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Joshua Samuel and Justin Anderson are Equity Analysts for Mawer Investment Management Ltd.

What springs to mind when you think of gaming?

Likely not the complex interplay of the industry’s value chain—the different engines, developers, publishers, and distribution platforms. You probably are thinking as a user: about which consoles dominated your childhood, joining online guilds or disappearing into intricate narrative games on your PC, and now scrolling through the ever-expanding downtime options available on your mobile phone.

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The shift in the gaming industry over the last 10 years has been significant, and with it, the investment potential.

A market size larger than the television industry

In terms of revenue, the gaming industry roughly measures US$160 billion. That’s purely from people purchasing the games up front or making in-app purchases—it doesn’t include hyper-casual games or ones monetized through advertising.

The gaming industry is now the largest entertainment industry. Television—the next closest—measures around US$105 billion. Contributing to its growth are the rapid shifts in technology; about half of that $160 billion comes from activity on smart phones and tablets. The proliferation of smart phones over the past decade has put a gaming device into the hands of their approximately 3.5 billion active users—by comparison there are about 300 million game consoles (PlayStation, Xbox, etc.) and 1.5 billion active desktops in the world. Furthermore, these smartphones are increasingly able to render high-end game experiences—the iPhone 12, for example, has comparable processing power to a PS4. These factors have democratized gaming and make interactive and engaging gameplay experiences available to the masses.

The value is in the value chain

The sheer market size, in combination with some key shifts in the value chain, have led to an emergence of business models with more attractive long-term characteristics—namely, recurring revenue.

To start, distribution has shifted from physical (discs) to digital (downloads). Digital encourages the development of more efficient distribution methods. No longer does physical space need to be literally accounted for; users can directly download games into consoles or phones, bypassing the expensive slotting fees retailers previously required to put products on their shelves. This effectively places a store in all devices, allowing for an increase in total addressable market (TAM). For example, a Japanese game developer told us that the size of their revenue pie has increased thanks to the ability to sell into emerging markets via digital means.

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Equally, if not more important, is that digital distribution has brought about new and effective means of monetizing. Tencent, the largest gaming company in the world, derives virtually all its games revenue from free-to-play games that monetize via in-app purchases (sales of virtual goods). This model aligns user engagement with monetization and stretches the revenue life cycle out over years as opposed to the upfront purchase model (simply paying upfront to download a game or purchase a CD).

Attract, retain, and monetize

This alignment of engagement with monetization incentivizes game developers to focus on what attracts, retains, and monetizes their users. This results in Live Operations (Live Ops) becoming a key success factor in the industry. Live Ops teams continually add new content while removing bugs from the game with the ultimate goal of keeping user engaged. Data plays an increasingly important part in this process. In interviews with management teams, we’ve learned that some companies employ an even split of data scientists to developers to produce content that’s much more relevant to the gamer, aiding increased engagement and revenue.

That said, competition is intense. While the level of intensity certainly depends where you are in the value chain, on the developer publisher side, it’s fierce. Engines are making it cheaper to develop a game, and it’s a fragmented market because direct distribution is relatively easy. This contributes to a rising customer acquisition cost (from $0.25 in 2014 to $4.85 in 2019) as developers slug it out to get gamers to download their app.

Management quality is key

The dynamic, competitive nature of this industry and rapidly evolving business models makes a compelling case for company-by-company analysis. And low barrier to entry means that success typically lies with the quality of the management teams—although exceptions exist, e.g., those with a distribution moat in China (Tencent, Bilibili) or those with established franchises (EA’s Sports IP, Tencent, NetEase’s hit Games IP).

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On top of our usual management assessment framework, we pay special attention to a management team’s: 1) ability to innovate (e.g. NetEase), 2) excellence with Live Ops (Tencent, NetEase, Nexon), 3) discipline with capital allocation, namely how they spend marketing dollars to acquire gamers.

Ultimately, we approach this industry similar to how we approach the pharmaceutical industry: we don’t try to predict which game developer will come out with the next big hit. Instead, we look for those that have better-than-average odds of success over the long run.

Of the companies mentioned in this article, Mawer owns shares in Tencent, Netease, and Nexon.

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