UK video games – General — Heterogeneous not homogeneous

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. 

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. Specifically considering investors wishing to invest in the UK games industry, we believe that the following factors should be borne in mind:

Reasons to invest in the games industry include:

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.

We will build on this very brief introduction to the games sector in future notes, but as an industry primer, it is worthwhile to note and comment on some of the themes driving growth in the games sector today and in the near future.

What makes the games sector so exciting is that occasionally titles break out and ‘go big’ (eg Clash of Clans, Candy Crush, Grand Theft Auto IV, World of Warcraft). Fortnite is the latest of these titles. Developed by Epic Games (US, private), after the title’s Battle Royale format captured the gaming public’s imagination, Fortnite has now attracted over 200 million registered users with 8.3 million concurrent players. The title is free to play (zero upfront cost), but monetised by the sale of in-game downloadable content, primarily cosmetic enhancements to a player’s characters (Epic is rumoured to have made profits in 2018 of US$2–3bn).

As well as cannibalising existing gamers, Fortnite has reached new audiences, so although a drag on competitor revenues in the short term, the title has likely expanded the overall games audience in the long term. How long will this phenomenon last and what title will be the next ‘big thing’?

The scale of Fortnite’s success has also allowed its developer, Epic Games, a platform to challenge the incumbent digital distribution platform, Steam, owned by Valve (see below for more detail).

Digital distribution has been to the benefit of all IP owners – developers can now afford to self-publish – but has marginalised retailers, forcing them to evolve their business models.

As with other industries, one of the big revolutions in gaming over the past 10 years has come from the transition from physical distribution of content (ie DVDs) to digital downloads.

This has allowed publishers to significantly reduce game launch costs (development and marketing costs remain) and avoid the sharp price falls that followed if initial sales were slower than forecast. Digital distribution offers a more flexible model, whereby games can be launched in limited Beta (ie playable but not fully debugged and polished) within a gaming community (for final testing and community engagement) and only formally launched when the game is ready, benefiting from feedback from the test community.

Importantly, this model also allows publishers to launch to a global audience without stock risk or the need to discount prices heavily post-launch.

Cheaper distribution is an unexpected bonus to both consumer and IP owner, particularly the most digitally advanced. Steam is well established and continues to provide a great service at a now reduced cost to larger publishers, but, needless to say, any reduction in overall distribution costs flows straight to the bottom line of IP owners.

Using the success of Fortnite as a Trojan horse, in Q418, Epic Games announced a challenge to the incumbent PC digital distribution platform, Steam (90% market share). Epic Games proposes to take just 12% of revenue from titles hosted on its platform, leaving 88% for the publisher, down from the established norm of a 30/70 split (Apple, Google and the console platform holders remain at 30%). In response, Steam reduced its revenue share to 25% (from 30%) for revenues in excess of $10m, and 20% for revenues above $50m – annoying small, independent developers but appealing to big publishers. Discord, a US-based messaging app developer for gamers, is looking to go further, offering developers a 90/10 revenue split. Other notable digital game stores include GOG (owned by CD Projekt), Humble, Itch and Kartridge.

GaaS describes the ongoing relationship with a game’s community post-launch, where the game developer manages the community and provides additional content or events (whether for free or at a charge) to extend the life of the game and increase its lifetime value (LTV).

Digital distribution has allowed a secondary revolution, whereby shorter, more limited core games can be launched, reducing upfront (ie risky) development costs, and then added to by way of downloadable content (DLC) over time, based on user feedback and demand (ie far less risky) to sustain the game’s community. Free or premium content can be used to improve the game and offer an opportunity for incremental future revenue from the title, drawing out the revenue profile, extending its life and strengthening the ongoing direct relationship between the publisher and the game’s community.

The GaaS business model underpinned by DLC is now established throughout the industry and is an important revenue stream for, eg Sumo Group, as well as a core part of Frontier Developments’ business model.

We expect a 2020/21 launch, but will Sony break first (the PS4 is leading this generation, but is showing its age) or Microsoft (losing this generation and trying to get a head start for the next)?

In the early 2000s, the console cycle was an ever-present factor overhanging the sector. Typically, every seven years or so, as the previous generation of hardware started to show its age, a new generation of hardware consoles was launched, building up a user base and seeking to monetise its audience to recoup the huge costs of developing and establishing the console.

Although the games sector is not dominated by the economic cycle, it is subject to the console cycle. With console sales, a smaller part of an expanding pie (vs online, PC, mobile, casual), together with the ability to remotely update platform software periodically with the increasing virtualisation of the console, the games sector as a whole is far more insulated from the cycle today than historically. Nevertheless, although timing is not certain, transition work has started, with 2020/21 being the expected window. We should hear more later this year.

Transition has a huge cost to the hardware manufacturers, Sony, Microsoft and Nintendo, but also delivers a ‘walled garden’ (where the user has restricted access to approved content and services) to their future benefit once the platform base is established.

Google has also thrown its hat into the ring with a streaming console codenamed Project Yeti. Amazon, too, is shortly expected to announce a streaming console.

Streaming (subscription-based models) is just around the corner for the back catalogue, but it may still be some time before front-line games are available to stream.

The ‘next big thing’ (although it is still a number of years away from significant user penetration) is streaming, whereby the game resides and is rendered in the cloud, and streamed live to a ‘dumb’ (or depowered) console. This approach requires robust global communications infrastructure, reduced latency and high-bandwidth, low-cost distribution.

Whether a publisher model or a channel model (think Netflix or Spotify), significant investment is going into developing effective video game streaming models and the associated hardware. There are rumours that Microsoft’s next console will feature both a cloud-based box that streams content and a home console as a hub. A number of the major publishers are also investing in this technology. The end game is that the publisher/console owner has a direct relationship with the consumer and the ability to offer content direct, by way of a subscription.

However, internet infrastructure in many core jurisdictions will need to improve markedly for streaming to become mass-market; latency and lag are currently prohibitive and are likely to remain so for years to come. However, ultimately, the lure of a subscription-based model will be compelling to both publishers and console manufacturers, even if only to monetise their archive of older titles.

This trend can be played through major publishers (eg Electronic Arts), the console manufacturers (Microsoft, Nintendo, Sony and Google) and cloud service providers (Google, Amazon, Microsoft).

From an investor’s perspective, although eSports is a technology with an evolving impact on the industry, the main beneficiaries are Google and Amazon. Pure-play exposure is hard to identify beyond a few specialist eSports companies.

eSports is another revolution in the games industry that will have a significant impact on its future development, but which today has relatively low visibility beyond its select audience. eSports are organised, multiplayer video game competitions, with sponsored professional players and teams.

Once upon a time, gaming was for the solitary player holed up in their bedroom, but that view is now outdated, with online collaborative games growing into eSports (eg League of Legends, Counter-Strike, Overwatch etc). Bizarrely (at least to an outsider), even titles such as Farming Simulator are now forming an eSports league. The necessary ingredients to success appear to be multiplayer titles with a strong community of sufficient size and players with a competitive edge. The audience will choose itself.

Today, eSports provides a further way to build a community around successful titles, extending the life of the game, growing its audience and providing ancillary revenue streams from advertising, sponsorship and merchandising.

These events can draw huge live-streaming audiences on Twitch/YouTube (as well as highlights for download) wanting to watch leading players show their mastery of the game.

Producers of games that may offer attractive future exposure to eSports include Activision Blizzard (for first-person shooters), and potentially Electronic Arts (FIFA, NBA) and Codemasters, who announced a global eSports partnership with Motorsport Network in February 2019, starting with its latest title Dirt Rally 2.0. Otherwise, pure-play exposure is hard to identify beyond a few specialist eSports companies, eg Gfinity in the UK and MTG in Sweden. eSports is also a core part of Game Digital’s strategy.

One of the major drivers behind the evolution of gaming hardware is the development of virtual reality (VR) and augmented reality (AR). Could a compelling consumer proposition appear in 2019, or 2020 or 2021? It is hard to say, but for the moment, while waiting for the consumer proposition to develop, the best commercial propositions can be found in out-of-home and enterprise VR solutions.

Gartner’s Hype Cycle analysis suggests that Enterprise VR has already arrived as a commercial proposition, but AR and consumer VR are still travelling the curve.

VR is where the user is offered total immersion in a virtual world via goggles or a headset, whereas AR is where a digital user interface is laid across the real world through a pair of glasses or other eyewear (think of a fighter-pilot’s heads-up display), allowing a mix of real and virtual objects.

These technologies have been held up as the future of gaming, offering a more compelling and immersive experience than current screen-based technology. However, the sector is still waiting for mass-market consumer adoption when hardware and content come together to offer a compelling consumer experience at an attractive price point.

Mass-market consumer adoption requires convergence of three principal factors:

The Oculus Quest headset (Oculus is owned by Facebook) is due to launch in Q119, and could be a big step forward, but a choice of compelling content is still needed for success. Industry insiders suggest mass-market consumer take-up could be seen as early as 2020/21.

However, today, an attractive commercial proposition can be found in ‘out-of-home’ and enterprise VR solutions, where exposure to high-end experiences can be offered commercially, or where the cost savings or other strategic benefits to the enterprise outweigh today’s limited experience.

There are a small number of UK-quoted companies offering exposure to VR: EVR Holdings (live concerts); VR Education (education); and Immotion Group (out-of-home VR). Additionally, one of Mercia Technologies’ largest holdings (‘Emerging Stars’), nDreams, is a leading VR video game developer (Mercia Technologies is an Edison client and a detailed review of nDreams can be found in our initiation note from October 2018: Mercia initiation).

The UK-quoted games companies offer minimal mobile exposure, as the more casual player base, the dominant freemium model and intense competition all contribute to an unattractive risk profile.

The fastest-growing segment of the games sector remains on the smartphone, where Newzoo forecasts global growth continuing at an IRR of c 19% from 2017–21.

Mobile offers the potential for huge scale and penetration, but monetisation is only becoming harder as premium titles struggle with the swathe of free content available, meaning that the most relevant business model is free-to-play (no up-front cost, discretionary micro-transactions and premium content).

From a games perspective, mobile remains a casual medium where tastes, fads and fashions move quickly, but meaningful revenues are hard to achieve. As a result, mobile gaming is not a core focus for a number of major games companies, eg Ubisoft, Frontier Developments. Activision Blizzard retains significant exposure to mobile through its acquisition of King (maker of Candy Crush), while Glu, Zynga, MAG interactive, Stillfront and Rovio (Angry Birds) offer pure-play quoted company exposure. In the UK, Codemasters has recently signed a significant deal for a mobile racing title with NetEase targeting a Chinese audience and Team17 offers a range of mobile and casual titles.

On mobile, consumer recognition is incredibly powerful, with the consumer drawn to names/IPs that they know and recognise, particularly those titles being played by their peers. This tends to reward successful titles (success begets success) and make the slope even more slippery for new IP. This phenomenon is highlighted by AppAnnie’s The State of Mobile 2019; incumbency matters:

The size of the Chinese market is hard to ignore, but cultural differences mean that many western IPs are not relevant. Western companies usually choose local partners to tackle the key Eastern territories individually. The recent hiatus in Chinese regulatory approvals has affected the pace of growth for mobile games in China as well as encouraging the local incumbents to look for growth (and diversification) overseas (see Exhibit 5 below).

The Asian markets have evolved independently to western markets, with cultural differences helping to shape different styles of game, gameplay and business models.

Japan, with two of the global console manufacturers (Sony and Nintendo), has greater crossover to western markets than China or Korea, the two other largest games markets. In 2018, a change to censorship and regulatory responsibilities brought the new games pipeline in China to a grinding halt, significantly affecting the major games companies, Tencent and NetEase. Games approvals restarted in December 2018, but only a few titles in a huge backlog have been released (to date).

Western studios are now more focused than ever on the opportunity offered by the Chinese audience, but games that are suited to such different markets are rare.

Most developers will partner with one of the strong local players, one of the BATs (Baidu, Alibaba, Tencent) or NetEase, to optimise games for the Chinese market and manage distribution of a game that complies with local requirements for censorship and regulation.

With a huge choice of local hardware manufacturers, the VR market in Asia has also followed a different development path than in the west with VR content largely free-to-play. As a consequence of this ecosystem, hardware sales are significantly ahead of the west, but the quality of game content is generally poor.

The benefits of the Video Games Tax Relief (VGTR) are considerable to many of the major UK developers.

The video games tax credit regime was introduced on 1 April 2014 as part of the British government’s broader efforts to support the creative industries in the UK. It provides a tax credit of up to 20% of production costs for developers of commercial video games (on all platforms – PC, console, mobile etc) that are certified as culturally British.

To be eligible the video game development company (VGDC) must be responsible for the majority of the planning, designing, developing, testing and producing of a game, with a minimum of 25% of eligible costs incurred in the EEA.

The VGTR regime has been well received and will continue until 2023 at the earliest (and may well be extended further), helping to support games development in the UK for the foreseeable future. The relief can be claimed for eligible games, though in practice not all developers claim the relief.

We see VGTR as a significant boost to the UK industry to maintain its global competitiveness. Although a future government could amend (or even curtail) the relief, this would seem to us to run counter to two government initiatives: 1) the broader initiative to support UK SMEs to generate employment; and 2) to support UK-based creative industries.

VGTR is a significant benefit for a co-developer such as Sumo Digital and games-engine owning developers such as Codemasters, whilst Frontier Developments prefers the alternative path of applying for R&D tax relief.

We hesitate before mentioning Brexit given the political and economic uncertainties it raises, not to mention the passions. However, looking at the UK sector in 2019, it at least deserves a mention.

In our assessment, the impact of Brexit on the UK video games industry will be negative, although as an international, largely digital service industry, the games sector is well placed by comparison with many other industry sectors.

A report by Games4EU (an anti-Brexit body) states: ‘We need to move our games (both digital and physical), our consoles and our people around the UK and EU – fast and frictionlessly (often referred to as 'just in time' mechanisms). We depend on the regulatory system to enable digital access to our products across the EU.’

We would highlight the key, identifiable issues as:

In summary, from an industry perspective, we expect a series of marginal losses, increasing friction and eroding the UK’s competitiveness, with little identifiable benefit in return.

The video games sector first emerged in the 1970s, with games such as Pong, Space Invaders and Pacman. The first games console was the Magnavox Odyssey – released in 1972 – though many still remember the Atari 2600 as their first console. These arcade games evolved into games such as Super Mario Bros on home consoles such as the NES and Elite on the BBC Micro. What started out as a niche pastime for technology-obsessed nerds in the west in the 1970s was adopted by bedroom coders in the 1980s and subsequently developed into an identifiable industry in the 1990s. The games sector has now evolved into a global business that is larger than film, TV or music.

Underlining games’ supremacy, the most valuable media IP is also a video game: GTA V is recognised as the ‘most financially successful media title of all time’ with 90 million sales worldwide, and $6bn in revenue.

From the initial inception on PCs, games have proliferated and have now been developed for all platforms and devices, offering compelling content wherever you are and whatever you are doing. Games have also evolved from a physical boxed product (cartridge, floppy, minidisk, CD or DVD) to a digital download; essentially all games content is now downloaded for smartphones and digital download is rapidly increasing for the larger file sizes on PC and console.

With the prospect of eSports, VR and AR, there are still plenty of technological hurdles to be surmounted towards ever more compelling and immersive gaming. And with the prospect of streaming content, games-as-a-service and increasing digitalisation, business models will continue to need to adapt to this rapidly evolving space.

It is useful to look at the global market as a whole, though recognising that there are significant differences between regions and countries, particularly in terms of platform (mobile vs console/PC), the balance between male and female gamers as well as cultural preferences that have an impact on content and playing style.

Looking forward, the largest single market will continue to be China, forecast by Newzoo to reach $50.7bn in 2021, with a CAGR of around 10% from $37.9bn in 2018. Asia-Pacific will remain the highest growth region (extending its lead), with the fastest-growing markets in the coming three years, India and other countries in South-East Asia, as well as China.

In terms of 2018 games revenues, the Asia-Pacific region is clearly the largest global gaming market, having generated $71.4bn in 2018 (16.8% y-o-y growth), 52% of the global total. This growth has been largely driven by the growth and increasing penetration of the smartphone, for which the region has, by far, the largest user base.

North America remains the second-largest region, with revenues of $32.7bn (a 10% y-o-y increase), representing 23% of the global total. EMEA is half a step behind, with revenues of $28.7bn (+8.8% y-o-y), representing 21% of the global market, while Latin America, with $5.0bn of revenues, represents the remaining 4%.

The gaming industry remains in a healthy state overall with growth continuing in all major segments of the games industry: mobile, console and PC.

Mobile gaming (smartphone and tablet gaming) was the largest single segment of the games industry in 2018, expected to have generated $70.3bn, accounting for 51% of the total global market. The segment also accounts for the largest player-base with 2.2 billion games players, the majority of whom use smartphones (as opposed to tablets or traditional handsets).

It is worth highlighting that, for the UK-quoted games companies at least, mobile exposure remains extremely limited (despite Codemasters’ recent announcement of a valuable F1 licensing deal with NetEase to target Chinese mobile users) as the more casual player base, the dominant freemium model and intense competition all contribute to an unattractive mix. Stripping out mobile growth, global PC/console growth is significantly slower, below 5% to 2021.

Console is the second-largest segment with revenues of $34.6bn in 2018. This will grow to $39.0bn in 2021, a CAGR (2017–21) of 4.1%.

The third-largest segment, PC, is expected to have generated $32.9bn of revenues in 2018. Continuing growth in downloaded/boxed PC games has been moderated by declining browser PC revenues, as browser gamers have largely transitioned to mobile.

Combining these two cuts into the data, when we look for the intersection between segment and region, the dominant class are mobile phone users in the Far East, with China far and away the most important single territory.

Overall games revenues are forecast to grow in excess of 10% between 2017 and 2021 (Newzoo), meaning that the games sector will have experienced a decade of double-digit annual growth by 2021. However, this high-level growth conceals divergent trends.

Firstly, much of this growth is attributable to the largest games sector, mobile, with a forecast CAGR of over 17% to 2021.

As a note of caution, the latest results from Apple, Samsung, LG Electronics and most recently Sony, suggest that global mobile growth may well be slowing, with smartphone adoption now close to saturation. Additionally, with the Chinese authorities having only just restarted approvals for new games in China, following a nine-month freeze on new game approvals, this source of mobile games growth is also likely to be constrained at least in the short term.

By comparison to mobile, although still offering attractive growth, PC and console are forecast to grow by a CAGR of approximately 4% and 5%, respectively, over the period, reflecting the relative maturity of the offering on these platforms.

Although not considered by Newzoo, the latest data from GfK/UKIE showed that the revenue generated from boxed video games in the UK declined by 2.8% y-o-y in 2018 to £770m, dropping by 7.1% to 22m units in terms of unit sales. This flags the challenges faced by retailers such as Game Digital, HMV, Green Man Gaming et al to stay relevant as their traditional business is digitalised. In parallel to the travails of GameStop in the US, these companies are rapidly seeking to evolve their business models to incorporate community and experiential elements, merchandising and digital sales to retain relevance as distribution moves online.

From another perspective, it is interesting to understand why physical sales are so enduring in what is an increasingly digital industry. This appears to be a factor of: 1) games sales being tied to hardware (ie console) sales; and 2) the prevalence of family gifting, where family members prefer that the recipient has a present to unwrap rather than just handing over a digital download code.

As an example of how retailers are reacting to an increasingly digital distribution model, Game Digital’s strategic priorities in its 2014 IPO prospectus were to:

Since IPO, Game Digital has placed progressively more emphasis on 4 above, linking its market development primarily to the customer experience, while relying on that relationship to attract related product sales. This has led to its increasing focus on events, eSports and digital.

In February 2018, in line with this increasing emphasis, Game Digital signed an agreement with its 25% shareholder, Sports Direct, to accelerate the roll-out of its BELONG gaming arena concept and GAME retail units. It commits to develop these in a range of formats:

The market recognises that Game Digital has significant execution risk around this change strategy, with the shares currently trading at c 28p, below end July 2018 net cash of 57p. Game Digital is a client of Edison.

Focusing in from an investment perspective, what can be learnt from the past?

Historically, the games industry has been fairly resilient to the broader macroeconomic cycle, though still exposed to the console cycle (eg transition from PS3 to PS4 and Xbox360 to Xbox One). The apocryphal example is that when times are tough, people go out less and spend more time at home; along with Netflix, games offer cost-effective in-home entertainment.

Looking ahead, although dynamics are hard to forecast, with the high growth of the games industry over the past two decades and more (Newzoo forecasts double-digit growth to continue throughout the decade), the global games industry is now so broad that its growth can no longer be considered to be independent of the consumer cycle. As such, games consumption is likely to correlate more closely to global consumer trends than it has in the past.

With the prospect of a looming consumer slowdown, coupled with a coming console transition likely to be announced later this year, there are definitely obstacles to continued growth on the horizon.

We believe that the console transition is more likely to be in 2020 (or even 2021), rather than 2019 as, talking to publishers, there appear to be few if any rumours of development kits (specialised versions of the new consoles that allow developers to create and test games for the new hardware) widely in the market. Although the release date tends to be a closely guarded secret for financial and strategic reasons, it is hard to suppress all noise and rumours inevitably leak into the market.

As we move towards the end of the cycle, games companies focus more on sequels than new IP, releasing evolutionary iterations of existing titles rather than taking the risk of trying to establish new titles on hardware that is reaching the end of its lifecycle. Games teams have now optimised their approach and processes for the current generation of consoles, with little further technological edge to be found from the hardware.

Sony’s PS4 has dominated Microsoft’s Xbox One in the current generation, but it appears closer to the end of its lifecycle than the Xbox One. Even so, Sony may choose to let Microsoft make the first move to try to get a competitive edge for the next-generation console battle, and be a fast follower.

For these reasons, with serialisation and relative under-investment in new IP evident in 2018, there is likely to be increasing pricing pressure as the year progresses, as titles compete for end users with other well-established franchises.

It will be critical to the success of the next-generation of consoles that there is a vibrant ecosystem of titles (a mix of established franchises and new IP) available at launch, developed by the console owners themselves (more likely to take risks to establish new IP to differentiate their platform) as well as by third-party publishers. This will be a critical factor behind who ‘wins’ the next console cycle. As such, before the console transition is formally announced, development kits will have been released to major developers and publishers so that they can start to get to grips with the new consoles and technology for early release of key titles on the new hardware.

With the cost of large teams at many of the major publishers tied up with launch titles for the new consoles, there are likely to be fewer resources dedicated to other titles. This could either mean that stretched resources are concentrated on key titles or that publishers will need to rely more heavily on outsourcing and work-for-hire studios to take up the slack.

Once manufacturers confirm the new console launches, 2019 could be a choppy year, with more marginal developers/publishers seeing increasing pricing pressure focused on the current platforms rather than investing in the next-gen consoles.

There is likely to be increasing polarisation between premium titles (established AAA franchises) and affordable games (low-cost, innovative, discretionary) with a squeezed middle of good or solid games that fail to achieve good reviews (75%+ on Metacritic) that consequently disappoint at retail; recent examples of titles that fell between the cracks include Starbreeze’s The Witcher IV and Bethesda’s Fallout 76.

From an investor’s perspective, it is important to have an understanding of why the quoted games sector is different this time around relative to its previous foray onto the public markets (1990s–2000s), from which time none of the UK companies now survives independently.

‘One of the problems in the UK that caused a lot of damage was that there were a lot of unsuccessful IPOs in the 1990s. If you look at Eidos, Argonaut...the City still remembers it. It's astonishing. And it has taken a while to get beyond that.’
David Braben, CEO, Frontier Developments

‘I don't think I truly appreciated the reputational damage to the industry in that era’, Debbie Bestwick says. ‘Certain names get brought up... nobody talks about them these days, but in the City they still remember.’
Debbie Bestwick, CEO, Team17

As can be seen from the table above, even the first wave of UK public games companies had 10–20 years of trading history at the time; these were not new companies. However, they had (largely) been founded by enthusiastic amateurs and operated within an entrepreneurial sector that was rapidly evolving; the challenges of keeping pace, while managing and growing a sustainable business were significant.

In a nutshell:

Games is a global industry: Perhaps the key difference this time, compared with the past, is that the games industry itself has grown exponentially and is no longer a fast-moving playground for amateurs but is dominated by 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: 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 are companies with an established track record, run by professional management teams; creative, but non-commercial management teams are not at the helm of the multi-studio businesses.

UK government support: 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, for example, Canada, France, the US and Ireland, and other regions with significant industry tax breaks.

Nevertheless, the games industry remains 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 than develop new hits themselves. The dynamic nature of the sector, where technology and creativity collide, means that volatility is inevitable (eg Starbreeze with The Witcher IV and Bethesda with Fallout 76). The shift to recurring revenue models may help ease this, but it will never completely go away.

The UK games sector has essentially re-emerged over the past 18 months, so it is tempting to consider an investment in the ‘UK games sector’. 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 different markets, and should not be considered as equal alternatives for exposure to a homogeneous sector:

To add to this list, companies that offer exposure to different elements of VR such as VR Education, EVR Holdings and Immotion Group should also be considered, and one of Mercia Technologies’ main portfolio holdings is a leading games VR developer, nDreams (see Edison’s Mercia initiation note).

We feel that it would be useful to the more generalist investor to try to highlight leading indicators for the sector.

The stock performance of the sector over the course of 2018 was an amplification of the bull H1/bear H2 of the overall market, following the valuations of the FAANGs (Facebook, Apple, Amazon, Netflix and Google) and the broader technology sector both up and then down.

The market became enthralled by Fortnite in H218, both the scale of its success and its potential collateral damage to competitors in the sector. As a consequence, there appears to have been some differentiation between stocks, particularly those that might suffer in a battle with Fortnite. Although they have sold well, a number of EA titles are seen to have underperformed against expectations (Battlefield V, FIFA 2019) exposing EA, at least in the short term, with a narrow portfolio of tiring franchises with little new or exciting to lift sentiment on the horizon. Activision Blizzard introduced a battle royale format to its lead FPS, Call of Duty, with the release of another of its titles, Destiny 2, delayed. Bethesda has also suffered at Fortnite’s sword, with Fallout 76 receiving poor reviews (Metacritic: 49–53) and consequently even worse sales.

What should investors make of this – is this just a correction following a bout of over-optimism in H118 or is there something more fundamental going on?

With valuations remaining high (by historical levels) and still at or around the five-year average, our belief is that investors are reassessing the defensive characteristics of the sector and its potential to outperform further in the short term. However, recognising that there have been no fundamental changes to the games sector, even if the growth forecasts for mobile need to be revisited, we believe that investor appetite for the medium to long term should return.

Share prices of the more established global games companies have pulled back significantly over the past six months, but this has been a mere dent in the valuation premium such that valuations are now more on par with the five-year average, with share prices rebased to the levels of H117. Nevertheless, despite these lower prices, the big picture remains that, across the board, share prices are multiples of their levels at the start of 2015 and have risen, in aggregate, by close to 600% over the past 10 years.

It is also instructive to look at other valuation multiples, and below we show similar charts showing the progression of EV/EBITDA and EV/sales for our basket of games stocks. EV/EBITDA has risen from 6–8x at the start of 2009 to 20–25x today, with the sales multiple rising from 1–2x between 2009–14 to closer to 5x today.

On the face of it, this multiple growth, particularly over the past five years, appears very aggressive. Yet the P/E multiples reflect a slightly different story, where the prevailing multiple from 2009–14 was 20–25x and now (following the recent share price falls) is close to 30x; far more subdued growth and a far less aggressive metric.

How should we explain this? In part, it reflects the growing up of the industry with more robust and better-managed businesses generating greater underlying profit per unit of sale. There is also an element related to the transformation of the industry from delivering physical product to retailers to digital self-publishing with the margin expansion this has allowed.

However, this does not fully explain why the EBITDA trend has closely mirrored the sales trend, suggesting that this is not about gross margins. Instead, the underlying profit has increased substantially despite slower growth in EBITDA and operating profit.

As well as the digital transformation of the industry, reduced levels of tax are certainly part of the equation, with tax breaks around the western world (Canada, US, Ireland, UK, France, etc) helping to support the profitability of the games industry, the growth it generates and the jobs it offers.

The UK has closely followed US valuation trends, with a relatively strong H118 being followed by a far softer H218, with companies handing back many of their share price gains following recent IPOs. However, in the context of the broader pullback in technology valuations as well as some of the poor performance of recent IPOs, as a group, the UK games companies have performed satisfactorily, with each achieving (or formally stating that they will achieve) their first FY forecasts post-IPO.

European games companies have proved far more resilient in the face of these global headwinds, outperforming strongly in H118 and holding onto many of these gains over the course of H218.

We remain positive about the prospects for the UK sector in 2019, although we would highlight that the ratings and growth expectations for some of the more mature players remain challenging.

However, our thesis remains that rather than seeking exposure to the ‘games sector’, investors should look harder to understand which of the different business models on offer best matches their risk appetite and approach.

In conclusion, 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; in 2018, the UK was the sixth largest games market in the world with $4.5bn spent and 37.3 million people playing (Newzoo).

Reasons to invest in games companies include:

With multiple IPOs over the past 15 months, there is now a meaningful choice of UK-listed games investments to suit investors with different preferences and risk appetites.

We highlight below some of the key trends that are likely to drive the games sector over 2019 and beyond and have provided our views on which of the UK-based games companies offers exposure to each of these separate trends.

As we look forward to 2019 and beyond, what sorts of companies do we think will do well and which do we think might struggle?