VIDEO GAMES: CLOUD INVADERS Bracing for the Netflix-Ization of Gaming

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VIDEO GAMES: CLOUD INVADERS Bracing for the Netflix-ization of Gaming

Citi GPS: Global Perspectives & Solutions June 2019

Citi is one of the world’s largest financial institutions, operating in all major established and emerging markets. Across these world markets, our employees conduct an ongoing multi-disciplinary conversation – accessing information, analyzing data, developing insights, and formulating advice. As our premier thought leadership product, Citi GPS is designed to help our readers navigate the global economy’s most demanding challenges and to anticipate future themes and trends in a fast-changing and interconnected world. Citi GPS accesses the best elements of our global conversation and harvests the thought leadership of a wide range of senior professionals across our firm. This is not a research report and does not constitute advice on investments or a solicitations to buy or sell any financial instruments. For more information on Citi GPS, please visit our website at www.citi.com/citigps.

Authors Jason B Bazinet Thomas A Singlehurst, CFA U.S. Entertainment, Cable & Satellite Analyst Head of European Media Research Team

+1-212-816-6395 | [email protected] +44-20-7986-4051 | [email protected]

Kota Ezawa Mark May Co-Head of Global Technology Research U.S. Internet Analyst

+81-3-6776-4640 | [email protected] +1-212-816-5564 | [email protected]

Walter H Pritchard, CFA Alicia Yap, CFA U.S. Software Analyst Head of Pan-Asia Internet Research

+1-415-951-1770 | [email protected] +852-2501-2773 | [email protected]

Expert Commentators Luke Alvarez Ralf Reichart Wil Stephens Founding Managing Co-CEO of ESL CEO, Founder of Fusebox Partner, Hiro Capital Games

Global Video Game Team Hillman Chan, CFA Arthur Lai China Internet & Media Analyst Greater China Technology Analyst +852-2501-2777 | [email protected] +852-2501-2758 | [email protected]

Carrie Liu ` Atif Malik Taiwan Technology Hardware Analyst U.S. Semiconductor and Semi Equip Analyst +886-2-8726-9086 | [email protected] +1-415-951-1892 | [email protected]

Rafal Materka Asiya Merchant, CFA Poland Investment Research Team U.S. IT Hardware & Tech Supply Chain Analyst +48-22-690-3288 | [email protected] +1-415-951-1752 | [email protected]

Minami Munakata Catherine T O'Neill Japan Metals & Mining, Media Analyst European Media Analyst +81-3-6776-4632 | [email protected] +44-20-7986-8053 | [email protected] +

Ashwin Shirvaikar, CFA Jim Suva, CPA U.S. Payments, Processors & IT Analyst IT Hardware & EMS, Telco & Network Equipment Analyst +1-212-816-0822 | [email protected] +1-415-951-1703 | [email protected]

Kyle Twomey John Yu Europe Small Cap Analyst Korea Internet & Media Analyst +44-20-7986-7955 | [email protected] +82-2-3705-0721 | [email protected]

VIDEO GAMES: CLOUD INVADERS Bracing for the Netflix-ization of Gaming

Kathleen Boyle, CFA What was your first memory of playing video games? Mine was playing Centipede Citi GPS Managing Editor at the local pizzeria. Armed with quarters and enough money for one slice of pizza, we would play until we were either broke or our fingers were sore from firing digital missiles. Eventually my friend got an Atari game system and after months of begging for the same, my Dad caved in and bought us a gaming system – an Intellivision game system. He told us over and over that it was a better system to Atari but it didn’t have all the cool games that my friends played. It was hard sometimes being the daughter of an engineer who cared about technology superiority, but at least the hockey game let you punch people.

Game choices moved quickly after that – Tetris on my Macintosh Plus, Donkey Kong on my Nintendo DS, Brickbreaker on my Blackberry, and now Candy Crush on my iPhone. The common constraint through the years was that the games I played continued to be dependent on the device I owned.

When the Internet came about, new firms started disrupting traditional media businesses such as newspapers, radio, and television by giving consumers what they wanted, when they wanted, and on the device they wanted. But it didn’t disrupt the video game industry. Game publishers were able to use the Internet to augment their revenues. They used the Internet to increase in-game sales and sell software directly to consumers, and tapped into the smartphone market and the growth of mobile gaming.

Are video game publishers immune from disruptive threats? The authors of the report that follows answer with a resounding no. There is a technology on the horizon that has all the characteristics of a disruptive threat to the video game ecosystems — the cloud.

The video game ecosystem has been evolving over the last few years — towards group play vs. single play, to in-game monetization vs. software sales, to renting vs. buying hardware, to video games being a spectator sport, and to software being made for all devices vs. software made specifically for hardware. These new trends in the video game industry could make it much easier for the big cloud players to come in and start pulling away revenue.

The cloud-based providers will be able to offer low-cost access to cloud-based gaming and a wide array of gaming content. They will also be able to monetize gaming in non-traditional ways that play to their strengths — through in-game monetization, in-game advertising, broadcasting, and digital. For consumers, cloud will make it easier to play games on different platforms and allow players to be device agnostic, hitting pause on a PC game and picking it up again on a mobile device. Game developers will be able to support more devices as compatibility issues decrease between software and hardware.

eSports, a $1billion business and growing, will have increased opportunities on the cloud and we believe game publishers will still be able to thrive in the emerging video game world but will have to adapt their business models to ensure they’re positioned appropriately..

If the report is right, I may finally be able to play PacMan!

Over the last 18 years, video games have experienced rapid growth, topping $100bn in global sales with much of the growth fueled by Internet connectivity

120% Pre-internet Today 100% Play alone Group play 80%

60% Buy In-game software monetization

40% Play at Play 20% home anywhere

0% Play Spectator ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17 ‘18 on own Sport Arcade Console PC Handheld Mobile VR

In the next wave of innovation, consumers will likely rent access to gaming hardware, using the cloud for processing. This will likely give the largest cloud infrastructure players an advantage. Amazon, Microsoft and Google make up 58% of the market.

Cheaper processing power Rent Delay More processing power

Software

Buy Hardware

Hardware Arcade Console Cloud

Software Arcade Disc, Download Stream

BENEFITS OF CLOUD GAMING PLATFORMS

For game developers: compatability For console manufacturers: For consumers: every issues are reduced and more devices revenues can migrate from screen will experience the can be supported episodic to monthly recurring same level of play

© 2019 Citigroup The shift from PC/Console processing to cloud Pricing for cloud services could be disruptive as cloud processing will prompt new business models. Cloud providers exploit the revenue disparity between hardware gaming is apt to exploit the rise of free-to-play (FTP) (small) and software (large). Cloud firms can also tap into and new revenues like eSports. fast growing revenues from eSports and AdTech.

Distant past Past Present Future Total Gaming Revenues:

Hardware Hardware Hardware Cloud Gaming

FTP FTP FTP FTP

FTP FTP FTP FTP 2008 Software

In-game spend Software 2018 AdTech

New monetization (eSports, Mobile, AdTech) eSports Hardware Buy Rent Free

Emerging cloud providers have low exposure to legacy game revenue and high exposure to emerging game revenue. Traditional publishers can’t easily replicate assets owned by cloud providers (like mobile AdTech and eSports broadcasters).

Amazon Microsoft Google Apple Incumbent Comments

Only Microsoft will be incented to Hardware protect legacy HW revenue (Xbox)

Incumbent software firms have Software material legacy software revenue to protect Legacy In-game Most cloud providers don’t generate Ads material in-game ad revenue

Game Incumbents have material in-game monetization monetization revenue to protect

Cloud Amazon, Microsoft and Google hardware are the large cloud providers

Due to Android and iOS, Google AdTech Emerging and Apple apt to benefit from (Mobile) mobile ad growth Amazon (Twitch) and Google Broadcaster (YouTube) will be able to monetize gaming via broadcasting assets 6

Contents Summary 7 The Console/PC Value Chain 11 Layer I: Intellectual Property 12 Layer II: Game Developers 14 The Genres 20 AAA Versus Independent Games 21 Layer III: Game Publishers 26 Layer IV: Hardware 29 Arcades: Where the Games Begin 29 Console and Handsets: Where the Market Expands 30 Handheld Market 32 PC Market 38 Layer V: Distribution 40 Cloud Gaming 45 Layer VI: Consumer 53 Layer VII: eSports 55 Mode of Distribution 55 Live Streamers 58 Sponsorships 63 Subscribers 64 Ads 64 Donations 65 Professional eSports 69 Turnover of eSports Titles a Key Consideration 79 Grassroots Competition 80 Live Streaming vs. eSports: The Broadcaster’s Perspective 81 The Mobile Value Chain 83 Layer I: Intellectual Property 86 Layer II: Developers and Publishers 87 Layer III: Installs 89 Layer IV: Mobile OS 92 Layer V: Generate Advertising 93 Layer VI: Advertiser 95 Layer VII: Consumer 96 Mobile Economics 97 Mobile Gaming Revenues 99 Industry Evolution 100 Internet-enhanced Gaming Profits 100 Foundation In Place for a New Model 102 What the New Model Might Look Like 107 Pricing of Cloud Gaming Services 114 Regulations 121 Prudent Strategic Responses 122 Potential M&A 122 How Publishers Should Respond 123 Expert Views 128 Expert Views from the Gaming Industry 129 A Conversation with Luke Alvarez 130 A Conversation with Ralf Reichart 138 A Conversation with Wil Stephens 146

Summary Eight years ago, Marc Andreesen – of Netscape fame – penned an article in The Wall Street Journal titled: ‘Why Software is Eating the World’. Mr. Andreesen’s idea, like all good ideas, was simple: software — riding on top of the Internet — was changing everything. For the software owners, it was a boon. But, for incumbents, it represented unrelenting value destruction.

In the wake of this software-induced upheaval, non-software centric firms have been dented, damaged, upended, or dethroned. The list of victims is long: book stores (Amazon), brick-based retail (Amazon), travel agencies (Expedia), taxi cabs (Uber), phone books (Google), photos (Apple), newspapers (Google), magazines (Facebook), radio stations (Spotify), and cable networks (Netflix).

Indeed, over the last 20 years, five U.S. leviathans have proven particularly adept at using software to create significant economic value. Wall Street’s shorthand for these firms is FAANG: Facebook, Apple, Amazon, Netflix, and Google. In Asia, there are three disruptive firms — Baidu, Alibaba and Tencent — or BAT. Each firm — and a handful of smaller entities — has used software and the Internet to give consumers what they want, when they want it, at far lower cost.

After the FAANG or BAT transformation is complete, these giants jockey for position to ensure they capture the lion’s share of the sector’s remaining, albeit diminished, profits. In the process, the largest Internet firms get bigger. Incumbent firms stall, shrink, or sometimes, disappear.

Within the entertainment sector, however, there’s a small collection of rarefied entities. To date, these few firms have been immune to the software-centric, Internet-enabled FAANG assault: Sports teams, concert promoters, and video game publishers. Indeed, each of these businesses has actually used the Internet to improve results:

 Sports teams sold digital content rights on top of traditional TV rights.

 Concert promoters — like Live Nation —- benefitted as lucrative CD sales collapsed. That’s because rock stars toured more often to preserve their lifestyles.

 Video game publishers have deftly used the Internet to: (1) sell copies of their software directly to consumers, disintermediating retailers; (2) augment game sales with in-game monetization (like loot boxes); and (3) tap into explosive smartphone growth to monetize mobile games.

But, will video game publishers remain immune to the FAANG threat? We don’t think so. A number of large firms — including Google, Amazon, and Microsoft — are rapidly building cloud scale. And, we suspect a natural way to leverage this infrastructure is to move into gaming. Moreover, there’s quite a bit of money up for grabs: $100 billion per year for software and $35 billion a year for hardware.

But, to understand why we’re so focused on Google, Amazon, and Microsoft, we need to understand five powerful trends that are — or will — rumble across the video game ecosystem.

First, video games are migrating from a solo to a group activity. Second, upfront software purchases are slowly being replaced by in-game monetization causing free-to-play games to explode in popularity. Third, consumers — especially young consumers — will migrate from buying upfront hardware to renting access to cloud infrastructure. Fourth, gaming will increasingly migrate from a non-spectator to a spectator activity driving the growth in popularity of eSports. Fifth, software used to be written for a specific piece of hardware. Today, software like Overtime will work on all devices, including mobile.

Figure 1. Trends Across the Video Game Ecosystem

From To Loser Winner

1 Play alone Group play Single-player games Multi-player games

2 Buy software In-game monetization Paid games Free-to-play

3 Buy hardware Rent access Hardware firms Cloud firms

4 Non-spectator Spectator n/a eSports broadcasters

Software made for Software for all devices Casual mobile Strong game titles 5 hardware

Source: Citi Research

If we’re right about these five trends, it has powerful implications for the gaming ecosystem. It means cloud-based providers will offer consumers low-cost access to a cloud-based gaming platform and a wide array of gaming content. And, it will monetize this content in non-traditional ways. But, these non-traditional methods of monetization will leverage existing assets already owned by the largest cloud providers. In short: Software is eating the world, but, clouds may eat software.

Figure 2. Cloud-Based Gaming and Video Game Ecosystem

Distant Past Past Present Future

Buy Hardware Hardware Hardware Rent Free Cloud + + + Gaming FTP Software FTP FTP FTP + + + In-game Spend

eSports New Mobile Monetization AdTech

Source: Citi Research

What assets will a cloud-based firm leverage? There are quite a few:

 First, Google, Amazon, and Microsoft are the largest providers of cloud-based services (with ~60% share as of the fourth quarter of 2018). This will enable low- cost cloud gaming services.

 Second, the largest game broadcasters are Twitch (owned by Amazon) and YouTube (owned by Google). This gives two cloud-based firms indirect methods of monetization that cannot be matched by incumbent game publishers.

 Third, a large portion of gaming revenues stem from in-game advertising, particularly on mobile devices. And, the mobile AdTech ecosystem is controlled by two firms: Apple and Google.

 Fourth, digital distribution — particularly for Amazon — is a core competency. As such, these cloud-based firms could open (or acquire) gaming distribution platforms like Valve’s Steam.

 Fifth, cloud gaming companies have ample means to cross-sell their offerings. Cross-selling opportunities span both hardware (FireTV, AppleTV, Alexa) and software (YouTube Premium, Amazon Prime).

If we’re correct, video game publishers that are over-monetizing their intellectual property (IP) by selling the game plus in-game content could see long-term top-line pressures. How can incumbent gaming firms respond? We think there are five key steps:

 First, incumbents should deemphasize titles that aren’t tied to sports, have weak IP, and don’t have a robust eSports (or live streamer) community. That’s because sports titles tend to have a very loyal following (and are likely less prone to cloud- based price competition). And, we expect eSports to play a larger role in the gaming ecosystem as fewer very popular games (with robust IP) increasingly dominate the gaming ecosystem.

 Second, publishers should redirect developer time to refreshing existing titles to keep in-game monetization robust and consumer engagement consistent.

 Third, for non-sports titles with weaker IP, publishers should begin to gradually lower the retail prices of the games while simultaneously investing in in-game monetization. This will make the transition to free-to-play less disruptive.

 Fourth, publishers should invest in eSports and develop games that are likely to have a strong live streaming following.

 Fifth, video game firms should ensure that every popular title has a viable mobile version. This will prepare firms for the inevitability of cloud gaming (when mobile/personal computer (PC)/console gaming platforms converge).

So, the ‘salad days’ for video game publishers — where the Internet enhanced profits — probably won’t last. But, there are clearly steps video game publishers can make today to ensure they still play a viable part in the new cloud-based, platform- converged, eSports-centric video game ecosystem.

To explore our thesis, we have divided this report into three main sections. First, we’ll unpack the video game value chain tackling the console/PC market and the mobile market separately. Second, we’ll suggest how the video game industry will likely evolve. Third, we’ll review the strategic implications — and potential next steps — for the video game incumbents.

Before we dive in, a quick disclaimer. As we did this work, we were struck by both the level and quality of debate related to cloud computing and its impact on the video game ecosystem. There are strong arguments on both sides of the debate. Obviously, we have our view. But, we are conscious not all readers will agree with us. With this in mind, we hope readers will find the ‘Expert Views’ section at the back of the report helpful. These experts have decades of experience in the space. We are also very open to feedback: Please do get in touch if you think we’ve missed something or have drawn the wrong conclusions. We are keen to engage.

The Console/PC Value Chain The video game industry has a long history. Back in 1958, a physicist, William Higinbotham, created the first video game: Tennis for Two. It took about 15 years before the business world took notice. The Magnavox Odyssey debuted in 1972. Over the next 60 years, a rather complex industry organically evolved. In the PC and console market, the video game value chain has seven layers:

 Intellectual Property (IP): At the top of the stack are owners of intellectual property. This includes sports leagues (FIFA, NFL), movies (Star Wars), books (Tom Clancy), and toys (Lego). This IP is often licensed for a royalty payment.

 Developers: Video game developers are one layer down the value chain. These entities write code to create the game. They receive a fee and perhaps a royalty (if the game is successful) from the game publisher. They may rely on — and pay for — game engines to accelerate game development. If not, they’ll use specific application programming interfaces (APIs) that allow the software to work easily with a variety of hardware platforms.

 Publishers: Toward the middle of the stack are game publishers. Publishers sell and market video games. They make three types of payments: (1) payments to the owner of the underlying IP (if applicable); (2) payments to the game developer; and (3) payments to the manufacturer of the console (but not PC firms). If the game is distributed digitally, they may also make a payment to the digital storefront.

 Hardware: The game developer and game publisher will agree to develop the game for a specific type of hardware. It could be a console — like PlayStation, Xbox or Nintendo — or a PC. In the future, this may be a ‘virtual hardware’ presence that is a streaming service across any hardware.

 Distributors: Toward the bottom of the stack are the distributors. They sell the game to the consumer. Delivery could be via a physical disc (GameStop, Amazon) or a digital file (Steam, Electronic Art’s Origin).

 Consumers: Near the bottom of the value chain, you’ll find the consumer. They spend money to enjoy the underlying game.

 eSports: The final layer of the value chain is eSports. eSports can include professional teams (in tournaments). Or, it may capture consumers watching amateurs play video games on a broadcast platform (like Twitch). These amateurs are also called ‘live streamers’.

Figure 3. The Console/PC Value Chain

Description Economics Owner of IP that is licensed to Share of game sales (may include Intellectual Property publisher minimum payment) Game Engine $ IP Receives advances from publisher SW Game Developer $ Pitches ideas to publisher Develops games for publisher Receives royalty payments from publisher (Studio)

SW $ “Green lights” game Pays royalties to IP owner (if applicable) Advances money to developer for game API Game Publisher Sells markets and distributes game Makes royalty payments to game developer Makes royalty payments to HW mfg $

Hardware $ Designs and manufactures hardware Receives revenue from hardware sales Manufacturer Receives royalty payments from publisher SW Distributes game in physical stores Pays wholesale price for game Distributer Distributes game digitally Receives retail price for game $ SW $ Plays game Pays retail price for game Consumer Spend on in-game items after purchase Ad Sponsor T $ Consumers watch professionals Players and leagues collect funds from eSports play video games (in person or consumers (donations, subscriptions) game $ over broadcaster like Twitch) developers, game publishers, advertisers and sponsors

Note: IP – Intellectual Property, SW = Software, T = Time. Source: Citi Research

Let’s walk through each step of the value chain in a bit more detail. Layer I: Intellectual Property

Over the last 40 years, only 70 global video game franchise games have generated over $1 billion in global sales. But, some of the highest grossing franchises — like Pokémon or Mario Brothers— have been around for 20 years, or more.

And, some of these iconic franchises are still selling briskly. A recent examination of the top-selling video games on Amazon.com in March 2019) shows that Pokémon Sword was the 13th best-selling item, the Sims4 ranked 14th, and Grand Theft Auto ranked 15th. So, brand recognition — that often leverages IP — clearly matters.

Figure 4. Number of Franchise Games Generating > $1 Billion (1981-2018) 80

20 Total Franchise Sales ($bn) Sales Franchise Total

0 Franchise Source: Wikipiedia, Citi Research

But, how important is third-party intellectual property? Do non-video game brands — like movies, sporting leagues, or books — propel video game sales? Over the last 40 years, top franchises — or those that sold over 100 million units — can be grouped:

 First, some games rely on IP that was developed in-house. Grand Theft Auto, Pokémon, and Fortnite are all good examples of in-house IP. And, nearly 80% of the top franchises fall into this category. Since these native IP franchises sell, on average, 72 million copies, these types of games make up nearly 80% of all software sales.

 Second, some top games rely on IP that’s non-sports based. These games leverage IP from a variety of sources: physical games (Lego), books (Tom Clancy), or movies (Star Wars). These games make up only 15% of the top- selling franchises, but they sell slightly fewer units than a typical top-ranked franchise (on average just under 50 million units per franchise). As such, this genre makes up just 10% of total software sales.

 Third, some top franchise games rely on sports IP. FIFA and Madden NFL are good examples. There are six top franchises within this category, or just 7% of top-selling franchises. But, on average, sports-based games sell more units — about 100 million units per franchise. As such, sports games make up about 10% of all software sales.

Figure 5. Top Game Franchise Titles Sold by IP Category

Franchise Games Titles Average Units Sold (mn) Total Units Sold (mn) (Number ‘81 to ‘18)

Native IP 67 x 72 = 4,809

x = Non-sports IP 14 48 600

x = Sports IP 6 100 665

0 50 100 0 50 100 0 2500 5000

Source: Wikipedia, Citi Research

Surprisingly, native IP comprises 80% of video game sales. And, non-native IP only makes up 20% of video game sales. This observation doesn’t suggest franchises aren’t important for video game sales. Clearly they are. But, as publishers seek to build a new franchise, this data suggests publishers should probably focus on the quality of the game (rather than making large royalty payments to an owner of third- party IP).

Put in blunt terms, sports and non-sports franchises are really niches in the broader gaming landscape. Sure, these niches have rabid fans. But, using third-party IP to bolster a game’s prospects does not guarantee a game publisher’s success. It may, however, reduce risks and lower customer acquisition costs and marketing outlays. Layer II: Game Developers

Let’s say you’re a game developer. Of course, you want your game to be successful. But, how can you ensure success? According to the Entertainment Software Association (ESA), the most important purchasing factors for consumers are: (1) the quality of the graphics; (2) the price of the game; and (3) an interesting story. ESA’s data is consistent with our analysis of historical sales: IP actually ranks last.

Figure 6. Video Games: Most Important Purchasing Factors for Consumers

70% 66% 63% 61% 60%

51% 50% 50% 47%

40%

30%

20%

10%

0% Quality Price Interesting Contin- Online Familiar of Story uation Gameplay IP Graphics of Favorite Series Source: Entertainment Software Association, Citi Research

Armed with this information, you set out to develop your game. But, how should you proceed? Game developers typically divide their work into four stages:

 Concept: In the first stage, you develop a short description of the game and the genre (like role-playing game or shooter). And, you lay out some preliminary sketches to give your team an idea of what the game would look like once it’s developed.

 Pre-production: In pre-production, you’ll create a storyboard with graphics and text to explain each scene in the game. You’ll begin to think about the technical limitations of the gaming platform. Then, you’ll lay out the game’s goal, the mechanics, and the overall design of each level. During pre-production, you’ll establish the intended player skill, game attributes, game design, and game play. (See Figure 7 for specific examples of game play.) And, your team will lay out due dates and key milestones for each software version including ‘first playable’, the ‘alpha’ version, and the ‘beta’ version of the software.

 Production: In the third stage, a larger team is brought in to assist with development. This includes producers, designers, artists, and programmers. The actual source code will be written for all key elements of the game including the library, the game engine, and the artificial intelligence (AI) embedded in the game. The production will end at the ‘code freeze’ which occurs a few months before the release date. After ‘code freeze’, keyboards are put away. A team of testers will play the game to identify bugs. At this stage, only bugs can be removed from the software. Once the bugs are removed, the ‘gold master’ of the game is locked down.

 Post-production: In post-production, the game will be approved by the console manufacturers — like Xbox, PlayStation, or Nintendo. Or, if the game is released via PC, a distribution platform — like Steam — may approve the game. (Some critics have suggested Steam’s approval process could be more robust.) Today, many games are released via the Internet versus a cartridge or a disc, so software patches and upgrades can occur post release. Indeed, some of the most popular games — like Fortnite — receive weekly updates.

Figure 7. Common Video Game Terms

Term Meaning Player Skill Skill floor Minimum skill to play a game well Skill ceiling Difficulty reaching high level of performance

Game Attributes Game pacing Rate of activity and tempo in the game Ludonarrative dissonance (LND) Game play conflicts with narrative Animation cancelling Allows player to keep playing before action is complete Random number generator (RNG) RNG allows random events to occur in the game Battle pass Rewards players with in-game content

Game Design Bullshot Publishers artificially enhance promo materials vs. real game Third-person shooter (TPS) Player is visible on the screen while shooting Downloadable content Additional content released in the video game Dynamic game difficulty Adjusting difficulty of game based on player ability Expansion pack Adds extra game content to an existing game Hit box Invisible box used for real-time collision detection Loot and loot box Player obtains in-game content (currency, weapons) Open world Virtual world where player can freely roam the game Paper doll A way to display a character's inventory (weapons, bullets, etc.) Power-ups Objects that confer extra power or benefits to a character Season Pass Discounted package of in-game content

Hardware Design Micro console Low-cost Android-based hardware used with app store games Console game High-end hardware used for gaming (Xbox, PlayStation, etc.)

Game Play Latency Noticeable delay between control inputs and action on screen Frame rates How smooth games run; High frame per second is fluid Pixelbitching Requires player to sweep screen to look for ways to progress Career mode Allows player to take control of a single character Spawning Live creation of a character Respawning Recreation of an entity after death Despawning Deletion of an entity within the game Strafing Moving a character side-to-side (vs. forward and backward)

Player Behavior Griefer Player derives pleasure from frustrating other players Hate In MMOPRGs, mobs prioritize which character to attack Let's Play (LP) Video commentary by the gamer Multi-boxing Playing multiple characters at the same time. Often viewed as cheating Noclip mode Prevents first person camera from being blocked by walls – a cheat command Trickjump Techniques that enhance mobility of a player Turtling Game play that emphasizes defensive behavior Cooperative gameplay Allows players to work together

Crowd control Allows player to limit number in an MMORPG Note: MMOPRG – Massive Multiplayer Online Role-playing Game Source: Citi Research

In total, the entire game development process may take three to four years. But, some titles have been known to take 10 years (or longer) if significant changes are made to the game’s look or feel after the pre-production phase. Somewhat famously, Duke Nukem Forever was conceived in 1996. But, it took the developer (3D Realms) 15 years to release the game. The total cost of a game can vary considerably. But, it’s not unusual for AAA games to cost $100 million or sometimes more to develop. (We should note there is no formal definition of AAA games. It’s an informal classification.)

Figure 8. Video Game Development Process

Pre- Post- Concept Production Production Production

Develop short Full storyboard Larger team of Approval required description of created including producers, for console games game sketches and text designers, artists to ensure to explain each and programmers standards are met Genre identified scene. added to team (RPG, shooter) Software patches Technical Source code for created as needed Rules established limitations and the game is written (for online console standards for library, engine versions) Preliminary reviewed and AI sketches Production plan Production ends AAA games can cost developed with ‘code freeze’ $100-200 million. including game usually 3-4 months Typical development goals, level before release. time is 3-4 years for designs and Only bugs can be a AAA game gameplay fixed post code mechanics freeze

Plan includes all Testers used to tasks and due identify bugs dates ‘Gold master’ is Key milestones final build used for established (first production playable, alpha version, beta version)

Source: Citi Research

So, let’s say your concept is complete. The next key decision is whether to use a game engine or develop the game organically. Game engines are used primarily for PC games and mobile games (but not console games). Game engines provide a software environment that allows developers to create games faster. They do this using pre-built software for things like graphics, audio, logic, physics, and collision detection. These engines are essentially frameworks that allow developers to avoid reinventing the wheel for every game. So, by buying an engine for a little money, developers can eliminate a lot of coding. Which engines are most popular? There are two:

 First, the market leader is Unity, which is owned by Valve. Valve also owns a game distribution platform called Steam. Unity has a free version, a relatively inexpensive option for $25 to $125 per month (depending on the version) and an expensive option called Unity Pro (which costs about $1,500). Unity uses C++ and JavaScript as its two primary programming languages. For many years, Steam collected 30% of a game’s revenue as a distribution fee. That sort of fee isn’t dissimilar from what other digital distribution platforms like Apple or Google take. But in the fourth quarter of 2018, Steam lowered the distribution fee it collects from game developers given competition from a rival engine, UE4. For games that generate $10-$50 million of revenue, the fee dropped to 25%. And for very popular games that generate more than $50 million in revenue, Steam’s distribution fee dropped to 20%.

 Second, Unreal Engine (owned by Epic Games) has been around a bit longer than Unity. Its latest engine is called UE4. UE4 uses C++ as its programming language. UE4 has a royalty rate of 5% if the game is released on Steam, but is free if it’s released in Epic Game’s site. On top of that, Epic Game only charges game developers a 12% distribution fee.

As a game developer that has to select a gaming engine and a distribution outlet, there are clear economic incentives to use Epic for distribution and its UE4 engine. The costs are far lower. But, Valve’s Unity engine and Steam distribution platform have more scale.

Figure 9. Developer Economics by Game Engine

Distribution Valve's Steam Epic Games Game engine Unity Unity Unity UE4 UE4 Unity Game revenue <$10M $10-50M >$50M All All All

Revenue 100 100 100 100 100 100 - Engine 0 0 0 5 0 0 = Sub-total 100 100 100 95 100 100 - Distribution fee 30 25 20 30 12 12

= Developer net 70 75 80 65 88 88 Source: The Verge, Citi Research

If you don’t use a game engine, the graphics environment must be built from scratch. And, if you build a game from scratch, you’ll need to use application programming interfaces (or APIs). There are two basic APIs: Microsoft’s DirectX (for Windows-based PCs and the Xbox) and OpenGL (for Sony’s PlayStation).

 DirectX: Microsoft’s original operating system, MS-DOS, allowed programmers to have direct access to a wide array of physical PC parts including the keyboard, mouse, speakers, and video cards. However, in 1994, Microsoft was ready to release Windows 95 but they feared that game developers wouldn’t create games that were compatible with Windows 95. So, Microsoft began working with NVIDIA to develop an API that developers could use for Windows-based PCs. This API was called DirectX. Ultimately, Microsoft would use this platform to build the DirectX Box, the original name for Microsoft’s console. (Later, the DirectX Box was rebranded Xbox.)

 OpenGL: OpenGL is the other primary video game API. Open GL was created in 1991 by Silicon Graphics for computer-aided design (CAD), flight simulation, and video games. Since 2006, the API has been managed by a non-profit consortium called Khronos Group. Key members of Khronos include chip manufacturers (NVIDIA, Intel, AMD), operating system owners (Apple, Google), and hardware firms (Sony, Samsung, Huawei).

Your next big decision as a game developer is to pick a hardware platform (or platforms). Some developers write code for every platform upfront. This helps increase awareness of the game. But, it also takes more upfront investment. As such, independent developers often launch on a single platform (most likely, the PC). And, if sales are robust, they will write new versions of the game for additional platforms.

Next, you’ll have to make a decision about graphics quality. Recall, we learned earlier that graphics quality is the most important factor to improve game sales. And, higher quality graphics means they mimic reality. But, how do developers mimic reality when they code? They use tricks. And, the tricks can be divided into three windows:

 First, in the early days, programmers used pixels. Pixels limited the granularity of the image. And, the images were always 2D. But, in the early days of video games, developers used pixels because the processing power of the computer — like 8-bit or 16-bit CPUs — was limited.

 Second, as graphics processing moved from the central processing unit (CPU) to the graphics processing unit (GPU), video games migrated from 2D to 3D. To create 3D images, developers began to use polygons. A polygon is any two dimensional shape formed with a straight line. Triangles, pentagons, and octagons are all examples of polygons. The beauty of programming with polygons is you only have to write code to move the vertices — the points — and the entire polygon changes shape. That means granular movement can happen on the screen with limited processing power. Programmers refer to this process as rasterization. And, with software that can shade polygons — called shaders — a polygon can look like wood, fire, water, or metal. Virtually all current video games use polygons and rasterization to render lifelike images. But, rasterization isn’t a science, it’s an art form. It simply tricks the brain into thinking it’s seeing a ‘real’ image.

 The third and final trick programmers can use to mimic reality is ray tracing. Ray tracing is the holy grail of graphics design. When the human eye processes an image, it actually creates an image of reality (in the brain) by processing the way light interacts with every physical object. If there was enough processing power in computers, developers could actually follow a computer generated photon from a simulated light source — like the sun or a candle — as it interacts with every object in the game. Most games today don’t use ray tracing. Rather, the programmer mimics what light should do by manually creating shadows or reflections (off water or shiny objects). While ray tracing renders more realistic graphics, it takes significant processing power. Parenthetically, most movies that use computer-generated imagery (CGI) — like Avatar or Star Wars — use ray tracing. But, movies can be carefully crafted and then released to the public. That’s because when you view a movie, you don’t interact with the image….you just sit back and watch. Gamers, of course, want to interact with the image. This makes ray tracing far more challenging for video games than for movies. But, game developers are moving in this direction.

Figure 10. Programming Tricks to Mimic Reality

Polygons Pixels (Rasterization) Ray Tracing

Source: Citi Research

NVIDIA’s GeForce RTX uses ray tracing versus screen space reflections that use polygons and rasterization. Battlefield 5 is the first game ever released using ray tracing. Although most gamers like the quality of the images, when gamers enable the ray tracing option, it tends to reduce the frame rate (frames per second, or fps) from about 130 fps to just 40 fps. In effect, today gamers have to trade-off the quality of the image with a less fluid rendering of the game. Most gamers don’t think the trade-off is worth it. Said another way, ray tracing may not be ready for the mass market. But, as processing power improves, we expect ray tracing to become more popular.

Indeed, NVIDIA recently patched its software with an enhancement called Deep Learnings Super Sampling (DLSS). DLSS uses AI to boost the frame rate to 45fps.

The Genres

By this point in the process, you’ve already developed your concept. And that means you are likely building a game in one of the six main genres: Action, Role Playing, Simulation, Sports, Strategy or Other (including casual games).

In truth, there is some overlap among these genres. But, there are key attributes of each type of game: (1) Action games require significant hand-eye coordination; (2) Role Playing Games (RPGs) follow a predetermined storyline; (3) Simulation games mimic the real world; (4) Sports games allow players to simulate a specific sport; and (5) Strategy games require careful planning (either in real-time or turn-based). Within each of these broad genres there are, of course, many sub-genres.

Figure 11. Video Game Genres

Description Examples Requires hand-eye coordination. Sub- Legend of Zelda, Grand Theft Action groups include: platform, shooter, fighter, Auto, Assassin’s Creed survival, and battle royale Progress thru predetermined storyline. Sub- Pokémon, Final Fantasy, Role Playing (RPG) groups include: Action PRG, sandbox (open Dragon Quest world), first-person Mimics reality. Sub-groups include: life The Sims, RollerCoaster Simulation simulation, vehicle simulation Tycoon

Mimics sports. Sub-groups include: racing, FIFA, Madden NFL Sports soccer, football, boxing, and wrestling

Strategy Requires careful planning. Sub-groups StarCraft, Warhammer include: real-time strategy and tactics and turn-based strategy and tactics

Casual games, trivia games, logic games, Candy Crush Other board games.

Source: Citi Research

Figure 12. Types of Video Game by Genre

Group Sub-Group Class Description Action Requires hand-eye coordination Platform Game play centers around jumping and climbing Shooter Lethal weapons used to damage opponents First player Played from protagonists perspective Third player Protagonist's body can be seen Fighter Close range combat Survival Player in an open-world, hostile environment Battle Royale Blends survival with last man standing objective Role-Playing Progress through predetermined storyline Action RPG Action based role-paying game MMORPG Massively multiplayer online role-playing game Sandbox Open world role playing game First-person RPG where player leads a party Simulation Mimic a real or fictional reality Life simulation Control one or more artificial lives Vehicle simulation Flight or racing simulator Strategy Requires careful planning to win 4X Four goals: Explore, expand, exploit and exterminate Artillery Two or three player typically with tanks Real-time strategy Action in the game in continuous Real-time tactics Simulates real time warfare MOBA Multi-player online battle areas; akin to Action Real-time Strategy Turn-based strategy Allows period of analysis before committing to action Turn-based tactics Mimics military tactics and operations Sports Mimic a sport Racing Auto racing Sports games Non-auto racing sport games Non-fighting Football, basketball, hockey, etc. Fighting Boxing or wrestling Other Casual games Designed for short bursts of playing time Trivia games Player answers questions Logic games Puzzle games Party games Designed for many players Board games Games like chess, checkers and Othello

Card games Solitaire, poker, and games like Go Source: Citi Research

AAA Versus Independent Games

In broad terms, there are two types of game developers: (1) developers that work for publishers and (2) independent publishers. Hardcore gamers typically divide the world into two types of games: AAA games and Independent games. Although there isn’t a formal definition of AAA games, there are widely agreed upon attributes: (1) AAA games typically work on both consoles and PCs; (2) AAA games have large 1marketing budgets; and (3) AAA games are often developed and published by the same firm. Independent games, on the other hand, usually only work on PCs. They have smaller marketing budgets and, they are often distributed on third party sites, like Steam.

The conventional view is that AAA games are high quality and Independent games are lower quality. But, in truth, if you speak with avid gamers, there are exceptions to this rule. That is, some Independent games are actually high-quality and garner significant game play while some AAA games flop at the time of release.

Figure 13. Independent vs. AAA Games

Conventional View Nuanced View

Rust High budget Overwatch Rocket League Console & PC Grand Theft Auto V Witcher 3 Heavy marketing Doom

Hearts of Iron IV High Quality High High Quality High One firm develops & Borderlands II publishes War Thunder Lower budget Mass Effect Andromeda

PC Mafia III Many

Lower marketing Home Front

Low Quality Low Low Quality Low Rely on third party Haze publisher Duke Nukem Forever Independent AAA Independent AAA Game Type Game Type

Source: Citi Research

We recently took a snapshot (March, 2019) of the most popular games on Steam. About one-third of the 30 most popular games were Independent games. These games make up about 10% of players. For this grouping, we classified games developed and released by Valve — like Dota 2 — as AAA games (even though Valve is a private firm that facilitates distribution for independent game publishers).

Figure 14. Top 30 Most Played Video Games on Steam

Game Title Players Release Date Developer Publisher Parent 1 Dota 2 1,000,450 2013 Valve Valve Valve 2 Player Unknown's Battlegrounds 875,095 2017 PUBG PUBG Bluehole 3 Counter-Strike: Global Offensive 584,092 2012 Hidden Path Valve Valve 4 Tom Clancy's Rainbow Six Siege 126,308 2015 Ubisoft Ubisoft Ubisoft 5 Grand Theft Auto V 113,227 2015 Rockstar Rockstar Take-Two 6 Warframe 109,184 2013 Digital Extremes Digital Extremes Leyou 7 Path of Exile 78,420 2013 Grinding Gear Grinding Gear Tencent 8 Devil May Cry 5 74,719 2019 CAPCOM CAPCOM CAPCOM 9 Rust 64,227 2018 Facepunch Facepunch Facepunch 10 Football Manager 2019 55,630 2018 Sports Interactive SEGA SEGA 11 Sid Meier's Civilization VI 54,015 2016 Firaxis Aspyr 2K 12 Team Fortress 2 53,151 2007 Valve Valve Valve 13 ARK: Survival Evolved 49,795 2017 Studio Wildcard Studio Wildcard Studio Wildcard 14 Garry's Mod 36,772 2006 Facepunch Valve Facepunch 15 Rocket League 35,404 2015 Psyonix Psyonix Psyonix 16 Monster Hunter: World 34,214 2018 CAPCOM CAPCOM CAPCOM 17 Hearts of Iron IV 30,923 2016 Paradox Paradox Paradox 18 Sid Meier's Civilization V 28,428 2010 Firaxis Aspyr 2K 19 Euro Truck Simulator 2 25,927 2012 SCS SCS SCS 20 Dead by Daylight 24,495 2016 Behaviour Behaviour Behaviour 21 Terraria 23,529 2011 Re-Logic Re-Logic Re-Logic 22 The Invisible Guardian 22,246 2019 New One Studio New One Studio 23 Ring of Elysium 21,039 2018 Aurora TCH Scarlet Tencent 24 NBA 2K19 20,325 2018 Visual Concepts 2K 2K 25 The Witcher 3: Wild Hunt 19,210 2015 CD Projekt Red CD Projekt Red CD Projekt Red 26 Arma 3 18,968 2013 Bohemia Bohemia Bohemia 27 War Thunder 18,674 2013 Gaijin Gaijin Gaijin 28 Total War: Warhammer II 18,364 2017 Creative Assembly SEGA SEGA 29 Unturned 18,296 2017 Smartly Dressed Smartly Dressed Smartly Dressed 30 Assassin's Creed Odyssey 17,754 2018 Ubisoft Ubisoft Ubisoft = Total 3,652,881

memo: Independent (bolded) 366,220 Source: Steam. Citi Research

So, how can we get a pulse of what game developers are thinking about the overall marketplace? One place to look is an annual survey conducted at the 2018 Game Developers Conference. The survey polled nearly 4,000 game developers. About 20% of these developers worked for very large firms (with over 500 employees). The balance worked for smaller firms (with nearly 20% working alone). The results are revealing.

 First, the PC is still the most dominant platform for game development. It’s more popular than and console platform (like PlayStation or Xbox).

 Second, mobile devices are the second most popular platform for game development capturing around one-third of developers.

 Third, Virtual Reality is still relatively unpopular. Only 15-20% of game developers are working on VR content.

 Fourth, when developers were asked what new platform is most interesting, around 35% of developers cited Nintendo’s Switch (a hybrid platform that incorporates both console and handheld devices).

Figure 15. Platform of Last Completed Game vs. Current Gamed Development

Current Game Development Last Completed Game

PC 60% PC 50%

Smartphone 36% Smartphone 32%

PS4 30% PS4 23%

Xbox One 26% Xbox One 19%

VR 19% VR 15%

Mac 20% Mac 14%

0% 25% 50% 75% 0% 25% 50% 75%

Source: 2018 Game Developers Conference, Citi Research

But, what is the preferred monetization model? Despite the success of free-to-play (F2P) games — like Fortnite and Apex Legends — paid to download is still a bit more popular than free to download (49% versus 39%). And, paid downloadable content (DLC) is still a bit more popular than free DLC (23% versus 20%).

Figure 16. Most Popular Downloadable Content

60% 49% 50% 40%

Models (%) Models 30% 23% 22% 21% 20% 13% 11% 10% 0% Popular PaidPopular Pay to Paid DLC / Paid Paid Paid Paid Download Updates In-game In-game Subscription Item Crates Items Currency 50%

(%) 39% 40%

30% 20% 20% 14%

10% Popular Free ModelsFree Popular 0% Free to Free DLC / Ad Download Updates Supported

Source: 2018 Game Developers Conference, Citi Research

Once the game is developed, how are developers marketing their games? There is remarkably little agreement. While social media (Twitter, Facebook) are certainly popular, this method of promotion only garnered 20% of the vote. Digital storefronts (like Valve’s Steam) were almost as popular. Surprisingly, Amazon’s Twitch garnered less than 10% of developer’s votes as the most effective method of promotion. Moreover, there was remarkably little difference between preferred methods to market the last game versus the next game. That is, marketing preferences don’t seem to be changing.

Figure 17. Most Effective Ways for Developers to Promote, Market New Games

Effective Discovery of Last Game Effective Discovery of Next Game

Twitter, Twitter, 22% 22% Facebook Facebook Digital Store 19% Digital Store 19% Word of 16% Word of Mouth 17% Mouth YouTube 13% YouTube 12%

Paid Ads 13% Paid Ads 12% Press, Press, 11% 11% Bloggers Bloggers Twitch 10% Twitch 8%

Live Events 8% Live Events 7%

Forums 7% Forums 7%

Discord, Slack 6% Discord, Slack 5%

0% 5% 10% 15% 20% 25% 0% 5% 10% 15% 20% 25% Source: 2018 Game Developers Conference, Citi Research

And, who will take the lead executing the marketing plan? About 40% of developers plan to handle their own marketing. And, about one-third pay a full-time or part-time public relations firm. Fewer (less than 25%) work with video game publishers. But, for those developers that work with publishers, nearly twice as many get paid by the publisher in advance (17%) versus a pure revenue share model (6%).

Figure 18. How Do Developers Market?

40% 38% 33% 30%

20% 17% 11% 10% 6%

0% Self Marketing Pay Internal Publisher Paid Pay External Publisher Not PR Firm Us in Advance, PR Firm Paid in Takes Share of Advance, Takes Sales Share of Sales Source: 2018 Game Developers Conference, Citi Research

In terms of funding, more developers are relying on their firm’s internal funds (55%) or personal funds (29%). Very few (about 15%) use a publisher for funding, similar to the share of developers that use crowdfunding. Nearly three times as many developers have no interest is using crowdfunding.

Figure 19. Source of Funds for Game Development

Source of Funds for Game Development Use of Crowdfunding

100% 100% 5% Failed 5% 16% Publisher 15%

15% Have Used 15%

75% 75% 34% Personal 29% Funds 25% May Use 25%

50% 50%

Existing 49% Funds 55% No 25% 25% 45% Interest 45%

0% 0% 2017 2018 2017 2018 Source: 2018 Game Developers Conference, Citi Research

Layer III: Game Publishers

When most investors think about investing in video games, they focus on video game publishers. But, who are the largest publishers? The answer depends on whether you’re talking about mobile games or non-mobile games. While most publishers don’t split console/PC revenues from mobile revenues, it can still be useful to look at composite gaming revenues. What’s clear is that Tencent is the largest publisher. But, publishing is quite fragmented.

Figure 20. Largest Video Game Publishers – Global Console/PC/Mobile Revenue

Company Region Listing 2010 2011 2012 2013 2014 2015 2016 2017 2018E Tencent China Public 1,812 2,260 3,264 4,318 7,236 9,238 11,926 16,847 18,343 + Microsoft* U.S. Public 2,612 2,744 2,490 2,321 2,806 4,038 5,626 6,333 8,988 + Activision U.S. Public 4,802 4,489 4,987 4,341 4,813 4,620 6,599 7,156 7,262 + NetEase China Public 1,375 1,566 1,706 1,915 2,065 2,473 3,997 5,183 5,742 + Electronic Arts U.S. Public 4,159 3,828 4,186 3,793 4,021 4,319 4,566 4,942 5,180 + Nintendo Japan Public 3,316 2,352 2,395 2,013 1,820 1,493 1,541 2,993 3,968 + Epic U.S. Private 200 250 300 350 450 540 636 2,400 3,800 + Sony Japan Public 761 1,349 1,168 1,543 1,592 1,689 2,081 2,986 3,608 + Take-Two U.S. Public 1,127 872 1,090 2,503 1,057 1,475 1,776 2,160 2,880 + Bandai Namco Japan Public 1,162 1,512 1,728 1,529 1,536 1,661 2,170 2,688 2,824 + Nexon Japan Public 1,122 1,155 1,313 1,541 1,559 1,571 1,678 2,103 2,272 + Ubisoft EU Public 1,193 1,455 1,379 1,645 1,259 1,684 1,603 1,723 1,923 + Square Enix Japan Public 749 909 1,076 943 1,017 1,323 1,834 1,725 1,844 + Netmarble Korea Public 185 245 326 486 528 912 1,244 2,272 1,819 + NCSoft Korea Public 583 529 709 721 769 326 816 1,647 1,544 + Aristocrat Australia Public 31 56 122 216 351 617 852 1,100 1,339 + Konami Japan Public 415 486 553 604 509 773 750 885 1,073 + Sanqi China Public ------655 798 1,033 + PUBG Corp (Krafton Game Union) Korea Private - - - - 4 1 1 253 944 + Zynga U.S. Public 166 298 358 429 515 618 741 861 907 = Top 20 publishers 25,770 26,355 29,149 31,210 33,906 39,372 51,092 67,054 77,291 + Other 25,381 30,892 31,716 31,790 34,711 33,554 29,671 24,954 24,079 = Global PC, console and mobile 51,151 57,247 60,865 63,000 68,617 72,926 80,762 92,008 101,371

Note: Microsoft includes Xbox licensing revenue Source: Citi Research

If we try to isolate console/PC revenue from mobile revenue, a slightly different picture emerges. First console/PC revenues comprise about 50% of total gaming revenues. Second, Tencent falls a few spots, but Sony rises to the top of the list. But, other than revenues, is there another way to assess which game publishers are the most successful? One way to measure success is to look at the average metacritic score for each developer over the last eight years (2010 to 2018). (Metacritic is a website that aggregates consumer reviews.) We looked at two dimensions: (1) the average score and (2) the average standard deviation across various titles. The implications are fairly clear.

Figure 21. Largest Video Game Publishers – Global Console/PC Revenue

Company Firm Listing 2010 2011 2012 2013 2014 2015 2016 2017 2018E + Microsoft* U.S. Public 2,612 2,744 2,490 2,321 2,806 4,038 5,626 6,333 8,988 + Tencent China Public 1,812 2,260 3,264 4,318 5,256 6,196 6,440 7,876 7,229 + Activision U.S. Public 4,802 4,489 4,987 4,341 4,813 4,620 5,013 5,158 5,177 + Electronic Arts U.S. Public 3,944 3,586 3,902 3,430 3,569 3,795 3,996 4,314 4,521 + Nintendo Japan Public 3,316 2,352 2,395 2,013 1,820 1,493 1,374 2,701 3,623 + Epic U.S. Private 200 250 300 350 450 540 636 2,400 2,800 + Take-Two U.S. Public 1,120 860 1,063 2,455 978 1,337 1,585 1,914 2,580 + Sony Japan Public 761 1,349 1,168 1,543 1,592 1,584 1,610 1,867 2,328 + Ubisoft EU Public 1,193 1,455 1,379 1,645 1,259 1,684 1,603 1,723 1,923 + NetEase China Public 825 985 1,056 1,154 1,215 1,395 1,622 1,705 1,777 = Top 10 publishers 20,585 20,330 22,004 23,570 23,758 26,680 29,505 35,992 40,945 + Others 25,928 30,320 29,519 26,104 23,741 18,212 15,442 13,174 11,810 = Global console/PC revenue 46,514 50,650 51,523 49,674 47,499 44,892 44,947 49,166 52,755

Note: Microsoft includes Xbox licensing revenue Source: Citi Research Firms with higher average scores also tend to have lower variance. Take Two, Nintendo, Capcom and Electronic Arts all score particularly well. On the other hand, Konami, Activision and Namco Bandi tend to receive lower average scores and higher variance in those scores.

Figure 22. Metacritic Scores for Top Developers 7

Konami 6

5 Activision

Bandai Namco Ubisoft Sega 4 Microsoft Take-Two

3 THQ Square Enix Capcom EA Nintendo Standard Deviation Standard 2 Sony 1

0 66 68 70 72 74 76 78 Average Quality of Title: 2010 to 2018 Source: Metacratic.com

Layer IV: Hardware

The next layer in the video game value chain is hardware. There are actually five distinct platforms: (1) Arcade; (2) Consoles; (3) PCs; (4) Mobile; and (5) Cloud. (We’ll skip mobile hardware in this section since we treat this gaming ecosystem separately in the next chapter.)

Figure 23. Types of Video Game Hardware

Description Examples

Game play occurs outside the PacMan, Space Invaders Arcade home. Expensive computing means consumers “lease” use

Specialized hardware for Atari, Odyssey, Coleco, Console gaming driven by lower cost Nintendo Wii, Sony computing hardware PlayStation, Microsoft Xbox

Less demanding games (simple PC, Mac PC graphics, lower processing power) means PCs can be used for some games.

Rise of smartphone allowed Apple iOS or Google Android Mobile game play to occur outside home

Gaming on demand. Can play Cloud on any device without owning processing hardware or a copy of the physical game

Source: Citi Research

Arcades: Where the Games Begin

Early video game consoles — including hardware and software — were first housed in large cabinets and cost about $2,500 per game. As such, consumers wouldn’t buy a video game. Rather, they would visit an arcade and rent consumption (at $0.25 per play). Just to recoup the original investment in the arcade game, an arcade owner would need to see 4,000 plays ($2,500 / $0.25).

Early hit games like Space Invaders (1978), Asteroids (1979) and Pac-Man (1980) were the pioneers in the arcade market. By 1982, global arcade revenues had reached over $25 billion a year. The U.S. market comprised about one-third of all arcade revenues.

But, in 1983, the video game market faltered. The decline was multi-faceted: a recession, persistent inflation, arcade hardware saturation, and the advent of the console/PC market. Today, the out-of-home arcade business is a shadow of its former self. The largest U.S. arcade company — Dave & Busters — operates just over 100 U.S. locations and generates $1.1 billion in revenue, with 50% stemming from games (with the balance stemming from food & beverage). In effect, lower cost and more powerful computing processing pushed the gaming industry from the mall to the living room.

Figure 24. Global Arcade Revenues ($ billions) 30

10 Global Arcade Revenues ($bn) Revenues Arcade Global 5

0 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12 '15 '18 Source: Fandom, Citi Research

Console and Handsets: Where the Market Expands

As hardware costs began to fall, consumers shifted their spending from arcades to home consoles and handheld devices. Over time, these devices have been divided into nine generations. In truth, the specific lines that separate one console generation from the next are a little fuzzy. But usually, the delineation reflects a discrete improvement in processing power. In the early days, the processing improvement happened in the central processing unit (CPU). Today, most of the improvement happens in the graphics processing units (GPU). As we walk through the various platforms, a few things are worth keeping in mind:

 First, an incredibly popular console (Sony PlayStation 2) or widely used handheld (Nintendo DS) will sell about 160 million units globally over its lifetime.

 Second, a successful console (Sony PlayStation 1) or successful handheld (Nintendo GameBoy Advance) will typically sell about 80 to 100 million units.

 Third, the handhelds and consoles of earlier generations (like the Sega GameGear and Atari 2600) would only sell 10-25 million units. In effect, unit volumes generally rose over time as gaming became more popular.

Figure 25. Unit Sales of Consoles and Handheld Devices 180 160 Console 140 Handheld 120 100 80

Units Sold (mn) Sold Units 60 40 20 0

Source: The Video Game Textbook, Citi Research

If we focus on consoles (but exclude handhelds for a moment), five important trends are important:

 First, in the 1st and 2nd generation, the console manufacturers were comprised of four main firms: Atari, Magnavox, Mattel and Coleco. Only one of these firms — Atari — would survive to the 4th generation.

 Second, between the 3rd and 6th generation, three firms battled for dominance: Atari, Nintendo and Sega. But, only one of these firms — Nintendo — would survive to the 7th generation. Both Atari and Sega dropped out.

 Third, during the 5th generation, Sony entered the market. And, two cycles later (7th generation), Microsoft entered the market. During the 7th and 8th generation, three firms competed for share: Nintendo (the stalwart), Sony, and Microsoft.

 Fourth, between the 1st and 7th generation, global console sales improved. Only in the most recent generation — the 8th generation — have console sales faltered. We suspect this is due, in part, to the rise of mobile gaming (which we’ll review in more detail a bit later).s

 Fifth, as we look at winners and losers within each generation, there isn’t a hard and fast rule for who takes the most market share. While we ran many regressions to crack the code for console sales, there doesn’t seem to be a clear set of variables that drive market share in each generation.

Figure 26. Console Unit Sales Sold by Generation

Console Generation 2nd 3rd 4th 5th 6th 7th 8th 120

100 )

mn In total, nearly 1 80 billion video game

Sold( consoles have been sold. 60 Each generation of improved graphics with

Console Units Units Console 40 richer colors, faster processing and improved 20 sound.

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Atari Magnavox Mattel Coleco Sega Nintendo Sony Microsoft

Source: The Video Game Textbook, Citi Research

Handheld Market

So far, we’ve focused on the console market. But, beginning in 1988 a new market developed: the handheld gaming market. With the exception of a few short periods (’90 to ’94) and (’04 to ’07), the console market sold more units than the handheld market. More recently, we’ve seen the entrance of hybrid devices that serve the console and handheld market with a single device (the 9th Generation Nintendo Switch).

Figure 27. Console, Handheld & Hybrid Units Sold 70

30 Console 20 Hybrid (Console + Handheld) Console & Handheld Units Sold (mn) Sold Units Handheld & Console 10

Handheld 0 '76 '80 '84 '88 '92 '96 '00 '04 '08 '12 '16 Source: The Video Game Textbook, Citi Research

If we look at the various firms that sold handhelds, it’s quite different than the console market. Since handhelds hit the market long after Atari, Magnavox, Mattel, and Coleco exited gaming, there are far fewer handheld players. Moreover, Microsoft has never rolled out a handheld device. As such, today, there is only one firm that sells handhelds — Nintendo — and, it’s a hybrid device.

Figure 28. Handheld Units Solid by Generation

Handheld Generation 60 2nd 3rd 4th 5th 6th 7th 8th

50 )

mn In total, nearly 575 40 million video game

consoles have Sold( been sold. 30 Each generation of improved graphics with 20 richer colors, HandheldUnits faster processing and improved 10 sound.

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Sega Nintendo Sony

Source: The Video Game Textbook, Citi Research

If we look at handheld market shares, there are a few important observations. First, Nintendo is the clear market leader with about 20 million units sold in 2018. Second, Sega exited the market back in the late 1990s. Third, Sony’s latest entry (the PlayStation Vita) will cease production in 2019. As such, in 2020, Nintendo will be the only firm selling handheld devices.

Figure 29. Handheld Units Sold by Manufacturer

30 In total, nearly 575 million 25 handheld video Nintendo game devices have been sold. 20 Nintendo is the 15 market leader, followed by Sony. Sony Handheld Units Units SoldHandheld(mn) 10

5 Sega

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Source: The Video Game Textbook, Citi Research

If we add up the console market and the handheld market — nearly 1.6 billion units have been sold over the last 40 years. And, we can get an idea of composite hardware market share each year. While there’s been a fair amount of change in relative rank over the years, today Nintendo is the leader, followed by Sony with Microsoft securing third place.

Figure 30. Hardware Market Share

Hardware Generation 2nd 3rd 4th 5th 6th 7th 8th 100% Microsoft 90% Atari Sega 80%

70% In total, nearly 1.6 Sony billion video game 60% consoles and handhelds have been sold. 50% Market is now 40% controlled by three major players: 30% Nintendo, Sony & Microsoft. 20%

Console & Handheld Market Share (%) Share Market Handheld & Console Nintendo 10% Other 0% '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 Atari Other Sega Nintendo Sony Microsoft

Source: The Video Game Textbook, Citi Research

Hardware Performance: Console and Handheld

So, how much have consoles improved over time? Unfortunately, there isn’t a single metric that encapsulates a computer’s performance into a holistic, unified performance metric like a vehicle’s velocity (MPH) or broadband Internet speeds (Mbps). But, in broad terms, there are four key variables that determine a machines performance: CPUs, GPUs, MIPS and MFLOPS.

Figure 31. Four Variables that Determine Hardware Performance

Central Processing Unit (CPU): The bits Graphics Processing per second the Unit (GPU): processor can handle. CPU GPU Bits of information that A bit is required to can travel between the perform any logical memory and the GPU. operation in software.

Millions of Mega Floating-Point Instructions per Operations per Second (MIPS): MIPS MFLOPS Second (MFLOPS): Measures the number The speed at which of machine instructions computers can perform a computer can execute floating-point in one second. calculations.

Source: Citi Research

Let’s start with CPU. The CPU measures the number of bits the processor can handle. Early consoles had 8 bit processors but as the consoles moved into the 6th generation, the CPUs improved to 128 bit processors. However, in the 7th generation consoles, hardware firms scaled back CPU capacity and began to use other levers to enhance machine performance. Indeed, the Microsoft Xbox (released in 2001) as a 7th generation console only had a 32-bit CPU. (And, parenthetically, the iPhone 6 only uses 64-bit CPUs.)

Figure 32. CPU Units Sold by Console Generation

Console Generation 2nd 3rd 4th 5th 6th 7th 8th 300

250

200

) CPUs improved between 2nd Generations and 150 6th Generation. Then, hardware

began to use CPU (number CPU 100 other ways to improve performance. 50

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Atari Magnavox Mattel Coleco Sega Nintendo Sony Microsoft

Source: The Video Game Textbook, Citi Research

So, how did hardware firms improve performance as we moved beyond 6th generation consoles? They turned from the CPU — the brains of the computer — to the graphics processing unit, or GPU. GPUs are often called the ‘heart of the console’ because it’s the chip that handles graphics.

While CPUs retrenched for a while, GPUs — the number of bits that can travel between the console’s memory and the GPU — generally improved. GPUs peaked at 256 bits. And, unlike CPUs, GPUs generally improved as hardware firm moved from 6th generation to the 7th generation consoles.

Figure 33. GPU Units Sold by Console Generation

Console Generation 2nd 3rd 4th 5th 6th 7th 8th 300

250

200 GPUs improved between 3nd 150 Generations and

7th Generation. GPU (number) GPU Then, it peaked at 100 256 bits per second.

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Atari Magnavox Mattel Coleco Sega Nintendo Sony Microsoft

Source: Forbes, Citi Research

Beyond CPUs and GPUs, there is one other way to measure a console’s performance: the number of instructions a machine can perform per second. This is often abbreviated with the acronym MIPS or ‘millions of instructions per second’. The first console with its own processor — the Fairchild Channel F — could only process 0.14 MIPS. Current consoles can process 200K MIPS. In effect, the PS4 is akin to running 1.4 million Channel F’s.

Figure 34. MIPS by Console Generation

Console Generation 2nd 3rd 4th 5th 6th 7th 8th 250,000

200,000

150,000 Millions of instructions per

MIPS (mn) MIPS second – or MIPS – have 100,000 dramatically improved over the last 40 years. 50,000

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Atari Magnavox Mattel Coleco Sega Nintendo Sony Microsoft

Source: Forbes, Citi Research

The final metric used to measure a console’s performance is MFLOPS, or mega floating-point operations per second. But, what are floating points? Since software engineers deal with limited memory, they cannot store numbers with infinite precision. At some point, they truncate the number. The easiest way to accomplish this is to convert all numbers into scientific notation (for example 123 = 1.23 x102). This means there are no fixed numbers before — or after — the decimal point. Instead, it just floats based on how you decide to represent the number in scientific notation. Floating point representations are less accurate than fixed point representations. But, floating point representations can handle a larger range of numbers.

If we look at the improvement in MFLOPS, it didn’t show up as a positive figure until 1982 when the Sega Model 1 could handle 80 MFLOPS. But, the Sony PS4 can handle 1,843,200 MFLOPS. That’s an improvement of 23,000x.

Figure 35. MFLOPS by Console Generation ` Console Generation 2,000,000 2nd 3rd 4th 5th 6th 7th 8th

1,800,000

1,600,000 ) 1,400,000

1,200,000 Floating point 1,000,000 calculations were not introduced th MFLOPS (number MFLOPS 800,000 until 7 Generation 600,000 consoles.

400,000

200,000

0 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Atari Magnavox Mattel Coleco Sega Nintendo Sony Microsoft

Source: Forbes, Citi Research

PC Market

So far, we’ve spent all of our time on arcades, consoles, and the handheld market. But, this isn’t to suggest that some gaming doesn’t occur on PCs. Indeed, on a global basis the PC market comprises about 50% of (non-mobile) software sales. PC gamers tend to fall into two groups: low-end gamers and very high-end gamers.

 First, at the low-end, these PC players engage with casual games, strategy games, and role-playing games (RPG). They don’t often play sports, action, or shooter games. Those types of games are typically played by the segment that uses consoles.

 Second, at the high-end, there are some gamers that don’t find off-the-shelf hardware — from Sony, Microsoft and Nintendo — robust enough. This small segment will purchase robust (and often expensive) gaming rigs that have extra performance and often have clever brand names like ‘Alienware ‘.

Figure 36. Some Game Genres Require Console Processing

Sports Action Shooter Other RPG Strategy Casual Total Console 13% 23% 25% 23% 12% 4% 1% 63% / PC 0% 4% 6% 9% 19% 36% 26% 70%

= Ratio 66.0x 5.6x 3.9x 2.7x 0.6x 0.1x 0.0x Source: NPD 2016

PC hardware volumes — including PCs for businesses — vastly outpace console and handset sales each year. Indeed, in 2018, there were about 5x more PCs sold than gaming hardware devices — like consoles and handhelds.

Figure 37. Global Units Sold by Gaming Device

400

350

) 300 mn 250 PC

Sold ( Sold There are 5x more 200 PCs sold each year than game 150 consoles or

handheld devices. Global Units Units Global 100

50 Console

0 Handheld '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Source: The Video Game Textbook, Citi Research

We can take this annual shipment data and make a few assumptions to get an idea for how much gaming hardware is in the field. We made the following assumptions:

 For PCs, we assume 40% are consumer-owned and 60% are business-owned; 25% of consumer-owned PCs are used for gaming; a PC lasts five years.

 For consoles, we assume 100% are for consumers; 100% are used for gaming; like PCs, we assume a gaming console lasts five years.

 For mobile devices, we assume 100% are used by consumers; the portion used for gaming increases each year, reaching about 45% by 2018; we use a three year mobile replacement rate.

All told, this suggests there are over 2 billion gaming devices in the field. But, nearly 90% of these gaming devices are mobile handsets. In 2018, this suggests there are about 250 million non-mobile gaming devices in the market.

Figure 38. Global Video Game Units Sold by Device

2,500

Console PC Handheld 2,000 Mobile

1,500

1,000 Global Video Gamers (mn) Gamers Video Global

500

0 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Citi Research

What sort of hardware are PC gamers using? Perhaps the best source of data we found is from Steam. Steam is one of the largest (if not the largest) distributor of PC games on the Internet. And, the Steam data has some interesting statistics.

– First, only 36% of Steam users are in English-speaking countries while 25% are Chinese and 12% are Russian. All other regions of the world make up 27% of Steam users. As such, we think this is a fairly representative set of users around the world.

– Second, the core CPU is dominated by Intel (82%) followed by AMD (18%). And the core CPUs have two (28%), four (56%) or six (11%) core processors.

– Third, as for the video card, a whopping 75% use NVIDIA’s chips, followed by 15% that use AMD and just 10% that use Intel.

– Fourth, only 1% of players use a VR headset. Layer V: Distribution

So far, we’ve reviewed the IP layer and discovered it’s not too important. And, we summarized the process video game developers follow to create games (including the use of engines and rasterization) and reviewed the differences among games genres. Then, we discussed the major video game publishers. This was followed by a closer look at the various forms of hardware (including consoles, PCs, and handhelds). Now, we’re in a position to move to layer five: the distribution of video game content.

There are three main methods to distribute video games. First, in the early days of video games, the consumer would purchase a physical disc at Wal-Mart or Best Buy. More recently, consumers have been able to download digital copies of gaming content from distributors like Xbox Live, PlayStation Network or Steam. And, in the

future, consumers may not need to download a game. Rather, they would just purchase a license from a cloud-based service provider.

Figure 39. Methods of Distributing Video Game Software

Description Examples

Physical delivery of software GameStop, Best Buy, Physical to retail outlet Wal-Mart

Download of the digital content Xbox Game Store, Digital Download over the Internet PlayStation Network, Steam

Access to license via the GeForce Now, Parsec, Cloud Internet Hatch

Source: Citi Research

Over the last decade, consumers have rapidly shifted away from physically purchasing a game toward digital distribution. About ten years ago, over 70% of all game revenues were physical game sales. Today, only 15% of game revenue comes from physical software sales.

Figure 40. Game Revenue Breakdown: Digital vs. Physical

100%

90% 31% 35% 80% 49% 54% 70% 61% Digital: 69% Full-game downloads 74% 60% 79% Digital add-on content 85% Subscription services 50% Mobile games Social network games 40% 69% 65% 30% 54% 46% 20% 39% 31% 26% Physical: 10% 21% 15% Software available at retail outlets 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: NPD Group, Citi Research

However, since this data includes mobile — which is both large and 100% digital — it may be more instructive to see how console/PC software sales are trending. Sony provides some useful data called the ‘download ratio’. This data suggests that in 2013, 92% of software sales were in disc form. By 2018, only 62% of console/PC sales were in disc form. The balance of the sales were digital downloads.

Figure 41. Sony Share of Software Downloaded 45% 40% 40% 38%

35% 33%

30% 25% 25%

20% 19%

15% 13%

10% 8% Sony Share of Software Downloaded Software of Share Sony 5%

0% 2013 2014 2015 2016 2017 2018 2019E Source: Sony, Citi Research

This shift has been driven by four distinct developments:

1. As Internet speeds have improved, consumers can readily download a full game to their console or PC.

2. Video game developers have been adding downloadable content (DLC) into games to help generate in-game sales.

3. Some video game publishers have created subscription services giving consumers access to older titles for a fixed, monthly fee.

4. As processing power inside smartphones has improved, it has allowed consumers to enjoy a wider selection of mobile games. These games generate revenue from in-game content and from advertising.

Let’s review each of the key drivers toward digital consumption of video games.

According to Steam, 30 countries make up about 70% of all traffic on the site. And, if we look at the broadband speeds in those 30 countries, it averages about 35Mbps. Moreover, the fastest ISP in each region can, on average, deliver 88Mbps. And, even the slowest ISP connected to Steam in each region can, on average, offer 17Mbps. These are remarkably robust speeds that make downloading video games over the web a readily accessible proposition for many households.

Figure 42. Broadband Connection Speed for Steam

Speed Fastest Slowest Country (Mbps) ISP Speed ISP Speed China 46 UNICOM Liaoning 54 CERNC 28 U.S. 47 Verizon 70 CenturyLink 15 Russia 24 OJS Moscow 45 PJSC MegaFon 10 Germany 28 Unitymedia 60 Vodafone DSL 18 S. Korea 100 Korea Telecom 96 Tbroad Suwon 49 U.K. 33 Virgin 55 TalkTalk 18 Brazil 17 COPEL 30 Oi Internet 6 Canada 42 Rogers 75 SaskTel 17 France 23 NVIDIA Ltd 567 Free SAS 14 Japan 61 Sony Network 109 Jupiter 46 Australia 20 Aussie Broadband 35 Dodo 9 Thailand 41 3BB 52 AIS Mobile 7 Poland 23 UPC 62 Play 8 Turkey 12 Turksat Uydu-Net 19 Demiroren 8 Sweden 68 Ownit 106 Telia 46 Ukraine 26 Lanet 42 PJSC 7 Spain 50 Jazztel 71 Orange 42 Taiwan 38 HiNet 42 Taiwan Mobile 18 Netherlands 58 NVIDIA Ltd 508 Euronet 23 Norway 51 Altibox 80 NextGen 21 Italy 20 Fastweb 22 Linkem 4 Finland 36 CSC-Tieteen 65 Elisa Oyj 29 Hungary 40 UPC 68 ZNET 16 Argentina 13 Telecentro 25 Telecom Personal 6 Belgium 47 VOO 57 M247 26 Indonesia 9 MyRepublic 30 Telkomsel 7 Mexico 16 Totalplay 29 Telcel 7 Malaysia 29 Tt Dotcom 73 U Mobile 4 Chile 27 VTR 48 Entel 6 India 15 Alliance 32 BSNL 4 = Top 30 35 88 17

Source: Steam

According to Sandvine, on a global basis, gaming now makes up about 8% of all downstream Internet traffic, and 3% of upstream Internet traffic. (Downstream traffic is from the cloud to the user; upstream traffic is from the user to the cloud.) That makes gaming the third most popular application for downstream traffic on the Internet (behind video delivery (i.e., Netflix) and generic web surfing). Xbox Live makes up about two-thirds of all gaming sessions and about one-third of all traffic. PlayStation Network makes up about 30% of all sessions and 40% of all traffic. Steam is a distant third with less than 10% of all sessions.

Figure 43. Breakdown of Upstream and Downstream Internet Traffic

2018 PlayStation Network Xbox Live Steam Down Up Down `Up Sessions Down Up Sessions Down Up Sessions Video 58% 23% + Web 17% 21% + Gaming 8% 3% 45% 40% 29% 33% 27% 64% 24% 16% 7% + Social 5% 4% + Markets 5% 2% + File sharing 3% 22% + Messaging 2% 8% + Security 1% 7% + Storage 1% 9% + Audio 1% 0%

= Total 100% 100% Source: Sandvine, Citi Research

One reason gaming consumes such a large portion of Internet traffic is current games are quite large. Sandvine estimates that to download Call of Duty: Black Ops 3 is a 100GB of data. That’s equivalent to 13 hours of 4K video streaming (100GB / 7.8 GB per hour = 13 hours). It’s also equivalent to nearly 60 hours of high definition (HD) video streaming (100GB / 1.7GB per hour = 59 hours).

Figure 44. Download Times for Call of Duty by Video Standard

Video Standard SD HF Full HD Quad HD 4K Call of Duty download (GB) 101 101 101 101 101 / Video GB per hour 0.3 0.8 1.7 6.9 7.8

= Hours of video 352 132 59 15 13 Source: Sandvine, Citi Research

For PC games, there are a handful of niche distributors. These include Steam, GOG and Desura, just to name a few. Steam is, by far, the largest distributor of independent PC-based games. Steam is a private company owned by Valve. Since inception, Steam has released over 30,000 games on its platform. The number of new releases has grown from under 600 per year in 2013 to over 9,000 a year in 2018. Although Steam is a private company so actual figures are hard to come by, but industry observers (i.e., SteamSpy) suggests there are 90 million active monthly users on Steam. And, they spent about $4.3 billion on video games in 2017. (This includes fees paid for titles but excludes in-game purchases.)

Figure 45. Number of New Games Released on Steam 10,000

9,000 Over 30,000 games 8,000

7,000

6,000

5,000

4,000

3,000 New Games Released on on Steam Released GamesNew 2,000

1,000

0 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Wikipedia; SteamSpy, Citi Research

Steam’s Main Rivals Include Epic Games and Discord.

Epic Games — the creator of Fortnite — recently launched a digital store front in 4Q18. And, as we showed earlier, Epic has given developers economic incentives to use its game engine (UE4) along with its new storefront.

Discord is another private company with significant venture capital (VC) backing. Discord raised $200 million from VC firms like Greylock, Benchmark, and Tencent.

Discord has focused on social features – like voice chat and instant messaging - to drive growth. Steam has responded by incorporating social features into its platform. In addition, Electronic Arts (EA) broke away from Steam in 2011 to form EA Origin. But, EA service still isn’t very popular.

We used Google Trends to assess popularity of the digital storefronts of Steam, Discord, and Epic. Discord has gradually grown in popularity over the past few years. And Epic is a relatively new upstart. Steam, it seems, is still the leader. Most gamers like Steam’s game selection, search functionality, and on-line support. Most gamers still think Discord and Epic haven’t yet caught up to Steam.

Figure 46. Popularity of Digital Storefronts by Game Distributors 100 Steam 90 Discord 80 Epic

40 (100 = Peak) = (100 30

U.S. Google Trends Interest Trends Google U.S. 20

Jan-15 Jan-16 Jan-17 Jan-18 Jan-19

Sep-14 Sep-15 Sep-16 Sep-17 Sep-18

May-14 May-15 May-17 May-18 May-16 Source: Google, Citi Research

Cloud Gaming

Cloud gaming is relatively simple. Rather than processing video game content on a PC or console, the processing is done inside the network, or in the cloud.

Cloud gaming has been a long-term aspiration for the video game industry. It all began with OnLive. OnLive launched the first cloud gaming platform back in 2009. Although OnLive officially had 1.5 million active users when the service shuttered, the service was losing money. Press reports such as The Verge suggested OnLive was burning through $60 million a year. Moreover, latency times were quite significant at around 150 milliseconds.

Despite the demise of OnLive, industry observers are still drawn to the technical elegance of cloud gaming. For the consumer, it eliminates the need to upgrade console hardware. And, if the cloud gaming platform is designed properly, it makes it easier for consumers to play games on different platforms (including smartphones and PCs). For the game developers, it allows firms to support more devices and reduces compatibility issues between software and hardware. And, for console manufacturers, it allows revenues to migrate to monthly recurring revenues (versus episodic hardware revenues). And, those transitions are usually good for valuations (due to expansion of the multiple).

There are, however, three fundamental challenges with cloud gaming. First, consumers must have sufficient broadband speeds. Second, the latencies must be sufficiently low to allow users to play a cloud based game without any erosion in game quality. Third, users will need a controller that works with any screen (including mobile handsets). Let’s look at each of these impediments.

Broadband Speeds

Cloud gaming requires, at a minimum, 15Mbps broadband speeds. Among the 10 Figure 47. Broadband Speeds for 10 Most most populous countries, all but three — Nigeria, Pakistan, and Indonesia — offer Populous Countries average broadband speeds in excess of 15Mbps. Moreover, most regions are Country Population Nov '17 YoY Chg experiencing double-digit annual improvements in speeds. As such, we don’t see (mil) (Mbps) (pct) broadband speeds as a major impediment to cloud gaming. China 1,420 61.2 42% + India 1,369 18.8 77% For gamers that want even better picture quality and higher frame rate, Google + U.S. 329 75.9 37% + Indonesia 270 13.4 19% recommends 25Mbps. That level of speed will deliver 1080p picture quality at 60 + Brazil 212 17.8 19% frames per second. + Pakistan 205 6.1 16% + Nigeria 201 9.5 4% Latency + Japan 127 73.5 21% + Bangladesh 168 16.1 14% Cloud computing for video games is very different than streaming video (Netflix) or + Russia 144 36.9 15% music (Spotify). That’s because video and music content are pushed to the + RoW 3,270 nm nm consumer, with almost no consumer interaction. This gives the content supplier the

= Global 7,715 nm nm ability to buffer content (masking any connectivity or latency issues). Buffering isn’t Source: Wikipedia possible for cloud gaming. Moreover, gamers want to interact with the game. So, low levels of latency are critical.

Most industry observers think latency — the time between a gamer’s command and the subsequent screen action — must fall below 40 milliseconds. That’s not a lot of time — 40ms is akin to 1/25th of a second. In that narrow slice of time, cloud gaming hardware must to three things:

 Process Delay: First, the cloud server must receive and process player commands and encode and transmit the frame to the user’s thin client. This step has four sub-elements: memory copy, format conversion, video encoding, and packetization.

 Playout Delay: Second, the thin client must receive and render the video frame on the display. This step has three sub-elements: frame buffering, video decoding, and screen rendering.

 Network Delay: Third, the signal must travel between the cloud server and the thin client

Figure 48. Sources of Cloud Gaming Latency

Time b/w user Response command & Delay screen action

Time for info Time for server to Time for client to Network Playout to travel Process receive & process receive, decode Delay between Delay player command; Delay & render frame cloud server encode & transmit on display & thin client frame to client

Time to receive Time to copy Frame all packets for Memory image out of Buffering current frame Copy game

Format Time for Conversion color-space Video Time for video conversion Decoding decompression

Video Time to compress Encoding Time to display video Screen decoded frame Rendering

Packetization Time to segment frame into packets

Source: Measuring the Latency of Cloud Gaming Systems, Citi Research

If you delve into the various building blocks of total Response Delay, about 60% of the latency stems from Process Delays (the cloud server), 25% stems from Playout Delays (the thin client in the home) and 15% stems from Network Delays (Internet transit).

Moreover, you’ll notice that video encoding (within Process Delay) and video decoding (within Playout Delay) are the two most significant causes of total latency. In total, video encoding and decoding makes up about 20 milliseconds of delay, or over one-third of the total. As such, if there is a way to improve on these speeds, latency can decline further. Video encoding may hold part of the answer.

Figure 49. Cloud Gaming Latency (milliseconds)

50 12 10

) 1 6 40 6

6 2 30 56

5 Latency Latency (milliseconds 44 20 9 40 31

Cloud Gaming Cloud 15

H.265

Buffer

Frame

Video Copy

Video

Screen

Render

Encode

Decode

Memory

Network

Format

Close host Close

Conversion Packetization Process Delay Playout Delay Transit (Cloud Server) (Thin Client)

Source: Measuring the Latency of Cloud Gaming Systems, Citi Research

To understand how video encoding impacts latency, we need to learn a bit more about video compression. There are two groups that set video compression standards: (1) Moving Pictures Experts Group (MPEG) and (2) Video Coding Experts Group (VCEG). The former (MPEG) began working on broadcast TV several decades ago. The latter (VCEG) started in 1988 to deal with video conferencing on circuit-switched copper phone lines (via ISDN). Since all forms of video are moving to the Internet, these two groups — MPEG and VCEG — now work together.

But, somewhat confusingly, each body uses different acronyms. The MPEG team uses MPEG-1 to MPEG-4 to identify the evolution of their standards. In parallel, the VCEG team use H.261 to H.265 to identify their standards. In 1993, the industry was using MPEG-1 and H.261. By, 2004 the most widely adopted standard was MPEG-4 and H.264. In the future, more equipment will support MPEG-H and H.265 (also referred to as HEVC).

Figure 50. Video Compression Standards

Year MPEG Part Layer Use VCEG 1984 N/A H.120 1988 N/A H.261 1993 MPEG-1 Video and TV Recording I Systems II Video VCD H.261 III Audio I II III MP3 1999 MPEG-2 Broadcast, DVD I Systems, Program, Transport II Video H.262 III Audio I II III MP3 2004 MPEG-4 Broadcast, Internet, Blu-ray I Systems II Video H.263 III Audio X Advanced Video Codec MPEG-5 AVC H.264 XIV MP4 Container MP4 2013 MPEG-H

II Video HEVC H.265 Source: Wolfcrow.com

If we want to understand the various video standards — from HD to 4K — and map these to specific bandwidth requirements (based on the type of compression), we need to perform a little bit of math. It starts with the pixels per frame (in both the horizontal and vertical directions). Better picture quality means more pixels per frame. We then convert these pixels per frame to quantify uncompressed bandwidth requirements.

A standard definition video signal (SD) would require 510 Mbps without compression. But, a 4K video signal would require 40x as much, nearly 21,000 Mbps. Clearly, even with improving broadband speeds, without compression, consumers couldn’t get a 4K signal. However, with MPEG-2, a 4K stream only requires 125Mbps. And, if the stream is compressed to MPEG-4, it only requires about 52Mbps. With the emerging H.265 compression standard, a home would only need 31Mbps.

Figure 51. Bandwidth Required by Video Standard and Compression

Video Standard SD HD Full HD Quad HD 4K Pixels per frame (horizontal) 720 1,280 1,920 3,840 4,096 x Pixels per frame (vertical) 480 720 1,080 2,160 2,304 = Pixels per frame (mil) 0.3 0.9 2.1 8.3 9.4 x Bits per pixel 8 8 8 12 12 = Total bits 2.8 7.4 16.6 99.5 113.2 x Colors (red, blue, green) 3 3 3 3 3 = Bits per frame (mil) 8 22 50 299 340 x Frames per second 60 60 60 60 60 = Bit rate (Gbps) 0.5 1.3 3.0 17.9 20.4 x Gbps per Mbps 1,024 1,024 1,024 1,024 1,024 = Bandwidth (Mbps) 510 1,359 3,058 18,346 20,874 x Compression (MPEG-2) 0.006 0.006 0.006 0.006 0.006 = Bandwidth (Mbps) 3 8 18 110 125

Bandwidth (Mbps) 510 1,359 3,058 18,346 20,874 x Compression (MPEG-4) 0.003 0.003 0.003 0.003 0.003 = Bandwidth (Mbps) 1 3 8 46 52

Bandwidth (Mbps) 510 1,359 3,058 18,346 20,874 x Compression (H.265) 0.002 0.002 0.002 0.002 0.002 = Bandwidth (Mbps) 1 2 5 28 31

Source: Citi Research

Today, H.264 is the most popular video format. It’s used by Netflix and YouTube. Most cloud gaming platforms use H.264 because there is plenty of hardware in the field that supports this standard. However, H.265/HEVC is waiting in the wings. The aim of H.265/HEVC is to reduce the bit rate by allowing for far more flexibility in the video grid size. When there is little movement on the screen, the grid size can be larger. And, where more movement occurs, the grid size is smaller. This, in turn, means a larger grid may not need to be refreshed for every frame of video, reducing bandwidth requirements and latency.

Figure 52. Comparing Video Formats – H.264 vs HEVC H.264 HEVC

Source: Boxcast, Citi Research

With HEVC, it may be possible to reduce the video encoding and video decoding from about 20ms to just 10ms. And, if cloud gaming servers can be placed locally, it may be possible to reduce total latency from 55ms to ~40ms.

Indeed, data from Wonder Network suggests latencies between New York and Toronto are just 12ms. And, latencies between New York and Washington DC are just 9ms. We suspect if the cloud server and the client were within the same city, these network latencies could be cut in half.

Figure 53. Latencies Between Different Cities (milliseconds)

Destination Source Barcelona Paris Tokyo Toronto Washington Amsterdam 34 16 246 90 81 Auckland 313 293 206 228 230 Copenhagen 40 21 276 113 207 Dallas 145 109 146 41 32 London 30 4 225 88 76 Los Angeles 144 145 108 68 61 Moscow 66 50 207 140 132 New York 93 74 209 12 9 Paris 29 nm 222 86 78 Stockholm 48 26 285 108 103

Tokyo 297 231 nm 165 168 Source: Wonder Network

So, can improvements in video compression and cloud infrastructure (that sits closer to the end-user) get latencies to 40ms or less? We think the answer is yes. Ken Moss (EA’s Chief Technology Officer) suggested to Barron’s in 2018 that technological impediments may be disappearing:

“The common view is that you can’t play high-end multiplayer games on the cloud because of the latency. But you can, and the bandwidth and latency continue to move in the right direction.”

Controllers

Although no cloud service has gone live, Google’s pending Stadia offer did release pictures of its game controller. The device has connections for both a headphone jack (3.5mm) and a USB-C port. It also has dedicated buttons for voice control (powered by Google Assistant) and capture video.

It’s unclear if the controller will be sold separately or bundled with a Stadia subscription. But, Google has suggested Stadia will support other gamepads.

Figure 54. Google Stadia Controller Figure 55. Konami Code on Back of Google Game Controller

Source: Google Source: Wikipedia

And, in a not so subtle nod to the hard-core gaming community, Google engraved the “Konami Code” on the back of the controller. For readers that aren’t avid gamers, the Konami Code dates back to 1985 when Kazuhisa Hashimoto was working on the arcade game Gradius. During testing, Kazuhisa developed a shortcut that would give him the full-set of ‘power ups’. Every time Kazuhisa pushed this specific sequence of controller buttons, it would allow him to live long enough, without dying, to test any part of the game. When the final game went live in 1986, the code was still in the game. It will be interesting to see how far Google takes this inside joke. That is, the Konami Code may not make it to final production. Or, perhaps it will!

So, who is likely to capture the lion’s share of this potential new cloud gaming market? We suspect cloud providers that already have scale have a distinct advantage. Not only will their services likely have lower latency (since they probably have cloud hardware closer to the gamer), but these scale players will likely be able to charge less for the service.

Already, we are beginning to see early signs of a ‘winner-take-all’ dynamic for cloud- based offers (beyond gaming). Collectively, Amazon, Microsoft, and Google increased their share of overall cloud services from 53% to 58% between the end of 2017 and the fourth quarter of 2018. The smaller players, which have far lower share, are ceding market to the larger players.

Figure 56. Cloud Market Share 100%

17% 90% All Other 21%

80% 15% 70% Next 10 17% 4% In the last year, 60% Alibaba 4% 7% the top three cloud providers have Share (%) Share IBM 8% 7% increase market 50% Google 6% share from 53% to 16% 58%. 40% Microsoft 13%

30% Cloud Market Cloud

20% Amazon 34% 35% 10%

0% 4Q17 4Q18 Source: Citi Research

This isn’t to suggest, however, that other players won’t enter the market. NVIDIA (a chip maker) has created the GeForceNow alliance (GFN). The alliance includes telecom providers like Softbank in Japan and LG Uplus in South Korea. NVIDIA will develop the software and manage the service. But, it will share the subscription revenue with alliance partners. NVIDIA claims they have 300K monthly active users (in beta) with one million on the waitlist.

What could cloud gaming mean for developers and publishers? We can think of a few things:

 First, cloud gaming will likely expand the market. Since the processing is one in the cloud, any screen can be used for gaming.

 Second, cloud gaming means developers will have control of their digital rights. Everything will be safely stored in the cloud.

 Third, over the very long run, cloud gaming may eliminate the need to develop software for specific platforms. Of course, if cloud services are expensive (and consoles still play a meaningful role) developers will still have to program for each unique hardware platform.

For consumers, there are also benefits:

 First, gamers will be able to play games almost immediately. Download times (or shipping times) will be a thing of the past.

 Second, the types of games that are developed will likely change. Once the market opens up to a larger audience — larger than the core gamer market — we will likely see new types of games that take advantage of the larger market and faster processing power.

 Third, historically, mobile games have been limited by the processing power that resides within the phone. This has given rise to casual, low-spec mobile games. With cloud gaming, higher-end games can be played on any device — including smartphones — with limited processing power.

 Fourth, consumers will have a seamless user experience. Gamers can pause the game their playing on one device and pick it up on another device. Layer VI: Consumer

So, cloud gaming may be just around the corner. But, what is the potential addressable market? To answer that, we need to begin by estimating the number of global gamers. If we start with global gaming hardware in use (which we reviewed earlier) and assume each mobile device is used by one person but each console and PC is used by 1.5 people (for gaming), it suggests there are just over 2.1 billion global gamers.

The vast majority — almost 90% — are mobile gamers. Handheld gamers are quite small. And collectively, we estimate there are about 380 million gamers that use PCs or consoles. Interestingly, the top-down data (based on hardware shipments) suggests console/PC gamers have actually contracted over the last seven years. Why is that?

Recall, we showed earlier that PC and console sales peaked in 2011. As such, either these lower hardware shipments are a function of fewer non-mobile gamers, or gamers are hanging on to their hardware for a longer period of time. We suspect it’s the former. And, we can’t help but wonder if the explosive growth in mobile gaming — which started in earnest in 2012 — has taken some of the wind out of the console/PC market.

Figure 57. Global Consumers Playing Video Games

2,500

2,000 Console PC Handheld Mobile 1,500

1,000 Global Video Gamers (mn)GamersVideo Global 500

0 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Citi Research

So, excluding mobile, around 380 million consumers play video games. But, some are casual players. And, others are hardcore gamers. Around 20% of gamers play less than 1 hour a week. These light gamers make up just 4% of total game time. At the other end of the spectrum, just 7% of gamers play more than 20 hours a week and make up 24% of total game time.

Figure 58. Share of Gamers Based on Game Hours

100% 25% Share of Gamers Share of Hours 100% 90% (RHS) (LHS) 20% 76% 80% 20% 18% 18% The average gamer 70% 17% plays 6 hours per week. 54% 60% 15% But, nearly 60% of all 50% 34% 12% gamers – comprising 18% of total game 40% 10% play – engage with video games less 8% 30% 18% 7% (%) Gamers of Share than 4 hours per week. 20% 5% 8%

Cumulative Share of Total Gaming Hours (%) Hours Gaming Total of ShareCumulative 10% 4%

0% 0% < 1hr 1-2 hrs 2-4 hrs 4-7 hrs 7-12 hrs 12 - 20 > 20 hrs hrs Video Game Hours per Week Source: Limelight., Citi Research

Around 25% of total game play occurs on mobile devices. The balance — around 75% occurs on consoles, PCs, and tablets. PCs generate more game play per week than any other type of hardware.

Figure 59. Video Game Hours by Device 6

5 1.76

4 1.03

3 5.96

1.80

2 Game Play per Week (hrs) Week per Play Game

1 1.37

0 Console PC Tablet Mobile Total Source: Limelight, Citi Research

Layer VII: eSports

Let’s shift to the bottom of the console/PC value chain: electronic sports and live streamers. Live streamers gain viewers when individuals watch an amateur — albeit a very good one — play games on a site like Twitch. Professional eSports is when individuals watch a professional team. Between live streaming and professional teams, there are a wide array of grassroots eSports competitions and events.

For older readers, eSports and live streaming might be a little difficult to understand. Most readers in their 40s or 50s might wonder: “Who wants to watch someone else play video games?” It’s a fair question. But, if you think about it, food lovers watch others cook (Food Network) and sports fans watch others play sports (ESPN). Video games shouldn’t be any different. Mode of Distribution

But, video games didn’t always have eSports. What caused the change? We think it was driven by the mode of distribution, which almost always changes the way consumers use an application.

Voice services were the first application that experienced this shift when voice migrated from a wired connection to a wireless connection. Since phone conversations are often between two people, this shift in distribution didn’t alter voice communications, per se. But, voice was supplanted by social media — apps like Twitter, Facebook, and Instagram. As such, communication migrated from a 1:1 activity to a group activity.

Video was the second application that experienced a shift in consumption patterns once distribution changed. From the 1950s to 2010, almost all TV shows were delivered over the air — or over coaxial cable — according to a predetermined schedule. Since content was ‘pushed’ the shows were consumed by groups. Today, of course, a significant portion of TV consumption (non-sports and non-news content) is ‘pulled’ off a server. As such, TV consumption is no longer a group activity. Rather it’s often for a single user.

Figure 60. Shift in Consumer Patterns for Various Modes of Distribution

Mode of Distribution Mode of Consumption Voice moved from wires to wireless

Voice Voice remained 1:1 , but wireless spawned group chat (like Twitter).

Video distribution moved from wireless to TV wires TV TV Consumption moved from group to 1:1

Game distribution moved from Cloud PC tethered to PC Games Cloud cloud TV TV TV Consumption moved from 1:1 to groups

Source: Citi Research

Something similar is going on with video games. In the past, a consumer would purchase and play a game by themselves (or with friends and family in close proximity). That is, the console or PC wasn’t connected to the Internet. But, with nearly ubiquitous connectivity, gamers today are often playing games in groups. This has spawned an entirely new type of gaming hardware: the gaming headset. The headset allows gamers to listen to and communicate with other gamers within the same virtual world. As communal gaming becomes more popular — augmented by virtual reality headsets — it promises to become even more social and immersive, a true ‘third space’.

Figure 61. Gaming & VR Headsets

Source: Shutterstock

This is particularly true for younger gamers. According to Nielsen, the average eSports / live streaming fan is just 28 years old. And, over 70% of these fans are male. But, how important are eSports / live streaming to this narrow slice of the population? Collectively, this cohort spends about 30 hours a week — or 4 hours a day — on screen-centric entertainment. eSports fans spend 25-30% of their total screen time playing video games. And, they spend another 10% watching others play video games. Collectively, the eSports / live streaming cohort spends more time playing and watching video games (35%) than they do watching linear TV plus streaming video on sites like Netflix (26%).

Figure 62. Hours Spent Streaming Different Forms of Media by Device

Video Content -----> Pay TV Stream Videos General Social Games eSports Example -----> Linear Netflix YouTube Websites Facebook Fortnite ESL Total TV 4.3 3.5 7.8 + PC, Console 4.5 3.7 2.8 6.2 2.2 19.4 + Mobile 3.0 2.0 0.2 3.0 = Total 4.3 3.5 4.5 3.7 5.8 8.2 2.4 30.2 memo: share 14% 12% 15% 12% 19% 27% 8%

Source: Nielsen, Citi Research

In the U.S., a nonprofit group called The National Association of Collegiate Esports (NACE) hopes to elevate eSports into a varsity sport. NACE has over 130 schools as members and awarded $15 million in eSports scholarships and aid to students. And several schools — including the University of Utah and University of California at Irvine — offer eSports scholarships to students.

But, the business model for eSports and live streaming are quite different. So, first we’ll review live streamers. Then, we’ll review professional eSports.

Live Streamers

The live streamer model has five important entities: (1) the person who uploads the their game play (the gamer); (2) the software firm that brings the gamer and the viewer together (the broadcaster); (3) the business that wants to advertise to the consumer (the advertiser); (4) the person that wants to watch an expert play the game (the consumer); (5) and the business that wants to promote a video game or other product or service (the sponsor).

Figure 63. Live Streaming Ecosystem

Description Economics

Top 20% of gamers collect 80% of Gamer collects funds from: (1) Gamer revenue. Popular gamers can make Sponsors, (2) Consumer donations, >$1M per year (3) Consumer subscriptions, and (4) $ (ads) $ (subscribe) Ads Content Broadcaster is the hub of the Broadcaster collects up to 50% of (1) Broadcaster ecosystem. Brings parties together. Consumer subscription fees and (2) Ads. Broadcaster does not collect $ (ads) $ (subscribe) portion of donations or sponsorships Views

Advertiser pays for impressions on Ads cost around $8 per 1000 Advertiser Broadcaster. impressions. Broadcasts can keep up Content to 50%. Balance remitted to gamer.

Consumer Consumer gets to see how best Consumer views game play for free. players play the game. Can donate or subscribe to gamer. $ (donate)

Sponsor Sponsor can use gamer popularity to Wide variance in economics. But, $ (sponsorship) promote products or services. Can game play typically worth $0.10 per be game play, YouTube videos, live viewer hour appearances, Tweets, or Instagram videos

Source: Citi Research

But, how can a consumer watch someone play video games? Well, any video game player can upload their live game to the cloud via a broadcaster. There are a handful of useful websites for this purpose. The most prominent site is Twitch (acquired by Amazon in 2014 for about $900 million). But, there are many rivals including YouTube (Google), Steam TV (Valve), Mixer (Microsoft), Facebook, Huya (China), Douya (China), and Caffeine. These streaming services are often called video game ‘broadcasters’. And, some of these broadcasters have purchased rights to specific eSports (something we’ll discuss in more depth in the eSports section).

Figure 64. Video Game Broadcasters

Broadcaster Country Status Rights Comments Caffeine U.S. Private $100M investment from Fox No need for OBS or XSplit Douya China Private Tencent investment Facebook U.S. Public ESL Pro League ESL One Series Paladine Premier League H1Z1 Pro League Gfinity Elite Series Huya China Public World Electronic Sports Games Tencent investment Riot Games' League of Legends Korea in China U.S. IPO in 2018 Mixer U.S. Public Hi-Rez Studios Acquired in 2016 (Microsoft) ESL Low latency Steam TV U.S. Private Dota 2 Counter-Strike Twitch U.S. Public Overwatch League Acquired for $970M (Amazon) NBA 2K DreamHack partnership YouTube U.S. Public FACEIT Esports Championship Can rewind (Google)

Source: Citi Research

How do video game broadcasters work? Let’s say you want to share your game play with others. First, you’d need to create a game channel on a third-party platform (like Twitch). If you play on a PC, you need broadcast software, like Open Broadcaster Software, or XSplit. You also need a headset and a webcam. For console devices (Xbox or PlayStation) you’ll also need a capture card (Avermedia LGP). This allows you to stream your gameplay. But, is anyone uploading their gameplay? And, if so, is anyone watching?

Using data from Twitchtracker (not affiliated with Amazon), Twitch has seen very rapid growth over the past eight years. In 2012, total viewers reached 0.1 million with 5,000 gamers uploading their game-play (or channel). Today, there are nearly 1.3 million viewers and almost 50,000 channels.

Figure 65. Growth in Broadcaster Twitch Figure 66. Viewers on Twitch by Time of Day 1.4 60,000 35 1.80

) Viewer per Viewers (RHS)

) Average Viewers Channel 1.60 1.2 30

(LHS) 50,000 (LHS) mn 1.40 1.0 25

40,000 1.20 Viewers ( Viewers

0.8 20 1.00 Channels (number Channels Average 30,000 Channels 0.80 Average Average 0.6 15 - (RHS)

Average Average 0.60

20,000 – 0.4 10

Twitch Twitch 0.40

Viewers per Channel (number) per Viewers Total Viewers or Streamers (mn) Streamers or Viewers Total

10,000 Twitch 5 0.2 0.20 Streamers (RHS)

0.0 0 - - '12 '13 '14 '15 '16 '17 '18 '19E 12 2 4 6 8 10 12 2 4 6 8 10 Midnight Lunch Late Night

Source: Twitchtracker, Citi Research Source: Twitch, Citi Research

And, according to Twitch, about 50,000 gamers are uploading their content at any given time (Figure 65, dark-blue line). And, on average, about 1.2 million consumers are watching these channels (Figure 65 light-blue line). So, on average, only about 25 people are watching each channel (Figure 66 grey line). That’s a very small audience.

You may also notice that the peak viewing hour for Twitch is about 2pm. That differs from TV (where the peak-hour occurs around 7pm). We suspect this speaks to the younger Twitch demographic. Recall, the average eSports fan is just 28 years old. As such, a large number of Twitch users are likely in school (rather than working). So, peak viewing for gaming is far earlier in the day, when school ends. Peak TV viewing is later in the day, when work ends.

In terms of geographic mix, around two-thirds of Twitch players speak English. The remaining one-third is spread across nine different regions. But, Russian, German, Spanish, and French users make up about 25% of the total user base. The reaming 15% are mostly in Asia-Pac (who typically converse in Korean, Chinese, and Japanese). In effect, Twitch is still very concentrated in North America and underrepresented in the rest of the world, particularly Asia.

Figure 67. Twitch Players by Language

2% 2% 100% 3% 2% 4% 90% 5% 5% 80% 7% 8% 70% 63% 60% 50% 40% 30% 20% 10%

French

Korean

Turkish

English

German

Russian Spanish

Chinese Japanese Portugese Source: Twitch, Citi Research

Gamoloco is another site that isn’t affiliated with Twitch. But, they do give fairly detailed information on Twitch users who upload their game (and create a channel). Crucially, the Gamoloco data is organized by both game title and by channel.

In aggregate, Gamoloco has similar figures to Twitch: about 78K people are uploading their game play at any given time. And, about 50% of all channels are for the 10 most popular games. The average channel only has about 15 people watching the live stream (versus 25 using Twitch data). While there’s some variance by game title, the general rule is this: the more channels a game title has, the fewer the viewers per channel.

Figure 68. Viewership of Top 12 Live Stream Games on Twitch

Apex League of Counter- Just Over- Hearth- Top 10 All Fortnite Legends Legends Strike Chatting Dota 2 watch stone PUBG GTA Sub-total Other Total Average channels 18,436 8,254 2,660 1,123 1,155 797 1,217 182 1,552 1,001 36,377 41,767 78,144 x Viewers per channel 9 17 48 85 74 79 39 154 18 23 22 8 15 = Avg viewers 159,574 138,092 128,675 95,302 85,009 63,102 47,122 28,010 27,187 23,003 795,076 352,661 1,147,737 x Hours per viewer per day 24 24 24 24 24 24 24 24 24 24 24 24 24 = Hours watched (mil) 3.8 3.3 3.1 2.3 2.0 1.5 1.1 0.7 0.7 0.6 19 8 28 x Days per week 7 7 7 7 7 7 7 7 7 7 7 7 7 = Average viewer hrs per week (mil) 27 23 22 16 14 11 8 5 5 4 134 59 193 memo: sh of viewing from top player 8% 12% 13% 47% 8% 55% 20% 4% memo: sh of viewing top 2 players 16% 16% 16% 58% 14% 6%

memo: sh of viewing top 3 players 23% 20% 69% 8% Source: Gamoloco, Citi Research

For example, about 18K people upload their Fortnite game to Twitch. But, on average, only 9 people are watching each channel. At the other extreme, Hearthstone only has 1% of Fortnite’s channels, just 182. But, 154 people are watching each channel, 15x more than Fortnite. Most other game titles fall in between these two extremes.

Figure 69. Viewership on Twitch by Channel and Viewer 180

160 Hearthstone 140

120

100 Counter-Strike 80 Dota 2 Just 60 Chatting League of Legends

Average perChannel Viewers Average 40 Overwatch Grand Theft Auto (GTA) 20 Apex Legends Fortnite Players’ Unknown Battleground 0 0 5,000 10,000 15,000 20,000 Average Channels Source: Gamoloco, Citi Research

If we focus on the top channels for each game, it gets more interesting. Just seven channels (out of 18,500) make up 34% of all Fortnite viewing. Similar results occur for Apex Legends: just five channels (out of 2,700) comprise 26% of all the viewing. A game like Counter-Strike is even more concentrated: just three channels (out of 1,100) make up 69% of all viewing hours. In effect, Twitch is serving significant traffic. But, the viewers are highly concentrated among the best players. The Pareto principle — 80% of consumption will occur on just 20% of channels — seems alive and well.

Figure 70. Share of Viewing and Number of Channels for Top Games

Fortnite Apex Legends Counter-Strike

100% 100% 100%

90% 90% 90%

80% 80% 80%

70% 70% 70%

60% 60% 60%

50% 50% 50%

40% 40%

40% Viewing of Share

Share of Viewing of Share Share of Viewing of Share 30% 30% 30%

20% 20% 20%

10% 10% 10%

0% 0% 0% 0 5 10 15 20 0 5 10 0.0 0.5 1.0 1.5 Channels Channels Channels (000s) (000s) (000s)

Source: Gamoloco, Citi Research

Using Gamoloco data we can also compare the average concurrent viewers to the total viewing hours to infer how much time a channel is actually ‘on-air’.

Figure 71. Average Concurrent Viewers and Total Viewing Hours of Top Live Streamers

Riot Soda Overwatch Gotaga shroud Games ESL CS:GO Pop League Concurrent viewers per channel 36,808 51,340 55,963 44,816 21,709 67,104 x Max hours per week (24 x 7) 168 168 168 168 168 168 = Viewing hours (if playing all week) 6.18 8.63 9.40 7.53 3.65 11.27 x Portion on-air 36% 33% 30% 100% 32% 39% = Viewing hours (mil) 2.2 2.8 2.8 7.5 1.1 4.4

memo: hours per week 60 55 51 167 53 65 Source: Gamoloco. Citi Research

When we perform these calculations, two things are clear:

 First, three of the top channels are likely operating under a team structure: ESL- CS:GO, gaules and SolaryFortnite. These channels are ‘on-air’ nearly 24 hours a day, seven days a week. We doubt any single person can game that much. (A little later, we’ll show why teams might pursue this strategy.)

 Second, the remaining top channels are ‘on-air’ between 30 hours and 80 hours a week. That’s reasonable as a part-time job or a full-time job (augmented with some weekend gaming).

Figure 72. Top Channels Hours of Gaming per Week vs. Viewing Hours

180 Maximum = 24 hours a day x 7 days a week

160 gaules ESL-CS:GO

140 SolaryFortnite 120

100

80 CSRuhub Gotaga Playhear Overwatch League 60 shroud Typical work Riot Games week of 30 to 40 Tfue 80 hours Dr Disrespect Ninja

20 Hours of Gaming per Week (number) Week per Gaming of Hours 0 0 1 2 3 4 5 6 7 8 Viewing Hours per Week (mn) Source: Gamoloco, Citi Research

But, do these ‘Twitch stars’ play and then broadcast their game for 50 to 80 hours a week for the fame induced psychic income? Fame certainly helps. But, fortune may also play a role. Indeed, popular Twitch stars can make quite a bit of money. Let’s see how they do it.

One popular Twitch channel uses the moniker Disguised Toast. He generates about 1.2 million viewers and typically has about 10,000 concurrent viewers (or about 1/5th the level of the channels we analyzed above). In a 2018 YouTube video, he laid out how much money he makes on Twitch. Disguised Toast suggests there are four main monetization levers: sponsorships, subscribers, ads, and donations. Let’s take these in turn. Sponsorships

Most sponsorship revenue comes from game publishers like Electronic Arts or Activision. These publishers are keen to have popular gamers — the influencers — play and promote their game. Sponsorships can cost as little as $0.01 per viewer hour to as much as $1.00 per viewer hour. We’ll use $0.10 per viewer hour as a reasonable average. If Disguised Toast plays sponsored games about 65 hours a month, it’s akin to $66,000 a month.

Figure 73. Twitch ‘Star’: Monthly Sponsorship Revenue Potential

Low Mid High Concurrent views 1,000 5,000 10,000 25,000 0,000 x Sponsorship per hour per viewer 0.10 0.10 0.10 0.10 0.10 = Revenue per hour 100 500 1,000 2,500 5,000 x Hours per month 66 66 66 66 66 = Monthly sponsorship revenue 6,600 33,000 66,000 165,000 330,000

Source: Twitch, YouTube

While we’ve modeled the sponsorship revenue based on gaming hours, a popular gamer can get sponsorship revenue from a variety of sources. These include:

– Sponsored game play, which we reviewed above.

– Sponsored YouTube videos which typically generate $5,000 per video for a 30 second ad.

– Sponsored live appearances which typically cost a sponsor $5,000 and $10,000 per event.

– Sponsored Tweets and Instagram posts are usually packaged into existing sponsorship contracts.

We should note that in the U.S., if a sponsor is paying a gamer to play a specific game, the Federal Trade Commission (FTC) requires specific disclosures so the viewer knows the player is being compensated. The on-screen disclosures might say “Sponsored by EA” or “#ad” or “#sponsored” in the title of the stream. Subscribers

Twitch viewers can subscribe to an individual channel for $4.99 per month. For most channels (those with fewer than 5,000 concurrent streams), Twitch keeps 50% of this revenue. So the gamer gets $2.50 per subscriber per month. But, for premium channels — those channels with 10,000 or more concurrent streams — Twitch allows the gamer to keep 70% of the revenue, or $3.50 per sub per month. Disguised Toast has about 4,000 paid subscribers. This is akin to $14,000 a month (after Twitch takes 30% of the revenue).

A viewer might subscribe to a gamer’s channel(s) because they get the right to chat with the gamer or use icons that the player makes available to paying subscribers. If a viewer links their Amazon Prime account to Twitch, they become a Twitch Prime customer. Twitch Prime customers get access to any single channel for one month, for free. In this case, the player that broadcasts their game still gets paid. But, the viewer doesn’t have to make a payment (because Amazon is making the payment for the Prime customer). Disguised Toast has about 4,000 paying subscribers. As such, he generates about $14,000 a month from subscriptions.

Figure 74. Twitch ‘Star’: Monthly Sponsorship Revenue Potential

Low Mid High Concurrent views 1,000 5,000 10,000 25,000 50,000 x Portion subscribing 40% 40% 40% 40% 40% = Subs 400 2,000 4,000 10,000 20,000 x Fee per month 4.99 4.99 4.99 4.99 4.99 = Monthly sub revenue 1,996 9,980 19,960 49,900 99,800 x (1 - Twitch take) 50% 50% 70% 70% 70% = Retained sub revenue 998 4,990 13,972 34,930 69,860

Source: Twitch, YouTube

Ads

When viewers turn on Twitch, an ad plays automatically. But, the broadcaster can elect to increase the ad load by simply hitting a button on their PC during play. Every time the ad button is pressed, the viewers get another ad. Internet ads — like all ads — are priced in cost per thousand viewers (CPM). We assume a CPM is, on average, about $8.

The Twitch live streamer known as Disguised Toast suggests he generates about $4,000 a month in advertising and does not push the ad button. That is, Disguised Toast only generates revenue from Twitch’s automatic ad. We’ll assume most players do use the ad button, doubling the ad load to about $8,000 a month for 10,000 concurrent views. (Ad blockers, of course, can limit this source of revenue.)

Figure 75. Twitch ‘Star’: Monthly Advertising Revenue Potential

Low Mid High Concurrent views 1,000 5,000 10,000 25,000 50,000 / 1000 1,000 1,000 1,000 1,000 1,000 = 1000s of viewers 1 5 10 25 50 x CPM 8 8 8 8 8 = Ad revenue per hour 8 40 80 200 400 x Hours per month 66 66 66 66 66 = Ad revenue per month 528 2,640 5,280 13,200 26,400 x (1 - Twitch take) 50% 50% 70% 70% 70% = Retained ad revenue (auto load) 264 1,320 3,696 9,240 18,480 x Ad button factor 2 2 2 2 2 = Retained ad revenue 528 2,640 7,392 18,480 36,960

Source: Twitch, YouTube

Donations

Donations are the fourth monetization lever for Twitch channels. Disguised Toast suggests he generates about $2,500 a month in donations with 10,000 average concurrent viewers. A payment platform often takes about 1% of this revenue. And, the donation revenues can vary considerably by streamer. Some streamers, for example, give incentives (like private Snapchats or agreeing to do something silly on screen).

Figure 76. Twitch ‘Star’: Monthly Donations Revenue Potential

Low Mid High Concurrent views 1,000 5,000 10,000 25,000 50,000 x Donation per view per month 0.25 0.25 0.25 0.25 0.25 = Monthly donations 250 1250 2500 6250 12500 x (1 - PayPal take) 99% 99% 99% 99% 99%

= Retained donation revenue 248 1,238 2,475 6,188 12,375 Source: Twitch, YouTube

If we pull all this data together — spanning sponsorships, paid subs, ads and donations — it suggest a popular Twitch broadcaster can generates $1 million a year if they generate about 10,000 concurrent viewers. Or, said another way, a concurrent viewer is worth about $100 a year in total monetization, or about $8 per month per concurrent viewer.

Figure 77. Twitch ‘Star’: Monthly Total Revenue Potential

Low Mid High Sponsorship 6,600 33,000 66,000 165,000 330,000 + Subscribers 998 4,990 13,972 34,930 69,860 + Ads 528 2,640 7,392 18,480 36,960 + Donations 248 1,238 2,475 6,188 12,375 = Monthly revenue 8,374 41,868 89,839 224,598 449,195 x Months per year 12 12 12 12 12 = Annual revenue 100,482 502,410 1,078,068 2,695,170 5,390,340 memo: revenue per concurrent viewer 100 100 108 108 108

Source: Twitch, YouTube

But, can we take these revenue estimates for a popular live streamer and use them to estimate how much revenue all live streamers generate? And, can we use the same data to estimate how much revenue Twitch generates? We think we can. But, we need to take seven steps.

First, recall Twitch has about 50,000 concurrent channels at any moment in time. If we decompose the broadcasters — separating ‘stars’ like Disguised Toast from niche broadcasters — while adhering to the Pareto principle (20% of broadcasters will capture 80% of views), it suggests the 50 top channels (0.1% of the total) make up about 40% of Twitch traffic.

Figure 78. Share of Viewing by Type of Live Streamer

Stars Popular Niche All Concurrent channels 50,000 50,000 50,000 50,000 50,000 50,000 x Cum share of channels 0.1% 1.0% 5.0% 10.0% 20.0% 100.0% = Concurrent channels 50 500 2,500 5,000 10,000 50,000 x Avg concurrent views 10,000 1,200 300 175 96 24 = Total concurrent views 500,000 600,000 750,000 875,000 960,000 1,200,000 / Total concurrent views 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 = Share of viewing 42% 50% 63% 73% 80% 100%

Source: Twitch, YouTube

Second, we can decompose the cumulative figures (from above) to isolate each cohort. The top cohort — the Stars — will generate $108 in revenue per concurrent viewer per year. But, any live streamer that doesn’t fall in the top 500 is unlikely to collect any Sponsorship revenue. They’ll rely on subscriber revenue, ads, and donations. As such, revenue drops to ~$20 per concurrent viewer per year. All told, this is akin to ~$75 million in revenue per year for the 50K concurrent live streamers.

Figure 79. Cohort Revenue to Live Streamer

Channel 1 to 51 to 501 to 2,501 to 5000 to 10,001 to Rank ------> 50 500 2,500 5,000 10,000 50,000 Total Avg concurrent views 10,000 222 75 50 17 6 24 x Streamer revenue per concurrent viewer 108 100 21 21 21 21 64 = Annual revenue per concurrent channel 1,078,068 22,222 1,596 1,064 362 128 1,533 x Number of concurrent channels in cohort 50 450 2,000 2,500 5,000 40,000 50,000 = Cohort revenue to Live Streamer 53,903,400 10,000,000 3,192,300 2,660,250 1,808,970 5,107,680 76,672,600

Source: Twitch, YouTube

Third, Twitch will collect about $11 per year per live streamer among the Stars. But, they will collect more — about $18 per year — for the other cohorts. Recall, Twitch collects 70% of ad and subscriber revenue for the less popular live streamers (versus 50% for popular live streamers). All told, Twitch collects about $18 million in revenue for the 50K concurrent live streamers.

Figure 80. Cohort Revenue to Twitch

Channel 1 to 51 to 501 to 2,501 to 5000 to 10,001 to Rank ------> 50 500 2,500 5,000 10,000 50,000 Total Avg concurrent views 10,000 222 75 50 17 6 24 x Streamer revenue per concurrent viewer 11 18 18 18 18 18 15 = Annual revenue per concurrent channel 109,872 4,069 1,373 916 311 110 366 x Concurrent channels 50 450 2,000 2,500 5,000 40,000 50,000

= Cohort revenue to Twitch 5,493,600 1,831,200 2,746,800 2,289,000 1,556,520 4,394,880 18,312,000 Source: Twitch, YouTube

Fourth, the total number of Twitch channels is far larger than the number concurrent channels (or channels that are ‘live’ at any moment in time). Twitch Tracker suggests there are about 3.4 million total monthly broadcasters. This suggests that only 1.2% of broadcasters are ‘live’ at any moment in time. Or, there are about 80 broadcasters for every broadcaster that is actually on Twitch streaming their game play.

Figure 81. Portion of Time Broadcaster is On-line

2012 2013 2014 2015 2016 2017 2018 Concurrent broadcaster 3,700 4,858 9,004 15,854 18,808 24,616 41,108 / Total broadcasters 300,000 400,000 750,000 1,300,000 1,550,000 2,000,000 3,390,000 = Portion of time broadcaster on-line 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2%

memo: total to concurrent ratio 81 82 83 82 82 81 82 Source: Twitch, YouTube

Fifth, from earlier analysis we know the Stars spend most of their time (30-80 hours a week) broadcasting game play. As such, the ratio of total live streamers to concurrent live streams must be low. We assume a ratio of 2:1. And, in step four we showed, on average, there are ~80 broadcasters for every concurrent live channel. Using these two data points, we can get a rough idea of the total live streamers to concurrent broadcasts for each cohort.

Figure 82. Number of Broadcasters On-line to Concurrent Broadcasts

Channel 1 to 51 to 501 to 2,501 to 5000 to 10,001 to Rank ------> 50 500 2,500 5,000 10,000 50,000 Total Concurrent broadcaster 50 450 2,000 2,500 5,000 40,000 50,000 / Total broadcasters 100 2,430 40,800 76,000 252,000 3,720,000 4,091,330 = Portion of time broadcaster on-line 50% 19% 5% 3% 2% 1% 1%

memo: total to concurrent ratio 2 5 20 30 50 93 82 Source: Twitch, YouTube

Sixth, using these ratios and multiplying by the revenue per concurrent live streamer (from step three), it suggests Twitch generates about $635 million in revenue. The live streamers generate about $875 million in revenue. All told, then, live streaming generates about $1.5 billion in total annual revenue. This suggests Twitch captures ~40% of the aggregate revenues. Twitch’s capture of revenue from the stars is lower (since Twitch doesn’t collect a portion of sponsorship or donations).

Figure 83. Twitch Revenue and Live Streamer Revenue by Cohort

Channel 1 to 51 to 501 to 2,501 to 5000 to 10,001 to Rank ------> 50 500 2,500 5,000 10,000 50,000 Total Revenue to Twitch per concurrent channel ($ mil) 5.5 1.8 2.7 2.3 1.6 4.4 18.3 x Ratio of total channels to concurrent 2 5 20 30 50 93 35 = Twitch revenue by cohort ($ mil) 11 10 56 70 78 409 634

Revenue to Live Streamer per concurrent channel 53.9 10.0 3.2 2.7 1.8 5.1 76.7 ($ mil) x Ratio of total channels to concurrent 2 5 20 30 50 93 11 = Live Streamer revenue by cohort ($ mil) 108 54 65 81 91 475 874

Total revenue per concurrent channel 59.4 11.8 5.9 4.9 3.4 9.5 95.0 x Ratio of total channels to concurrent 2 5 20 30 50 93 11 = Total Live Streamer and Twitch revenue ($ mil) 119 64 121 150 170 884 1,508

memo: share to Twitch 9% 15% 46% 46% 46% 46% 42% Source: Twitch, YouTube

Seventh, earlier we showed that Twitch’s viewership has growth from 200 million in 2012 to 1.25 billion in 2018. Our $1.5 billion live streaming forecast suggests total revenue from live streaming is about $1 per sub per year. This, in turn, suggests Twitch was probably generating less than $250 million a year in 2014 (when Amazon acquired the service). This suggests Amazon may have paid about 4x Twitch’s revenues.

Figure 84. Total Live Streaming Revenue

2012 2013 2014 2015 2016 2017 2018 Twitch revenue 88 153 241 274 358 526 634 + Live Streamer revenue 121 211 333 378 494 726 874 = Total Live Streaming revenue ($ mil) 209 364 574 652 852 1252 1,508 memo: Twitch share 42% 42% 42% 42% 42% 42% 42%

Twitch - Average viewers 207 350 536 591 749 1069 1250 x Total revenue per viewer 1.01 1.04 1.07 1.10 1.14 1.17 1.21

= Total Live Streaming revenue 209 364 574 652 852 1,252 1,508 Source: Twitch, YouTube

But, is this forecast reasonable? We suspect it is. We estimate Twitch generates $635 million in total revenue. We estimate about half of this is from ads (which the balance from subscriber revenue). That suggests about $350 million of ad revenue. In 2018, Bloomberg reported that Twitch’s CEO (Emmett Shear) suggested $1 billion in ad sales as a target for Twitch.

Professional eSports

So, if they have a robust following, live streaming can be lucrative for amateur gamers that broadcast game play. But, there is another side to the broadcaster’s business model: eSports. However, eSports is still nascent. As such, it doesn’t (yet) closely follow the traditional sports ecosystem. And, this makes it a little confusing.

To understand the differences, we’ll need to explore the traditional sports value chain. It begins with the consumer. The consumer typically subscribes to a pay TV platform (like Sky in the U.K. or AT&T in the U.S.). The pay TV platform pays for specific sports-centric TV channels (like ESPN or Fox Sports). These channels then secure TV rights to specific sporting events from a league, like the National Football League (NFL) or National Basketball Association (NBA). And, the sports league does many other things beyond selling TV rights. For example, the league approves additional teams or changes to a team’s host city. The league organizes a formal draft. The league organizes the season — and rule play — which culminates with a championship game (like FIFA World Cup or the NFL Super Bowl). And, the league can receive sponsorship revenues and facilitate sponsorship payments to specific teams or even specific players.

Figure 85. Traditional Sports vs. eSports Ecosystem

TV Affiliate TV $ Rights fee Pay TV fee League Channel Consumer Firm

Ad $ $ Traditional Advertiser Sports $ Tickets Sponsor Team / Venue

$ Players

TV 1 $ rights Publisher Broadcaster Consumer 5 4 Ad $ $ eSports $ Advertiser Sponsor Teams Tickets $ $ Organizer Venue

$ 3 2

$ Players

Source: Citi Research

If we compare the value chain for traditional sports versus eSports at a conceptual level, today there are five key differences. First, the consumer can get access to eSports for free (via broadcasters like Twitch). Second, the consumer doesn’t buy a ticket from the team. Rather, they purchase a ticket to a specific eSports venue, which is often leased (while most traditional sports teams own their own facility). Third, since eSports events are episodic, organizers often help promote the event. Fourth, for some eSports events, it’s possible for broadcasters (like Twitch) to acquire rights directly from a game publisher, like Activision. (There are instances where media rights are sold by event organizers as well.) Fifth, in eSports, it’s possible for the publisher to act like a league owner in traditional sports.

This leads to a subtle, but important, point. For traditional sports, in the U.S., the league has a commissioner. The commissioner is hired by the team owners and, collectively the team owners decide if they want to change the rules of the game, add a team to the league, or make any other rule change. In other markets, even if there is a more fluid system — where grassroots teams can access top tier leagues without buying a franchise — there is usually a body who controls the parameters which determines league access.

For eSports, the public firms that sell the franchise rights (i.e., Activision) are public companies. As such, they serve the interest of shareholders. And, the intellectual property associated with the league is owned by game publisher. So, any eSports team tethered to particular IP is beholden to the game publisher. Of course, in traditional sports, team franchise owners aren’t beholden to anyone. That’s one reason — but not the only reason — why a traditional sports franchise in the U.S. might sell for several billion while an eSports franchise in the U.S. might only sell for tens of millions.

Beyond these five major differences, however, there are a slew of other subtle differences between eSports and traditional sports. The key differences include: (1) the drafting of players; (2) professional team structure; (3) sports leagues; (4) venues to watch live event; (5) tournament play; (6) ways to watch less popular, niche events; and (7) ways to watch popular events. For five of these seven attributes, it is clear that eSports is at a much earlier stage of evolution than traditional sports. Let’s take a closer look:

Figure 86. Traditional Sports vs. e-Sports

Traditional Sports Electronic Sports

Formal process Informal process to Draft to identify best identify best players players except NBA and NASCAR

Tight link between Professional Best teams play team and sport teams multiple games

Formal league Some leagues Leagues A B C D structure. Teams in place tied to a city

Each team has Venues leased Venue Stadium dedicated venue or shared.

1st Formal structure to Tournaments in Tournaments Place find best team place

Outlets for niche eSports Niche PC viewing (NFL Sunday broadcasters Viewing ticket, RSNs, ESPN+) (Twitch)

Mass Most economics from Some TV rights TV Viewing TV rights sold

Source: Citi Research

Draft

Unlike traditional sports, most eSports don’t have a formal draft to recruit teams. There are two exceptions in the U.S.: NASCAR and the NBA. Both of these traditional sports leagues have instituted a formal draft for the video game version of the traditional sport. For example, the National Basketball Association (NBA) historically had three leagues: (1) the NBA for professional men; (2) the WNBA for professional women; and (3) the G League for developing players. But, the NBA just launched a fourth league: the 2K League managed by Brendan Donohue. The NBA 2K League gets its name from Take-Two’s game NBA 2K. NBA 2K has sold 90 million copies of its software making it the third highest grossing video game title in the sports genre (behind FIFA and Madden NFL). And, in 2018 the NBA held a draft recruiting 102 players after a three month winnowing process that began with 72,000 gamers.

Professional Teams

In traditional sports, a team plays a single sport. However, some of the best eSports teams play multiple games. For example, Counter-Strike is played by 16 of the top 20 eSports teams. At the other end of the spectrum, Madden and World of Warcraft are only played by one or two top eSports teams. Most other game titles fall in between. Although each of these eSports teams do have dedicated players that specialize in a specific video game, this provides some anecdotal evidence that eSports is still nascent.

Figure 87. Games Played by Best eSport Teams

Counter League of Hearth- Rainbow Call of Over- Star- World of Team Team Country Strike Legends PUBG stone Dota 2 Fortnite Six Siege Duty watch FIFA craft Madden Warcraft Total FaZe Clan U.S. x x x x x 5 Team Liquid Holland x x x x x x x x x x 10 Cloud9 U.S. x x x x x x x 7 Team SoloMid U.S. x x x x 4 OpTic Gaming U.S. x x x x x x 6 Fnatic U.K. x x x x x x 6 G2 Esports Spain x x x x x x 6 100 Thieves U.S. x x x 3 NRG eSports U.S. x x x x 4 Luminosity Gaming Canada x x x x x x x x 8 Team Envy U.S./France x x x x x x x x 8 Astralis Denmark x 1 Evil Geniuses U.S. x x x x 4 Ninjas in Pyjamas Sweden x x x x 4 Team Secret Turkey x x x 3 Natus Vincere Ukraine x x x x x x 5 compLexity Gaming U.S. x x x x x x 6 SK Gaming Germany x x x x 4 SK Telecom T1 S. Korea x 1 Virtus.pro Russia x x x x 4

Total 16 11 10 9 9 9 9 8 6 6 3 2 1 memo: publisher Valve Riot Bluehole ATVI Valve Epic Ubisoft ATVI ATVI EA ATVI EA ATVI memo: game type FPS MOBA BR Card MOBA BR TS FPS FPS Sports Strategy Sports MMORPG memo: avg Twitch viewers 95,302 128,675 27,187 28,010 63,102 159,574 47,122

Source: Ranker Citi Research

Leagues

All traditional professional sports have a league. For example, domestic English football has the Premier League and U.S. football has the NFL. However, only the most popular video game titles have a formal league:

– Overwatch: Activision recently created two divisions for the Overwatch League (Atlantic and Pacific). And, they sold franchises to 20 new team owners. The first round of teams sold for about $20 million. Some of the buyers were quite prominent. Robert Kraft (owner of the NFL’s New England Patriots) bought the Boston Uprising. Comcast acquired the Philadelphia Fusion. The expansion slots sold for $30-60 million each.

– Call of Duty: Activision is currently selling Call of Duty franchises for around $25 million per franchise.

– League of Legends: Riot Games has sold 10 franchises to the North American League Championship Series (NA LCS). Each team paid around $10 million in franchise payment to Riot Games.

– PlayerUnknown’s Battleground (PUBG): Bluehole plans to roll-out professional leagues for the PUBG video game in four major global regions in 2019.

– NBA 2K: While the traditional NBA has 30 teams around the U.S., the NBA launched 17 teams for the 2K League. Each team is named after the traditional team. So, for example, in Los Angeles, the 2K League is called “Lakers Gaming”.

Other titles — like Counter-Strike: Global Offensive — appear to be more oriented toward tournaments versus leagues. This is similar to PGA golf or tennis versus NFL football. And, for these games, it looks like multiple tournaments (and even titles) can coexist. This is similar to boxing where different boxers can be recognized as world champions by different boxing organizations. We look at this in more detail below.

Some game publishers — like Valve and Electronic Arts — appear to be less focused on forming game franchises. Epic games (owner of Fortnite) struggled with early tournament play. Many players complained about the on-line lag and the tedious game play. Fortnite will likely have to figure out tournament play before it can consider setting up a league and selling the rights to specific teams in particular cities.

Venues

Fans can watch any professional sport in person at an area or stadium. The tickets are sold for both regular season play and championships. And, professional sports team usually own and operate a venue in each city. For eSports, consumers can also watch game play in person. But, these venues are usually repurposed for eSports. There are many, many venues that are general purpose facilities that have been used for various eSports tournaments. These repurposed facilities typically seat more than 10,000.

Figure 88. Venues Repurposed for eSports Tournaments

Seating Size Venue City Country Capacity (sq ft) Example Tournaments Air Canada Center Toronto Canada 19,800 665,000 League of Legends N.A. Finals Bill Graham Civic Auditorium San Francisco U.S. 6,000 31,140 League of Legends World Champions Chicago Theatre Chicago U.S. 3,533 4,500 League of Legends Quarterfinals Commerzbank Arena Frankfurt Germany 55,000 429,480 ESL One Dota 2 Tournament Copper Box London U.K. 5,000 25,833 Gfinity G3 Key Arena Seattle U.S. 17,072 400,000 International Dota 2 Tournament Lanxess Cologne Germany 20,000 86,111 ESL One Cologne – Counter-Strike Madison Square Garden NYC U.S. 19,830 20,976 League of Legends - N.A. Finals Rotterdam Ahoy Rotterdam Netherlands 40,000 581,251 League of Legends - EU Spring Finals Royal Opera House London U.K. 2,268 11,349 Call of Duty EU Championship Sang-am World Cup Stadium Seoul S. Korea 45,000 115,674 League of Legends - World Championship SAP Center San Jose U.S. 19,190 450,000 Intel Extreme Masters Tournament Staples Center LA U.S. 20,000 950,000 League of Legends World Champions

Wembley Arena London U.K. 12,500 56,000 EU League of Legends LCS Champions

Source: Journal of Applied Sport Management, Citi Research

Figure 89. eSports Dedicated Venues

Seating Size Venue City Country Capacity (sq ft) Example Tournaments Blizzard Arena Los U.S. 450 50,000 Angeles Blizzard eStadium Taipei Taiwan 250 17,500 eLeague Arena Atlanta U.S. 300 10,000 eSports Arena Santa U.S. 1,000 15,000 Ana Dota 2 (2015 to present)

Counter-Strike: Global Offensive Starcraft II GaneSync Gaming San U.S. 100 6,000 League of Legends Diego Minecraft Counter-Strike World of Warcraft Gfinity Arena Fulham U.K. 600 12,000 Call of Duty Microsoft Mixer Center NYC U.S. n/a n/a Madden 18 Launch event Gears of War 4 Tournament MLG.tv Columbus Columbus U.S. 500 14,000 MLG Counter-Strike: GOMC Nexon eSports Stadium Seoul S. Korea 500 6,000 EA Sports FIFA Kart Rider League Street Fighter V Crash UCI eSports Arena Irvine U.S. 80 3,500 n.a. Ultimate Weapons Grade Huntington U.S. 300 20,000 eSports training Studio Beach eUnited Call of Duty Training broadcast

Yongsan eSports Seoul S. Korea 1,000 9,000 ONGameNet Source: Journal of Applied Sport Management. Citi Research

Less often, eSports organizers use facilities that are dedicated for eSports. But, given the nascent nature of eSports, even these dedicated venues are shared among various game titles. In Figure 89 we provide a non-exhaustive list of eSports venues that are dedicated to eSports. These facilities tend to be far smaller, typically seating less than 1,000 people. But notice, several game titles are played in each venue. We think this speaks to the nascent eSports industry.

Each year, publishers and third parties host several hundred major eSport events. In 2016, Newzoo suggested there were 425 events with at least $5K in prize money. In 2017, the number of events grew to almost 590.

There are a number of firms that organize these live events. The largest firm is Electronic Sports League, now known as ESL. ESL launched in 2000. And, it was acquired by Modern Times Group (MTG) in September, 2015 for about $85 million (for a 76% stake). We conduct an interview with its founder and Co-CEO, Ralf Reichert, in the Expert Commentary section at the end of this report. ESL used to compete with DreamHack, a rival events and production company founded in 1994. In 2018, about 300,000 people attended a DreamHack event (13 shows across 8 countries). Current eSports events include Counter-Strike GO, Dota 2, and Hearthstone (among others). In November, 2015, Modern Times Group acquired 100% of DreamHack for an EV of $25 million.

Figure 90. ESL One, Cologne aka The Cathedral of Counter-Strike (2018)

Source: MTG

Tournaments

Both traditional sports and eSports often offer prize money during tournaments. When we compare these prize pools it’s clear that eSports offer prizes that are similar in size to many professional sporting events. Independent game publisher Valve tends to pay higher prices. Activision, on the other hand, pays toward the low- end of video game publishers. Although the prize money hasn’t yet been awarded, Epic Games agree to offer a $100 million prize pool for the top Fortnite players in 2019. If this does occur, eSports will likely eclipse the prize money for the most lucrative traditional sport: the U.S. Open (which awards $50 million in prizes).

Figure 91. Top 25 Prize Pools in Sports

Event Sport Publisher Prize Pool U.S. Open - 2017 Tennis 50.4 The International -2017 Dota 2 Valve 24.7 Counter-Strike: Global Offensive CS: GO Valve 22.5 Confederations Cup - 2017 Football (Soccer) 20.0 Fortnite Fortnite Epic 20.0 League of Legends League of Legends Riot 14.1 Indy 500 Racing 13.1 NBA Championship Basketball 13.0 US Open - 2017 Golf 12.0 The Masters - 2017 Golf 11.0 Stanley Cup - 2018 Hockey 7.0 Player Unknown's Battlegrounds PUBG Bluehole 6.7 Overwatch Overwatch Activision 6.7 Heroes of the Storm Heroes of the Storm Activision 6.5 Melbourne Cup Horse Racing 6.2 LoL World Championship - 2016 League of Legends 5.0 Hearthstone Hearthstone Activision 4.9 ICC Championship - 2017 Cricket 4.5 StarCraft II StarCraft Activision 4.2 Call of Duty Call of Duty Activision 4.2 Dota 2 Asia Championship - 2015 Dota 2 Valve 3.0 Halo World Championship - 2016 Halo 5 2.5 PDC World Darts - 2018 Darts 2.4 Tour de France - 2017 Cycling 2.3 World Snooker Championship Snooker 2.0

Source: Business Insider, Citi Research

Niche Viewing

Traditional sports fans have many ways to consume less popular content (or content that won’t garner a sufficient audience to warrant scare linear TV time). In the U.S., there are regional sports networks that air all the games of a local sports team (even if it’s not very popular). The NFL (through AT&T) sells Sunday Ticket allowing subscribers to watch all the games played by a specific team. That is, Dallas Cowboy fans that live in NYC, will struggle to find every Cowboys game on TV. But, with Sunday Ticket, you can get access.

eSports does quite well with niche viewing. After all, the same broadcasters that air game play for live streamers also broadcast the most popular eSports teams and the most popular tournaments. Consumption of eSports on sites like Twitch and YouTube is not small. Dota 2 garners about 18 million hours of professional eSports consumption in 1Q18. (Nearly as many hours — about 20 million — occurred from amateur play.) So, if you are an avid fan of professional eSports, there are ample ways to consume the content.

Figure 92. eSports Average Monthly Viewing Hours vs. Total Monthly Viewing Hours

League of Legends 25

CS:GO 2018 Average Average 2018

– 20 Dota 2

15 (millions)

10 Overwatch

Hearthstone 5 Rainbow 6 PUBG Apex Legends Fortnite

eSports Monthly Hours ViewingMonthly eSports World of Warcraft 0 0 20 40 60 80 100 120 140 160 Total Monthly Viewing Hours – 2018 Average (millions)

Source: NewZoo, Citi Research

Mass Viewing

The most popular traditional sports are typically aired on free-to-air broadcast TV networks (like ABC, NBC, CBS, and FOX in the U.S.). Games that are less popular are typically aired on specialized cable networks (like ESPN or Fox Sports).

There are a few — but only a few — eSports events that are popular enough that warrant distribution on traditional TV platforms. In 2017, there were only 30 U.S. telecasts of eSports events. Disney partnered with the publisher of Overwatch League (Activision) and aired various Overwatch telecasts across several Disney owned channels (Disney XD, ESPN2, and ESPN). AT&T, owner of TBS and CW, aired events for ELeague’s Counter-Strike tournaments. And, the NFL Network (owned by the NFL) aired eSports related to the Madden NFL gaming franchise. So, while mass market distribution via the television does exist for eSports, it is still relatively limited. And, until eSports can garner very large audiences, it won’t be able to approach the economics of traditional sports.

Figure 93. Telecasts of eSports in 2017

Network Telecast Duration Description Count (mins) Disney XD 13 1,015 Overwatch League TBS Network 7 1,135 ELeague: CS:GO ESPN2 5 439 Overwatch League NFL Network 3 230 Madden 2017 ESPNU 1 188 Overwatch League CW 1 60 ELeague: CS:GO

ESPN 1 60 Overwatch League Source: Nielsen. Citi Research

To put traditional sports in perspective, if we look at the top 40 U.S. broadcasts during 2018, live sports — including the NFL, Olympics and college sports — comprised 33 of the top 40 broadcasts and made up about 82% of all viewing. So,

clearly live sports dominate linear TV. And, that’s what makes owning a traditional sports franchise so lucrative.

Figure 94. Viewership of Traditional Sports Telecasts

Rank Telecast Network Viewers Rank Telecast Network Viewers 1 Super Browl LII NBC 103.4 11 Olympics Opening NBC 28.3 2 State of the Union Multiple 45.6 12 NFC Division Playoff FOX 27.1 3 AFC Championship CBS 44.1 13 This is Us NBC 27.0 4 NFC Champtionship FOX 42.3 14 104th Rose Bowl ESPN 26.9 5 NFC Division Playoff FOX 35.6 15 AFC Divison Playoff CBS 26.7 6 AFC Division Playoff CBS 31.4 16 90th Academy Awards ABC 26.5 7 NFC Wild Card Playoff FOX 31.1 17 Thanksgiving Day Game CBS 26.5 8 Thanksgiving Day Game FOX 30.5 18 Winder Olympics NBC 26.0 9 Royal Wedding Multiple 29.2 19 SCOTUS Broadcast Multiple 25.6 10 College Championship ESPN 28.4 20 AFC Wild Card Playoff CBS 25.3 = Total 421.6 = Total 265.9 memo: sports share 82% memo: sports share 70%

Rank Telecast Network Viewers Rank Telecast Network Viewers 21 National Window (NFL) FOX 25.1 31 Winder Olympics NBC 22.6 22 National Window (NFL) CBS 24.6 32 Winder Olympics NBC 22.3 23 Winter Olympics NBC 24.2 33 AFC Wild Card ESPN 22.3 24 National Window (NFL) CBS 23.9 34 National Window (NFL) FOX 22.2 25 Sunday Night Football NBC 23.7 35 60 Minutes CBS 22.2 26 National Windown (NFL) CBS 23.7 36 National Window (NFL) FOX 22.1 27 Macy's Thankgiving Parade NBC 23.7 37 Sunday Night Football NBC 22.1 28 National Window (NFL) FOX 23.3 38 National Window (NFL) FOX 22.1 29 National Window (NFL) FOX 23.2 39 Thanksgiving Day Game NBC 21.9 30 NFC Wild Card Playoff NBC 22.8 40 84th Sugar Bowl ESPN 21.7 = Total 238.2 = Total 221.5 memo: sports share 90% memo: sports share 90% Source: Nielsen .Citi Research

For big events in the eSports arena, most consumers just use Twitch. For three popular video games — Dota 2, League of Legends and Counter-Strike: Global Offensive — the Twitch viewership increased during major tournaments during 2015 and 2016. But, in truth, the bump is fairly modest: usually a 2x to 6x increase in Twitch followers. And, this lift is transitory, typically helping just one month. Far more viewership, it seems, occurs outside the episodic, one-time events.

Figure 95. Twitch Viewership for Three Popular Video Games

60 World Championship 2015

50 ESL One Manila Cologne Major 2015 Intel 2016 Extreme 40 North America Masters ESL One League MLG Major Frankfurt Legends Columbus 2016 Championship Dota2 30 The Frankfurt Major 2015 League of Legends

20 Twitch Viewing Hours (mn) Hours Viewing Twitch CS::GO

0 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Source: NewZoo, Citi Research

So, professional eSports isn’t nearly as mature as traditional sports. And, the lack of a large TV audience is another reason — alongside the power of the publishers — that eSports teams can be acquired for so little. But, how much does the eSports business generate in revenues? Collectively, the eSports business is growing about 30-40% per year and generates just under $1 billion in revenues. Sponsorship and advertising make up the bulk of the revenues, or about $500 million. The fees broadcasters pay for media rights is about $160 million. And, the fees game publishers make to eSports is about $100 million. Ticket sales for the live events (along with merchandise) make up another $100 million of revenue.

Figure 96. eSports Business Total Revenue

2012 2013 2014 2015 2016 2017 2018 Sponsorship 31 55 88 123 178 235 359 + Advertising 23 37 55 80 113 140 174 + Media Rights 8 13 23 36 58 93 161 + Game Publisher fees 28 43 58 75 94 105 116 + Merchandise & Tickets 40 46 27 12 50 82 96 = Total 130 194 250 325 493 655 906

memo: growth 49% 29% 30% 52% 33% 38% Source: NewZoo, Citi Research

Turnover of eSports Titles a Key Consideration

Recall, there are just a handful of very popular terrestrial sports — football, soccer, cricket, basketball and baseball. But, it’s very difficult for a new terrestrial sport to become popular. There are powerful network effects that help explain this:

 First, younger players watch and learn how to play just a handful of the most popular sports.

 Second, this creates large amateur pool of young fans and young players.

 Third, some of the players become quite proficient. The best players can receive scholarships to college. Some are even drafted into the professional leagues.

 Fourth, as better players enter the game, the quality of the game improves. This, in turn, attracts more fans.

 Fifth, some fans become interested in the ‘story’ around a particular team, even if the team isn’t very good. Chicago Cubs fans famously waited 108 years to win the World Series. But, the Cubs still had a loyal following even during the difficult years.

 Sixth, since large audiences that are willing to watch sports — whether a team is winning or not - TV broadcasting is economically viable.

 Seventh, economic viability allows professional players to become famous and earn large salaries.

 Eighth, the fame and wealth of the most popular players captures the attention — and imagination — of younger players. And, the cycle repeats.

Figure 97. Network Effects in eSports

Attracts Good Players Young Capture Players Large Wages

Large TV Broadcast Amateur Economically Pool Viable

Fan Interest Best Players in the Drafted “Story” Grows

Quality of Fans Game Play Grows Improves

Source: Citi Research

Against this backdrop, it is very difficult for a new terrestrial sport to launch. It’s even difficult for rival leagues to challenge incumbent leagues for popular sports. For example, in the U.S., a rival professional football league called the XFL tried in 2001, challenging the NFL. The league only played one season (2001). There are currently attempts to relaunch the XFL. But, even at the league level, the economic challenges are daunting.

eSports, hitherto, has had a very different experience. There are game titles that have had sustained success. Counter-Strike: Global Offensive (CS:GO) stands out as a good example. But, there are also a number of examples of significant disruption. Fortnite is, perhaps, one of the better examples.

So, as eSports becomes more popular, it is an open question whether similar network effects will take hold. Our suspicion is that there is still scope for new games to become very popular and disrupt established IP (even games with established eSports infrastructure). But, as the video game industry matures, we expect successful entry by new games to become increasingly difficult. Grassroots Competition

So far, we’ve explored ‘masters’ or ‘pro-level’ eSports competition. But, below the large stadium events and mass-streamed competitions, there are a significant number of ‘challenger’ and ‘open’ competitions that arguably are just as important to player engagement for both eSports and the game title itself.

And, even beyond pure competition, we should also consider ‘digital festivals’ like those organized by firms like DreamHack. For these festivals, competition is often secondary to community.

Figure 98. Understanding Competitive Style, Prize Levels, and Target Figure 99. MTG: Number of Owned & Operated Properties by Type Audience for eSports

200 Master Challenger ESL 180 ONE Open Intel Extreme 160 35 Masters 32 Mega Prizes MASTERS Mass-Market & Stages + 140 29 ESL Online 26 Watch & Play Pro League 120 23 20 100 18 Large Prizes CHALLENGER Enthusiasts 16 111 & Stages + 80 106 Online 101 ESL 12 96 National 91

Championships Events of Number 60 86 Watch & Play 82 68 40 60

Teaser Prizes & Friends & OPEN 20 Online Family 29 32 20 23 26 9 10 12 17 ESL 0 Watch, Play, Engage, Learn Open 2017 2018 2019 2020E 2021E 2022E 2023E 2024E 2025E COMPETITION STYLE; Event Example Prize Level & Target Venue Size Audience Source: Company Reports Source: Citi Research

Figure 100. DreamHack BYOC (2018)

Source: MTG

Live Streaming vs. eSports: The Broadcaster’s Perspective

Before we delve into the next chapter (Mobile Games), it’s worth highlighting one very important point about broadcasters. We suspect Amazon acquired Twitch because it thought eSports would become a very big business. And, we’ve shown that wasn’t a bad hypothesis. Indeed, eSports is growing.

But, we suspect Amazon didn’t fully appreciate the growth in live streaming. And, when we look at the broadcaster business model, it’s clear that live streaming is superior to eSports. Why do we say this? There are two reasons:

 First, in the live streaming business model, a broadcaster collects two sources of revenue: (1) 50-70% of the subscriber fees that a live streamer collects and 2) 50-70% of the ad revenue a live streamer generates. In the eSports world, there aren’t any subscribers. As such, in eSports, the broadcaster only collects one revenue stream: ads.

 Second, in the live streaming business model, a broadcaster doesn’t have any costs associated with rights. But, in the eSports model, the broadcaster has to pay a publisher for the right to stream a particular eSport event. These payments can be material. For example, press reports suggest Twitch paid $90 million for two years of Overwatch League rights.

So, live streaming likely has higher revenue and lower costs. As such, if we had visibility into Twitch’s P&L, we’d probably find that live streaming is the better business. This will have important implications as we get deeper into the likely evolution of the gaming industry.

Figure 101. Live Streaming vs. eSports Business Models

Live Streaming eSports

100% Live 50-70% Subscribers Subscribers eSports Streamer

100% Live 50-70% 100% 100% 50% Ads Ads eSports Publisher Streamer Broadcaster Broadcaster 100% Live Donations Donations eSports Streamer

100% Live 100% Sponsorship Sponsorship eSports Streamer

Source: Citi Research

The Mobile Value Chain In the last section, we reviewed the value chain for PC and console gaming. But, we (largely) avoided talking about mobile games. There’s a reason for this omission. The mobile value chain is very distinct from console and PC gaming. But, what caused the value chain — and the business model —- to evolve so differently?

In the early days of mobile data, third party application development — including mobile gaming — was stifled. There were three main reasons for this:

 First, handset screen sizes were small. That made gaming difficult.

 Second, bandwidth was limited. With nascent air interface standards — like 1G or 2G — spectrum (MHz) couldn’t efficiently be converted into bits of information. As such, game software had to be preinstalled and reside on the device when the hardware left the factory. Downloading games just wasn’t feasible.

 Third, wireless carriers only let specific handsets work with their networks. Moreover, the application (preloaded on the device) had to be pre-approved by the wireless carriers. This, of course, was in sharp contrast to the desktop environment where application development was (relatively) open, particularly for the Windows operating system.

Figure 102. Evolution Desktop vs. Early Mobile

Desktop Early Mobile

Network Service Yahoo, AOL

Apps Web browser

User Interface Windows, iOS

Hardware Keyboard, mouse, monitor Motorola, Nokia, Blackberry

Form Factor X86 (Intel, AMD) Various User

Source: Citi Research

Over time, Apple and Google altered the mobile ecosystem by developing competing mobile operating systems (OS). Apple created iOS and Google launched Android. While Apple only deployed its operating system on Apple handsets, Android licensed its OS to a large number of device manufacturers: Samsung, LG, Huawei, Lenovo, and Sony (just to name a few).

In parallel, app development was opened up to third parties. This helped propel Android and Apple market share because consumers could get more utility from an open device relative to the closed devices (like Symbian or Blackberry). And, as Apple and Google took more share, developers stopped creating apps for less popular devices. In effect, the virtuous cycle kicked in: more apps prompted more device sales which, in turn, caused more app development on those devices.

Given Android’s ubiquity, these devices capture a far larger share — about 85% — of the global smartphone market. Apple controls the balance. Symbian and Blackberry are almost extinct.

Figure 103. Share of Smartphone Market 100%

90%

80%

70%

60% Android 50% Apple Symbian 40% Blackberry Other 30%

20%

10%

3Q10 1Q16 1Q10 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 3Q16 1Q17 3Q17 3Q09 Source: Citi Research

With that bit of history, let’s shift gears and review the mobile game value chain. There are seven main layers:

 Intellectual Property: Similar to the PC and console markets, owners of IP sit at the top of the stack. IP can include everything from sports leagues (FIFA) to toys (Lego).

 Developers / Publishers: Similar to the console/PC market, the developers write code for the game and the publisher sells and markets the game. Unlike the console/PC market, however, these two functions are typically performed by the same entity.

 Installs: Faced with many mobile games, publishers often pay third parties — an app store, a search engine or a website — a fee for every consumer that installs the game. This is called the CPI, or cost per install.

 Mobile OS: Once the game is installed on the device, the firms that control the mobile operating system — Google and Apple — collect about 30% of the money a consumer spends on a game. The app stores do not typically collect a slice of the ad revenue.

 Ad Revenue: In the mobile world, there’s a fairly complex ecosystem that matches ad buyers (marketing firms and ad agencies) with the ad sellers (mobile game publishers). To match the buyer and seller — with the right inventory and the best price — typically reduces a mobile game publisher’s gross ad revenue by 40-60%. Most publishers report net revenue (after the AdTech fee).

 Advertiser: Mobile advertising is one of the fastest growing segments of overall advertising. Within mobile advertising, gaming represents about 20% of total (non-search) mobile advertising. But, since mobile gaming firms have to share this revenue with the AdTech firms, the global ad opportunity is quite small, just $10 billion per year.

 Consumer: The consumer typically enjoys the game for free. But, they have options to spend money within the game for things like extra lives or virtual tokens.

Figure 104. Mobile Gaming Ecosystem

Description Economics Owner of IP that is licensed to Share of game sales (may include Intellectual Property publisher minimum payment) $ Game Engine $ IP Develops games Pays royalties to IP owner (if applicable) Software API Game Developer Sells, markets and distributes Publisher pays $2-3 in cost per install (CPI) (Studio) Developer & Publisher usually a Publisher looking for “whales” Game Publisher single entity

Installs $ $ App store, search engine or Installs Receives revenue from publisher if web site gets paid for each (AdTech) game installed. $ consumer that installs game (CPI) Game Distributes game digitally Mobile app store keeps 30% of Mobile OS within Apple or Android app consumer spend on game store $ Ad Revenue AdTech firms matches buyer AdTech firms remit as little as 50% Inventory (AdTech) (advertiser) & seller (game of ad dollars to game publisher publisher) of inventory Inventory $ Advertiser pays AdTech firms AdTech may keep up to 50% of Advertiser for access to consumers total ad spend Views Ads Game Plays game 80% of games are free Consumer High churn rates May pay for virtual currency May watch ads for game benefits

Source: Citi Research

When you compare console/PC gaming to mobile gaming, you’ll notice that the value chain is similar at the top of the stack. But, things look quite different at the bottom of the stack. Indeed, we see four key differences between console/PC gaming and mobile gaming:

 First, in mobile games, subscriber acquisition is far more important.

 Second, there are fewer gatekeepers in the mobile gaming world: the global mobile OS platforms.

 Third, the complex AdTech ecosystem is used for both subscriber acquisition (encouraging game installs) and ad-based revenue within the game.

 Fourth, advertising plays a more prominent role in mobile gaming.

With those differences in mind, let’s dig into each layer of the value chain. Layer I: Intellectual Property

We learned that for console/PC games, external IP isn’t particularly important. Recall, for PCs and consoles internally developed IP (versus third-party IP) accounted for 80% of game sales (with 10% of sales coming from sports IP and 10% of sales from non-sports IP). But, are mobile games any different? We looked at the data in two ways.

 First, we examined the most downloaded mobile games and mobile games that generated the most revenue. These data are from App Annie for Google Play over the last seven years: 2012 to 2018. (The data excludes China.) The data suggest there isn’t a single title among the top 10 that relies on third-party IP. That holds true whether we rank the games by number of downloads or by revenue. In addition, the correlation between downloads and monetization is poor. That is, only Candy Crush and Clash of Clans rank in the top 10 for both downloads and revenue. But, third-party IP didn’t cause that tight linkage. Rather, it was the design of a mobile game that caused downloads and monetization to both rank well.

Figure 105. Mobile Games on Google Play: Download Rank vs. Spend Rank

Download Rank Spend Rank Game Title Company Subway Surfer 1 Outside top 10 Kiloo Candy Crush 2 4 Activision My Talking Tom 3 Outside top 10 Outfit7 Pou 4 Outside top 10 Zakeh Temple Run 2 5 Outside top 10 Imangi Hill Climb Racing 6 Outside top 10 Fingersoft Clash of Clans 7 6 Supercell Minion Rush 8 Outside top 10 Vivendi 8 Ball Pool 9 Outside top 10 Miniclip Fruit Ninja 10 Outside top 10 Halfbrick Puzzle & Dragons Outside top 10 1 Gung Ho Monster Strike Outside top 10 2 Mixi Fate / Grand Order Outside top 10 5 Sony Lineage M Outside top 10 6 NCSoft Pokémon Go Outside top 10 7 Niantic Lineage 2 Revolution Outside top 10 8 Netmarble Game of War – Fire Age Outside top 10 9 MZ Clash of Kings Outside top 10 10 Elex

Source: App Annie for Google Play Jan 2012 to Aug 2018 (excludes China)

 Second, we looked at the top 100 Apple Store mobile game in the U.S. during March of 2019. And, 92% of the most downloaded games relied on internal IP. Around 7% of downloads relied on third-party, non-sports IP including Marvel, Game of Thrones, Star Wars, Star Trek, and Yu-Go-Oh! (a card game). Only 1% of mobile game downloads relied on third-party sports IP.

Figure 106. Most Downloaded Games on Apple Store by IP Type

Game Examples of Third-party IP Daily Downloads Share Internal IP None 1,302,314 92% Sports IP Madden: NFL Overdrive 11,461 1% Non-sports IP Marvel, Game of Thrones, Yu-Gi-Oh!, Star Wars, Star Trek 96,650 7% = Top 100 iPhone Mobile Games in U.S. 1,410,425 100%

Source: Citi Research

What does all this mean? Anyway we slice the data, third-party IP doesn’t seem to be very important for mobile games. In fact, third-party IP is actually less important for mobile games than it is for PC or console games. Why is this? We can think of two reasons:

First, the monetization of a mobile game is far lower than it is for a console or PC game. That may make mobile game publishers reluctant to incur incremental costs related to IP licenses. Second, since the IP can’t be fully leveraged with a small screen — or a fancy controller—- third-party IP may be less valuable in a mobile game relative to a PC or console game. Layer II: Developers and Publishers

In the PC and console market, the game developer is often distinct from the game publisher. But, for mobile games, the developer and publisher are almost always the same entity. There are five main reasons for this:

 First, the cost to develop a mobile game is typically far lower than the cost of a console or PC game. This means third-party assistance — particularly for funding — isn’t as necessary.

 Second, unlike PCs and consoles, mobile devices have limited computing power (typically 1-3 Gigabytes of RAM). This makes game development easier and far less expensive.

 Third, the game developer doesn’t need to make multiple versions of the software (PC, PlayStation, Xbox, Nintendo). There are only two mobile platforms: iOS and Android. This helps lower upfront launch costs diminishing the need for a publisher.

 Fourth, there is a fairly robust mobile AdTech ecosystem. This ecosystem can be used to: (1) acquire subs and (2) generate in-game ad revenue. As such, one of the key publisher roles — sales and marketing — is diminished relative to PC and console games.

 Fifth, there are two primary ways to distribute your game: Apple’s app store and Google’s app store (with a small slice coming from Facebook). That’s in sharp contrast to the legacy PC and console gaming market. Historically, distribution would include a wide array of physical stores (Wal-Mart, Best Buy, GameStop), e-commerce sites (Amazon) and pure digital distribution (like publisher’s own digital storefronts). So, the publisher’s role — for marketing and distribution — is less prominent in mobile gaming.

We don’t mean to suggest game developers don’t need help. Some developers do. But, third-party assistance usually comes from firms with expertise related to effective subscriber acquisition given the complex AdTech ecosystem.

So, let’s say you want to develop a mobile game and you’ve decided to eschew third-party IP. How many apps — both gaming and non-gaming — will you compete with? It turns out there are about 3.3 million apps for both Android and Apple phones. And, while these apps can come in many flavors — business apps, education apps, travel apps — the largest category is gaming.

Indeed, back in 2008 around 50% of all apps were for mobile games. Today, that figure has dropped to about 25% of all apps. But, this means there are nearly 825,000 gaming apps available on both Android and Apple phones! That’s quite a bit of competition.

Figure 107. Game Apps vs. Total Apps on Apple Store Figure 108. Game Share of Total Apps on Apple Store 3,500 50% Non-Game Game Non-Game Game Game Share of Total (LHS) 45% Free 1,967 663 78% 81% 3,000 Total Apps + $0.01 to $0.99 228 85 9% 10% (RHS) 40% + $1.00 or more 314 75 13% 9% 2,500 35%

) = Total (1Q19) 2,509 823 100% 100%

2,000 30% 25% 1,500 20%

1,000 15% Total Apps(%) Total

Non-Game of GameShare Apps(000s 10% 500 (LHS) Game 5% (LHS)

- 0%

Apple App Mobile Store App Apple

Jul-08 Jul-15

Jan-19 Jan-12

Mar-13

Nov-10 Nov-17

Sep-09 Sep-16 May-14

Source: Pocketgamer.biz Source: App Annie, Citi Research

So, entry barriers for mobile gaming seem pretty low. Virtually anyone can make a mobile game. But, as a developer, how much are you going to charge for your app? The vast majority of mobile game apps — over 80% — are free. Another 10% cost less than $1. Very few — just 10% of mobile games — cost more than $1. This means the vast majority of mobile gamers need to make voluntary purchases within the game for the business to be viable.

Developers can — and do — insert ads to supplement revenues. And, although there is a wide degree of variance by firm, in rough terms in-game monetization generates about $2 in revenue for every $1 of net advertising (after AdTech firms take a cut of the gross ad revenue). Most mobile game firms report net ad revenue.

Who are the largest publishers / developers in mobile gaming? Although our revenue figures are just estimates — since many firms don’t disclose mobile gaming revenues separately — it should give readers a rough idea of the key players. In 2018, we estimate the top 10 mobile game firms generated about $26 billion in revenue. Smaller and independent firms generated another $19 billion in revenue.

Figure 109. Top 10 Mobile Game Firm Revenues

Company Firm Listing 2010 2011 2012 2013 2014 2015 2016 2017 2018E Tencent China Public - - - - 1,980 3,043 5,486 8,971 11,114 +NetEase China Public 550 581 650 761 850 1,079 2,375 3,478 3,964 +Activision U.S. Public - 58 64 164 1,890 2,284 1,586 1,998 2,085 +Bandai Namco Japan Public 215 425 712 682 749 865 1,463 1,801 1,903 +Netmarble Korea Public 185 245 326 486 528 912 1,244 2,272 1,819 +Aristocrat Australia Public 31 56 122 216 351 617 852 1,100 1,339 +Sony Japan Public - - - - - 106 471 1,119 1,280 +Epic U.S. Private 10 20 30 40 50 75 100 600 1,000 +Zynga U.S. Public 166 298 358 429 515 618 741 861 907 +NCSoft Korea Public ------14 932 822 =Top 10 Publishers 1,157 1,683 2,262 2,778 6,912 9,598 14,332 23,131 26,234 +Others 480 1,914 4,079 7,548 11,206 15,435 17,983 16,211 18,882

=Global mobile revenue 1,637 3,597 6,342 10,327 18,118 25,033 32,315 39,342 45,116 Source: Citi Research

If we group these firms geographically based on the location of each firm’s headquarters — not based on consumer spending in each region — it’s clear that firms in China, Japan, Korea, and Australia dominate the sub-sector. U.S. firms rank second and European firms lag far behind.

Layer III: Installs

So, there are many, many mobile games and many mobile game firms. As such, competition is fierce. And, most games are free. This means you can’t offer a lower retail price to attract installs. So, as a developer/publisher, how are you going to get consumers to install your game on their smartphone? Well, there are a few important steps:

 First, after your game is developed, you’ll need to tailor the app to each region. Local customization will certainly include language changes. But, it may also require other tweaks — like cultural modifications.

 Second, with your geographically tailored app in hand, you have three broad options to encourage local users to install your app:

– Adjust Keywords in the App Store: Developers can adjust keywords associated with the app. By doing this, when consumers go to an app store, your app can rank toward the top of the list. Many developers will use App Annie and Sensor Tower to help with keyword adjustments. These websites allow you to see where your app ranks relative to other apps for each keyword. If a user types “candy game” in the keyword, where does your game compare to Candy Crush? Of course, a higher ranking app is more likely to be installed.

– Tap into Firm’s Internal Audience: You can encourage your internal audience to use your app. This might mean promoting your game on your social media page, your firm’s website, or promoting the game by using an internal email list of customers.

– Purchase Access to External Audience: The last option is to tap into third- party audiences. If you pursue this last option, you’ll need a marketing budget. You can pay for ads on social media, in the app store, on third-party websites, or on video sites like YouTube.

Figure 110. Blueprint for Getting Mobile Installs

Description Free

Use App Annie or Sensor Tower to Yes App Store Key Word Search find relevant keywords used by games similar to yours

Promote on social media Yes Social Media

Own Web Site Available on internal web site Yes Final Geo Your Game Tailor Audience Blogs Promote on blogs Yes

Email Promote game on internal email Yes list

Social Media Pay for ad on Facebook, Twitter No or other site Search in App Pay for ad within Google Play or No Store Apple Store Cost per Third-Party rd Pay for ad on third-party site No Install Audience 3 Party Web Site (CPI) typically No runs $2-3 Video Links Pay for ad on YouTube

Email Promote game on acquired email No list

Source: Citi Research

If you tap into third-party audiences versus tinkering with app store keywords or using your internal audience, you’ll typically pay $2-3 for every install. Recent data from the Chartboost Network suggest game publishers were willing to pay a higher CPI for Apple versus Google. This seems reasonable since Android has a higher share of mobile devices outside the U.S. (where game spending tends to be lower than the U.S.). The recent data suggests the CPI has compressed a bit. More recent data suggests a $2 CPI may be more typical. Historically, $3 was closer to the mark.

Figure 111. Cost per Install: Apple vs. Google Figure 112. No. of Apps Downloaded vs. Used on Android $4.00 India 35 27 $3.50 Indonesia 33 29 Brazil 33 37 $3.00 Mexico 37 44 Apple $2.50 France 36 44 $2.00 Germany 36 46 Google $1.50 U.K. 36 47 Japan 34 64 $1.00

Cost per Install per Cost S. Korea 40 60 $0.50 U.S. 37 65 $0.00 Australia 39 64

0 20 40 60 80 100 120

Apr-17 Apr-18

Apr-16 Used Installed

Dec-15 Dec-16 Dec-17 Dec-18

Aug-16 Aug-18 Aug-17 Source: ; eMarketer; Chartboost, Network Citi Research Source: App Annie, Citi Research

Although averages can be a misleading, according to App Annie, the average Android smartphone uses between 35 and 40 apps (including games and non- games). And, in most countries, smartphone users download 1-2x more apps than they actually use. In emerging economies — like India or Brazil — the ratio of downloaded apps to used apps is 1:1. But, in developed economies — like the U.S. or Australia — the ratio of downloaded apps to used apps is closer to 2:1.

This dynamic poses a bit of a conundrum for mobile game firms. In markets where disposable income is higher — which results in greater in-game spending and higher ad revenues — the likelihood of a consumer downloading, but not using, your app increases. That suggests in developed markets, you may pay for more installs but not generate as much revenue.

So, let’s say that you get some consumers to download your gaming app. How long will these new users stick around and play your game? With such a heavily reliance on free subs, it may not come as a surprise that mobile game churn rates are very high.

Although mobile game firms don’t disclose churn rates, many do disclose Monthly and Daily Active Users (MAU and DAU, respectively). If we compare DAUs to MAUs, it suggests that about one-quarter of the monthly users use the gaming app daily. This highlights a truism about mobile gaming: avid fans drive most of the economics. But, most players only occasionally play the game.

Figure 113. Monthly & Daily Active User Rates for Zynga and Glu

2016 2017 2018 Zynga + Glu Daily Active Users (DAU) 23 25 26 / Zynga + Glu Monthly Active Users (MAU) 100 110 110 = Share of subs engaged daily 23% 23% 24% memo: Zynga daily engagement 30% 26% 26% memo: Glu daily engagement 12% 14% 16%

Source: Company Report, Citi Research

We can come at the data one other way. Both Zynga and Glu disclose beginning and ending period DAUs. They also disclose marketing outlays to get new installs. If we assume a cost per install (of $2.50), it suggests monthly churn rates run 25- 30%.

Figure 114. Monthly Churn Rates for Mobile Games

2016 2017 2018 Revenues 942 1,148 1,274 x Share spent on sub acquisition 18% 20% 19% = Sub acquisition costs 169 225 243 / Cost per install 2.50 2.50 2.50 = New installs (gross adds) 67 90 97

Beginning subs (DAU) 23 23 25 + Annual gross adds 67 90 97 - Annual churned subs 67 88 96 = Ending subs (DAU) 23 25 26

Annual churned subs 67 88 96 / Months per year 12 12 12 = Monthly churned subs 5.6 7.4 8.0 / Average monthly users (DAUs) 23 24 26

= Monthly churn rate 24% 30% 31% Source: Company reports, Citi Research

A 25% monthly churn rate would imply that a game had 100 initial installs would only have three original subs playing the game 12 months later.

Figure 115. Decline in Retained Subs for Mobile Games 100 100 90

80 75 70

60 56 50

40 42 Retained Subs Subs Retained 32 30 24 18 20 13 10 8 10 6 4 3 0 0 1 2 3 4 5 6 7 8 9 10 11 12 Months Source: Statista

Layer IV: Mobile OS

Clearly, most mobile subs don’t play a game for very long. But, if you wanted to pick a mobile operating system to focus on, which one is better: Google or Apple?

Google, of course, has 85% of the global smart phone market. But, Google Play only captures about 70% of downloads and 35% of spending. In effect, Google’s customers tend to download far fewer apps and spend far less on apps than Apple customers. (Note: Google Play isn’t available in China.)

Figure 116. Apple vs. Google: Global Share of Downloads vs. Spend

Global Share of Worldwide Downloads Global Share of Worldwide Spend 100% 100%

90% 90% 33% 32% 30% iOS App 80% 39% Store 80% 46% 54% 70% 70% 62% 62% 69% 66% 66% 60% 60% 86% 50% 50%

40% 40% 67% 68% 70% 30% 61% 30% 54% 46% 20% 20% 38% 38% Google Play 31% 34% 34% 10% 10% 14% 0% 0% '12 '13 '14 '15 '16 '17 '12 '13 '14 '15 '16 '17

Source: App Annie

Layer V: Generate Advertising

In addition to generating revenue within the game — called in-app purchases (IAP) — mobile games serve ads. There are four basic types of ads for mobile games:

 Rewarded Video Ads: These ads grant a player access to some in-game item or feature as an incentive. The ad could grant extra points, extra lives, or access to a coveted item in the game. These types of ads must be integrated into the game’s design.

 Full-screen Picture Ads: Full-screen ads place a static picture across the entire screen at predetermined points in the game.

 Banner Picture Ads: Banner ads place a static ad above or around the game during gameplay.

 Interstitial Video Ads: Interstitial ads interrupt game play at a predetermined point in the game. These videos can, however, be skipped by the gamer.

So, let’s assume you’ve decided on the types of ads you’re going to integrate into your game. What’s the next step? We’re going to delve into the world of mobile advertising. Our intent isn’t to go into all of the nuances (and there are many). Rather, our aim is to give a basic overview of the mobile AdTech ecosystem.

The process begins with an advertiser or an ad agency, like WPP or Omnicom. (See left side of Figure 117). The agency wants to spend money on an ad campaign and believes mobile ads should be part of the mix. But, there are ~4.5 billion mobile devices scattered around the world and each mobile user has unique attributes: country of origin, user interests, age, etc. So, to make your advertising spend more effective, you’d like to place your ad on a subset of mobile devices that reach your intended target audience.

Perhaps you sell energy drinks. And, as a marketer you know the target audience is men, aged 18-24. Your research also suggests that energy drink consumers also over index on first person shooter (FPS) games. You might want to push your ad to that specific subset of mobile games. But, how would you go about that? The best place to go is a Demand Side Platform, or DSP, which allows ad buyers to bid for ad space on specific digital sites. Google’s DV360 is a good example of a DSP.

At the other end of the process is the mobile game publisher like Zynga or Glu. (See right side of Figure 117). The game publisher has a specific amount of inventory that it wants to monetize. The game publisher would make the inventory available to a Supply Side Platform (SSP), which allows publishers to sell inventory to advertisers at a competitive price. Examples of SSPs include Google’s DoubleClick or Unity Ads.

Since the DSP has an idea of demand and the SSP has an idea of supply, there needs to be a way for the market to clear in an efficient way. And, there are two main options — an Ad Exchange and an Ad Network.

Figure 117. Advertising Ecosystem

Ad Exchange: Sales channel for buying & selling inventory. Prices determined via bidding.

Example firms: Google’s DoubleClick, Facebook Exchange

Ad Exchange

Demand Side Supply Side Ad Game Platform Platform Agency Publisher (DSP) (SSP)

DSP: Allows ad SSP: Allows buyers to bid for publisher to sell space on digital inventory to sites. advertisers at competitive prices Example firms: Google’s DV360 Example firms: f/k/a DoubleClick Ad Google’s Bid Manager, DoubleClick, Unity MediaMath, ONE Network Ads by AOL Ad Network: Outsourced sales capability for publishers. Sorts audiences from various sources. Provides value to both agency & publisher (like targeting, optimization)

Example firms: Google, Media.net

Source: Citi Research

But, what’s the difference between an ad exchange and an ad network?

 An Ad Exchange — like Facebook Exchange or Google’s DoubleClick — is a sales channel where prices are determined via bidding. The ad buyer bids on available inventory. If they place the highest bid, the have the right to place their ad on that specific slice of inventory.

 An Ad Network — like Google or Media.net — is just an outsourced sales capability that can sort audiences from various game publishers. They provide value to both the buyer (ad agency) and the seller (game publisher) by matching the supply and demand in a way that helps the buyer get a higher price and the seller meet their marketing objectives.

Figure 118. Ad Networks vs. Ad Exchanges

Ad Network Ad Exchange

Transaction: Arbitrage Auction

Offload unsold inventory Competitive bidding Innovation: Sell inventory across sites Better rules (set ad budget, maximum bid)

Ad Target: Contextual Behavioral

Challenge: Limited transparency Limited for rich media

Source: Citi Research

Layer VI: Advertiser

With 4.5 billion mobile devices and a relatively easy way to target a subset of the aggregate users, mobile advertising has emerged as one of the fastest growing types of ads. According to Magna Global, total global ad outlays for all mediums — Internet, TV, print, outdoor — has grown from $368 billion in 2010 to $535 billion in 2018.

Interestingly, in 2010 mobile advertising didn’t exist. But, today, the mobile ad market generates about $150 billion in revenue. Said another way, over the last eight years, 90% of the growth in total ad spending has accrued to mobile platforms (90% = $150B / ($535B - $368B)).

Within mobile advertising, however, there are two basic types of ads: search and non-search. As a mobile gaming company, therefore, the addressable market is closer to $80 billion a year (with the balance accruing to search firms like Google).

But, virtually every social media company and every mobile website is vying for that $80 billion. We estimate mobile gaming captures ~20% of the $80 billion, or just $18 billion a year. And, the AdTech players are going to capture about 40% of this spending since they match the ad buyer (say Omnicom) with the ad seller (Zynga). This means mobile gaming firms are competing for just $10 billion of net mobile ad revenue each year.

Figure 119. Global Ad Spending; Mobile Ads vs. Non-Search Mobile Ads

Total Global Ad Spending ($bn) 2018 Non-Search Mobile Ad Spending ($bn) 90 600

80 Total 535 500 508 Ads 488 70 ~20% of 461 442 non- 421 search 400 60 405 mobile ad 386 spend is 368 50 61 for gaming AdTech captures 300 Mobile ~40% of 40 79 gaming ad spend firms 200 30 capture ~$10B a Total Mobile 150 year Ads 20 100 79 7 10 18 Non-Search 10 Mobile Ads 0 0 '10 '11 '12 '13 '14 '15 '16 '17 '18 Non- Non- Gaming AdTech Mobile Search Gaming Game Ads

Source: Magna, Citi Research

Layer VII: Consumer

The propensity of global consumers to play mobile games varies significantly. Consumers in North America generate, on average, $2 per month per smartphone in advertising and in-game purchases. But, in Asia and Latin America, the revenue per smartphone is about half as much. And, the figure gets cut in half again when you look at Latin America. (Since we are using all smartphones in this calculation — not just smartphones that play games — the revenue per device among gamers is, of course, higher.)

However, given the sheer size of the smartphone market in Asia, the region represents over 50% of the aggregate mobile game market. North America, on the other hand, is less than 20% of the total.

Figure 120. Mobile Game Revenue by Region

North Asia Europe America LatAm RoW Total 2018 installed base of smartphones (mil) 2,422 653 321 448 684 4528 x 2018 mobile game revenue per device 11.38 9.70 23.91 5.95 1.30 9.96 = 2018 mobile game revenue 27,559 6,334 7,668 2,667 889 45,116 memo: monthly ARPU 0.95 0.81 1.99 0.50 0.11 0.83

memo: ARPU index to average 114% 97% 240% 60% 13% Source: Citi Research

Mobile Economics

Now that we’ve walked through all these layers of the mobile value chain, let’s synthesize some of the key learnings.

If an advertiser spends $1 on ads, the mobile gaming firm would report about $0.60 after the AdTech firms take their portion of the revenue. The consumer then typically spends about 3x more on in-game revenue. All told, revenues would be $2.40. The app store would collect 30% of the in-game spending. And, if the consumer plays within another ecosystem — like Facebook or Kakao — they would take 30% of the remaining revenue. Finally, if the game relies on third-party IP (which is atypical), we assume the IP holder collects 10% of revenue. The remaining funds are left for the game publisher and game developer.

Figure 121. Mobile Gaming Monetization 250%

54% 240% 200%

36%

150% 180% 24%

Monetization (%) Monetization 126% 100% 64% 100% 15% 10% 15%

50% Mobile Gaming Gaming Mobile

60% 64%

0% Advertiser DSP Ad SSP Publisher Consumer Total Mobile OS Platform IP Mobile Publisher Developer Ad Exchange Ad In-game Revenue Gaming Spend Revenue Spend Source: Citi Research

However, aggregate margins are far lower than this. That’s because in our example (from above), we excluded subscriber acquisition costs. And, we’ve ignored churn. So, let’s take a look at the economics over time including acquisition costs. We’ll assume a few things:

 First, we begin with 100 app installs. We assume 90% cost $2.50 per install (with the remaining 10% captured via ‘free’ distribution channels like the mobile game company’s website).

 Second, we’ll assume 30% monthly churn.

 Third, we start with a very low average revenue per user (ARPU) of $1.25 per month. But, as subscribers defect, we’ll assume those that remain (that like the game), spend $8 a month, augmented by $2 of ads.

 Fourth, we assume the app stores collect about 30% of in-app spending and the AdTech firms capture 40% of ad revenue.

Figure 122. Mobile Gaming Economics

Months 0 1 2 3 4 5 6 7 8 9 10 11 12 Gross ad\ds 100 x Portion paid 90% = Paid installs 90 x Cost per install -2.50 = Marketing cost (225)

Begin subs 100 70 49 34 24 17 12 8 6 4 3 2 x Churn (pct per month) 0.3 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% = End subs 70 49 34 24 17 12 8 6 4 3 2 1

Begin ARPU 1.25 1.50 1.80 2.25 2.93 3.80 4.94 6.43 8.03 10.04 12.05 x ARPU growth 120% 120% 125% 130% 130% 130% 130% 125% 125% 120% 115% = End ARPU (with gross ad revenue) 1.25 1.50 1.80 2.25 2.93 3.80 4.94 6.43 8.03 10.04 12.05 13.86 memo: ARPU with net ad revenue 1.07 1.18 1.41 1.74 2.22 2.88 3.75 4.87 6.20 7.75 9.47 11.10 memo: consumer outlay 0.80 0.88 1.06 1.30 1.66 2.16 2.81 3.65 4.65 5.81 7.10 8.33

Avg subs 85 60 42 29 20 14 10 7 5 3 2 2 x Avg ARPU (monthly) 1.25 1.38 1.65 2.03 2.59 3.36 4.37 5.68 7.23 9.04 11.05 12.95 = Contribution to annual revenue 106 82 69 59 53 48 44 40 35 31 27 22 memo: share of revenue 17% 13% 11% 10% 9% 8% 7% 6% 6% 5% 4% 4%

Ad spend 38 29 25 21 19 17 16 14 13 11 9 8 +In-app spend 68 53 44 38 34 31 28 26 23 20 17 14 = Monthly revenue 106 82 69 59 53 48 44 40 35 31 27 22 - App store share of spend (30%) 20 16 13 11 10 9 8 8 7 6 5 4 - AdTech share of ad spend (40%) 15 12 10 8 8 7 6 6 5 4 4 3 = Monthly EBITDA 71 54 46 39 35 32 29 26 24 21 18 14

Begin cum EBITDA (225) (154) (100) (54) (15) 20 52 81 107 131 151 169 + Period EBITDA 71 54 46 39 35 32 29 26 24 21 18 14 = End cum EBITDA (154) (100) (54) (15) 20 52 81 107 131 151 169 183

Source: Citi Research

With these assumptions, the Lifetime Value (LTV) of a subscriber is about $185. This reflects an outflow of $225 when we first acquire 100 subscribers offset by $410 of earnings before interest, tax, depreciations, and amortization (EBITDA) over the course of the year. Of course the LTV would be a bit higher than this because some subscribers — perhaps the most attractive ones — would continue to play the game beyond 12 months. In this hypothetical example, the mobile gaming firm would recoup their upfront marketing spending after about five months.

If you work through the math on this hypothetical game, those subscribers that continue to play the game for a year generate about 20% of all game revenues (even though they comprise less than 2% of the original subscribers that were acquired). Some games are even more skewed toward the best customers. Some gaming firms suggest they a single player (out of 650) can drive 50% of aggregate revenues. As such, mobile game marketers aren’t really trying to get many installs. Rather, they are hunting for what the industry calls “whales”. These highly attractive customers keep the ‘free’ mobile gaming market viable.

Figure 123. Time to Recoup Upfront Marketing Cost in Mobile Games 300

Only 2 customers remains But, generates $11 per month 200

100

0 Total EBITDA CPI) less EBITDA Total ( Breakeven (100) CPI

(200) Acquire 100 subs @ $2.25 per install Cumulative Value Value Cumulative (300) 0 1 2 3 4 5 6 7 8 9 10 11 12 Months Since Acquisition Source: Citi Research

Mobile Gaming Revenues

How big is the mobile gaming market? With about 4.5 billion smartphones, we estimate about 40% (or 1.8 billion people) play mobile games. If the monetization rate per player is $2 per month (spanning both net ad revenue and in-game monetization), it suggests the mobile game business is worth about $45 billion a year.

Figure 124. Global Mobile Game Revenues

2010 2011 2012 2013 2014 2015 2016 2017 2018 Global population (mil) 6,558 7,043 7,128 7,213 7,298 7,383 7,467 7,550 7,633 x Smartphone adoption 8% 13% 17% 22% 32% 40% 47% 54% 59% = Installed base smartphone units (mil) 555 888 1,216 1,602 2,339 2,968 3,529 4,067 4,528 x Share play games 15% 20% 25% 30% 35% 37% 39% 40% 40% = Active mobile gamers (mil) 83 178 304 481 819 1,098 1,376 1,627 1,811 x Monthly ARPU 1.64 1.69 1.74 1.79 1.84 1.90 1.96 2.02 2.08 = Monthly revenue 136 300 528 861 1,510 2,086 2,693 3,279 3,760 x Months 12 12 12 12 12 12 12 12 12 = Mobile game revenue ($ mil) 1,637 3,597 6,342 10,327 18,118 25,033 32,315 39,342 45,116

memo: growth 80% 120% 76% 63% 75% 38% 29% 22% 15% Source: Citi Research

Industry Evolution So far, we reviewed the value chain for both the Console/PC market and the mobile market. If we pull the various segments together — mobile, console, PC, and handhelds — it suggests the industry has experienced fairly rapid growth over the past few years. Indeed, we estimate total spending on video games (excluding hardware sales) generates just over $100 billion in annual sales. Ten years ago, revenues were just half as much.

Figure 125. Click here to add title 120

100 eSports / Live Stream

80 Mobile

60 Handheld

40 PC Global Video Game Revenues ($bn) Revenues Game Video Global 20 Console

0 Arcade '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Citi Research

But, three crucial points are masked by these composite top-line figures.

 First, historically, the Internet-enhanced video game profitability.

 Second, the foundations are in place for a new business model for gaming that could impinge on the publisher’s profits.

 Third, new providers will likely bundle hardware and game access for a single monthly fee. This will be driven by three forces: (1) consumer’s desire to rent versus buy hardware and software; (2) the rise of cloud gaming; and (3) the growing popularity of free-to-play titles.

Let’s delve into each issue. Internet-enhanced Gaming Profits

The video game industry has been remarkably adept at using the Internet — in both fixed and mobile forms — to improve the attractiveness of the business. Video game companies accomplished this four ways:

 First, gaming firms leveraged high-speed Internet connections to sell consumers in-game content (often in addition to upfront outlays for the game itself).

 Second, publishers distributed full-versions of the games using the Internet as a means of distribution. So, instead of capturing ~$40 of wholesale revenue per game by selling the software to a retailer (like Amazon or Best Buy), the gaming firm would capture ~$60 of retail revenue per game by selling it over the web. Parenthetically, this pivot also reduced costs associated with: (1) the physical product including the disc, case, and artwork; (2) the warehousing and distribution of physical games; and (3) damaged and returned physical goods.

 Third, the Internet allowed publishers to sell subscription services to access the deep libraries of older gaming content.

 Fourth, many traditional console/PC gaming firms began to make mobile versions of their game available on Android and Apple smartphones. These mobile revenues were largely incremental.

Although we don’t have industry level data to assess how much each of these four pivots is worth, we used disclosures from Electronic Arts (EA) between 2010 and 2018 to get a rough idea. Over the last eight years, EA’s revenues have increased 2.8% per year (from $4.2 billion to $5.2 billion). And, in parallel, EBITDA improved 25% per year from $0.3 billion to $1.8 billion.

Figure 126. Electronic Arts: Use of Internet to Grow Business

CTG CAGR 2010 2011 2012 2013 2014 2015 2016 2017 2018 '10-'18 '10-'18 Packaged goods 3,589 2,995 2,959 2,130 2,228 2,089 2,023 1,908 1,642 -191% -9.3% + Live services 281 497 722 1,079 1,018 1,287 1,459 1,682 2,196 188% 29.3% + Mobile 215 242 284 363 452 525 570 628 659 43% 15.0% + Full-game downloads 74 94 221 221 323 418 514 724 683 60% 32.0% = Non-GAAP revenue 4,159 3,828 4,186 3,793 4,021 4,319 4,566 4,942 5,180 100% 2.8% x EBITDA margin 7.2% 10.8% 11.9% 12.8% 21.0% 27.8% 31.1% 34.1% 35.5% nm nm

= Adjusted EBITDA (Non-GAAP) 298 415 499 485 843 1,202 1,419 1,684 1,837 nm 25.5% Source: Electronic Arts. Citi Research

We explore five potential drivers of the EBITDA improvement:

 First, we estimate the largest contribution to the EBITDA improvement stemmed from the sale of in-game content (a subset of what EA calls ‘Live Services’). That innovation likely contributed about $1.3 billion to the firm’s EBITDA growth over the last eight years.

 Second, full game downloads (FGD) are likely the second biggest contributor to the firm’s improvement in EBITDA adding about $0.2 billion.

 Third, subscription services to older games — like EA’s Origin Access — contributed an additional $0.2 billion to EBITDA over the last eight years.

 Fourth, a smaller EBITDA lift likely came from mobile gaming. That’s because mobile gaming generally garners lower margins than the console or PC gaming market (and EA is a smaller player in mobile games).

 Finally, offsetting these benefits, increased costs (below cost of goods sold) for things like marketing, sales, G&A, and R&D likely pushed EBITDA about $0.15 billion lower over this timeframe.

Figure 127. EA Adjusted EBITDA

2100 211 218

203 1,837 1800 1,284 1500

1200

900 ($millions)

EA Adjusted Adjusted EBITDA EA 600

298 300

0 2008 In-game Full game Mobile Subs Other 2018

Source: Citi Research

So, the Internet has been a boon to video game publishers and there are several underlying drivers of the EBITDA improvement. But, in-game monetization is by far the most important driver. Foundation In Place for a New Model

What’s striking about these findings is this: most other media businesses have actually been damaged by the Internet. These include: ad agencies, phone directories, newspapers, magazines, radio stations, and cable networks. (And, there are some non-media victims as well, including traditional retail, travel agencies, and cab services.)

In effect, video game publishers are members of a fairly exclusive club: media businesses that haven’t been harmed by the Internet. This club includes only a handful of U.S. media companies: sports franchises (Formula One, WWE), concert promoters (Live Nation), and video game publishers (EA and Activision).

Figure 128. Effect of the Internet on Industries

Cable Networks

Radio Stations

Magazines Concerts Newspaper Sports Franchises Phone Books Video Games Cabs

Ad Agency

Travel Agency

Retail Internet

Source: Citi Research

So, what is the root cause of this dichotomy? And, why have video games, thus far, been immune? Is it because video games are ‘digital’? We don’t think that’s the underlying cause because both concert promotion and sports franchises are non- digital. Is it because video games are highly concentrated with a few dominant players? That’s also true for sports franchises and concert promoters. But, the video game industry is highly fragmented.

Something else, it seems, has kept video games immune to Internet threats. To get to the bottom of this mystery, we need to explore how web-centric rivals usually disrupt traditional businesses. There are typically five steps in the process:

 First, the Internet attackers wait until several enabling technologies are in place: fast Internet connections, ubiquitous wireless connectivity, and robust computing power.

 Second, the attacker builds a new ecosystem.

 Third, the attacker needs to demonstrate the superior value proposition of its new offer.

 Fourth, as more consumers become aware of the superior value proposition, consumer behavior begins to change.

 Fifth, the attacker begins to capture a larger share of the diminished profit pool. In tandem, the attackers build a competitive moat around the business.

Crucially, investors can be slow to realize the nature of the threat posed by Internet insurgents. But, once the realization crystalizes, value destruction can also be abrupt.

Figure 129. Disruption Pyramid

Netflix Lyft Capture Large Firm still FCF breakeven. Share of But, Street ascribes EV/sub Firm burns FCF Profits of $1000

Reduced viewing of TV Change Consumer Reduce taxi share & begins to cause pay TV Behavior create new demand penetration rates to fall

Offer Better Value Proposition Lower price point Lower price point Video available on demand Track vehicle No commercials

Build New Ecosystem Licensing content Get consumers to Vast server capacity install app Software installed on hardware Sign up drivers

Faster Internet Ubiquitous Faster Computing Firm shifted from DVDs by Firm needed mass Connections Connectivity Power mail to streaming video once adoption of these elements were in place smartphones

Source: Citi Research

Here’s one simple example: the impact ride sharing services had on taxi cabs medallion prices. (Recall, a taxi medallion is required to operate a yellow cab in Manhattan.) Fifteen years ago, a NYC taxi medallion cost about $275K. Medallion prices peaked in 2014 at about $1.3 million. Today, a NYC taxi medallion is worth less than $200K. There are two interesting facts about these trends.

 First, peak medallion price occurred six years after Uber was founded and two years after Lyft was founded.

 Second, ten years of medallion appreciation — from 2004 to 2014 — unwound in just four years. In effect, investors were slow to realize the impact, but then the quantum of value destruction occurred rather abruptly.

Figure 130. NYC Taxi Medallion Value

1,400 Lyft NYC Uber launch 1,200 founded Uber NYC launch 1,000

800 Individual

600

400 Lyft

founded NYC Taxi Medallion Value ($ 000) ($ Value Medallion Taxi NYC 200 Corporate

3Q04 1Q06 3Q14 1Q16 1Q05 3Q05 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 1Q15 3Q15 3Q16 1Q17 3Q17 1Q18 3Q18 1Q04 Source: Citi Research, AEI, Wikipedia

So, what about video games? The base of the disruption pyramid — including all the enabling technologies — is well established. Who doesn’t have access to a robust console, a fast PC, a fast Internet connection, or a 4G wireless smartphone?

But, nobody has built a new video game ecosystem. Steam has given independent game developers a way to distribute their games. But, Steam hasn’t radically disrupted the legacy video game publishers. AAA games and independent games co-exist. Amazon has levered ubiquitous connectivity and its acquisition of Twitch to create a new business model: a video game broadcaster. But, the business isn’t designed to disrupt the legacy players. Indeed, it could be argued that Twitch enhances the awareness of video games. In effect, no Internet-based rival has challenged the legacy video game business model.

Figure 131. Disruption Pyramid for Video Game Industry

Steam Amazon

Capture N/A N/A Large Share of Profits

Steam is growing, but Niche service for avid Change Consumer has not materially gamers. Doesn’t Behavior disrupted incumbents directly disrupt publishers

Offer Better Value Proposition Games often lower cost Novel business model

Get developers to upload Allow consumers to Build New Ecosystem game to platform watch others play games

Steam leverages robust Twitch leverages PCs, Faster Internet Ubiquitous Faster Computing PCs and fast Internet mobile devices and fast Connections Connectivity Power connections Internet connections

Source: Citi Research

So, it’s clear that the Internet often disrupts traditional media businesses. But, to date, video game publishers have not only survived, they’ve thrived with ubiquitous Internet connectivity. In parallel, it’s also clear that no web-based rival has built a competing ecosystem to challenge the incumbents. The key question, therefore, is this: is this about to change? We think the answer is ‘yes’. But, what will shape the attacker’s strategy?

What the New Model Might Look Like

We suspect the new business model will lease access to console/PC processing and a stable of games for a single monthly fee.

Figure 132. Cloud-Based Gaming and Video Game Ecosystem

Distant Past Past Present Future

Buy Hardware Hardware Hardware Rent Free Cloud + + + Gaming FTP Software FTP FTP FTP + + + In-game Spend

eSports New Mobile Monetization AdTech

Source: Citi Research

Why do we think this is likely? There are three reasons: (1) Young consumers prefer renting to owning; (2) Cloud gaming is poised to replace PC and console sales; and (3) The rise of free-to-play games will help facilitate the cloud transition since it will be frictionless for the cloud firm to offer processing and content for a single, bundled price. Let’s look at each of these items a bit more closely.

Young Consumers Prefer Renting

First, in the distant past hardware was purchased discretely; software was purchased discretely. But, consumers — particularly younger consumers — like the idea of monthly recurring expenses without the burden of ownership. Uber (transport), Spotify (music), and Netflix (video) are all good examples of the rental model. We don’t think video games should be any different. As such, we expect the cloud-based firms to bundle hardware access and software access into a single monthly fee.

Cloud will Replace PC and Console Sales

For 60 years, a single variable has shaped the video game industry: the cost and processing power of computers.

 In the beginning, processing was expensive. Heavy upfront costs forced consumers to the arcade to enjoy the game at $0.25 per play. As such, both hardware and software were rented.

 Next, as processing power improved — and processing costs declined — consumers were able to buy their ‘personal arcade’ for in-home use. The console and game cartridge market was born.

 Finally, as processing power improves further, we expect consumers to migrate to cloud gaming. In effect, consumers will again rent access to hardware and software, just like the old arcade days. The only difference: rental access will occur in the comfort of your home.

So, improved computing processing power pushed gaming out of the arcade and into the living room. Faster broadband speeds gave rapid access to software downloads. And, in the final phase, improved processing power and bandwidth will allow the rental model — for both software and hardware — to flourish once again.

Figure 133. The Shift From Renting to Owning to Renting

Cheaper Processing Power

Software

Rent Delay

Hardware

More Processing Power Processing More Buy

Hardware Arcade Console Cloud Software Arcade Disc, Download Stream

Source: Citi Research

In effect, if you take a long-term perspective, the notion of purchasing a specific piece of hardware — like an Xbox or Nintendo — to perform a specific task like video gaming will likely be viewed as an aberration, not dissimilar to phone answering machines (to record messages), cameras (to take pictures), and VCRs or DVRs (to record TV shows).

If we get a bit more granular with our high-level description, we can see this broad pattern from a rental market, to an owned model, back to a rental model. And while the rental model started with software (old games), it will eventually move to hardware and may ultimately include newly released video games.

Figure 134. Video Game Ecosystem and Shift from Buy to Rent

Physical Digital Cloud Gaming

Console/ PC / Console/ PC / Console/ PC / Rig Gaming on Arcade Handheld Mac Handheld Mac Handheld Mac Rental Demand Rent

Digital Buy N A

Software Rent

Physical Buy

Rent Physical Hardware Buy

Software Tencent, Sony, Microsoft, Nintendo, Activision, EA, Bandai Namco, Independents Publisher Bandai Sony Dell Sony Dell Sony Dell Capcom Shadow Hardware Nintendo Lenovo Nintendo Lenovo Nintendo Lenovo GeForce Microsoft xCloud Design Microsoft Apple Microsoft Apple Microsoft Apple Google Project Stream Wal-Mart Wal-Mart PlayStation Now Software Dave & Amazon Busters Amazon Amazon EA (Origin) Access Distribution GameStop Steam Xbox Game Pass

Source: Citi Research

Indeed, over the past year, there’s been quite a bit of movement on the cloud gaming front from big, well established cloud providers:

Microsoft: In 2018, Microsoft announced Project xCloud. The service is designed to allow gamers to stream high-quality console and PC games to any screen. While Microsoft already has a cloud based service called Game Pass, with xCloud Microsoft hopes to expand the availability of the service to many additional devices, including mobile devices with the Android operating system. (Recall, Microsoft no longer has a mobile phone platform of its own.)

Google: In 2019, Google announced its new cloud gaming service called Stadia (formally known as Project Stream). Google has called its service “the future of gaming”. With Stadia, Google hopes to allow users to play any game on any device without a console or PC. And, Stadia will embrace cross-platform play. That means software developers can create games that allow owners of various forms of hardware — PlayStation, Xbox, Switch, PC, Mac, or mobile — to play together. Moreover, it promised to deliver games in 1080p at 40fps. With Stadia, Google hopes to bring together a number of discrete assets:

1. Users will need a Chromecast dongle to access video content on TV. The dongle plugs into the HDMI port on the TV and can be used to access a wide array of other apps on the TV (Netflix, YouTube, Hulu, or the Google Play Store).

2. Stadia will leverage the Android OS. By leveraging Android, gamers will also be able to play games on Android mobile devices.

3. Stadia will also incorporate YouTube.

4. Google will perform game processing using Google’s data centers.

5. Stadia launched with a game controller. The controller communicates using WiFi with the router. This allows a gamer to seamlessly transition from one screen — like a TV — to another — like a smartphone — seamlessly.

Unfortunately, to date, Google hasn’t disclosed Stadia’s retail price point. Nor has Google disclosed the business model. At launch, Google will have access to some games from Ubisoft and a game from id Software: Doom Eternal. (Prior id Software titles include Wolfenstein, Doom, Quake and Rage.)

Amazon: The Information reports that Amazon may enter the cloud gaming market as soon as 2020. And, The Verge reported four job listings at Amazon for ‘cloud gamers’.

New Model App to Embrace Free-to-Play

So, a cloud-based rental model seems poised to launch relatively soon. When Google, Amazon, and Microsoft do enter the market, we expect each of them to leverage free-to-play titles. Recall, earlier we showed that ~90% of mobile games are free-to-play (FTP). But, fewer PC and console games are free, although they do exist.

We used a list from Digital Trends that reviewed 35 high-quality FTP titles that span all popular genres: action, battle royale, role play, and shooter. Virtually all of these games are available on PCs, with about 50% available on Xbox or PlayStation platforms. We cross-checked these games with Metacritic to ensure (most) of the games were high quality (with a score of 70 or above).

Figure 135. Availability of Free-to-Play Games

Metacritic Platform No. Title Publisher Score Genre PC Xbox One PS4 Switch Mobile Comments 1 Warframe Digital Extremes 71 Action Yes Yes Yes Yes Like Mass Effect of Halo 2 World of Tanks Wargaming 83 Action Yes Yes Yes Yes WWII game 3 World of Warships Wargaming 81 Action Yes WWII game 4 War Thunder Gaigin 81 Action Yes Yes Yes WWII game 5 Let it Die Gung Ho 72 Action Yes Yes Hack and slash video game 6 PUBG - Mobile Bluehole 82 Battle Royale Yes Yes Yes Yes Yes Realistic Battle Royale game 7 Fortnite Epic 78 Battle Royale Yes Yes Yes Yes Yes Like PUBG with cartoon overlay 8 H1Z1 Daybreak 70 Battle Royale Yes TBA Yes In b/w PUBG and Fortnite for realism 9 Apex Legends Electronic Arts 88 Battle Royale Yes Yes Yes Viewed as potential rival to Fortnite 10 Darwin Project Scavenger na Battle Royale Yes Yes Dystopian landscape 11 Hearthstone Activision 88 Card Game (CCG) Yes Yes Builds on Warcraft series 12 Gwent CD Projekt 80 Card Game (CCG) Yes Yes Yes From Witcher 3: Wild Hunt 13 Elder Scrolls: Legends Bethesda 80 Card Game (CCG) Yes Yes Yes Yes Yes Richly detailed open worlds 14 Killer Instinct Microsoft na Fighting Yes Yes Like Street Fighter, Mortal Kombat 15 Brawlhalla Blue Mammoth na Fighting Yes TBA Yes Like Super Smash Bros 16 League of Legends Riot Games 78 MOBA Yes Inspired by Warcraft III 17 Dota 2 Valve 90 MOBA Yes Popular eSports game (The International) 18 Heroes of the Storm Activision 86 MOBA Yes Yes Yes Activision pulling back on investment 19 Smite Hi-Rez 83 MOBA Yes Yes Yes Yes Successful eSports franchise 20 Eve Online Simon & Schuster 69 Role Play Yes Difficult to get into; dedicated fans 21 Star Wars: Old Republic Electronic Arts 85 Role Play Yes Started as subscription based game 22 Neverwinter Perfect World 74 Role Play Yes Yes Yes Like Diablo and Dungeons & Dragons 23 Path of Exile Grinding Gear na Role Play Yes Yes Like Diablo 24 DC Universe Online Daybreak 84 Role Play Yes Yes Yes Top free-to-play on PS3/PS4 25 Guild Wars 2 NCSoft 90 Role Play Yes Started as subscription based game 26 Pokémon Go Niantic 69 Role Play Yes AR video game 27 MapleStory 2 Nexon na Role Play Yes No game goal; improve character status 28 Trails Frontier Ubisoft na Sports Yes Yes Yes Yes Yes Egregious microtransactions (fuel) 29 Rec Room Against Gravity na Sports Yes Yes VR game 30 Kingdom Rush Armor Games 89 Strategy Yes Yes Tower defense game 31 Starcraft II: Wings of Liberty Activision 93 Strategy Yes Science fiction; free to play in 2017 32 Total War: Arena Wargaming 75 Strategy Yes Ceased live operation in Feb 2019 33 Team Fortress 2 Valve 92 Shooter Yes Yes Yes Went free-to-play in 2011 34 Paladins: Champions Hi-Rez 83 Shooter Yes Yes Yes Yes Like Overwatch

35 Planetside 2 Sony 84 Shooter Yes Yes Massively Multiplayer Online FPS Source: Digital Trends; Metacritic, Citi Research

But, are these games popular? We went to Twtichmetrics.net for clues. It turns out that 50% of the 12 most popular games on Twitch are free-to-play games. On average these top 12 games have 2,200 gamers uploading their play and 66K people watching. At peak, 250K people watched these popular games being played by others. Crucially, the FTP games over-indexed on all metrics:

 Nearly 3,400 gamers were uploading FTP games — or channels — versus just 1,100 non-free games. That’s a 3:1 advantage for free games.

 Nearly 80K viewers were watching FTP games versus just 53K for non-free games. That’s nearly a 2:1 advantage for free games.

 At peak, nearly 300K viewers were watching these FTP games versus 200K for non-free games. That’s a 1.5:1 advantage for free games

Figure 136. Popularity on Twitch of Free-to-Play Games

Twitch: Last 30 days Platform Peak Avg Channels No. Title Publisher Free-to-Play Genre PC Xbox One PS4 Switch Mobile (000s) (000s) (000s) 1 League of Legends Riot Games Yes MOBA Yes 348 143 2.6 2 Fortnite Epic Yes Battle Royale Yes Yes Yes Yes Yes 384 132 10.9 3 Grand Theft Auto V Rockstar No Action Yes TBA Yes 300 91 0.7 4 Just Chatting nm No nm nm nm nm nm nm 192 77 1.2 5 Apex Legends Electronic Arts Yes Battle Royale Yes Yes Yes 305 75 4.8 6 Sekiro: Shadows Die Twice Activision No Action Yes Yes Yes 279 69 1.3 7 Dota 2 Valve Yes MOBA Yes 356 66 0.7 8 Counter-Strike: Global Offensive Valve Yes Shooter Yes Yes Yes 291 39 1.2 9 Overwatch Activision No Shooter Yes Yes Yes 248 31 1.1 10 Player Unknown's Battleground PUBG No Battle Royale Yes Yes Yes 110 28 1.1 11 Hearthstone Activision Yes Card Game Yes Yes 108 20 0.2 12 World of Warcraft Activision No Role Play Yes 79 19 1.0 Average 250 66 2.2 memo: avg free-to-play 299 79 3.4

memo: avg not free 201 53 1.1 Source: Twitchmetrics, Citi Research

We cross checked the Twitchmetrics data by looking at another source: NewZoo. NewZoo publishes total viewing time for the top 10 games on Twitch and YouTube each month. And, total broadcaster viewing of the top 10 games is growing about 20% per year.

Figure 137. Total Viewing Hours, Top 10 Games by Broadcaster Figure 138. Total Viewing Hours, Top 10 Games

700 600 Not Free

Total ) 10 10 600 mn 500 Twitch

Top Top 400

500 ( ’19

– ) 300

mn 400

Hours 200

300 Games10 Top

100

Games ( Games Total Viewing Hours Hours Viewing Total

200 Mar to ’18Jan YouTube 0

100

Total

Total Viewing Total

Other

Dota2

PUBG

Strike Fortnite

0 Counter

Legends League of League Jan Mar May Jul Sep Nov Jan Mar Overwatch Hearthstone Source: New Zoo, Citi Research Source: New Zoo, Citi Research

If we look at the average viewing hours — between January, 2018 and March, 2019 — it suggests that five of the top seven games are free: Fortnite, League of Legends, Dota 2, Counter-Strike and Hearthstone. PlayerUnknown’s Battleground (PUBG) and Overwatch are the only two titles that are both popular and paid games.

Here’s a little color on the free broadcast titles:

 Fortnite: The game launched in 2017 as a free-to-play game. Fortnite players purchase the in-game currency call “V-Bucks” (with $1 equal to 100 V-Bucks).

 League of Legends: The game launched in 2009 as a free-to-play game. Players can purchase in-game currency (called Riot Points) or earn another type of currency (called Blue Essence) by playing the game and leveling up.

 Hearthstone: The game was released in 2014. It is a free digital card game developed and published by Activision’s Blizzard Entertainment.

 Apex Legends: Apex Legends was released in 2019 by EA as a free-to-play game. Respawn Entertainment created both Titanfall (2014) and Titanfall 2 (2016) as an independent studio. In 2017, Electronic Arts acquired Respawn. As Respawn looked at the evolution of the gaming community — particularly the popularity of PlayerUnknown’s Battleground, Respawn elected to not developer Titanfall 3. Rather they pivoted their development efforts to Apex Legends, a free game.

And, for the handful of titles that still charge a fee for the game, there seems to be downward pressure on selling prices:

 Player Unknown’s Battlegrounds: PUBG is an online multiplayer battle royale game developed by South Korean video game company Bluehole. The game was released in 2017. The game originally cost $30. But, in 2018 the firm lowered the price. The game now costs just $20 on Steam. Some believe the discount is designed to respond to the success of Fortnite. In Thailand, PUBG recently began offering a separate free title called PUBG Lite.

 Dota 2: This game was released in July, 2013 by Valve. While the game originally had some restrictions that prevented everyone from playing for free, by December of 2013 Valve opened up the game to everyone for free. It is often the most popular game on Valve’s site Steam.

 Counter-Strike: Global Offensive: Counter-Strike was first released about 20 years ago (in 2000). The game migrated to free-to-play in June 2018.

 Overwatch: Overwatch was released in 2016. Over the last two years, Overwatch’s retail price has dropped from $60 to $40. In January, 2019, EA dropped the price again to $20. Many expect it will soon be available for free.

How do the trends look for free-to-play games versus paid games? About 15 months ago, free-to-play games were generating about as many viewing hours as paid games. But, today, there are more than two minutes of broadcast consumption on free games versus paid games.

Figure 139. Top Viewing Hours, Top 10 Game by Cost 700 Total 600 Free-to 500 -Play

400

300 Top 10Games(mn) Top Total Viewing Hours Viewing Total 200 Paid

100

0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar 2018 2019

Source: Citi Research

There are five main drivers behind this rapid shift in consumption from paid to free games:

 First, Fortnite’s consumption has doubled from about 60 million hours in January, 2018 to about 120 million hours of consumption in March, 2019.

 Second, Apex Legends didn’t exist in January, 2018. But, by March of 2019, it was generating about 60 million hours of consumption (about half the level of Fortnite).

 Third, League of Legends — a popular eSports title — has remained relatively steady at 100 million hours of consumption over the last 15 months.

 Fourth, Player Unknown’s Battlegrounds — a paid title — has seen consumption on Twitch and YouTube fall from 65 million hours to about 30 million hours.

 Fifth, Counter-Strike: Global Offensive was a paid title until June, 2018. At that date, the game converted to a free-to-play title. We suspect the shift in monetization was driven by the steep decline in consumption in early 2018. Pricing of Cloud Gaming Services

So far, we’ve suggested nobody has launched a new gaming business model that could hurt publishers. But, we also suggested that consumer’s preference for renting, the rise of cloud computing, and the growing popularity of free-to-play all strongly suggest that new cloud based firms — Microsoft, Google, Amazon — will likely launch the ‘Netflix of gaming’. That is, a single monthly subscription for both hardware access and software access.

How will the services be priced? If the price is too high, adoption will be limited and disruption to existing publishers will be limited. On the other hand, if the price is very low, it could be quite disruptive to the existing ecosystem. So, how can we think about the potential pricing for these new services?

Figure 140. Pricing of Cloud Gaming

1 Consumer Does the consumer derive utility at the offered price?

5 2 “Shadow” Revenue Cloud Cost Does the cloud provider cross Pricing of What does it cost to offer subsidize with shadow revenues cloud gaming services? (Broadcaster, mobile AdTech)? Cloud Gaming

4 3 Business Model Console Cost Does the cloud provider If the cloud provider sells bundle software access? consoles, will pricing be Are these free-to-play influenced by cannibalization games? risk?

Source: Citi Research

We suspect five factors will determine cloud gaming retail prices: (1) The consumer must find utility at the retail price point; (2) The cloud provider will need to earn a return based on the cost of providing cloud processing; (3) Cloud providers that currently sell consoles — like Microsoft — may incorporate cannibalization risks into their pricing calculus; (4) The business model used by the cloud provider will almost certainly impact pricing; and (5) Some cloud providers may subsidize pricing based on ‘shadow’ gaming revenues like Broadcasters (Google, Amazon) and mobile AdTech (Google, Apple). Let’s take a closer look at each.

Consumer

A recently released game console — like the Xbox One or the PlayStation 4 — costs around $350. Since cloud gaming still requires a thin client — a small device that does minimal processing that’s connected to a TV — it suggests the consumer would save about $300 in upfront capital costs (assuming the thin client costs $50). Depending on the console’s replacement rate — which we assume varies from 3 to 8 years – the breakeven monthly costs for cloud gaming is probably $3-8 per month.

Figure 141. Cost to Consumer of Cloud Gaming

Fast Slow Replacement Replacement High-end console price 350 350 350 350 350 350 - Thin client 50 50 50 50 50 50 = High-end processing hardware cost 300 300 300 300 300 300 / Replacement rate 3.0 4.0 5.0 6.0 7.0 8.0 = Annual replacement cost 100 75 60 50 43 38 / Months per year 12 12 12 12 12 12 = ARPU 8 6 5 4 4 3

Source: Citi Research

Cloud Cost

But, is there anything we can use to test these hypothetical cloud price points? There are around 10 cloud gaming services available today (excluding those in beta testing). On average, these services cost about $18 per month, $2.25 per day, or $1 per hour of game play. As such, these start-up price points suggest that consumers will likely be spending more on cloud gaming than they do on console hardware. The average gamer might spend $160 per year ($18 for cloud gaming less $5 for console costs per month = $13 incremental fees x 12 months a year). But, the larger cloud firms – like Google, Microsoft and Amazon – could probably see some cost benefits from scale. As such, we view these prices as the high-end of what the scaled players will likely charge.

Figure 142. Likely Cost of Cloud Gaming

Firm $ per $ per $ per Windows Chrome macOS Android iOS Linux Xbox One month day hour Shadow Y Y Y 29.95 LOUDPLAY Y Y Y Y 0.26 PLAYCLOUD Y Y Y Y 2.25 Vortex Y Y Y Y 9.99 GeForce Now Y Y N/A N/A N/A Project Stream (Google) Y N/A N/A N/A Project xCloud (Microsoft) Y Y Y N/A N/A N/A Blacknut Y Y Y Y Y 16.90 Gaming: Solved Y Y 1.49 GLOUD Y Y 7.69 PixelStellar Y 1.30 WADE Y Y 13.00 PlayKey Y Y 32.37 Average 18.32 2.25 1.02

Source: Company websites, Citi Research

Console Cost

If a cloud provider wants to protect legacy console revenues, we suspect they will perform analysis that’s similar to the consumer analysis (from above). That is, if the retail price point for a console is $350 and the retail mark-up $50, then the console manufacturer would probably need to charge about ~$5 per month for a cloud gaming service to not erode the firm’s top-line (assuming a firm’s cloud market share is equivalent to their console share).

Business Model

Some cloud providers may only sell access to a hardware platform. Others may bundle game access as well. As such, the cloud providers could open a digital storefront. Or, they could acquire a digital store (like Steam, Discord, or Epic). This would allow the firm to generate revenues from any game sale (including a portion of any in-game content).

Since Valve is a private company, our estimates of Steam’s historical revenues should be taken with a grain of salt. But, to give readers a rough idea, we think Steam generates about $1-2 per month from every monthly active user. As such, if a cloud gaming firm also operates a digital store (and charges a 25% distribution fee, similar to Steam) they could lower the cost of cloud gaming by $1-2 a month.

Figure 143. Steam: Estimated Revenue

2015 2016 2017 2018 Comments Total users 178 228 291 321 Monthly users 50 64 82 90 Wiki suggests 90 million in 2018 Daily users 26 33 43 47

Monthly users 50 64 82 90 x Upfront game spend per month 5.18 4.56 4.39 4.25 = Monthly spend 258 292 358 383 x Months 12 12 12 12 = Annual revenue 3,100 3,500 4,300 4,590 SteamSpy suggests $4.3 billion in 2017 x Steam share 30% 30% 30% 25% Lower fee due to UE4 rivalry = Steam revenue 930 1,050 1,290 1,148

Monthly users 50 64 82 90 x In-game spend per month (30%) 1.55 1.37 1.32 1.28 Assume 30% of upfront spend = Monthly spend 78 88 108 115 x Months 12 12 12 12 = Annual revenue 930 1,050 1,290 1,377 x Steam share 30% 30% 30% 30% = Steam revenue 279 315 387 413

Total Steam revenue 1,209 1,365 1,677 1,561 Excludes hardware, merchandise / Monthly users 50 64 82 90 = Revenue per user per year 24.23 21.35 20.55 17.34 / Months 12 12 12 12 = Monthly Steam revenue per user .02 1.78 1.71 1.45

Source: Wikipedia; StreamSpy, Citi Research

Shadow Revenue

The last area worth exploring is ‘shadow’ gaming revenues. We call these ‘shadow’ revenues because they aren’t in the purview of traditional game publishers. But, these revenues do exist. And, large shadow revenues mean the cloud gaming firms can monetize their new services in indirect ways.

Shadow revenues include two things: (1) payments made to the AdTech ecosystem in the mobile gaming world and (2) eSports and live streaming revenues from players like Twitch. Earlier, we showed that traditional gaming revenue (mostly software) just topped $100 billion in revenues in 2018. Shadow revenue is worth about $8 billion with an additional $33 billion in gaming hardware sales.

Figure 144. Total Gaming Revenue

120

Traditional 100 gaming revenue

40 AdTech

eSports Total Gaming Revenue Revenue ($bn) Gaming Total 20 Hardware (PC, console, handheld)

0 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: Citi Research

If we allocate 70% of eSports Broadcast revenues to Amazon (Twitch) and 30% to Google (YouTube) plus 20% of mobile AdTech to Apple and 80% to Google, it suggests $6.1 billion of shadow revenue collected by Google and $1.1 billion by Amazon. These figures are not immaterial within the context of total hardware revenues for gaming. This suggests there is some scope for cross-subsidization among cloud providers.

Figure 145. Cloud Gaming Shadow Revenue

2011 2012 2013 2014 2015 2016 2017 2018 Amazon (70% Broadcaster) - 0.2 0.2 0.3 0.4 0.6 0.8 1.1 + Apple (20% AdTech) 0.1 0.2 0.3 0.6 0.8 1.0 1.2 1.4 + Google (30% Broadcast, 80% AdTech) 0.4 0.8 1.4 2.4 3.3 4.2 5.2 6.1 = AdTech and Broadcasters 0.6 1.2 1.9 3.3 4.4 5.8 7.2 8.5 + Hardware 32.9 28.9 25.5 26.3 26.0 27.3 33.2 32.6

= Shadow revenue 33.4 30.1 27.4 29.6 30.4 33.1 40.5 41.1 Source: Citi Research

Summing Up

Let’s put these various pieces together. If we start with the cloud pricing of the start- up firms of $18 a month, remove $0 to $6 per month for scale benefits from larger cloud providers (like Google, Amazon and Microsoft), remove $0 to $2 for revenues from a digital store and remove $0 to $1 for shadow revenues (like broadcasters or AdTech) it suggests a new, vertically-integrated scale player with ancillary assets could charge as little as $9 per month. That’s akin to a three-year life for a console or PC. As such, we would not be surprised if these new services launch with a monthly price point of $9.99. Of note, we have not given any benefit from game titles that could also be owned by the cloud provider. Recall, Amazon purchased video game developer Double Helix in 2014. And, Microsoft is a large game publisher (Xbox Game Studios).

Figure 146. Retail Monthly Price of Cloud Gaming

Low High Avg cloud cost from private firms 18 18 18 18 - Scale of larger cloud firms 6 4 2 0 - Revenue from digital store (e.g. Steam) 2 2 2 0 - Shadow revenue 1 1 1 0 - Software ownership 0 0 0 0 = Retail monthly price of cloud gaming 9 11 13 18 x Months 12 12 12 12 = Annual cloud pricing 108 132 156 216 / Implied PC or console useful life 2.9 2.3 1.9 1.4 = Console cost (less thin client) 300 300 300 300

Source: Citi Research

So, if we’re right, cloud gaming will adopt the mobile model for upfront purchases: the up-front payments will go away for both hardware and software. And, the in- game monetization — including ads, game monetization and eSports — will mirror the console/PC market. That’s because the game’s functionality on the mobile screen will be the same as the console/PC screen.

Figure 147. Where Cloud Plays in Global Gaming Ecosystem

Legacy New

PC Console Mobile Cloud Comments

Hardware Cloud will not require expensive Purchase hardware

Upfront Cloud providers likely to offer free-to- Software play games (Fortnite, Apex Legends) Purchase

Likely that cloud will adopt PC / Ads console ad loads (i.e. less than mobile)

Games will mirror PC / console game In-game Game play. As such, in-game monetization Monetization will be similar

Cloud will expand eSports opportunity since PC/console games can be eSports played on mobile devices

Source: Citi Research

If we look at legacy gaming revenue — for hardware, software, in-game ads, and in- game monetization — the three large cloud providers aren’t particularly exposed. Microsoft, with its legacy Xbox revenue, is the exception.

And, if we look at emerging cloud gaming revenue — for leased cloud hardware, the AdTech ecosystem (in mobile) and eSports broadcasters — the three large cloud providers are heavily exposed. Google, in particular, seems particularly well suited to benefit given the nearly ubiquitous nature of Android’s operating system and YouTube (as a game broadcaster).

Amazon is also well positioned with Twitch. Microsoft isn’t as well positioned to monetize future revenue streams (with the exception of direct cloud leasing revenues).

Figure 148. Where Large Cloud Providers Play in Global Gaming Ecosystem

Large Cloud Providers

Amazon Microsoft Google EA Apple Comments

Hardware Only Microsoft will be incented to protect legacy HW revenue (Xbox)

Software Only EA has material legacy software revenue to protect

Legacy Most cloud providers don’t generate In game ads material in-game ad revenue

Game EA has material in-game monetization monetization revenue to protect

Cloud Amazon, Microsoft and Google are the hardware large cloud providers

Due to Android and iOS, Google and Ad Tech Apple apt to benefit from mobile ad (Mobile) growth

Emerging Amazon (Twitch) and Google (YouTube) Broadcaster will be able to monetize gaming via broadcasting assets

Source: Citi Research

If we summarized the dynamics we’ve reviewed so far, we would divide the key developments into five waves. Items toward the top of the page have already occurred. Items toward the bottom of the page are still apt to unfold. The five waves include:

 The first wave was enabled by pervasive broadband Internet access. This prompted four second-wave developments.

 In the second wave, we’ll see (or have seen) enhanced video game profits, higher levels of group play, the rise of eSports, and the enablement of cloud gaming.

 In the third wave, we’ll likely see game complexity rise, lower barriers to entry for consumers, the console/PC and mobile market converge, and the rise of new gaming entrants with cloud infrastructure (like Google and Amazon).

 In the fourth wave, we’ll see game updates and refresh rates accelerate (like Fortnite), low-end games — particularly casual games — struggle, and new business models (from cloud providers) evolve.

 In the fifth wave, we’ll likely see far fewer games supported by the video game publishers and a rapid rise in free-to-play. The new business model — from the cloud gaming firms — is apt to be supported by cloud lease payments, in-game monetization, and the mobile AdTech ecosystem (for Google and Apple).

Figure 149. Five Cloud Waves

1st Wave 2nd Wave 3rd Wave 4th Wave

In-Game Monetization Internet Connectivity

Encourages Games Refresh Group Complexity Rate Play Rises Accelerates

Enables eSports

Enables Lowers Cloud Barriers for Fewer Gaming Consumers Games Supported

Mobile & Low-end PC/Console Games Converge Struggle More Free- to-Play

Allows New Adopt New Corporate Business Entrants Models

3rd Wave 4th Wave 5th Wave

Source: Citi Research

Regulations

As the industry evolves, one area worth keeping an eye on is regulation. A number of countries — including China, Japan, and South Korea — have imposed some form of regulation on the video game industry. Lawmakers in Europe and the U.S. are also raising concerns. The general fear is that video gaming can be addictive and may be particularly harmful to children.

Indeed, the World Health Organization (WHO) recently named video game addiction an official disease. All 194 members of the WHO voted unanimously to add this addiction to their list. The classification goes into effect on January 1, 2022.

Prudent Strategic Responses So far, we’ve reviewed the value chain for the console/PC and mobile markets. And, we’ve suggested cloud-based providers will likely offer a relatively low-priced service that gives consumers access to both processing and many free-to-play games.

In this section, we want to address two questions. First, what M&A, if any, is likely to occur as cloud gaming moves to the forefront? Second, what steps, if any, should incumbent game publishers take to thrive in this emerging world of video games? Potential M&A

We’ve mapped each of the major player’s assets in 10 different categories (from IP at the top down to eSports at the bottom). What’s clear from this graphic is the video game space is fairly complex. No single firm has assets that span the entire value chain. As such, we could see three types of M&A:

 First, we suspect that the emerging cloud gaming firms — including Amazon, Google, and Microsoft — might be keen to acquire firms that distribute video games over the web today.

 Second, we could also see consolidation among the various video game publishers. This would put more game titles in a single firm and (perhaps) allow these firms to launch their own cloud gaming platform.

 Third, we don’t think large publishers should acquire standalone mobile games firms. As cloud computing gains share, lower-end mobile games will likely diminish in importance.

Figure 150. Major Game Player Assets by Category

Valve Activision EA Epic Ubisoft Nintendo Sony Microsoft Google Amazon Tencent Unity

League Intellectual Call of Assassin’s Gran Dota 2 Anthem Fortnite Pokémon Halo of Duty Creed Turismo Property Legends

Unreal Lumber- Game Engine Unity yard Engine (UE)

Game Microsoft Double Riot Valve Treyarch Respawn Epic Red Storm NDcube Sony Developer Studio Helix Games

Game Activision Electronic 343 Amazon Riot Valve Epic Ubisoft Nintendo Sony Publisher Blizzard Arts Industries Games Games

Graphics OpenGL DirectX GameOn APIs

Hardware Play- Switch Xbox Manufacturer Station

Play- Origin Epic Game Google Steam Uplay Station Amazon WeGame Distributer Access Games Pass Store Now

Stadia / Start / Project Stream / Beta Instant Cloud xCloud Yeti Play

Huya Broadcaster Steam Mixer YouTube Twitch Douya (stakes)

Major eSports League Gaming Source: Citi Research

How Publishers Should Respond

Beyond M&A, how should incumbent video game developers and publishers respond to these potential changes? We would suggest a handful of steps:

 First, incumbent publishers should segment their existing games into titles based on very strong IP, sports-centric titles, popular eSports titles, and ‘Other’. The ‘Other’ titles should be deemphasized over time.

 Second, publishers should redirect developer resources to keep existing popular titles fresh. This will encourage current players to stay engaged. It will also help in-game monetization.

 Third, for non-sports titles, publishers should begin to gradually lower the retail prices of the games to make the migration to free-to-play less disruptive.

 Fourth, publishers should embrace eSports and the live streaming business. Any popular game that doesn’t have an eSports or live streaming following, should cultivate one.

 Fifth, video game publishers should ensure all popular titles have a mobile version. This will ensure a seamless transition for popular titles as cloud gaming gains share.

#1 - Segment Existing Titles

We showed earlier that sports-based franchises play a niche role in the broader gaming ecosystem. But, we suspect this segment of the gaming population will remain relatively immune to many of these secular changes. Titles with a heavy eSports following, immersive AAA games — particularly if they are free-to-play — should also perform well. We also suspect immersive AAA games with high production value (and commensurately high production budgets) — games like Red Dead Redemption, Grand Theft Auto or the forthcoming Cyberpunk 2077 — will also continue to play a role. Finally titles with heavy a heavy eSports following — particularly if they are free-to-play — should also perform well. But, titles that don’t have a live streaming or eSports following or don’t mimic a real sport or don’t have high-quality IP should probably be de-emphasized.

#2 - More Frequent Software Updates

As developers focus on fewer games that span both the cloud and mobile environments, we expect more resources to be spent refreshing game titles. That is, the rate of software updates is apt to increase. Indeed, since the launch of Fortnite in 2017, the Epic Games development team has been updating the software at a breakneck pace. A new update to the software occurs (almost) every week. While the pace of update was a little more rapid in 3Q17 (when the game was new and had bugs), since then the cadence has been relatively consistent. By the first quarter of 2019, Fortnite players have benefitted from nearly 100 updates. Updates don’t just fix bugs, they add features: like new weapons and new maps. This helps keep in-game monetization at robust levels.

Figure 151. Number of Fortnite Updates

100 90

80 2019 ) 70 60 50 2018 40

Updates (number Updates 30 20 2017

10 Fortnite

1-Apr 7-Oct

7-Jan 3-Jun

9-Dec

5-Aug

15-Jul

22-Apr 28-Oct

28-Jan 24-Jun

11-Mar

18-Feb

18-Nov 26-Aug 16-Sep 30-Dec 13-May

Date of Update Source: IGN. Citi Research

#3 - Lower Retail Prices of Non-sports Titles

We showed earlier that many titles are gradually lowering up-front prices for the game as in-game monetization becomes more prevalent. We think this is a prudent step and would encourage publishers to gradually migrate to a free-to-play portfolio. This will make the inevitable transition to free-to-play less disruptive.

#4 – Embrace eSports and Live Streaming

Viewing hours on broadcasters like Twitch are growing rapidly. But, some games — like Fortnite and League of Legends — have a more robust following. Game developers should focus on games that lend themselves to third-party viewing. We think it’s less important, however, to focus on the mix of consumption that is true eSports versus live streaming. Either mode of consumption is attractive.

Figure 152. Average Viewing Hours – eSports and Live Streaming

60%

Rocket League 50% Counter-Strike

StarCraft II Dota2 40%

Overwatch 30% League of Legends

20% Hearthstone FIFA

Share of Hours from eSports (%) Hours eSports from of Share 10% Call of Duty

World of PUBG Fortnite 0% Warcraft 0 50 100 150 Average Viewing Hours – Jan ’18 to Mar ’19 (mn) Source: Twitchmetrics, Citi Research

#5 - Add Mobile Game Functionality

The largest cloud providers — Microsoft, Google, and Amazon — are all gearing up for cloud gaming. The most important implication of this shift is this: every screen will be able to play PC or console quality game. As such, the processing power of the mobile device will no longer restrict the quality of the game. It also means the potential market for video games will likely expand (since there are far more mobile devices than PCs or consoles).

In the current world of gaming, smartphones are typically less powerful than off-the- shelf PCs. And, gaming consoles like the Xbox are typically less powerful than gaming rigs. This disparity is processing does two things: (1) it influences the types of games that are created by developers and (2) it segments the market, allowing a gamer to spend more (on high-end gaming rigs) if they are avid fans.

Once the cloud is used for gaming, the performance of any TV, smartphone, or off- the-shelf PC will be similar. We suspect that consoles and gaming rigs will still offer superior performance. But, by elevating the performance of low-end devices, game developers will no longer need to limit the quality of mobile games. Standalone, low-end mobile games will likely be far less prominent in the marketplace.

Figure 153. Screen Capability With Cloud Gaming Screen Capability Before and After Cloud Gaming

Current Off-the- Gaming Shelf Rig Cloud PC

Nintendo Xbox PlayStation

Android iOS

TV TV

Cloud

Processing Power

Source: Citi Research

If true, then it suggests that existing publishers should be extending existing console/PC games to mobile devices. Today, this effort will just cement in the eyes of consumers that their favorite titles are indeed mobile games. But, when cloud gaming becomes more popular, the mobile functionality of the game will be better since it will mirror the console/PC game.

But, where are publishers today? If we look at Activision, the firm has mobile versions of Skylanders, Spyro Reignited, and Hearthstone. But, popular titles like Call of Duty do not have a mobile version. Activision, it seems, is moving in the right direction, however, because both Call of Duty and Diablo are slated to get a mobile version soon. More Activision titles may follow.

Figure 154. Activision: Mobile Readiness of Popular Titles

Mobile Mobile Title Console/PC Currently Planned Comment Call of Duty x x Announced on 1Q19 earnings; no timeline given Sekiro x Skylanders x x Launched February 2019 Spyro Reignited x x Overwatch x World of Warcraft x Industry speculation of mobile development but no confirmation from ATVI Hearthstone x x Starcraft II x Heroes of the Storm x Industry speculation of mobile development but no confirmation from ATVI Diablo x x Announced at Blizzcon 2018; no timeline given

Candy Crush Saga x Source: Citi Research

Electronic Arts, on the other hand, seems to be further along the mobile path. Only a handful of games — NHL, Anthem, Apex Legends, Battlefield and Titanfall — don’t have mobile versions. But, like Activision, the firm is poised to make more progress. Both Apex Legends and Battlefield may soon get mobile version of the game.

Figure 155. Electronic Arts: Mobile Readiness of Popular Titles

Mobile Mobile Title Console/PC Currently Planned Comment FIFA x x Madden x x NBA Live x x NHL x Anthem x Apex Legends x x Announced on F4Q19 earnings; no timeline given The Sims x x Star Wars x x Command and Conquer x x Need for Speed x x UFC x x Plants vs. Zombies x x Warfriends x Battlefield x x EA said several years ago that a mobile version is in development. No updates since Need for Speed x x A Way Out x Unravel Two x Mass Effect x x Titanfall x

Source: Citi Research

Expert Views

Expert Views from the Gaming Industry

In this section we include the transcripts from three separate discussions we have had with prominent industry experts on the video games industry focusing on their view of the landscape and the opportunities/challenges for various stakeholders as ecosystem evolves.

In these conversations we not only try to get some insights on how the landscape is likely to evolve more broadly but have tried to focus in on some of the key layers in this quite complex ecosystem:

 Ralf Reichert is co-CEO of ESL, one of the world’s largest organizers and producers of video game competitions worldwide. eSports is an area that has seen significant growth both in terms of audience over the years and Ralf’s commentary is a reminder of how big the opportunity could be, not only for the event organizers themselves but for all the stakeholders in the landscape, including the publishers, the teams and brands using eSports as a platform for branding/sponsorship.

 Wil Stephens is CEO and Founder of Fusebox, a mobile game developer and publisher focused on developing interactive narrative games. Wil talks about the challenges associated with building successful mobile games, in particular with regard to customer acquisition and retention, but also reminds us of the power of non-native IP (Fusebox’s games are based on hit TV shows like Baywatch and Love Island) as well as the importance of cultivating new demographics (around 85% of Fusebox’s players are women) to drive returns in what is a ferociously competitive landscape.

 Finally, Luke Alvarez is an industry veteran and Founding Managing Partner of Hiro Capital. He talks more broadly about the evolution of the industry and paints a picture of the future where we see both significant disruption but also value creation. His view is ultimately positive: with 4-5 bullion gamers worldwide he see the video games industry moving from being an important part of the TMT landscape to being ‘a central pillar of the mid-21st century economy’.

Although wide-ranging, obviously these conversations don’t capture all the layers of the gaming landscape, nor will they capture the full range of views held by people in the industry. At the same time, each of our experts agree that the landscape is evolving fast and that this will no doubt create some extraordinary businesses as well as some high profile casualties along the way. In summary, it is an exciting time to be looking at video games.

With that summary, let’s dive into the discussions…

A Conversation with Luke Alvarez Founding Managing Partner, Hiro Capital

Before we start and to set the scene, can you give us a bit of detail on your background in the video games industry?

I am a lifetime gamer and sportsman. My first video game experience was Pong in an arcade on holiday in a small town in Italy in the mid-1970s. I was born in 1968, so I’m proper Gen X — we’re the first generation that grew up with video games, but we didn’t get the Internet until our late 20’s. The best present I ever got in shabby, messed-up 1970s London was a LED screen handheld proto-Space Invader type game that my godfather brought over from the U.S. — amazing. Then I had Atari’s and Nintendo’s in the 1980s and a Sega Dreamcast (Streetfighter!) in the 1990’s. That really sparked my enthusiasm for the sector.

I also come from a family background where games — poker, chess, backgammon, monopoly — featured very prominently in my upbringing. Games and sports and competition are at the heart of human life and I see video games as a huge and expanding part of that.

My background in the industry is co-founding a business called Inspired Technology Group in 2001, which became Inspired Gaming Group. We initially started making mobile casual games for GSM LCD phones. This was the first generation of phones that had SMS and we were making games for that environment together with a kind of software platform that distributed those games and other content across all the

mobile operators in the U.K. and Europe and charged for them.

Luke has 28 years’ experience in technology In candor we were a bit too early. It was six or seven years before the iPhone and and 18 years in digital Gaming and Sports. the App store. But having started with that we moved into ‘skill with prize’ and quiz He was founder & CEO of Inspired games. We then pivoted into virtual sports which were photorealistic sports games Entertainment Inc., a Nasdaq listed mobile for the regulated lottery and sports betting sector. games and virtual sports technology company with operations worldwide. Luke I first met Ian Livingstone, who’s my co-founding Partner in Hiro Capital, in China in was a founding board member of The Cloud about 2014. Ian (co-founder of Games Workshop/Warhammer and Eidos) is Network, the UK’s largest public access Wi- obviously a video game pioneer and a true legend in the industry. We worked Fi operator, and Gmatica SRL, one of Italy’s together on a couple of projects at the intersection of mobile casual games and skill first government gaming concessions. games. We had a lot of fun and got to like working together.

Can you talk a bit about the founding philosophy of Hiro Capital? How it came Luke was a Case Leader at the Boston about and how you approach the landscape? Consulting Group, earned a First Class Honours in Philosophy at the University of As a consumer and a player and also having spent 20 years in games and Cambridge and was a Fulbright Scholar to regulating gaming, I have seen the sector evolve significantly, driven by technology the University of California Berkeley. disruption, and globalization.

Luke is also an old skool rock climber With this in mind, the fundamental thesis of Hiro Capital is based on two things. One, this sector has gone from niche to very, very large over the past 10 years. It has gone from 100 million players of video games in the mid-1990s, to 200 million in the mid-2000s and to almost 3 billion now. So it's gone from niche to mass and our thesis is that this will now go from being mass market to being an absolutely central pillar of the mid-21st century economy and society and humans’ lives. So we have seen it move from small-ish to very large today to being absolutely pivotal in the future.

Thesis two is that the financial investment community has been slow to catch on to the pace of that growth. In particular in the U.K. and Europe, where as a creative continent we are extraordinarily good at creating both the games and the technology around this sector, there's a real gap in capital not so much at the seed or angel stage, where there's quite a lot, but at the level after that where there is very, very little. So that covers the economic and market logic for why we started Hiro.

I suppose the personal story part of this comes from my own experience. As a climber for the last 45 years I get to hang out (sometimes literally) with a wide range of people including younger millennials and post-millennials and it really strikes me that these guys consume media in a very different way. They consume video on platforms like Twitch and Instagram and Tick Tock and they play games, or watch people play games, often with family or friends. Their media consumption is almost all interactive and social.

This is what they're spending their time doing. And the 30 hours a week I would have spent watching TV when I was their age — when I wasn’t working or playing or in school/uni — they spend on gaming. I know it is an anecdotal thing but I think those conversations at the climbing wall woke me up to how profound this generational shift, even between the 35-year olds and the 20-year olds, has been. This is another key motivation behind why we are doing Hiro.

The pace of evolution within the video games sector is dramatic and this must make investing in the space challenging. With the move to subscription/services, do you think it will become more predictable over time?

My co-founder Ian Livingstone over the years built and invested in many great games companies including a couple of 1990s unicorns (including Eidos Lara Croft) but he makes the point that the investment community has historically been skeptical, and occasionally has had its fingers burnt, by the video games industry because of the traditionally non-recurring nature of it. In the 1990s/2000s that hit all sorts of publishers in the U.K., U.S. and internationally who had extraordinary periods of growth but then screwed up a big sequel and struggled. Even more recently we've had a couple of mobile- and Facebook-driven stories of growth and subsequent decline for games businesses.

But fundamentally, the business model is now clearly moving and shifting and although a great majority of the income in the industry is still from upfront sales or downloads, you've got this move to new models. And that's good because it’s long- term and recurring. Free-to-play with all the in-app purchases is great and you can see that model doing very well on mobile and more recently doing well cross- platform with Fortnite and many others.

But this is just the start. We are now seeing the advent of the subscription model from a number of providers, Apple and Google Stadia and others. I recognize people tend to make portentous predictions around future adoption, but I do see parallels with the evolution of retail and eCommerce: Multiple models co-existing.

What we are learning in retail is not that traditional retail is dead but that it is having to transform. Mid-tier, undefined retail is suffering severely but all sorts of innovative and new retail and niche retail is flourishing while ecommerce continues to grow and expand.

And I think this industry will be like that from a pricing model point of view. I think there will be very successful subscription ecosystems, no doubt Apple and Google and Amazon and other FAANGs and BATs. Netflix will also probably move into games and add games to their subscriptions. And of course Sky/Comcast, Disney, and AT&T and people like that may end up moving in orthogonally as well.

So I think we're going to see all the media players and the games players trying to create subscription services for games alongside their TV and movie subscription services if they have them. And those will converge in interesting ways and some of them will succeed, and some of them won't.

But I think you're also going to have big ‘free-to-play’ ecosystems with lots of money inside them and lots of ways to spend that money and new ways being invented all the time.

And I think there’ll still be a sales and download upfront market place: On Steam, Epic, Discord, the App Stores etc. There are certain developers who remain passionate about that and who have a particularly authentic, artist-driven, independent vision that they don't want to be interfered with, with any kind of advertising or in game commerce, or with other barriers to the player. And you will have others who stick to the traditional AAA model, and there will be a hardcore niche of players who still like that, probably bigger than it is today.

In short, I suspect in 10 years we will have lots of different games products and ecosystems. I think there's going to be some extraordinary, new entities and models created along the way and probably some savage casualties. Music is a really interesting analogy in this context because we have already seen something similar happen there.

So, building on the analogy with the music industry: some of the parallels are perhaps obvious — for Twitch we should perhaps think about the similarities with Spotify — but how should we think about other stakeholders in this analogy? Should we think of ‘developers’ in the same way we do ‘music artists’ and, if so, will they be better or worse off in this new world?

Actually, I think the real analogy is between Twitch and YouTube just because, crudely, they are doing the same thing. They enable watching and self-publishing of videos. They are both business models that you wouldn’t have conceived of only 20 years ago. And they are both huge and owned by competing FAANGs.

But the one in a way I think is most like Spotify is Epic with Fortnite. Because Spotify is not just about watching/listening content, it's about downloading an experience and of course paying for it, while Twitch and YouTube are mostly free. Fortnite, like Spotify has an entry level free-to-play experience, but you pay more as you get more committed to it. We should also remember that both companies are ‘new entrants’ (even if Epic has been around forever) that have up-ended their respective industries and taken share from everybody. The Netflix CEO cites Fortnite (not HBO) as his biggest threat. But coming back to developers, from their perspective I think what’s happening is extraordinarily beneficial. Twenty years ago, if you had games and you wanted to get them to market, you needed distribution, manufacturing, and expensive advertising for mostly physical titles. And if you were small you probably had to go to a publisher, and it was hard to get cut through.

In some ways, it's harder now because there are so many games in the App Store if you are going mobile or cross-platform, and there's so much creativity out there and so much noise.

But on the other hand, you've got both the app stores, you've got the whole Tencent / NetEase / Asian ecosystem, you've got Steam, you now have the Epic store, you've got Discord, you've got what Sony are doing, what Microsoft are doing, and of course Google Stadia and the Apple Arcade.

You have got so many different routes to market. And they've all got slightly different spins. And actually, if you want to be independent, you can get your publishing tool off the shelf, you can run your servers in the cloud, and you can buy in a lot of affiliates and marketing and all sorts of services. There are all these routes to market to generate money.

Now within all of that, there are loads of other developers to compete with, so if you're going to cut through, you have got to have something special and unique and interesting and good.

When we invest in a front end studio — which is going to be about half of our investment allocation, we look for something that's really, really good, and very different, because that's how you get cut through.

At an industry level there is a lot of focus on AAA games, free-to-play, and multiplayer, but how do you as an investor consider the value in legacy IP and AA formats? In the physical world we are seeing board games and vinyl seeing a resurgence — is there an analogue in the video games world?

There absolutely is. My partner Ian is a kind of Yoda on gameplay. Judging whether the core mechanic of a game is compelling or not is fundamental and this applies both in the physical world and in video games. And of course owning your IP, so you can monetize across channels and across time.

As regards physical formats, I think the reason why vinyl and physical board games are in vogue is because digital is amazing and increasingly ubiquitous but it flattens things. Interestingly, the new generations who have grown up with the Internet are fascinated by the early 1990s, which in the U.S., Japan, and Western Europe was a completely modern era that just didn't have the Internet. It was as modern as today in pretty much all respects — styles of music, clothes, street style, hip hop, extreme sports — all the same stuff as now and people were pretty prosperous and happy in a lot of the West but we didn't have the Internet or mobile phones until the mid-90’s.

Digital media is extraordinary but the digital experience is still quite thin and being able to touch and feel a record and hear that analogue crackle is cool — the fractal detail goes much deeper than in a stream. Equally, we've seen a resurgence in board games, Warhammer is doing extraordinarily well with physical figures and so on. You're seeing all sorts of clubs and bars and pop up venues doing ‘Dungeons and Dragons’ competitions and things like that on board game nights. And you have things like Escape Rooms where people are going to play a physical game or adventure in the real world. And I think that's a good thing.

At Hiro, from a fund point of view, we invest in three sub pillars. Video games over PC, mobile and console is one, as well as AR/VR/MR. eSports is the second. But Digital Sports (DSports) — meaning the digitization of real world sports — is the third. And that's because we think the physical world and the digital world are converging in interesting ways. Games and sports are the sharp end of where that's happening for the consumer, and they will continue to be and that will accelerate over the next decade or so. The really interesting action is going to be in where those things come together. Ultimately, we want games where people aren't just sitting on their backsides all the time; they are up and interacting with the real world and taking pleasure in physical movement while shooting aliens and all that.

Coming back to the bleeding edge of gaming, clearly there is a lot of focus at the moment on alternative revenue models e.g., advertising, licensing & merchandising etc. Two questions: first, what does this mean for paid-for titles longer term? Will we inevitably move to a free-to-play world? Second, what other revenue models have you seen/are excited about that could get traction?

I do think we'll still have paid-for titles in a decade in a market that is much bigger than it is today. But we strongly feel that ‘free to play’, ‘in-game’ spend and ‘subscription’ is going to eat much of the new income.

There’s going to be a much larger market overall in ten years’ time but it is going to be a majority free-to-play and subscription market but with still a very substantial upfront ecosystem. If I had to quantify it, if upfront sales are 80% today, I would guess it will be a third of a much larger market in 10 years’ time and subscription, free-to-play and in-game will be the rest.

There will be all sorts of gyrations about what the right level of pricing for a subscription model will be and who has the scale and breadth of content to make a subscription platform attractive but most players probably will have capacity for two or three subscription services at most so some won’t succeed.

When we talk about ‘free-to-play’ and in-app purchases, I think that's a small set of words for what is going to become a much more interesting thing. At Hiro, we often talk about the ‘third space’; how platforms like Fortnite are becoming a community like Second Life was before but with much better graphics and a much larger user base. And I think in those worlds, clearly money is going to be spent on stuff like skins or equipment that relates to the game and the core gameplay. But once they are in, they are in this third space where they're making friends and the kids’ status in the playground next day at school is based on what they did in the game the night before, partly. And not necessarily just on how they played, but often on stuff that isn't so helpful, like how cool their skin is, and sometimes stuff that is helpful, like how they communicated or problem solved.

And that’s turning this environment into a social space, part of people's extended friendship networks, community, and sense of themselves. Their self-esteem is based on what they're doing in the game, and how they are playing and what they look like. And that creates as many opportunities for spending money and earning money as there is in the real world.

Our long-term thesis is that the range of digital goods and in-app purchases in games today is very narrow relative to where it's going to be in a decade or so. These games aren’t just games. Some of them are on their way to becoming social communities where you do most of the things you do in the real world.

It is clear with the announcement around Google Stadia that we are on the cusp of a significant evolution in the rise of cloud computing. How disruptive do you think this will be? What are the barriers to take up in your view?

I think it will be hugely disruptive and hugely liberating. Thinking back to the late 1990s, I remember how hard it was building data centers if you wanted to do anything Internet-based and this was the case all the way through to nearly five years ago. The cloud, more generally, has completely transformed that and many of us forget how recent it is and how painful and expensive and specialist it was having to do that stuff yourself and what a barrier to entry it was. I think it's extraordinary that it's happening and I think it's great that it's happening to games.

Cloud-based gaming is great for developers because, first of all, you can find your dev kit in the cloud and you don't have to develop it yourself. And any software platform outside the game that you do develop, is contributing to your uniqueness and allowing you to make a special kind of game. So that's a good thing. Obviously, then, when you want to push that game and publish it and get it out there AWS or Azure or AliCoud or whomever is there.

And then obviously, the specific cloud-based gaming services: we have all heard about Google Stadia and Sony's had its subscription initiative for a while, although this has flipped from streaming only to download as well. Rovio has a spinoff, NVIDIA has a platform, Intel and Tencent have been investing, no doubt Amazon etc. will do things - all the big guys are going to do something around it,.

That said, it will likely take a while to be really good. There are some interesting technical, unit economics scaling challenges with how you build out your gaming cloud service. You want it to have 10s of millions, ultimately, 100s of millions of users worldwide but you don't want to have it architected such that you have to put loads of physical GPUs in all the data center near where all those users are playing.

And some of the models online seem to have taken that approach. And this means someone that has 10 million users around the world playing a game, you're going to need many millions of GPUs and that is an awful lot of capex and depreciation of physical assets and stuff like that.

So you need the right technical approach and we look have looked at a lot of streaming solutions and approaches and startups and so on and some of them have very clever streaming approaches, and some of them less so.

And then when it's out there, there will be lots of ecosystems and there will be lots of competition and this will, generally, be very good for developers, particularly independent developers who get taken up by these guys.

I think it will be quite painful for some of the big and medium sized publishers, some of whom will get disintermediated by the big services and their role in the value chain and their ability to capture margin will struggle. Ultimately, though, I think it will be really good for the industry, because it will open up the ecosystem and you will have a lot more self-publishing, smaller developers.

Can we talk a little bit about hardware? In a cloud computing world, what in your view happens to consoles and handhelds?

Our view is ‘yes and no’. This is all about time horizon. In the next five years or so we've got another generation of consoles coming, and those will probably do really well because the market is continuously expanding and that's good.

I think 10 years out, we see a more bifurcated ecosystem where, if you've got 4 or 5 billion people playing games, most of them will be playing games on their next generation smartphone or communication device. And indeed that will have a much more powerful chip and graphics than anything in today's consoles, so will be able to run full AAA mega games. And of course, you will be able to attach to that thing through next generation Bluetooth all sorts of peripheral devices, including controllers as well as AR/VR/MR wearables.

At the same time, obviously, we have an eSports ecosystem which is accelerating and growing very fast, and has now got big sports owners and media companies and advertisers and brands getting behind it.

That grew out of countries like South Korea, where people couldn't afford consoles, so everything was done on PCs in Internet cafes. What we think we're going to see is, as we've already got, to some extent with today’s specialized PCs, you're going to see hyper-specialized, athlete-level PCs and gaming consoles, that allow people to really refine their performance and that are the equivalent of the Sky Tour de France team, carbon fiber, mega bikes. And there will likely be a halo market of very good amateurs who want to play on the same kit that their heroes play on and that will be huge.

This is not wildly dissimilar to today. Consoles today are kind of mid-market — they have some mass market fun games but they skew a bit towards the hardcore gamer base, but it is still a compromised experience — you mostly can’t play as aggressively and as precisely as you can with a PC. So we think the mid-market disappears long term and you have hardcore athlete consoles and PC’s and a vast mass market on smartphones with peripherals.

There is a lot of excitement about VR and AR in the context of video games do you think this hype is justified?

Again, it's all about timing. We first the saw commercial VR companies being set up in the 1980s, so we have already been through a few VR Gartner Hype Cycles — periods of over excitement, followed by a trough of disappointment. VR has been through a few of those over the past thirty or so years. The current headsets have not crossed the technology adoption curve chasm, they're not mass market, and, although they are getting better, it still does not feel imminent. The next gen are definitely closer, but I think still for the early adopters not the mass. AR is possibly a little bit ahead. And smartphone based AR just isn’t very good and won’t be for a while.

So we think both of those things are coming. They are a big theme for us. We will probably make one or two investments related to that space on the tech and platform side rather than the game side in our first fund. I would expect by fund two or three will be making a lot more.

We prefer to be investing at the point when the tech is crossing the chasm and is on the way to becoming mass market.

I'm a big reader — and I still read a lot Sci-Fi. I still think the world of your imagination can create a more compelling environment than any digital media can today. There are three canonical texts of science fiction about virtual reality. One is William Gibson’s Neuromancer from the 1980s. In the 1990s, there was Neal Stephenson’s Snow Crash. And in the 2000s there was Ernest Cline’s Ready Player One. I fundamentally believe that world is coming and loads of people who run the big tech companies have also read those books, grew up thinking about that stuff, and also playing video games and wanting to build those worlds. So they're coming, it’s just the tech is not great yet so they’re not coming tomorrow. (Hiro Capital by the way was inspired by Hiro Protagonist, the VR hero of Snowcrash. And of course, when you play a game, you’re a hero, and so are our entrepreneurs.)

You have talked in the past about the opportunity in eSports which could be very significant. Can you scale this and also tell us who do you anticipate is the main winner from this longer term? Will it be the IP owners, the teams, the event organizers or the streaming platforms? Or can it be all four?

It's a weird industry at the moment, because you’ve got 600 million people watching video games online and some eSports but almost all the corporate participants in the industry are not making much or any money for the moment.

A lot of them are venture funded and losing venture funded money. The winners today, and I think the winners in perpetuity, are going to be the really talented athletes and teams as in other big audience sports like football. And I would expect that, as the industry matures, the current dynamics between multiple independent and publisher-owned or -controlled leagues will shake out.

We probably won’t end up with a FIFA-style overarching body but will end up with a well ordered ecosystem of privileged leagues. In certain games we might have competing leagues like we have competing boxing belts.

An important point is to remember that “eSports” isn’t like football. It is like physical sports. There are loads of sports within it correlating to the different games. Some of those sports will be very profitable like football is and some of them won’t be very profitable like rock climbing, because it's just too small. DOTA and League of Legends are soccer and NBA equivalents and there are a bunch of games that you might consider as being the equivalent of rock climbing. There are lots of small games with an eSports component that aren’t making any money today as eSports and still won't be in 10 years’ time.

The athletes will make money. Some of the leagues will make money. And advertisers and brand owners will spend money and do very well out of it targeting the next generation.

How do you see the developer/publisher/distributor landscape developing longer term? Will we see consolidation amongst the larger players do you think? And what form do you think it will likely take – vertical integration (distribution merging with developer/publishers) or horizontal consolidation amongst publishers/developers?

I think we will see all of those things. We already see lots of vertical integration, with e.g., Tencent and Microsoft (both platforms) investing in and acquiring and JVing studios (Supercell/Epic/Minecraft/Roblox and many many others). That’s active vertical integration. We’ve also seen defensive vertical integration.

Of course we will continue to see lots of horizontal integration with big publishers buying small studios. Will we see mega mergers between big publishers? I think we probably will — it’s a classic response in a transforming industry with big new entrants, partly because even our biggest game publishers are minnows compared to the FAANGS and the BATS and some of the big publishers will end up stuck in the middle: too big to innovate great new games, too small to take on Google or Apple or Tencent on Cloud Streaming. This has already happened in Music.

And will we see Netflix or Disney buy a big publisher? As Video streaming and subscription morphs into Game streaming? Maybe so.

A Conversation with Ralf Reichart Co-CEO of ESL

Before we begin, can you give us a bit of detail on your background?

Being born in 1974 gave me one big advantage and it is probably one of the reasons why I am here within eSports now. I received an Atari gaming console at the age of six, so I grew up with video games. In those days video games were a very niche entertainment but even then I was using them for normal entertainment very much like we do today.

I grew up with two brothers and we were very competitive. We competed in football, tennis, and video games. Video games back then were not online multiplayer but there were sports simulation games, fighting games, strategy games or second person shooter games. Playing digital games competitively is sort of the basis for eSports nowadays; I grew up doing this from a young age without knowing that it was eSports.

Can you give us a bit a bit of background on how you got into the eSports business? What made eSports interesting in the first place and what were the major milestones in bringing together the ESL assets under one roof?

Ralf founded Turtle Entertainment in 2000. The first milestone was when I started university in 1993, where I had more access He is also a Board member of WESA. Ralf to the Internet and online video games. These weren’t necessarily competitive yet was previously a Member of the Board of — these were more role playing and strategy games — but in combination with my GIGA Television GmbH (2006-2007), formal studies in Economics this led to the next milestone in 1996, which was when Managing Director of SK Gaming (1997- Quake was released. This was the first game that had an online community of size 2001) and Assistant to the Managing which competed. Players could found teams called ‘clans’ and clans could compete. Director of BMW Zwirner (1991-2000). Ralf So my brothers who I used to compete against became my teammates and we holds a Master’s degree in Economics from would compete with people from all over the internet. As a result, in June 1997 we the University of Duisburg-Essen. founded the team SK Gaming (which still exists) with my brothers and a few friends.

We found it so fascinating because (1) the thrill of competition was the same as the traditional sports we were used to competing in; and (2) there were fewer logistical challenges to competing in this game as we could do it from home, at virtually anytime. The flexibility of time and physical space was a big advantage compared to football, where you may have to wait until Sunday to compete whilst ensuring you practice on a Monday and Wednesday. As with Quake you could play a practice game immediately or a competitive game within the hour.

It was also a lot more international than traditional sports. In my football career I probably played 200 official matches and maybe only two were with teams from other countries. In eSports of our first 200 official matches, half were with people from other countries, albeit most of these would have been in Europe where the internet connection was good enough. This opened a totally new world and online community for us.

In 1998 when my brother and I took an opportunity to go to a tournament and my mum actually joined us. At this point it was already clear to us that it was going to be a competitive sport but what changed that weekend was that we realized it could also be a spectator sport. My brother ended up finishing second — which was exciting and depressing at the same time because second place is really the first loser — but the main thing was that my mum said that she would probably be happy to watch us compete regularly as it is not very different from watching us play soccer.

We already knew this was going to be a participatory sport because we were so excited about it but knowing your mum is willing to watch it as well, told us that it could be a spectator sport.

Fast forward two years to 2000, I finished university and met a few guys from Cologne who want to start a gaming company and I said we should focus on what I then called ‘Fiber-Athlete Competitive Gaming’, as the term eSports wasn't coined back then. This is the founding story of ESL.

My logic at the time was that there was no true infrastructure, no organized league, and no organized tournaments on a global scale. There were a few individual projects but nothing of the size we were thinking. We wanted to build these amazing stages and tournaments for players to become star players and to make a living out of it, because at that stage it was such a niche. It was the social aspect we wanted to bring to it. Even if the business model was unclear, our view was that it would become a spectator sport and that if enough people watch it, the revenue will follow. There’s a simple saying ‘revenue follows relevance’. So, like in football, we believed we could make a living if we could get enough people watching.

We expected it to take three to maximum five years, we were incredibly wrong. We definitely got the vision right but the timing was a little more challenging. From 2000 to 2010 we start to build products, with the launch of Extreme Masters in 2006 a key milestone, but it took time for it to become a true market, it was still too niche.

It was between 2009 and 2012 it went from being really niche to become lot more mainstream. The business model began to change to ‘free-to-play’ with more live video streaming via YouTube Live and Twitch. Social media was also a key platform for extending awareness. On the back of this, eSports became a market.

Then the most important breakthrough came between 2013 and 2015, when we started to do stadium events. This was the point where eSports became something that everyone could ‘touch’. Seeing a full stadium, hearing people shout in an even more enthusiastic way than seen at most traditional sports, has taken our vision through from being a fairy tale for a digital first kid, into becoming something everyone can relate to and understand.

That is certainly one of the most striking developments because before that I had to explain in every single interview why it was a sport and why it was a business model worth pursuing. After that everyone who entered the arena understood that this was a sport. The debate now is how big it will be, whether it will be an Olympic sport in time. That fundamental question of this being the next generation of sport was finally answered.

Fast forward three to five years and eSports has become a massive phenomenon, it is now one of the largest sports in the world and we already have some of the largest brands involved. The sport is well on its way to becoming a multibillion dollar business. Now we are really focused on scaling it and building the right models behind it. Even though it is still incredibly early we know that gaming video is going to become the primary entertainment channel for the generations to come. We are just scratching the surface of what the potential could be in 20, 30, or 40 years.

ESL is now one of the biggest eSports businesses in the world. Can you tell us a little bit about what makes it different?

Firstly, we organize tournaments and leagues. We are a promoter of eSports and it is our mission to create the most exciting content. I think it is important to highlight what we don’t do: we don't build games, we’re not primarily a distribution platform, and we don't produce hardware around video games or eSports.

We carry out our mission by creating ecosystems; this means it is incredibly important that whenever we talk about competitions, we don't talk only about the stadium events. Yes, they are the most exciting and visible competitions but we want to really build a story from zero to hero, from amateur to the big stage.

That is the idea we aspire to and we're building this not only in North America but globally. I think that distinguishes us and is unique about what we are doing.

Together with our sister company DreamHack, we're doing it in a very layered process starting from the online competition, to festivals, to national championships all the way to what we call ‘Pro League’. ‘Pro League’ is our Champions League equivalent. The Intel Extreme Masters-Katowice or ESL One-Cologne (known as the Cathedral of Counter-Strike) or ESL One-New York are what we compare internally to Wimbledon or the PGA Masters in Augusta.

Looking at this space from the perspective of the publisher/developer, how in your view has the approach to ‘community’ changed in recent years? What does this do to the life time value of a particular property/brand?

Pre-2010 there were a handful of publishers who cared about the community and really invested into it even if there was no direct return on investment (ROI) because the publisher model was still based on selling games every now and then for $60; it could be yearly or every four years.

For these publishers, investing in the customer more than three months after the game release didn't have a direct ROI. It only had a long-term effect which was that it increased loyalty to the publisher or the game IP which then may be monetized if a sequel was ever released. So back then only a minority invested in directly into the community.

I think this all changed in 2010 when the game as a service model began to evolve. This fundamentally changed the model. The key point is that where you start is not as important as where you finish. Having 100 million players on day one of the game is not as important as how many players you have after one, two or three years. It is the opposite of the traditional model.

We have seen these stories like Counter-Strike, like League of Legends, or like Zelda which have continued to grow, even after a decade.Games and publishing used to be a sprint and now it is a marathon. This totally changed the economics around it as well.

In this context, eSport is one of these incredible tools that will help you to create such a curve. eSport allows you to create additional content outside of the game, which creates touch points for your consumer. If the content is of a decent/good enough quality it can add to the retention of the game, maintaining consumer’s interest and possibly exposing the game to people who probably haven’t heard of it or had large engagement with the game previously. It all boils down to additional marketing.

One of the pushbacks on the eSports space is the view that IP owners will want to organize eSports events in house. With this in mind, can you talk about the different stakeholders in the ecosystem and why, from your perspective, you feel there is long-term opportunity for independent eSports businesses?

The overarching philosophical discussion is insourcing vs. outsourcing or vertical integration vs. focus on the core of the business.I think that there are a few reasons why we are fairly relaxed on this topic.

We believe that game publishers will try and are already trying to do it all themselves but it is important to remember there is a lot of variety amongst developers. Some are two students in a dorm room trying to become incredibly successful. Others are multibillion dollar companies such as EA and Activision. Each of these groups of developers will have a very different approach.

If you look at the most successful eSports games in history, they were mostly created by developers in the ‘two kids in a dorm room’ category.

This variety in developer backgrounds makes it very clear that there will be very different approaches to running eSports. Also the variety leads to plenty of opportunities for a company like ESL.

Looking at the skill set, running an eSports live entertainment business is very different from running a games and services business. I don't think there are operational synergies between doing it in house just because fundamentally they are different businesses. Also it boils down to the company's philosophy: do they want to be the best in the world in one thing or very vertically integrated? I don't think that there's a right or wrong answer.

A final point to make is that while eSports dramatically increases the life cycle, games come and go. Yes there are a few cases such as Counter-Strike which has been around for nearly 20 years, there is a high probability that games will only live so long. If a person’s goal was to industrialize eSports on a large scale, then I feel there is a good argument to suggest you need a portfolio of eSports games to efficiently build it on a global scale. This supports what we see with ESL on a global level.

We feel good about industrialization and we want to find a diverse way of approaching it. There is probably no right or wrong way of doing it. As long as we deliver a significant value to our partners, we are excited for the future.

Can you talk a bit about some of the other stakeholders, for example the relationship you have with the teams?

As I came from being a team owner (SK Gaming), we are generally big fans of teams. We understand the role of the team and we know we need to work jointly to create monetization models, so that both of our businesses can be sustainable. Running a team is a tough business because there's a lot of competition. Going back to the founding story of ESL, we needed to build these ecosystems to create stages for players and teams. We want ecosystems that give longevity and allow teams to thrive. Our ecosystems can be operated alone, with a publisher or as a service for a publisher.

We started WESA as a body to work with teams directly. We now have a many relationships with team owners; there are a few teams who have worked with us for more than a decade. However, when we look at this as a whole industry there is a lot to be figured out. We need to grow the pie and create value for all the stakeholders we're working with, so that the pie is big enough to provide for everyone. In my opinion this is extremely similar to traditional sport but with a couple of key differences: yes, there are lower barriers to entry at each level but then there is a lot more potential digital scale.

Let’s talk a little bit about the pie. Looking at industry trends, it’s clear that Sponsorship has been the key driver of industry revenues hitherto. Can you talk about how the opportunity in sponsorship has evolved? How much of this is the game/tech industry advertising to itself and how much is the platform being used as a genuine new medium for more ‘traditional’ brands?

There are a few ways to look at it. If we start by looking how this has evolved over time, we can learn a lot. Looking back at 2000 when we founded ESL, there was no market; the product was still in development so we had to sell a vision, which was challenging. This said, I think we did a good job.

A key achievement in the first 10 years was creating a global relationship with Intel. You could say Intel is equivalent to the Nike or Adidas of football. They were an endemic partner which was wholeheartedly supporting the growth of the sport at a very early stage.

We had plenty of other endemic partners in there, but they were mostly in for campaign reasons. From 2006-2007, we started to see opportunistic sponsorship start to become a bit more strategic with the endemic sponsors. From 2010 the market became a lot stronger and by 2013-2014 the same process started with non- endemic companies. At this stage, it shifted from more campaign driven, individual marketer-oriented engagements (e.g. specific deals with Adidas and DHL as early as 2008) to long term contracts.

From 2013-2015, non-endemic companies really began to look strategically into sponsorship and nowadays, we have a number of engagements with brands like Mercedes, DHL, Vodafone, and AT&T which are multiyear, multimillion dollar engagements and are comparable to where we started with the endemic umbrella brand Intel. It's a completely different world from where we came from. Today sponsorship is strategic both with endemic and non-endemic brands and that makes it extremely sustainable longer term.

The second point is that we have seen the size of the pie dramatically grow over the last decade but compared to traditional sports I feel we are still under monetized in terms of media value.

Traditional sports create around 3-5x more than we do compared to the media they generate. The amount of partners is much higher for traditional sport as well, so arguably there is still scale to be created, although, I think from a pure ESL perspective, we'd rather work with a handful of partners in a very deep way, than 20 partners in a very shallow way.

When we look forward and consider new revenue opportunities, clearly the big one is media rights. Can you talk about how you see this opportunity evolving? Is this something that is only an opportunity for so-called Masters events?

Looking at traditional sports, a lot of the value (around 70-80%) is in media rights revenue. This is still very different to eSports. Sponsorship is probably the largest revenue stream in eSports. We look a bit similar to Formula One when you put in all the host city fees and local contributions; however, the more media-live sports have a very different profile.

So for us, media rights are in an early stage of evolution. We expect it will contribute dramatically more to eSports in the coming years. Looking back at our pyramid we believe it will be a bigger opportunity for the ‘Challenger’ and the ‘Masters’ level events; as in any other sports the bigger the competition, the bigger the relevance and the more aggressive the media rights competition is likely to be.

We believe that in the future local content will play a significant role, more so on the ‘Challenger’ level. So there is scope for at least half of the pyramid to see significant further growth from media rights over time.

Can you talk about the interplay with eSports in a live setting and the streaming platforms like Twitch and YouTube? Are they a threat to your business or a complement?

They have a very different business model to us.

The question is not unusual as the industry is still relatively new, so people try to find boxes to put companies in. A good way to compare us is asking the question, are documentaries going to be a substitute to Hollywood movies? Both platforms are primary distribution channels, they have been incredibly important and are one of the reasons why the sport inflected in around 2010.

Yes, they are competing as content creators with us but that is only 5% of our business, maybe less. There are always certain things companies from different segments will do at the same level, this may lead to the occasional competition for a team or sponsorship but it is really minimal.

I think the key question here is how we as an industry can improve monetization around content and build premium content offerings that are being presented in the right way. This is where the industry is lagging behind in my opinion.

Looking at the CPM (cost per thousand impressions) model in the old traditional linear world, they're still a lot higher than they are on digital media platforms like Twitch and that's without any data.

So that is one challenge, combined with ad blocking, which is a big challenge for the industry and that means we need to keep working on a way to improve the monetization for these distribution platforms. This is where the Asian distribution platforms are really interesting. In Asia, the distribution platforms have mostly replaced advertising models with consumer payments, with consumer engagement, with micro transactions. I'm not saying that one or the other model is better, but the combination of both and the continuous shift from traditional media toward digital media, will play a big role in filling the gap and making digital content more monetizable.

There is a lot of potential excitement about the rise of cloud computing – what’s your take on platforms like Google Stadia and next gen consoles in an eSports setting?

The overarching message here is more people will have access to higher quality and more complex video games. This is great news for me because it increases engagement with video games and this increases the probability of deeper engagement with eSports. It increases the chance that developers will create better and more eSports-ready games as well as more viewership-capable games.

As a micro trend, it usually takes a while for eSports to pick up on a platform. Looking back, PC games didn’t really take off until the late 90s with Quake, Starcraft, and Counter-Strike. Touchscreen mobile games have been around 2007 and this took about 9-10 years: Clash Royale is the game I label as the early eSports mobile game. In both cases it took about a decade for the platform to develop and the software to cater for a rich multiplayer experience which is actually watchable.

With cloud streaming, it's probably going to take a while to find the right game genre and quality that really distinguishes the platform vs. PC or mobile. As a micro trend it will probably take a while for it to make a real impact. Longer-term, though the biggest opportunity will be the ability to really create participatory tournaments at scale as it should be a really accessible platform but this will take a while.

Battle Royale games, have been a bit more of a challenge in terms of how you make an eSports proposition exciting. Can you give us your latest thoughts on why this has been a challenge and how you think it will evolve?

The technical challenges in broadcasting a Battle Royale game go deep and are very obvious as the first half of the match is impossible to capture from a spectator’s point of view as so much is going on. In the first five minutes 50 people leave the match and every three seconds something significant is happening. In Counter- Strike, by contrast, the first few minutes are quite slow and then the match begins to climax.

For a spectator watching a Battle Royale game, you have a situation where they move from a situation where they may not understand what is happening in the beginning, to a midgame which you can start to get a grip on what is happening, to an endgame which is very similar to all the traditional games.

Trying to make these first 10 minutes, or 50%, of a match interesting is a story telling, technical and experience challenge. We did this big Katowice Royale Fortnite tournament where we believe we implemented a few tricks/technical things that made the first 10 minutes a decent experience, but there is still a way to go but this is more of a development and technical challenge. To tackle this we need to create more content and do tournaments and then iterate again.

Eventually, we will get to the point where the start is not super confusing and is decent to watch. If we can tell that story from the beginning to the climax, it's going to be good enough. The sheer amount of players and interest in Battle Royale in general, and Fortnite specifically, is certainly helping to make it a viable eSports business.

Do you think the video game ecosystem will consolidate longer-term or will it become more fragmented?

Looking at the game landscape we think we will see both. There is a concentration at the top with Tencent, Electronic Arts, Activision etc. they have dramatically grown in the last 10 years.

Also, at the same time Epic Games, PUBG Corp, Valve, Supercell, and many, many others (even companies like Innogames which is owned by MTG) show that there are a myriad of highly successful medium sized corporations being built, even if I am not sure we can label Epic as medium-sized now or not — that is a little bit more of philosophical discussion.

But the opportunity of distribution being easier than ever will certainly lead to more and more creativity being out there and having direct access to large audiences.

I believe that there will be more amazing games and more amazing game companies, and at the same time we will have a handful of huge ones with awesome portfolios. But we are fundamentally not going to see an oligopolistic market. This confirms the trend of the last 10 years.

Creativity is still the core piece to it and it's not scale or distribution it’s not all the other things. It is a creative industry at its heart and that is the beauty of it.

How does being part of a bigger group like MTG impact you at ESL?

We made a very conscious decision in 2015 to join the MTG family. The clear logic behind this was to have a relationship a larger strategic. There were a few reasons for this.

First, we didn’t want to be constantly raising money because we didn't know how fast the industry would scale. Being part of MTG helped us to really focus on our business and it has allowed us to grow at the pace we have done over the last for four and a half years, which has been quite a fast pace.

The second point was that MTG has been a media company and a games company but not in a way that it was competing with some of our key clients, i.e., the publishers. I think that was always important as well because it was like the ‘Switzerland’ of the entertainment industry in the past and now the games/eSports industry of today.

Lastly, with our sister company DreamHack, we have some economies of scale but more knowledge and R&D synergies there too. So the last four and a half years this has been have been the right decision and the right track to move on.

Looking beyond ESL and MTG, how do you think about the future? What do you think are the key challenges?

One of the reasons why we're so incredibly excited about what we're doing is that we're in a linear growth industry. When there is hockey stick growth, you face a lot of operational and sustainability challenges because there is a risk that growth might prove temporary.

Gaming and eSports have always been a much more linear experience albeit with the odd bump — certainly the Battle Royale issues have definitely levelled up the industry — but most of the areas we are exposed to have long-term sustainable growth potential.

In this context, we are trying to grow a tree with very strong roots. We have the time to make sure that these roots stick across a certain amount of games on a handful of platforms. I am more excited about building this than rushing to build a ‘skyscraper’ in the next 12 months which is at risk of falling part because we were too crazy.

A Conversation with Wil Stephens CEO / Founder of Fusebox Games

Before we start and to set the scene, can you give us a bit of detail on your background in the games industry?

I’ve spent 10 years building businesses at the cross-section of television and gaming, seeking opportunities within the seismic shift in viewing, consumption and participation of media.

As part of that process, I’ve been fortunate enough to found, build and exit businesses in this space giving me a front row seat to the rapidly evolving media landscape.

Can you talk a bit about Fusebox? How did the business come to be founded and what are your key franchises so far?

Fusebox was founded in 2016 on the premise that the cost of acquiring users at scale was becoming prohibitively expensive for small mobile players, therefore we needed to use well-known brands as a catalyst to drive our downloads. At the same time television companies revenues were at best flatlining and at worst falling and were therefore actively looking for new revenue streams. At the intersection of that particular Venn diagram we created Fusebox.

Wil is a Welsh entrepreneur with extensive Our flagship titles are Love Island in partnership with ITV, The X Factor in experience of building transformational partnership with RTL Group’s Fremantle and Baywatch. businesses in television, games and interactive entertainment. Wil is CEO of Figure 156. Love Island Fusebox Games, an interactive entertainment company he co-founded in 2016 that develops and publishes mobile games based on hit TV shows.

Wil founded his first business aged 23 and as CEO of Cube Interactive, led the company to win BAFTAs and Broadcast Digital Awards for their ground-breaking TV formats and games. After growing Cube Interactive to offices in Cardiff and London, he joined the leadership team at New York based video streaming company Boxee to build out their international business, later acquired by Samsung.

Wil was born and raised in Aberystwyth and now lives in Brixton, London. He is a member of ‘Speakers for Schools’ which provides talks to state schools to empower the next generation, is a Fellow of the RSA and a member of BAFTA.

Source: Fusebox Games

The gaming sector is a fast-paced industry at the best of times but mobile gaming can be especially frenetic. For those of us who are uninitiated with the space, what are the key attributes/variables that you think drives success in the space? How has this changed or evolved over the time you have been active in the industry?

Firstly, quality is paramount. The start and end point is a great game crafted by an exceptional team. Nothing beats raw unfiltered feedback from millions of players and if you haven’t delivered on their expectations, you’ll know about it. Negative reviews and sentiment kills good games and only the great survive.

Secondly, on metrics, the market is shifting (again) and it’s becoming very hard if not impossible to play the short-term acquisition/monetization arbitrage game. You’ll see consolidation and a huge shakeout in the hyper casual market as this new reality bytes.

The reality of mobile now is you’re better be building your franchises for the long haul, say 3-5 years plus, to capitalize on the repeat monetization of your user base you’ve worked so hard to acquire. Returns are getting longer to deliver but ultimately end up being much bigger. Scale matters.

In an industry which appears to be obsessed with the importance of creating proprietary IP, what is interesting about Fusebox is that you have partnered with third parties like ITV to bring established TV brands into a gaming context. Can you talk about the pros and cons of the partnership model vs. internally generated IP?

Firstly, scale is hugely important in mobile games. We got to scale quickly through leveraging IP to rocket us forward and by giving players an opportunity to play within familiar worlds. This familiarity led to increased and faster monetization, strong retention and all other key metrics indexing higher than our peers. It’s a great model that’s worked out well for us and our commercial partners.

However, you only have to look at the Netflix playbook to see how scale can translate into an opportunity to create and deploy original IP. Netflix took years in building its platform on catalogue content before moving their vast eyeballs onto their own content. A similar opportunity will present itself for Fusebox as all the users we acquire, we control and we learn through data about their interests, behavior and gameplay patterns.

When to make that move is a big question and all I know today is we’re some way off being ready to do that shift.

Fusebox games are centered on choice-based narrative. Do the points you make about IP apply only to this genre or could it apply more broadly?

We chose choice-based narrative games as it’s a great genre to be in: huge monetization opportunities and long gameplay retention. It’s unbeatable as a category in terms of return on investment on your development costs. It also fits with our belief of creating mass-market entertainment for all, not only for niche gamers. Everyone loves a good story.

The opportunity to work with IP is across all genres, however, and there are a number of successful studios deploying different styles of games for all sorts of IP. For now, we’re staying focused and will continue to innovate the narrative genre.

Can you also talk about the behavior of gamers how this differs by age/gender and across different gaming genres in mobile? Can we make generalizations about different cohorts of mobile gamers?

Absolutely. Different genres of games appeal to different demographics, as you’d expect. Games are typically categorized as hyper-casual, and as the name suggests are fleeting players with zero loyalty, mid-core that tend to attract a wider group of non-gamers and then core gamers who are really the more stereotypical gamer who’d traditionally been heavy console players.

Looking at Fusebox in particular, as you have mentioned in the past, your games are extremely popular amongst the female demographic. What impact do you think this has had on your performance and how does this impact what kind of IP/genre you focus on going forward?

Fusebox targets the mid-core market, so players that don’t necessarily identify themselves as gamers and have a wide range of interests. We have a strong female demographic, around 85% of our players are women, and that’s been a deliberate move on our part. Our players spend more money, are more loyal and are more open to sharing the game within their friendship groups. All three of those core metrics, monetization, retention and virility are a huge driver of our success.

Looking at broader industry developments, with services like Google Stadia we are on the cusp of a significant evolution in the rise of cloud computing where mobile devices could end up being used for much more sophisticated gaming experiences. How disruptive do you think this will be for the so-called casual (mobile) gaming sector?

It will likely make casual games easier to plug into vast networks and become multiplayer by default. This has historically been an arduous task where each develop re-writes an entire software platform to facilitate real-time social action within their games. That could send us back to the early days of Facebook games with FarmVille updates taking over your social feeds or could lead to more innovation and more interesting co-development between studios that have a similar player base.

It looks like the mobile game development industry is relatively fragmented. Can you talk about the benefits of scale in this context? What is the ideal size for a mobile game developer? And is there any benefit in being part of a bigger group?

Scale matters. To compete in this market you need a very strong balance sheet to continuously deploy vast UA budgets until you get to such size that that the network effects of being able to move your players around your network of games becomes a material advantage over those still having to purely pay for players.

How do you see the developer/publisher/distributor landscape developing longer term? Will we see the mobile gaming segment begin to consolidate? And what form do you think it will likely take — vertical integration (distribution merging with developer/publishers) or horizontal consolidation amongst publishers/developers?

In mobile, we’ll start to see the classic studio model deployed, a model successfully rolled out for years by the TV industry, where a common owner controls a number of studios each autonomously creating their own games and run as independent creative endeavors.

The key to mobile game studios is understanding that it’s all about the people and the talent, disrupt that and you’ve lost all the goodwill you’ve paid a lot of money for, so we’ll start to see these common controlled network of studios all share support services but operate fiercely independent of each other. Tencent do this very well and its model that will become more prevalent.

The market is dividing into three key groups: the sub $100m companies are all a tasty snack for the big $1bn+ players, anything between $100 and $500 are largely orphaned and are finding it very hard and finally the big $1bn+ players are all going around eating the world.

The key for the small snack sized companies such as Fusebox is to cross the chasm to become their own $1bn player. It’s a perilous journey; you don’t want to be stranded half way across but if you do make it, well, wouldn’t it be great to see a British player emerge to join the elite group of the $1bn+ mobile powerhouses.

COMPANY NOTES Amazon

Amazon is one of the largest firms in the world. The firm began in Internet retailing. But, it has expanded into a wide array of adjacent businesses, including gaming.

The major push in gaming began in 2014. That year, Amazon acquired Twitch, a video game broadcaster, for $970 million. That same year, Amazon acquired Double Helix, a video game studio.

Double Helix was formed in 2007 after The Collective and Shiny Entertainment merged. Double Helix developed seven titles including Silent Homecoming (2008), G.I. Joe: The Rise of Cobra (2009), Front Mission Evolved (2010), Green Lantern: Rise of Manhunters (2011), Battleship (2012), Killer Instinct (2013), Strider (2014), and UFOs Love COWs (2014).

In 2018, Chris Hartmann joined Amazon Games. He will lead the entire studio and marketing organization including development teams in Seattle, Orange County, and San Diego. Mr. Hartmann spent two decades at Take-Two. And, while he was there helped develop key video game franchises (NBA 2K, Borderlands, Bioshock, and Civilization). Currently, Amazon is working on two new titles: New World and Crucible. In a recent interview, Mr. Hartmann said:

“Between the teams at AGS, the incredible tools and technology from AWS, the global communities of Twitch and Twitch Prime, and all of the other assets around Amazon, there are few companies in the world set up to take gaming to the next level.”

Amazon recently developed a gaming API called GameOn. GameOn is made for video game developers to integrate competitions, leagues and prizes. The API is platform agnostic across PCs, consoles, and mobile devices. In 2016, Amazon created Lumberyard which is a game engine for independent developers. Lumberyard is still a niche service relative to more established game engines (like Unity and Ultimate Engine).

Apple

Although Apple is a key hardware (Mac, iPhone) and software player (macOS, iOS), the firm plays a relatively small role in the broader video game ecosystem. Of course Apple does operate the Apple App Store. In their app store, Apple collects 30% of any one-time purchase. And, if a consumer subscribes to a service – and remains a subscriber for a year — the distribution fee drops to 15%. The installed base of iOS is about 900 million units. And the installed base for Mac is about 100 million units. As such, we suspect Apple is generating the lions’ share of the service fees from the mobile platform.

Apple recently announced Apple Arcade. The service will allow a user to subscribe to the arcade and get access to many game titles for a fixed monthly fee. At this time we don’t know the retail price point of the service. Nor do we know now many games will be available at launch. But, we don’t expect iconic hit games to be part of the offering. We expect the service to launch in 2H19. We suspect Apple Arcade will appeal to casual gamers and families who want to control the content of their child’s games.

Aristocrat

Aristocrat is a publicly listed Australian based gaming company. The firm began by manufacturing slot machines in 1953. In 2017, the firm began to expand into mobile gaming via M&A. It first acquired Plarium, a mobile game developer. Plarium made games like Vikings, War of Clans and Sparta. In 2018, the firm acquired Big Fish. Big Fish published game titles like Gummy Drop, Cooking Craze and Big Fish Casino. (Previously, Big Fish was owned by Churchill Downs.)

Bandai Namco Entertainment

Bandai is a Japanese video game developer. Best known for developing PacMan and Tekken game franchises. Owned by Bandai Namco Holdings, a Japanese entertainment conglomerate. Formerly known as Namco Bandai.

BioWare

A game development studio acquired by EA in 2007. Best known for its development of Mass Effect, Anthem, and EA’s previous Star Wars titles.

Bluehole

South Korean game developer best known for its development of PlayerUnknown’s Battlegrounds (PUBG) via its PUBG Corp. subsidiary. Bluehole rolls up to a holding company called Krafton Game Union. Bluehole is privately held; its second largest shareholder (after the founder) is understood to be Tencent.

Bungie

An independent game development studio founded in 1991. Best known for its development of Halo (for Microsoft) and Destiny (for Activision). Acquired by Microsoft in 2000 and spun out again in 2007. Made news in early 2019 by announcing a termination of its partnership with Activision on Destiny; Bungie plans to self-publish future iterations of the game. Bungie has significant equity backing from NetEase.

Caffeine

Livestreaming platform founded in 2016. Still small relative to other livestreaming platforms. Founded by former Apple TV programmers with backing from (new) Fox. Competes with Twitch, Mixer, and UStream (IBM Cloud Video).

Capcom

Japanese video game developer founded in 1979. Best known for development of Street Fighter and Resident Evil. Publicly traded.

CD Projekt

Polish developer/publisher and owner of GOG.com, the digital distribution platform. As a developer/publisher, best known for The Witcher 3: Wild Hunt. Also responsible for development of Cyberpunk 2077 franchise (we expect to be released in 2020).

Discord

Owner of a communications software application popular among gamers as well as a recently-launched online game storefront. Discord’s chat software is popular on live streaming services like Twitch. In 2018, Discord introduced a digital storefront to compete with Valve’s Steam and Epic’s Games Store. Initially, Discord’s revenue split is lower than those of Valve and Epic.

DoubleU Games

DoubleU is publicly listed Korean casino mobile games firm that makes four popular games for Android and iOS. They include DoubleU Casino, Take 5, Hello Vegas, and DoubleU Bingo. As games require an in-app purchase but are ad free. DoubleU Games acquired Double Down Interactive (a subsidiary of International Game Technology) in 2017 for 2.9x LTM revenue. DDI’s flagship game is DoubleDown Casino but the firm also has smaller games including Texas Tea, Golden Goddess, Ultimate Poker, and Firehouse Hounds. The pro forma entity is poised to generate more revenue than Zynga.

Epic Games

A developer/publisher of video games, the developer of Unreal Engine, and owner of the Epic Games Store. As a game developer, Epic has been active for nearly 30 years and is best known for Fortnite Battle Royale. As the developer and owner of Unreal Engine, Epic has provided the architecture upon which many titles (both independent and publisher-backed) have been written. The Epic Games Store was opened in late 2018 and competes with Steam. Epic has equity backing from Tencent and KKR, among others.

GameStop

Retailer that’s traditionally focused on physical game and game hardware/accessory sales. Has recently made investments in both professional and amateur eSports initiatives in an effort to diversify its business as physical game sales have declined. Put itself up for sale last year; announced early in 2019 that no deal had been struck.

Google

One of the world’s largest firms. A pioneer and key player in Internet search. Google developed the mobile Android operating system (used on many non-Apple smartphones). Heavy exposure to the mobile AdTech ecosystem. Firm also owns YouTube, which is increasingly competing with Amazon’s Twitch and is a significant player in the cloud ecosystem (competing with Amazon and Microsoft). Recently the firm announced new cloud gaming platform: Stadia. Google has a significant number of other material ‘moonshot’ investments: Waymo (driverless cars), Verily, Calico, etc.

IBM

Tech conglomerate who owns and operates IBM Cloud Video (formerly Ustream), which it acquired in 2016. IBM Cloud Video is a service that allows users to stream and host videos and is used in the gaming community to broadcast games and other content. IBM Cloud Video is a competitor to Twitch.

Jam City

Jam City is a private mobile games company (formally known as SGN). Popular titles include Cookie Jam and Jam Juice. The firm recently released Harry Potter: Hogwarts Mystery which press reports suggest generated 30% of the firm’s total revenue. The firm is private, but press reports suggested management was considering an IPO. They recently acquired the mobile games rights for the Peanuts cartoon series. In 4Q19, the firm also reached an agreement with Disney to license the firm’s Disney Emoji Blitz characters. Key investors include Netmarble (South Korean mobile games company) and Jeff Bezos’ Bezos Expeditions.

Kabam

Kabam was a private mobile games company founded in 2006 under the moniker Watercooler. The firm changed its name in 2010. In 1Q17, Netmarble acquired the vast majority of the firm. Kabam does still retain some IP.

Konami

Japanese entertainment conglomerate whose holdings include a video game development studio and publisher. Best known for developing Yu-Gi-Oh, Metal Gear, and Dance Dance Revolution. Publicly traded.

Microsoft

Microsoft is perhaps the most vertically integrated video game firm in the world. The firm own IP (Halo), has a game development arm (Xbox Game Studio), a publisher (343 Industries), controls graphics APIs (DirectX), makes hardware (Xbox), distributes games (Game Pass), is testing cloud gaming (Project X Cloud) and owns a game broadcaster (Mixer). Phil Spencer aims to bring Game Pass to every device (including Android mobile phones) with the Project X Cloud initiative. Moreover, the firm has begun to invest is more first-party games, albeit on a limited basis. The firm formed a new studio — called The Initiative — and acquired four studios to help jumpstart the process: Ninja Theory, PlayGround Games, Undead Labs, and Compulsion Games.

Modern Times Group

Modern Times Group is a pure play video games business with operations across eSports and mobile/web gaming. The group started life as a free and pay TV broadcaster with operations across the Nordic region as well as Central and Easter Europe. In 2015 the group began to diversify into eSports with the acquisition of ESL (82% owned) and DreamHack (100%) and in 2016/2017 expanded into mobile/web games with the acquisitions of Innogames (51%) and Kongregate (100%). In 2019 the group spun-off its broadcasting business and now operates as a pure play video games business.

MZ is a private U.S.-based mobile games company which was founded in 2008. Previously, the firm was called Addmired and Machine Zone. The firm’s breakout game is Game of War: Fire Again which was released in 2012. The firm launched Mobile Strike in 2015. In 2016, MZ partnered with Square Enix to develop Final Fantasy XV.

Netmarble

Netmarble is a publicly-listed Korean mobile games company. Key titles include Lineage 2: Revolution and Seven Knights. The firm tends to focus on massively multiplayer online role-playing games (MMORPG). But, in 1Q17 it acquired Kabam (who developed video games for the Marvel franchise, among other games).

NetEase

NetEase is a publicly-listed Chinese Internet company. Around 50% of the firm’s total revenues come from online games (with the balance from e-commerce, ad services, email and other services). Key titles include Fantasy Westward Journey, Onmyoji, New Ghost as well as a number of games licensed from Activision Blizzard (including Hearthstone).

Niantic

Niantic Labs was started in 2010 as an internal start-up of Google. The firm became an independent company in 2015 but it is still private. Niantic has made a number of acquisitions. In 2017, the firm acquired Evertoon, an app that allows consumers to make short films. In 2018, the firm acquired three firms focused on augmented reality (AR): Escher Reality, Matrix Mill and DigiLens. Later in 2018, Niantic acquired Seismic Games, the co-developer of Marvel Strike Force. Niantic also created Pokémon Go in partnership with Nintendo. Pokémon Go was downloaded over 750 million times.

Nintendo

Japanese developer/publisher and hardware manufacturer that’s been focused on gaming since the 1970s. As a developer/publisher, best known for Mario, Zelda, and Pokémon franchises (Nintendo has partial IP ownership of Pokémon). As a hardware manufacturer, best known for Nintendo 64, GameCube, Wii, GameBoy, and Switch. The Switch product has broken ground as a hybrid handheld/console. Publicly traded.

Nvidia

A manufacturer of electronics components, including semiconductors, that has a significant presence in the video game market. Its primary gaming products are its GeForce and Grid graphics processing units (for consoles and cloud gaming, respectively), which enable real-time 3-D graphics to be displayed. Also produces Nvidia Shield, a set-top box that facilitates gameplay (via either downloaded or streamed games).

Oculus Rift

Manufacturer of a virtual reality headset that can be used to play video games. To play a game using Oculus, the game must support Oculus specifically; the hardware is used in conjunction with specific software from distributors such as Steam. Oculus is owned by Facebook (acquired in 2014). Competes with other VR hardware products such as HTC’s Vive and Sony’s PlayStation VR.

Playtika

Playtika is a mobile game company owned by Caesars Entertainment. The firm focuses on social casino games. Titles include Caesars Slots, World Series of Poker, and Poker Heat. Playtika competes with firms like Aristocrat. But, many believe Playtika is the market leader in social casino games. In 2016, a consortium of Chinese firms (led by Giant) agreed to acquire Playtika for $4.4 billion from Caesars.

Respawn

A game development studio acquired by EA in 2017. Best known for its development of Titanfall and Apex Legends. Also responsible for the development of EA’s latest Star Wars adaptation, due for release in 2019.

Riot Games

U.S. video game developer founded in 2006. Best known for developing League of Legends. In addition to game development, Riot is active in eSports: it operates the League of Legends competition (in which team franchises and broadcast rights were sold). Fully acquired by Tencent in 2015.

SciGames

Scientific Games is a U.S. public listed company that focuses on the gaming business. About 10-15% of the firm’s revenues come from their interactive division. Notable apps include Jackpot Party Social Casino, Gold Fish Casino Slots, and Bingo Showdown.

Sega Games

Japanese company whose current activities include developing and publishing video games. As a publisher, best known for Sonic the Hedgehog. Until 2001, was also active as a manufacturer of gaming hardware, including consoles. Operates as a subsidiary of Sega Sammy Holdings.

Slack

Slack is a communications software company whose web chat technology can be used within video games. Within the context of gaming communications, it competes with companies like Discord and Vivox (Unity).

Sony

Sony is a Japanese tech-driven entertainment conglomerate. It has been behind the PlayStation brand console game business for more than two decades now. Recently it has taken the PlayStation as a platform and expanded it, as the PS Plus, into a networked business, which has more than 36mn paying subscribers. It is expanding the franchise still further, with the PS VR virtual reality headsets, the PS Now cloud game services, and the PS Vue TV broadcasts. Some 20% of game software is developed in-house and recently Sony has been turning out hits such as Spider-Man and God of War.

Square Enix

Japanese game developer founded in 1975. Best known for developing the Final Fantasy franchise, which has sold >115 copies since 1987. Known to use both Unreal Engine and Unity Engine for game development in addition to its internal, proprietary game engines. Has made entrees into the cloud gaming market (with limited initial success). Publicly traded.

Supercell

Supercell is a publicly-listed Nordic company focused on the mobile games business. The firm was founded in 2010. In 2013, Softbank bought 51% of Supercell for about $1.3 billion. Softbank increased its stake to 73% of the firm over the next few years. In 2016, Tencent acquired 84% of Supercell for $8.6 billion. Key titles include Clash Royale and Brawl Stars.

Take-Two Interactive

Video game publisher founded in 1993. Best known for developing Grand Theft Auto and Red Dead at its Rockstar Games studio. Also develops sports titles, such as NBA 2K.

Tencent

A Chinese tech conglomerate considered to be the world’s largest gaming company. Has also invested aggressively in Western gaming companies in recent years, including having acquired or taken equity stakes in Riot Games (fully owned), Epic Games (minority stake), Activision (minority stake), Ubisoft (minority stake), and Bluehole (minority stake). Owner of Honor of Kings, the world’s highest-grossing mobile game, and League of Legends (via Riot). Also active in eSports via the latter title. On the cloud front, Tencent recently began testing a cloud-based gaming platform in China with Intel called “Tencent Instant Play”.

Treyarch

A game development studio acquired by Activision in 2001. Best known for its development of the Call of Duty franchise.

Ubisoft

Ubisoft Entertainment is one of the world’s leading vertically aligned developers, publishers and distributors of video gaming content for consoles, PCs, smartphones and tablets in both physical and digital formats. The group’s key franchises, all developed organically, include Assassin’s Creed, Tom Clancy’s Ghost Recon, Tom Clancy’s Rainbow Six, Tom Clancy’s The Division, Watch Dogs, For Honor, and The Crew. The group has a strong market position (about 10% share) within console and PC gaming in developed Western markets but has a much smaller share (around 2%) when compared with the broader global video game market, with significant underweight positions in Asia Pac (by geography) and mobile (by platform). In 2018, the group signed a long term strategic partnership agreement with Tencent.

Unity

A game engine used to power a significant portion (~50%) of games, both in the mobile and console/PC setting. Especially popular among developers due to economic arrangement: Unity takes a fixed fee for use of its technology rather than a split of revenues, as some other engine owners do. Competes with Epic’s Unreal Engine.

Valve

Valve is a game developer, best known for Counter-Strike and Dota 2. Also coordinates and operates professional tournaments and match play for both titles. As owner of Steam, Valve offers a large distribution platform for independent game developers.

Vivendi (Gameloft)

Vivendi is a publicly traded French company with a diversified collection of media assets. One of those assets is Gameloft, a video game publisher. Gameloft was founded in 1999 by one of the five founders of Ubisoft. In 2015, Vivendi acquired a 6% stake in Gameloft. By 2016, Vivendi owned over 95% of in the firm. Popular Gameloft titles include Asphalt and Gangstar New Orleans OpenWorld.

Vivox

A communications service owned by Unity. Used primarily for text and voice chat within games. Prominent due to its use in Fortnite, PUBG, and League of Legends. Competes with Discord’s chat product (among others).

Zynga

Zynga is a publicly listed U.S. company focused on mobile games. FarmVille was one of the firm’s best known games (which was launched in 2009). Every year, it seems, Zynga acquires another mobile games entity. Prior acquisitions include OMGPop (2012), NaturalMotion (2014), Harpan (2017), Peak Games (2017), and Small Giant Games (2018).

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