UK video games – Heterogeneous not homogeneous

Author: Richard Williamson

UK video games – Heterogeneous not homogeneous

Over the past two to three years, we have seen the re-emergence of a listed small- and mid-cap games sector in the UK and Europe, with a wave of IPOs supported by a period of sustained outperformance of the industry majors against the backdrop of a healthy equity market. The more recent reversal of performance in the sector has been equally dramatic and largely indiscriminate. Mixed trading results from the industry majors reflect, in our view, the re-basement of expectations from unrealistic highs and the disruptive impact from digital distribution channels and more recurring monetisation models. The small-cap games sector mainly comprises companies with business models designed to exploit this new economic model, and trading for the most part has been robust. The dynamic nature of the market will continue to create disruption, offering opportunities and risks, but we believe that the small-cap European sector now offers exposure to a number of well-run, innovative businesses and those that execute well will generate significant value.

The UK is back and internationally competitive

After a wave of enthusiasm for technology-led games company IPOs in the early 2000s, 2018 brought a series of fresh AIM listings. Keywords Studios (a games service provider) and Frontier Developments (a developer and publisher) had both listed in 2013. They were joined by Sumo Group (a co-developer), Team17 (an indie publisher) and Codemasters (a racing studio), offering a real spectrum of choice. Added to this list are Game Digital (a retailer), Gfinity (eSports) and virtual reality (VR) companies such as VR Education, EVR Holdings and Immotion Group. The introduction of Video Games Tax Relief (VGTR) in April 2014 has been a key factor underpinning the UK sector, helping to level the international playing field.

A global industry offering double-digit growth

In 2018, western markets represented c 44% of global games revenues estimated at $138bn, with 51% of revenues on mobile devices. Overall revenues are forecast to offer 10%+ growth between 2017 and 2021, with high-teens growth expected for mobile CAGR, while PC and console offer single-digit growth (source: Newzoo).

Digitalisation is transforming business models

Digitalisation has significantly reduced the financial resources and capital intensity required to launch new titles, as well as offering the opportunity to sell downloadable content to sustain games and their communities post-launch – increasing the recurring revenue base and reducing the risk profile. Together, this has allowed greater business model diversity, more flexibility and better profitability.

Heterogeneous not homogeneous

The UK-quoted companies offer exposure to key global trends by way of different business models, and should not be considered equal alternatives for a homogeneous sector. Company risk profiles differ significantly and investors need to consider carefully which is likely to best match their investment criteria.

Executive summary

Investing in the UK games sector – why is it different this time?

Games is a global industry: Perhaps the key difference this time, compared with the past, is that
the games industry has grown exponentially and is no longer a fast-moving playground for
amateurs, but instead is a focus for some of the world’s largest companies. The market opportunity,
ie the addressable player base, has ballooned in parallel.

Digitalisation: There have been a number of important changes to the games business model,
particularly in relation to the move from physical content to digital distribution (squeezing the
retailers, eg HMV, GameStop and Game Digital). Digitalisation has significantly reduced the
financial resources and capital intensity required to launch a new title, as well as offering the
opportunity to manage a game’s community post-launch, offering downloadable content to sustain
a game, increase LTV and maximise recurring revenues. Together, this has allowed greater
business model diversity, more flexibility and better profitability.

Professional management: This latest wave of games businesses comprises companies with an
established track record, run by professional management teams.

UK government support: Finally, the UK government’s decision to foster and support games with
the launch of Video Games Tax Relief (VGTR) in April 2014 is a critical success factor. Not only
does it recognise video games alongside film and TV as a core creative industry, critical to the UK’s
future competitiveness, but it also rebalances the cost of operating in the UK, allowing the domestic
industry to compete on an equal footing with, eg Canada, France, the US and Ireland, and other
regions with significant industry tax breaks.

The games industry can still be a risky, hit-based business. The formula for success is hard to
pin down and few companies achieve serial ‘hits’; larger companies prefer to acquire proven IP and
franchise successful titles rather than develop new hits themselves. The dynamic nature of the
sector, where technology and creativity collide, means that volatility is inevitable. However, the shift
to building community-orientated titles, serviced by downloadable content and expansion packs, to
offer recurring revenue models helps to mitigate this risk, but it will never completely disappear.

Other factors to consider

Positives:

• The old model of upfront inventory risk and cost is disappearing with physical product.
• Distribution costs are falling as high street retail is disintermediated.

– There is still an online distribution toll to pay, but this is also falling.

• • Power has shifted towards the IP owners and developers.
    

– With IP owners able to self-publish, the route to market has become democratised.

• The retail channel remains crowded – there has never been more high-quality content.
  

Negatives:

• • The hit-based business model persists at the high end.
    

– However, risk is being mitigated through a Games-as-service mentality.

• The retail channel remains crowded – there has never been more high-quality content.
  

Investment thesis

Games development in the UK is in good health, with the UK remaining one of the most important
markets in the global video games industry. This remains a fragmented market with the quoted
companies offering unique exposure to different industry segments and market dynamics.
UK video games | 26 February 2019 3
Specifically considering investors wishing to invest in the UK games industry, we believe that the
following factors should be borne in mind:

• In 2018, the UK was the sixth largest games market in the world with 2018 revenues of $4.5bn
  and 37.3 million people playing games (source: Newzoo).
  
• Western Europe accounted for $20bn of revenues and over 200 million gamers
  

Reasons to invest in the games industry include:

• • Exposure to strong forecast growth of >10% to 2021 (source: Newzoo);
    
  • Singular exposure to a global youth demographic;
    
  • The UK industry leads the world, well supported by the UK government’s tax breaks;
    
  • Businesses are more robust than in the early 2000s – stronger management, flexible cost
    bases and more diversified revenue profiles;
  • Technological advances will only make games content more compelling
    
  • Multiple avenues for future growth, including VR, AR, games-as-a-service (GaaS) and eSports.
    

Heterogeneous not homogeneous

The UK games sector has essentially re-emerged over the past 18 months, so it is tempting to
consider an investment in the sector. In our view, however, we would highlight that this tier 1
analysis is not sufficient in itself – the five UK-quoted businesses (six if you include Game Digital),
differ significantly in terms of risk profile and investors need to consider carefully which is likely to
match their investment criteria most closely. Each company operates a different business model,
with exposure to separate market segments, and should not be considered as equal alternatives for
exposure to a homogeneous sector

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