This article, written by Tim Merel, first appeared in the China Daily on December 31, 2010 under the title “Global games there for the taking”.
The global video games market is growing rapidly, driven by online/mobile games. China has produced some of the world’s best games companies, which are now looking to international markets for additional growth. This offers a significant opportunity, but investing internationally isn’t as simple as they might hope. To explain why, let’s start by looking at the global market.
A great market for Chinese games companies
The video games industry is big, getting bigger and changing, rivalling Hollywood in 2009 ($77B video games vs $85B film global revenue). Online and mobile games should grow total video games market size to $87B in the next five years, and take 50% revenue share at $44B (18% CAGR 09-14F). The historically strong pure console sector is flat to down.
Asia Pacific and Europe should take 90% revenue share for online and mobile games (China 49%, Europe 17%, Japan 14%, South Korea 11%). While North America remains important, the dominant market for online and mobile games is and will be China. If you want to be in online and mobile games, if you aren’t in China then you aren’t anywhere.
A complex and fragmented market
There are different subsectors within the video games market. These include casual online (simple single player online games on online casual games platforms e.g. Spil Games), browser based Massively Multiplayer Online or “MMO” (thousands of simultaneous online player games on browser based online MMO platforms e.g. Bigpoint), social online (multiplayer online games on social platforms like Facebook e.g. Zynga), iPhone/iPad and other smartphone/tablet (mobile casual, social and web based MMO games on smartphones/tablets e.g. Rovio), online/smartphone/tablet middleware (technology for online/smartphone/tablet games using a Software as a Service (“SaaS”) B2B business model e.g. Live Gamer), online skill based gaming (online gambling based on skill, not chance, with thousands of simultaneous online players e.g. King.com), pure console (retail/digital download console games on PS3, XBox360 or Wii e.g. Electronic Arts), retail MMO (thousands of simultaneous online player games on PC/Console via retail or digital download e.g. Activision Blizzard) and online gambling (online versions of offline gambling on PCs or smartphones e.g. Betfair).
Video game consumer markets are becoming increasingly fragmented. For example, Wii grew the Casual Console market (60M+ Wii’s sold), Apple grew the Casual/Social Mobile market (3B+ Apps sold), World of Warcraft grew the Hardcore Online market (12M+ subscribers), Zynga, Spil, Playfish and Yahoo! grew the Casual/Social Web market (200M+ players), King.com grew the Casual Skill Web market (20M+ players), Bigpoint bridged the Casual to Hardcore browser market (web delivery, PS2 quality, no downloads), and Onlive hopes to expand Casual to Hardcore markets across TV and web (digital delivery, no console, PS3 quality).
A high revenue growth, high profit market
Yet while fragmented, these markets are delivering a rare combination of high revenue growth and profitability. The best online/mobile games companies are growing revenue 100%+ annually while also generating 20-50% operating profit margins. They are using a combination of one-off purchases, subscriptions, in-game items (micro-transactions), rake of user bets and advertising, with prices for online/mobile games, in-game items and subscriptions range from 99c to $14.99.
Operating successfully in these markets requires specific skills and approaches: multiple, parallel game development business platforms (not “one game” hit driven companies), multiple distributors (not just Facebook), rapid, low cost game development and continuous daily redevelopment cycles for rapid market response, and fast failure (rapidly cut commercial losers and back commercial winners).
The Chinese advantage
Chinese companies have significant advantages in these markets. With 29% internet penetration, but 382M users, China is forecast to reach 56% internet penetration (754M users) by 2015. The scale, growth and profitability of Chinese games companies is something international firms can only dream about.
For example, Tencent is one of China’s leading games companies. It holds dominant or leading stakes in many Chinese online/mobile markets (IM, games, eCommerce, search, mobile services). Tencent’s Chinese games market share was 20% in 2009 with forecast 27% by 2012. Tencent’s market cap (~241Rmb B ≈ $35B with Enterprise Value ≈ 35x 2009 EBITDA in August 2010) was greater than Activision Blizzard, Electronic Arts, GamesStop, Take2, THQ, Atari, Game Group and Ubisoft combined. When you look at the numbers, it is not hard to see what this strength delivers; ~50% operating margin, with online/mobile games (MMO, board & chess, casual/social) generating >40% of its revenue.
Of particular importance, Tencent has an integrated business model with upgrades/privileges across online, mobile and offline (not just games), delivering a significant advantage for customer acquisition, development and retention. It capitalises on enhanced capabilities to cross-promote, upsell and cross-sell. Facebook could learn a lot from Tencent about how to make even more money.
The gap in the online/mobile games investment market
Yet there is a gap in the online/mobile games investment market.
Major console publishers are struggling to invest in online/mobile games. They are focused on existing large console games franchises, as the console games market is flat to down, with declining profitability. Major publishers’ core competencies focus on management of $20m+ serial, high risk, complex developments, launches and commercialisation, while online/mobile games require rapid, multiple, small scale parallel development platform investments, completely different to major publishers’ business cultures. So major publishers are not driving online/mobile games investment as they did in the console games sector. The CEOs of major global console publishers are wary of large scale online/mobile video games M&A in early stage, fragmented markets where market dominance is not yet clear.
In parallel, generalist VC video games investment has also declined. Despite rapid market growth, VC investment across video games in 2009 had dropped by 60% from its high point in 2007 due to general VC market weakness and limited knowledge and relationships across complex, fast moving online/mobile games sectors. VC investment is not maximising growth during the critical stage before industry consolidation.
Quality investment demand exceeds supply, with high quality, high growth online/mobile games companies struggling to find investment to accelerate growth. Yet this is happening despite major publisher/media online/mobile games consolidation deals (e.g. Electronic Arts/Playfish $400M, Disney/Playdom $763M, DeNa/Ngmoco $400M, Tencent/DST $300M and Shanda/Mochi Media $80M).
Filling the online/mobile games investment gap
I am currently looking at ways to fill the investment gap with an online/mobile games growth capital fund, investing in quality online/mobile video games companies that are already delivering 50-100% annual revenue growth, 20-30%+ operating margins or potential and $10M+ revenue. The most interesting companies from an investment standpoint have domestic strength with East/West ambitions (China to Europe/US or Europe/US to China), strong management teams, intellectual property and commercial track records with clear exit strategies, and a specific sector focuson casual/social online, iPhone/iPad, other smartphone/tablet, browser based MMO and online/smartphone/tablet middleware. My view is that you need a clear investment strategy to manage risk and optimise returns, so focusing on investing $10M on average per investment with a focus on for growth capital investment returns (30%+ IRR, 3-5x money multiple).
There is significant demand from quality online/mobile games companies in both Chinese and international markets for growth capital investment in working capital (debt convertible into equity via convertible loan notes), pure equity capital and equity capital plus bank debt. However you need the knowledge, relationships and ideas to focus on companies with clear exit paths via trade sale to strategic video game and media corporates as the market consolidates, or with IPO potential depending on market conditions.
International opportunities for Chinese companies and investors
While the growth within the Chinese games market is very exciting, I have also seen an almost universal desire to leverage Chinese strength into international markets. When speaking at GDC China in Shanghai in December, I outlined the broad themes for Chinese companies and investors to invest and grow internationally:
- Major Chinese video games companies: (1) invest in online/mobile games fund (2) invest in, partner and acquire international online/mobile games companies, but (3) avoid large, value destroying acquisitions
- Independent Chinese video games companies: (1) exit to major international games / media / private equity company (2) license successful Chinese IP internationally (3) license successful international IP for China domestically (4) invest organically, raise funding or partner with major video game/media company to build an international subsidiary or (5) provide high quality, efficient outsourcing services to international companies
- Chinese institutional investors: invest in online/mobile games fund
- Chinese venture capital/private equity firms: co-invest with online/mobile games fund for specialist knowledge, relationships and ideas
- Chinese technology, media and telecommunications companies: (1) invest in online/mobile games fund (2) joint venture with international major/ independent video games companies for domestically licensed game marketing/ investment or (3) make strategic international investments to build capability and leverage domestic Chinese platforms
International challenges and approaches for Chinese games companies
While investing and growing internationally is very exciting, it isn’t as simple as you might hope. There is no guarantee of success, but there are approaches to the major pitfalls which should increase the chances of avoiding them.
For international market entry, strong Chinese games companies are looking for additional sources of growth. Yet international markets represent both an opportunity and a challenge for leveraging Chinese strength. Market entry requires strong local knowledge, relationships and ideas, and choosing and delivering the right market entry strategy is critical. The key decision is whether to buy an international company, build an international subsidiary, or partner with an international market leader. The best approach is to acquire strong local knowledge of international markets.
For investment, mergers and acquisitions, and partnerships, Chinese companies bring more to deals than just cash. When dealing with international companies, Chinese companies offer access to the Chinese domestic market, high quality, efficient resources and relatively high valuations to enable accretive deals which no other companies can match. High quality international online/mobile games companies offer significant opportunity, and the a gap in the international online/mobile game investment market, plus strong interest in China, places Chinese companies ideally to do such deals. Yet quality dealflow requires strong local relationships, market knowledge and deal making capability, so it is best to build deep international relationships.
For business relationships and culture, “Guanxi” is very important in China – international business relationships tend to have less depth. So knowledge of potential international partners’ motivations is very important. Chinese business culture is more sophisticated, subtle and less direct than international business culture, where details and business rules are more important than context. Most international discussions are also direct, particularly disagreements – indirect international discussions can confuse. The best path is to secure international partners with existing relationships.
For management style, international management is both “bottom up” and “top down”, with hierarchy less structured and subordinates openly challenging the views of superiors. Managers are used to working with a great deal of autonomy, consensus is seen as being less important than rapid, local decision making, and staff loyalty is more closely linked to personal satisfaction and ambition. Clear performance management is appreciated, with rewards tied to specific targets. International deals seem to work best when Chinese acquirers set goals, provide autonomy, and manage performance against targets.
For business model and player culture, international consumers have relatively high disposable incomes, so higher price points than in China are possible, although staff and marketing are relatively expensive. Market dynamics and infrastructure differ across countries, and players have high quality expectations and many alternative sources of entertainment. International cultures vary significantly, localisation is critical and success in one country is not a guarantee of success in another. To succeed internationally, Chinese games companies must customise their business model and games for international markets.
So in summary, the opportunity for Chinese games companies to dominate global video games is there for the taking. The only question is who will do so, and when.