Monday, June 30, 2008

Huh?:Jeetil Patel and Wagner James Au Tribute Edition

I guess doom and gloom stories get more attention than happy stories. From personal experience, I can tell you, it is easier to write an angry rant than a happy smiley one. At least it is more fun. Maybe this is why Jeetil Patel and Wagner James Au decided to predict the end of the game business last week. Mr. Patel chooses not to recognize diversification, so he says game companies must eat each other to survive - "This would imply that publishers need to gain share cycle-to-cycle to achieve similar levels of profitability." Mr. Au's story rose to number 1 on gametab when he chose to compare a month's GTA IV sales to several years of San Andreas sales to tell us the market is just not what it used to be. Mr. Au is right, it was a much better world when Presto made The Journeyman Project for USD 175k and sold it direct for USD 99. It was even better when Jordan Mechner made Karateka for a negligible amount of money in his bedroom and Broderbund sold through 500k. Maybe we should listen to these guys and pack it all in. Or maybe, we should just look at the market and realize the business is finally going mainstream.  

I agree with one aspect of their argument, the business will not be the same going forward, and that will be good for all of us.

Gamedaily reports, Mr. Patel wrote:

"We continue to believe that, despite healthy industry growth, the interactive entertainment software industry remains structurally challenged as a doubling in development costs cycle-to-cycle (offset by 25% higher ASPs) is forcing publishers to produce ~40%-60% higher unit volumes per title to maintain breakeven profits (or prior-cycle profits) Patel said. "In other words, the unit threshold on comparable profits has materially moved higher cycle-to-cycle; however, industry fundamentals are clearly not helping as console software units are generally flat cycle-to-cycle. This would imply that publishers need to gain share cycle-to-cycle to achieve similar levels of profitability, particularly as flat software unit comparison are further hampered by share gains by Nintendo as a 1st-party publisher."
Mr. Au departs one stop later from the doom and gloom train. He feels GTA IV is the last of the tentpole games. Or as he says, “next-gen’s siren song.” He writes about the cost/return of the game and points out, quite convincingly, that one month’s sales fail to meet the bar set by years of San Andreas sales. He also says the games are more expensive, and therefore, with strong conviction, we will see a lot of less graphically intensive, watered down games for the masses. I can forgive Mr. Au for not having access to this magical crystal ball like thing I like to refer to as the Internet. It does get kind of costly with monthly fees and all, but he can pick up a game magazine and see there is a strong pipeline of the very games he says don’t exist. In fact, we can look forward to many of these games coming out over the next three years, and new ones are entering production on a regular basis. But once again, if I stop there, I can’t write any more, and I really want to say some more stuff about his horribly misguided post.

The two gentlemen are right about the costs, but wrong about everything else. More expensive titles mean the publishers must sell more to break even. This is common sense. The publishers knew this cycle was going to be more expensive, but no one knew how much more expensive. In case any readers have been asleep for the past few years, it is A LOT more expensive to develop for this generation - can we agree to stop calling the 360, Wii and PS3 next gen now? What Mr. Patel fails to consider, are the tie ratios for two of the three platforms are increasing over the previous cycles, and the number of skus has increased. The tie ratio for the first 30 months of the Xbox, PS2 and Gamecube were 6.8, 5.2 and 6.3, respectively. As of last Christmas, the tie ratios on 360, PS3 and Wii were 7.6, 8.11 and 5.04 respectively (I expect PS3 will be higher with the release of GTA IV and MGS 4). This is reflected in unit sales. According to NPD, there are more million plus sellers, than in the prior cycle. While the tie ratio will likely fall a bit, unit sales will increase with hockey stick growth portion of the console penetration cycle. The volume increase will occur just as the publishers start to take advantage of the technology bases they invested in at the beginning of the cycle, and surprise, surprise, production costs at the larger publishers will decline. This would be critical if it was the only source of publishing revenue. Fortunately, it is not.

Both gentlemen are relying on some key wrong assumptions to make their case. While my econ professors in college were able to build whole courses and theories on assumptions, they were wise enough to keep those assumptions within the confines of the classroom and scholarly papers no one reads. This gave them the benefit of hindsight, so if they were right, they could pull the out, and waive them over their heads, proudly shouting “I told you so!” If they were wrong, they left them hidden away to gather dust and be eaten by silverfish in the dark bowels of the library. Messrs Patel and Au choose the road of premature assumption presentation and fail remember the wise words of everyone’s mother, “when you assume, it makes and ass of u and me.” She also said you point three fingers at yourself when you point at someone, but we can talk about that one later.
The two men assume the revenue model is limited to those available during the last console generation. The last generation allowed for the release of two viable skus for each front line product. Once released, it had a short shelf life, followed by bargain bin obscurity and little or no value. We also had a game market limited to the hardcore player of PS2 and Xbox and the children playing on Gamecube. Today’s world of connected boxes, MMOGs and mass market penetration of the Wii is very different. The structural change Mr. Patel calls for has already happened, it just happened on the distribution and content sides, not the production side. It will help Mr. Au as well.

Publishers have more platform choices and revenue streams than prior cycles, as well as a more diverse market of game players. PS2 remains a strong platform, and will be supported for the next few years, while mobile, on line and casual are just hitting their stride. So while the publishers are investing tens of millions into frontline games, they are still able to invest US 3 to 5 million into a PS2 game and sell several million units, and are starting to invest PS1 budgets into games for distribution via Xbox Live, PSN and Wiiware. These titles and channels carry economics very similar to those enjoyed two cycles ago. Even better, the AAA games are sold into connected consoles, providing the opportunity for add on content. The add on kings are definitely Rock Band and Guitar Hero, with millions of songs sold, but on line games are successfully selling additional content to players. All those COD 4 add on levels create additional revenue the publishers never dreamed of in prior cycles. The same can be said of the new GTA installments, which will leverage the technology investment of the initial game for lower production costs, and make it to market digitally, for higher margins. In short, publishers are investing more, but also leveraging more dollars out of each investment. If we look at the market on a continuum from free to play casual games through hard core MMOGs, the market is expanding at all ends, and getting really fat in the middle.

When he is done with software, Mr. Patel questions the installed base numbers:
With the console hardware installed base and console software unit shipments finally catching up to the previous cycle (on both counts), the industry should perform better in CY 2008E, but woefully below the ~50% improvement necessary to offset the higher industry development costs. While the hardware and software ASPs are higher this cycle (vs. the same period in the last cycle), we note that CY2009E and CY2010E embeds a robust console hardware and software unit outlook that may prove ambitious (considering that numbers have only caught up with the last cycle this year).
I don't know how Mr. Patel is measuring the pace of console uptake during this unprecedented staggered launch. Mr. Au seems to believe console sales are over, and does not even address the back half of the cycle. While it is not as necessary as he writes, I believe the 50% improvement in pace may be closer than he thinks. Both are ignoring the hockey stick nature of the installed base growth. Platforms start slow, and then take off with price reductions. History says Microsoft, and possibly Sony, will make price cuts this holiday season. I wrote last week about the perennial nature of software sales, and the holiday centric sales of hardware, price reductions occur for the holidays. Game hardware is a relatively big ticket item and people wait for the holidays. The core gamer comes in early when the consoles are still expensive. Over the course of the console's life, the hardware changes, the research costs are amortized, the retail price is reduced, and the uptake pace increases exponentially. This happens at the time when publishers are utilizing technology developed earlier in the cycle and reducing the costs of production. In other words, more profit for everyone on the back end the cycle. A fact ignored by both of our “analyst” friends.

This gets us to the final point. Both gentlemen conclude the market for development will be shrinking. Mr. Patel, through consolidation and Mr. Au through reduction in scope of titles. I admit I came to the same conclusion in my first cycle. Mr. Patel feels publishers will consolidate and developers will be pitching into a smaller pool of publishers, making it more difficult for independent developers. Mr. Au feels publishers will no longer want to invest in blockbuster titles. This conclusion is logical if you make all those assumptions we made in economics classes. It does not fit in the real world. Will there be publisher consolidation? Absolutely, but he makes they both make a critical mistake by assuming publishers are the only option, and the distribution channel is static with barriers to entry. There is no question the market for independent development is tougher than it's been for years, but it is not attributable to consolidation or lack of interest in epic titles.

As I said earlier, publishers found this cycle to be more difficult and more expensive than they anticipated. They also have to sell more units than they did in earlier cycles - not 40% more, but more. These pressures caused them to question their ability to choose titles and just about paralyzed their decision making process. But as we move into the second half of the cycle, or second quarter if you believe Sony's statement about PS3's life cycle, the base will start to support title production, especially the reduced cost associated with building on existing technology.

When it comes time for a solution, rather than looking to market expansion, Mr. Patel uses the same myopic view of some of the game publishers. He feels the market is a zero sum game and publisher can only gain what others lose. Fortunately, some publishers are growing out of this mind set and Mr. Patel should as well. The industry must look to market growth, not market share growth. Fortunately some are, thanks to products like the Wii, Rock Band, Guitar Hero and other accessible games is growing even faster. Guitar Hero 3 passed 8 million units in sales, and I would venture to guess production cost was not on a par with Call of Duty. Nice margins. Almost as good as the first Zork. As Mr. Au pointed out in his article, this market will continue to grow. Contrary to Mr. Au’s position, it will not grow at the expense of the existing market, any more than the independent film market grew at the expense of the summer blockbuster. At the other end of the spectrum, publishers will invest deeper into the core gamer market because it is easier to pull more money out of each consumer than ever before. The investment of USD 100 million into World of Warcraft nets revenue from 10 million subscriptions a year. Sure not everything is WOW, actually, nothing is WOW, but the folks behind Lord of the Rings, Conan, Eve Online, Dark Age of Camelot or any of the other very profitable MMOGs - a non existent market last cycle - are not complaining about increased production costs.

We can’t forget the people who make the games. No Mr. Au, it is not the end of the developer they too will see more opportunity. Senior executives who joined through acquisition will vest, profit and choose to leave to start new development, just like they always do. It may feel impossible, but it is happening as we speak. Some will make big games, others will make companies like Big Fish, or Tell Tale. The market they are entering may have fewer publishers operating under the current model, but it will have more options than ever before. New entrants to the community include Warner, Universal and Paramount. Independent finance is coming to the market through publishers like Brash, as well as slate financing and title finance. Venture finance is backing the disruptive models they hope will overtake the EA and Activisions of the world, and other models are emerging as I write this post. In short, Mr. Patel and Mr. Au, yes publishers will consolidate, because they can, but ever since this Lincoln freeing the slaves thing, the talent is free to go where they choose, fortunately, those who survive will have plenty of choice.

1 comment:

Jon said...

Bravo. Can't tell you how irritating it is to see tripe like those articles reported without any of the flaws in the reasoning picked out - I don't have the business nous to argue it, so I'm glad that you're on the case.