‘…with EA’s cloud gaming service and Microsoft’s plan to build a streaming, subscription-based service. Faster average broadband speeds mean lower latency is achievable – although graphic-heavy games may require the equivalent of the 5G network rolling out initially in Asia. The EA system uses essentially the same content delivery technology as used by Netflix and it is betting that the technological shifts that upended the music and movie industries are now coming to games, which looks shrewd. The advantage of owning the distribution platform which is the essence of the Tencent/NetEase strategy is clear in the mobile games space…the industry is slowly evolving toward subscription-based cloud gaming – game ownership, whether via disc or download, will become redundant and gaming publishers will boost recurring revenue. Of course, the flipside is that missing out on a key title launch can reverberate through lower earnings trends for several years – the quality of earnings improves for sector winners, but the volatility is higher for losers so sector performance dispersion will rise sharply.’ – Weekly Insight, September 18th 2018
“Games are no longer episodic consumptive media for most people — they are now really the basis of new massive online communities that are a lot more like social networks in the way that they function and that we invest spend time in them. So much happening in the pattern of consumption of this medium that no one is paying attention to. You can’t put humans in a space like [Fortnite] for that long and not have massive, profound social consequences. We are just not seeing them yet. I’m almost a little bit ashamed as a gamer myself not to have seen just how big this is. This is staggeringly large.” Improbable co-founder Herman Narula interviewed recently
He’s right about the potential for massive multiplayer games to become the ultimate social network, and it behoves every equity portfolio manager to understand how fast this sector is now evolving. I’ve been a secular bull of the global gaming sector as a key play on the dematerialisation of consumption and the rise of the digital ‘metaverse’ in which real money is spent on acquiring virtual utility and status. As immersive technology becomes more sophisticated (particularly as AR/VR becomes practical via edge computing), more and more incremental consumption will shift from tangible ‘stuff’ to virtual experiences.
We remain long a global gaming exposure stock basket which is up almost 20% YTD and the point I made in that note last September was that the video gaming industry, which looks set to become the dominant form of entertainment for under 30s (directly playing, watching on video and other forms of live engagement such as esports), was inevitably set to follow the wider media transition to an on-demand subscription model. The legacy model of creating a hardware platform, such as Sony’s PlayStation and Nintendo’s Switch, and then charging publishers for the right to access it, is now under relentless pressure. The Japanese companies have responded by creating subscription services and offering content other than games, but Google’s push into the industry is a seminal moment. The search giant however not only has to provide a smooth lag-free experience, but also convince key game title publishers to port their content.
As Nintendo prepares to launch two new models of its Switch console (which generates over 80% of total revenue) the risk of annual sales peaking at just under 18m units is growing as the industry undergoes a paradigm shift. As cloud subscription-based streaming goes mainstream, the company’s real value may lie in its well-known game franchises, such as Pokémon licensed to the web giants hungry for content. The US web giants are likely to follow Tencent in vertically integrating to obtain content. The Netflix analogy is relevant – we are set to see a bidding war for game IP and an M&A surge for publishers over the next couple of years.
On its earnings call last month, Sony’s CFO said cloud gaming could pose a threat to PlayStation in the next five years but that the company believed that would take a much longer time horizon – that looks dangerously complacent. Google has set the bar at producing images in ultra-HD (also known as 4K) which is ahead of today’s consoles and at a fast-enough frame rate to make movements appear smooth (Google is matching the 60 frames per second of the latest Xbox and PlayStation consoles). Google’s data centres are among the world’s most powerful – to render images smoothly for Stadia, Google has built optimised new server “blades” that can be slotted into racks in its data centres.
These are embedded with custom-designed GPUs produced by AMD and in terms of raw computing power these generate over 10 teraflops to the individual user versus Microsoft’s Xbox One X at about 6 teraflops (though the next generation of consoles will likely double that). A key technological challenge will be to eliminate the latency, or lag, that can slow the response time when a player presses a button on the game controller. Google claims more than 7,500 nodes on its global computing network, increasing the chance that players will be close enough to see a fast response time but users outside large cities could find themselves many miles from a Google node. The new game controller is connected through Wi-Fi and communicates directly with Google’s data centre, but it will rely on local network operators for the household connection. Google must be betting that its latest video compression algorithms will be able to deliver the seamless quality of service required to be competitive.
Recent progress in this field has been impressive. For instance, Microsoft’s new Project Zipline compression algorithm is fast enough to compress data while it’s being written to an SSD or uploaded from an IoT device and can deliver up to 96% compression of the original data on the Microsoft internal network. The reason it’s so fast and so efficient is that it uses a custom hardware accelerator to look for many times more patterns than compression algorithms can usually handle; data that matches any of those patterns gets replaced by a reference to the pattern, taking up much less space.
The long-term implications for the hardware storage market of this AI pattern recognition/compression software approach are clearly adverse – the optimisation of slack which defines the tech sector is coming to data transmission and storage hardware. Google said it recommends broadband speeds of at least 25mbps to deliver HD images (known as 1080p). Some potential customers won’t have enough bandwidth. It also limits playing games on mobile devices, unless they are connected over Wi-Fi to wired networks. Future upgrades to mobile networks will help, but tellingly Google itself made no mention of the potential of 5G networks, which in the US/Europe won’t go mainstream until the mid-2020s given the gradual planned telco rollout.
As highlighted in that sector note last year, viewing activity on Twitch or Huya offers a useful insight into overall game popularity – watching expert players live-stream on these platforms correlates highly with game download/in app purchase activity. While Fortnite still has the largest number of Twitch channels, its share of viewers have been declining in recent months, down from a peak of 19% to 9%, being displaced the Apex Legends, which accounted for over 20% of viewers after its recent launch before settling at around 6-7% viewership while the PUBG share of viewers has been steady. Apex Legends has had the best launch month of any free-to-play game in history, having generated $92m last month from in-app spending. Fortnite (which is constantly updated) has been impacted, but recently reached over 250m players since launch.
While new game approvals in China have resumed, Tencent has yet to get permission to monetise Fortnite or the mobile version of PUBG. Sales from the Value-Added Services unit, which includes online games and messaging, climbed 9% to 43.7bn RMB but costs surged 43% y/y as investment in content and server financial technology surged. Tencent plans to introduce a new category of sales when it next reports to break down specific categories in the “others” revenue section in its financial statement. Tencent’s one-off costs contributed to a 19 ppt drop in operating margins to 20% but as a result its biggest revenue growth now comes from cloud services, where sales more than doubled last year, to 11% of revenues.
This is a crucial infrastructure investment for Tencent, not just to diversify away from gaming/WeChat revenue dependence but also to create the infrastructure to launch its own cloud gaming system (which is apparently already in beta testing). The web giants will likely demand exclusivity/original publisher content to drive subscription package differentiation as Microsoft, Tencent and Google launch competing cloud platforms within 12-18mths. As elsewhere across the media sector under the impact of streaming, content creators are in the sweet spot…