Video games could prove to be disruptor in digital age

"Video gaming has an impressive global footprint, and the industry leaders are benefiting from an improved business model", explains Josh Spencer, Portfolio Manager at T. Rowe Price. The transition to digital games is occuring at a rapid pace. It coincides with several other industry-wide tailwinds, including favorable demographics, technological advances, and industry consolidation.

The rules have changed
The video gaming industry is maturing. While it has been around for nearly half a century, Josh Spencer from T. Rowe Price believes this fast-growing market segment is entering a new and potentially disruptive stage. Over the past decade, the consumer video game market underwent a significant transformation. Smartphones made everyone a potential gamer, and the emergence of more powerful consoles with increased storage capabilities paired with faster Internet connectivity further supported the move from packaged to digital games. The net result has been a durable and consumer-friendly business model with impressive global consumption growth.

Perhaps the most exciting aspect of gaming from an investment standpoint is the ways in which it resembles the software industry. Mobile gaming companies can also eschew consoles and opt to efficiently load games and updates for customers using digital platforms. Anyone with a smartphone is just one app away from becoming a gamer. Furthermore, thanks to increased Internet connectivity and console storage, games and additional content can easily be downloaded to gaming systems. These trends have expanded the addressable market for the industry.

Gamers have matured
A shift in gamers’ demographics represents another significant tailwind. Many gamers are young adults with disposable incomes. These gamers also demonstrate a strong willingness to spend incrementally on gaming, suggesting they equate spending on video games with entertainment. This is coupled with higher expectations. Today, consumers demand sophisticated graphics and complex storylines with multiplayer and immersive gameplay. Consumers now play fewer titles but for longer periods of time. These demands, coupled with the cost of supporting games across platforms, have increased development costs over the past decade. Additionally, the move to digital also allows these companies to assess engagement and make additional changes in content. The changes, which benefit top publishers who have created scale and an effective distribution model, contributed to the industry’s considerable consolidation over the last 10 years—a move which helped eliminate some of the unpredictability that previously characterized the space.

Paradigm shift in technology
Technological changes and consumption patterns are helping digital games generate recurring revenues. Add-on digital content purchased after initial game sales enables consumers to increase their engagement with their favorite titles and publishers as well as expands the monetization of intellectual property. Doing so generates new and ongoing revenue streams at higher profitability. In-game content on console and PC games yields gross margins of more than 90%. Leading video game publishers are continuously getting better at delivering this extra content, and the more content they create, the more time gamers have been willing to pay to play. T. Rowe Price believes that this represents a significant growth opportunity for the industry. Additionally, most mobile games are free to play and then monetized through similar high-margin digital content that is continuously added to the game. As mobile devices increase the addressable market, mobile gaming will continue to play an important role in spurring growth for the industry. Finally, the transition to full-game downloads offers an additional upside for video game publishers. Digitally downloaded console games generate approximately 80% gross margins, while their packaged counterparts generate about 60% gross margins. T. Rowe Price believes increased storage capacity on consoles, faster Internet speeds, and growing consumer comfort with buying digital goods will help increase full- game digital downloads and enable companies to capitalize on this margin gap.

Global innovation
Some of the most promising gaming markets are in Asia, which has seen the arrival of two esports championships that rival professional sports viewership. These include the League of Legends and Dota 2 championships. In 2016, the former brought in 43 million people throughout the finals, with a peak viewership of 14.7 million for the final matchup. For comparison, the most recent NBA Finals generated an average of 20.4 million viewers across the series. Competitions like League of Legends are helping to drive engagement levels—and revenues—higher.

The social aspects should also contribute to higher revenues as digital applications of the industry not only promote competition, but sharing. While this form of entertainment is relatively new, publishers could expect to benefit from essentially free advertising among new audiences. The success of Twitch, a leading video platform for gamers, suggests that this trend will continue. In early 2015, Amazon.com’s Twitch Interactive reported that it averaged 100 million viewers per month. Now, Twitch boasts approximately 9.7 million daily users.

Success in investing in gaming is not dictated by one variable. Recent changes within the industry have produced a strong business model that is further supported by several key tailwinds, making it appealing by additional upside potential. Still, any of these variables in isolation is not enough to create meaningful shareholder value. Investors must be strategic. For this reason, T. Rowe Price seeks to invest in innovative gaming companies capable of effectively navigating the digitally driven business model. The asset manager also looks for companies that can grow their addressable markets and seek out shares trading at reasonable valuations.