdom turned out to be wrong in the last console cycle— consumers embraced “old” technology, with demand for the Wii outstripping supply for a full two years past launch, but demand for the “new” technology offered by the Xbox 360 and PS3 sorely lagged expectations at the onset of the last cycle. In the next generation, we think that investors will see a return to the pattern of the past, and early sell-through of the next generation consoles from Sony and Microsoft reinforces our belief.

To us, the early sell through pattern suggests that the life cycle of next generation consoles will be more compressed than in past cycles, and we think that the console manufacturers may seek to drive higher online membership by offering a slew of value-added services (for a price), accompanied by ever- changing console SKUs. While we admire and respect Nintendo’s accomplishment in winning the last console race, it appears to us that Nintendo did so by attracting non-traditional households to gaming. We estimate that over half of Wii households are non-traditional, meaning that they would not have bought a console but for the novelty and innovation offered by the Wii. While this was a good thing, insofar as it expanded the ultimate market for video games, the early success of the Wii created a misperception that Sony and Microsoft consoles would forever lag behind, to the detriment of the publishers who made bets that the success of the Wii would not be repeated.

There are several differences between the next generation cycle and past cycles that may be sufficient to trigger an outcome that differs from conventional expectations. Perhaps the most significant difference is console pricing in the current cycle. Sony and Microsoft launched at slightly lower price points than in the prior cycle, and the prices of their legacy consoles remain high. We expect each manufacturer to cut price by $50 for their current generation consoles before year-end, and we think that

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the price cuts will allow new entrants to purchase PS3s and Xbox 360s, with many of them likely coming from the Wii installed base. We think that it is essential for Sony and Microsoft to win over former Wii owners who have developed an affinity for complex console games, and as each is able to upsell this audience to a PS3 or Xbox 360, they are likely to win a future PS4 or Xbox One customer.

In past console cycles, approximately 90% of all consoles purchased were sold at price points below $200. Consumers have figured out how to wait until console prices come down, yet both the PS3 and Xbox 360 core models remain priced above $200 as of the time of this writing; once prices drop below $200 (expected later this year), we expect to see a dramatic increase in unit demand.

In summary, fewer people will buy consoles at high prices than will buy them at low prices. We expect PS4 pricing to remain below Xbox One pricing for the foreseeable future, but we believe that Microsoft will despair should its sales lag those of its rival, and may consider either unbundling Kinect from its Xbox One, or may choose instead to drop the Xbox One price to a level competitive with the PS4. Either way, consumers should win, and we think that the rapid ramp of sell-through for the next generation consoles is sustainable. Our forecast calls for combined sales of 77.8 million PS4s and Xbox Ones in the first three full years following launch, compared to sales of only 49.7 million at the same point in the last cycle. The difference reflects market share captured from the Wii, which had 56.7 million consoles sold in its first three years; we expect the Wii U to sell only 11.3 million units over its first three full years. Thus, our forecast actually calls for a decline in console sales the first three years, with total sales of 89.1 million units among the three manufacturers this cycle compared to 106.4 million in the last cycle. We believe the conclusion to be drawn here is that those companies focused on next generation consoles from Sony and Microsoft have the most to gain, while those companies most focused on the Wii U have the most to lose.

Console pricing is impacted in the manufacturing, with console redesigns driving cost savings for the manufacturer. In prior cycles, we saw two PS1 SKUs and two PS2 SKUs, with only one Xbox SKU. In the current generation cycle, there have been eleven PS3 SKUs and eight Xbox 360 SKUs offered, each time with more features packed into the box at the same price or with a discount for the existing console. Much to our surprise, the Xbox 360 core model has come down in price only $100 after more than eight years on the market, albeit with several features (built-in Wi-Fi, a quiet fan, and a very large hard drive) not available in the original launch model. In contrast, the PS3 core model sells for approximately 40% of the launch price, also with many new features packed into the box. Manufacturers have a huge incentive to redesign their consoles to use less expensive components. At the same time, the potential for downloading digital content has grown in inverse proportion to the cost of storage, and manufacturer intent to exploit digital revenue streams is demonstrated by ever-increasing hard drives in each new console SKU.

We were modestly surprised at the relatively “small” hard drives in the next generation consoles, with the PS4 and Xbox One each having “only” 500 GB of storage space. As hard drive storage continues to come down in cost, we would not be surprised to see a terabyte of storage offered as standard fare by the end of next year.

The endgame for the console manufacturers in the next generation is the re-positioning of their devices as Internet and Entertainment hubs in the living room. Microsoft was first mover with the Xbox 360, creating access points for Netflix, , Last.fm and Twitter via its Xbox Live dashboard. Sony and Nintendo followed suit in the current generation, and emulated many of Microsoft’s value added product offerings. In the next generation, we expect to see Sony and Microsoft seek to penetrate the delivery of television over the Internet, again with Microsoft likely the first mover. We think that the Xbox One was built with this in mind, but believe that a new console SKU will be required from Sony to catch up once Microsoft launches IPTV.

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Digital Downloads Are Here and Now Digital downloads of complete console games have become a reality. Sony has pioneered the download of full games day-and-date with their release in physical form, offering a handful of PS3 games and every PS4 game (so far) for digital download on the same day as they are released on DVD. While there is only scant information about sales, anecdotal evidence from several publisher earnings releases suggests that digital download rates on PS4 are approximately 10% of overall software sales in the first several weeks following launch. To date, Microsoft has been slower to offer full game downloads on the same day as physical release, but we expect them to do so with all games later this year.

Games that are downloaded do not have a physical disc that can be traded in at the local GameStop. The number of games traded annually is striking; we estimate the overall used game market to be $2 billion in the U.S., with an average ticket of around $20 per used game. This means that an estimated 100 million units of used games are traded in each year, representing around 1/3 of all games sold annually. Thus, the option value of trading a game is quite high, and we can only surmise that 1/3 of game consumers place some measurable value on the ability to resell a game. This option is eliminated with downloads. We think that the resale option will ultimately serve to lower demand for digital downloads, and expect that packaged goods will continue to be offered over the next ten years, with migration to digital content absorbing much of the overall growth of video game sales.

Another factor limiting the likely adoption of digital downloads is the lack of portability. With a physical disc, consumers can take games to different locations (to play with others, or to loan the game to a friend). Digital downloads, in most cases, eliminate portability. Again, we believe that consumers will perceive some value to portability, meaning that some portion of consumers will prefer packaged products to digital downloads.

Until storage capacity in the installed base grows sufficiently to allow full game downloads, we expect to see a meaningful increase in sales of creeping downloads (selling a game in installments). The average game takes up 15 – 25 GB of storage on next generation consoles, and the consoles themselves have relatively large operating systems and a significant amount of storage consumed by multimedia functionality. We expect some uptake of full game downloads to occur this year, but think that the shift of market share to full game downloads will progress modestly, at a rate of 10% market share shift (at most) each of the next five years. We firmly believe that the ultimate market share for digital downloads will peak at 50%, provided that physical DVDs are still manufactured. In our view, the publishers will still make physical DVDs so long as there is demand for them, and we anticipate demand will remain strong so long as portability concerns and resale value exist. We think that a far more likely result is a slow migration of market share to digital downloads, with 5% annual share shifts for each of the next ten years.

In ten years, we envision a world where the typical console has several terabytes of storage, and where full game downloads are the norm. As stated above, there will always be a sizeable number of consumers who value the trade-in option and portability, and we expect those consumers to favor physical goods over digital downloads. Thus, we expect that digital downloads will represent less than 50% of total game sales ten years hence. If we’re right about game sales growing at above GDP rates for the next ten years, it is likely that by 2024, packaged goods sales will grow modestly (around 2% per year, to around $14 billion in the U.S. and Europe) and that full game digital download sales will grow exponentially (greater than 50% per year, to over $8 billion). These combined rates of growth suggest overall game sales growth of 7% per year for the next ten years, creating an opportunity for the publicly traded publishers to grow revenues and to dramatically grow earnings.

The Wii U Appears to Be a Bust: We Believe Nintendo Must Rethink Its Strategy We believe Nintendo is smart. Very smart. However, its past success in the console business is unlikely to be repeated in the next generation. In the last cycle, the company decided to avoid cutting-edge technology, and chose not to offer a console that competes graphically or technologically with either the Xbox 360 or the PS3. Rather, Nintendo offered a completely different game play experience. Nintendo

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chose to build a console in the current cycle that used relatively inexpensive, commodity components, and to compete against its better capitalized rivals by changing the control scheme. Its Wii console sold an amazing 100 million units over its lifetime to become the second best-selling home console of all time.

However, we believe the company made the mistake of repeating this strategy with the Wii U, with a completely different outcome. Once again, Nintendo chose to innovate by changing the control scheme, this time by including a “Game Pad” with its console. In essence, Nintendo’s Wii U sought to change the console experience from single screen to dual screen, much in the same way it achieved success with its DS and 3DS line of handheld devices. The difference, however, was that the DS and 3DS controls were set up in such a way that the player could easily view both screens at once, as they two screens in the handhelds are stacked one above the other; with the Wii U, one screen is in the player’s hands, while the other screen hangs on the wall, making it awkward to focus on both at the same time. After more than a year on the market, the Wii U has not resonated with consumers, with sales of only 4.9 million units.

In our view, Nintendo will continue its pursuit of a turnaround in the Wii U’s fortunes for another two years. Nintendo’s biggest advantage against its competition is its deep library of first-party content, including Mario , Zelda , Metroid , Pokémon , , Yoshi and several others. Its other big advantage is its demographic focus on younger gamers. While this demographic is not likely to grow dramatically, it is a robust group that has largely be ignored by Sony and Microsoft in their quest to capture older and more affluent gamers. We also believe that a generation of “Nintendads” has emerged that has helped Nintendo secure a sizeable niche following.

We believe that Nintendo management expects a reversal of fortune when its high profile Wii U titles, such as Mario Kart and Super Smash Bros. , are released later in 2014. While we believe that each of these key titles has tens of millions of fans, we think that their release is unlikely to drive more than a couple of million console sales each, as the barrier to entry is the sum of the cost of a Wii U (owned by fewer than 10 million at the time of their expected launch) plus the cost of the games. We acknowledge that these titles will drive Wii U sales modestly higher, but at a great cost, as we expect many current generation Wii owners to defect to the PS4 and Xbox One platforms in the interim. As such, we do not expect a significant change in Wii U hardware sales, and think that the console will likely be the worst- selling console from Nintendo in 20 years.

We think that the rate of adoption of HD technology worked against Nintendo’s interests, compounded by its late introduction of the Wii U. When the Wii launched in late 2006, fewer than 40% of households had an HD monitor, and the standard definition Wii was accessible to the remaining 60% of households. By 2010, HDTVs had penetrated over 80% of U.S. and European households, and the de facto gaming standard became the current generation HD consoles offered by Sony and Microsoft. Each of the latter two console manufacturers saw hardware sales actually accelerate, while Nintendo saw a significant drop off in Wii hardware sales. The company remained largely silent about its plans to release a new console until summer 2011, and by then, the HD world had passed Nintendo by. When the Wii U was released in late 2012, it was perceived to be comparable to the cheaper PS3 and Xbox 360, with a scant library of games and few compelling first party titles. In hindsight, the Wii U was at least two years too late, and set Nintendo back several years.

The Handheld Market Is Likely to Continue to Shrink There was never much of a “battle” for portable dominance between the Sony PSP and the Nintendo DS, with the DS regularly trouncing the PSP. Similarly, there has never been much of a “battle” between the Sony PS Vita and the Nintendo 3DS, again with Nintendo’s entry trouncing Sony’s. Over its lifetime, the DS sold over 135 million units, compared to 64 million for the PSP. The figures are far worse for the next generation from each company, with Sony’s PS Vita selling only 6.4 million in its first two full years on the market, compared to almost 40 million for the 3DS in a similar period of time.

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It is important to note that sales of the 3DS have begun to significantly lag sales of the DS. Nintendo DS sales averaged a remarkable 28 million units annually between April 2006 and March 2010; in contrast, the 3DS appears to have peaked at around 14 million annual units in only its second full year on the market. We think that the rapid increase in smartphone and tablet sales drove a portion of the decline early in the 3DS lifecycle, and penetration of smartphones and tablets among younger consumers will limit future growth in 3DS hardware sales. We expect Nintendo’s handheld business to deliver profits going forward, but at approximately half the level delivered in the past; in the meantime, the company’s console profitability is likely to be nil, if not negative, meaning that Nintendo will not return to its peak profitability until it addresses the likely failure of its home console.

Blizzard Is the Past of Online Gaming Roughly eleven years ago, we said that we thought that online gaming was a joke. Our view was that while there was potential for online gaming to grow into a meaningful niche, we did not believe that any single game could capture significant market share with a subscription model. We were clearly wrong then, as Blizzard’s massively multiplayer online (“MMO”) game World of Warcraft grew its subscriber base to 12 million, with approximately half paying an average of $15 per month to play the game, and the other half paying on a time basis in Chinese Internet cafes. Blizzard proved that a single game could capture disproportionate market share, and we estimate that World of Warcraft accounted for approximately half of all subscription MMO activity at its peak in 2010.

Today, we believe it is clear that online gaming is real, and is here to stay, but it has taken a different form than we anticipated, and far different from the subscription form pioneered by Blizzard. Several new MMOs launched in the last five years, with most becoming spectacular failures. Most notably, the much hyped The Old Republic from EA flamed out almost immediately, being converted from a subscription game to free-to-play less than a year after its release. Almost as notorious was the high- profile bankruptcy of 38 Studios, developers of the never released MMO code-named Copernicus .

Today, World of Warcraft continues to generate more revenue than any other subscription MMO, but the genre has seen a shift to the freemium model, with free-to-play access for most players and virtual goods sales generating the bulk of revenues. World of Warcraft saw its subscriber base decline from a peak of 12.2 million active users to 7.8 million users in the most recent quarter, and its revenues decline from a peak of $1.25 billion in 2010 to under $750 million in 2013, according to Activision. We think that the primary reason for the decline is fatigue, with a large number of free-to-play alternatives offered. The list of current MMOs offered by other publishers/developers is large, and few have succeeded to capture large market share in the West.

We expect Blizzard to renew interest in its subscription MMO business when it releases its new MMO, code named Titan , likely in 2016. The company created World of Warcraft as an RPG only after enjoying phenomenal success with its Warcraft series of RTS games. The second installment of the immensely popular StarCraft RTS launched in 2010, and we expect Blizzard to capitalize on its installed base of subscribers, servers and call centers, with the launch of a World of StarCraft MMO. The phenomenal success of StarCraft II , with over 10 million units sold, suggests that Blizzard could deliver a multi-million player MMO virtually overnight.

The company has announced that its new MMO will not be a subscription business, but has not provided details on its revenue model. We presume that the game will be sold in packaged form or for download at approximately $50 retail, and that its revenue model will be from the sale of virtual items. Rather than cannibalizing World of Warcraft subscribers, we believe that the Titan MMO will supplement World of Warcraft revenues. We envision that Blizzard will offer a virtual goods credit for all money spent on its subscriptions, meaning that WoW players will receive a $15 monthly credit in Titan , giving the subscribers a huge advantage over non-subscribers. We think that this type of model will appeal to both current and former WoW players, and we would expect the two games to attract a greater number of paying subscribers than WoW does today.

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The area with the most explosive growth in online game play is Asia. While China and Korea have been relatively small markets for console games, both countries have seen dramatic growth of online gaming, with an estimated 15 million monthly active players of several MMOs. Although time-based payments are generally lower in Asia than subscriptions paid in the West, these payments add up to a $500 – 700 million recurring annual revenue streams from MMOs, typically by the minute. Other game genres have proven far more popular, with a single game ( Crossfire from ) generating over $1 billion in virtual goods sales in a single year. We think that the potential for online gaming growth is greater for multiplayer online shooter games than it is for MMOs, which we believe are destined to be a niche product in Asia. As the emerging middle class in China has now approached a size comparable to the middle class in Europe, China alone may support overall video game sales approaching $7 billion annually, with MMOs only a small fraction (perhaps 20%). The potential of this market is too large to ignore, and companies like Activision (with the planned launch of Call of Duty China ), EA (with the launch of FIFA Online ) and Take-Two (with the launch of NBA Online and the possible launch of GTA Online ) have begun to make inroads into this large market. We discuss this market potential further below.

Digital Downloads Will Likely Limit GameStop’s Growth There is a commonly held perception that used game sales limit new game sales growth, and that digital downloads will replace packaged products sales, killing off GameStop in the process. We firmly believe that in the aggregate, used game sales have no impact on new games sales. The commonly held perception is that GameStop (the industry leader in used game sales, with an estimated 90% market share in the U.S.) “pushes” used games on unsuspecting customers lined up to purchase new games. This perception (perpetuated in the past by publisher executives) led many to conclude that GameStop’s used game business largely replaces sales of new games. We do not believe this to be true.

On the contrary, we think that used game sales benefit new game sales by providing currency to gamers with less disposable income, thereby enabling the purchase of additional games. The vast majority of used games are not traded in until the original new game purchaser has finished playing, typically well beyond the window for a full-retail priced new game sale. Thus, while there may be some limited substitution of used game purchases when GameStop employees “push” used merchandise upon consumers lined up to buy new games, the vast majority of used game purchases occur more than two months after a new game is released. Other than the potential impact at holiday (when new game lives are extended beyond the typical two month sell-through pattern), used game sales just don’t impact new game purchases very much.

To the extent that there is a substitution effect, we estimate that fewer than 5% of new game sales are impacted. We estimate that more than one-third of all games purchased in the U.S. end up as used games. This means that one-third of game consumers derive some currency from the trade-in of games, and if these trade-ins occur at GameStop, they should position the trade-in customer to buy more new games than he/she would otherwise normally purchase. Because the average used game value is around 20% of the new game price, we think that used game trade-ins fuel incremental sales of over 6% of total new game sales, suggesting that the cannibalization from the used game “push” is more than offset by the benefit from used game currency.

Notwithstanding our views, investors seem to expect a precipitous end to the practice of used game sales, with full-game downloads replacing physical goods sales over the next several years, thereby eliminating the potential for trade-ins of physical product. Over the last several years, we have seen an increase in the number of map packs, downloadable levels and other downloadable content available for retail sales. At the same time, we have seen a marked increase in the number of players taking advantage of online multiplayer functionality, particularly in sports and shooter games. It is clear that “DLC” (for downloadable content) and longer game play due to online multiplayer has cut into the addressable market for packaged products, as gamers are both playing games longer and are obtaining content digitally. The argument goes that once full-game downloads of every game are offered (expected by the end of 2014 for all next generation games), they will spell the end for GameStop.

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This logic posits that if games are downloaded, they cannot be resold, and games that are downloaded will not be purchased as packaged goods at GameStop. As more games become available for download, their availability will inevitably lead to a shift in purchase patterns away from packaged goods and in favor of download. Necessarily, any growth in game downloads will reduce the addressable market for GameStop. Many industry observers have concluded that like the music industry, the video game industry will rapidly adopt full downloads, resulting in the end of consumer retail sales of packaged goods.

We believe the increased incidence of digital downloads does not necessarily mean an end for GameStop. In our view, one of the drivers of new game sales is the perception on the part of many consumers that the game will have value when the purchaser is finished playing it. The consumer may choose to trade in the game for nominal credit at his local GameStop, or may choose to give the used game to a friend. While it is true that most gamers do not trade in games, we note that the used game business is a substantial one.

GameStop’s used video game product sales were an estimated $2.35 billion in 2013. We believe that roughly 80% of these sales occurred in the U.S., and that 65% of the U.S. portion of used product sales represented software sales. Thus, we estimate that GameStop sold around $1.2 billion in used games in the U.S. in 2013. At an average retail price of $24 (to make the math simple), this means that GameStop handled 50 million used games units last year. Comparing this figure to 2013 overall U.S. and handheld software unit sales of around 150 million, we conclude that 1/3 of all new games sold ended up traded in at a GameStop last year.

Clearly, used games can be sold more than once, but we think that our estimate is a fair proxy for the magnitude of the audience that values used games as currency to buy new games. In other words, if one-third of all games are traded in, it is likely that one-third of all consumers see a value proposition in used games, and are attracted to used games as a currency for new game purchases. We do not believe that this market will evaporate; rather, we think that demand for packaged products will continue, even after a substantial percentage of the installed base has upgraded to new consoles with very large hard drives.

We expect the console manufacturers to increase storage capacity with each new wave of next generation console SKUs. We believe that the next SKUs offered for the PS4 and Xbox One will have one terabyte of storage; as hard drives get larger, we expect to see an expanded offering of full-game downloads, available at the same price as the competing packaged product, but offered through Xbox Live or the PlayStation Network. Publishers would benefit in two ways: first, full-game downloads will generate higher margins, with the console manufacturer taking an estimated 30% of the retail price instead of 20% to the manufacturer and 20% to the retailer for a packaged product sale; and second, insofar as digital downloads will not enter the market again as used games.

While full game downloads are imminent, we do not expect wide substitution for packaged goods sales until a significant portion of the installed base has purchased next generation consoles, and even then, we think the migration will be gradual. Average game sizes are 15 – 25 GB, and the average hard drive on the next generation consoles from Sony and Microsoft is 500 GB, so there is plenty of room for most gamers to download every game, should they wish to do so. However, both next generation consoles are positioned as multimedia devices, and gamers are likely to find their storage rapidly absorbed by movie, music and photo downloads. As we discussed above, we think that somewhere between 5 – 10% of game sales annually will shift from physical media to digital download, and we expect the shift to take 5 – 10 years until digital sales capture 50% of the full game sell-through market.

In our view, the video game market is likely to grow at or above a 7.2% rate for the next ten years, at least doubling over that time. We envision digital downloads to account for all of the growth. The “rule of 72s” says that if demand for video game software averages 7.2% for ten years, the industry will

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exactly double. We think that this is highly likely, and think that digital downloads will grow exponentially during that period, limited only by the pace of adoption of high storage next generation consoles. In our view, digital downloads will incrementally capture 5 – 10% of overall game sales market share each year for the next 10 years, peaking at around 50% market share. We envision a world in 10 years with twice as much demand for used games, but with only a constant level of packaged product sales, due to growth of digital downloads.

If we are right, GameStop is positioned to thrive for many years to come. Assuming that the company manages its slowing growth effectively, GameStop should see its packaged products sales flatten over the next few years. At the same time, it should see demand for used games grow with the overall market, while the available supply of used games (which must be packaged products) stalls. Simple economics dictate that if demand for a product doubles over time, while the available supply of that product remains , pricing must go up.

Thus, we see the potential for GameStop to generate flat new game sales, but see the company selling a similar number of used game units at ever-increasing prices over the next ten years. Should the company manage its SG&A costs effectively, it should generate profits from higher used game pricing that are sufficient to offset its escalating costs, resulting in relatively stable earnings over a ten-year period. In the meantime, the company has augmented its revenue streams with digital game sales, used consumer electronics sales, and its recent entry into new mobile phone sales and as an Apple product reseller. We believe that these new businesses have the potential to allow GameStop to grow its revenues for the next few years, and while we expect its video game business to peak and possibly decline, we think that the company’s new lines of business and commitment to returning cash to shareholders could allow its earnings to grow indefinitely.

GameStop’s competitors have long sought to promote used game trade-in programs of their own, but none has yet captured significant market share. In our view, GameStop has a real and sustainable competitive advantage due to the makeup of its “core” customer. GameStop welcomes boys under 18 to hang around in their stores and to test games, and provides a generally pleasurable experience within the store for teenagers. In contrast, Best Buy is not particularly friendly to young teens, and Wal-Mart is not a desirable place for young teens to hang out. Both Best Buy and Wal-Mart are relatively inconvenient to get to for kids without cars, while GameStop’s strip mall penetration makes them a short bike or skateboard ride away for most kids.

We believe the key to GameStop’s competitive advantage lies in the fact that its core customer is more likely to trade in games than most other demographics. Boys under 18 are more likely to be unemployed than the core demographic at Best Buy or Wal-Mart, and are generally more self-indulgent. An unemployed 14 year-old seeking immediate gratification has few options when a “must have” game is released, other than to trade in a handful of older games. We estimate (in an unscientific manner) that around 70% of all used games traded in at GameStop are traded in by boys under 18. The other 30% is traded in by every other demographic. In our view, Best Buy and Wal-Mart will have difficulty attracting these trade-in customers (and likely do not desire them), and we therefore estimate that the addressable market for their kiosk offering is limited to “everyone else”.

Amazon is a different story. Although Amazon does not offer immediate gratification, the barriers to its ability to reach boys under 18 are lower. Anyone with an email account and a credit or debit card (perhaps 1/3 of the GameStop trade-in clientele in the under 18 group) can be reached by Amazon. In the Amazon model, the consumer enters the games intended for trade-in, and prints out a postage-paid mailing label. Credits are posted to the consumer’s account when the discs are received in good condition. Because Amazon makes it so convenient for consumers, we think that it has some potential to capture market share.

The bigger issue for GameStop is the threat that one or more of these competitors will compete on price. Few products sold by Best Buy, Wal-Mart or Amazon generate margins as high as the 50% captured by

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GameStop on used games. Because each competitor’s program has failed to progress beyond the test phase, we cannot yet determine whether any intend to compete on price. However, each has the ability to discount used games (or pay higher trade-in prices) to the point that they generate only a 30 – 40% margin. It is likely that each company’s third party partner will seek 10% or so margin, but we think that any of the companies would be happy to price at a 30 – 40% gross margin, and to generate a 20 – 30% net margin after paying its partner. We estimate that round-trip postage will cost Amazon an incremental 10%, so the company may not be willing to discount as steeply as the others. Notwithstanding, we think that should any of these companies be serious about gaining market share, discounting is likely.

If one of GameStop’s competitors competes based on price, GameStop has two choices: either match pricing, or lose market share. We expect Best Buy, Wal-Mart and Amazon to capture between 5 – 10% market share over the next 10 years (assuming all three decide to expand their presence). At that level, it is inevitable that some GameStop customers will notice if one or more of the competitors offers higher trade-in prices or lower used game prices. We would expect some portion of GameStop sales to be price protected in such a case. For example, if the average GameStop transaction involves a trade-in for $10 and a subsequent sale for $20 (50% margin), we think it is likely that one or more of its competitors will offer $11 for the trade-in and charge $19 for the used game (around a 40% margin) in order to attract more merchandise and to capture market share.

The math here is a bit fuzzy, as we are dealing with a hypothetical. However, we think that a 10% margin discount is likely, and believe that such a discount will cause at least 10% of GameStop’s used game customers to seek a price match. We estimate such a result would cause GameStop to lose 1% margin on its used business (10% discount offered to 10% of its customers). GameStop’s used software business in North America was an estimated $1.2 billion in 2013, so a 1% margin hit would represent $12 million in lost pre-tax profits, or an EPS cost of around $0.06 per share. If one or more of its competitors discount by 20%, it is likely that even more customers will notice. In that case, we envision price protection of 20% offered to as many as 20% of GameStop customers, resulting in a 4% margin hit, or around $0.24 per share.

We don’t expect this to materialize overnight. None of GameStop’s competitors has advanced beyond the test phase since 2009, and we do not expect a widespread rollout for several more years, if ever. Our best guess is that the EPS hit will be $0.04 or so in 2016, and an incremental $0.04 – 0.08 for the next year or two, before the market stabilizes and GameStop’s competitors once again give up. GameStop can combat this margin hit by being more aggressive with used game promotions, sacrificing margin in favor of greater velocity of used game sales at higher overall prices. We saw some evidence of this strategy in 2013, and believe that GameStop can actually grow its used game gross profits at lower margins while keeping its competitors at bay. Thus, we don’t expect an onslaught from competitors for several more years.

Free-to-Play Games Are the Mass Market Present and Future Several years ago, a business model emerged in Asia that provided online game play for free to consumers, with microtransactions generating billions of dollars for the sponsors. On average, an estimated 700 million Chinese play free-to-play games, with a small percentage (1 – 5%, on average) purchasing virtual items (such as tires, weapons, horses, or resources) that make their game play more enjoyable. The success of these games triggered emulation in the West, and we have seen games like World of Tanks (estimated revenues of $350 million annually), League of Legends (estimated revenues of $650 million annually), Candy Crush (estimated revenues of $800 million annually) and Clash of Clans (estimated revenues of over $1 billion annually) thrive based upon a free-to-play model. There are also several games that thrive in Asia, with Gung Ho’s Puzzles and Dragons and Tencent’s Crossfire the market leaders.

Companies like Electronic Arts have been pursuing the free-to-play genre for many years. EA introduced NBA Street, FIFA Online and Battlefield Heroes over the last several years, but none has achieved the level of success of any of the titles listed above. We think that the fact that each of the

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games listed in the preceding paragraph is made by a different publisher/developer reflects the difficulty of “catching lightning in a bottle”, as there is no clear cut formula for success. While each company has attempted to create other free-to-play games, none has approached the level of success that it experienced with the games listed above. In our view, consumers embrace certain games for a variety of reasons, and it is difficult to replicate the precise formula of a given game without appearing to be offering the same game. The more things change from the original successful game, the less likely the next iteration is to be successful.

The free-to-play market is large, and is growing at a rapid pace. SuperData research estimates that the U.S. mobile game market alone has reached $3.1 billion in revenue. If we extrapolate this estimate to include free-to-play PC games and social games, it is likely that the overall U.S. market exceeds $5 billion annually. We believe that the European market is at least as large, and we estimate that the Asian market for free-to-play games exceeds $7 billion at present. Thus, we think that the overall market opportunity for free-to-play games is approximately $17 billion, and we expect it to continue to grow, particularly as more people purchase smartphones and tablets. We discuss the mobile opportunity below.

Mobile Phone Games Should Drive Overall Growth The market for mobile phone games was elusive until the introduction of the smartphone. Prior to the introduction of smartphones, games on “feature” phones were simplistic, limited to games like Tetris and JAMDAT Bowling . Although several feature phone games were successful in Japan, the market did not begin to grow rapidly in the West until the introduction of the smartphone.

U.S. mobile phone game sales were an estimated $3.1 billion in 2013, up 288% in the last two years, according to SuperData Research. We believe that growth of mobile games is closely correlated to growth of smartphones, and we believe that the European mobile game market is roughly the same size as the U.S. market, with the Japanese market slightly larger. The big prize will be emerging markets in the BRIC countries, which should see smartphone sales that mirror the growth in the U.S. and Europe over the next few years. In all, we think that the addressable market for mobile game sales could approach $20 billion annually within the next five years.

With that said, we do not expect any publisher to dominate the mobile phone game market. Electronic Arts has the leading market share in the U.S. and Europe, but with under $500 million in mobile sales, the company is capturing less than 10% market share. Notwithstanding its relatively high level of sales, it is not clear that EA generates much profit from its mobile division. However, recent cost cuts likely position EA to make money at the $500 million level, and its future growth should mirror overall growth in smartphone and tablet penetration. Competing firms Gameloft and have struggled to grow profits, as competition on the iPhone and Android handsets is fierce. We believe one impediment to growth has been the way store fronts have developed for mobile downloads, with handset maker Apple running all game downloads on its , but with fragmented distribution on Android and phones. Thus, discovery on Android and Windows 8 phones is more difficult, and those markets have not evolved as quickly as the iPhone game market.

Mobile game downloads have been the beginning of the end for handheld gaming platforms, in our view. We had expected Nintendo handhelds to hold their own against the onslaught from mobile games, but the evidence to the contrary is compelling. Nintendo has a wealth of proprietary software, but the CPU in its 3DS handheld is not sufficiently more complex than the average iPhone. We had not expected parents to purchase such phones for their young children five years ago, but with smartphones the de facto standard, smartphones have increasingly become the entry level phone for younger and younger children. Data plan pricing has come down, with many family plans costing only $10 – 20 per month, down 80 – 90% over the level just five years ago. We think that the increasing popularity of tablets has further encroached upon the addressable market for dedicated handheld gaming devices, with many parents preferring a multi-purpose tablet for their children than a single-purpose handheld gaming

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device. We have observed Nintendo’s 3DS sell-through lagging its predecessor DS sales by approximately 50%, and we expect further sales erosion going forward.

Notwithstanding the impact on dedicated handheld software sales, we think that growth of mobile gaming could end up a good thing for console software sales. The mobile phenomenon has attracted a large percentage of the estimated 1.5 billion smartphone and tablet users to try games, and we believe that penetration among this market is likely to increase over the next several years, with as many as 1.5 – 2 billion people playing mobile and tablet games by 2020. This dwarfs the estimated 250 million person console addressable market, and we believe that by conditioning people that games are fun, the console market is likely to benefit over the long run. It logically follows that if more people play games on phones and tablets, more will be attracted to games on dedicated gaming consoles.

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POST SCRIPT—LESSONS LEARNED FROM THE LAST CONSOLE CYCLE

We don’t expect the publishers to provide the same level of support to each console. Over the last 15 years, the publicly traded publishers have endeavored to be platform agnostic, continuing to support next generation consoles at launch while still supporting the legacy consoles as the transition between consoles lasted longer and longer each cycle. We believe the publishers suffered in each transition, making mistakes such as abandoning the original PlayStation too soon or chasing the Wii with limited success. Each company supported the PS2 well into the last cycle, devoting significant resources to PS2 game development. At the same time, the publishers were quite conservative with the launches of the Xbox 360, PS3 and Wii, with only a handful of titles produced at launch for each, followed by throwing all of their resources behind each of the three consoles by 2008.

In hindsight, the publishers appear to have made several mistakes. While the Wii was a runaway success, few companies other than Nintendo had lasting success with Wii games. There were exceptions, such as Ubisoft with its Just Dance games and Take-Two, with its Carnival Games , but each of these saw their franchises diminish in value as the Wii lost its luster.

In the next generation, we expect most third-party publishers to support the PS3 and Xbox 360 with their biggest brands, and to support the PS4 and Xbox One with all of their brands. We do not expect continuing support for the Wii past 2014, and think that most third-party publishers will abandon Wii U development by the end of 2015, provided that Nintendo doesn’t cease production of the console before that. EA made a very deliberate decision to abandon the Wii U in 2013, producing no new games for the platform. This appears to have been a smart decision, as the installed base of the Wii U is so small as to all but guarantee that games developed for the platform will lose money.

Similarly, we expect a continuing focus on owned intellectual property. Licensed properties have largely been abandoned. Over the course of the last decade, we observed a decline in licensed intellectual property in video games, with increasing emphasis on owned content and sequels. Licensed content used to dominate game sales, with popular titles such Harry Potter , Lord of the Rings , Spider- Man , SpongeBob , Finding Nemo , Cars , Scooby Doo , Yu-Gi-Oh , and Dragon-Ball Z leading the charts in the first half of the last decade. As licensed content has faded in popularity, the publishers have reduced the number of licensed titles to a handful of sports titles and a handful of movie titles. The publishers are chasing bigger propositions, and have endeavored to make their original IP (such as Call of Duty , Battlefield and Skylanders ) appeal to the mass market to a greater extent. This decision appears wise, as the “mass market phase” of the last console cycle, which typically brings casual gamers into the market, appears to have shifted in favor of free-to-play PC and mobile games. Each of the historically strong licensed brands listed above has been largely discontinued, and the poster child for licensed content, THQ, declared bankruptcy in 2012.

We believe that the publicly traded publishers have begun to demonstrate pricing discipline, instead of training consumers to wait for price cuts. New game pricing held up throughout the last console cycle, with highly successful games like Call of Duty continuing to debut at $60 and maintaining launch pricing for more than six months. The publishers learned from past cycles that rapid price cuts and discounts on premium titles led to consumers waiting for discounts. Over the last seven years, we have seen more discipline in pricing, with a greater number of “collector’s edition” games selling for a $10 premium, and little consumer resistance to very expensive bundles such as Collector’s Edition for $99.99. The publishers learned from past cycles that they cannot afford to allow game discounting, especially given prohibitively high development costs. We expect front-line pricing to remain at $59.99 throughout the next cycle.

Shorter games entail lower risk. As development costs continue to escalate, publishers have an incentive to cut expense wherever possible. The biggest component of development expense is manpower, so it follows that shorter games are less expensive to develop than longer games. It follows logically that if shorter games are less expensive to develop, they require fewer units sold in order to

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break even, thus entailing lower risk. Shorter games have two disadvantages: first, they are more susceptible to rental; and second, they are more susceptible to poor reviews. Because the average rental outlet offers a week of game play for only $6, consumers can play a short game through to completion in two to three weeks for far less than the retail cost of the game. Interestingly, most Call of Duty games (among the best-selling games of all time) are typically quite short, with an estimated 10 hours of game play. Consumers appeared not to mind, as the multiplayer component of the game allowed countless hours of enjoyment. We believe that the shift to shorter single player campaigns will continue, with extra content packed into DLC packs that can be sold for $15 apiece. The typical game with DLC has three or four DLC packs, and the typical attach rate is 25 – 33%, meaning that the average revenue per user from a game is around $75, compared to just $50 in the PS2 era.

Conclusion The big takeaway is that the past is not necessarily prologue for the next console generation. Digital downloads have grown immensely, but have not yet spelled the end of console games, nor do we believe they are likely to; Nintendo’s success with the Wii is unlikely to be replicated with the Wii U; underwhelming technology improvements for the next generation consoles from Sony and Microsoft don’t appear to be a damper on sales; game streaming services are unlikely to be the “next big thing”; mobile games will continue to encroach on handheld game sales; MMOs will migrate from subscription- based to free-to-play; and free-to-play play has become the mass market norm.

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INDUSTRY CONSOLIDATION

M&A Doesn’t Make Sense For much of the past decade, there has been much discussion about the imminent consolidation of the video game publishers, with much of the discussion involving several of the major media companies. To date, only one U.S. publisher was acquired (and that publisher recently bought its stake back), while several have gone out of business. Over the last 11 years, 3DO, Acclaim, Midway and THQ declared bankruptcy, BAM!, Interplay, Brash Entertainment and startup Gizmondo (Tiger Telematics) ceased operations, and Atari, Infogrames and Majesco were financially weakened to the point of irrelevance. In the last decade, Sega merged with Sammy, Square merged with Enix and subsequently acquired Eidos (who had earlier been acquired by SCi), TDK was acquired by Take-Two, and Electronic Arts acquired JAMDAT, Digital Illusions, Pandemic, Bioware, and PopCap. Other acquisitions have been far more minor and strategic, including the News Corp acquisition of online video game site IGN, ’s purchase of social networking site Xfire, MTV’s purchase of Gametrailers.com and , Warner Bros.’ acquisition of TT Games, Disney’s acquisition of Junction Point Studios, Microsoft’s acquisition of Massive, and Google’s purchase of Adscape. Many of these acquisitions turned out badly, with the assets acquired later disposed of or sold. Only Warner Bros. has made consistently successful acquisitions.

The economics of game development have made publishing an increasingly costly endeavor, and the hit-driven nature of the business has made it difficult to predict winners and losers among the publishers. Smaller publishers, such as Atari, Midway and THQ, struggled to compete with the larger publishers for consumer dollars and retail shelf space during the last cycle, even though each had a relatively strong lineup of proven intellectual property, and all three declared bankruptcy. Exacerbating the problem is the cost of obtaining intellectual property rights from “sure-fire” sources, with royalties for new licenses rising in cost substantially.

In the past, we consistently believed that the most likely acquirers would be either Electronic Arts or Microsoft, due to the former’s desire to expand into digitally delivered gaming and the latter’s desire to control more first-party content. Electronic Arts made several acquisitions intended to position it to grow its digital revenues, with the purchase of JAMDAT the only successful one. The company’s purchase of Pandemic and Bioware provided it with a handful of new brands, but its high-risk effort to develop the Star Wars MMO was a bust. Similarly, EA’s purchase of Playfish was intended to jump start its move into social gaming, and that effort has largely been abandoned. Finally, its acquisition of PopCap was structured with approximately half of the consideration in the form of an earn-out that will apparently never be paid. Microsoft went in a different direction, buying Skype and Nokia’s device business to bolster its overall hardware presence. The company’s purchase of Massive (an in-game advertising platform) was a complete bust. We do not expect either company to engage in large scale M&A in the game business over the next several years.

We continue to believe that the acquisition of a U.S. publisher by a media company is unlikely. Disney and Viacom were most active last decade, and each of their high-profile acquisitions was a bust. In our view, the uncertainty involved in choosing winners and losers in the next cycle is too great, and media companies have become increasingly risk-averse. We therefore believe that discussions of consolidation at this time are premature. We believe that a prudent company such as Viacom or Disney is likely to defer an acquisition decision until it has more visibility regarding the costs of such an acquisition. The high costs of current and next generation console development have kept profits in check for most companies for the last several years, and though we believe that companies such as Electronic Arts and Activision are in a very strong position to grow revenues and earnings, this conclusion is likely not as apparent to a potential acquirer. Because Electronic Arts expenses its development costs, we believe it is in a position to grow earnings dramatically in 2014 and beyond. However, we believe that a prudent Viacom or Disney Board of Directors would prefer to wait until the earnings leverage from R&D investment has been demonstrated before making an acquisition, as it will have significantly more information about the future costs of doing business.

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One overarching concern for a media company should be the status of current license arrangements, and what happens to those licenses upon a change of control. We discuss our views about likely acquisition targets more fully in the Industry Consolidation section immediately following.

We Believe Competition from Media Companies Doesn’t Make Sense Another area of discussion is looming competition from media companies. Some of the major media companies appear to covet the profits that are generated by video game publishers, and these companies appear to believe that the value added in publishing is more attributable to the underlying intellectual property than to execution. We disagree.

Companies like Disney and Warner Bros. made the decision last decade to bring in house, with mixed results. Until 2013, Disney consistently lost money in its interactive entertainment division, and its costly acquisition of Playdom in 2010 (for a reported $760 million) was a complete bust. On the other hand, Warner Bros. has consistently executed well, and its acquisitions have generally been small and profitable.

We think that Disney will focus on its Infinity business, and will make modest investments in its owned IP (such as Pixar titles) using internal studios. The company has already licensed the next installment in the Star Wars series to EA, demonstrating its lack of commitment to further growing its internal capability. We do not expect the company to make a large-scale acquisition in order to compete.

We feel the same about other media companies, with the notable exception of Warner Bros. That company has consistently produced hits, with its , and Injustice games generating sizeable profits. The company has also produced LEGO games based upon the Batman , Star Wars and Indiana Jones franchises, also with some success. We think that the company has taken a prudent approach, exploiting a particular expertise of its TT Games subsidiary, adding teams from Rocksteady and Netherrealm, and developing content that is consistent with its expertise.

Perhaps the greatest media company bust was Viacom’s purchase of Harmonix Games. While that studio’s release, Rock Band , generated over $1 billion in game sales, Viacom lost money in the process, and ultimately spun the studio off. Given several high-profile failures, we expect the media companies to “stick to their knitting” and only produce content at a modest cost based upon owned intellectual property. We expect those who have ramped up to continue to exploit competitive advantages when those advantages exist, but we do not expect any of them to make meaningful acquisitions in the foreseeable future.

We do not see imminent consolidation of the video game industry. We discussed this in a preceding section, and in this section, we explore the consolidation prospects for each of the major publishers.

Electronic Arts Until the merger of Activision and Blizzard, Electronic Arts was the largest third-party video game publisher, with over 20% market share in the U.S. and Europe. Now solidly in second place, Electronic Arts remains too large a target for other video game companies. The company’s share price has declined over the last ten years, dropping from above $50 to almost $10 before settling in the low $20s, and its market capitalization is currently over $8 billion. EA generates revenues in excess of $4 billion, and has $1.5 billion in net cash including marketable securities (around $5/share). The company has a solid management team, a stable lineup of game franchises, recurring revenue streams from its sports franchises, a solid online presence, is the leading mobile gaming publisher, and has a growing presence in the Asian market. Notwithstanding its recent restructuring and downsizing, it is clear that the company intends to grow revenues and earnings for the next several years. EA is exploring opportunities in online gaming, in-game advertising, and other areas.

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Electronic Arts currently spends approximately $1 billion per year on game development, giving the company a technological head start over much of its competition; because the company expenses R&D (in contrast to its competitors, all of whom capitalize and amortize), its earnings potential is significantly depressed until its investment is recovered via higher revenues. This amount translates to roughly $2.40/share in after-tax expense, given that the company currently expenses all of its development costs. Console games for the PS4 and Xbox One are expected to cost an average of $30 million to develop, while Wii U and handheld games far less; it should be noted that EA does not currently support the Wii U, and makes very few of its titles for dedicated handheld consoles. Instead, the company produces a large number of mobile games at an estimated annual expenditure of approximately $200 million (included in the $1 billion above). Electronic Arts’ fully phased-in R&D costs are likely to remain at around $1 billion per year, or $2.40 per share, for the foreseeable future, with some increase should the company determine that investment in other opportunities is prudent. A risk-averse acquirer will likely wait until it has greater visibility into the cost curve for software development and into the revenue opportunities from “all other” before paying a premium to enter the video game business.

Electronic Arts has a deep library of licensed content, but has de-emphasized most of its legacy titles (such as Harry Potter ) in favor of its new license with Disney for Star Wars and a handful of sports licenses. It is not clear whether the licensors have the ability to terminate relationships with Electronic Arts upon a change of control, although we believe that this is standard fare in most licensing agreements. More problematic is EA’s license arrangement with ESPN, calling for $850 million in advertising guarantees over a 15-year period (approximately half of the term remains). We believe that media companies other than Disney (parent of ESPN) would find the ESPN relationship problematic.

In our opinion, Electronic Arts has no interest in being acquired. Revenues and operating margins consistently grew through FY:04 (ended March 31), but over the last six years, the company’s sales have hovered around $4 billion, and its margins have been uneven. We expect EA to grow revenues at least in line with industry growth this year and next. Operating margins have once again begun to expand over the last five years, from a negative margin in FY:09 to an estimated 13% in FY:14. The company appears to us to be positioned to grow operating margin by 200 bps or more per year for the next several years, as it has cut costs (and continues to do so) and appears well positioned to grow revenues. As such, we think that the company would command at least a 30% premium to the current share price (around $24), and believe that any would likely be hostile. We think that company management shares our view that it is in a great position to grow the business, and would likely perceive a takeover offer as a distraction. We think that should a major media company make a serious offer to acquire Electronic Arts, the latter would take steps to accelerate growth or to drive up its share price, including an acquisition or stock buy-back. Accordingly, we view an acquisition of Electronic Arts by a major media company as unlikely.

Activision Blizzard We believe Activision is equally unlikely to be an acquisition target. The company has a market capitalization of over $12 billion, with around $1 billion in net debt (around $1.50/share). Its revenues have been between $4 billion and $5 billion each of the last five years, and it has industry leading operating margins. Company management appears focused upon growing revenues and earnings over the next several years, and Activision is the world leader in online subscription games.

Activision recently repurchased Vivendi’s majority ownership stake, assisted by an investment group led by two of its executives. We think insider ownership makes Activision a difficult target for a media company, and think that the company’s high margins make acquisition synergies more difficult to achieve than with an acquisition of one of its competitors.

Take-Two Interactive We believe that Take-Two is a solid acquisition candidate for a company looking for a strategic partner, and on a fundamental basis, we think that an acquisition may make some sense to media companies. The stock is relatively inexpensive on an earnings multiple basis, given its recent strong performance,

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but the company is highly dependent upon one brand (and one development studio) for the bulk of its earnings power. Take-Two might attract potential suitors, as it has some of the best development talent in the business, a stable of decent brands (including the best-known brand of all time in Grand Theft Auto ), and the always-desirable geographic proximity to major media companies. In addition, Take-Two has almost no meaningful long-term licenses other than its NBA license, meaning that a media company could acquire Take-Two with little risk of license termination.

Take-Two has a market capitalization of over $2 billion as of the time of writing. The stock trades at a discount to its peer group, likely due to its uneven earnings performance and perceptions of its “one-hit wonder” status.

We continue to believe that an acquisition in the video game space is premature, and think that an acquisition of Take-Two is unlikely. The stock trades at 16x our EPS estimate for next year (excluding cash, and adjusted for normalized taxes), and should be considered “bite-sized” by a potential acquirer. At a 30% premium, an acquisition would cost less than $2 billion (after crediting cash). However, current management rejected a bid at this level in 2008, and given the substantial appreciation in equities over the last several years, we think that a $2 billion offer (around $25/share) would be rejected.

We think that the most likely acquirer for Take-Two is Activision, which has a stable of successful, but aging brands. We do not believe any major media company would have interest in Take-Two, as its success has been uneven for several years.

Majesco Majesco is a relatively young company, and has not been consistently profitable. It is primarily a distribution company, taking little development risk while co-publishing titles developed by third parties, and it has not generated consistent profits over its existence. We think that it would be difficult for a media company to evaluate its worth in an acquisition.

Ubisoft Ubisoft is a fine acquisition candidate, and reminds us of Activision ten years ago. The company has a large slate of owned (or fully controlled) intellectual property, including ownership of the Tom Clancy stable of titles (including Recon , Rainbow Six and Splinter Cell ). In addition, Ubisoft owns brands such as Rayman , , Assassin’s Creed , Haze , Driver and the Petz line of games. The company has several strong relationships with licensors, and has the second largest development studio in the world, behind Electronic Arts. Ubisoft’s market cap is around $1.1 billion, with a small amount of net debt. We think that an acquirer would be required to pay at least a 50% premium, suggesting a valuation of around $1.7 billion.

We believe Ubisoft is unlikely to be acquired by a media company, as it is headquartered in France, making consolidation difficult. We believe its most likely suitor is Electronic Arts, but think that an acquisition is unlikely, as EA shares have fallen by over 50% from their peak, primarily due to unsuccessful acquisitions.

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VIDEO GAME HARDWARE FORECAST

We expect the total installed base for the three next generation consoles to approximately equal the 260 million installed base for current generation consoles. Total current generation hardware shipments were 202 million in the U.S. and Europe (the addressable market for U.S. and European publishers) by the end of 2013 (eight years after the first console launched). In comparison, 128-bit hardware shipments were 132 million units at the end of 2008 (also eight years) and 32/64-bit shipments totaled only 93 million units between 1995 and 2003. This increase translates into a compound annual growth of 8.1% in unit sales from the end of the 32/64-bit cycle, notwithstanding that the average price for current generation hardware was $291 compared to only $153 for the earlier cycle. This hardware sales growth is much higher than our estimate of 2% per annum growth in the GDP during the same period in these markets. We think that the overall potential for the next generation is at least equal to the current cycle, and we expect penetration through year-end 2020 of at least 200 million consoles, with sales of 33 million forecast through the end of this year. The following figure illustrates the ratios of console sales to households in the U.S. for the last four console cycles and our estimate for the next generation cycle.

Figure 22: Average U.S. Console Ownership by Household

Average U.S. Consoles Peak Households Households Owned Console Installed (mil) at Period Consoles/ That Ow n (console Cycle Period Cycle Base (mil) Start Household Consoles owners) 1985-90 8-Bit 36.3 86.8 0.42 31% 1.35 1989-95 16-Bit 38.4 92.8 0.41 33% 1.25 1994-00 32/64 Bit 49.7 97.1 0.51 38% 1.35 1999-06 128 Bit 76.8 103.9 0.74 50% 1.48 2005-13 Current-Gen 108.3 113.3 0.96 65% 1.47 2013- Next-Gen 5.9 122.5 0.05 70% 0.07

Source(s): U.S. Census Bureau, NPD, and Wedbush Securities estimates.

We expect continued household penetration for next generation consoles, increasing from 65% in the last cycle to 70% in the current cycle, primarily due to our belief that the Wii expanded the gamer demographic and made more people amenable to buying consoles. We expect the number of consoles owned per household that owns a console to decline slightly to 1.4 units, below the last cycle, as we believe that the many households owning a Wii will drop out of console ownership.

It is possible that the percentage of households globally owning at least one console will increase even more dramatically. This could occur as positive demographic drivers and improved technological functionality drive increasing console penetration. We estimate that during the 8-bit console cycle, 31% of U.S. households owned at least one console. This percentage increased to an estimated 38% during the 32/64-bit console cycle, increased further to 50% in the 128-bit cycle and increased to 65% in the last cycle due to the popularity of the Wii. Current generation consoles offered increased multimedia functionality over their predecessors, enhanced multimedia functionality, wireless controllers, built-in online capability, high definition display, and an HD disc drive (in the Xbox 360 and PS3). With the current generation, we also saw a much broader range of high-quality content than was offered with earlier generation machines. The combination of these features, rapid adoption of high-definition television monitors, increased marketing, an aging and more affluent addressable market, and the emergence of the mass-merchandise retailers as a significant distribution channel, in turn drove rapid growth of online multiplayer.

With the emergence of online multiplayer, an ever increasing number of consumers consider themselves “hardcore”, leading us to conclude that the number of households owning more than one console will

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remain close to the rate in the current cycle. We expect the number of consoles owned by each household owning a console to remain at around 1.5 in the next generation. One key driver for multiple console ownership is the increasing segmentation and specialization within the console market. Many families owning a Wii also purchased either a PS3 or Xbox 360 to satisfy different gamers within the household—Wii for young (and old) gamers and PS3 or Xbox 360 for those gamers in between. With the next generation, we think an increasing percentage of PS4 owners will purchase an Xbox One, and vice versa, depending upon the number of exclusive games for each platform. As we believe that the economics of game development will make it more difficult for publishers to offer exclusives to either Microsoft or Sony, we do not anticipate many third party exclusive titles over the next few years. At the same time, first party (Sony and Microsoft) development capability has improved over the past few years, and we anticipate several “killer app” exclusives for each console, such as games like , and Halo from Microsoft and God of War , Gran Turismo and from Sony.

We speculate that competition for market share will drive console prices lower over the next few years. At launch, Microsoft priced the fully equipped Xbox One at $499.99, and Sony priced its console at $399.99. Sony learned its lesson from the current generation cycle, and priced the PS4 competitively, while Microsoft determined that the value proposition (not to mention the manufacturing cost) of the Xbox One (which includes Kinect) justified its higher price. We expect the price point for the Xbox One to come down to $399.99 as soon as manufacturing efficiencies permit, but think that a cut to this likely will not occur until 2015. As we expect the Xbox One to remain priced at least $50 higher than the PS4 (we think Sony will match Microsoft with price cuts of its own), Microsoft must convince consumers that the premium is justified. We believe that a large percentage of customers will make their console purchase decision based upon price, and think that so long as the PS4 has a price advantage over the Xbox One, it will sell a greater number of units. We expect both Sony and Microsoft to cut the prices of the PS3 and Xbox 360 before this holiday, as we believe both manufacturers understand that late adopters of current generation technology are likely to become late adopters of their respective next generation consoles, as well.

Nintendo is likely to lag far behind its competitors in the next generation, as the Wii U has not resonated with consumers. Notwithstanding the current price of the Wii U, priced at $299.99, including the Nintendo Land game, the console is not selling well. The Wii U does not have mass appeal, and thus far, Nintendo has done a poor job of supporting its console with compelling software. We expect another price cut for the Wii U to $249.99 later this year, but ultimately think that the console is doomed to a distant third place in the console wars.

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Figure 23: Console Unit Sales U.S. and Europe (2003 – 2016E)

U.S. Hardware Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 1.1 0.7 0.0 N64 0.0 PlayStation2 6.3 4.6 5.5 4.7 4.0 2.5 1.8 0.7 0.2 PS3 0.7 2.5 3.5 4.2 4.7 4.5 3.5 2.4 2.0 1.5 1.0 PS4 2.0 5.0 5.5 6.0 GameCube 3.3 2.3 1.7 0.8 0.2 Wii 1.1 6.4 9.8 9.0 7.4 4.9 2.0 0.8 0.5 Wii U 0.9 1.2 1.2 1.2 1.2 Xbox 3.1 4.0 2.2 0.4 0.0 Xbox 360 0.6 3.8 4.4 4.9 4.8 7.0 7.7 6.3 3.2 2.5 2.0 1.5 Xbox One 1.8 4.5 4.5 5.0 All Other 1.0 0.5 Total Home Console 14.8 12.1 10.1 11.5 17.5 20.7 19.8 19.8 17.3 12.7 11.3 15.7 14.7 14.7 Growth % (18.3%) (16.8%) 14.1% 52.2% 18.3% (4.3%) – (12.7%) (26.6%) (10.9%) 38.9% (6.4%) –

GB Advance/SP 7.8 7.1 4.3 3.2 1.1 DS/DSi 1.2 2.6 5.1 8.8 10.2 10.4 8.4 3.6 1.9 0.6 0.2 3DS 4.1 3.7 4.2 4.5 4.0 3.5 PSP 3.6 3.0 3.6 3.8 2.5 1.8 1.2 0.3 0.1 PS Vita 1.2 0.5 0.5 0.5 0.5 All Other 0.0 0.1 0.1 0.1 Total Portables 7.8 8.4 10.6 11.4 13.5 14.0 12.9 10.2 8.9 7.1 5.4 5.2 4.5 4.0 Growth % 7.7% 25.9% 7.7% 18.4% 3.7% (7.9%) (20.9%) (12.3%) (21.2%) (23.4%) (3.7%) (13.5%) (11.1%)

Total Hardware 22.6 20.5 20.7 22.9 31.0 34.7 32.7 30.0 26.2 19.7 16.7 20.9 19.2 18.7 Growth % (9.4%) 0.7% 10.8% 35.4% 11.9% (5.8%) (8.3%) (12.6%) (24.8%) (15.4%) 25.1% (8.1%) (2.6%)

European Hardware Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 0.5 0.7 0.4 0.2 0.1 0.1 N64 0.1 PlayStation2 7.6 5.8 6.7 4.4 3.8 2.8 1.2 0.7 0.2 PS3 3.4 4.2 4.8 5.3 6.3 5.4 3.7 2.0 2.0 2.0 PS4 2.2 6.5 6.5 6.5 GameCube 1.4 1.6 1.1 0.4 0.1 Wii 0.7 5.1 8.4 6.8 5.7 4.1 2.0 1.0 0.5 Wii U 0.5 0.9 1.0 1.0 1.0 Xbox 2.3 2.7 1.6 0.2 Xbox 360 0.3 1.8 2.0 3.5 3.7 4.1 4.2 3.3 2.4 2.0 1.5 1.0 Xbox One 1.4 4.5 5.0 5.5 All Other Total Home Console 11.9 10.8 10.1 7.7 14.5 19.0 16.5 15.8 14.8 11.2 11.6 16.5 16.0 16.0 Growth % (8.9%) (6.5%) (23.8%) 88.3% 31.0% (13.2%) (4.2%) (6.3%) (24.3%) 3.6% 42.2% (3.0%) –

GB Advance/SP 5.3 5.6 3.5 2.5 1.7 0.1 DS/DSi 2.0 6.0 10.7 11.7 9.5 6.4 3.1 0.7 0.2 3DS 3.6 4.0 5.0 5.0 4.5 4.0 PSP 2.0 3.3 4.1 3.5 2.6 2.3 2.3 1.7 1.5 0.5 PS Vita 1.4 0.9 1.0 1.0 1.0 All Other 0.2 0.3 0.4 0.2 Total Portables 5.5 5.9 7.9 12.0 16.5 15.3 12.1 8.7 9.0 7.8 7.6 6.5 5.5 5.0 Growth % 7.3% 33.9% 51.9% 37.5% (7.3%) (20.9%) (28.1%) 3.4% (13.3%) (2.6%) (14.5%) (15.4%) (9.1%)

Total Hardware 17.4 16.7 18.0 19.7 31.0 34.3 28.6 24.5 23.8 19.0 19.2 23.0 21.5 21.0 Growth % (3.7%) 7.8% 9.4% 57.4% 10.6% (16.6%) (14.3%) (2.9%) (20.2%) 1.1% 19.8% (6.5%) (2.3%)

U.S. and Europe Sales 40.0 37.2 38.7 42.6 62.0 69.0 61.3 54.5 50.0 38.7 35.9 43.9 40.7 39.7 Growth % (6.9%) 3.9% 10.2% 45.5% 11.3% (11.2%) (11.1%) (8.2%) (22.6%) (7.3%) 22.3% (7.3%) (2.5%)

Source(s): The NPD Group and Wedbush Securities estimates.

Entertainment: Software | 84

Figure 24: Console Unit Sales Japan and Worldwide (2003 – 2016E)

Japan Hardware Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 0.1 N64 PlayStation2 3.0 3.0 2.1 1.4 0.8 0.5 0.3 PS3 0.4 1.2 1.0 1.7 1.6 1.5 1.2 1.1 0.5 0.3 0.3 PS4 1.0 2.0 2.0 GameCube 1.0 1.0 0.3 0.1 0.0 Wii 0.8 3.7 2.9 2.0 1.7 0.9 0.5 0.1 Wii U 0.6 0.8 1.0 1.0 1.0 Xbox 0.1 0.2 0.0 Xbox 360 0.1 0.2 0.3 0.3 0.3 0.2 0.1 0.1 0.0 0.2 0.2 0.2 Xbox One 0.2 0.1 0.1 All Other Total Home Console 4.2 4.2 2.5 2.9 6.0 4.7 4.3 3.5 2.5 2.4 2.0 2.9 3.6 3.6 Growth % 0.1% (39.6%) 13.5% 107.8% (21.4%) (8.7%) (18.5%) (28.2%) (5.6%) (16.0%) 44.7% 24.3% –

GB Advance/SP 4.3 2.8 1.3 0.4 0.1 DS/DSi 0.8 4.0 8.2 7.3 4.0 4.0 3.0 0.6 0.1 3DS 4.3 5.5 5.5 6.0 6.5 6.5 PSP 1.5 2.2 1.8 3.1 3.5 2.3 2.9 2.0 0.9 0.5 0.2 PS Vita 0.4 0.7 1.3 1.0 1.0 0.8 All Other Total Portables 4.3 5.1 7.5 10.4 10.5 7.6 6.3 5.9 7.3 7.2 7.3 7.2 7.5 7.3 Growth % 17.1% 48.2% 38.3% 1.2% (27.7%) (16.4%) (7.6%) 24.7% (1.8%) 1.8% (1.4%) 4.2% (2.7%)

Total Hardware 8.5 9.3 10.0 13.2 16.5 12.3 10.6 9.3 9.8 9.5 9.3 10.1 11.1 10.9 Growth % 8.7% 8.3% 32.0% 24.4% (25.4%) (13.4%) (12.0%) 4.9% (2.8%) (2.6%) 8.5% 9.9% (1.8%)

WW Hardware Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 1.7 1.4 0.4 0.2 0.1 0.1 N64 0.1 PlayStation2 16.9 13.4 14.4 10.5 8.6 5.8 3.3 1.4 0.4 PS3 1.1 7.1 8.7 10.7 11.6 12.3 10.1 7.2 4.5 3.8 3.3 PS4 4.2 12.5 14.0 14.5 GameCube 5.7 4.9 3.1 1.3 0.3 Wii 2.6 15.2 21.1 17.8 14.8 9.9 4.5 1.8 1.0 Wii U 2.0 2.9 3.2 3.2 3.2 Xbox 5.5 6.9 3.9 0.6 0.0 Xbox 360 1.0 5.8 6.7 8.7 8.8 11.3 12.0 9.7 5.6 4.7 3.7 2.7 Xbox One 3.2 9.2 9.6 10.6 All Other 1.0 0.5 Total Home Console 30.9 27.1 22.7 22.1 38.0 44.4 40.6 39.1 34.6 26.3 24.9 35.1 34.3 34.3 Growth % (12.2%) (16.2%) (2.8%) 72.0% 16.9% (8.6%) (3.7%) (11.5%) (24.1%) (5.2%) 40.9% (2.3%) –

GB Advance/SP 17.4 15.5 9.0 6.1 2.9 0.1 DS/DSi 2.0 8.6 19.3 26.8 25.9 23.9 17.8 7.3 2.7 0.8 0.2 3DS 12.0 13.2 14.7 15.5 15.0 14.0 PSP 1.5 7.9 8.1 10.8 10.8 7.4 7.0 5.5 2.9 2.1 0.7 PS Vita 0.4 3.3 2.7 2.5 2.5 2.3 All Other 0.2 0.4 0.5 0.3 Total Portables 17.6 19.4 26.0 33.8 40.5 36.9 31.3 24.8 25.2 22.0 20.3 18.9 17.5 16.3 Growth % 9.9% 34.1% 30.0% 19.9% (8.9%) (15.0%) (21.0%) 2.0% (12.8%) (7.8%) (6.9%) (7.4%) (6.9%)

Total Hardware 48.5 46.5 48.7 55.4 74.5 79.9 70.7 61.1 59.1 29.3 67.9 63.0 91.2 Growth % (4.2%) 4.7% 13.7% 34.6% 7.2% (11.4%) (13.6%) (3.3%) (50.5%) 132.0% (7.2%) 44.8%

Source(s): Wedbush Securities estimates.

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Figure 25: Console Dollar Sales U.S. and Europe (2003 – 2016E)

U.S. Hardware Sales ($mm) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $73 $36 $2 N64 $0 PlayStation2/PS2 $1,186 $726 $823 $627 $523 $326 $190 $70 $19 PS3 $404 $1,257 $1,462 $1,408 $1,492 $1,280 $918 $612 $398 $224 $149 PS4 $806 $2,000 $1,925 $1,800 GameCube $362 $228 $163 $77 $19 Wii $274 $1,585 $2,457 $1,968 $1,441 $768 $268 $92 $50 Wii U $305 $352 $299 $239 $179 Xbox $559 $612 $344 $69 Xbox 360 $231 $1,463 $1,655 $1,470 $1,309 $1,894 $2,178 $1,616 $704 $498 $298 $224 Xbox One $900 $2,138 $1,800 $1,750 All Other $55 $20 $0 Total Home Console $2,237 $1,622 $1,565 $2,913 $5,040 $5,715 $4,874 $4,897 $4,245 $3,108 $3,465 $5,381 $4,485 $4,101 Growth % (27.5%) (3.5%) 86.2% 73.0% 13.4% (14.7%) 0.5% (13.3%) (26.8%) 11.5% 55.3% (16.7%) (8.6%)

GB Advance/SP $716 $599 $329 $248 $86 DS/DSi $182 $356 $656 $1,153 $1,338 $1,551 $1,308 $532 $214 $59 $16 3DS $755 $633 $727 $581 $476 $347 PSP $911 $679 $680 $712 $479 $325 $170 $35 $10 PS Vita $304 $110 $95 $90 $90 All Other $7 $13 $13 $13 Total Portables $724 $794 $1,609 $1,595 $1,919 $2,050 $2,030 $1,633 $1,457 $1,185 $905 $691 $566 $436 Growth % 9.7% 102.7% (0.9%) 20.3% 6.8% (1.0%) (19.6%) (10.7%) (18.7%) (23.6%) (23.7%) (18.1%) (22.9%)

Total Hardware $2,960 $2,416 $3,174 $4,509 $6,959 $7,765 $6,904 $6,529 $5,703 $4,292 $4,371 $6,072 $5,051 $4,537 Growth % (18.4%) 31.4% 42.0% 54.3% 11.6% (11.1%) (5.4%) (12.7%) (24.7%) 1.8% 38.9% (16.8%) (10.2%)

Europe Hardware Sales ($mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $38 $34 $20 $10 $5 $5 N64 $4 PlayStation2/PS2 $1,710 $1,154 $1,199 $656 $490 $361 $119 $81 $23 PS3 $2,380 $2,306 $1,915 $1,829 $2,048 $1,512 $921 $398 $298 $298 PS4 $880 $2,600 $2,275 $1,950 GameCube $189 $158 $109 $32 $7 Wii $238 $1,428 $2,512 $1,693 $1,169 $689 $298 $138 $50 Wii U $200 $314 $299 $249 $199 Xbox $518 $456 $238 $30 Xbox 360 $120 $718 $758 $1,152 $1,055 $1,169 $1,155 $822 $670 $458 $269 $129 Xbox One $770 $2,363 $2,250 $2,200 All Other Total Home Console $2,458 $1,803 $1,686 $1,683 $5,068 $6,335 $4,782 $4,246 $3,914 $2,831 $3,693 $6,167 $5,341 $4,776 Growth % (26.6%) (6.5%) (0.2%) 201.1% 25.0% (24.5%) (11.2%) (7.8%) (27.7%) 30.4% 67.0% (13.4%) (10.6%)

GB Advance/SP $583 $476 $263 $175 $85 $4 DS/DSi $270 $774 $1,380 $1,509 $1,416 $1,062 $512 $90 $24 3DS PSP $558 $690 $816 $662 $439 $472 $343 $235 $173 $58 PS Vita $391 $224 $209 $199 $189 All Other $40 $48 $48 $20 $796 $850 $700 $585 $480 Total Portables $623 $524 $1,138 $1,659 $2,281 $2,175 $1,855 $1,534 $854 $1,512 $1,270 $967 $784 $669 Growth % (15.9%) 117.3% 45.7% 37.5% (4.7%) (14.7%) (17.3%) (44.3%) 76.9% (16.0%) (23.9%) (18.9%) (14.7%)

Total Hardware $3,080 $2,327 $2,824 $3,342 $7,349 $8,510 $6,637 $5,780 $4,769 $4,343 $4,963 $7,134 $6,125 $5,445 Growth % (24.5%) 21.4% 18.3% 119.9% 15.8% (22.0%) (12.9%) (17.5%) (8.9%) 14.3% 43.7% (14.1%) (11.1%)

U.S. and Europe Sales $6,041 $4,743 $5,999 $7,850 $14,308 $16,274 $13,541 $12,309 $10,471 $8,635 $9,334 $13,206 $11,175 $9,982 Growth % (21.5%) 26.5% 30.9% 82.3% 13.7% (16.8%) (9.1%) (14.9%) (17.5%) 8.1% 41.5% (15.4%) (10.7%)

Source(s): The NPD Group and Wedbush Securities estimates.

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Figure 26: Console Dollar Sales Japan and Worldwide (2003 – 2016E)

Japan Hardware Sales ($mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $5 N64 PlayStation2/PS2 $674 $585 $318 $140 $40 $24 PS3 $243 $706 $495 $689 $553 $450 $330 $274 $100 $45 $39 PS4 $400 $700 $600 GameCube $156 $119 $30 $6 $1 Wii $247 $990 $666 $452 $432 $161 $65 $7 Wii U $210 $260 $300 $250 $200 Xbox $23 $36 $2 Xbox 360 $31 $68 $94 $103 $100 $71 $25 $14 $4 $36 $36 $36 Xbox One $100 $45 $40 All Other Total Home Console $857 $740 $381 $703 $1,830 $1,288 $1,241 $1,056 $636 $618 $545 $935 $1,076 $915 Growth % (13.6%) (48.5%) 84.3% 160.4% (29.7%) (3.6%) (14.9%) (39.8%) (2.7%) (11.9%) 71.7% 15.0% (15.0%)

GB Advance/SP $367 $277 $112 $25 $3 DS/DSi $112 $548 $1,058 $958 $544 $600 $504 $77 $8 3DS $882 $935 $825 $780 $715 $715 PSP $449 $532 $372 $587 $528 $404 $506 $258 $105 $50 $20 PS Vita $100 $160 $259 $179 $159 $103 All Other Total Portables $367 $837 $1,192 $1,456 $1,548 $1,072 $1,004 $1,009 $1,317 $1,209 $1,133 $979 $874 $818 Growth % 128% 42% 22% 6% -31% -6% 1% 30% -8% -6% -14% -11% -6%

Total Hardware $1,224 $1,577 $1,573 $2,159 $3,378 $2,359 $2,245 $2,066 $1,952 $1,827 $1,678 $1,914 $1,950 $1,733 Growth % 28.9% (0.3%) 37.2% 56.5% (30.2%) (4.9%) (8.0%) (5.5%) (6.4%) (8.2%) 14.1% 1.8% (11.1%)

WW Hardware Sales ($mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $115 $70 $22 $10 $5 $5 N64 $4 PlayStation2/PS2 $3,570 $2,465 $2,341 $1,422 $1,053 $711 $309 $150 $42 PS3 $646 $4,343 $4,262 $4,012 $3,873 $3,778 $2,760 $1,807 $896 $566 $486 PS4 $1,686 $5,000 $4,900 $4,350 GameCube $707 $505 $302 $115 $27 Wii $759 $4,003 $5,635 $4,113 $3,042 $1,617 $631 $236 $99 Wii U $715 $926 $898 $738 $578 Xbox $1,099 $1,104 $585 $99 Xbox 360 $383 $2,249 $2,507 $2,725 $2,463 $3,133 $3,358 $2,451 $1,378 $991 $602 $388 Xbox One $1,670 $4,600 $4,095 $3,990 All Other $55 $20 $0 Total Home Console $5,551 $4,165 $3,633 $5,299 $11,938 $13,338 $10,897 $10,199 $8,795 $6,557 $7,703 $12,484 $10,901 $9,792 Growth % (25.0%) (12.8%) 45.9% 125.3% 11.7% (18.3%) (6.4%) (13.8%) (25.4%) 17.5% 62.1% (12.7%) (10.2%)

GB Advance/SP $1,666 $1,353 $704 $449 $174 $4 DS/DSi $294 $1,175 $2,488 $3,492 $3,391 $3,566 $2,874 $1,120 $312 $83 $16 3DS $1,637 $1,568 $1,552 $1,361 $1,191 1061.5 PSP $449 $2,001 $1,740 $2,083 $1,901 $1,323 $1,302 $771 $375 $232 $77 PS Vita $100 $854 $592 $483 $448 381.7 All Other $47 $60 $60 $32 $796 $850 $700 $585 480 Total Portables $1,713 $2,155 $3,939 $4,710 $5,748 $5,296 $4,889 $4,176 $3,628 $3,905 $3,309 $2,636 $2,224 $1,923 Growth % 25.8% 82.8% 19.5% 22.1% (7.9%) (7.7%) (14.6%) (13.1%) 7.6% (15.3%) (20.3%) (15.7%) (13.5%)

Total Hardware $7,264 $6,320 $7,572 $10,009 $17,686 $18,634 $15,786 $14,375 $12,424 $10,462 $11,012 $15,120 $13,125 $11,715 Growth % (13.0%) 19.8% 32.2% 76.7% 5.4% (15.3%) (8.9%) (13.6%) (15.8%) 5.3% 37.3% (13.2%) (10.7%)

Source(s): Wedbush Securities estimates.

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PERSONAL COMPUTER VIDEO GAMES

The PC games market is fragmented, and tracking it is difficult because an estimated 70% of all sales are through digital downloads. We do not include sales of PC hardware or peripherals in our industry hardware definition, as most PC owners own the machines for other purposes. However, we do include packaged PC software sales in our software industry numbers, as these represent a significant slice of the software market. Software produced for the PC will run on compatible computer equipped with the minimum system requirements. Currently, the overwhelming majority of PC games are made for Windows-based PCs, while relatively few are sold for the Mac or Linux-based PC systems. According to the NPD group, in 2013, over 90% of all PC software sold was for Windows-based computer systems.

We estimate that packaged PC game sales totaled $350 million in North America in 2013, down 50% in just five years. However, we think that PC game software has actually seen a resurgence, with download services such as Steam capturing over 70% of game sales, implying that the U.S. figure is actually over $1 billion including downloads. Worldwide, we estimate that packaged PC game sales totaled $1.27 billion in 2013; if our assumption about download market share of 70% is applied to global sales, this implies that overall PC software sales were around $4.2 billion, or around 30% as large as the console and handheld software market. Packaged PC game software sales have trended downward for 13 years, roughly coinciding with the increasing adoption of broadband Internet, but if our overall estimate of sales is close to the mark, the PC software market is at its highest point ever, and appears to be growing. The following figure illustrates actual and estimated packaged PC game sales by major geographic market for the 2004 – 2016 period.

Figure 27: PC Entertainment Software Sales (2004 – 2016E)

$4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 2004 2006 2008 2010 2012 2014E 2016E

Japan North America Europe Worldwide

Source(s): Wedbush Securities estimates.

Demand for PC software is driven by three trends: (1) gains from rising home PC penetration; (2) gains from an increasing percentage of PC owners who play games; and (3) losses from the shift in PC gamers toward console games as console penetration increases. NPD reports that home PC penetration rates increased from 39% in 1996 to 93% in 2013. Home PC penetration undoubtedly grew due to, among other things, the continued reduction of PC prices, desirability of connecting to the Internet and, more important for the game industry, the lowering of costs associated with graphics cards, high-end monitors, and sound systems. We estimate that the average price of a fully loaded desktop computer has fallen 80%, to below $400, over the past 13 years. As better technology at lower cost is available to a greater number of PC owners, an increasing number of high-quality games has lured more PC owners

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into the gaming community. A 1998 survey by IDC indicated that 76% of all PC households have someone who uses the computer to play games. We think that the mass appeal of free-to-play casual and social games has grown this figure to something approaching 90% of PC households.

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SOFTWARE ECONOMICS

This section of our report analyzes the two main components that determine gross margin for publishers, video game pricing and video game production costs.

Retail Pricing Trends We expect pricing for next generation software to remain at $60 for new releases throughout the cycle. Video game software is sold in the U.S. market at prices between $5 and $70 per game, with higher price points for specialty bundles that include controllers (such as Guitar Hero and Rock Band ). Most new games made for current generation consoles are priced in the $40 – 60 range, and games for next generation consoles are priced at $59.99, with higher price points for “collectors’ editions”. PC games on the CD-ROM format are inexpensive to manufacture, and tend to have the lowest price points, averaging $25 or so. Games sold on DVD (Wii/Wii U, PS3/PS4 and Xbox 360/Xbox One) are slightly more expensive to create and purchase. Nintendo sells games using flash memory for the 3DS, with a slightly higher manufacturing cost. Sony’s PS Vita uses a proprietary flash format, also with manufacturing costs higher than DVD costs. The following figure illustrates the average retail U.S. prices between 2000 – 2016 for software sold on various hardware platforms.

Figure 28: Average U.S. Retail Software Price by Platform $70 PlayStation $60 GB Advance/SP DS/DSi $50 3DS PSP $40 PS Vita PlayStation2/PS2 $30 Xbox GameCube

PS3 $20 Xbox 360

Wii $10 Wii U

PS4

$0 Xbox One

Weighted ASP 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E Source(s): Wedbush Securities estimates.

In the past, average selling prices (ASPs) for console games trended down over the first four years following console launch. Through 2005, launch prices for new titles held steady at the $49.99 price point for AAA titles, $39.99 for most casual titles, and $29.99 for most budget titles, with the number of new titles introduced each year holding steady at around 850 SKUs. As of 2013, most front-line titles for the current generation remained priced at $59.99, showing no erosion in front-line pricing during the eight years of the current generation console cycle. The reason ASPs come down over time has nothing to do with discounting of new releases; rather, it is attributable to an increasing mix of catalog titles, which are customarily discounted by $20 – 40 within two years of release. We believe that high development costs for next generation games are likely to keep game pricing high for longer than in the past in order to allow the publishers to recoup their investment and to maximize revenues. The average life of a new game is over a year, with price cuts occurring infrequently unless the game is selling poorly. As an example, in the 128-bit cycle, a game like Madden NFL Football might debut in August at $49.99, drop in price after the holidays to $39.99, drop to $29.99 following the Super Bowl, and drop again to $19.99 the following June. In the current generation cycle, pricing for a game like Call of Duty typically remains at $59.99 for more than a year after the game’s fall launch. The publishers have developed

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creative methods to keep new game pricing high, such as offering year-old versions of their games including DLC that has come out over the prior year, and charging full price or more for the bundle.

Average selling prices are important, as all games serve as close substitutes for other games. Thus, if a consumer purchases a console, the publishers should care if the consumer buys two or three old titles for a relatively low price or two or three new titles for full price. The ASP of the prior generation console (32-/64-bit) game declined from $47 in 1997 to $33 in 2000. The ASP for PS2 software in 2000 was $49.14 per game, consistent with the PlayStation One’s average price during its launch phase, and pricing increased following the launches of the GameCube and Xbox a year later. The ASP for last generation console games dropped from $49.14 in 2000 to $30.02 in 2006 as a proliferation of older “greatest hits” titles attracted consumer attention at $20 price points.

We saw dramatic price increases for current generation software since launch, with most games launching at a $59.99 price point ($49.99 for Wii games), and handheld and portable games launching at $29.99 – 39.99. Thus far, eight years into the current generation, ASPs for PS3 games were $44.72, while Xbox 360 and Wii games were $43.30 and $29.49, respectively. The ASP for all console and handheld games in 2013 was $40.41, up a full $10 over the ASP in 2006.

It is important to note that in the current generation cycle, the typical “half-life” of a title is only three months, so 75% of all units were typically sold within the title’s first six months. With few exceptions, this all but guarantees that average selling prices for most games will remain very high.

We expect premium games for the next generation console cycle to maintain pricing for a majority of units, keeping the ASP high. We expect the number of games produced each year to remain relatively constant, due to the economics of game development and the contraction of the publisher community over the past few years. We expect discounting will be similar to past practices, and expect ASPs to grow initially to over $45 by 2016, then to revert back to around $40 by 2020.

The average price of PC games has moderated over the last twelve years at an average of around $28 – 29. We believe that lower PC software pricing is due to competition from better marketed software products available for the consoles at the high end, and competition from piracy. We believe that the stability in average pricing is attributable to a shift of budget titles now available for consoles through PlayStation Network and Xbox Live Arcade. We note that our PC game pricing estimates do not include game downloads from the Internet. We expect to see PC game average selling prices remain at around $29/unit.

We believe that ASPs will decrease only slightly over time, similar to the rate of decline in the current generation cycle. We think that the line from the previous figure that best illustrates this point is “weighted ASP all”. This line reflects the average selling price for all games, whether produced for the PC, legacy consoles, handhelds, portables, legacy generation consoles or current generation consoles. Between 2000 and 2006, the weighted ASP all fluctuated between $31.11 and $28.55, averaging $29.89. As of the end of 2013, weighted ASP all rose to $39.57, down from its peak of $40.49 during the music game era, but holding steady for the last five years or so. Going forward, we expect to see an increase in weighted ASP all to $44.36 by 2016, and then a relatively slow decline back to current levels by 2020.

We strongly believe that weighted average selling prices of all games is the most accurate barometer of retail pricing trends, and note the trend has been toward price increases, rather than toward price declines. In our view, all video games (regardless of platform) are close substitutes for all other video games. Further, as was discussed more fully in our industry report 11 years ago (see Myth #6—Average Selling Prices Always Decline Over Time), we believe that as the current and next generation consoles required significant increases in development spending, a portion of the higher costs must be passed through to consumers in the form of higher ASPs.

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There are only three drivers for a reduction in retail pricing, in our view: a decline in the economics of software production (the “supply” side); increasing competition; or erosion in consumer demand at current price points (the “demand” side). We do not believe that any of the three drivers are present or will arise over the next few years, for the following reasons.

On the supply side, we see no signs that software economics are improving dramatically for the publishers. In the PS1 cycle, Sony’s first-party titles were among the best sellers, and it was the dominant software publisher. The company was also in a position to discount its manufacturer’s software royalty at will in order to induce third-party publishers to write software for its PS1. As Sony chose to cut pricing on software during the PS1 cycle, we believe other publishers felt compelled to follow suit. In the current cycle, Sony is one of many publishers, with a market share smaller than each of the four largest U.S. and European publishers. Sony has adopted the “razor and razor blades” business model, historically selling PS Ones, PS2s and PS3s at a very low margin in order to profit immensely from software royalties paid by third parties. We see no indication that Sony is willing to discount the royalty, except in cases where a game has achieved “greatest hits” status (more than 400,000 units sold), or where an exclusive on a Sony platform is offered (such as was the case for Grand Theft Auto: San Andreas ). This logic applies equally to Microsoft, which also has smaller market share on its Xbox 360 and Xbox One consoles than the four largest publishers.

We also see no sign that research and development costs are coming down. Current and next generation video games cost dramatically more than prior generation titles to produce, given more intense graphics and much more demanding specs for the consoles. Over the first few years of the current cycle, we saw publishers spending more and more in development, with each trying to build the “perfect” game. Of course, during the 128-bit cycle, retail prices came down by $10 per unit a mere 10 months into the cycle. We note that the average PS1 game cost somewhere around $750,000 to produce. Spread over 250,000 units, the R&D cost was only $3/unit. In the 128-bit cycle, the average game cost was around $2.8 million (increasing to $4 – 5 million in 2004 and 2005). Spread over the same 250,000 units, the R&D cost is $11/unit. In the current generation, games cost an average of $20 million to produce, meaning that the cost for a 250,000-unit seller will be a staggering $80 per unit; this makes it uneconomical to produce a game unless the game projects to sales of 3 million units or more. At this level of development cost, publishers have opted to pass on games with marginal prospects, limiting the number of games produced and placing greater emphasis on established brands and sequels. One way to insulate publishers against the risks of poor sales was to raise the retail price of current generation games.

Also on the supply side, we see ever-increasing license fees for the rights to a familiar figure or brand. We understand that the first Tony Hawk game (in the 1990s) cost publisher Activision a mere 50¢ in license fees per unit. Activision’s cost of the Spider-Man 3 license was several times that figure (an estimated $3/unit), and the average motion picture license in the current generation approached 15 – 20% of sales, leading to lack of profits (and ultimately, bankruptcy) for companies like THQ that were dependent upon licensed properties. A $60 retail game that wholesales for $48 could command a royalty of between $7.20 and $9.60 per unit, eroding profits on most licensed games. As a result, we have seen a dramatic decline in the number of licensed game properties, with recent terminations of long-time licenses from college football and due to their respective publishers’ lack of profits from the licensed games.

On the competitive front, we also see no indication of pricing pressure. Most games do not compete head-to-head, and there was no reason to believe that a consumer with $120 wouldn’t purchase two games from different genres if both are compelling. If one or the other were discounted, we believe it unlikely that the consumer would expect that both should be discounted. It is true that some games, notably sports and racing titles, do compete head-to-head. Because of this, it is common to see early discounting of competitive games. This was the case at holiday 2013 for pricing on EA’s and Activision’s Call of Duty Ghosts , with both games cut to $40 during Black Friday weekend. Pricing for both reverted to $60 shortly thereafter, however.

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We expect the average publisher cost of a video game for current generation games to be approximately $19 – 33 per unit, consisting of $12 manufacturing and royalty, $5 – 12 R&D, and $2 – 9 in license fees (the latter two figures will vary based upon the number of units produced). A $59.99 retail title will generally wholesale for $48, resulting in a $15 – 29 (expected value of $22) per unit gross margin to the publisher. If the publisher were to discount the game to $49.99, the wholesale price would drop to $40, and the gross margin would drop to $10 – 23 per unit (expected value of $16.50). We think it highly unlikely that unit sales of such a lower priced game would increase by the 33% necessary to compensate for the reduced margin.

On the demand side, we also see no evidence of pricing pressure. We estimate that the average PS1 game had a rated playing time of 10 hours. This means that if a player was perfect, and never made an error, the game could be completed in 10 hours. Mere mortals typically take as much as four times as long to complete games, so the maximum time a PS1 game could be enjoyed was 40 hours. We estimate that the average PS2 game had a rated playing time of 40 hours, or 160 hours of maximum enjoyment. The most recent installments in the Grand Theft Auto series were approximately 4x as long as the average PS3/Xbox 360 games, and recent increases in online multiplayer have driven average playing time to well over 100 hours.

Another factor that should support retail pricing near current levels is the wide availability of trade-in credits. GameStop allows customers to trade in used games for store credit toward the purchase of a new game. The trade-in supports retail pricing in two ways: first, it increases demand by making new games more affordable ( e.g. , three trade-ins plus $20 instead of $60 cash); and second, it makes the risk of a bad purchase more affordable (the newly purchased game can be exchanged shortly after it is purchased, usually for more than 50% of the price paid).

In addition, the interactive entertainment experience is greater than ever before. The graphics and sound quality of current generation games are an order of magnitude better than in the prior cycle. Finally, we note that the $40 PS1 game of 1997 would cost approximately $58 in 2013 dollars, according to the federal Bureau of Labor Statistics. In 2005, with the introduction of the Xbox 360 and its HD graphics, we saw consumers embrace the $59.99 price point without complaint.

A fourth factor is pressure at retail—we don’t think that publishers will be as susceptible to retail pressure to discount in the future. As game development costs rose in the current and next generation cycles, fewer SKUs were produced; it is important to note that retail shelf space has increased over the last ten years due to dramatic declines in other packaged entertainment sales (especially for music CDs). Of course, retailers have ordered fewer units than in the past, and publishers have become more reliant upon reorders of popular games to drive revenues.

For 2014, we have modeled an overall weighted average retail price increase in the U.S. of $2.76 per unit for video game software. In Europe, we have modeled a $4.00 per unit increase for video game software, primarily due to foreign currency exchange rates.

Production Costs Over time, we expect a decline in the cost of making console games. There are many participants in the video game value chain – hardware manufacturers, licensed content providers, developers, publishers, and retailers – each contributing some added value to the creation and sale of a video game. The amount of compensation that each of these participants receives varies greatly from game to game and impacts the cost of goods sold for these games. The gross margin earned on a particular game by a publisher is a direct function of which players are involved and their level of involvement. For instance, producing Transformers for the PC, PS3, PS4, Xbox 360, Xbox One, Wii, Wii U, PS Vita and 3DS requires widely differing payouts for the various players involved in the creation of each of these games, and the payouts are likely quite a bit higher than payouts on a game such as Need for Speed . The result is that the publisher of the former, Activision, has a very different gross margin on each game, and in

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most cases, the margin will be lower than the margin earned by Electronic Arts on Need for Speed . Although many variables affect which participant gets what share of a game’s revenues, we believe that three most leveraging variables are (1) game platform, (2) content source, and (3) level of developer involvement. Following is a more detailed explanation of how these major variables affect the economics of a game as well as a brief description of some of the other drivers that factor into determining the production costs for a game.

Game Platform A game’s platform is the single biggest variable in determining the ultimate margin a publisher receives for a game. Games developed for dedicated consoles (e.g. , PS3, PS4, PS Vita, Wii, Wii U, 3DS, Xbox 360 and Xbox One) require the approval of the console manufacturer before they are produced and sold. The hardware manufacturer is thus able to control the number of titles produced for the platform, ensure minimum quality standards, and most important, collect the manufacturer’s royalty on the production of the game. The three console manufacturers (Sony, Nintendo, and Microsoft) actually oversee manufacture of the game software to ensure control over the process. Publishers compensate the console companies through a per-game royalty and manufacturing payment. Production costs vary slightly among console manufacturers, with direct costs of around $1 per DVD ($2 charged to the publisher), and a $10 per game net royalty charged for a premium-priced DVD title (the average royalty plus manufacturing charge is typically around 25% of the wholesale price of the game, with some price breaks for volume sales). All platform manufacturers offer tiered rates based on a title’s intended retail price, thus allowing budget titles priced at $19.99 to be profitable. We estimate that the console manufacturers charge approximately $12 per unit to produce a current generation console game (production costs plus manufacturer’s royalty) and approximately $6 – 8.50 per unit for 3DS and PS Vita games. We expect the 25% all-in cost to hold throughout the next generation cycle. There are no manufacturer royalty payments for PC software, and the per title cost of creating a game DVD is approximately $1 including the box art. Distribution costs and reserves for price protection impact the cost of sales by between 0 – 10% of sales, depending upon the game. The cost of sales as a percentage of revenues for the typical console game runs at around 30 – 35% ($14 average cost, including reserve, divided by an expected $45 average wholesale price for a next generation game). The average for the typical handheld game is between 35 – 45% ($10 average cost, including reserve, divided by $29 average wholesale price for 3DS and PS Vita games). Because manufacturing royalties are paid at the time of manufacture and reserves are taken after a game is sold to the retailer, the provision for reserves impacts gross margin without a corresponding benefit on the royalty side.

Content Source The next most leveraging driver in determining the margin on video game software is the source of the game’s content. If a game is based on content licensed from an external party, ( e.g. , sports leagues, movies, television franchises, book, comic book or toy characters), then the game’s publisher will typically pay a royalty of approximately 5 – 20% of gross sales (usually between $3 – 10 per unit) to the content owner. Often, these license arrangements carry a minimum guarantee to the licensor, whereby the licensee promises to pay a fixed dollar amount regardless of the ultimate number of units sold. These guarantees can be quite high, with an estimated $15 – 20 million guarantee from THQ when it produced Pixar titles and an estimated $50 million annual guarantee for the NFL and Major League Baseball licenses. As a result, Take-Two recently terminated its Major League Baseball license when it determined that it was unlikely to make a profit from its MLB game.

Games that are original concepts owned by the publisher generate higher margins because they require no royalty payments. For example, one of Electronic Arts’ most profitable franchises is its wholly owned Sims series, which requires no third-party royalties. Over the past five years, licensed content has become increasingly uncommon as publishers turned to owned franchises and brands to increase profitability in their product portfolios. This began in the middle of the current generation cycle, accelerating as major media companies brought development of many licensed properties in-house. The lack of profits for the publishers for licensed content was due to declines in sales for most licensed properties, as the publishers were increasingly forced to sacrifice development spending in order to

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afford the high royalties charged for licensed content. Only 10 of the 30 best-selling brands in 2013 were based on some form of licensed content (down from 20 in 2004), with five sports titles, WWE , LEGO , Batman , Injustice , and Disney Infinity . The games based on three of the five non-sports brands were produced by the media company owning the brand.

It is important to note that the top three brands ( Grand Theft Auto , Call of Duty and Mario ) are original brands owned by the major publishers. It is clear that publishers understand the operating leverage potential from owned intellectual property, and the centerpiece of most corporate strategies is the creation of new owned I/P.

Development Costs The third key variable adding to the cost of a video game is the cost of development, paid either through internal staff compensation expense or through royalties to third-party developers. Development costs for a video game can vary widely based on the platform and scope of the project. Games built for the DS in the last cycle only cost around $1 million to create, while a game built for the Xbox 360 or PS3 typically costs as much as $20 million to create. We expect the average for next generation games to settle at around $15 million apiece over time, compared to an average development cost for 128-bit console games of $2.5 – 4 million. Sequels built on a pre-existing “engine” (the artificial intelligence that determines how the game’s characters will interact) generally cost less to develop than newly created games, and we expect development costs for next generation games to decline as engines are utilized well into the cycle. As a rule of thumb, we estimate game development costs are budgeted at 20% of a video game’s expected revenues, but the actual percentage depends upon the ultimate success of the underlying game. Whether a game is developed internally or externally will frequently affect how the game’s costs are classified on a publisher’s income statement and how the revenues are shared.

Because a game’s development occurs prior to revenue recognition, a publisher can entirely expense the cost of building a game before any revenues are received (this method of accounting is practiced by Electronic Arts). Publishers can also track specific game development costs, capitalize these costs on the balance sheet, and later amortize the costs as the games are sold (this method is practiced by all other major U.S. and European publishers). Games built internally are much more likely to be expensed rather than capitalized because external developer payments are much easier to track to a particular game. As a general rule, publishers capitalize software development if the development expenditure is incurred in one period and revenues from the developed game are expected to be realized in a different period. As the time for development has expanded with the added complexity of the current generation consoles, more game development costs have been capitalized than ever before. Once capitalized, development costs are amortized under the “units-of-production” method, in which the publisher estimates total unit sales for a particular title, and amortizes a portion of the capitalized development as each unit is sold. For example, a game with $5 million of capitalized development costs that is expected to sell one million units would bear amortization of $5 per unit as the units are sold. Many publishers include amortization of software development in the cost of goods sold line, while others separately state amortization as an expense below the gross profit line.

Even more confusing is the treatment of royalties paid to external developers. Often, external developers are paid upfront fees for the development of the game, and a per-unit royalty for units in excess of a threshold amount. Thus, it is possible for publishers to minimize development costs by allowing the external developers to share in the risks and rewards inherent in any title. If the game is a success, the developer receives a windfall; if not, the developer receives only the fixed payment. These arrangements have an impact on gross margins, as almost all of these expenditures are included in the cost of goods sold.

Despite its impact on the gross margin, classifying external development costs as either “cost of goods sold” or as “research and development” has no impact on the ultimate profitability of a game. In contrast, the revenue-sharing arrangement with an external developer for a particular game may have a significant impact on the game’s profitability. Games built by external developers frequently provide

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incentives that include additional royalty payments if a game’s sales meet a certain threshold level. Extremely successful games built by external developers are generally not as profitable as similarly successful games built by internal studios. The benefit to a publisher of using external developers is typically lower overhead costs and frequently lower overall costs. In addition, external developers are typically less constrained by corporate culture, and are therefore less constrained creatively. Similar to the leverage opportunity with licensed vs. owned intellectual property, the publishers have recognized the opportunity to improve operating margins by migrating toward internal development, and the use of external developers has declined over the past several years.

Other Costs There are other less leveraging costs that factor into the economics of producing video games. Two other costs that frequently lower a publisher’s gross margin are the use of third-party distributors and allowance for returns and price discounts. Most publishers handle the bulk of distribution themselves, but in some territories (primarily international) and with some smaller customers, publishers turn to third- party distributors to warehouse and place their titles on retailer shelves. Third-party distribution typically costs between 7 – 15% of a game’s wholesale price (around $3 – 4 per unit) but usually affects only a small percentage of major publishers’ games. One highly variable factor influencing costs is the allowance for price protection that publishers must provide to retailers. In the video game industry, publishers take the bulk of price risk on the games that they create. Retailers often expect that a game will sell for a predetermined price, and are invoiced at this price. If the game does not sell for the predetermined price, the publisher must provide a credit to the retailer for the difference between the sale price and the predetermined price for all units remaining in the retailer’s inventory. Industry-wide, we estimate that publishers maintain a reserve of 20% of receivables, or approximately 14% of shipped quarterly revenues (wholesale price) as price protection for their games. It is important to note that price protection doesn’t always involve games that aren’t selling well; rather, planned price reductions also carry price protection, for the simple reason that publishers are interested in keeping the channel well- stocked, and must protect retailers when retail prices are cut on older games. Additions to and charges against the price protection reserve are closely guarded secrets among publishers, and we estimate that actual charges for price protection and returns range from 7 – 10% of annual revenues. These numbers can vary widely depending on the specific titles shipped and the publisher’s success in maintaining premium pricing.

The following figure illustrates the impact of these cost variables on a publisher’s gross margin for a hypothetical game produced on the major hardware platforms (excluding third-party distribution and price protection costs).

PC games typically produce the highest gross margin while 3DS games produce the lowest margins. PC games are also less likely to carry any licensed content fees, as more PC games are based on original content than console games. Despite these advantages, PC games rarely achieve the margins indicated in our side-by-side comparison. PC software tends to be distributed through a larger number of small specialty retailers (versus mass-market super stores), resulting in lower inventory turnover and higher product returns. The market for PC games also tends to be more hit-driven than the market for console games, resulting in a few mega-hits and many busts. As a result, PC games are either extremely profitable because of their favorable margins or are marked down to just above development costs. On the other hand, average console games are far more likely to turn a profit than the average PC game. The highly volatile nature of the PC game market has driven almost all publishers to focus on the console market as their primary revenue platform.

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Figure 29: Sample Gross Margin Calculation

Current / Next Gen 128-Bit Downloadable Console DVD Console DVD PC CD-ROM 3DS / DS PS Vita / PSP Content

Retail Price $59.99 $39.99 $49.99 $34.99 $39.99 $9.99

Retailer Take $12.00 $8.00 $10.00 $7.00 $8.00 $3.00 Wholesale Price to Publisher $47.99 $31.99 $39.99 $27.99 $31.99 $6.99

Cost of Goods Sold Manufacturing/Packaging $2.00 $2.00 $2.00 $3.00 $2.00 $0.00

Hardware Royalty Fee $10.00 $6.00 $0.00 $4.00 $5.00 $0.00

Licensed Content Royalties $0 - 9.50 $0 - 6.00 $0 - 8.00 $0 - 6.00 $0 - 6.00 $0 - 1.50

Development Costs $1 - 10.00 $1 - 5.00 $1 - 7.00 $1 - 3.00 $1 - 4.00 $1 - 3.50

Total COGS Low $13.00 $9.00 $3.00 $8.00 $8.00 $1.00 High $31.50 $19.00 $17.00 $16.00 $17.00 $5.00 Average $22.25 $14.00 $10.00 $12.00 $12.50 $3.00

Publisher Gross Proft Margin* High 73% 72% 92% 71% 75% 86% Low 34% 41% 57% 43% 47% 28% Average 54% 56% 75% 57% 61% 57%

*Does not include possible external distributor costs ($3/title) or price protection for returns (7%-10%). Third-Party Distributor $0 - $4.00 $0 - $4.00 $0 - $4.00 $0 - $4.00 $0 - $4.00 $0

Source(s): Wedbush Securities estimates.

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SOFTWARE GENRES

Video games fit into broad categories or ‘genres’, classified by their general subject matter and style of game play. The NPD Group, a firm that tracks retail sales of video games, defines 12 genres: strategy, role-playing, sports, extreme sports, action, adventure, racing, shooter, fighting, simulation, family and children’s (which includes the music genre). These genres are generally recognized throughout the industry as primary game genres, although many sub-categories within these definitions also exist. In addition, many games simply cannot be described by one genre and it is becoming more common to build games that combine elements of many different genres, ( e.g. , fighting/role-playing- games, driving/shooting games, and strategy-simulation games).

Figure 30: U.S. Video Game Software Market by Genre, 2001 – 2013

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Action 17% 24% 23% 26% 25% 21% 18% 16% 16% 19% 16% 20% 33% Adventure 7% 6% 4% 3% 4% 4% 4% 5% 5% 6% 8% 7% 5% Arcade 2% 1% 1% 1% 1% 0% 0% 0% 0% 0% 0% 0% 0% Casual 3% 3% 3% 2% 3% 3% 3% 3% 4% 4% 3% 2% 2% Children's Entertainment 5% 4% 4% 4% 3% 2% 1% 1% 0% 0% 0% 0% 0% Family Entertainment 1% 1% 2% 3% 3% 4% 18% 21% 13% 9% 9% 6% 4% Fighting 4% 6% 6% 5% 4% 4% 4% 5% 4% 3% 4% 4% 4% Flight 3% 2% 2% 1% 1% 1% 1% 0% 0% 0% 1% 0% 0% Racing 11% 8% 9% 8% 10% 9% 6% 7% 5% 5% 5% 5% 4% Role-Playing 8% 7% 8% 10% 9% 11% 8% 6% 6% 8% 9% 9% 7% Shooter 7% 12% 11% 14% 13% 13% 15% 12% 15% 20% 24% 26% 23% Sport Games 20% 18% 18% 17% 17% 18% 14% 16% 22% 18% 16% 17% 14% Strategy 9% 8% 7% 7% 7% 9% 8% 7% 7% 5% 3% 3% 4% Other Games/Compilations 1% 1% 1% 1% 1% 1% 1% 1% 1% 2% 1% 1% 1% None 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Total 100%100%100%100%100%100%100%100%100%100%100%100% 100%

Source(s): The NPD Group and Wedbush Securities estimates.

Despite the subjective nature of classifying games by content and game play, we believe that an analysis of historical trends in gaming genres will lead to useful and interesting conclusions. Demand for games in any particular genre tends to be relatively stable from year to year, but over a multi-year period, definite trends will emerge. Although the overall size of the market for entertainment software has grown substantially and best-selling titles vary tremendously from year to year, demand for certain game genres has remained stable over time, with others showing higher demand and yet others showing lower demand. For example, the strategy/role-playing-game (RPG) genre was the fastest growing genre from 1997 – 2000, with a combined 17% of all game sales, but showed the greatest decline from 2000 – 2013 with only 11% share. We believe that the increased popularity of strategy/RPG games was largely due to the rapid increase in the quality of these games during the 32/64-bit console cycle, and other games caught up in quality during the 128-bit cycle, with realistic shooter gaining the most in popularity in the current generation. As we forecasted 12 years ago, growth rates for several genres reverted to the mean during the last console cycle. Games with a shooter component (the action and shooter genres) experienced the largest market share increase, from 26% in 2000 to 56% of total sales in 2013. The family/children’s genre declined the fastest over the last five years, due to the introduction of the impossibly popular Guitar Hero and Rock Band games followed by their complete collapse. At the peak of popularity in 2008, music-themed games drove the category to 22% market share, and the genre reverted to 4% share in 2013.

The following is a more detailed description of these game genres and our evaluation of future trends.

Strategy/RPG Strategy/Role Playing Games are those in which players’ characters are placed in realistic situations and typically follow a pre-determined storyline. As the storyline progresses, the chosen character is typically

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required to manage resources ( e.g. , money, weapons, armies) to be utilized at some point during the game. The emphasis of a Strategy/RPG game is to manage the character’s actions and build necessary skills in an effort to complete all given tasks. Because of their size and the sheer volume of game play (deep story line and intricate artwork), RPGs are often the most expensive games to develop. RPGs can also take a very long time to develop – typically as long as five years to finish and as much as $60 – 100 million. Past RPGs were tremendously important to the success of a hardware system, particularly in the Japanese market. We believe that a key success factor in Sony’s PlayStation triumph over Nintendo was the decision by since-merged Square ( Final Fantasy series) and Enix ( series) to support Sony rather than Nintendo. Some of the biggest games of all time are RPGs. Square-Enix is now selling the 13th sequel to its Final Fantasy franchise and has sold more than 50 million copies of the franchise worldwide since its debut in Japan in 1987. The thirteenth and fourteenth editions of Final Fantasy came out five years ago, with the last version exclusive to the PS3. Other examples of Strategy/RPG games that are popular in the U.S. include Elder Scrolls , , Fable , , Warcraft , , and Baldur’s Gate .

Figure 31: U.S. Top Video Game Software – Strategy and Role Playing Games

2013 STRATEGY Sales Rank Title Publisher Platform (% of Total) 1 Microsoft Xbox 360 15.1% 2 Animal Crossing: New Leaf Nintendo Nintendo 3DS 12.6% 3 Starcraft II: Heart of the Swarm Expansion Pack (Activision Blizzard) WIN/Mac 7.0% 4 Sim City 2013 Electronic Arts WIN 6.3% 5 : Awakening Nintendo Nintendo 3DS 5.9% 6 Nintendo Wii U 5.0% 7 : University Life Expansion Pack Electronic Arts WIN/Mac 3.2% 8 The Sims 3: Island Paradise Expansion Pack Electronic Arts WIN/Mac 2.2% 9 Starcraft II: Wings of Liberty Blizzard Entertainment (Activision Blizzard) WIN/Mac 2.0% 10 Lego Battles Ninjago Warner Bros. Interactive Nintendo DS 1.9%

2013 Role Playing Game Sales Rank Title Publisher Platform (% of Total) 1 Pokemon X Nintendo Nintendo 3DS 14.2% 2 Pokemon Y Nintendo Nintendo 3DS 13.5% 3 Diablo III Blizzard Entertainment (Activision Blizzard) Xbox 360 6.2% 4 Elder Scrolls V: Skyrim Bethesda Softworks Xbox 360 5.3% 5 Mario & Luigi: Dream Team Nintendo Nintendo 3DS 4.2% 6 Diablo III Blizzard Entertainment (Activision Blizzard) PlayStation 3 4.2% 7 Kingdom Hearts HD 1.5 ReMIX Square Enix Inc PlayStation 3 4.0% 8 Pokemon Black Version 2 Nintendo Nintendo DS 3.9% 9 : Wrath of the White Witch Namco Bandai Games PlayStation 3 3.5% 10 Elder Scrolls V: Skyrim Bethesda Softworks PlayStation 3 3.3%

Source(s): The NPD Group and Wedbush Securities estimates.

The Strategy/RPG game genre has experienced a modest decline in popularity over the last five years, with large sales increases in the late 1990s followed smaller declines in this decade. In the first years following the PS2 launch, RPGs benefited from better graphics and more data storage capability, as faster processors in consoles and PCs allowed for more visually stunning games. The DVD format has allowed for more data in the games, resulting in better graphics, movies, and storytelling, attracting hardcore gamers. Additionally, with increasingly improved fighting and shooting aspects, the RPG genre captured market share from the “fighting” and “shooting” genres late last decade, only to give back market share to these genres over the past four years. We expect the Strategy/RPG genre to maintain a

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high-teen market share over the next five years, as game graphics are dramatically better on current generation consoles.

Sports The Sports category is consistently one of the most popular genres in gaming. Sports games have existed since the earliest days of consoles, and include games that are primarily adaptations or simulations of real-world sporting activities. Successful sports games are valuable franchises for a publisher because the games have excellent potential for recurring revenues. Each year, a publisher can produce a new sequel to a popular sports game, ( e.g. , Madden NFL or FIFA Soccer ), because professional rosters and teams change significantly from year to year. A sequel does not require a complete overhaul of the game every year; rather, the publisher can just add new players, stadiums, and rule changes, thus minimizing development costs. In 2014, we expect sports games to gain some share due to the popularity of FIFA World Cup , but think that the genre will lose share in 2015 and beyond, due to discontinuation of college sports by EA and discontinuation of Major League Baseball by Take-Two.

Figure 32: U.S. Top Video Game Software – Sports

2013 SPORTS Sales Rank Title Publisher Platform (% of Total) 1 Madden NFL 25 Electronic Arts Xbox 360 11.7% 2 Madden NFL 25 Electronic Arts PlayStation 3 7.8% 3 NBA 2K14 Sports (Take 2) Xbox 360 7.4% 4 NBA 2K14 2K Sports (Take 2) PlayStation 3 5.0% 5 NCAA Football 14 Electronic Arts Xbox 360 4.7% 6 FIFA 14 Electronic Arts Xbox 360 4.1% 7 NBA 2K13 2K Sports (Take 2) Xbox 360 4.0% 8 MLB 13: The Show Sony Computer Ent. (Sony) PlayStation 3 3.4% 9 FIFA 14 Electronic Arts PlayStation 3 3.1% 10 NCAA Football 14 Electronic Arts PlayStation 3 3.1%

Source(s): The NPD Group and Wedbush Securities estimates.

Because of predictable demand for the genre, a deep and high-quality library of sports titles will generally launch with a new console. We believe that one of the main reasons Sega’s Dreamcast platform failed was due to Electronic Arts’ decision not to produce any of its extremely popular sports games for that platform. Microsoft recognized the importance of the sports genre to the success of the Xbox, securing Electronic Arts as a third-party publisher that supported its Xbox Live service. Some of the best-selling video games are sports franchises, including Madden NFL , NBA Live / NBA 2K , and FIFA Soccer . We expect the sports category to grow in line with the overall industry. The importance of sports to EA was reinforced in 2004, when the company signed a highly publicized exclusive arrangement with the NFL, adding this license to its other exclusives (including FIFA Soccer ). Competitor Take-Two responded by signing its own semi-exclusive arrangement with Major League Baseball, since discontinued due to lack of profits.

Extreme Sports The extreme sports category was a subset of the overall sports genre, appealing to a slightly different (and smaller) audience than conventional sports games in the last few console cycles. Extreme sports gained some share of overall software sales last decade, as games like Shaun White Snowboarding and Tony Hawk were popular, but faded to almost zero sales in recent years. An extreme sports game typically involves a single player trying to perform tricks or race through a course while sustaining minimal damage. There has been some crossover between the sports and extreme sports lines, with games such as NBA Street , FIFA Street and NFL Street including features of both genres.

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Action/Adventure Action/adventure games are those in which players select a character to control throughout a mission consisting of various shooting, fighting, and sometimes puzzle solving aspects. The difference between an action/ and a strategy/role-playing-game is the former’s emphasis on game play versus the latter’s emphasis on character development. Fast and fun game play is the focus of the action/adventure genre while the strategy/RPG genre stresses decision-making and the game’s storyline. Included within the NPD definition of action/adventure games is the platform/scrolling character genre (such as Super Mario Bros. ), as well as classic action games (such as Spider-Man ) and classic adventure games (such as Resident Evil ). The biggest action/adventure game of all time is probably the Grand Theft Auto series, which causes the category to balloon in popularity every few years when a new installment is released. Action/adventure games are designed to have short learning curves so that players can pick up a game controller and play immediately. This category is the largest single genre over the last decade, and we expect the Action/Adventure genre to maintain market share in the 20 – 25% range over the next five years.

Shooter Another highly descriptive genre title, shooters are simply games in which a character travels through various settings, shooting other characters or objects. Shooters typically come in three varieties, shooters shown looking down the barrel of a gun (first-person shooters), character controlled shooters (third-person shooters), and vehicle shooters (which are far less popular). First-person shooters allow the player to “see” his surroundings through the eyes of his character while third-person shooters provide the player with a view of his character in the character’s surroundings. Vehicle shooters usually provide a third-person perspective of the vehicle so that the player can see his vehicle reacting to the controls.

The shooter genre has maintained its popularity over the past few years, notwithstanding the increased hybridization of Strategy/RPG games that now include a shooter element and that threatened to capture market share from the shooter genre. In addition, conventional wisdom would suggest that as the mass- market audience grows in size relative to the hardcore audience, the significance of this genre shrinks – mass-market gamers have historically not played these games to the same extent as hardcore gamers – however, the mass market has become the hard core market in recent years. The genre was historically popular among a narrow audience – males aged 15 – 30 – but expanded during the current console cycle due to the popularity of shooter games including Call of Duty , Gears of War , Battlefield and Halo .

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Figure 33: U.S. Top Video Game Software – Action / Shooter

2013 ACTION Sales Rank Title Publisher Platform (% of Total) 1 Grand Theft Auto V (Take 2) Xbox 360 16.3% 2 Grand Theft Auto V Rockstar Games (Take 2) PlayStation 3 11.4% 3 Sony Computer Ent. (Sony) PlayStation 3 4.1% 4 Assassin's Creed IV: Black Flag Ubisoft Xbox 360 3.2% 5 God of War: Ascension Sony Computer Ent. (Sony) PlayStation 3 2.1% 6 Assassin's Creed IV: Black Flag Ubisoft PlayStation 3 1.9% 7 Disney Infinity Disney Interactive Studios Xbox 360 1.9% 8 Batman: Arkham Origins Warner Bros. Interactive Xbox 360 1.8% 9 Skylanders SWAP Force Activision (Activision Blizzard) Wii 1.8% 10 Disney Infinity Disney Interactive Studios Wii 1.6%

2013 SHOOTER Sales Rank Title Publisher Platform (% of Total) 1 Call Of Duty: Ghosts Activision (Activision Blizzard) Xbox 360 18.0% 2 Call Of Duty: Ghosts Activision (Activision Blizzard) PlayStation 3 10.2% 3 Battlefield 4 Electronic Arts Xbox 360 6.0% 4 Call of Duty: Black Ops II Activision (Activision Blizzard) Xbox 360 5.5% 5 Call of Duty: Black Ops II Activision (Activision Blizzard) PlayStation 3 3.7% 6 Call Of Duty: Ghosts Activision (Activision Blizzard) Xbox One 3.7% 7 Bioshock Infinite 2K Games (Take 2) Xbox 360 3.7% 8 Call Of Duty: Ghosts Activision (Activision Blizzard) PlayStation 4 3.3% 9 Battlefield 4 Electronic Arts PlayStation 3 3.3% 10 Gears of War: Judgment Microsoft Xbox 360 3.0%

Source(s): The NPD Group and Wedbush Securities estimates.

Racing Racing games place the player in the driver’s seat of some sort of vehicle ( e.g. , car, motorcycle, jet ski, or boat), racing against the clock and/or competitors in an enclosed or defined setting. The racing genre has been around since the earliest video games, and historically was one of the easiest games to produce; however, recent iterations of racing games have included hyper-realistic cars and increasingly real driving simulation. Game play is extremely important in this genre; how the vehicles ‘handle’ in the virtual world determines the level of enjoyment, and players tend to continue to play enjoyable games. Even with enhanced game play, the nature of the racing genre tends to cause gamers to lose interest in racing games more quickly than other genres. Some of the most popular racing games include Gran Turismo , Need for Speed , Burnout , NASCAR , Forza and . The racing genre lost significant market share in the past 13 years, declining from 11% of sales to only 4% in 2013, and we think that it will likely remain a small niche going forward.

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Figure 34: U.S. Top Video Game Software – Racing

2013 RACING Sales Rank Title Publisher Platform (% of Total) 1 5 Microsoft Xbox One 12.4% 2 Nintendo Nintendo 3DS 8.8% 3 Mario Kart Wii Nintendo Wii 6.6% 4 Need For Speed: Rivals Electronic Arts PlayStation 4 6.5% 5 Sony Computer Ent. (Sony) PlayStation 3 4.4% 6 Need for Speed: Most Wanted 2012 Electronic Arts Xbox 360 4.4% 7 Microsoft Xbox 360 4.1% 8 Need for Speed: Most Wanted 2012 Electronic Arts PlayStation 3 3.7% 9 Need For Speed: Rivals Electronic Arts Xbox 360 3.7% 10 Need For Speed: Rivals Electronic Arts Xbox One 3.4%

Source(s): The NPD Group and Wedbush Securities estimates.

Fighting Fighting games involve characters that fight hand-to-hand, usually in a one-on-one situation. NPD includes games under this genre, which has firmed up sales for this genre. Fighting games tend to be most popular with young males ages 10 to 14. Popular Fighting games include the WWE , , Mortal Kombat , Dead or Alive and UFC . With the continued popularity of professional wrestling and the revival of UFC from Electronic Arts, we expect the Fighting genre to grow market share slightly to the 5 – 6% range.

Figure 35: U.S. Top Video Game Software – Fighting

2013 FIGHTING Sales Rank Title Publisher Platform (% of Total) 1 Injustice: Gods Warner Bros. Interactive Xbox 360 19.4% 2 Injustice: Gods Among Us Warner Bros. Interactive PlayStation 3 15.3% 3 WWE 2K14 2K Sports (Take 2) Xbox 360 9.2% 4 WWE 2K14 2K Sports (Take 2) PlayStation 3 7.1% 5 Naruto Shippuden: Ultimate Ninja Storm 3 Namco Bandai Games Xbox 360 5.5% 6 Naruto Shippuden: Ultimate Ninja Storm 3 Namco Bandai Games PlayStation 3 5.2% 7 Super Smash Bros: Brawl Nintendo Wii 4.7% 8 PlayStation All-Stars Battle Royale Sony Computer Ent. (Sony) PlayStation 3 3.0% 9 Mortal Kombat: Komplete Edition Warner Bros. Interactive Xbox 360 2.1% 10 WWE 13 2K Sports (Take 2) Xbox 360 2.0%

Source(s): The NPD Group and Wedbush Securities estimates.

Simulation Simulation games attempt to re-create a realistic situation in a virtual world (note that this category does not include one of the most popular sim games – The Sims – as it is classified as Strategy/RPG). Situations usually involve control of various vehicles such as planes, helicopters, and submarines. The most popular simulation games are designed for the PC. These games are not very time-intensive and usually attract an older audience. We expect this genre to continue to remain relatively small over the next several years.

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Family Entertainment/Children The Family Entertainment genre includes interactive versions of puzzle, board, dancing, music and trivia-based games suitable for people of all ages, as well as games based upon popular children’s characters. Throughout the last decade, many publishers licensed cartoon or book content aimed at children and developed the content into popular games such as Harry Potter , SpongeBob , The Incredibles (note that NPD characterizes Harry Potter and Little Big Planet as Action/Adventure games while SpongeBob falls under the Family/Children’s game). Casino and puzzle games such as Hoyle Casino and Tetris , round out this genre. The growth in this genre in the middle part of the last decade came primarily from music themed games Rock Band and Guitar Hero , requiring players to follow a rock music soundtrack while playing an interactive guitar, drums or microphone. The Children’s category has declined to only 4% share over the last two years, with the dance category responsible for the lion’s share of sales. Music themed games have all but disappeared in the last five years, causing the category to shrink from its peak of 22% market share five years ago to the current 4% share.

Figure 36: U.S. Top Video Game Software – Family / Children

2013 FAMILY / CHILDREN Sales Rank Title Publisher Platform (% of Total) 1 Just Dance 2014 Ubisoft Wii 17.2% 2 Ubisoft Wii 9.0% 3 Just Dance 2014 Ubisoft Xbox 360 5.6% 4 Rocksmith 2014 Ubisoft Xbox 360 4.9% 5 Rocksmith 2014 Ubisoft PlayStation 3 3.6% 6 Island Tour Nintendo Nintendo 3DS 3.6% 7 Just Dance 4 Ubisoft Xbox 360 3.5% 8 Nintendo Wii 3.2% 9 Microsoft Xbox 360 2.1% 10 Just Dance 2014 Ubisoft Wii U 2.1%

Source(s): The NPD Group and Wedbush Securities estimates.

Other Some of the more popular games that we include in the “Other” category include arcade games, such as the Pac-Man series, learning games, and some ex-games. This category also includes a small number of games that are not classified in any genre, usually because the publisher does not include a description of the game and the game play is not obvious to the data-gathering company.

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CONTENT OVERVIEW

Notwithstanding the specific game genre definitions used by the NPD group, we think that it is important to focus on content in a manner useful to investors. Several factors determine overall interactive entertainment software sales. We believe that the primary drivers of software unit volume are (1) the number of consoles sold each year, (2) the installed base of consoles sold in prior periods, and (3) the “tie” ratios of software sales to hardware purchases. Overall software sales are a function of price multiplied by volume, so increases in price per unit will drive sales growth. As discussed in a prior section, front line pricing has increased in the current generation, primarily due to higher starting price points and the introduction of peripheral bundles. We expect software pricing to hold relatively steady over the next few years, with front line games remaining at $59.99 and peripherals and premium editions increasing in number.

Approximately 23 million current and next generation home consoles were sold in the U.S. and Europe in 2013, down 4% from the prior year due to the launch of new consoles and lack of price cuts for the PS3 and Xbox 360. We estimate the installed base in those two regions as of this writing to be approximately 202 million consoles, not counting next generation consoles. As the next generation installed base grows, we expect a reversal of the past five year trend, and we expect to see growth in overall software sales. We note that “tie” ratios slightly exceeded the historic 3.5 – 4 units annually for each current generation console in the first two years following launch (averaging 3.84 units in 2008) but declined to barely over 1 unit per console in 2013. We think that the dominance of the Wii in the current cycle skewed tie ratios late in the cycle, as a large number of Wii owners are more casual players than has historically been the case in past cycles.

As is the case with motion pictures, it is always difficult to determine which titles will be sure-fire “hits,” which will be moderately successful, and which will be “bombs”. This problem is exacerbated by the constant shift in consumer hardware purchase patterns among handhelds, portables, old consoles at discount prices, and new consoles at relatively high prices. There are as many theories as there are forecasts for the successful video game formula, and in this report, we offer yet another thesis.

In our view, content is the primary determinant in the consumer decision to purchase a video game, as well as a driver in the selection of consoles. By “content”, we mean a combination of the game’s brand, game play, genre, target demographic, and “buzz” ( e.g. , online and magazine reviews, word-of-mouth, etc.). We offer a brief summary of these factors below.

Brand A large number of titles produced by U.S. and European publishers have brand identity. By “brand”, we do not mean the publisher’s name ( e.g. , Activision or Electronic Arts), although we acknowledge that the success of similar games sold by a particular publisher can create name recognition for other games sold by the same publisher (as has been the case with Rockstar titles). Rather, we use the term “brand” to refer to the main character or main title of a particular game. For example, we would classify Electronic Arts’ Madden Football as a brand (also known as a franchise).

There are several ways for publishers to brand their content. The most sure-fire way to create a new brand is through licensing. Thus, in the past, brands such as Harry Potter , Lord of the Rings , Transformers , WWE , Cars , Shrek , Spider-Man , and were licensed from the creators of the intellectual property, and provided the licensee immediate recognition with consumers. Through licensing, the publisher can be confident that consumers will feel comfortable in making a game purchase, and therefore more willing to incur the risk of developing the particular title.

Another way to create a brand is by using a celebrity endorser. For example, the Tony Hawk , Madden , Tom Clancy , and Tiger Woods brands all have name recognition that is sufficient to give their respective publishers the confidence to take development risk. This approach was very successful in the

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development of sports and extreme sports games in the past, but its prevalence has lessened in recent years, likely because of increasing royalty rates.

Still another way to create a brand is through the successful sequels of original content. Mario , Zelda , Halo , , Grand Theft Auto , Need for Speed , Mortal Kombat , and Call of Duty are all examples of brands developed by publishers that saw successful sequels launched in the current console cycle.

In the past, the most successful branding strategy was practiced by Electronic Arts. In the 128-bit cycle, the company focused on delivering approximately 40 brands to market each year that either were sequels or had the potential to become sequels. Over the past decade, Electronic Arts licensed the rights to Harry Potter and Lord of the Rings , established the Tiger Woods Golf brand, created the SSX snowboarding, Def Jam , Need for Speed and Medal of Honor brands, and purchased the Sims , Battlefield and Burnout brands. The company saw its escalating development costs and large royalty payments erode its profitability late last decade, and sharply cut the number of licensed properties produced, in turn lessening its dependence upon licensed brands. The company recently obtained the rights to the Star Wars brand, but outside of this one-off opportunity and its sports games, EA is largely focused on owned intellectual properties.

The industry’s other big player, Activision, has largely focused on owned intellectual property with sequel potential. During the last cycle, Activision used the significant cash flow generated from its Tony Hawk brand to launch the extremely successful Spider-Man brand. It then reinvested in creating new wholly owned brands , Call of Duty and Gun . Two of these brands were disappointments, highlighting the risk inherent in creating a brand from the ground up. However, Call of Duty (and its Modern Warfare spin-off) provided the capital necessary to purchase the Guitar Hero brand, and the success of these brands led indirectly to a combination with , owner of the World of Warcraft , StarCraft and Diablo brands. Over the past several years, Activision has focused on its internally developed Skylanders brand and its externally developed Destiny brand to drive future sales growth.

Other publishers tried to create brands with sequel potential, with mixed results. THQ had the most difficult time, with modest success from Saint’s Row , a wholly owned intellectual property, offset by poor performance from sequels to the Juiced , Stuntman and uDraw brands, ultimately leading to the company’s bankruptcy.

Take-Two, on the other hand, has produced mixed, but generally positive results with its branding strategy, producing a string of unsuccessful games based upon licensed strategy, but producing a large number of successful brands from internally developed intellectual property. The company has been able to leverage the huge success of its flagship Grand Theft Auto brand into smaller successes with brands like Civilization , BioShock and Midnight Club , and its management succeeded in changing the company’s strategy.

Perhaps the most successful publisher at reinventing itself is Ubisoft, has established a line of casual brands as well as a hard core brand, with surprising success. The company’s Petz , My Coach and Imagine brands generated €325 million in sales in 2008 from virtually zero just three years prior, then replaced these brands with wholly owned intellectual property Assassin’s Creed and Just Dance driving even higher revenues. We expect Just Dance to ultimately fade, but the company has developed new brands and over the last several years, and we expect continued success.

Game Play All publishers strive to make high-quality games that are fun to play. A bad game with good brand recognition is still a bad game, and poor reviews and word-of-mouth can kill a game’s sales potential (the exception to this rule was Vivendi Games’ 50 Cent , a million unit seller with lower ratings than its title). A large portion of the amount spent to develop a game is dedicated to getting the right look and

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feel, although games produced for the handheld platforms can look comparable to console games with lower overall software development costs due to the small screen size. With the proliferation of big- screen televisions and surround-sound home entertainment systems, a console game with poor graphics or poor sound quality is likely to be a poor seller.

As we noted in our industry report published 12 years ago ( Content is King ), there is a high correlation between a game’s average rating by third-party reviewers and its unit sales. Most games are rated on a 100-point scale, with the average rating hovering around 70. Games rated 80 or higher tend to dominate the best-seller lists, and games rated below 60 are seldom on the best-seller list for more than a few weeks. Each time a publisher releases a sequel to a successful brand, industry pundits quickly note the third-party ratings. A rating of less than 85 for an established franchise brand such as Madden or Call of Duty generally begins the debate about the pending demise of the brand, and in some cases (notably with NBA Live ), declining ratings can lead to a redesign of the game from the ground up.

There is some variability among ratings from different sources, leading to speculation as to whether ratings can be “bought”. While we do not believe this to be the case, we have noted that many reviewers are biased in favor of or against certain games, with review scores easy to predict in advance. For example, most RPG games receive very high scores because most reviewers have an affinity for the genre, while most movie-based games have difficulty receiving scores above 80 because most reviewers find the games predictable. We have also seen reviewers exhibit a tendency to rate sequels more harshly than originals, although there are exceptions for games such as Grand Theft Auto V (“the best game ever”, according to many reviewers). Similarly, most children’s games are rarely taken seriously by reviewers, even though there may be a large market for them. There are exceptions, but on balance, we think that review scores can provide a useful statistic to consider in determining the likely success of a game.

Genre Publishers have historically developed competencies and competitive advantages within specific software genres and gamers tend to stick to familiar genres when purchasing software. Several companies earned well-established reputations for their competency in producing and marketing games targeted at specific genres such as Electronic Arts (sports games), THQ (children’s games), Activision (music and superhero games), and Take-Two (mature-themed games). The decline in the children’s category over the last 10 years is likely the key reason for THQ’s bankruptcy.

Figure 37: Percentage of U.S. Publishing Sales by Genre, 2013 ATVI EA COOL Nintendo TTWO UBI.FP Action 21% 0% 12% 29% 58% 52% Adventure 0% 4% 4% 15% 0% 1% Arcade 0%0% 0% 0% 0% 0% Casual 3%1% 8% 1% 0% 0% Children's Entertainment 0% 0% 0% 0% 0% 0% Family Entertainment 2% 0% 3% 5% 0% 36% Fighting 0% 0% 0% 2% 4% 0% Flight 0%0% 0% 0% 0% 0% Racing 1% 7%11% 7% 1% 0% Role-Playing 5% 2% 0% 30% 0% 0% Shooter 64%29% 1% 0% 11% 9% Sport Games 1%50% 60% 3% 24% 1% Strategy 2% 7% 0% 9% 1% 1% Other Games/Compilations 0% 0% 0% 0% 1% 0% Total 100%100%100% 100%100% 100%

Source(s): The NPD Group and Wedbush Securities estimates.

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We believe that the NPD genres, although generally descriptive of each particular game’s focus, are not suitably descriptive of the potential audience for the game. For example, NPD classifies Take-Two’s WWE brand as a , comparing the brand to other fighting games such as Warner Bros.’ Mortal Kombat and Sega’s . In our view, the typical customer for the WWE brand is a fan of the real-life World Wrestling Entertainment, and has a lot more in common with fans of NASCAR than with fans of fighting. WWE video game customers purchase the game for the same reasons that NFL fans purchase Madden Football ; they like to control a simulated game in which their heroes compete on the small screen. Customers of the Mortal Kombat and Virtua Fighter series are looking for an altogether different gaming experience.

We believe that investors are better served by having the various genres simplified into fewer and more general categories as follows:

Kiddie Content This category includes games targeted at children under the age of 12. The category would include Pokémon , Hannah Montana , Mario Brothers , Shrek , Scooby-Doo , Harry Potter , Pixar titles, SpongeBob and other internally developed and licensed brands targeted at children. Though it is true that many brands such as Mario are enjoyed by a much wider demographic, in our view these brands generate the bulk of their sales by providing family-friendly content that is always safe for play by children. The typical game in this category is built upon the platform/scrolling character model, in which the character traverses a landscape and overcomes various obstacles placed in its way. The object of most kiddie games is to move to ever-higher levels, and the games are typically designed to allow a 10-year old to progress to the end. Because of the relatively simple content, these games are easily developed for the handheld platforms, which are disproportionately owned by small children. To date, titles such as Harry Potter , Mario Galaxy , LEGO and have all been bona fide hits on the current generation consoles. Games included in this category are almost always “E” rated. We believe that the relevant question to ask in determining whether a particular game is a kiddie game is “would grandma buy it for junior as a birthday present?”

Sports This category is better defined by what is NOT included. It does not include extreme sports, nor does it include “edgy” over-the-top sports titles. The category can generally be defined as including family- friendly team and individual sports, including most of the EA Sports and 2K Sports titles. The target audience is truly “everyone”, hence the “E” rating on the label. It is important to draw a distinction between “E”-rated sports games and other “E”-rated content—unlike the “Kiddie” games described above, which are targeted at small children, the “E”-rated sports games are truly aimed at the whole family, and we believe that the typical consumer includes parents as well as children. The object of sports category games is to win the race, score more points than your opponent, or win the boxing match.

Extreme Sports Activision can lay claim to inventing this category with its Tony Hawk brand, although it dropped the license following the failure of its peripheral-based game, Tony Hawk Ride , in 2009. Extreme Sports games are targeted at early teens, although a large percentage of sales is attributable to consumers outside the target audience. These games are “edgy”, and provide an out-of-control gaming experience in which the player is always on the verge of crashing. Content is very important, and almost all U.S. publishers offered a game in this category ( e.g. , Activision with Tony Hawk , Electronic Arts with SSX and its Street games, THQ with MX vs. ATV and Take-Two with Amped ) in the last decade. Following Activision’s termination of its Tony Hawk license and the bankruptcies of Midway and THQ, almost every publisher dropped the category. Acclaim (bankrupted in 2004) had a disastrous experience in trying to raise the bar with its “M”-rated BMX XXX game released in late 2002. The game was a poor seller, with fewer than 200,000 units sold across three platforms. We believe that the inclusion of sexual innuendo and adult humor alienated the core late teen male audience and limited opportunities for purchases by parents as a gift, perhaps contributing to Acclaim’s ultimate bankruptcy. We continue to believe that

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there is consumer demand for games in this category, although the high-profile failure of several publishers may keep the remaining publishers on the sideline for the next few years.

Edgy Content This category includes almost all shooter and fighting games, as well as several crossover-category role-playing, action, and racing games. The games that best describe the category are Take-Two’s Grand Theft Auto games, in which the central character is a criminal sent on various missions. In order to complete the increasingly difficult missions, the character is required to steal cars and money, kill other characters, and avoid the police. Each game is part racing, part shooter, and part role-playing. We also include most shooter games, such as Halo , Call of Duty , Gears of War , Resident Evil and Battlefield in this category and note that one thing these games have in common is that all were blockbusters. On the fighting front, we believe the edgy category includes games in which the object is to kill the opponent in a gory manner, and we therefore include Warner’s Mortal Kombat in the category. There are other titles, like Saint’s Row and that very comfortably fit the “edgy” definition.

All Other It’s easy to lump all of the remaining genres together and leave it at that. This category includes non- edgy action games, such as Activision’s Bond game, role-playing games such as EA’s series, strategy games such as The Sims and Final Fantasy , and resource management games such as Minecraft . These games are aimed at a broader demographic than are kiddie games.

Target Demographic In order to support the more than the expected 92 million next generation consoles in the worldwide installed base at the end of 2016, everyone should be considered as a potential customer. We believe that in the past, many publishers overlooked certain groups in their quest to grow market share. With the success of the Wii, many publishers shifted focus in favor of more casual games, and even hard core games were constructed with the mass market in mind.

In the past, Electronic Arts focused on the entire family with almost all of its product offerings. In the current generation cycle, the company narrowed the number of products it offered, and instead focused more on the hard core with a move into a higher mix of M-rated titles. As a result, only a few of Electronic Arts’ offerings fit within the Kiddie category (most notably the Harry Potter brand, likely now defunct), and several fit within the Edgy category ( and Battlefield ).

Activision, Ubisoft and Take-Two emulated Electronic Arts’ strategy of developing brands susceptible to sequels. Each company has taken a different path, with Activision focused on only a few brands that address the entire market, Ubisoft focused on both mass market and hard core, and Take-Two squarely focused on the Edgy category. Although Electronic Arts, Activision and Ubisoft all were focused on developing brands that allow sequels, each was late in the Edgy category, following the success of Take-Two with its Grand Theft Auto brand. Electronic Arts had real success with Battlefield only a few years ago, and Activision’s Call of Duty brand, while successful almost immediately, didn’t really explode into blockbuster status until 2009. Ubisoft, no stranger to M-rated games with its Tom Clancy series, launched Assassin’s Creed as a new brand in 2007, and has grown the brand to an annual 10 million unit seller in the past few years.

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Figure 38: Percentage of U.S. Software Genre Sales by ESRB Rating, 2013

Role Sport Action Adventure Arcade Casual Children's Family Fighting Flight Racing Playing Shooter Games Strategy Other Not Specified 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 6% Early Childhood 0% 0% 0% 0% 4% 0% 0% 0% 0% 0% 0% 0% 0% 10% Everyone 11% 36% 56% 57% 96% 22% 0% 33% 54% 46% 0% 90% 24% 40% Everyone 10+ 23% 20% 5% 31% 0% 58% 0% 11% 35% 9% 0% 7% 35% 25% Mature 59% 39% 0% 0% 0% 0% 6% 0% 1% 33% 99% 0% 2% 12% Teen 8% 5% 39% 12% 0% 20% 93% 56% 10% 12% 1% 3% 38% 6% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Source(s): The NPD Group and Wedbush Securities estimates.

In our opinion, target demographic is significant for two reasons: first, the largest (and growing) group of consumers, consisting of males ages 16 and older, is interested in edgy content. Over 70% of primary current generation console users fit this demographic and we expect this market share to expand as the PS4 and Xbox One capture share formerly held by the Wii. Because of the relatively high prices for the PS4 and Xbox One, early adopters are squarely within the sights of the edgy content producers. As such, there were not a large number of “E”-rated games for the PS4 or Xbox One at launch, nor are many expected over the next few years. We think that few consumers pay attention to ESRB ratings, but we think that the hard core looks for M-rated titles. Much as the “G”-rated motion picture is an anathema to teens, we believe that the “E”-rated video game can cause a similar aversion to early adopters of the PS4 and Xbox One.

Figure 39: Percentage of U.S. Software Publisher Sales by Ratings, 2013

ATVI EA COOL Nintendo TTWO UBI.FP Not Specified 0% 0% 0% 0% 0% 0% Early Childhood 0% 0% 0% 0% 0% 0% Everyone 6% 46% 61% 85% 24% 6% Everyone 10+ 17% 13% 30% 12% 0% 27% Mature 70% 35% 0% 0% 70% 58% Teen 7% 6% 9% 3% 5% 9% Total 100%100% 100% 100% 100% 100%

Source(s): The NPD Group and Wedbush Securities estimates.

The only companies to focus on “everyone” are Nintendo (with virtually all of its titles), EA and Take-Two with sports titles, and Ubisoft with its Just Dance brand.

We see a trend in growth rates of interactive entertainment software sales when segmented by ESRB rating. Over the last 13 years, the “E” category has declined in popularity, with the “T” and “M” ratings capturing market share. When combined, “T” and “M” have generally captured 50% of game sales each of the last 13 years, peaking at 57% of overall game sales in 2013 while “E” has seen its market share cut in half. We expect the edgy category to maintain its market share this year, with a number of expected “M”-rated titles scheduled for release on current and next generation consoles.

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Figure 40: Percentage of Total U.S. Console Software Sales by Rating, 2001 – 2013

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Not Specified 4% 2% 1% 1% 0% 0% 0% 0% 0% 0% 0% 0% 0% Adults Only 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Early Childhood 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Everyone 58% 50% 50% 48% 43% 40% 38% 39% 43% 41% 34% 31% 27% Everyone 10+ 0% 0% 0% 0% 7% 12% 11% 10% 10% 10% 14% 13% 16% Mature 12% 17% 14% 20% 17% 16% 19% 19% 21% 30% 34% 42% 46% Teen 25% 31% 35% 31% 33% 32% 32% 32% 25% 19% 17% 14% 11% Grand Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Source(s): The NPD Group and Wedbush Securities estimates.

“Buzz” We think that a game’s rating and word-of-mouth are almost as important as brand and game play in the consumer’s purchase decision. This “buzz” can carry a game beyond the ordinary hype surrounding its release, and will position the publisher to create a successful sequel the following year. Consumers can determine a game’s rating from a variety of sources, including and magazines, and most consumers will ask others’ opinions before plunking down $60 for a game.

Publishers, who tend to promote their games aggressively, create much of the “buzz.” The larger publishers advertise on television, and all publishers advertise in print and online. In addition, publishers send copies of games to research analysts (full disclosure—we seldom purchase games from the companies that we cover, and Activision, EA, Ubisoft, Sony, Nintendo, and Microsoft have been especially generous with product), the press, and anyone else who can influence purchase decisions.

We believe that the most influential “buzz”-creating group consists of employees at specialty retailer GameStop. GameStop hires hardcore gamers, and customers are quite comfortable asking their employees about a particular game’s rating and game play. A second source of influence is dedicated gaming magazines, with a combined circulation of over 3 million subscribers. Ratings in these magazines can determine the success or failure of a game. Perhaps even more influential are online ratings, led by IGN/GameSpy, with over 25 million monthly visitors, and GameSpot, with over 15 million visitors. There are two popular websites that aggregate game ratings, .com and .com.

It is important to note that a large percentage of games receiving positive “buzz” fall within the Edgy category. It is common to find four or five of the most popular games on www.GameSpot.com at any given time to be “M”-rated edgy games.

Conclusion We expect sales of interactive entertainment software to increase at an annual growth rate of 14.5% over the next three years. Statistically, it is unlikely that each genre will grow at exactly that rate. We expect the kiddie, and other categories to decline by 5% annually, the sports genre to grow in line with industry growth, and the edgy category to grow as much as 18% annually. We think that there may be a resurgence in the popularity of extreme sports, and expect one or more publishers to identify an opportunity to capture market share by releasing an extreme sports title.

We think that each of the five categories (except for extreme sports) we have listed above currently account for between 5% and 25% of overall video game sales. We expect the following growth rates:

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Kiddie (5%) Sports 15% Extreme Sports0% Edgy 18% Other (5%)

Our bias is obvious: we expect today’s 18 – 35 year olds to drive interactive software sales growth for the next several years. As the boys behind this group grow into young men, they will become bored with kiddie and family-oriented content and will look for more edgy content. We expect strong growth of the edgy category as younger children age and emulate their older brothers.

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SOFTWARE GROWTH FORECAST

With the expected dramatic ramp in sales of next generation hardware, we expect an equally dramatic ramp in console software sales. Our outlook for sales of interactive entertainment software is very positive over the next three years, with industry growth of 50% in the U.S. and Europe. The installed base of next generation consoles is expected to reach 82 million units in the U.S. and Europe by the end of 2016, and we expect annual console sales of over 25 million annually for the next several years. Current generation software sales have declined precipitously over the last five years, lessening the impact of further declines on overall sales growth; we expect current generation software sales to decline by 30% each year for the next three years, to a point where sales are down 82% from peak levels. The following figure illustrates historical and forecasted sales of interactive entertainment software worldwide.

Figure 41: Worldwide Interactive Entertainment Software Sales (2004 – 2016E)

$30,000

$25,000

$20,000

$15,000

$10,000

$5,000

$0

Source(s): Wedbush Securities estimates.

We forecast the worldwide interactive entertainment software market to grow at a 14.0% CAGR from 2013 to 2016, with slower growth in Japan offset by higher growth in the rest of the world.

We expect U.S. and European software sales – the addressable markets for U.S. and European publishers – to grow at a 14.5% CAGR over 2013 – 2016. We expect the U.S. publishers to focus on the console, handheld and European markets over the next three years, as we believe that these will provide the most upside, with some investment in Asian online gaming.

In order to accomplish these growth rates, we believe that the industry must achieve console hardware penetration rates similar to those in the past and must manage the inevitable decline in overall software “tie ratios”. Our forecast assumes strong contribution from sales of software for the current generation consoles and handhelds ( e.g. , Xbox 360, PS3 and Wii), representing approximately 49% of total worldwide console software sales in 2014. We assume that the tie ratios for the current generation consoles will be remain at around 1 unit per console in 2014, and that future declines will continue at a 30% annual rate. At the same time, we expect handheld and portable software sales to be flat for the next three years, reflecting greater hardware penetration and continued loss of software share to mobile phones and tablets. We think that these assumptions are conservative, and think that there is potential for upside, as our estimates presume that many households will have both a current generation console

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and at least one handheld/portable device, and may make purchases for each during this time. Going forward, we expect many households to purchase more than one console, pressuring tie ratios, but expanding the market for software even further.

As discussed in the Hardware Platform section, the combined U.S. and European current generation console installed base was 202 million home console units at the end of 2013. By year-end 2016, we expect some portion of this installed base to continue buying software, and expect purchasers of next generation consoles to buy software at a rate similar to the ramp of the last cycle. We believe that strong demographic fundamentals, additional functionality, increased market segmentation, and much higher marketing spending will increase console penetration rates in this cycle in every major geographic segment. We believe these same drivers will also allow overall software “tie ratios” throughout the industry to remain at around 3.0 annually.

A “tie ratio” is defined as the number of software units sold per hardware unit. All tie ratios are measured over a specific time period, e.g. , the first three months of a system launch, the first year, or the life of a hardware platform. Over the “life-of-platform” for the current generation consoles, we expect tie ratios to hit record levels, as we expect these consoles to have a longer life than in past cycles. The “life-of- platform” tie ratio refers to all software units sold for a platform divided by all hardware units sold for the platform during the platform’s entire lifecycle (usually six to seven years for most consoles, but likely closer to 10 years for the current cycle). Historical tie ratios for the 32-/64-bit console cycle and 128-bit console cycles averaged approximately 11 units of software for each console. Tie ratios during the current cycle declined to just over 9 units, reflecting the more casual nature of the audience and the increasing popularity of online multiplayer. Our forecast projects a total tie ratio of 6.8 units of software for next generation consoles for the period 2012 (the launch of the Wii U) through 2016.

As a result of higher console penetration rates and stable tie ratios, software sales are expected to return to a growth trajectory, but are unlikely to exceed those of the last console cycle. The charts in the following figures illustrate our worldwide forecast for software sales, as well as sales by geographic and platform segments.

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Figure 42: Software Unit Sales U.S. and Europe (2003 – 2016E)

U.S. Software Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 18.4 7.9 2.1 0.4 0.1 N64 0.2 0.0 0.0 Dreamcast 0.1 0.1 0.0 0.0 PlayStation2/PS2 79.6 84.1 76.2 73.5 56.1 40.0 17.5 5.8 1.6 0.8 PS3 1.3 13.7 34.3 40.8 52.6 57.4 48.6 38.8 29.1 21.8 16.4 PS4 4.2 22.6 39.9 56.3 GameCube 23.3 26.2 21.7 17.2 6.0 Wii 3.0 35.3 83.5 90.1 84.3 71.6 44.0 14.6 9.0 3.0 0.5 Wii U 2.3 4.5 9.0 10.3 11.0 Xbox 27.4 42.4 37.3 22.2 7.3 2.0 0.4 0.1 0.1 Xbox 360 2.6 17.9 39.1 60.5 59.3 61.0 63.0 65.0 56.6 42.5 31.9 23.8 Xbox One 4.8 20.4 36.1 50.7 All Other 0.0 0.1 0.4 0.8 0.2 0.1 Total Home Console 149.1 160.7 139.9 135.5 157.7 220.7 208.9 204.0 193.8 160.7 123.5 132.6 143.0 158.7 Growth % 7.8% (12.9%) (3.2%) 16.4% 40.0% (5.3%) (2.4%) (5.0%) (17.1%) (23.2%) 7.4% 7.8% 11.0%

GameBoy/Color 3.3 0.6 0.1 GB Advance/SP 34.0 40.3 32.5 25.1 13.5 0.8 0.1 DS/DSi 1.4 8.2 22.4 36.8 67.6 68.8 56.8 44.7 26.6 9.7 5.5 1.0 3DS 10.4 11.9 15.2 18.8 21.5 22.8 PSP 9.8 14.3 15.7 16.7 15.3 11.8 8.2 2.9 1.7 0.8 PS Vita 3.4 1.9 2.0 1.9 1.7 All Other 0.1 0.1 0.1 0.0 Total Portable 37.4 42.4 50.6 61.8 66.0 85.2 84.2 68.6 63.3 44.8 28.5 27.1 24.4 24.5 Growth % 13.3% 19.5% 22.2% 6.8% 29.0% (1.1%) (18.5%) (7.7%) (29.2%) (36.4%) (4.9%) (9.9%) 0.4%

Total Console 186.5 203.0 190.5 197.3 223.7 305.8 293.1 272.6 257.1 205.5 152.0 159.7 167.4 183.2 Growth % 8.9% (6.2%) 3.6% 13.4% 36.7% (4.1%) (7.0%) (5.7%) (20.1%) (26.0%) 5.1% 4.8% 9.4%

PC Unit Sales 52.8 47.0 38.0 39.8 35.0 29.1 22.7 19.9 15.7 13.1 12.2 15.0 15.0 15.0 Growth % (11.1%) (19.0%) 4.7% (12.0%) (16.8%) (22.1%) (12.3%) (21.2%) (16.6%) (7.0%) 23.2% – –

Total Software 239.3 250.0 228.5 237.1 258.7 335.0 315.8 292.5 272.8 218.6 164.2 174.7 182.4 198.2 Growth % 4.5% (8.6%) 3.8% 9.1% 29.5% (5.7%) (7.4%) (6.7%) (19.9%) (24.9%) 6.4% 4.4% 8.6%

Europe Software Units (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 16.0 6.0 3.0 2.0 1.0 0.5 N64 0.5 0.4 0.3 0.2 Dreamcast 0.5 PlayStation2/PS2 64.2 78.1 77.8 77.8 55.6 32.2 10.0 5.6 1.8 0.4 PS3 13.6 32.8 37.0 42.2 45.6 47.4 38.0 28.5 21.4 16.0 PS4 5.0 28.0 48.6 65.9 GameCube 8.8 12.0 10.9 8.9 2.9 0.3 Wii 1.5 16.9 55.5 49.0 42.0 34.8 18.4 11.3 5.0 1.0 0.5 Wii U 0.9 3.7 6.8 7.9 8.6 Xbox 12.3 22.8 21.0 12.2 4.1 1.2 0.3 Xbox 360 1.5 2.9 13.8 30.8 34.0 36.4 40.3 39.8 34.7 26.0 19.5 14.6 Xbox One 4.2 19.0 36.3 52.6 All Other Total Home Console 102.2 119.2 114.6 105.5 107.8 153.3 130.3 126.2 122.5 106.9 96.9 113.3 134.7 158.2 Growth % 16.6% (3.9%) (7.9%) 2.2% 42.2% (15.0%) (3.2%) (2.9%) (12.7%) (9.4%) 16.9% 18.9% 17.5%

GameBoy/Color 1.0 0.5 0.3 0.2 GB Advance/SP 20.6 26.2 22.5 18.5 9.6 2.0 0.2 DS/DSi 4.5 10.7 26.7 43.5 32.3 28.4 17.5 9.7 7.8 3.5 1.0 3DS 5.7 7.4 11.8 20.1 23.2 24.9 PSP 5.0 5.8 15.9 13.1 9.4 9.9 5.1 2.3 2.3 1.1 PS Vita 2.6 2.3 3.1 3.2 3.4 All Other Total Portable 21.6 26.7 32.3 35.2 52.2 58.6 41.9 38.3 28.3 22.0 24.2 27.8 27.5 28.3 Growth % 23.9% 21.0% 8.9% 48.4% 12.2% (28.4%) (8.7%) (26.1%) (22.3%) 10.0% 14.9% (1.2%) 3.2%

Total Console 123.8 145.9 146.9 140.7 160.1 211.9 172.2 164.5 150.8 128.9 121.1 141.1 162.1 186.6 Growth % 17.9% 0.7% (4.2%) 13.8% 32.4% (18.7%) (4.5%) (8.3%) (14.5%) (6.1%) 16.5% 14.9% 15.1%

PC Unit Sales 66.5 63.5 62.0 60.0 57.5 45.0 40.0 30.0 25.0 25.0 25.0 25.0 25.0 25.0 Growth % (4.5%) (2.4%) (3.2%) (4.2%) (21.7%) (11.1%) (25.0%) (16.7%) – – – – –

Total Software 190.3 209.4 208.9 200.7 217.6 256.9 212.2 194.5 175.8 153.9 146.1 166.1 187.1 211.6 Growth % 10.1% (0.3%) (3.9%) 8.4% 18.1% (17.4%) (8.4%) (9.6%) (12.4%) (5.1%) 13.7% 12.7% 13.1%

U.S. and Europe Sales 429.6 459.4 437.4 437.8 476.3 591.9 528.1 487.0 448.6 372.6 310.3 340.8 369.6 409.8 Growth % 7.0% (4.8%) 0.1% 8.8% 24.3% (10.8%) (7.8%) (7.9%) (17.0%) (16.7%) 9.8% 8.4% 10.9%

Source(s): The NPD Group and Wedbush Securities estimates.

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Figure 43: Software Unit Sales Japan and Worldwide (2003 – 2016E)

Japan Software (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 0.2 N64 Dreamcast PlayStation2/PS2 20.4 16.3 14.8 19.4 10.5 6.3 2.7 0.8 PS3 0.5 3.0 5.5 8.0 10.3 13.4 12.7 14.5 11.0 8.0 5.0 PS4 3.0 8.0 12.5 GameCube 7.3 3.5 2.6 0.6 0.5 Wii 2.0 11.9 14.2 13.3 12.0 8.7 5.0 1.8 Wii U 0.8 2.4 5.0 7.5 9.0 Xbox 0.3 0.2 0.1 Xbox 360 0.1 0.7 1.3 1.9 2.2 2.1 1.9 1.3 1.0 0.6 0.3 Xbox One 0.4 0.9 1.2 All Other Total Home Console 28.2 20.0 17.5 23.2 26.7 28.5 26.2 25.2 24.0 19.8 19.7 20.0 24.7 27.7 Growth % (29.1%) (12.5%) 32.6% 15.1% 6.7% (8.1%) (3.8%) (4.8%) (17.5%) (0.5%) 1.5% 23.5% 12.1%

GameBoy/Color GB Advance/SP 11.5 12.7 4.5 2.7 0.4 DS/DSi 1.7 12.2 37.2 36.7 27.5 26.4 21.9 6.7 4.4 0.4 3DS 7.8 16.9 24.0 30.0 32.0 34.0 PSP 0.7 2.6 5.3 5.7 9.2 8.8 16.5 14.8 8.5 5.0 2.0 1.0 PS Vita 0.4 2.1 4.9 7.5 7.5 7.5 All Other Total Portable 11.5 15.1 19.3 45.2 42.8 36.7 35.2 38.4 29.7 31.9 34.3 39.5 40.5 41.5 Growth % 31.3% 27.8% 134.2% (5.3%) (14.3%) (4.1%) 9.1% (22.7%) 7.4% 7.5% 15.2% 2.5% 2.5%

Total Console 39.7 35.1 36.8 68.4 69.5 65.2 61.4 63.6 53.7 51.7 54.0 59.5 65.2 69.2 Growth % (11.6%) 4.8% 85.9% 1.6% (6.2%) (5.8%) 3.6% (15.6%) (3.7%) 4.4% 10.2% 9.6% 6.1%

PC Unit Sales 8.0 7.8 7.6 7.4 7.3 7.2 7.0 6.5 6.0 5.5 5.0 5.0 5.0 5.0 Growth % (2.5%) (2.6%) (2.6%) (1.4%) (1.4%) (2.8%) (7.1%) (7.7%) (8.3%) (9.1%) – – –

Total Software 47.7 42.9 44.4 75.8 76.8 72.4 68.4 70.1 59.7 57.2 59.0 64.5 70.2 74.2 Growth % (10.1%) 3.5% 70.7% 1.3% (5.7%) (5.5%) 2.5% (14.8%) (4.2%) 3.1% 9.3% 8.8% 5.7%

Worldwide Software (mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation 34.6 13.9 5.1 2.4 1.1 0.5 N64 0.7 0.4 0.3 0.2 Dreamcast 0.6 0.1 0.0 0.0 PlayStation2 164.2 178.5 168.8 170.7 122.2 78.5 30.2 12.2 3.4 1.3 PS3 1.8 30.3 72.6 85.8 105.1 116.4 108.7 91.3 68.6 51.2 37.4 PS4 9.2 53.6 96.5 134.7 GameCube 39.3 41.7 35.1 26.7 8.9 0.8 Wii 6.5 64.1 153.2 152.4 138.3 115.1 67.4 27.7 14.0 4.0 1.0 Wii U 4.0 10.6 20.8 25.7 28.6 Xbox 40.0 65.4 58.4 34.4 11.4 3.3 0.7 0.1 0.1 Xbox 360 4.2 21.5 54.2 93.2 95.5 99.5 105.2 106.1 92.3 69.1 51.7 38.4 Xbox One 9.0 39.7 73.3 104.5 All Other 0.0 0.1 0.4 0.8 0.2 0.1 Total Home Console 279.5 299.9 272.0 264.2 292.2 402.5 365.4 355.4 340.4 287.5 240.1 265.9 302.4 344.6 Growth % 7.3% (9.3%) (2.9%) 10.6% 37.7% (9.2%) (2.8%) (4.2%) (15.5%) (16.5%) 10.7% 13.7% 14.0%

GameBoy/Color 4.3 1.1 0.4 0.2 GB Advance/SP 66.1 79.2 59.5 46.3 23.5 2.8 0.3 DS/DSi 3.1 24.9 70.3 100.2 138.6 127.5 107.1 68.9 40.7 17.9 9.0 2.0 3DS 23.9 36.2 51.0 68.9 76.7 81.7 PSP 0.7 17.4 25.4 37.3 39.0 33.5 38.2 28.1 13.7 9.0 3.9 1.0 PS Vita 0.4 8.1 9.1 12.6 12.7 12.6 All Other 0.1 0.1 0.1 0.1 Total Portable 70.4 84.2 102.2 142.2 161.0 180.4 161.3 145.3 121.3 98.7 87.0 94.4 92.4 94.3 Growth % 19.5% 21.5% 39.1% 13.2% 12.0% (10.6%) (9.9%) (16.5%) (18.6%) (11.9%) 8.5% (2.1%) 2.1%

Total Console 349.9 384.1 374.2 406.4 453.2 582.9 526.8 500.7 461.7 386.2 327.1 360.3 394.8 439.0 Growth % 9.8% (2.6%) 8.6% 11.5% 28.6% (9.6%) (5.0%) (7.8%) (16.4%) (15.3%) 10.2% 9.6% 11.2%

PC Unit Sales 127.3 118.3 107.6 107.2 99.8 81.3 69.7 56.4 46.7 43.6 42.2 45.0 45.0 45.0 Growth % (7.1%) (9.0%) (0.4%) (6.9%) (18.5%) (14.3%) (19.1%) (17.2%) (6.6%) (3.2%) 6.7% – –

Total Software 477.3 502.3 481.8 513.6 553.1 664.3 596.5 557.1 508.3 429.8 369.3 405.3 439.8 484.0 Growth % 5.3% (4.1%) 6.6% 7.7% 20.1% (10.2%) (6.6%) (8.7%) (15.5%) (14.1%) 9.8% 8.5% 10.0%

Source(s): Wedbush Securities estimates.

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Figure 44: Software Dollar Sales U.S. and Europe (2003 – 2016E)

U.S. Software ($ mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $269 $100 $20 $5 $1 – – – – – – – – – N64 $3$0$0 – – – – – –– –– –– Dreamcast $1 $0 $0 $0 – – – – – – – – – – PlayStation2/PS2 $2,810 $2,817 $2,530 $2,304 $1,767 $1,218 $434 $127 $33 $14 – – – – PS3 – – – $77 $817 $1,946 $2,070 $2,575 $2,735 $2,139 $1,735 $1,280 $916 $656 PS4 – – – – – – – – – – $241 $1,267 $2,157 $2,925 GameCube $808 $839 $664 $482 $139 – – – – – – – – – Wii – – – $146 $1,656 $3,993 $4,019 $3,362 $2,348 $1,316 $431 $234 $72 $11 Wii U – – – – – – – – – $119 $214 $414 $451 $462 Xbox $1,008 $1,485 $1,282 $603 $137 $23 $4 $1 – – – – – – Xbox 360 – – $146 $987 $2,276 $3,429 $3,042 $3,070 $2,967 $2,954 $2,451 $1,743 $1,244 $881 Xbox One – – – – – – – – – – $276 $1,181 $2,022 $2,739 All Other $0 – – – $1 $5 $10 $2 $1 – – – – – Total Home Console $4,899 $5,243 $4,642 $4,602 $6,794 $10,613 $9,579 $9,138 $8,084 $6,542 $5,347 $6,119 $6,862 $7,674 Growth % 7.0% (11.5%) (0.9%) 47.6% 56.2% (9.7%) (4.6%) (11.5%) (19.1%) (18.3%) 14.4% 12.1% 11.8%

GameBoy/Color $56 $7 $1 – – – – – – – – – – – GB Advance/SP $846 $949 $744 $519 $250 $11 $1 – – – – – – – DS/DSi – $47 $258 $642 $996 $1,799 $1,759 $1,434 $1,055 $596 $201 $105 $16 – 3DS – – – – – – – – $362 $395 $515 $602 $667 $685 PSP – – $420 $501 $441 $436 $394 $292 $169 $48 $20 $10 – – PS Vita – – – – – – – – – $124 $59 $59 $54 $44 All Other $2 $2 $1 – – $1 – – – – – – – – Total Portable $903 $1,004 $1,424 $1,662 $1,688 $2,247 $2,154 $1,726 $1,586 $1,163 $795 $776 $737 $729 Growth % 11.2% 41.8% 16.7% 1.5% 33.2% (4.2%) (19.9%) (8.1%) (26.7%) (31.6%) (2.5%) (5.0%) (1.0%)

Total Console $5,803 $6,247 $6,066 $6,264 $8,482 $12,860 $11,733 $10,864 $9,669 $7,704 $6,143 $6,895 $7,598 $8,403 Growth % 7.7% (2.9%) 3.3% 35.4% 51.6% (8.8%) (7.4%) (11.0%) (20.3%) (20.3%) 12.2% 10.2% 10.6%

PC Unit Sales $1,221 $1,111 $953 $979 $818 $701 $539 $488 $445 $374 $353 $420 $405 $390 Growth % (9.0%) (14.2%) 2.7% (16.4%) (14.3%) (23.2%) (9.5%) (8.8%) (15.9%) (5.6%) 18.9% (3.6%) (3.7%)

Total Software $7,023 $7,358 $7,019 $7,243 $9,300 $13,562 $12,272 $11,352 $10,114 $8,078 $6,496 $7,315 $8,003 $8,793 Growth % 4.8% (4.6%) 3.2% 28.4% 45.8% (9.5%) (7.5%) (10.9%) (20.1%) (19.6%) 12.6% 9.4% 9.9%

Europe Software ($ mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $272 $90 $30 $16 $15 $9 – – – – – – – – N64 $11 $4 $1 $0 – – – – – – – – – – Dreamcast $10 – – – – – – – – – – – – – PlayStation2/PS2 $2,540 $3,122 $2,879 $2,490 $1,807 $998 $255 $134 $40 $8 – – – – PS3 – – – – $925 $1,902 $1,998 $2,152 $2,234 $2,180 $1,786 $1,311 $963 $688 PS4 – – – – – – – – – – $310 $1,695 $2,867 $3,625 GameCube $345 $456 $370 $267 $72 $6 – – – – – – – – Wii – – – $78 $981 $2,886 $2,303 $1,890 $1,288 $607 $367 $150 $27 $13 Wii U – – – – – – – – – $52 $207 $355 $396 $414 Xbox $493 $911 $801 $366 $89 $12 – – – – – – – – Xbox 360 – – $105 $196 $939 $1,879 $1,785 $1,875 $1,955 $1,871 $1,562 $1,170 $839 $599 Xbox One – – – – – – – – – – $256 $1,157 $2,177 $2,999 All Other – – – – – – – – – – – – – – Total Home Console $3,671 $4,583 $4,187 $3,413 $4,827 $7,692 $6,341 $6,051 $5,516 $4,719 $4,488 $5,838 $7,268 $8,337 Growth % 24.9% (8.6%) (18.5%) 41.4% 59.3% (17.6%) (4.6%) (8.8%) (14.5%) (4.9%) 30.1% 24.5% 14.7%

GameBoy/Color $18 $9 $3 $2 – – – – – – – – – – GB Advance/SP $565 $701 $573 $423 $230 $28 $2 – – – – – – – DS/DSi – – $157 $348 $935 $1,305 $872 $753 $455 $243 $179 $74 $17 – 3DS – – – – – – – – $234 $296 $437 $704 $790 $821 PSP – – $245 $232 $558 $367 $244 $238 $107 $44 $37 $18 – – PS Vita – – – – – – – – – $104 $81 $99 $97 $96 All Other – – – – – – – – – – – – – – Total Portable $583 $710 $978 $1,005 $1,723 $1,700 $1,119 $990 $796 $686 $733 $894 $904 $917 Growth % 21.8% 37.8% 2.7% 71.5% (1.4%) (34.2%) (11.5%) (19.6%) (13.8%) 6.9% 21.9% 1.1% 1.5%

Total Console $4,254 $5,293 $5,165 $4,418 $6,550 $9,391 $7,460 $7,041 $6,312 $5,405 $5,221 $6,731 $8,171 $9,254 Growth % 24.4% (2.4%) (14.5%) 48.3% 43.4% (20.6%) (5.6%) (10.4%) (14.4%) (3.4%) 28.9% 21.4% 13.3%

PC Unit Sales $1,862 $1,969 $1,984 $1,860 $1,696 $1,215 $1,000 $765 $750 $750 $775 $750 $725 $700 Growth % 5.7% 0.8% (6.3%) (8.8%) (28.4%) (17.7%) (23.5%) (2.0%) – 3.3% (3.2%) (3.3%) (3.4%)

Total Software $6,116 $7,262 $7,149 $6,278 $8,247 $10,606 $8,460 $7,806 $7,062 $6,155 $5,996 $7,481 $8,896 $9,954 Growth % 18.7% (1.5%) (12.2%) 31.4% 28.6% (20.2%) (7.7%) (9.5%) (12.8%) (2.6%) 24.8% 18.9% 11.9%

U.S. and Europe Sales $13,139 $14,619 $14,168 $13,521 $17,546 $24,168 $20,732 $19,158 $17,176 $14,233 $12,492 $14,796 $16,900 $18,747 Growth % 11.3% (3.1%) (4.6%) 29.8% 37.7% (14.2%) (7.6%) (10.3%) (17.1%) (12.2%) 18.4% 14.2% 10.9%

Source(s): Source: The NPD Group and Wedbush Securities estimates.

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Figure 45: Software Dollar Sales Japan and Worldwide (2003 – 2016E)

Japan Software ($ mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $4 – – – – – – – – – – – – – N64 –––––––––––––– Dreamcast – – – – – – – – – – – – – – PlayStation2/PS2 $857 $636 $518 $640 $326 $183 $68 $15 – – – – – – PS3 – – – $30 $174 $297 $400 $474 $576 $521 $566 $429 $296 $175 PS4 – – – – – – – – – – – $180 $464 $700 GameCube $365 $158 $99 $20 – $8 – – – – – – – – Wii – – – $100 $571 $653 $585 $528 $348 $190 $65 – – – Wii U – – – – – – – – – $48 $139 $280 $405 $468 Xbox $13 $8 – – – $1 – – – – – – – – Xbox 360 – – $6 $39 $65 $86 $95 $97 $74 $48 $35 $21 $11 – Xbox One – – – – – – – – – – – $24 $52 $67 All Other – – – – – – – – – – – – – – Total Home Console $1,238 $801 $623 $829 $1,136 $1,227 $1,147 $1,114 $998 $807 $805 $934 $1,228 $1,410 Growth % (35.3%) (22.2%) 33.0% 37.1% 8.1% (6.5%) (2.9%) (10.4%) (19.2%) (0.3%) 16.1% 31.4% 14.9%

GameBoy/Color – – – – – – – – – – – – – – GB Advance/SP $345 $356 $113 $57 $7 – – – – – – – – – DS/DSi – $65 $403 $1,153 $1,064 $743 $660 $569 $147 $88 $8 – – – 3DS – – – – – – – – $312 $659 $912 $1,110 $1,152 $1,190 PSP – $32 $109 $212 $217 $331 $299 $561 $444 $221 $120 $48 $24 – PS Vita – – – – – – – – $16 $74 $162 $233 $218 $203 All Other – – – – – – – – – – – – – – Total Portable $345 $452 $624 $1,422 $1,288 $1,074 $959 $1,130 $919 $1,042 $1,201 $1,391 $1,394 $1,393 Growth % 30.9% 38.2% 127.8% (9.4%) (16.6%) (10.7%) 17.8% (18.7%) 13.3% 15.3% 15.7% 0.2% (0.1%)

Total Console $1,583 $1,253 $1,247 $2,250 $2,424 $2,301 $2,107 $2,244 $1,918 $1,848 $2,006 $2,325 $2,621 $2,803 Growth % (20.9%) (0.4%) 80.5% 7.7% (5.1%) (8.5%) 6.5% (14.5%) (3.6%) 8.5% 15.9% 12.8% 6.9%

PC Unit Sales $345 $330 $310 $305 $285 $270 $245 $215 $174 $154 $140 $140 $140 $140 Growth % (4.5%) (6.1%) (1.6%) (6.6%) (5.3%) (9.3%) (12.4%) (18.9%) (11.5%) (9.1%) – – –

Total Software $1,928 $1,583 $1,557 $2,555 $2,709 $2,571 $2,352 $2,459 $2,092 $2,002 $2,146 $2,465 $2,761 $2,943 Growth % (17.9%) (1.6%) 64.1% 6.0% (5.1%) (8.5%) 4.6% (14.9%) (4.3%) 7.2% 14.9% 12.0% 6.6%

Worldwide Software ($ mil) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E PlayStation $544 $190 $50 $21 $16 $9 – – – – – – – – N64 $14 $4 $1 $0 – – – – – – – – – – Dreamcast $11 $0 $0 $0 – – – – – – – – – – PlayStation2/PS2 $6,207 $6,575 $5,927 $5,433 $3,899 $2,399 $757 $276 $72 $23 – – – – PS3 – – – $107 $1,915 $4,145 $4,468 $5,201 $5,545 $4,840 $4,087 $3,020 $2,175 $1,519 PS4 – – – – – – – – – – $551 $3,142 $5,487 $7,250 GameCube $1,518 $1,452 $1,133 $769 $210 $14 – – – – – – – – Wii – – – $324 $3,208 $7,532 $6,908 $5,780 $3,984 $2,113 $863 $384 $99 $24 Wii U – – – – – – – – – $219 $560 $1,050 $1,252 $1,344 Xbox $1,513 $2,404 $2,083 $969 $227 $36 $4 $1 – – – – – – Xbox 360 – – $257 $1,221 $3,280 $5,393 $4,922 $5,041 $4,995 $4,873 $4,047 $2,934 $2,093 $1,479 Xbox One – – – – – – – – – – $532 $2,362 $4,251 $5,805 All Other $0 – – – $1 $5 $10 $2 $1 – – – – – Total Home Console $9,808 $10,627 $9,451 $8,843 $12,757 $19,532 $17,068 $16,303 $14,598 $12,067 $10,640 $12,891 $15,357 $17,421 Growth % 8.3% (11.1%) (6.4%) 44.3% 53.1% (12.6%) (4.5%) (10.5%) (17.3%) (11.8%) 21.2% 19.1% 13.4%

GameBoy/Color $74 $16 $4 $2 – – – – – – – – – – GB Advance/SP $1,756 $2,006 $1,430 $999 $487 $39 $3 – – – – – – – DS/DSi – $111 $818 $2,143 $2,995 $3,847 $3,291 $2,756 $1,658 $926 $388 $178 $33 – 3DS – – – – – – – – $907 $1,350 $1,864 $2,416 $2,608 $2,696 PSP – $32 $774 $945 $1,216 $1,134 $937 $1,090 $720 $312 $177 $75 $24 – PS Vita – – – – – – – – $16 $302 $301 $390 $368 $343 All Other $2 $2 $1 – – $1 – – – – – – – – Total Portable $1,831 $2,166 $3,027 $4,089 $4,699 $5,021 $4,232 $3,846 $3,301 $2,890 $2,730 $3,060 $3,034 $3,039 Growth % 18.3% 39.7% 35.1% 14.9% 6.9% (15.7%) (9.1%) (14.2%) (12.4%) (5.6%) 12.1% (0.9%) 0.2%

Total Console $11,639 $12,793 $12,478 $12,932 $17,456 $24,553 $21,299 $20,149 $17,899 $14,958 $13,370 $15,951 $18,391 $20,460 Growth % 9.9% (2.5%) 3.6% 35.0% 40.7% (13.3%) (5.4%) (11.2%) (16.4%) (10.6%) 19.3% 15.3% 11.3%

PC Unit Sales $3,428 $3,409 $3,247 $3,144 $2,799 $2,186 $1,784 $1,467 $1,369 $1,278 $1,268 $1,310 $1,270 $1,230 Growth % (0.5%) (4.8%) (3.2%) (11.0%) (21.9%) (18.4%) (17.8%) (6.7%) (6.6%) (0.8%) 3.3% (3.1%) (3.1%)

Total Software $15,067 $16,202 $15,725 $16,076 $20,255 $26,739 $23,083 $21,616 $19,268 $16,236 $14,638 $17,261 $19,661 $21,690 Growth % 7.5% (2.9%) 2.2% 26.0% 32.0% (13.7%) (6.4%) (10.9%) (15.7%) (9.8%) 17.9% 13.9% 10.3%

Source(s): Wedbush Securities estimates.

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SECTION 2: INVESTING IN SOFTWARE PUBLISHERS

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INVESTING IN SOFTWARE PUBLISHERS

With the economic downturn, the historical gains in share prices for the major publishers were all but wiped out. The average forward multiple for a video game publisher has historically been 25 – 50% higher than the overall market multiple, reflecting the superior growth prospects for the industry and the tremendous earnings leverage generated by massive early investments in R&D. However, as of this writing, most of the public video game publishers trade at or below the market multiple, reflecting investor concern about the health of the industry.

We believe that the interactive entertainment industry offers secular dynamics that will provide extended and sustainable growth. Several publishers stand poised to capitalize on this growth, providing investors with an opportunity to participate. In this section, we analyze historical returns for the industry, and compare and contrast the publishers in order to provide insight into how their different strategies and assets produce different risk and return profiles.

In prior console cycles, U.S. investors in this industry were offered few domestic investment alternatives. Given rapid growth and industry consolidation during the last console cycle, we believe that the industry now offers investors fewer viable choices, while at the same time limiting risk. The following figure lists the key publicly traded entertainment software publishers.

Figure 46: Key U.S. Publicly-Traded Interactive Entertainment Software Publishers

Share Market CY2013 2013 U.S. Price Cap. Revenues Market Ticker 2/7/2014 ($ Mils) ($ Mils) Share Activision Blizzard ATVI $19.62 $15,064 $4,342 18% Electronic Arts EA $27.41 $8,619 $4,147 17% Majesco Entertainment COOL $0.54 $24 $39 1% Nintendo 7974.JP ¥13,560 ¥1,734 ¥592 10% Take-Two Interactive Software TTWO $18.73 $2,313 $2,484 17% Ubisoft UBI.FP € 10.54 € 1,040 € 1,003 8%

Note: As of February 7, 2014. Source(s): Company reports, Bloomberg, and Wedbush Securities estimates.

The universe of publicly traded entertainment software publishers includes companies with market capitalizations ranging from under $25 million to over $15 billion. The industry offers two large-cap companies (Nintendo and Activision Blizzard), one mid-cap company (Electronic Arts), two small-cap companies (Take-Two and Ubisoft), and one micro-cap company (Majesco) to consider as investment opportunities. Over the last eight years, seven micro-cap companies (Acclaim, Atari, Bam!, Interplay, Midway, THQ and 3DO) declared bankruptcy or ceased operations.

Industry Price Performance Investing in a portfolio of entertainment software publishers over the last ten years has not been a profitable venture, primarily due to the bankruptcies of seven companies. An index of U.S. and European entertainment software publishers (Activision, Acclaim, Atari, BAM!, Electronic Arts, Interplay, Midway, Take-Two, 3DO, THQ and Ubisoft) over the past ten years produced a negative 3.2% compound annual return, compared to positive returns for the broader market indices. There have been clear winners, with Activision investors realizing returns of 29% over the last ten years, with more modest returns for Ubisoft, EA and Take-Two investors in the mid-to-high single digits. There were also clear losers, with publishers Acclaim, Atari, BAM!, Interplay, Midway, THQ and 3DO all going out of business over the last ten years. However, investors who sought quality still lost money, as share prices for the “quality” names also failed to keep up with the market averages. The index of the six largest publishers

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(Activision, Electronic Arts, Nintendo, Take-Two and Ubisoft) generated a CAGR of 8.5% over the last ten years, lagging the broader market. In part due to the underperformance of the past ten years, we think that the rewards of investing in video game publisher stocks far outweigh the risks.

Historical Industry Returns Share prices of U.S. entertainment publishers increased roughly in tandem with the top-line growth of these companies during the past two console cycles. Revenues within the entertainment software industry grew at a 20% CAGR during the 1991-2002 period. Similarly, the share-price returns of U.S. and European publishers during this period grew at a 20% CAGR. We note that share prices grew quite rapidly during the 16-bit cycle, and somewhat more slowly during the 32-/64-bit cycle. This result was largely driven by the success of Electronic Arts during the 16-bit cycle and the underperformance of several small firms during the 32/64-bit cycle. In contrast, the average share price declined by a 28% CAGR during the first two full years of the 128-bit cycle, but rebounded significantly over the next four years. The industry was not immune to the broader market downturn, with share prices declining faster than the overall market in 2008 – 2009. The failure of the group to rebound significantly since then, lagging the market by a large amount, presents an opportunity as we expect a reversion to the mean sometime in the next few years. The following figure illustrates the share price appreciation for the U.S. and European publishers over the last two console cycles. We include the universe of U.S. and European publishers (plus Nintendo) in this index (Acclaim, Activision, Atari, BAM!, Electronic Arts, Interplay, Majesco, Midway, Nintendo Take-Two, THQ, 3DO and Ubisoft).

Figure 47: Industry Stock Performance (1999 – 2013)

Stock Price as of Close

1/4/1999 Other Date 12/31/2013 CAGR $ 11.44 $ - -100% Activision Blizzard$ 0.91 $ 17.83 22% Atari$ 237.50 $ - -100% BAM! $ 8.00 11/14/2001$ - -100% Electronic Arts$ 12.63 $ 26.30 5% Interplay$ 1.75 $ 0.01 -29% Majesco Entertainment$ 12.50 1/26/2005$ 0.54 -30% Midway Games$ 10.94 $ - -100% Nintendo¥ 10,710.00 ¥ 14,010.00 2% Take-Two Interactive Software$ 5.75 $ 18.00 8% 3DO $ 35.00 $ - -100% THQ $ 8.69 $ - -100% Ubisoft€ 7.18 € 10.28 2%

Source(s): Bloomberg, Thomson One, and Wedbush Securities estimates.

Revenue Size and Growth The publicly traded publishers vary tremendously in terms of size. Total revenue for each U.S. publisher includes both publishing and distribution revenues. Only three publishers – Electronic Arts, Activision, and Take-Two – currently derive any significant portion of their total revenues from distribution. Because publishing revenues generally grow faster and deliver higher margins than distribution revenues, we believe that investors value publishing revenues more.

We forecast publishing revenues for four of the five largest companies to grow slightly faster than our forecasted industry CAGR (14.5%) over the next three years, as we expect each to expand its international market share over this period (in Ubisoft’s case, we expect growth in the U.S.). We think that only Nintendo will lag the other publishers, as the company’s software sales are clearly leveraged to

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its proprietary hardware platforms, and we do not expect these platforms to perform well over the next three years. Although it is highly likely that market share for some publishers will change dramatically during the next console cycle, we have little specific product visibility after 2014. However, we believe that the industry will continue to experience contraction or consolidation, and our long-term forecasts for some of these publishers assume that some of them will slightly outperform the industry average. Accordingly, our revenue models assume that some will gain market share in 2015 and beyond.

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COMPANY STRATEGIES

Software publishers employ a variety of strategies to differentiate themselves from one another and to gain competitive advantages. In this section, we analyze the publishers along seven key strategic lines:

1. Platform focus 2. Internal versus external development 3. Third-party distribution 4. Geographic sales dispersion 5. Online (including microtransactions and in-game advertising) 6. Intellectual property ownership 7. Game genre focus 8. Mobile

Platform Focus Choosing the right platform can make a difference to the publisher’s bottom line. Deciding how best to allocate development resources is an important decision for publishers. In some cases, publishing games on every platform is a good idea (such as when a mass-market title like Madden NFL Football or Transformers is published). Other times, it makes more sense to limit development to those platforms that have the right target demographic for a particular game. For example, some games that are clearly aimed at the kiddie audience (such as games) may be profitable if published only on the 3DS and Wii U. Different game platforms require varying development costs, time to market, and marketing budgets, and generate different gross margins.

The first decision a publisher faces is whether to produce console, handheld or PC software. Although generally ignored by sell-side analysts, the PC software market is still quite large, and expected to generate sales of as much as $4 billion annually for the next several years, although packaged goods sales are likely to be only a fraction of this amount. While software sales for each major hardware platform exceeded PC software sales in 2013, the significant size of the PC software market (a combined $1.1 billion in U.S. and European 2013 packaged goods sales, implying an overall market of close to $4 billion) makes this option an immediately attractive one. Unfortunately, the PC software market is also the most highly competitive and highly saturated, and we expect the overall market to remain around the same size over the next three years. Games sold for the PC platform produce below average unit and dollar sales, and generally carry ASPs well below most console games, with few PC titles achieving bona fide “hit” status.

PC gamers also tend to be more demanding customers than console gamers, most likely due to a much older and affluent demographic profile. Because of this, successful PC games often require development budgets and development periods similar to current generation console games. We estimate that the average new property takes over two years to develop for the PC, similar to the current generation consoles. High development costs and a hit-driven market combine to produce a difficult competitive environment, and few publishers can generate sustainable profits with a PC focus. In our view, publishers (like Blizzard) that approach the PC platform cautiously and stick to developing games within proven PC genres and with a history of success (like StarCraft II and Diablo 3 ) will be the most successful. Over the long term, we expect PC software sales to decline, especially as the specs for the current generation consoles are similar to those of the most powerful PCs, and we believe that publishers will devote development dollars primarily to the faster-growing console market.

Most publishers take a diversified approach to platform development, concerned that committing a disproportionate amount of development budgets to a particular platform is risky. The economics of game development in the 128-bit cycle often dictated that games were developed for the PS2 first, as that platform had the largest installed base. This changed in the current console cycle, as publishers initially developed for the PS3 and Xbox 360, discounting the potential of the Wii. When it became clear that the Wii was the clear winner, it became obvious that ignoring this platform was a big mistake.

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Development for the Wii added a layer of complexity due to its different architecture. While Wii development carried generally lower development cost, making a bet on the platform less risky, games for the console had to be built from scratch, as they could not easily be ported from the other two consoles. Console games for the PS3 and Xbox 360 typically required 24 – 36 months to develop and bring to market and cost an average of $20 million each, with many costing twice that amount. Therefore, at launch, publishers were forced to forecast the future market climate at least two years in advance before they decided which games to publish on which platforms. Committing funds and resources to a slow-growth platform can be costly; similarly, publishing a game for a hot platform can turn a mediocre title into a winner (as evidenced by Take-Two’s Carnival Games for the Wii). The Dreamcast platform provides a good example. Publishers such as Acclaim and Midway suffered in 2000 when the Dreamcast platform failed to sell enough hardware to make software releases for this platform profitable. Similarly, publishers like THQ went bankrupt by relying too much on the Wii platform, and seeing their core business fade as many consumers put their Wii into the closet. Publishers must also attempt to gauge likely future competition on a particular platform, favoring a diversified strategy. In general, most publishers match their platform development to their expected platform market share, i.e., the largest number of games is produced for the largest expected platform. Although profitable publishing opportunities can exist on relatively small platforms if the competitive landscape is favorable, we expect publishers to employ this strategy cautiously.

Choices about platform focus in the current cycle are a moving target. Many games produced for the Xbox 360 were ported to the PS3, but it is not clear whether this was the most efficient method. Because the PS3 has a seven-core processor and the Xbox 360 has a three-core processor, development for the PS3 was somewhat more complicated than for the Xbox 360. This has worked to Microsoft’s advantage, as early in the cycle, publishers chose to develop all games for the 360 because of the relative ease of development; conversely, in the future, it could work against Microsoft, should publishers choose to develop first for the more complex device, anticipating an easier time porting to the competitor’s device.

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Figure 48: Covered Companies Publisher Sales Mix by Platform, 2010 and 2013

2010 ATVI EA COOL Nintendo TTWO UBI.FP Nintendo DS 7% 3% 49% 31% 3% 10% PlayStation 2 2% 2% 0% 0% 3% 0% PlayStation 3 25% 30% 2% 0% 32% 13% PlayStation Portable 0% 2% 0% 0% 2% 1% Wii 17%12% 40% 69% 7% 47% WIN 2%5% 0% 0% 5% 1% WIN/Mac 10% 5% 0% 0% 0% 0% Xbox 360 36% 42% 9% 0% 48% 28% Total 100%100% 100% 100% 100% 100%

2013 ATVI EA COOL Nintendo TTWO UBI.FP Nintendo 3DS 3% 0% 9% 58% 0% 1% Nintendo DS 2% 0% 19% 11% 0% 1% PlayStation 3 25% 29% 1% 0% 37% 21% PlayStation 4 4% 8% 0% 0% 2% 7% PlayStation Vita 0% 1% 0% 0% 0% 1% Wii 9% 1% 40% 15% 0% 19% Wii U 2% 0% 2% 17% 0% 5% WIN 1% 3% 0% 0% 1% 1% WIN/Mac 3% 5% 0% 0% 0% 1% Xbox 360 45% 45% 26% 0% 57% 39% Xbox One 5% 7% 3% 0% 2% 5% Total 100% 100% 100% 100% 100% 100%

Source(s): Company reports and Wedbush Securities estimates.

Development Assets Bringing R&D in-house subjects publishers to greater risk, but results in higher profits when the games are successful. Publishers create games using either full-time employee developers or by hiring an external developer. The number of internal development personnel can greatly impact a publisher’s cost structure. Maintaining a large internal development team raises the publisher’s fixed overhead costs, but gives the publisher the opportunity to increase operating margin should sales exceed forecasts. Utilizing external developers typically shifts some of the commercial product risk to the developer as developers frequently trade some near-term compensation for royalty payments on highly successful titles.

There is no rule for the appropriate mix of internal and external development. Most publishers approach development opportunistically, hiring those developers who are truly exceptional (“own the best and hire the rest”). We believe highly talented developers are rare and can mean the difference between good games and great games; publishers have tended to move quickly to hire truly talented developers. However, we believe that development has become more of a commodity than ever before, and we do not endorse internal development capability if the reason for an acquisition is to give the publisher greater control. Several publishers have shown that external developers can be used effectively to produce excellent games on schedule without adding these costs to their income statement and increasing operating leverage. Good examples of top-notch development talent, wisely acquired by

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publishers include Electronic Arts’ purchase of ( SimCity and The Sims ), Activision’s purchase of Entertainment ( Tony Hawk’s Pro Skater ) and ( Call of Duty and Modern Warfare ), Take-Two’s purchase of Angel Studios ( Midnight Club ), (2K Sports games), Irrational (BioShock ) and Firaxis ( Civilization ), and THQ’s purchase of ( Saint’s Row and ).

Several publishers have fallen on hard times over the last few years, largely due to their cost structure growing faster than their revenue base. At Electronic Arts and THQ, one of the biggest factors depressing earnings was the decision to bring development in-house; THQ went bankrupt last year, and EA has been under almost constant restructuring for the last five years involving the closure of studios and layoffs of development personnel.

One trade-off that should be considered when determining the benefit of a shift in favor of internal development is the likelihood of “groupthink”. We believe that internal studios are often more creatively constrained than are external studios, due to a combination of corporate hierarchy, comparisons to past internally developed products, and constant scrutiny by management. Additionally, over-dependence upon internal personnel can serve to limit the flow of “new” ideas, solely by virtue of limiting the potential number of creative people consulted. We believe that over the past year, declining game quality at several U.S. and European publishers is attributable to over dependence upon internal creative talent.

Eleven years ago, we noted that the companies with the highest percentage of internal development personnel and highest operating leverage were 3DO and Midway Games. 3DO declared bankruptcy in 2003, and Midway declared bankruptcy in 2009. Another highly leveraged publisher, Acclaim (with over 60% internal development talent), declared bankruptcy in 2004. Still another, Eidos, was acquired for a fire sale price earlier this year. As noted above, THQ and Electronic Arts fell on hard times, largely due to overhead that was growing faster than revenues. We estimate that Take-Two and Activision each have approximately 90% of development performed in house. Both companies have acquired external studios in the past seven years, and appear intent to move even more development in house over the next few years.

Development Synergies One of the foreseen consequences of current generation console cycle was the dramatic increase in the cost of game development. Each of the last three console transitions involved significant advances in hardware technology, with correspondingly significant advances in the quality of software produced for the new consoles. We think that the success of past console cycle transitions was determined more by advances in software development than by advances in hardware technology. The terms 8-bit, 16-bit, etc., refer to the amount of information processed by the console during each microprocessor cycle. The total amount of information processed is therefore a function of both the “bits” and the “cycles”. When microprocessors routinely doubled in power every 18 months during the 1980s and 1990s, the amount of information that could be processed in a finite period of time also routinely doubled. When Sony replaced its PS1 (which processed 32 bits of information per cycle at 33 megahertz cycle speed) with the PS2 (which processed 128 bits of information per cycle at 295 MHz), it increased the amount of information seen each second by almost 40-fold. This allowed for significant improvements in graphic design, with more fluid and a greater number of characters on screen performing more detailed maneuvers. To the extent that software developers were able to take advantage of this processing speed, games were longer, more complex, more visually stunning, and generally more interesting.

Unfortunately, providing greater information carries a greater cost, both in terms of time and money. The average PS1 game took a team of 10 – 12 developers approximately nine months to complete. If we assume fixed costs of $100,000 per game plus variable costs of $100,000 per year per developer (including office expense, systems support, taxes, benefits, etc.), the typical PS1 game cost publishers approximately $900,000 to produce. The average PS2 game took a team of 15 – 24 developers approximately 20 months to complete. If we assume no changes to fixed or variable costs, it’s easy to understand the estimated average cost of $3 – 4 million per PS2 game.

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The Xbox 360 and the PS3 CPUs were 4 – 10x faster than those in their predecessors, with RAM that is 8 – 16x greater than legacy console memory. This means that current generation software carries as much as 60 times the amount of information contained in legacy software. Middleware and development tools significantly reduce the cost of creating games containing this exponential increase in information, but we estimate that at least a two- to four-fold increase in manpower or time was required to complete a current generation game. Current generation games frequently require the efforts of 100 person development teams, and cost between $20 – 30 million to produce. Increasingly, substantial investments in common development tools and processes allow for “learning curve” benefits, with subsequent games using the same as a predecessor costing as much as 20% less to produce. The average current generation console game took at least two full years to complete (with some efforts taking three to four years), compared with the average 20-month completion time for legacy generation games.

We do not foresee a meaningful increase in cost for next generation software development. The Wii U is similar in processing speed to the Xbox 360 and PS3; the Xbox One and PS4 are much more powerful devices, but the incremental power will likely be used primarily to run games at 60 frames per second throughout at an output of 1080p. This contrasts with current generation games that only occasionally run at 60 fps, and suggests that the primary difference in development cost will be the addition of a greater number of graphic artists to the next generation development teams. We expect costs for next generation development to average 10% higher than for current generation development, taking the total cost of games to the $22 – 33 million level.

As we pointed out in our industry report 11 years ago ( The Definition of Insanity ), most of the large publishers lamented overspending on PS2, Xbox, and GameCube software development and abandoning the large PS1 installed base too early when the last cycle launched. In the first three quarters of calendar 2000, Electronic Arts had a net loss of $73 million, while Activision and THQ eked out profits of $7 million and $5 million, respectively. The latter two companies capitalized software development, while EA expenses its development; on an apples-to-apples basis, all three companies lost a significant amount in the months leading up to the 128-bit console launch. Profits suffered again in 2006 – 2008, as the publishers who made bets on the Xbox 360 and PS3 (EA, THQ, and to some extent, Take-Two) had rocky results, while the publishers with an emphasis on the Wii (Activision with its Guitar Hero brand and Ubisoft with its Imagine and Petz brands) thrived. We saw some pressure on earnings in 2012 – 2013 as the publishers experienced a transition, but the publisher group was generally profitable, because they expected a tough time and prepared adequately for the software downturn.

The greatest potential synergy is likely to come from focusing on only two consoles instead of three. We think that Nintendo’s early struggles with the Wii U will publishers with an excuse to ignore the console altogether. To date, EA has chosen not to develop any of its games for the Wii U, citing a small installed base, and we expect other publishers to follow suit. As such, we expect SKU counts to decrease, and selection to narrow, driving profits higher.

Third-Party Distribution Every major publisher owns distribution assets sufficient to place the majority of its products on U.S. store shelves. We estimate that Nintendo and the U.S. and European publishers distribute between 90% and 95% of their published software using their own internal resources. Many of these publishers also own international distribution assets, particularly in Europe, that are used to place their own software products with retailers. Some publishers also pursue a strategy of using these internally owned distribution assets to distribute product for other publishers. Some publishers such as Activision and Electronic Arts acquired their international distribution assets primarily to distribute their own products, but now also distribute some third-party software. In the case of Activision and Take-Two, some publishers also distribute hardware.

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Third-party distribution is a low-margin, low-risk line of business that we expect to decline during the current console cycle. The amount of software distributed by publishers using internal resources grew significantly over the past two console cycles as publishers expanded their operations to capture this link in the software value chain. We expect this trend to continue and to limit the growth rate for third-party distribution businesses in the future. However, as a greater number of games appear on retail shelves, particularly with the large boxes for the music themed games and several new peripheral bundles, we believe that distribution assets could provide some margin expansion as underrepresented independent publishers seek distribution for their products.

We believe that publishers should only pursue third-party distribution revenues when they maintain some form of competitive advantage or unique market position. Distribution is highly competitive, and with low margins and low growth rates, we believe that publishers should place a priority on growing publishing assets. We believe that most U.S. and European publishers have shed their marginal distribution assets and now only own value-added or strategic distribution assets, though we continue to believe that Take-Two’s U.S. distribution business is non-strategic.

Geographic Dispersion of Revenues As we noted earlier in our discussion of geographic markets, we believe that the addressable market for U.S. and European publishers includes the North American and European markets. The Japanese and other Asian markets are very difficult for U.S. companies to penetrate because of differences in consumer preferences and challenging distribution and retail networks. Going forward, we expect some further penetration of Asian online markets by U.S. and European publishers, though (with the exception of Activision Blizzard), we do not expect significant penetration over the next two years. EA intends to penetrate Asian markets with its free-to-play games, but we think that the company will likely generate only modest revenues over the near term. Several other large potential geographic markets exist, notably Australia, the Middle East, Eastern Europe and South America; however, we estimate that total sales for all these markets combined amounts to less than 8% of overall interactive industry sales. The software publishers that we cover generally sell less than 10% of their products directly into these markets, and retail presence for U.S. and European based companies is minor. Interactive software sales in other regions comprise approximately 4% of global software sales, with an additional contribution of over $10 billion in sales of mobile game downloads and virtual content worldwide.

We believe that approximately 70 – 85% of all U.S. software has the same appeal to European consumers as to U.S. consumers. Some products, such as U.S.-based sports games ( e.g. , football and baseball) and games based on U.S.-specific pop culture or media trends ( e.g. , children’s cartoons and some music themed games), simply do not carry the same appeal with European consumers. Other products, such as soccer games or racing games, generally perform better in Europe than in the U.S. We estimate that U.S. publishers with established distribution channels in Europe should expect to earn 45 – 50% of total revenues from this region by 2011. While some U.S. publishers have already achieved this level of international reach, we note that several U.S. publishers still have ample room to grow in this area.

Online Strategies Online has become the “elephant in the room”, with each publisher acknowledging its importance, but with varying strategies for generating online income. When it merged with VU Games, Activision jumped past the rest of the publicly traded publishers to become the most successful online game publisher. There are many Chinese companies involved with online gaming, and many are enjoying great success, but among the packaged goods video game publishers, only Activision Blizzard has managed to generate significant profits from its online endeavors. Electronic Arts is perhaps the next farthest along among U.S. and European publishers in adopting an online gaming strategy with several free-to-play games, but the company has experienced significant growing pains. EA has had mixed results in the past, developing several online games aimed at a massively multiplayer audience with its Online , Sims Online and Star Wars MMOs, but none achieved the level of success most expected. The company also made an expensive acquisition of Playfish to enter the social games

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business, but abandoned the effort last year. We do not believe that Electronic Arts has been profitable in online gaming, as the size of its audience has consistently been smaller than generally expected. As we discussed in our industry report 11 years ago (see Myth #8—Online Gaming is the Next Great Thing), we believed that this market would take several years to develop and mature. So far, the other major U.S. and European publishers have been modest in their approaches to online gaming, with most incorporating multiplayer features into PC and console games. Among Western publishers, only Activision Blizzard has managed to generate immense success with its World of Warcraft , and we expect the company to deliver solid success when it launches Call of Duty in China, expected later this year.

All of the large U.S. and European publishers are looking for ways to add revenue streams through microtransactions. For several years, Activision led the charge in developing a rate card for in-game , but since its merger with VU Games in 2008, we have not heard much about the in-game advertising opportunity, and we think that the company has abandoned that effort. Electronic Arts has been working hard to deliver microtransactions to customers with its free-to-play games, but we remain skeptical that its choice of Western content ( FIFA Online , NBA Street and Battlefield Heroes , so far) will resonate with Asian audiences. The other Western publishers appear to have adopted a “wait and see” approach, and we expect that many will selectively exploit whatever opportunities arise in the future.

Intellectual Property Strategies All publishers strive to own their intellectual property and brands, but each has a handful of licensed properties as well. Content source is a key driver in determining the margin on video game software sales. A game’s content can be based upon an original concept (or sequel to an original concept), or may be based upon a concept owned by a third party. In most cases, third party intellectual property (“IP”) will have value only if the IP has been developed and used in another medium, such as film, television, comic books, toys or literary works. Games also may be based on “real-life” content, such as sports leagues or prominent celebrities.

A typical video game is burdened by both fixed and variable costs. On the fixed side, costs usually consist solely of development costs for the game (typically $10 million or more for a PC game, $20 – 30 million for current and next generation console games, and $300,000 to $1 million for a handheld game). Variable costs include the manufacturer’s royalty (typically 20 – 25% of gross sales for console and handheld games, zero for PC games), manufacturing costs ($1 – 2 per unit), distribution costs (zero to 15% for large publishers), royalties for licensed content (5 – 20% of gross sales, depending upon the license), royalties paid to third-party developers (typically 20 – 30% offset by any advance for R&D), and vendor allowances and other marketing support (zero to 10% of gross sales). The highest margin game in a is a PC sequel based upon original content that is internally developed, requires no license fee, and requires little marketing support. In such a case, the gross margin could approach 90%. We believe that Electronic Arts’ The Sims games generate gross margins that approach 90%. The lowest margin game will be externally developed, based upon licensed content, and published on a console, with margins below 30%. We believe that most EA Partners games (including Rock Band ) provide examples of low-margin games, primarily due to the revenue sharing arrangement with the third party developer. We believe this was the reason that EA closed the EA Partners division.

It follows then, that when content is original, margins can be quite high, because the games produced require no royalty payments. However, the risk associated with original content is quite high, as publishers are burdened with the expense of brand building. Although the margins generated from original properties can cushion some of the brand-building burden, publishers have tended to take the more conservative route over the past few years, and have increased reliance upon proven brands, especially as the “mass market” phase of the console cycle emerges. Of the 30 top-selling games in 2013, seven were licensed and 22 were sequels (only Disney Infinity was a new intellectual property), and we expect similar figures in 2014. Due to the console transition, few high profile new intellectual properties were released. The following paragraphs detail the intellectual property strategies of the eight publishers we cover.

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Activision Blizzard Activision Blizzard has de-emphasized its licensed portfolio, although it continues to produce major licensed properties based on Marvel properties ( Spider-Man , X-Men , Marvel Ultimate Alliance ) and several one-off licenses, including World Series of Poker , 007 , Walking Dead , Fast and Furious , Transformers , Angry Birds and Cabela’s . Over the last five years, the company’s publishing sales mix has steadily declined to around 20% derived from licensed content, as the company increased its focus on growing the percentage generated from owned IP. It developed Call of Duty and Skylanders (and the ill-fated True Crime , Gun and Blur ) over the last ten years. Activision limited its losses from its disappointing owned brands, and in 2006 purchased the Guitar Hero brand. It merged with VU Games in 2008, gaining control of the Blizzard stable of franchises, including Warcraft , StarCraft , Diablo and World of Warcraft . The company now derives over three-quarters of its revenues from owned IP, and we expect this percentage to grow in the future.

Activision’s licenses will begin to expire later this decade, with its license for Spider-Man locked up through 2017. While Activision does not disclose the terms of its licensing arrangements, we believe that its Spider-Man license carries a royalty rate of 12 – 15%. Its license with Bungie for Destiny likely is structured as a profit share, and we think that there is a recurring revenue model that will allow that game to drive very high margin, comparable to owned IP. Because of the balance between licensed and owned IP, Activision is able to generate overall publishing gross margins in excess of 60%. We do not believe that any of Activision’s licenses represent more than 5% of total revenues.

Electronic Arts Electronic Arts has lessened its dependence upon licensed content, with approximately 60% of revenues derived from third party IP ten years ago declining to approximately 30% in the current year. The company has supported much of its licensed content with heavy marketing spending. Its sports franchises are included as licensed content, and EA has the dominant market share for golf, football and soccer. Its licenses with the NFL, NBA and other sports leagues are likely to be renewable indefinitely, although it recently lost its license with the NCAA. Electronic Arts typically often is granted a “first look” from IP owners, and in the past, it successfully exploited both the Harry Potter and Lord of the Rings licenses. While the company does not disclose the terms of its licensing arrangements, we believe that it pays royalties at an average rate of approximately 12%, with a range of between 5 – 20%. The higher end properties likely command royalties at the full 20% rate, while sports licenses on average probably command lower overall royalties. We note that in 2004, the company signed exclusive licenses with the NFL and its players that we believe cost significantly more than its licenses in the past (we estimate an annual guarantee of $50 million). However, due to the exclusive terms of its license, the company has been able to generate profits over time.

Because of its ability to scale R&D expense due to the large number of units sold per game, we believe that Electronic Arts is able to generate margins in excess of 55% on most of its licensed content. EA has relinquished licenses for the James Bond (to Activision) and Lord of the Rings franchises over the last several years, and recently obtained the rights to the Star Wars license from Disney. We do not believe that Electronic Arts is at risk to lose any meaningful licenses over the next few years. Given the shift by EA and its competitors to owned intellectual property, we believe that EA is well positioned to win any licenses it chooses. Only the FIFA license represents more than 10% of EA’s total revenues.

The company also has several high profile brands that are wholly owned. Among these are The Sims , Battlefield , Burnout , Dead Space , Need for Speed , Medal of Honor , , Spore , Mass Effect , , Mercenaries and . Each of these brands has some potential to offer a sequel over the next five years.

Majesco Entertainment Majesco has a relatively brief history as a publisher, with only a handful of games published to date, generally with disappointing results. Its games based upon original content ( BloodRayne , ,

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and ) generally performed poorly, and it released several more based upon third party IP (Jaws , Aeon , and Taxi Driver ) which also performed poorly. Because of disappointing sales of its first few releases, it cancelled its other new games, and decided to focus the company’s efforts on more modest budget and value titles. Its Game Boy Advance Video products (since discontinued) were all licensed, and its gadget business (also discontinued) was substantially dependent upon third party licenses, and both delivered results substantially below expectations. We believe that the company does not intend to grow its internal development capability, and we do not expect it to develop original IP over the next several years. Instead, Majesco is focused on gaining rights to 3DS and Wii titles that have been overlooked by its larger competitors. It has had tremendous success with this strategy, and has established three brands, , Jillian Michaels Fitness Ultimatum and Zumba Fitness in the last seven years, with more likely on the horizon. Majesco’s key problem is that it has not had sufficient critical mass of titles to drive it solidly into profitability, and there is little visibility into its future lineup.

Nintendo Nintendo is laser focused on developing owned intellectual property, and 100% of its first party publishing revenues are derived from owned IP. The company is different from the other publishers we cover insofar as it is also a hardware manufacturer, and its software strategy is intended to provide differentiated content that will support its proprietary hardware. Thus, Nintendo first party games are available only on its 3DS, Wii and Wii U consoles, providing an incentive to consumers to purchase those platforms instead of competitive platforms offered by Sony and Microsoft.

Take-Two Interactive Take-Two’s content, until 2006, consisted almost exclusively of owned IP. In 2005, the company purchased a development studio from Sega, allowing it to produce and publish branded sports games. The company has had disparate results with its sports business, with its NBA game performing very well, its hockey game likely breaking even, and its baseball games consistently losing money. The baseball losses were the result of an onerous contract with Major League Baseball (which expired in 2012) that all but ensured that Take-Two would not generate a profit from these games. Take-Two recently decided to drop its MLB game, and will focus exclusively on its NBA license. The company also purchased the WWE license as a result of THQ’s bankruptcy. Because of the phenomenal performance of Grand Theft Auto , we expect licensed products to drive around 15% of publishing revenues in FY:14, but to comprise closer to 30% in most years. Take-Two owns the rights to the Civilization franchise, and owns Firaxis, its developer. The company also acquired Irrational Software, and obtained the rights to the highly successful BioShock . Because of the incredible margins earned on its flagship Grand Theft Auto franchise, we expect Take-Two to generate publishing gross margins of around 55 – 60% over the next three fiscal years, but think that the company’s relatively high fixed cost structure could limit its profitability. We do not expect any of Take-Two’s licensed properties to represent more than 20% of total revenues over the next few years.

Ubisoft Ubisoft has an impressive lineup of owned IP, having purchased the licenses for the Tom Clancy series of games. The company produces three top-selling Tom Clancy games ( Splinter Cell , Rainbow 6 and Ghost Recon ), owns the Rayman , Driver , Far Cry , Petz and Imagine properties, and has rights to Prince of Persia , Brothers in Arms , Teenage Mutant Ninja Turtles , Open Season , Surf’s Up and Star Trek games. In the current generation, Ubisoft had phenomenal success with wholly-owned Assassin’s Creed and its Wii brand, Just Dance . Every few years, Ubisoft releases a large scale game based upon a licensed property, such as in 2005 and in 2009, but it is not clear that it generates much profit from these titles.

Ubisoft’s strategy is to develop and control an ever-increasing mix of owned IP, with a smattering of licensed content to enable it to broaden its exposure to the Nintendo platforms. It’s overall blended license rate is probably less than 5% of sales, giving the company the greatest operating leverage in the industry, should it be able to successfully grow revenues over the next three years.

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Mobile Strategies Mobile is a difficult business, with few participants producing more than a handful of bona fide hits. Of the publishers we cover, only Electronic Arts has made a real commitment to monetizing its intellectual property on mobile platforms. Zynga is a pure digital publisher, and recently began to see success with its mobile initiatives, expecting more than 50% of its revenues from mobile. EA has been in the mobile business since 2004, jump starting its progress with its 2006 acquisition of JAMDAT Mobile.

EA’s mobile revenues are around $465 million, or approximately 7% share of the 2013 U.S. and European $6 billion addressable mobile games market. We expect mobile game revenues to grow at a faster rate than penetration of smart phones and tablets, and think that the current addressable market will grow by 25% per year for at least the next three years. At 50% of revenues from mobile, Zynga expects to generate $400 million or so from mobile game sales in 2014. We have modeled EA to grow its mobile revenues to $600 million in 2014, maintaining its market share.

The other game publishers have done little more than license some content to others for exploitation. Ubisoft has a relationship with Gameloft (the CEOs of the two companies are brothers), and Activision and Take-Two have licensed content with some modest success. Nintendo has thus far declined to play in the mobile space, and recent comments from its CEO suggest that the company has no intention of publishing its iconic games on mobile platforms.

We think that mobile presents a compelling opportunity, if done right. We will closely monitor the progress of our covered companies in the coming year to capitalize on the mobile opportunity, and will update our report then.

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CONTENT COMPARISON

The most successful publishers in the past have been those who built diverse libraries of branded games, producing sequels and recurring revenue streams. With steady, sequel-driven revenues, publishers have better visibility into their future performance, leading to better planning and investment. Less volatile revenue and earnings models have tended to engender more confidence from and higher public valuations. In this section, we identify the most lucrative entertainment software brands and the publishers profiting from them.

For purposes of the following discussion, we examine U.S. retail sell-through figures provided by the NPD Group, but we are precluded under our contract with NPD from listing dollar sales. Instead, we list market share in percentages of overall retail sales, to reflect how powerful each particular brand is. We compare the reported sell-through figures for each brand to reported overall U.S. retail sell-through for each publisher, in order to extrapolate the contribution of each brand to the publisher’s overall success. Although NPD reports sell through (i.e., sales to consumers) rather than sell in (i.e., wholesale sales) and reports on a retail dollar basis rather than actual amounts realized by the publishers, we believe that this “apples to apples” comparison is useful in determining publisher dependence on individual brands.

Brand Building The publishers with the greatest success in creating and nurturing high-quality branded entertainment software are Nintendo, Activision and Electronic Arts. Nintendo is unquestionably the most successful creator of entertainment software over the past 20 years and captured the number one position in U.S. sales among software publishers each year until 2001. Many of the brands that Nintendo introduced in the 1980s and early 1990s for the NES and SNES consoles are still dominant brands today such as Mario , Zelda , and Donkey Kong . Similarly, Electronic Arts has built a portfolio of recurring revenue streams by growing its library of established brands. Electronic Arts now dominates the sports genre and its hit football, soccer, , and golf games (among many others) are best sellers year after year. Electronic Arts also has expanded beyond the sports game genre and built successful brands in many other genres, including the real-time-strategy genre ( Command & Conquer and Battlefield ), strategy/RPG genre ( The Sims ), extreme sports ( Skate ), kiddie ( Harry Potter ) and the driving genre (Burnout and Need For Speed ). Activision’s results are far more concentrated, with its top two brands (Call of Duty and Skylanders ) responsible for over 75% of its domestic sales. According to NPD, in 2013, Electronic Arts captured the highest market share for entertainment software sales in the U.S., with its 20.3% market share slightly ahead of second place Activision’s 16.7% share, with Nintendo in third place with 16.6% market share.

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Top Brands of 2013 A look at the top-selling brands of 2013 provides a proxy for which publishers currently own mega-hit content. We note that Electronic Arts published eight of the top 30 brands, with four from Take-Two, three each from Activision, Warner Bros. and Nintendo, two each from Ubisoft and Sony, and one apiece from five other publishers.

Figure 49: Top Interactive Entertainment Software Brands (U.S. % Sales 2011 – 2013)

Rank % of Total Sales 2013 2012 2011 Brand Publisher 2013 2012 2011

1 1 1 Call Of Duty Activision Blizzard (Corp) 10.8% 12.6% 10.9% 2 37 48 Grand Theft Auto Take 2 Interactive (Corp) 9.7% 0.5% 0.5% 3 2 2 Mario Brothers Nintendo 4.7% 5.6% 4.8% 4 5 4 Madden Football Electronic Arts 3.9% 4.0% 3.1% 5 18 6 Battlefield Electronic Arts 3.7% 1.1% 2.8% 6 6 9 NBA 2K Take 2 Interactive (Corp) 3.5% 3.0% 1.9% 7 4 11 Assassin's Creed Ubisoft 3.3% 4.0% 1.7% 8 12 7 Pokemon Nintendo 2.6% 1.7% 2.0% 9 8 29 Skylanders Activision Blizzard (Corp) 2.4% 2.3% 0.8% 10 7 3 Just Dance Ubisoft 2.1% 2.9% 3.4% 11 10 27 LEGO Warner Bros. Interactive 2.0% 1.9% 0.8% 12 11 14 FIFA Electronic Arts 1.9% 1.9% 1.2% 13 NA NA Disney Infinity Disney Interactive Studios 1.7% 0.0% 0.0% 14 25 10 Batman Warner Bros. Interactive 1.5% 0.8% 1.8% 15 NA NA Injustice: Gods Among Us Warner Bros. Interactive 1.4% 0.0% 0.0% 16 317 194 Bioshock Take 2 Interactive (Corp) 1.4% 0.0% 0.1% 17 NA NA The Last of Us Sony (Corp) 1.3% 0.0% 0.0% 18 16 17 NCAA Football Electronic Arts 1.2% 1.3% 1.1% 19 19 21 Need For Speed Electronic Arts 1.2% 1.0% 0.9% 20 20 16 The Sims Electronic Arts 0.9% 1.0% 1.2% 21 445 305 Tomb Raider Square Enix Inc (Corp) 0.8% 0.0% 0.0% 22 98 86 God Of War Sony (Corp) 0.8% 0.2% 0.2% 23 15 249 Diablo Activision Blizzard (Corp) 0.8% 1.3% 0.0% 24 33 41 NHL Electronic Arts 0.7% 0.6% 0.6% 25 2270 2403 World Wrestling Entertainment Take 2 Interactive (Corp) 0.7% 0.0% 0.0% 26 42 24 Deep Silver 0.7% 0.5% 0.9% 27 92 8 Gears Of War Microsoft (Corp) 0.7% 0.2% 1.9% 28 50 13 Zelda Nintendo 0.7% 0.4% 1.2% 29 191 40 Dead Space Electronic Arts 0.7% 0.0% 0.6% 30 17 5 Elder Scrolls Bethesda Softworks 0.7% 1.2% 2.8%

Top 30 Brands as a % of Total U.S. Retail Sales 68.9% 50.1% 47.0%

Source(s): The NPD Group and Wedbush Securities estimates.

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Top Brands by Publisher The table in the figure below lists the top 10 brands for each publisher (U.S. sales) and the percentage of total company sales that these ten brands generated for their publishers and illustrates the depth of each publisher’s portfolio of “hit brands” and dependence on these brands. We believe that brand depth is one the most important indicators of a publisher’s future prospects. Strong software brands provide a publisher with sequel titles for several years and a deep library of brands provides a steady base of recurring revenues. We note that all but one of the top 30 brands is an established brand with a history of producing successful titles prior to 2013. These mega-hit brands are the result of growing and developing successful brands over several years. Possessing a deep library of solid brands is the first step to producing one of these mega-hit brands in the future.

Figure 50: Publisher Top Brands (U.S. % of Sales 2013)

CY 2013 ACTIVISION CY 2013 ELECTRONIC ARTS

Rank Brand % of Total Rank Brand % of Total 1 Call Of Duty 61.7% 1 Madden Football 23.3% 2 Skylanders 13.9% 2 Battlefield 22.3% 3 Diablo 4.6% 3 FIFA 11.5% 4 The Walking Dead 2.2% 4 NCAA Football 7.3% 5 .1% 5 Need For Speed 6.9% 6 Starcraft 2.0% 6 The Sims 5.2% 7 Wipeout (TV) 1.8% 7 NHL 4.4% 8 Cabela's 1.2% 8 Dead Space 4.2% 9 1.2% 9 2.8% 10 Spider-Man 1.1% 10 Tiger Woods 2.0%

Total Top 10 Brands 91.8% Total Top 10 Brands 90.1%

CY 2013 MAJESCO CY 2013 NINTENDO

Rank Brand % of Total Rank Brand % of Total 1 Zumba Fitness 57.9% 1 Mario Brothers 45.4% 2 Monster High 18.0% 2 Pokemon 25.4% 3 Cooking Mama 6.6% 3 Zelda 7.0% 4 Barbie 3.4% 4 Animal Crossing 4.7% 5 3.4% 5 LEGO 3.5% 6 Hello Kitty 2.9% 6 .1% 7 Young Justice: Legacy 1.8% 7 Fire Emblem 2.2% 8 NBA 1.6% 8 .0% 9 Greg Hasting's Tournament Paintball 0.9% 9 Wii Sports 0.7% 10 0.7% 10 Kirby 0.7%

Total Top 10 Brands 97.3% Total Top 10 Brands 94.6%

CY 2013 TAKE-TWO CY 2013 UBISOFT

Rank Brand % of Total Rank Brand % of Total 1 Grand Theft Auto 56.7% 1 Assassin's Creed 41.9% 2 NBA 2K 20.6% 2 Just Dance 27.0% 3 Bioshock 8.3% 3 Far Cry 8.4% 4 World Wrestling Entertainment 4.4% 4 Tom Clancy 6.8% 5 MLB 2K 2.2% 5 Rocksmith 6.5% 6 2.0% 6 Rayman 2.4% 7 1.3% 7 Hip Hop Dance Experience 1.3% 8 2K Sports Combo Pack 0.7% 8 Smurfs 0.9% 9 Midnight Club 0.7% 9 0.5% 10 X-Com 0.6% 10 ZombiU 0.5%

Total Top 10 Brands 97.5% Total Top 10 Brands 96.2%

Source(s): The NPD Group and Wedbush Securities estimates.

As the figure above illustrates, Electronic Arts and Ubisoft are the only publishers with significant brand diversification. The previous figure provides insight into the U.S. revenue concentration of the publishers, and reflects that only EA and Ubisoft saw contribution of greater than 5% of their revenues from five or more different games in 2013. These companies generated 23.3% and 41.9% of their U.S. sales,

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respectively, from their top single brand. The least diversified companies last year were Activision, Majesco and Take-Two; notwithstanding their brand concentration, Activision and Take-Two had the best financial performance of the group, reflecting that diversification may not always be a good sign, particularly if the average game in a company’s portfolio is unprofitable. However, the high level of revenue concentration begs the question about what to do when the brand fades, as is likely the case for Majesco this year, in our view.

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ACCOUNTING ISSUES

Capitalized Software Development and Prepaid Royalties Under GAAP, companies are required to capitalize amounts paid for intellectual property that relate to future periods. “Payments” consist of advances paid to third parties for licenses, progress payments to third party developers, and amounts paid as salaries and occupancy for internal developers prior to the release of the game that is being developed. Because some licensing and development arrangements represent efforts that may extend over several years, video game publishers are required to capitalize amounts paid in one period when the underlying game is expected to be delivered in a later period. There is little flexibility under the accounting rules regarding the amounts to be capitalized, once a decision is made that the game being developed is “feasible”. However, great flexibility is offered to companies in determining the rate at which capitalized license and royalty fees are amortized. In general, these amounts are amortized on a units-of-production basis, whereby each company makes its best estimate of the number of units of a game that will likely be produced. Should the estimate be lower than the actual units sold, the game’s capitalized license fees will be amortized relatively rapidly; should the estimate be greater, the license fees will be amortized relatively slowly.

As a general rule, many people are confused by the treatment of capitalized software development and prepaid royalties. It appears to us that investors are frequently confused or concerned about how various publishers treat software development costs, and many investors believe that the companies are deferring recognition of expense (and managing earnings) by making additions to the capitalized software or prepaid license account. In particular, investors are confused about the "current asset" account treatment of capitalized software and prepaid licenses, as amortization of the current asset account should be expected to impact earnings over the next 12 months.

Under GAAP and SFAS No. 86, companies are required to make every effort to match expense and revenue within the same period (meaning, for example, that if an expense is incurred in the first quarter of the year that results in revenue in the third quarter, the recognition of the expense should be deferred until the third quarter). Most of the companies in the interactive entertainment software publishing business follow SFAS No. 86, and have been capitalizing software development for several years. Electronic Arts has chosen to expense software development when incurred, creating the appearance of negative operating leverage when the expenses are incurred, and positive operating leverage when the underlying games are released. Electronic Arts has managed to convince its auditors that it cannot determine whether a game is “viable” (requiring capitalization) until the game is released, and therefore, the company has chosen to expense all software development (continuing to capitalize prepaid royalties). We think that volatility in EA’s share price has in large part been attributable to the fact that the company continues to invest in development without any underlying revenues, causing investors to believe that its growth sometimes has stalled.

The problem many investors perceive is a gradual and substantial increase in the amounts capitalized. Take-Two has built sizeable capitalized software and prepaid royalty balances over the last few years. These balances are a function of two factors: first, the number of games under development expected to be released during the year; and second, the escalating development cost of the typical game. In the current console cycle, it is clear that each publisher is interested in capturing as much market share as possible. In addition, the launches of three major console platforms, as well as the launches of the Nintendo 3DS and the Sony PS Vita required the development of as many as eight versions of each new title, contributing to the proliferation of games under development. The cost of development has from an average of $100,000 (handheld) and $500,000 (console) in the PS1 cycle to an average of $350,000 (handheld) and $3 million (console) in the PS2 cycle (our estimates), to an average of $30 million in the PS3 cycle. Next generation console games are likely to cost as much as 10% more than they did in the last cycle. Taken together, these factors have contributed to a large increase in development costs for every publisher.

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Activision has become more like EA throughout the current cycle. The company’s capitalized software balance is relatively low as a percentage of its sales, as it has adopted the conservative policy of deeming new games infeasible until launch. As a result, development spending on games like Destiny (a new game) has been largely expensed rather than capitalized. Although Activision’s capitalized balance has grown slightly (from a low of $233 million to $388 million at present), it remains well below its peers as a percentage of sales. We expect Activision to deliver far more leverage than is typical from a company that capitalizes software development, due to its conservative approach.

The timing of game development and release is yet another important factor. In the PS1 cycle, game development seldom took more than a year, and often took as little as three months. Thus, there were fewer occasions that created a mismatch in timing between development spending and revenue recognition. In the PS2 cycle, the major console games typically took 18 months or longer to develop. The bulk of development spending therefore seldom occurred within the same year as games were released, creating a need to capitalize to the current asset account. In the current and next generation cycles, game development often takes as long as three years, resulting in even larger growth of long- term capital accounts. In addition, the typical console game has enjoyed an extension of its “shelf” life, due to tiered pricing for new releases and catalog titles. Thus, games that used to sell 90% of total units within six months of release now sustain reasonable sales levels for as long as a year.

We believe that growth in the capitalized software account balance is necessary for companies choosing to participate in the current console cycle, notwithstanding that many industry observers see it as a deferral of expense. Increases in prepaid royalties are a function of company strategy, with companies that are more heavily dependent upon licensed content (such as THQ was prior to its bankruptcy) spending more to acquire key licenses. In our view, spending on new products reflects management commitment to growth, and we think that additions to the capitalized software and prepaid royalty account balances reflect such commitment. We expect to see continued additions to the capitalized software account balances at each publisher that capitalizes over the next two years, as the publishers ramp up their capability to create current generation games.

As we approach the middle of this console cycle, we believe that higher and higher development spending will be the norm. First, developing games for multiple platforms is likely to increase overall development spending. Second, most publishers are concerned about conceding a competitive advantage to the others, and each continues to incur investment in development tools for the next generation consoles. So long as the next generation console cycle creates growth in demand, we expect to see net additions to capitalized software development costs. The pace of the additions for current generation consoles will slow as the rate of growth of the installed console base slows, but will likely be more than offset by significant development spending for next generation console games.

Reserves Another area of concern for investors is an account called “reserves for returns and allowances”. This account is created by companies to protect against the financial risk arising from either returns of games that underperform in the marketplace or from planned price cuts for games that were released in prior periods. Because of the negotiating leverage of video game retailers (such as Wal-Mart, Best Buy, Target, and GameStop), the publishers must also protect against “requested” price concessions for any game not selling well.

Each of the interactive entertainment software publishers maintains a reserve against the potential for product returns and price protection. Historically, these reserves have been managed by adding a sufficient amount to the reserve balance to create a cushion, and drawing down against the reserve whenever price protection is granted. We estimate that actual charges against reserves for most companies in the industry average approximately 6 – 9% of sales, and we expect additions to reserves to be sufficient to maintain a cushion. In other words, we believe that overall reserve balances should grow in line with revenue growth, and that quarterly additions should generally offset actual charges during the preceding quarter.

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Unfortunately, the practice in the industry has been to compare the absolute dollar amount of the reserve against the absolute dollar amount of gross accounts receivable, creating a misleading “reserve ratio” that is analogous to the more typical bad debt reserves maintained by manufacturers of other products. Investors are often confused by this ratio, and any downward movement in the ratio typically causes downward pressure on the publisher’s stock price. We believe that reserves for allowances and returns are much more closely correlated to sales than they are to receivables balances, for two reasons:

First, receivables balances in this sector are more volatile than in other sectors due to the nature of interactive entertainment software publishing. Most publishers offer relatively few products each quarter (an average of 10 – 15), and each shipment of product will cause receivables to swell temporarily. This is in contrast to classic manufacturing, where 1,000 widgets flow off the assembly line each day, and sales are relatively constant from week to week. Thus, reserve ratios will fluctuate wildly as the denominator (accounts receivable) fluctuates, even if the numerator (reserves) remains constant.

Second, the reserve balance reflects the risk that a portion of sold product will be returned or will be discounted through vendor concessions. Although highly subjective, the underlying analysis of reserves should consider the quality of the products sold, and whether they are being sold at expected levels and at full price. Again, this relationship is more closely correlated to sales than it is to receivables. In addition, reserves would be maintained even if all purchases were paid for in cash (i.e., no accounts receivable balance), so it is clear that the reserve balance should reflect the risk that a portion of the company's sales, and not receivables, will be returned or offered price protection. Because sales occur throughout the quarter and receivables are merely a snapshot in time, trying to gauge a relationship between reserves and receivables will always be a moving target; measuring them against sales more closely reflects the risk inherent in the sales.

Each company we cover appears to have sufficient reserves, with most maintaining reserves of approximately 20% of peak quarter sales. In our view, reserves in excess of 10% of peak quarter publishing revenues are excessive. We believe that five of the companies we cover may have reserves in excess of what will be required to provide price protection to customers, but believe that each of these companies has maintained a conservative reserve balance in order to minimize the likelihood of earnings shortfalls in subsequent periods attributable to games that underperform.

In summary, we believe that reserves should reflect the likelihood that a portion of full-price sales will be returned or discounted. We think that although subjective, the adequacy of a particular company’s reserve should be a function of the quality of its products. This measure will apply regardless of the level of receivables, and we caution investors against accepting a reserve “ratio” as proof of reserve adequacy.

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UPSTARTS AND STARTUPS

Amazon Amazon is reportedly developing a set-top box that runs the Android , allowing for the streaming and downloading of games, music, movies, and TV content. The hardware is being developed with Lab 126, the designers of Amazon’s Kindle. Upon launch, the Amazon box is expected to compete against Apple TV, , and other Internet-connected set top boxes. We do not expect the Amazon box to take meaningful share from the Xbox One or PlayStation 4, at least in the near-term, as its development has yet to be confirmed by the company, with no indication of the ultimate release date or product specifications.

Oculus VR is a head-mounted display technology being developed for immersive gaming by Oculus VR. The company, like Ouya, launched a Kickstarter campaign in 2012, and raised over $2.4 million with the support of other video game companies including Valve, , and . In 2013, Oculus VR raised Series A and Series B rounds of financing for roughly $91 million combined from venture capital firms such as Spark Capital, Matrix Partners, Founders Fund, and Andreessen Horowitz. Oculus Rift is expected to be available at the end of 2014 or in 2015. It remains unclear whether Microsoft and Sony will develop proprietary wearable or virtual reality technologies for the Xbox One and PlayStation 4, respectively. The companies have also not disclosed whether third-party virtual reality technology will be compatible with the next-gen consoles upon successful development. is another wearable eye technology that could conceivably compete with Oculus Rift in the gaming space.

Ouya Ouya is a console that runs on the Android operating system and was funded through a Kickstarter campaign that raised approximately $8.6 million in August 2012. The console was released to the general public in June 2013 at a price of $99. While Ouya was the second-highest earning Kickstarter campaign after the Pebble, retail sales were relatively light in the first few months of release according to NPD data. We believe that the ubiquitous nature of smartphones and tablets makes it difficult for casual gamers to opt for the Ouya system. As ExtremeTech mentioned in its review of the Ouya, “games that have no trouble running on your phone will stutter on the Ouya.” We do not expect the Ouya to take meaningful market share from the next-gen consoles released in November 2013, both of which will benefit from more power, better online functionality, strong first-party titles, and superior third-party publisher support.

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SECTION 3: COMPANY PROFILES

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PROFILES – COVERED PUBLICLY TRADED COMPANIES

Profiles – Covered Publicly Traded Companies

Activision Blizzard

Founded: 2008 Headquarters: Santa Monica, California Key People: Robert A. Kotick (Director, President, CEO), Eric Hirshberg (President and CEO of Activision Publishing), Michael Morhaime (CEO of Blizzard Entertainment) Known for: Call of Duty, Skylanders, StarCraft, Warcraft Description: Activision Blizzard develops, publishes, and distributes interactive entertainment software for PCs, home consoles, handheld devices, and the Internet. Rating: OUTPERFORM Pros: Relatively low share count provides much more operating leverage than in the Price Target: $22 past; Strong release slate for 2014; Call of Duty will be shifted to a three-year Ticker: ATVI development cycle, which should positively impact game quality; World of Warcraft Share Price: $19.39 subscribers stabilized in Q4:13; Solid digital revenues Shares (mm): 757 Cons: Competition and fatigue continue to cause concern about the long-term stability Mkt. Cap. (mm): $14,678 of WoW subscribers; Continued dependence on Call of Duty and WoW; Skylanders Ent. Val. (mm): $14,919 may have to share the market with competitive offerings 52 Week: $11.77-18.55 FYE: December 31 Investment Thesis: We think it has many attributes that could lead to further multiple Rev. 1A (mm): $4,489 expansion. Catalysts include: (1) positive commentary around Call of Duty sales, (2) Rev. 2A (mm): $4,987 announcements about strong Skylanders sales, (3) long-term stability in WoW subs, Rev. 3A (mm): $4,342 (4) greater visibility into the 2014 slate, (5) positive reviews for Bungie’s Destiny, and Rev. 4E (mm): $4,650 (6) margin expansion from digital. We remain fans of Activision Blizzard. We believe EPS 1A: $0.93 the company communicates clearly, executes well, and its management appears to EPS 2A: $1.18 truly understand how to make money. We are maintaining our OUTPERFORM rating EPS 3A: $0.94 and price target of $22. We value the shares at a market multiple of roughly 19x our EPS 4E: $1.28 2014 $1.28/share EPS estimate. Risks: Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price (ASP) for game software, the effects of competition, changes in macroeconomic factors, and lower-than-expected consumer demand for video game hardware.

Notes: As of 2/7/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company , , Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

Electronic Arts

Founded: 1982 Headquarters: Redwood City, California Key People: Andrew Wilson (CEO), Blake Jorgensen (CFO), Peter Moore (COO), Patrick Söderlund (EVP, EA Studios), Frank Gibeau (EVP, EA Mobile) Known for: Battlefield, FIFA, Madden, Mass Effect, NHL, SimCity, The Sims Description: Electronic Arts develops, publishes, and distributes interactive entertainment software for PCs, home consoles, handheld devices, and the Internet. Rating: OUTPERFORM Pros: Solid digital results lead us to expect further growth in FY:15; EA’s strong Price Target: $30 presence on the next-gen consoles at launch paid dividends, with an estimated 35% Ticker: EA market share of software sold; The company has exceeded its expectations to keep Share Price: $26.69 operating expenses flat in a transition year, a feat never accomplished at EA before; Shares (mm): 317 We believe EA has the lineup to deliver revenue and EPS growth for at least the next Mkt. Cap. (mm): $8,461 two years (In FY:15, EA has UFC, FIFA World Cup, Dragon Age, and a likely fall shooter Ent. Val. (mm): $6,966 to replace Battlefield 4; In FY:16, Battlefield should return, plus Mirror’s Edge and Star 52 Week: $16.65-28.13 Wars); No FY:15 guidance yet, but upbeat commentary FYE: March 31 Cons: Game quality concerns remain after the launch of NBA Live 14 and freezing Rev. 1A (mm): $4,186 issues with Battlefield 4; The death of Medal of Honor: Warfighter leaves a hole in EA’s Rev. 2A (mm): $3,793 portfolio; The console transition is ramping quickly, but current generation software Rev. 3E (mm): $3,927 sales have dropped off more rapidly than expected Rev. 4E (mm): $4,310 Investment Thesis: Maintaining our OUTPERFORM rating and our 12-month price EPS 1A: $0.85 target of $30. Our PT is based upon a forward P/E of 18x our $1.65 EPS estimate for EPS 2A: $0.84 FY:15, and reflects improving execution, and the positive impact of digital and next- EPS 3E: $1.31 gen. We recommend investors accumulate shares while they trade at a discount to EPS 4E: $1.65 our PT Risks: Risks to attainment of our share price target include changes to game release timing, greater-than-expected deterioration of the average selling price (ASP) for game software, the effects of competition, changing macroeconomic factors, and lower-than-expected consumer demand for video game hardware.

Notes: As of 2/7/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

GameStop

Founded: 1984 Headquarters: Grapevine, Texas Key People: J. Paul Raines (CEO), Tony Bartel (President), Robert A. Lloyd (EVP, CFO), Michael K. Mauler (EVP, GameStop International) Known for: PowerUp Rewards; leading market share of console gaming sales in U.S. Description: GameStop is the largest video game and PC entertainment software specialty retailer in the world, with more than 6,000 stores. Rating: OUTPERFORM Pros: GameStop has a recent history of positive earnings surprises; PowerUp Price Target: $60 Rewards program has led to strong customer loyalty; It will likely be the dominant Ticker: GME retailer for next-gen console sales; It should continue to gain a disproportionate share Share Price: $36.50 of new game sales for a slew of high-profile releases; It remains committed to Shares (mm): 118 returning 100% of free cash flow to shareholders through its share repurchase Mkt. Cap. (mm): $4,311 program and dividend; Strong mobile and digital growth potential Ent. Val. (mm): $3,662 Cons: Video game industry sales have declined for four consecutive years, and have 52 Week: $22.57-57.74 been worse than we had expected so far in 2013; GameStop shares will likely be FYE: February 1 negatively impacted by any negative developments around the next-gen console Rev. 1A (mm): $9,551 launches; In mid-January, GameStop reported holiday sales results that reflected a Rev. 2A (mm): $8,887 mix of sales below our bullish expectations, resulting in lower EPS guidance Rev. 3E (mm): $9,209 Investment Thesis: Maintaining our OUTPERFORM rating and 12-month price target Rev. 4E (mm): $9,823 of $60. Our PT is based on 15x our FY:14 EPS estimate of $4.02. Although many EPS 1A: $2.87 quality retailers trade at 20x EPS, GME faces headwinds from digital and the impact of EPS 2A: $3.17 the next-gen console transition on current-gen sales. We continue to believe that EPS 3E: $3.07 GameStop’s core business will have a long tail. As long as physical video game EPS 4E: $4.02 products are produced, we expect GameStop to remain the market leader at retail. Risks: Risks to attainment of our share price target include changes to game release timing, the effects of competition, supply of video game products, macroeconomic factors, and slower-than-expected consumer demand for video game hardware and software.

Notes: As of 1/24/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

Majesco Entertainment

Founded: 1986 Headquarters: Edison, Key People: Jesse Sutton (CEO), Michael Vesey (CFO)

Known for: Zumba, Mama games, Monster High, Young Justice Description: Majesco Entertainment is a global developer, publisher and marketer of interactive entertainment software and accessories. Rating: NEUTRAL Pros: Cost-cutting initiatives and the strategic realignment to a variable expense Price Target: $1 model helped decrease operating expenses; Majesco could benefit from the next- Ticker: COOL generation console transition as pricing for current-gen products comes down; Share Price: $0.57 Majesco’s investment in GMS Entertainment Limited positions it to drive top- and Shares (mm): 44.5 bottom-line growth from Real Money Gaming; In June, Majesco announced the Mkt. Cap. (mm): $25.4 extension of its partnership agreement with Zumba Fitness through 2016 Ent. Val. (mm): $10 Cons: With only approximately $18 million in liquidity, we believe Majesco must 52 Week: $0.51-0.79 improve its financial performance in the next few years in order to continue as a going FYE: March 31 concern; Management did not provide FY:14 guidance; Heavy dependence on the Rev. 1A (mm): $132 Zumba Fitness games, with no additional Zumba release planned for later in FY:14; Rev. 2A (mm): $47 We have little visibility into Majesco’s long-term release schedule Rev. 3E (mm): $45 Investment Thesis: We recommend that investors take a wait-and-see approach Rev. 4E (mm): $45 before accumulating shares due to slowing Zumba sales, a thin release slate of EPS 1A: $0.10 games, and no guidance. Although we continue to believe that the company is one hit EPS 2A: ($0.25) game away from significant appreciation beyond its current share price, it is not clear EPS 3E: ($0.18) that such a game is included in its pipeline. Our PT reflects cash of $0.35 per share, EPS 4E: ($0.18) and reflects our confidence that it can once again bounce back, as it has in the past. Risks: Risks to attainment of our share price target include negative changes in performance of the company’s products, access to capital, balance sheet and cash liquidity risks, changes to game release timing, the effects of competition, changing macroeconomic factors, and changes in consumer demand for video game hardware.

Notes: As of 1/24/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

Nintendo

Founded: 1889 Headquarters: Kyoto, Japan Key People: (President, Director), (GM of Nintendo EAD, game developer), Reggie Fils-Aime (President, COO of Nintendo of America) Known for: Mario, Donkey Kong, Pokémon, Zelda, Wii, Wii U, DS, 3DS Description: Nintendo, based in Kyoto, Japan, is a leading manufacturer of video game consoles and publisher of video game software. Rating: NEUTRAL Pros: Strong IP including some of the industry's most iconic characters; World-class Price Target: ¥12,000 development studios; Handheld video game hardware leader; Strong release slate for Ticker: 7974.JP the 3DS, with an improving release slate for the Wii U; Pays a dividend; Recently- Share Price: ¥11,490 announced reevaluation of business may result in licensing of its IP for third-party Shares (mm): 128 hardware, including consoles, mobile phones, and/or tablets Mkt. Cap. (bn): ¥1,469 Cons: Recently lowered FY:14 financial guidance due in part to slumping demand for Ent. Val. (bn): ¥503 its products, prompting it to lower dividend guidance; Wii U has underperformed 52 Week: ¥8,330-16,150 expectations since its release; Microsoft and Sony introduced next-gen consoles in FYE: March 31 November 2013 that are viewed by many as superior to Wii U in terms of power, online Rev. 1A (bn): ¥648 functionality, and third-party support; Sales of the Wii have decreased rapidly; Rev. 2A (bn): ¥635 Widespread adoption of mobile and tablet gaming has hurt sales of Nintendo's Rev. 3E (bn): ¥590 handheld devices and games; We view certain aspects of guidance as unrealistic Rev. 4E (bn): ¥578 Investment Thesis: Maintaining our NEUTRAL rating and 12-month price target of EPS 1A: -¥338 ¥12,000. Our PT reflects a 10x forward EV/adjusted EPS multiple, and is a premium to EPS 2A: ¥56 its ¥9,000/share in cash and investments. We would continue to avoid the stock until EPS 3E: -¥196 Nintendo can demonstrate that its sales can again grow to its guidance level, or it cuts EPS 4E: ¥0 spending sufficiently to support sustainable profitability at its guidance level. Risks: Risks to attainment of our share price target include changes to game release timing, greater-than-expected deterioration of the ASP for game software and hardware, the effects of competition, changing macroeconomic factors, unexpected changes in f/x rates, and slower than expected consumer demand for video game hardware and software.

Notes: As of 2/7/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Bloomberg (for stock price chart), Wikipedia, and Wedbush Securities.

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Profiles – Covered Publicly Traded Companies (Continued)

Take-Two Interactive

Founded: 1993 Headquarters: City, New York Key People: Strauss Zelnick (CEO), Karl Slatoff (President), (President of Rockstar), Dan Houser (VP of Rockstar), Les Benzies (Rockstar producer) Known for: Grand Theft Auto, BioShock, NBA 2K, Description: Take-Two develops, publishes, and distributes interactive entertainment software for PCs, home consoles, and handheld devices. Rating: NEUTRAL Pros: The company’s large cash balance is available for a share repurchase Price Target: $19 program; We believe full-year guidance factors in only modest continuing catalog Ticker: TTWO sales of GTA, NBA2K and WWE; The recent addition of the WWE franchise; Game Share Price: $18.48 quality has consistently been high, and the company’s commitment to producing high- Shares (mm): 125 quality games should translate into consistent profits eventually, although on-time Mkt. Cap. (mm): $2,311 delivery and visibility remain uneven Ent. Val. (mm): $1,339 52 Week: $14.08-19.67 Cons: Any slippage of titles decreases investor confidence; Long game development FYE: March 31 cycles limit profitability; Management has become more opaque about the company’s Rev. 1A (mm): $826 lineup in recent years; We think that GTA V sales were front-end loaded, and a next Rev. 2A (mm): $1,222 generation version of the game is unlikely to achieve its historical attach rates Rev. 3E (mm): $2,391 Investment Thesis: Maintaining our NEUTRAL rating, $19 price target. We believe Rev. 4E (mm): $1,200 investors should be cautious about its product pipeline; although it has consistently EPS 1A: ($0.71) produced successful games, it hasn't produced a sufficient number of them to EPS 2A: $0.36 generate consistent profits. Our PT is based upon a market multiple (15x) applied to EPS 3E: $4.30 “sustainable” earnings of $0.70 plus $8.45 net cash. This multiple is in line with EPS 4E: $0.40 industry peers, and reflects an improving outlook for publishers on next-gen consoles Risks: Risks to attainment of our share price target include performance of the company’s games, levels of competition, changing macroeconomic factors, changes in consumer demand for video game hardware, and the ability of the company to attract merger partners.

Notes: As of 2/7/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

Ubisoft

Founded: 1986 Headquarters: Montreuil-sous-Bois, France Key People: Yves Guillemot (Co-Founder, CEO), Alain Martinez (CFO), Christine Burgess-Quémard (Executive Director, Worldwide Studios) Known for: Assassin's Creed, Far Cry, Rayman, Tom Clancy games, Watch Dogs Description: Ubisoft Entertainment is a leading worldwide developer, publisher, and distributor of interactive entertainment products. Rating: OUTPERFORM Pros: A strong slate of games headlined by an industry leader, Assassin's Creed; Price Target: € 14 Management has strong expectations for FY:15 and FY:16 after the recent delays of Ticker: UBI.FP Watch Dogs and The Crew; We believe the delay of Watch Dogs is probably the right Share Price: € 11.35 move, as it is a new franchise and was previously positioned to compete with well- Shares (mm): 105 established franchises on next-gen consoles; Ubisoft’s release slate has become far Mkt. Cap. (mm): € 1,186 more predictable; Appears intent on being a leading publisher on next-gen consoles Ent. Val. (mm): € 1,329 Cons: We believe the delays of Watch Dogs and The Crew damaged Ubisoft’s 52 Week: €7.50-12.25 credibility, and caused its share price to decline; Management may have been overly FYE: March 31 bullish about Assassin’s Creed IV: Black Flag’s prospects; We expect casual revenue Rev. 1A (mm): € 1,061 to continue to decline as the Wii U fails to capture Wii market share Rev. 2A (mm): € 1,256 Investment Thesis: Maintaining our OUTPERFORM rating and our 12-month price Rev. 3E (mm): € 1,000 target of €14. Our price target reflects a multiple of 14x our FY:15 EPS estimate of Rev. 4E (mm): € 1,400 €1.00. Despite the recent pre-announcement, we remain fans of the company’s EPS 1A: € 0.39 improving execution and management’s long-term vision, and believe Ubisoft will EPS 2A: € 0.71 benefit from the stronger Watch Dogs franchise that should emerge from more EPS 3E: (€ 0.34) development time. In addition, it has one of the strongest stables of games in the EPS 4E: € 1.00 industry, an asset that is especially important given the recent console refresh. Risks: Risks to attainment of our share price target include changes to game release timing, greater-than-expected deterioration of the average selling price (ASP) for game software, the effects of competition, foreign exchange changes, macroeconomic factors and lower-than-expected consumer demand for video game hardware.

Notes: As of 2/11/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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Profiles – Covered Publicly Traded Companies (Continued)

Zynga

Founded: 2007 Headquarters: , California Key People: Mark Pincus (Founder, Chief Product Officer, Chairman), (CEO), Clive Downie (COO), Mark Vranesh (CFO) Known for: FarmVille, , , CityVille, other Ville games Description: Zynga is a leading social game developer. Its free-to-play games are accessible on Zynga.com, Facebook, other social networks, and mobile platforms. Rating: OUTPERFORM Pros: Q4:13 bookings exceeded guidance due in part to positive trends for key titles; Price Target: $6 Zynga provided much stronger-than-expected FY:14 guidance, reflecting positively on Ticker: ZNGA the steps that management has taken to refresh the product portfolio and rationalize Share Price: $4.45 spending; Strong mobile momentum expected to continue through 2014; Shares (mm): 820 Management recently articulated its turnaround strategy Mkt. Cap. (mm): $3,651 Cons: The NaturalMotion acquisition came at a somewhat hefty price tag; Zynga has Ent. Val. (mm): $2,109 yet to demonstrate that it can be consistently profitable; User metrics continued to 52 Week: $2.50-4.97 decline in Q4:13, but should rebound as the game slate improves in 2014; The vast FYE: December 31 majority of Zynga’s players continue to be non-payers; It is unclear whether Zynga can Rev. 1A (mm): $1,140 truly identify a new franchise title; Zynga has seen its market leadership in social Rev. 2A (mm): $1,281 gaming erode; Web-based games appear to be fading fast Rev. 3A (mm): $873 Investment Thesis: Maintaining our OUTPERFORM rating and price target of $6. Our Rev. 4E (mm): $905 price target reflects an EV/bookings multiple of 4.5x, applied to our 2014 bookings EPS 1A: $0.24 estimate. We believe the multiple is warranted, as the risk of negative earnings or EPS 2A: $0.07 cash flow has been mitigated and bookings have begun to grow EPS 3A: ($0.04) EPS 4E: $0.04 Risks: Risks to the attainment of our share price target include changes to game release timing, decreasing interest in Facebook and other social networks among the general public, changes to the terms or economics of its Facebook agreements, the inability to create popular mobile games, and increased competition, among other risks.

Notes: As of 2/7/2014; Revenue and EPS estimates are from most recent Wedbush Securities research report; Sources: Company website, Wikipedia, Wedbush Securities, and Yahoo Finance (for stock price and volume charts).

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PROFILES – NON-COVERED PUBLICLY TRADED COMPANIES

Profiles – Non-Covered Publicly Traded Companies

Atari, SA

Founded: 1972 Headquarters: , France Key People: Frédéric Chesnais (Chairman of the Board and CEO), Laurence Betito (CFO), Jim Wilson (CEO of Atari Inc.) Known for: Asteroids, Centipede, , , RollerCoaster Tycoon

Ticker: ATA Description: Atari is a multi-platform, global interactive entertainment and licensing Exchange: company. The original innovator of video gaming, founded in 1972, Atari owns and/or Currency: Euro manages a portfolio of more than 200 games and franchises, including brands like Share Price: 0.63 Asteroids, Centipede, , Pong, Test Drive, and Shares (mm): 30 RollerCoaster Tycoon. Mkt. Cap. (mm): 19 52 Week: 0.01-1.00 Atari capitalizes on these powerful properties by delivering compelling games online FYE: March 31 (i.e. browser, Facebook and digital download), on smartphones and tablets and other Rev. 1A (mm): connected devices. The Company also develops and distributes interactive Rev. 2A (mm): entertainment for video game consoles from Microsoft, Nintendo and Sony. Rev. 3E (mm): Rev. 4E (mm): As a licensor, Atari extends its brand and franchises into other media, merchandising EPS 1A: and publishing categories. Atari is listed on NYSE Euronext Paris stock exchange. EPS 2A: EPS 3E: EPS 4E: Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, , Thomson ONE, Wikipedia, and Wedbush Securities. Capcom

Founded: 1983 Headquarters: Osaka, Japan Key People: Kenzo Tsujimoto (Chairman and CEO), Haruhiro Tsujimoto (President and COO) Known for: , , Resident Evil,

Ticker: 9697 Description: Capcom has created some of the most iconic characters and franchises Exchange: TYO in gaming. From the ubiquitous Mega Man and Street Fighter franchises to the genre- Currency: JPY defining Resident Evil and Devil May Cry series, Capcom has utilized its talent to Share Price: 1,930 create recognizable and entertaining games all over the world. Guided by the idea of Shares (mm): 56 fostering a culture of entertainment, Capcom has consistently acted on this view by Mkt. Cap. (bn): 109 creating innovative and hugely popular games that push technical and creative limits. 52 Week: 1,388-2,007 FYE: March 31 A charter member of the Entertainment Software Association (ESA), Capcom develops Rev. 1A (bn): 82.1 products for all age groups and supports the programs and guidelines established by Rev. 2A (bn): 94.1 the Entertainment Software Rating Board (ESRB). Capcom's “E” rated games for Rev. 3E (bn): 97.8 Everyone (content suitable for persons 6 and older) include the Mega Man franchise of Rev. 4E (bn): 98.9 games. Capcom's “T” rated games for Teens (content suitable for persons 13 and EPS 1A: 116.10 older) include the Street Fighter, Breath of Fire, and franchise of products EPS 2A: 51.64 and Capcom's “M” rated games for mature audiences (content suitable for persons 17 EPS 3E: 131.48 and older) include the Resident Evil, Devil May Cry and Dead Rising series of EPS 4E: 136.15 products. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Profiles – Non-Covered Publicly Traded Companies (Continued)

Disney Interactive

Founded: 1999 Headquarters: Glendale, California Key People: Jimmy Pitaro (President)

Known for: Disney Infinity, Epic Mickey, Disney's Planes, Playdom

Ticker: DIS Description: Disney Interactive is the part of responsible Exchange: NYSE for the global creation and delivery of interactive entertainment, multi-platform video Currency: USD games, and family-focused content across all current and emerging digital media Share Price: 72.72 platforms. Disney Interactive produces and distributes a broad portfolio of content from Shares (bn): 1.76 Disney Interactive Games and Disney Interactive Media. Products and content Mkt. Cap. (bn): 128 released and operated by Disney Interactive include blockbuster mobile, social and 52 Week: 53.41-76.84 console games, online virtual worlds, #1 kid's entertainment destination Disney.com FYE: September 30 and the #1 Family/Parenting portfolio on the Web. Rev. 1A (mm): 42,278 Rev. 2A (mm): 45,041 For Core Games, Disney creates content for the Wii, Wii U, Xbox 360, and PS3, Rev. 3E (mm): 47,938 presumably as well as the Xbox One and PS4 at some point in the future. The games Rev. 4E (mm): 51,072 feature characters from Disney, Marvel, and Pixar. EPS 1A: 3.07 EPS 2A: 3.39 On July 27, 2010, The Walt Disney Company acquired Playdom in a $763 million deal. EPS 3E: 3.94 Disney initially paid $563 million for Playdom, which was the No. 3 social game EPS 4E: 4.53 company with about 42 million monthly players at the time of the acquisition. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Gameloft

Founded: 1999 Headquarters: Paris, France Key People: Michel Guillemot (Founder, President, CEO)

Known for: , Brothers in Arms, Gangstar, Modern Combat, N.O.V.A., Real Football Ticker: GFT Description: A leading global publisher of digital and social games, Gameloft has Exchange: Euronext established itself as one of the top innovators in its field since 2000. Gameloft creates Currency: Euro games for all digital platforms, including mobile phones, smartphones and tablets Share Price: 7.97 (including Apple iOS and Android devices), set-top boxes and connected TVs. Shares (mm): 82 Gameloft operates its own established franchises such as Asphalt, Order & Chaos, Mkt. Cap. (mm): 655 Modern Combat or Dungeon Hunter and also partners with major rights holders 52 Week: 4.40-8.42 including Universal, Illumination Entertainment, Disney, Marvel, , FOX, Mattel FYE: December 31 and Ferrari. Rev. 1A (mm): 164 Rev. 2A (mm): 208 Gameloft is present on all continents, distributes its games in over 100 countries and Rev. 3E (mm): 236 employs over 5,000 developers. Rev. 4E (mm): 270 EPS 1A: 0.23 Gameloft is listed on NYSE Euronext Paris (Euronext: GFT.PA, Bloomberg: GFT FP, EPS 2A: 0.11 Reuters: GLFT.PA). Gameloft is traded OTC in the US (sponsored Level 1 ADR ticker: EPS 3E: 0.19 GLOFY). EPS 4E: 0.32 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Giant Interactive

Founded: 2001 Headquarters: Shanghai, China Key People: Yuzhu Shi (Founder, Chairman of the Board of Directors), Wei Liu (Director, CEO), Xuefeng Ji (President) Known for: ZT Online series, ZT Online 2, Giant Online, XT Online, The Golden Land

Ticker: GA (ADR) Description: One of China's leading online game developers and operators in terms Exchange: NYSE of market share. Focuses mainly on massively multiplayer online, or MMO, games that Currency: USD are played through networked game servers in which tens of thousands of players are Share Price: 10.88 able to simultaneously connect and interact. Many of its games are designed on a Shares (mm): 240 “Free-To-Play” model, by which users can access a Free-To-Play game at no cost, but Mkt. Cap. (mm): 2,607 pay for virtual products and services within the game. In November 2007, it 52 Week: 5.75-11.47 successfully carried out an initial public offering on the New York Stock Exchange FYE: December 31 (“NYSE”) under the ticker symbol “GA”. Rev. 1A (mm): 285 Rev. 2A (mm): 345 Its flagship game, ZT Online, was launched in January 2006, and was voted the most Rev. 3E (mm): 388 popular online game in China in 2006 according to the International Data Corporation, Rev. 4E (mm): 447 or IDC, a leading market research firm. It has since significantly expanded its games EPS 1A: 0.74 portfolio. EPS 2A: 0.82 EPS 3E: 0.93 EPS 4E: 1.00 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Glu Mobile

Founded: 2001 Headquarters: San Francisco, California Key People: Niccolo de Masi (CEO), Eric Ludwig (EVP and CFO), Matt Ricchetti (President of Studios), Chris Akhavan (President of Publishing) Known for: Gun Bros, , Blood & Glory, and Samurai vs. Zombies Defense

Ticker: GLUU Description: Glu Mobile is a leading global developer and publisher of free-to-play Exchange: games for smartphone and tablet devices. Currency: USD Share Price: 3.89 Glu is focused on creating compelling original IP games on a wide range of platforms Shares (mm): 78 including iOS, Android, and MAC OS. Glu’s unique technology Mkt. Cap. (mm): 303 platform enables its titles to be accessible to a broad audience of consumers globally. 52 Week: 2.00-4.39 FYE: December 31 Founded in 2001, Glu is headquartered in San Francisco with teams outside Seattle Rev. 1A (mm): 73 and in Canada, China, India, Korea and Russia. Consumers can find high-quality Rev. 2A (mm): 88 entertainment created exclusively for mobile devices wherever those customers see Rev. 3E (mm): 103 the ‘g’ character logo or at www.glu.com. Rev. 4E (mm): 121 EPS 1A: (0.07) EPS 2A: (0.08) EPS 3E: (0.15) EPS 4E: (0.05) Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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GRAVITY

Founded: 2000 Headquarters: Seoul, South Korea Key People: Hyun Chul Park (CEO)

Known for: Ragnarok Online

Ticker: GRVY (ADR) Description: Established in April 2000, GRAVITY is a global online game company Exchange: NASDAQ listed on the NASDAQ. Currency: USD Share Price: 1.09 GRAVITY is widely known for its successful development of the internationally Shares (mm): 28 acclaimed MMORPG title, Ragnarok Online, and is currently servicing the game to a Mkt. Cap. (mm): 30 wide range of gamers around the world. GRAVITY is also preparing a full lineup of next- 52 Week: 0.90-1.52 generation game titles including the sequel Ragnarok Online II and Requiem Online, FYE: which will continue the success of Ragnarok Online in the years to come. Rev. 1A (mm): Rev. 2A (mm): GRAVITY is strengthening its publishing business by providing a wide variety of Rev. 3E (mm): renowned game titles to its users based on the company's powerful global network. Rev. 4E (mm): EPS 1A: EPS 2A: EPS 3E: EPS 4E: Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. GREE

Founded: 2004 Headquarters: , Japan Key People: Yoshikazu Tanaka (Founder and CEO), Kotaro Yamagishi (Founder, Director, EVP), Masaki Fujimoto (Director, CTO, SVP) Known for: Beyond the Dead, Call to Arms, Knights & Dragons, Legends at War, Modern War, NFL Shuffle, War of Nations Ticker: 3632 Description: GREE is a global mobile social company with businesses that include Exchange: TYO social gaming, social media, advertising, licensing and merchandising, and venture Currency: JPY capital. Established in December 2004, GREE created the world's first mobile social Share Price: 1,180 game in 2007 and today is a global leader in free-to-play, reaching audiences around Shares (mm): 232 the world with its portfolio of first-party and partner titles. GREE has studios in Tokyo, Mkt. Cap. (bn): 274 San Francisco, Vancouver, and Seoul, and is listed on the Tokyo Stock Exchange 52 Week: 676-1,445 (3632). FYE: June 30 Rev. 1A (bn): 158.2 In May 2007 GREE combined gaming and social features to create Tsuri-Sta, the Rev. 2A (bn): 152.2 world’s first mobile social game. Since then GREE has continued to expand its lineup Rev. 3E (bn): 143.6 of games in a range of genres from virtual pets to RPGs and sports, producing Rev. 4E (bn): 145.7 original hit titles such as Clinoppe and Driland, forming a strategic partnership with EPS 1A: 206.74 leading Japanese developer Pokelabo while partnering with a range of other EPS 2A: 96.83 developers to bring many more games to users worldwide. GREE games are EPS 3E: 86.12 available for Android and iOS devices, among other devices, on the Facebook EPS 4E: 99.57 platform, among other platforms. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Konami

Founded: 1969 Headquarters: Tokyo, Japan Key People: Kagemasa Kozuki (Founder, Chairman), Takuya Kozuki (President and Representative Director) Known for: , , , , ,

Ticker: KNM (ADR) Description: Konami Digital Entertainment, Inc. (KDEI), a wholly owned subsidiary of Exchange: NYSE Konami Corporation (NYSE: KNM), is a leading, global developer, publisher and Currency: USD manufacturer of electronic entertainment properties, specializing in the home video Share Price: 22.35 game market. Headquartered in Tokyo Japan, Konami Corporation first began Shares (mm): 139 operating in North America in 1982, and has been publishing computer and video Mkt. Cap. (mm): 3,098 games as Konami of America (KOA) since 1999 from its offices in Redwood City, 52 Week: 17.51-28.32 California near San Francisco. In October of 2003, Konami Corporation moved to FYE: March 31 strengthen its content planning and production by expanding its operations to Los Rev. 1A (mm): Angeles, California under the new name of Konami Digital Entertainment, Inc. Rev. 2A (mm): Rev. 3E (mm): Konami is famous for popular video game series such as Castlevania, Contra, Dance Rev. 4E (mm): Dance Revolution, , Frogger, , , Metal Gear, Pro EPS 1A: Evolution Soccer, Silent Hill and Yu-Gi-Oh!. The 2012 purchase and absorption of EPS 2A: resulted in the addition of several other popular franchises, including EPS 3E: Adventure Island, , , Far East of Eden and . EPS 4E: Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Interactive

Founded: 1989 Headquarters: San Diego, California Key People: Darren Richardson (President and CEO), Thomas Brown (Chairman), Karen McGinnis (CFO) Known for: Controllers, headphones,

Ticker: MCZ Description: Mad Catz Interactive is a global provider of innovative interactive Exchange: NYSEMKT entertainment products marketed under its Mad Catz (gaming), Tritton (audio), and Currency: USD Saitek (simulation) brands. Share Price: 0.472 Shares (mm): 64 Mad Catz also develops flight simulation software through its internal ThunderHawk Mkt. Cap. (mm): 30 Studios; publishes games under its Mad Catz brand; and distributes games and 52 Week: 0.36-0.89 videogame products for third parties. FYE: March 31 Rev. 1A (mm): Mad Catz distributes its products through most leading retailers offering interactive Rev. 2A (mm): entertainment products and has offices in North America, Europe and Asia. Rev. 3E (mm): Rev. 4E (mm): EPS 1A: EPS 2A: 0.02 EPS 3E: (0.06) EPS 4E: 0.10 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Microsoft Studios

Founded: 2002 as Microsoft Game Studios, 2011 as Microsoft Studios Headquarters: Redmond, Washington Key People: Phil Spencer (Head of Microsoft Studios), (WW Corporate VP), (Director of Programming for Xbox Live), Marc Whitten (GM Xbox Live) Known for: Hardware (Xbox, Xbox 360, Xbox One, Kinect) and software (Halo, Fable, Forza Motorsport) Ticker: MSFT (Parent) Description: Microsoft Studios is the video game production wing for Microsoft, Exchange: NASDAQ responsible for the development and publishing of games for the Xbox, Xbox 360, Currency: USD Xbox One, and Windows Phone platforms. Share Price: 36.81 Shares (bn): 8.35 Microsoft Studios was established in 2002 as Microsoft Game Studios to coincide with Mkt. Cap. (bn): 307 the release of the Xbox, before being re-branded in 2011. Microsoft Studios develops 52 Week: 27.10-38.98 and publishes games in conjunction with first and third party development studios FYE: June 30 under its publishing label. Rev. 1A (mm): 73,723 Rev. 2A (mm): 77,887 Microsoft Studios contains studios worldwide for game development, as well as Rev. 3E (mm): 84,387 entertainment technology advancement and publishing. Notable studios included 343 Rev. 4E (mm): 89,833 Industries, Good Science Studio, , Rare, and . EPS 1A: 2.73 EPS 2A: 2.65 EPS 3E: 2.70 EPS 4E: 2.90 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Namco Bandai Games

Founded: 2006 Headquarters: Tokyo, Japan Key People: Satoshi Oshita (President, Director), Shin Unozawa (EVP, Director)

Known for: Dark , Ni No Kuni, Ridge Racer, Soulcalibur, , Tekken

Ticker: 7832 (Parent) Description: Namco Bandai Games Inc. (NBGI) is an arcade, mobile and home video Exchange: TYO game developer and publisher based in Japan. It is the product of a merger between Currency: JPY the video game development divisions of Bandai and Namco. Namco Bandai Games Share Price: 2,195 is a wholly owned subsidiary of Namco Bandai Holdings (NBHD) and specializes in Shares (mm): 220 production and sales of home video games. It is the head company of Bandai Namco Mkt. Cap. (bn): 482 Group's Game Contents Strategic Business Unit (SBU). 52 Week: 1,239-2,359 FYE: March 31 In North America, the U.S.-based Namco Bandai Games America represents the Rev. 1A (bn): 454.2 company as a regional publisher, while in PAL territories, publishing is handled by Rev. 2A (bn): 487.2 Namco Bandai Games Europe with distribution through . The Rev. 3E (bn): 492.2 company has its headquarters in Shinagawa, Tokyo. Rev. 4E (bn): 500.4 EPS 1A: 85.62 In early 2005, Namco Ltd. and Bandai Co. Ltd. announced plans to combine EPS 2A: 147.40 operations. On March 31, 2006, the game division of Bandai was merged to Namco EPS 3E: 140.65 and renamed Namco Bandai Games. In the United States, the Namco Hometek EPS 4E: 148.93 subsidiary was renamed to Namco Bandai Games America. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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NCSOFT

Founded: 1997 Headquarters: Seoul, South Korea Key People: T.J. Kim (Founder, CEO)

Known for: Aion, , Guild Wars, Lineage, WildStar

Ticker: 036570 Description: NCSOFT is the world’s premier publisher and developer of massively Exchange: KRX multiplayer online games. Established in 1997 in Seoul, South Korea, NCSOFT Currency: KRW quickly became the leader in online games with the successful launch of its flagship Share Price: 206,500.00 product Lineage. Today, NCSOFT is well positioned for continued success in the Shares (mm): 20 Asian, North American and European markets and expanding its reach throughout the Mkt. Cap. (tn): 4.12 world with its excellent products and franchises. 52 Week: 125,000-253,000 FYE: The company’s mission is to bring fun to everyone, and this allows NCSOFT to stand Rev. 1A (tn): out in the industry. With a successful history creating a diverse catalog of MMO games, Rev. 2A (tn): NCSOFT has made an indelible mark on the games industry. Rev. 3E (tn): Rev. 4E (tn): EPS 1A: EPS 2A: EPS 3E: EPS 4E: Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. NetEase

Founded: 1997 Headquarters: Guangzhou, China Key People: William Lei Ding (CEO, Director, major shareholder)

Known for: World of Warcraft (in China), StarCraft II: Wings of Liberty (in China), Westward Journey, Youdao search engine Ticker: NTES (ADR) Description: Through its subsidiaries and contracts with affiliates Guangzhou Exchange: NASDAQ NetEase, Guangyitong Advertising, and Shanghai EaseNet, and respective Currency: USD shareholders, NetEase operate a leading interactive online community in China and Share Price: 74.65 is a major provider of Chinese language content and services through its online Shares (mm): 130 games, Internet , e-mail and wireless value-added services businesses. Mkt. Cap. (mm): 9,693 52 Week: 44.30-84.35 It generates revenues from fees it charge users of its online games and from selling FYE: December 31 ads on the NetEase websites, and to a lesser extent, from e-mail, wireless value- Rev. 1A (mm): 1,158.4 added and other fee-based premium services, including e-commerce services. Its Rev. 2A (mm): 1,316.4 service offerings on NetEase websites are available without charge. Rev. 3E (mm): 1,540.3 Rev. 4E (mm): 1,775.4 It uses two revenue models for games: a time-based model, in which players pay for EPS 1A: 3.92 game playing time, and an item-based model, in which players can play the basic EPS 2A: 4.44 features of the game for free and can purchase virtual items that enhance the playing EPS 3E: 5.47 experience. A majority of its revenues come from its in-house games that use the time- EPS 4E: 6.08 based model and from World of Warcraft and StarCraft II: Wings of Liberty. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Perfect World

Founded: 2004 Headquarters: Beijing, China Key People: Michael Yufeng Chi (Founder, Chairman), Robert Hong Xiao (CEO), Kelvin Wing Kee Lau (CFO) Known for: Blacklight Retribution, Dungeons & Dragons Neverwinter, Perfect World International, , II Ticker: PWRD (ADR) Description: Perfect World is a China-based online game company specializing in Exchange: NASDAQ MMORPGs. It primarily develops online games based on proprietary game engines Currency: USD and game development platforms. Its strong technology and creative game design Share Price: 18.41 capabilities, combined with its extensive knowledge and experiences in the online Shares (mm): 49 game market, enable it to frequently and promptly introduce popular games designed Mkt. Cap. (mm): 906 to cater changing customer preferences and market trends. 52 Week: 9.72-22.82 FYE: December 31 Its U.S. subsidiary, Perfect World Entertainment, was founded in 2008, and has Rev. 1A (mm): 474.0 published 10 popular titles, including Blacklight Retribution, Forsaken World, Perfect Rev. 2A (mm): 444.7 World International, and Star Trek Online. Perfect World Entertainment doubled Rev. 3E (mm): 496.9 revenues each of its first three years, and continues to grow at a steady pace. The Rev. 4E (mm): 595.3 company works closely with its American development teams and partners such as EPS 1A: 3.06 , developer of the highly anticipated MMORPG Dungeons & Dragons EPS 2A: 1.92 Neverwinter, and , developer of the hit Torchlight series, to provide EPS 3E: 1.52 unparalleled quality of service and game experiences to its players. EPS 4E: 1.91 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Sega

Founded: 1940 Headquarters: Tokyo, Japan Key People: (Chairman, CEO, Director of parent ), David Rosen (Founder) Known for: Sonic, Aliens, , , Warhammer 40k Dawn of War Ticker: 6460 (Parent) Description: Subsidiary of Sega Sammy Holdings. Exchange: TYO Currency: JPY As one of the leading interactive entertainment companies, SEGA cultivates creative Share Price: 2,539 talent worldwide with offices in America, Japan and its European HQ in . Its Shares (mm): 243 acclaimed UK based studios include and The Mkt. Cap. (bn): 617 who are responsible for award-winning titles and iconic franchises such as Football 52 Week: 1,493-3,015 Manager, Aliens, and the Total War series. , the newest UK studio in the FYE: March 31 SEGA family, is the talented team behind Sonic the Hedgehog's latest adventures on Rev. 1A (bn): 395.5 mobile platforms and . SEGA's much loved blue hedgehog Rev. 2A (bn): 321.4 mascot is a true global brand crossing over from video games into toys, stationary, Rev. 3E (bn): 443.9 apparel and much more. Rev. 4E (bn): 456.2 EPS 1A: 86.73 SEGA is growing and has recently completed an acquisition of Canada based Relic EPS 2A: 137.14 Entertainment Studio, famed for high quality strategy games including Warhammer EPS 3E: 191.22 40k Dawn of War and the Company of Heroes series. The company is determined to EPS 4E: 200.52 set new standards in interactive entertainment. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Sony Computer Entertainment America

Founded: 1994 Headquarters: San Mateo, California Key People: Andrew House (President and Group CEO of Sony Computer Entertainment), Jack Tretton (President and CEO of SCEA) Known for: Sony is known for consoles (PS1, PS2, PS3, PS4) and handhelds (PSP, PS Vita); SCEA studio releases include Uncharted, The Last of Us, MLB: The Show Ticker: SNE (Parent, ADR) Description: Sony Computer Entertainment America LLC (SCEA), a subsidiary of Exchange: NYSE Sony, is responsible for keeping PlayStation growing and thriving in the United States, Currency: USD Canada and Latin America. Based in San Mateo, California, SCEA serves as Share Price: 16.73 headquarters for all North American operations and is a wholly owned subsidiary of Shares (bn): 1.04 Sony Corporation of America Inc. Mkt. Cap. (bn): 17.40 52 Week: 13.36-23.38 It makes advanced hardware that enables developers to produce vanguard titles and FYE: March 31 set new standards in interactive entertainment. Its goal is to make a family of products Rev. 1A (mm): 79,186 that completely changes the definition of home entertainment. It doesn’t matter if Rev. 2A (mm): 72,349 you’re a hard-core gamer whose thumb calluses can deflect machine gun fire or if you Rev. 3E (mm): 72,927 just love Blu-ray movies, PlayStation entertainment products have something for you. Rev. 4E (mm): 78,918 EPS 1A: (5.55) Notable SCE studios, among others: in North America, and SCE Santa EPS 2A: 0.43 Monica Studio; in Europe, and ; in Asia, Polyphony EPS 3E: 0.18 Digital and SCE Japan Studio EPS 4E: 1.03 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Square Enix Holdings

Founded: 2003 as Square Enix, 2008 as Square Enix Holdings Headquarters: Tokyo, Japan Key People: Yosuke Matsuda (President, CEO)

Known for: , Final Fantasy, , Dragon Quest, EverQuest, , Kingdom Hearts, Thief, Tomb Raider Ticker: 9684 Description: The Square Enix Group has four lines of business: Digital Entertainment, Exchange: TYO Amusement, Publication and Merchandising. The SQUARE ENIX Group plans, Currency: JPY develops, distributes and operates Digital Entertainment content primarily in the form Share Price: 2,081 of games. The Group develops and provides a variety of Digital Entertainment content Shares (mm): 115 worldwide through its global network of leading development studios and marketing Mkt. Cap. (bn): 240 operations located around the world. 52 Week: 943-2,081 FYE: March 31 The original Square Enix was formed as the result of a merger between Square and Rev. 1A (bn): 127.9 Enix. The merger occurred on April 1, 2003 with Enix as the surviving company. The Rev. 2A (bn): 148.0 company also owns Corporation, best known for arcade games such as Space Rev. 3E (bn): 148.1 Invaders and Bubble Bobble, and former game publisher Eidos Interactive, which has Rev. 4E (bn): 153.7 been absorbed into . Square Enix now publishes all of Eidos' IPs EPS 1A: 52.66 and runs Eidos' development studios. Eidos was most well known for publishing the EPS 2A: (119.19) Tomb Raider, Hitman, Deus Ex, and Thief series of games. EPS 3E: 54.81 EPS 4E: 80.60 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Tecmo Koei Holdings

Founded: 2009 as Tecmo Koei Holdings Headquarters: Yokohama, Japan Key People: Keiko Erikawa (Chairman), Yoichi Erikawa (President, CEO)

Known for: Dead of Alive, Dynasty Warriors, , , Ticker: 3635 Description: Tecmo Koei Holdings Co., Ltd. is a created in 2009 by Exchange: TYO the merger of Japanese video game developers and publishers Koei and Tecmo. Currency: JPY Share Price: 1,184 Koei Europe changed its name to Tecmo Koei Europe, Ltd. and now releases video Shares (mm): 87 games under the new moniker. In January 2010, Tecmo, Inc. and Koei Corporation Mkt. Cap. (bn): 103 merged into Tecmo Koei America Corporation. Tecmo has been declared disbanded 52 Week: 722-1,408 in Japan, effective as of April 1, 2010. Koei Canada, Inc. has since changed its name FYE: March 31 to Tecmo Koei Canada, Inc. Rev. 1A (bn): 35.5 Rev. 2A (bn): 34.6 Rev. 3E (bn): 38.4 Rev. 4E (bn): 39.6 EPS 1A: 53.52 EPS 2A: 65.23 EPS 3E: 70.25 EPS 4E: 77.88 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Tencent

Founded: 1998 Headquarters: Shenzen, China Key People: Ma Huateng (Chairman, CEO), Zhang Zhidong (Director, CTO), Lau Chi Ping Martin (Director) Known for: Call of Duty China, FIFA Online (in China), The Sims Social (in China)

Ticker: 0700 Description: Tencent has grown into one of China's largest and most used Internet Exchange: SEHK portals. Tencent provides value-added Internet, mobile and telecom services and Currency: HKD online advertising under the strategic goal of providing users with "one-stop online Share Price: 501.50 lifestyle services". Tencent’s leading Internet platforms in China – QQ (QQ Instant Shares (bn): 1.86 Messenger), WeChat, QQ.com, QQ Games, Qzone, 3g.QQ.com, SoSo, PaiPai and Mkt. Cap. (bn): 933 Tenpay – have brought together China's largest Internet community to meet the 52 Week: 237-536 various needs of Internet users including communication, information, entertainment, FYE: December 31 e-commerce and others. Rev. 1A (mm): 28,496.1 Rev. 2A (mm): 43,893.7 As of Dec 31, 2012, the active QQ users accounts for QQ IM amounted to 798.2 million Rev. 3E (mm): 60,008.7 while its peak concurrent users reached 176.4 million. The development of Tencent Rev. 4E (mm): 80,373.7 has profoundly influenced the ways hundreds of millions of Internet users EPS 1A: 5.49 communicate with one another as well as the lifestyles of those users. It also brings EPS 2A: 6.83 possibilities of a wider range of applications to the China’s Internet industry. EPS 3E: 8.66 EPS 4E: 11.24 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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The9 Limited

Founded: 1999 Headquarters: Shanghai, China Key People: Jun Zhu (Chairman, CEO), George Lai (CFO)

Known for: Firefall and Qiji2

Ticker: NCTY (ADR) Description: The9 Limited is an online game developer and operator. Exchange: NASDAQ Currency: USD The9 develops and operates, directly or through its affiliates, its proprietary MMO Share Price: 2.53 games including Firefall and Qiji2. Shares (mm): 23 Mkt. Cap. (mm): 58 The9 also develops and operates web games and social games. In 2010, The9 52 Week: 2.08-4.50 established its Mobile Internet Unit to focus on mobile internet business. The9 FYE: December 31 develops and operates three mobile platforms under The9’s Mobile Internet Unit Rev. 1A (mm): 16.9 including mobile game platform The9 Game Zone, mobile advertising platform Juzi Rev. 2A (mm): 24.8 and mobile reading platform KingReader. In 2013, The9 formed a joint venture with Rev. 3E (mm): 37.4 Shanghai ZTE to develop and operate Smart TV business. Rev. 4E (mm): n/a EPS 1A: (1.80) EPS 2A: (3.37) EPS 3E: (3.25) EPS 4E: n/a Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Turtle Beach Systems

Founded: 1975 Headquarters: Valhalla, New York Key People: Juergen Stark (CEO, Parametric Sound Corporation), John Hanson (CFO, Parametric Sound Corporation), Richard Kulavik (CTO) Known for: Gaming headsets

Ticker: PAMT (Parent) Description: Parent company is Parametric Sound Corporation, which is the byproduct Exchange: NASDAQ of a merger first announced on August 5, 2013 and officially closed on January 15, Currency: USD 2014, between Parametric Sound and Voyetra Turtle Beach. Share Price: 14.54 Shares (mm): 7.22 According to NPD data, Turtle Beach is the number one console gaming headset Mkt. Cap. (mm): 105 manufacturer in the U.S. based on dollar sales for the calendar year 2012, with a 53 52 Week: 8.00-22.39 percent dollar share of the market. FYE: September 30 Rev. 1A (mm): n/a Turtle Beach headsets are now distributed in 44 countries across North America, Rev. 2A (mm): n/a South America, Europe, the Middle East, Africa, Australia, and Asia. The headsets are Rev. 3E (mm): 242 sold at more than 27,000 storefronts, including major retailers such as Amazon, Rev. 4E (mm): 344 Argos, Best Buy, Carrefour, GameStop, HMV, Sainsbury, Target, Tesco and Walmart. EPS 1A: n/a EPS 2A: n/a In the past 12 months, Turtle Beach announced new partnerships with Microsoft, EPS 3E: 0.40 Sony, Activision, and Marvel that will make a series of innovative new headsets EPS 4E: 0.85 available to consumers and introduced a new line of wireless media headsets. Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

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Profiles – Non-Covered Publicly Traded Companies (Continued)

Warner Bros. Interactive Entertainment

Founded: 1993 Headquarters: Burbank, California Key People: Martin Tremblay (President)

Known for: Batman, F.E.A.R., Lego, Mortal Kombat

Ticker: TWX (Parent) Description: Warner Bros. Interactive Entertainment (WBIE) is a division of Warner Exchange: NYSE Bros., which is a subsidiary of Time Warner. Currency: USD Share Price: 63.32 It is a worldwide publisher, developer, licensor and distributor of video games for both Shares (mm): 905 internal and third party titles. Under the WBIE umbrella is Warner Bros. Games (also Mkt. Cap. (mm): 57,287 the division's major publishing unit), which focuses on the creation, development and 52 Week: 49.50-70.77 production of first-party titles. Because of the distribution, marketing and sales FYE: December 31 infrastructure of Warner Home Video, WBIE is a significant worldwide publisher for Rev. 1A (mm): 28,974 both internal and third-party game titles. Rev. 2A (mm): 28,729 Rev. 3E (mm): 29,594 In recent years, WBIE has garnered acclaim for its Batman and Lego games, and Rev. 4E (mm): 30,636 been applauded for the successful reintroduction of Mortal Kombat. EPS 1A: 2.89 EPS 2A: 3.28 EPS 3E: 3.75 EPS 4E: 4.26 Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities. Webzen

Founded: 2000 Headquarters: Bundang-gu, South Korea Key People: Kim Tae Young (CEO)

Known for: Archlord, Metin2, MU, S.U.N.

Ticker: 069080 Description: WEBZEN Inc. is a Korea-based company engaged in the development Exchange: KOSDAQ and provision of online game services. Currency: KRW Share Price: 6,730 Its products include MU online, Archlord, Soul of the Ultimate Nation and R2, which are Shares (mm): 31 three-dimensional (3D) massive multiplayer online role playing games (MMORPGs); Mkt. Cap. (bn): 211 C9, a full 3D action role playing games (RPGs), and Arctic Combat, which is a first- 52 Week: 6,330-10,650 person shooter (FPS) game and others. FYE: Rev. 1A (bn): The Company distributes its products through Internet, (PC) Rev. 2A (bn): rooms and mobile phones, as well as to overseas markets, including China, Japan, Rev. 3E (bn): Taiwan, Vietnam, America and Europe. On February 15, 2013, the Company acquired Rev. 4E (bn): a 100% stake in the United States-based online game service company, Gala-Net. EPS 1A: EPS 2A: EPS 3E: EPS 4E: Notes: Data as of 1/24/2014 and 1/27/2014; Revenue and EPS figures are from Thomson ONE; Sources: Company website, Google Finance, Thomson ONE, Wikipedia, and Wedbush Securities.

Entertainment: Software | 161

PROFILES – PRIVATE COMPANIES

Profiles – Private Companies

Bethesda Softworks

Founded: 1986 Headquarters: Rockville, Maryland Key People: Vlatko Andonov (President), (Executive Producer and Game Director at )

Known for: , Fallout

Description: Bethesda Softworks, LLC, is an American video game publisher. A subsidiary of ZeniMax Media, the company was originally based in Bethesda, Maryland, and eventually moved to its current location in Rockville, Maryland.

Consisting of a broad portfolio of games in role-playing, racing, simulation, and sports, Bethesda Softworks' major franchises are distributed worldwide. It currently publishes games for three other ZeniMax Media subsidiaries: , Bethesda Game Studios, and , among others.

Arkane Studios is known for .

Bethesda Game Studios is known for The Elder Scrolls and Fallout.

id Software is known for , , RAGE, and , among a slew of titles. On June 24, 2009, ZeniMax Media acquired id Software, whose titles would be published by Bethesda Softworks. It was later announced that any games using the 5 game engine would be published by Bethesda Softworks as well.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Bungie

Founded: 1991 Headquarters: Bellevue, Washington Key People: Jason Jones (Founder, Project Director), Alex Seropian (Founder), Harold Ryan (President)

Known for: Halo, Destiny

Description: Bungie is an American located in Bellevue, Washington. The company was established in May 1991 as Bungie Software Products Corporation. Originally based in , Illinois, the company concentrated primarily on Macintosh games during its early years and created Marathon and Myth. A West Coast offshoot produced the PC and console title Oni.

Microsoft acquired Bungie in 2000; the project it was working on was repurposed into a launch title for Microsoft's Xbox console, called Halo: Combat Evolved. Halo became the Xbox's "", spawning a billion dollar franchise. On October 5, 2007, Bungie announced that it had split from Microsoft and become a privately held independent company, Bungie LLC. The company later incorporated and signed a ten-year publishing deal with Activision Blizzard.

Among Bungie's side projects are Bungie.net, the company's official website, which includes company information, forums, and statistics-tracking and integration with many of its games. Bungie.net also serves as the platform from which Bungie sells company-related merchandise out of the Bungie Store. The company is working on multiple projects with Activision, starting with a new IP under the name Destiny.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Codemasters

Founded: 1986 Headquarters: Southam, Warwickshire, U.K. Key People: David Darling (Founder), Richard Darling (Founder), Jim Darling (Founder)

Known for: Brian Lara Cricket, Colin McRae Rally/Dirt, , F1, LMA Manager, Micro Machines, , Overlord, TOCA/ Description: is an award winning games developer and publisher with a 25-year heritage. Its popular game brands include DiRT, GRID, Cricket and Operation Flashpoint. The company also retains the exclusive worldwide video game rights to . F1 2010, the first multi-format high-definition FORMULA ONE , is the fastest-selling FORMULA ONE game ever. It entered the charts at number one in six countries and secured a BAFTA award. In 2009 Codemasters won the coveted Grand Prix Award at the 2009 Develop Industry Excellence Awards, an award bestowed on the company felt by Develop to have contributed the most to the games medium in recent times.

Around the world, Codemasters employs over 500 people in development and publishing. It has two development studios in the UK– one at its Warwickshire HQ with a further site in Birmingham. An additional art studio is based in Kuala Lumpur, Malaysia.

In March 2010, Reliance Big Entertainment Ltd. (RBEL), a part of India’s Reliance ADA group, acquired a 50 per cent shareholding in the company, alongside existing investor, Balderton Capital, the leading European venture capital firm that first invested in Codemasters in 2005.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

Founded: 1999 Headquarters: Frankfurt, Germany Key People: Avni Yerli (Founder), (Founder), Faruk Yerli (Founder)

Known for: CryEngine, Crysis, Far Cry, , Homefront, Ryse: Son of Rome

Description: Crytek is an independent company at the forefront of the interactive entertainment industry, and is dedicated to pushing the boundaries of gaming by creating standout experiences with its cutting-edge 3D game technology, CryEngine.

Since its establishment, Crytek has consistently been recognized for excellence in its field – earning accolades such as the 2011 Develop Award for Best Independent Studio and a 2010 Red Dot Design Award. Its award-winning games include Far Cry, Crysis, , , Fibble – Flick ‘n’ Roll, , and Warface.

Crytek is committed to creating high-quality products powered by its CryEngine technology. In 2009, Crytek launched CryEngine 3, the first game development platform for PC, Xbox 360 and PlayStation 3 that is next-gen ready.

In 2010, Crytek announced Warface, its first free-to-play game service and a major milestone in the studio’s history. The announcement was followed by the 2012 release of Fibble – Flick ‘n’ Roll, its debut on mobile devices.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Deep Silver

Founded: 2002 Headquarters: Planegg, Bavaria, Germany Key People: Dr. Klemens Kundratitz (CEO)

Known for: , Sacred, Saints Row

Description: Deep Silver develops and distributes interactive games for all platforms. The Deep Silver label means to captivate all gamers who have a passion for thrilling in exciting game worlds. Deep Silver works with its partners to achieve a maximum of success while maintaining the highest possible quality, always focusing on what the customer desires.

Deep Silver has published more than 200 games since 2003, including its own brands like the critically acclaimed zombie action franchise Dead Island, action role-playing games from the Sacred world, successful adventures such as the series and the role-playing realms of Risen. Notable recent releases from Deep Silver include Saints Row IV and : Last Light, with Sacred 3 expected in 2014. Deep Silver also owns the development studio Volition based in Champaign, IL.

Deep Silver was founded by parent in 2002.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Epic Games

Founded: 1991 Headquarters: Cary, North Carolina Key People: Tim Sweeney (CEO, Founder), Mark Rein (Founder, Vice President), (Former Design Director)

Known for: Gears of War, , Unreal,

Description: Established in 1991, Epic Games, Inc. develops cutting-edge games and cross- engine technology. It is responsible for the bestselling “Unreal” series of games, the billion-dollar blockbuster “Gears of War” franchise and the groundbreaking “Infinity Blade” line of mobile games. Epic’s award-winning Unreal Engine technology is available for licensing. It is the parent company of game developers Chair Entertainment and . Key developers at Epic Games include chairman, CEO and technical director Tim Sweeney, and lead programmer Steve Polge. Jerry O'Flaherty was the studio art director from 2003 to 2007. Chris Perna has been the art director since O'Flaherty's departure from the company. Cliff Bleszinski, design director, announced his departure on October 3, 2012.

In July 2012, Chinese company Tencent Holdings acquired approximately 48.4% of Epic then issued share capital, equating to 40 percent of total Epic — inclusive of both stock and employee stock options, for $330 million. Tencent Holdings has the right to nominate directors to the board of Epic Games and thus accounted for as an associate of the Group. A number of high profile staff left the company months after the deal was announced.

On January 27, 2014, Microsoft Studios announced that it had acquired the rights to the "Gears of War" franchise for an undisclosed sum. Notes: As of 1/27/2014; Sources: Company websites, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Infinite Game Publishing

Founded: 2011 Headquarters: Montreal, Quebec Key People: Kelly Zmak (President)

Known for: MechWarrior Online, MechWarrior Tactics, Sins of a Dark Age

Description: Infinite Game Publishing (IGP) is a new Digital publisher based in Montreal, Quebec, specializing in publishing free-to-play online games.

IGP is a subsidiary of 7G Entertainment, a Montreal based entertainment firm created and partially owned by Fonds de solidarité FTQ, a Quebec economic development fund.

This year it is publishing MechWarrior Online and MechWarrior Tactics.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Kabam

Founded: 2006 Headquarters: San Francisco, California Key People: Chou (Founder, CEO), Michael Li (Founder and General Manager, China), Holly Liu (Founder and Chief of Staff), Andrew Sheppard (President, Kabam Game Studio) Known for: Kingdoms of Camelot, Dragons of Atlantis, Edgeworld, The Godfather: Five Families

Description: Kabam is the leader in the western world for free-to-play core games with 1st and 3rd party published titles available on mobile devices and the Web. The company is revolutionizing the video game industry by innovating in the business of gaming, game discovery, and great games. Unlike traditional console video games, Kabam games are available to play for free virtually anywhere gamers look for entertainment—on mobile devices via the Apple Store or and on the Web via Facebook, Yahoo, Kabam.com and other platforms.

Kabam’s “freemium” business model enables players to access games at no cost or obligation, unlike console games that are expensive to buy or inconvenient to rent, and are played only on stationary and costly hardware devices that are upgraded about every seven years. Players who enjoy Kabam games can pay for premium content in the game to enhance the playing experience. The average Kabam player is highly engaged, playing more than two hours a day.

Kabam also publishes games by third party developers, including Book of Heroes (iOS) and Wartune (Kabam.com). Launched in 2012, Kabam Publishing provides outside developers access to the same technology platform and marketing tools that Kabam’s in-house development teams use to bring wildly popular games to players worldwide.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

King

Founded: 2003 Headquarters: London, U.K. Key People: Riccardo Zacconi (CEO)

Known for: Candy Crush Saga, Bubble Witch Saga, Farm Heroes Saga, Papa Bear Saga, Pet Rescue Saga, Pyramid Solitaire Saga

Description: King is a worldwide leader in casual games with more than 30 billion games played per month globally. It is a leading interactive entertainment company for the mobile world. Its mission is to provide highly engaging content to its audience to match mobile lifestyles: anywhere, anytime, through any platform and on any device. In June 2013, an average of 92 million daily active users played its games more than one billion times per day. Its top title to date, Candy Crush Saga, is one of the largest interactive entertainment franchises of all time.

Its focus is to provide a highly engaging, differentiated entertainment experience where the combination of challenge and progress drives a sense of achievement. It makes its games available for free, while players can purchase virtual items priced relative to the entertainment value provided. Its embeds social features in its content that enhance the player experience. It builds on a unique and passionate company culture predicated on collaboration, humility and respect. Its believes all of these in combination have made its content a core part of its audience’s daily entertainment.

King has offices in London, Hamburg, Stockholm, Malmö, Barcelona, Malta, Bucharest and San Francisco.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Mojang

Founded: 2009 Headquarters: Stockholm, Key People: Markus Persson (Chairman, Founder), Carl Manneh (CEO)

Known for: Minecraft, Scrolls, Cobalt

Description: Mojang is an developer studio based in Stockholm, Sweden. It develops a game called Minecraft and another game called Scrolls.

Minecraft is a sandbox construction game where the gamer can build anything he imagines. It also has scary monsters, like creepers who tend to want to destroy what the player has built.

Scrolls takes place in a world where the essence of conflict is stored on a parchment. You use the power of , spells, and ancient machines to gain the edge in battle, deploying forces by using scrolls: some rare, some common, some brutal, some tactical.

Cobalt is Mojang’s first 3rd party published game. Cobalt is an of running, jumping, rolling, shooting, throwing, dancing, hacking, rolling, flying, sliding, climbing, looting, deflecting, racing, passing, and scoring. Cobalt is developed by Oxeye Game Studio in collaboration with Mojang.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Nordic Games

Founded: 2011 Headquarters: Vienna, Austria Key People: Lars Wingefors (Founder)

Known for: ArcaniA, , , MX vs ATV, Painkiller, Red Faction, We Dance, We Sing

Description: Nordic Games GmbH is a wholly owned publishing subsidiary of Nordic Games Group AB. Founded in 2011, the Vienna/Austria based company Nordic Games GmbH puts great emphasis on its extensive game catalogue. The core portfolio comprises products and brands which have been acquired from JoWooD Entertainment AG and DreamCatcher Interactive Inc., and other IPs and . The company will pursue the long-term goal of delivering quality products that live up to expectations of gamers worldwide.

Nordic Games Group AB (based in Karlstad, Sweden) is the holding entity for multiple privately owned companies, predominantly active within the industry. The Nordic Games Group AB has been, and still is under constant change ever since the early 90s. Even though the business models have varied, the core of the company has remained firm and stable, without doubt personified throughout the years by serial entrepreneur, founder and majority owner Lars Wingefors. As a multi-disciplined group of small-to-medium size companies, the broad market reach is only an arm’s length away.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Riot Games

Founded: 2006 Headquarters: Santa Monica, California Key People: Brandon Beck (Founder, CEO), Marc Merrill (Founder, President)

Known for: League of Legends

Description: Riot Games is an American video game publisher that was established in 2006. The main office is based in Santa Monica, California. It currently has additional offices located in Saint Louis, Dublin, Seoul, São Paulo, Istanbul, Moscow, , and Taipei. Riot is known for its first and only title, League of Legends, which was released in both North America and Europe on October 27, 2009.

Riot Games, Inc. was founded as an independent game studio in 2006 by Brandon Beck, and Marc Merrill in . The company announced its first game, League of Legends: Clash of Fates, in October 2008, and released the game in October of 2009 as simply League of Legends. The game uses a free-to-play model, supported by microtransactions rather than ads or boxed copy sales.

In 2008, Riot Games obtained initial funding of US $7 million provided by venture capital firms Benchmark Capital and FirstMark Capital. In a second round of funding in 2009, the company raised $8 million from Benchmark, FirstMark, and Chinese technology company Tencent Holdings. In early 2011, Tencent Holdings bought out a majority stake in Riot Games. Though the details of this deal were never disclosed, Bloomberg Businessweek and VentureBeat estimated the transaction to be roughly $350 to $400 million. Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Rovio Entertainment

Founded: 2003 Headquarters: Espoo, Finland Key People: Mikael Hed (CEO), Teemu Suila (COO), Peter Vesterbacka (CMO)

Known for: Angry Birds, , , The Croods

Description: Limited, previously known as Relude and Rovio Mobile, is a Finnish video game developer and entertainment company based in Espoo, Finland. The company was founded in 2003 as a mobile game development studio named Relude, and was officially renamed as Rovio (Finnish for bonfire) in 2005. The company is best known for creating the Angry Birds video game franchise.

Angry Birds, a casual puzzle game, is the number one paid app of all time. Rovio has launched nine blockbuster games so far for different platforms: Angry Birds, , , , , Amazing Alex, Bad Piggies, and Angry Birds Star Wars II.

Following this success in mobile gaming, Angry Birds has expanded in entertainment, publishing, and licensing to become a beloved international brand. Rovio has grown alongside Angry Birds, and the multifaceted entertainment house currently employs more than 700 professionals in its headquarters in Espoo, Finland, and offices in Tampere, the United States, China, Sweden, Japan and the U.K.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Supercell

Founded: 2010 Headquarters: Helsinki, Finland Key People: Ilkka Paananen (CEO)

Known for: Clash of Clans, Hay Day

Description: Supercell is a video game development company founded in June 2010 in Helsinki, Finland. Ilkka Paananen is the company's CEO. The company's debut game was Gunshine.net, which could be played in any browser on any computer operating system. The company makes online games that offer a deeper experience than basic social media games while being more accessible than the hard-core PC online games.

Supercell started developing games for mobile devices in 2011, and has since released: Clash of Clans, Hay Day and Boom Beach. Clash of Clans and Hay Day are freemium games and have been very successful for Supercell, as Clash of Clans and Hay Day combined have reported to make a revenue of 2.4 million a day. Battle Buddies was pulled out of market due to poor monetization, despite getting positive reviews from critics.

Accel Partners invested $12 million in Supercell in 2011. In October 2013 it was announced that Japanese companies SoftBank and GungHo had acquired 51% of the company for a reported $1.5 billion.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Telltale Games

Founded: 2004 Headquarters: San Rafael, California Key People: Dan Connors (Founder, Director, CEO), Kevin Bruner (Founder, Director, President, CTO), Steve Allison (Senior VP of Publishing), David Fox (VP of Online) Known for: Adventure-game adaptations of Back to the Future, Borderlands, Fables, Game of Thrones, , Jurassic Park, Monkey Island, Sam & Max, and The Walking Dead Description: is an independent digital publisher founded in June 2004 as Telltale, Incorporated. Based in San Rafael, California, the studio includes designers formerly employed by LucasArts. Its business model revolves around episodic gaming and digital distribution, and it is best known for its various graphic adventure game series based on popular licensed properties.

Many of the games that have been developed by Telltale Games are released episodically. Several episodes, released together in a season, are released periodically through a certain timeframe, often concluding around half a year or so.

Telltale aims to have a presence on as many platforms and avenues of digital distribution as possible. To date, it has released games through GameTap, on Windows and Mac through Steam and similar services in addition to its own online store, on Wii via WiiWare and disc, on Xbox 360 via Xbox Live Arcade and disc, on PlayStation 3 through PlayStation Network and disc, on iPhone and iPad through iTunes, on PlayStation Vita, and on Kindle Fire HDX. It normally ports its own games to other systems, but CSI: 3 Dimensions of Murder was ported to the PlayStation 2 by Ubisoft Bulgaria and Bone: Out from Boneville was ported to Mac OS by Vanbrio. Telltale Games was one of the companies who Sony confirmed have pledged third party support for the PlayStation 4 at the PlayStation Meeting 2013. Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Trion Worlds

Founded: 2006 Headquarters: Redwood City, California Key People: Lars Buttler (Founder, CEO), Jon Van Caneghem (Founder), David Luehmann (VP of Third Party Development)

Known for: ArcheAge, Defiance, End of Nations, Rift

Description: Trion Worlds is the leading publisher and developer of premium games for the connected era. Powered by a breakthrough development and publishing platform, Trion delivers high-quality, fully dynamic and massively social content across video game genres, gaming platforms and mass-market entertainment formats. Its world-class team, comprised of some of the most respected names in the industry, is revolutionizing online gaming. Its innovative technology and gameplay combines the best of online, gaming and traditional media to revolutionize the way connected games are designed, developed and delivered.

Trion’s current online game portfolio consists of RIFT and Defiance, among other titles. RIFT is the critically acclaimed MMORPG that eclipsed more than one million activations in less than four months and generated $100 million in revenue in its first year. The game opens new vistas in the realm of fantasy games with a dynamic world that never plays the same way twice. The award-winning title transitioned to a free-to-play model in June 2012, alleviating all barriers to entry. Defiance, which launched in April 2013, is the first-of-its-kind collaboration developed by Trion and Syfy and is a new science fiction franchise with a successful massive third-person online for PC and console and a highly rated global television program on Syfy.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Valve Corporation

Founded: 1996 Headquarters: Bellevue, Washington Key People: (Founder, Managing Director), Mike Harrington (Founder)

Known for: Counter-Strike, Half-Life, Left 4 Dead, Portal, Team Fortress, Source game engine, Stream distribution platform, Valve Anti-Cheat Description: (formerly Valve Software, commonly referred to as Valve) is an American video game development and digital distribution company. Founded in 1996 by former Microsoft employees Gabe Newell and Mike Harrington, Valve became famous for Half-Life (released in 1998) and Portal sub-series (released in 2007). Valve is also well-known for its platform Steam (released in 2002), and the Source engine (released in 2004).

Steam is a digital distribution, DRM, multiplayer, and communications platform used to distribute games and related media online. In October 2012, Valve expanded the service to include non-gaming software. Steam provides the user with installation and automatic management of software across multiple computers, as well as community features such as friends lists and groups, cloud saving, and in-game voice and chat functionality.

In 2012, Valve announced that it was working on a console/PC hybrid for the living room which was unofficially dubbed by media as the "Steam Box". A precursor to such a unit is SteamOS, a freely-available Linux-based OS that builds upon the Steam client functionality that includes media services, live streaming across home networks, game sharing within families, and . SteamOS was officially announced in September 2013 as the first of several announcements related to the Steam Machine platform as well as its unique game controller. Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities. Wargaming.net

Founded: 1998 Headquarters: Nicosia, Cyprus Key People: Victor Kislyi (CEO)

Known for: World of Tanks, , World of Warplanes

Description: Wargaming is an award-winning online game developer and publisher and one of the leaders in the free-to- play MMO market. Founded as a privately held company in 1998, Wargaming has shipped more than 15 titles and employs around 2,200 professionals across such key regions as North America, Europe, Russia, Asia and Australia.

Currently, Wargaming is focused on its team-based MMO war series dedicated to mid-20th century warfare that will include the company's flagship armored MMO World of Tanks, launched in April 2011 and currently boasting over 75 million players worldwide, the flight combat World of Warplanes that took off in November 2013 with over 4.5 million pilots, and the naval World of Warships, scheduled for release in 2014.

In June 2012, Wargaming announced the Wargaming.net Service, the epicenter of a battle centric gaming universe that gathers the series under a single portal, www.wargaming.net.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Profiles – Private Companies (Continued)

Yuke's

Founded: 1993 Headquarters: Osaka, Japan Key People: Yukinori Taniguchi (CEO)

Known for: WWE 2K, UFC Undisputed

Description: Yuke's Co. Ltd. (also known as YUKE's Future Media Creators) is a video game company based in Osaka, Japan. It was established on February 26, 1993 by Yukinori Taniguchi.

The company is best known for its development of the WWE SmackDown! game series (known as Exciting Pro Wrestling in Japan). Other games it has made include WWE Day of Reckoning, Evil Zone, EOE: Eve of Extinction, Sword of the Berserk: Guts' Rage, Berserk Millennium Falcon Arc: Chapter of the Holy Demon War, Soukaigi, , The Incredibles: Rise of the Underminer, UFC 2009 Undisputed, and the D1 Grand Prix series (which it also sponsors).

Recently, the company developed and published Neves, a puzzle game for the Nintendo DS.

From 2005 to 2012, Yuke's also owned 54% of New Japan Pro Wrestling, the top wrestling promotion in Japan. It was also its DVD production house.

Notes: As of 1/23/2014; Sources: Company website, Wikipedia, and Wedbush Securities.

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Covered Companies Mentioned in this Report (priced intraday on February 11, 2014)

COMPANY TICKER RATING PRICE PRICE TARGET ACTIVISION BLIZZARD ATVI OUTPERFORM $19.49 $22 AMAZON AMZN NEUTRAL $358.94 $330 BEST BUY BBY UNDERPERFORM $25.25 $18 ELECTRONIC ARTS EA OUTPERFORM $27.10 $30 FACEBOOK FB OUTPERFORM $63.47 $80 GAMESTOP GME OUTPERFORM $35.95 $60 GOOGLE GOOG NEUTRAL $1,176.50 $1,200 MAJESCO ENTERTAINMENT COOL NEUTRAL $0.54 $1 NETFLIX NFLX UNDERPERFORM $428.36 $175 NINTENDO 7974.JP NEUTRAL ¥12,105 ¥12,000 TAKE TWO INTERACTIVE TTWO NEUTRAL $18.87 $19 TIME WARNER TWX OUTPERFORM $64.60 $76 TWITTER TWTR NEUTRAL $53.59 $58 UBISOFT ENTERTAINMENT UBI.FP OUTPERFORM €11.39 €14 VIACOM VIAB NEUTRAL $82.77 $86 ZYNGA ZNGA OUTPERFORM $4.61 $6

Analyst Certification

I, Michael Pachter, Nick McKay, Nick Citrin, certify that the views expressed in this report accurately reflect my personal opinion and that I have not and will not, directly or indirectly, receive compensation or other payments in connection with my specific recommendations or views contained in this report.

Disclosure information regarding historical ratings and price targets is available at http://www.wedbush.com/ResearchDisclosure/DisclosureQ413.pdf

Investment Rating System: Outperform: Expect the total return of the stock to outperform relative to the median total return of the analyst’s (or the analyst’s team) coverage universe over the next 6-12 months. Neutral: Expect the total return of the stock to perform in-line with the median total return of the analyst’s (or the analyst’s team) coverage universe over the next 6-12 months. Underperform: Expect the total return of the stock to underperform relative to the median total return of the analyst’s (or the analyst’s team) coverage universe over the next 6-12 months.

The Investment Ratings are based on the expected performance of a stock (based on anticipated total return to price target) relative to the other stocks in the analyst’s coverage universe (or the analyst’s team coverage).*

Rating Distribution Investment Banking Relationships (as of December 31, 2013) (as of December 31, 2013) Outperform:54% Outperform:18% Neutral: 43% Neutral: 2% Underperform: 3% Underperform: 0%

The Distribution of Ratings is required by FINRA rules; however, WS’ stock ratings of Outperform, Neutral, and Underperform most closely conform to Buy, Hold, and Sell, respectively. Please note, however, the definitions are not the same as WS’ stock ratings are on a relative basis.

The analysts responsible for preparing research reports do not receive compensation based on specific investment banking activity. The analysts receive compensation that is based upon various factors including WS’ total revenues, a portion of which are generated by WS’ investment banking activities.

Wedbush Equity Research Disclosures as of February 11, 2014

Company Disclosure Activision Blizzard 1 Amazon.com 1 Best Buy 1 Electronic Arts 1 Facebook 1 GameStop 1 Google 1 Majesco Entertainment Co. 1 Netflix 1

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Nintendo 1 Take-Two Interactive Software 1 Time Warner 1 Twitter 1 Ubisoft Entertainment Viacom n/a Zynga 1

Research Disclosure Legend 1. WS makes a market in the securities of the subject company. 2. WS managed a public offering of securities within the last 12 months. 3. WS co-managed a public offering of securities within the last 12 months. 4. WS has received compensation for investment banking services within the last 12 months. 5. WS provided investment banking services within the last 12 months. 6. WS is acting as financial advisor. 7. WS expects to receive compensation for investment banking services within the next 3 months. 8. WS provided non-investment banking securities-related services within the past 12 months. 9. WS has received compensation for products and services other than investment banking services within the past 12 months. 10. The research analyst, a member of the research analyst’s household, any associate of the research analyst, or any individual directly involved in the preparation of this report has a long position in the common stocks. 11. WS or one of its affiliates beneficially own 1% or more of the common equity securities. 12. The analyst maintains Contingent Value Rights that enables him/her to receive payments of cash upon the company’s meeting certain clinical and regulatory milestones.

Price Charts Wedbush disclosure price charts are updated within the first fifteen days of each new calendar quarter per FINRA regulations. Price charts for companies initiated upon in the current quarter, and rating and target price changes occurring in the current quarter, will not be displayed until the following quarter. Additional information on recommended securities is available on request.

* WS changed its rating system from (Strong Buy/Buy/Hold/Sell) to (Outperform/ Neutral/Underperform) on July 14, 2009. Please access the attached hyperlink for WS’ Coverage Universe: http://www.wedbush.com/services/cmg/equities-division/research/equity- research Applicable disclosure information is also available upon request by contacting Ellen Kang in the Research Department at (213) 688- 4529, by email to [email protected] , or the Business Conduct Department at (213) 688-8090. You may also submit a written request to the following: Business Conduct Department, 1000 Wilshire Blvd., Los Angeles, CA 90017.

OTHER DISCLOSURES RESEARCH DEPT. * (213) 688-4505 * www.wedbush.com EQUITY TRADING Los Angeles (213) 688-4470 / (800) 421-0178 * EQUITY SALES Los Angeles (800) 444-8076 CORPORATE HEADQUARTERS (213) 688-8000 The information herein is based on sources that we consider reliable, but its accuracy is not guaranteed. The information contained herein is not a representation by this corporation, nor is any recommendation made herein based on any privileged information. This information is not intended to be nor should it be relied upon as a complete record or analysis; neither is it an offer nor a solicitation of an offer to sell or buy any security mentioned herein. This firm, Wedbush Securities, its officers, employees, and members of their families, or any one or more of them, and its discretionary and advisory accounts, may have a position in any security discussed herein or in related securities and may make, from time to time, purchases or sales thereof in the open market or otherwise. The information and expressions of opinion contained herein are subject to change without further notice. The herein mentioned securities may be sold to or bought from customers on a principal basis by this firm. Additional information with respect to the information contained herein may be obtained upon request.

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EQUITY RESEARCH DEPARTMENT (213) 688-4529

DIRECTOR OF RESEARCH Mark D. Benson (213) 688-4435

MANAGER, RESEARCH OPERATIONS Ellen Kang (213) 688-4529

RETAIL AND CONSUMER TECHNOLOGY, INTERNET, MEDIA & SOCIAL MEDIA LIFE SCIENCES AND HEALTH CARE

Consumer Products Communications and Biotechnology/Biopharmaceuticals/BioDefense Rommel T. Dionisio (212) 938-9934 Shyam Patil, CFA (213) 688-8062 Gregory R. Wade, Ph.D. (415) 274-6863 Kurt M. Frederick, CFA CPA (415) 274-6822 Andy Cheng (213) 688-4548 David M. Nierengarten, Ph.D. (415) 274-6862 Alicia Reese (212) 938-9927 Christopher N. Marai, Ph.D. (415) 274-6861 Communications Equipment Footwear, Apparel and Accessories Rohit Chopra (212) 668-9871 Emerging Pharmaceuticals Corinna Freedman (212) 668-9876 Sanjit Singh (212) 938-9922 Liana Moussatos, Ph.D. (415) 263-6626 Ryan Flanagan (212) 938-9942 Richard Lau, CFA (415) 274-6851 Healthy Lifestyles Kurt M. Frederick, CFA CPA (415) 274-6822 Computer Services: Financial Technology Healthcare Services - Managed Care Gil B. Luria (213) 688-4501 Sarah James (213) 688-4503 Restaurants Aaron Turner (213) 688-4429 Nick Setyan (213) 688-4519 Medical Devices Colin Radke (213) 688-6624 Enterprise Software Tao Levy (212) 938-9948 Steve Koenig (415) 274-6801 Specialty Retail: Hardlines Kevin Ikeda (213) 688-4423 Medical Diagnostics and Life Sciences Tools Joan L. Storms, CFA (213) 688-4537 Zarak Khurshid (415) 274-6823 , CFA (213) 688-4523 Entertainment: Retail Michael Pachter (213) 688-4474 Seth Basham, CFA (212) 938-9954 Nick McKay (213) 688-4343 Nick Citrin (213) 688-4495 RETAIL/CONSUMER MARKET RESEARCH Entertainment: Software Gabriella Santaniello (213) 688-4557 Michael Pachter (213) 688-4474 Nick McKay (213) 688-4343 INDUSTRIAL GROWTH TECHNOLOGY Nick Citrin (213) 688-4495

Clean Technology Internet: Media and Gaming Craig Irwin (212) 938-9926 Michael Pachter (213) 688-4474 Min Xu (212) 938-9925 Nick McKay (213) 688-4343 Nick Citrin (213) 688-4495 Environmental Services / Building Products Al Kaschalk (213) 688-4539 Internet: Social Media, Advertising & Technology Taryn Kuida (213) 688-4505 Shyam Patil, CFA (213) 688-8062 Andy Cheng (213) 688-4548 Water and Renewable Energy Solutions David Rose, CFA (213) 688-4319 Media James Kim (213) 688-4380 James Dix, CFA (213) 688-4315

Movies and Entertainment Michael Pachter (213) 688-4474 Nick McKay (213) 688-4343 Nick Citrin (213) 688-4495

Semiconductors Betsy Van Hees (415) 274-6869 Ryan Jue, CFA (415) 263-6669

EQUITY SALES EQUITY TRADING Los Angeles (213) 688-4470 / (800) 444-8076 Los Angeles (213) 688-4470 / (800) 421-0178 San Francisco (415) 274-6800 San Francisco (415) 274-6811 New York (212) 938-9931 New York (212) 344-2382 (617) 832-3700 Boston (617) 832-3700 CORPORATE HEADQUARTERS 1000 Wilshire Blvd., Los Angeles, CA 90017-2465 Tel: (213) 688-8000 www.wedbush.com