April 9, 2009 | Alex Ferrara | Bessemer Venture Partners Notes on the Video Game Industry

Video Game Industry Themes Large and growing industry Digital distribution Connected & multiplayer Freemium Conclusions

Large and growing industry

Digital distribution

Connected & multiplayer

Freemium

Conclusions

$500 million First Week Sales $239 million First Week Revenue Source: Associated Press Scale of Dark Knight vs. GTA4

Worldwide Gaming is bigger than Music, DVDs, or Box Office Source: Citigroup, NPD, October 2007; ESA 2008 Asia $11.5bn Europe $11.4bn U.S. $10.7bn

$34+ Billion Industry Worldwide Source: Citigroup, Brent Thill $68 Billion of Total Consumer Spend in 2007

Video Game Industry Themes Large and growing industry Digital distribution Connected & multiplayer Free-to-play Conclusions

Large and growing industry

Digital distribution

Connected & multiplayer

Free-to-play

Conclusions

Traditional Video Game Value Chain Publishers Console Vendors Retailers Consumers Spend Value Capture $68 billion $9 billion $25 billion $33 billion Royalties & Licenses Independent Studios

Console Game Publishers Face Challenging Economics Low contribution margin and high fixed costs make “hits” critical to success Revenue from a $50 Console Game Trend Ad agencies and media Overhead, freight, co-op, bad debt, etc… Developer Retailer Retailer Console vendor Media manufacturer Paid To Publisher Marketing $6 (12%) Publisher Operating cost $10 (20%) Publisher Development cost $8 (16%) Publisher Markdown reserve $3 (6%) Consumer Retailer profit $13 (26%) Publisher Publishing license $7 (14%) Publisher Cost of goods $3 (6%) Paid By Purpose Amount

Console Game Publishers Face Challenging Economics Electronic Arts Activision Blizzard Despite strong revenue growth, the profitability of major publishers continues to decline Activision has pursued M&A opportunities to grow the bottom line Blizzard (World of Warcraft - MMOG) <- Not a console games business Red Octane (publisher of Guitar Hero) Source: Capital IQ

Despite strong revenue growth, the profitability of major publishers continues to decline

Activision has pursued M&A opportunities to grow the bottom line

Blizzard (World of Warcraft - MMOG) <- Not a console games business

Red Octane (publisher of Guitar Hero)

Video Game Value Chain Publishers Console Vendors Retailers Consumers Spend Value Capture $67 billion $9 billion $25 billion $33 billion Long-Term Trend Themes Undergoing shift to online Console not profitable, online very profitable Increasing costs & complexity of game dev Consolidation due to EOS in dev, marketing U.S. Broadband penetration 75%+ PC & console penetration high Proliferation of choice (online, PC, console, portable, mobile) Higher quality content Free-to-play models popular Desire for content that is more Interactive, social, fun Consolidation Competition from online retail Margin pressure from console vendors Used game sales remain good business but at risk long term Digital Distribution Currently control distribution Razor blade model of low HW margins high licensing fees Consoles very price competitive Long-term risk from digital distribution

Undergoing shift to online

Console not profitable, online very profitable

Increasing costs & complexity of game dev

Consolidation due to EOS in dev, marketing

U.S. Broadband penetration 75%+

PC & console penetration high

Proliferation of choice (online, PC, console, portable, mobile)

Higher quality content

Free-to-play models popular

Desire for content that is more Interactive, social, fun

Consolidation

Competition from online retail

Margin pressure from console vendors

Used game sales remain good business but at risk long term

Currently control distribution

Razor blade model of low HW margins high licensing fees

Consoles very price competitive

Long-term risk from digital distribution

Digital Distribution Publishers Platforms & Aggregators Consumers Both distribution models will continue to exist, however the latter will grow more rapidly particularly in the emerging online-only category Majors: Nintendo, EA, Activision Blizzard, Ubisoft, Sony, Take Two, Sega, THQ, Microsoft, Square Enix, Konami Emerging Online-Only: Playfish, Zynga, BigFish, Sulake, Jagex, OMGPOP, etc… Facebook Myspace Miniclip AddictingGames RealNetworks …

Majors:

Nintendo, EA, Activision Blizzard, Ubisoft, Sony, Take Two, Sega, THQ, Microsoft, Square Enix, Konami

Emerging Online-Only:

Playfish, Zynga, BigFish, Sulake, Jagex, OMGPOP, etc…

Consoles provide standards which have historically promoted the growth of the game developer ecosystem Some believe that the best games come from developers who have deep platform knowledge Distribution is moving to the cloud, but will traditional console vendors successfully leverage their advantages in publishing to get there first? Xbox Live PS Cloud WiiWare … Or will the challenges of cannibalization, bureaucracy, and the risks of upsetting the existing retail distribution prove too challenging? Startups such as OnLive, GaiKai, and Zeebo will introduce open virtual consoles and have the potential to “unlock” billions of consumer spend Virtual consoles pose a potential threat to console vendors but these models faces substantial technical and business challenges How Will Digital Distribution Impact Console Vendors?

Consoles provide standards which have historically promoted the growth of the game developer ecosystem

Some believe that the best games come from developers who have deep platform knowledge

Distribution is moving to the cloud, but will traditional console vendors successfully leverage their advantages in publishing to get there first?

Xbox Live

PS Cloud

WiiWare

… Or will the challenges of cannibalization, bureaucracy, and the risks of upsetting the existing retail distribution prove too challenging?

Startups such as OnLive, GaiKai, and Zeebo will introduce open virtual consoles and have the potential to “unlock” billions of consumer spend

Virtual consoles pose a potential threat to console vendors but these models faces substantial technical and business challenges

Today’s popular console games are typically 720p and 60 fps and require 60ms response time Latency, bandwidth, and designing for peak load are key challenges Issue #1: Latency & QoS Speed of light is a fundamental issue Distance from New York to Palo Alto is 4,828 km Speed of light in vacuum is 300 x 10^6 m/s Speed of light in fiber is ~66% of the speed in a vacuum = 200 x 10 ^6 m/s One-way delay from NY of 4,828 / 200 x 10^6 = 24.14 ms Theoretical round-trip time from NY to CA of 48.28 ms Practical ping time (round trip) of [~85] ms or ~[2x] Video encoding would introduce 50 ms of latency for a total of 135 ms (OnLive claims 1 ms!?) Customer probably has to be within 1000 miles of the game cloud -> implies 3+ data centers in U.S. Issue #2: Bandwidth Server-side video encoding creates a tradeoff between either requiring higher bandwidth or higher latency Moore’s law will improve over time, but FIOS would probably be required today Issue #3: Peak Load Infrastructure Hardware expense is substantial due to design for peak load, high-end PC requirements, and low utilization due to #1 above implies investments on the order of several tens of millions of $$ Issue #4: Moore’s Law will continue to drive requirements upward Larger screens, 1080p HD, higher fps, physics engines Challenges are surmountable but require FIOS adoption, better video encoding, partnerships with ISPs, and substantial infrastructure investment, not to mention business model Consoles aren’t going anywhere soon Virtual Consoles Must Overcome Substantial Technology Challenges

Today’s popular console games are typically 720p and 60 fps and require 60ms response time

Latency, bandwidth, and designing for peak load are key challenges

Issue #1: Latency & QoS

Speed of light is a fundamental issue

Distance from New York to Palo Alto is 4,828 km

Speed of light in vacuum is 300 x 10^6 m/s

Speed of light in fiber is ~66% of the speed in a vacuum = 200 x 10 ^6 m/s

One-way delay from NY of 4,828 / 200 x 10^6 = 24.14 ms

Theoretical round-trip time from NY to CA of 48.28 ms

Practical ping time (round trip) of [~85] ms or ~[2x]

Video encoding would introduce 50 ms of latency for a total of 135 ms (OnLive claims 1 ms!?)

Customer probably has to be within 1000 miles of the game cloud -> implies 3+ data centers in U.S.

Issue #2: Bandwidth

Server-side video encoding creates a tradeoff between either requiring higher bandwidth or higher latency

Moore’s law will improve over time, but FIOS would probably be required today

Issue #3: Peak Load Infrastructure

Hardware expense is substantial due to design for peak load, high-end PC requirements, and low utilization due to #1 above implies investments on the order of several tens of millions of $$

Issue #4: Moore’s Law will continue to drive requirements upward

Larger screens, 1080p HD, higher fps, physics engines

Challenges are surmountable but require FIOS adoption, better video encoding, partnerships with ISPs, and substantial infrastructure investment, not to mention business model

Consoles aren’t going anywhere soon

PlayStation 3 has sold 21.3 million units worldwide (December, 2008) 20 million PlayStation Network (PSN) members Around 60 downloadable PS3 games on U.S. store ranging in price from $5 - $30 1.88 PSN accounts per PlayStation 3 10 million accounts connect to PSN every month Cumulative sales of $180 million @ 2/2009 Xbox 360 has sold 28 million units life to date 17 million Xbox Live (XBL) members Around 196 XBLA games available in NA, ranging in price from free to $20 125 million XBLA games downloaded $1.14 million average gross sales per game (devs keep 50% - 66%) Cumulative sales of ~$200 million @ 2/2009 Wii has sold 45 million units life to date 73 games currently available on the WiiWare NA store, price $5 - $15 Meanwhile, Penetration of Console Networks is Increasing…

PlayStation 3 has sold 21.3 million units worldwide (December, 2008)

20 million PlayStation Network (PSN) members

Around 60 downloadable PS3 games on U.S. store ranging in price from $5 - $30

1.88 PSN accounts per PlayStation 3

10 million accounts connect to PSN every month

Cumulative sales of $180 million @ 2/2009

Xbox 360 has sold 28 million units life to date

17 million Xbox Live (XBL) members

Around 196 XBLA games available in NA, ranging in price from free to $20

125 million XBLA games downloaded

$1.14 million average gross sales per game (devs keep 50% - 66%)

Cumulative sales of ~$200 million @ 2/2009

Wii has sold 45 million units life to date

73 games currently available on the WiiWare NA store, price $5 - $15

If digital distribution is a big trend, why has PC gaming failed? North American PC game sales and market share have declined despite strong growth in the overall gaming market Many publishers no longer develop for the PC despite potential for higher margins Source: Citigroup North American PC Game Sales Annual Sales ($ billion) Share of Overall Market (%)

North American PC game sales and market share have declined despite strong growth in the overall gaming market

Many publishers no longer develop for the PC despite potential for higher margins

Lack of a standardized platform for development U.S. PC Penetration > 80% vs. 50% console, but PC hardware profiles vary Developers must design for a minimum hardware profile, but don’t want to alienate customers PC customer support can be a nightmare Piracy remains a problem Console experience is more enriching; better controllers, accessories Gamers prefer to play on big-screen TVs If digital distribution is a big trend, why has PC gaming failed? Source: Steampowered, March 2009 Gamer PC Hardware Profile Stats from Steampowered.com Users Various Operating Systems in Use including XP, Vista, 32 bit, 64 bit More than 50 different graphics cards in use with varying degrees of performance DirectX 9 & 10

Lack of a standardized platform for development

U.S. PC Penetration > 80% vs. 50% console, but PC hardware profiles vary

Developers must design for a minimum hardware profile, but don’t want to alienate customers

PC customer support can be a nightmare

Piracy remains a problem

Console experience is more enriching; better controllers, accessories

Gamers prefer to play on big-screen TVs

Flash has 500m installs, 98% desktop reach, and may soon ship embedded in TVs Flash 10 includes a range of improved performance themes Visual Performance (hardware acceleration, vector graphics, 3D effects) Rich Media (streaming, XMP data, RTMFP, P2P) Adobe Flash is Ubiquitous and May Be the Key Enabler Flash Player 6 Flash Player 7 Flash Player 8 Flash Player Penetration in Mature Markets 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Flash Player 6 Flash Player 7 Flash Player 8 Flash Player 9 Flash Player 9 Mar-08 Junr-08 Sep-08 Flash Player 10.0 Flash Player 10 Dec-08 Source: Millward Brown: June 2006 – Present, NPD: 2000 - 2005

Flash has 500m installs, 98% desktop reach, and may soon ship embedded in TVs

Flash 10 includes a range of improved performance themes

Visual Performance (hardware acceleration, vector graphics, 3D effects)

Rich Media (streaming, XMP data, RTMFP, P2P)

Starting to see successful flash-based publishers [To come]

[To come]

Video Game Industry Themes Large and growing industry Digital distribution Connected & multiplayer Freemium Conclusions

Large and growing industry

Digital distribution

Connected & multiplayer

Freemium

Conclusions

Consumers Desire Social Gaming Experiences Source: MMOGChart

Next Gen Defined by Connectivity/Community Wii 76% of users are online gamers Xbox 360 70% of users are online gamers 40% have an Xbox Live account (vs. 10% on Xbox 1) PS3 70% of users are online gamers 49% of gamers play online at least 1 hour per week Source: NPD, October 2007; ESA 2008

Wii

76% of users are online gamers

Xbox 360

70% of users are online gamers

40% have an Xbox Live account (vs. 10% on Xbox 1)

PS3

70% of users are online gamers

49% of gamers play online at least 1 hour per week

Consumers Desire Social Gaming Experiences Source: Gamer DNA Rock Band and Guitar Hero III share common game design themes, however Rock Band is designed for a more social gaming experience. Do these social elements contribute to increased player activity? Rock Band - Players/Day Guitar Hero III - Players/Day

Case Study: Nintendo DS Source: VGChartz, press releases Nintendo DS is 2X stickier despite comparable number of titles and similar platform maturity One of the more profitable platforms for publishers including Ubisoft, Activision

Nintendo DS is 2X stickier despite comparable number of titles and similar platform maturity

One of the more profitable platforms for publishers including Ubisoft, Activision

Case Study: Nintendo DS Source: VGChartz, March 2009 <- Weekly Puzzle Downloads via Wifi <- Multiplayer and ghost data sharing <- Virtual pets can play together <- Local multiplayer & capture the flag <- Multiplayer competition DS is the first portable device designed for connected multi-player local games

Publishers Benefit Because Connected Games Reduce Secondary Market Game Sales Source: CapitalIQ Used video games sales represent a billion dollar industry GameStop (NYSE: GME) – Largest Games Retailer in the U.S. 6,200 locations worldwide 2008 Revenue of $7 billion Used Game Sales represent 25% of revenues and 48% of gross profit, or approximately $1 billion Multi-player titles are stickier and less likely to be resold Reducing supply of secondary market increases publisher revenue Still potentially good for GME, which sells more new titles

Used video games sales represent a billion dollar industry

GameStop (NYSE: GME) – Largest Games Retailer in the U.S.

6,200 locations worldwide

2008 Revenue of $7 billion

Used Game Sales represent 25% of revenues and 48% of gross profit, or approximately $1 billion

Multi-player titles are stickier and less likely to be resold

Reducing supply of secondary market increases publisher revenue

Still potentially good for GME, which sells more new titles

Video Game Industry Themes Large and growing industry Digital distribution Connected & multiplayer Freemium Conclusions

Large and growing industry

Digital distribution

Connected & multiplayer

Freemium

Conclusions

Traditional Retail Pricing Model for Console Games Source: VGChartz

Business Models in Flux Video games are shifting from packaged products to connected, on-demand services Consumer behavior online differs substantially from behavior in a retail environment Psychological differences between buying products vs. services Fewer payment options online More difficult to “return” a service than a product Proliferation of free content online As the nature of the game delivery model shifts, so does the optimal business model

Video games are shifting from packaged products to connected, on-demand services

Consumer behavior online differs substantially from behavior in a retail environment

Psychological differences between buying products vs. services

Fewer payment options online

More difficult to “return” a service than a product

Proliferation of free content online

As the nature of the game delivery model shifts, so does the optimal business model

The Penny Gap & Online Game Business Models The toughest part for many online services is getting users to pay anything at all If the cost to acquire a paying customer online is high enough, a free model starts to make sense Furthermore, in the case of connected multi-player games, free services are usually necessary in order to build an audience MMOs and virtual worlds are only fun for a new player if the world is not empty Demand Price Traditional retail economics assume a linear relationship between price and demand… Demand Price Free $0.01 However online the price/demand relationship typically looks more like this Source: Josh Kopelman

The toughest part for many online services is getting users to pay anything at all

If the cost to acquire a paying customer online is high enough, a free model starts to make sense

Furthermore, in the case of connected multi-player games, free services are usually necessary in order to build an audience

MMOs and virtual worlds are only fun for a new player if the world is not empty

Freemium Pricing Source: VGChartz What is Freemium? Give the games away for free Attract an audience through word of mouth, SEO/SEM, social networks, affiliate networks Offer premium priced value added services Examples of premium value added services: [To come]

What is Freemium?

Give the games away for free

Attract an audience through word of mouth, SEO/SEM, social networks, affiliate networks

Offer premium priced value added services

Examples of premium value added services:

[To come]

More to come…

Video Game Industry Themes Large and growing industry Digital distribution Connected & multiplayer Freemium Conclusions

Large and growing industry

Digital distribution

Connected & multiplayer

Freemium

Conclusions

Conclusions [to come]

[to come]

Conclusions Comments? Questions? Have an interesting gaming company? Contact me – [email_address]

Comments?

Questions?

Have an interesting gaming company?

Contact me – [email_address]