Big Gaming Industry Primer
The Competitive Moats of AAA Gaming Studios Are Like the Cigarette & Casino Industries Combined
Highlights:
Big Gaming sector, The Mightiest Moat
Infinite FCF cheat code —
Microsoft’s Marvel Moment — MSFT’s recent bid for ATVI at 37x PE portends the coming convergence of the Big Gaming & Big Media sectors, aptly described as ‘Transmedia Synergy’. We believe that this ecosystem play is analogous to Disney’s $4B acquisition of Marvel & Star Wars in 2009 and 2012 — and CDPR could someday become a prime target for future Media sector incumbents in the impending land grab for scarce beloved AAA gaming brand franchises to make hit content with. And while the recent rumor about Sony’s acquisition turned out to be unfounded, this new development only lends further credibility to the latent acquisition potential hidden within CDPR’s future.
When Warren Buffett first started his investing career, he initially subscribed to the “cigar butt” style of investing taught to him by his mentor Benjamin Graham. However, he had a change of heart after meeting Phil Fisher and Charlie Munger — who taught him about the “wonderful business at a fair price” style of investing. This was evident in the stocks which he invested in during the later parts of his career — which were defined by having defensive competitive “moats” which protected the businesses from the scourge of competition.
Most industries are commoditized industries, and only a handful of them possess business traits which give its incumbents such competitive moats. Among them, participants of the Big Gaming industry stand out for having competitive moats which are completely indomitable — high barriers to entry, high bargaining power with customers, a sturdy recurring revenue profile, and Buffett’s favorite business characteristic — pricing power.
In this article, we’ll explore all of them — as well as the shifting developments in the Big Gaming industry which will further reward incumbents over the coming decades.
Big Gaming’s Superman Moats
Unscalable Barriers To Entry: The development of a new AAA video gaming title like EA’s Star Wars Battlefront or SquareEnix’s Final Fantasy XVI tends to be a 3-5 year endeavor involving millions of dollars before first revenue is even achieved — making producing one unattainable to all but the largest AAA gaming studios (i.e. Big Gaming), with huge war chests & steady recurring cash flows. Big Gaming incumbents can easily copy any new successful genres (‘hits’) which pop up overnight under a different wrapper (e.g. battle royale genre — Epic’s Fortnite vs. Blizzard’s Overwatch) — so even if an indie studio somehow manages to score a sleeper hit, they have little choice but to accept a lucrative acquisition from sector incumbents or get bullied off the market by them. This is why to-date only a handful of small gaming studios have managed to graduate to the big leagues (e.g. Minecraft, Valve, CDPR) — which has contributed to extreme industry consolidation over time (on top of traditional M&A), resulting in <10 US-listed pure-play Big Gaming companies today and similarly few in the rest of the world.
Hit-Based Franchises: The video game industry possesses a hit-based business model, similar to the Media industry — which is where the top 10% of industry participants (‘hits’, e.g. Justin Bieber, Taylor Swift or Tom Cruise) enjoy 90% of the entire industry’s profits, since entertainment media consumers (gamers, music & TV) only have enough bandwidth to consume 10% of all media content produced. This leads to a fat-tailed distribution of consumer attention span where success in the industry boils down to achieving “hit” titles (i.e. branded) — but which new game/song/show becomes a hit is not a predictable formula, and is very much up to the current whims & fancies of the consumer. This high uncertainty ‘dice roll’ business model necessitates a diversified “VC-like” content production approach, where only 1% of newly produced content achieves “unicorn status” and makes up for the losses of everything else. Without being able to match the outsized production & marketing budget of the AAA Big Gaming players, new entrants or indie developers simply have no chance to reliably succeed — as even a genuinely good show/song/game can end up falling flat at the box office for no particular reason. Even the large incumbents are hostage to this phenomenon when producing new content, which is why many of them find it easier to simply recycle old successful hit media franchises (i.e. branded) — where the probabilities of success are markedly higher. However, these are only owned by the Big Gaming/Media companies — further raising the impossibly high barriers to entry for new entrants (on top of the ease of acquiring those with a successful hit).
However, this hit-based business model also means that it is frictionless to simply recycle last year’s hit game and resell it as a new game at full price. Perhaps the worst offender of this practice is EA’s FIFA gaming franchise, where FIFA 2023 tends to be nearly identical to FIFA 2022 (except for a few cosmetic changes). While not as egregious, we can also see this phenomenon being widely practiced across many other hit gaming franchises as well (e.g. Battlefront, Call of Duty, Overwatch) — and while the resulting lack of innovation in new games is the bane of the gaming community, the latter continues to vote with its wallet despite that. This leads to very little consequences for large AAA gaming studios to simply recycle their old development assets (highest cost item) — making the existing ownership of a hit gaming franchise a truly recurring revenue experience. Many studios like Activision or Ubisoft even take it to the next level by “milking” their Call of Duty or Assassin’s Creed franchises — where they create a legitimate new game (rather than simply a “reskin”) on an annually recurring cycle. CDPR actually does follow this model to some extent, but instead of the low-effort “milking” of their franchises like so many other AAA studios do, they actually provide full-blown expansion packs which geuinely add significant depth to the original title (e.g. the upcoming Phantom Liberty expansion pack for Cyberpunk 2077 in June).
Cigarettes & Casinos, Combined: Both the cigarette & casino industries benefit from a captive customer base who are addicted to their products — and while it may sound unflattering, the video game industry bears some similarities. Video gamers exhibit the same unbridled affinity towards their favorite video games and are willing to go the distance to ensure their victory in-game — leading to Big Gaming studios capitalizing on such behaviors with the microtransaction and lootbox mechanics. Microtransactions are tiny in-game purchases that can be made to augment a player’s gaming experience (e.g. power-ups or cosmetic upgrades) — and is such a compelling mechanic that it has been formerly accused by gamers of turning AAA gaming titles into ‘pay-to-win’ experiences. Lootboxes take this concept one step further by introducing a “slot machine” mechanic to microtransactions with only a randomized chance of success but a much lower cost-of-entry — and where expensive in-game items (‘loot’) can potentially be scored if the odds land in your favor. Both of these in-game mechanics represent very reliable and recurring revenue streams for Big Gaming studios, who understandably exploit them to their maximum extent — much to the chagrin of gamers.
On a side note, CDPR is actually quite unique in the Big Gaming sector for not participating in such predatory practices — choosing instead to release cosmetic upgrades for free while selling new expansion packs at fair prices (e.g. aforementioned Phantom Liberty). This has actually generated a lot of goodwill for the CDPR brand amongst the gamer/customer base (i.e. successful marketing), which we’ll be touching on in the following section. However, we feel that it is only a matter of time before CDPR itself (as a Big Gaming company) complies with the beckoning siren call of reliably recurring FCF from microtransactions/lootboxes — which is a low-hanging fruit that’s simply too tempting for any business to ignore in the perpetual pursuit of growth.
Pricing Power: The combined effect of the aforementioned phenomena makes the Big Gaming sector an extremely “moaty” industry. New entrants simply have no chance of matching the production & marketing budgets of Big Gaming incumbents — and even those that manage to score a sleeper hit will likely be forced into a lucrative buyout. Furthermore, the hit-based nature of success in the video game industry means that there is no beaten path for new entrants to follow — much of a new game’s success depends on luck. This drives the industry’s economics towards creating hit-based franchises — which are impossibly hard to create at first, but once you have one you’re pretty much golden.
Big Gaming studios who already own an existing AAA hit franchise are able to exploit this by coasting on their past development successes and simply recycling their old development assets — generating frictionless recurring revenue streams via microtransaction and lootbox in-game mechanics. At the end of the day, this gives immense pricing power to companies in the Big Gaming sector — which allows the largest AAA studios to grow revenues even as sales volumes flatten. And while the AAA studios do need to worry about competition with each other, the Big Gaming industry has consolidated to the point where it is largely oligopolistic in nature — where the failure of any given title barely moves the needle downwards anyway.
For a deeper-dive into the Big Gaming industry, check out this excellent podcast below: <transcript>
The Coming Sector Convergence: Big Media + Big Gaming (+ Big Tech?)
Microsoft’s Marvel Moment: MSFT’s recent $68.7B bid for ATVI is not cheap at 37x PE, for one of the largest & most mature businesses in the sector. Which begs the question — how did they justify the hefty price tag? This bid reminded me of Disney’s $4B acquisition of Marvel & Star Wars in 2009 & 2012 respectively — both price tags made my jaw drop at the time, similarly to MSFT’s $68B bid for ATVI today.
However, Disney was clearly buying the franchises for their brand value alone — they couldn’t have replicated similarly powerful brands without substantial effort, but they could synergize the acquired brands into their existing operations in order to produce the movie universes & related merchandise that we’ve since come to know & love.
In a similar vein, Microsoft may be willing to pay top dollar for ATVI’s branded gaming franchises if it thinks it can better synergize them into its vast product ecosystem to produce lucrative gaming assets — even if it doesn’t think ATVI’s business can justify a steady-state 37x PE. The catalyst for this could be the Metaverse, which the recently demonstrated Project Starline at Google I/O and Zuckerberg’s recent comments on Meta’s 1Q23 earnings call shows is far from dead. In the same way that OpenAI dramatically changed the competitive landscape between Bing and Google Search, there may also be lucrative gaming opportunities based on beloved gaming franchises hiding in the wings of the Metaverse which we are simply not aware of yet. More related news could come hot on the heels of the EU’s anticipated approval of the ATVI acquisition in the coming months.
Transmedia Synergy: The best current example for such latent potential can be seen in the hugely successful Netflix anime Cyberpunk:Edgerunners — which is a companion animation that mirrors the storyline of the Cyberpunk 2077 game. The show was lauded as a critical hit on par with Netflix’s Arcane animation from the prior year — also a critical hit based on Riot Studio’s hit game League of Legends — as well as in the upcoming 3rd season of the Netflix series The Witcher.
CDPR describes their transmedia content strategy as a ‘franchise flywheel’ above — and the effects are plain for all to see — as we can see above, the number of concurrent players of Cyberpunk 2077 on the PC game platform Steam jumped to a post-launch high in Sep 2022 amidst the recent success of Cyberpunk:Edgerunners on Netflix; the same effect can be observed for The Witcher 3 game in Dec 2021 as well, when Season 2 of The Witcher series ran on Netflix. This in turn created more awareness about the franchise’s brand, contributing to the self-fulfilling growth flywheel across different media mediums (i.e. “transmedia”). This is current proof of the potentially immense synergies between the Big Media & Big Gaming sectors — which are both mature industries starved for growth with hit-based business models.
Hit-based business models: Given the hit-based business models of both industries, creating new hit content is pretty much a dice roll — a big-budget production like House of Cards can unexpectedly be overtaken by a small-budget show like Squid Games or Paranormal Activity. And since creating a new hit show/game is so rife with uncertainty, the incumbents of both industries have fallen upon a more predictable rinse-and-repeat business model of either: 1) recycling their old content assets or 2) acquiring smaller competitors who have created a new hit. While the latter is a predictable business model, it’s also quite understandably less lucrative — since acquirers would have to pay fair market value when engaging in M&A for scarce hit content.
Over successive market cycles, one observation that can be made in both the Big Media & Big Gaming industries is that they’ve both consolidated so much over time that they have run out of room for further acquisitions. The only remaining potential M&A in both sectors which can move the needle for incumbents is if they merged with one another (alà ExxonMobil) — anything else is too small to make a material difference to growth, given their already gluttonous baselines (regulatory hurdles notwithstanding). But what if… you could merge the two sectors together instead?
Convergence between Big Media + Big Gaming sectors: Merging the two sectors would allow the disparate franchises & brand assets from both sectors to be applied across mediums — for instance, a merged Media/Gaming entity could make a show about the popular Final Fantasy game franchise, or turn the popular show House of Cards into a game for different audiences. Crucially, the franchise assets of both industries barely overlap — spelling plenty of opportunity for growth. In fact, we’ve recently seen this with the successful debut of The Last of Us on HBO in Jan 2023 — which actually started life as a video game 10 years ago, and was recently remade for the PS5 with updated graphics. See the franchise flywheel spinning?
Given the limited growth runway and large number of similarities between both industries, it makes perfect sense for a LT convergence of the two sectors in the pursuit for further growth. In addition, there also appears to be a possible 3rd contender in such a convergence scenario — the Big Tech sector, e.g. MSFT has already made a play for ATVI. There is plenty of reason to believe that the Metaverse and its Internet 3.0 cousins will have plenty of synergistic overlap with the Media sector — and I can see the current Big Tech megacaps with their infinite free cash flows looking for a home in future M&A with Big Media & Big Gaming players (e.g. Amazon’s $8.5B acquisition of MGM Studios)
How Is This Relevant to CDPR? Due partly to the sector’s incredibly hostile environment for new entrants, CDPR is unique amongst its Big Gaming peers for being one of the only industry players which still possesses a huge growth runway. This is because while most of its peers already have dozens of gaming franchises (and 10x CDPR’s market cap), CDPR only has two (i.e. Witcher + Cyberpunk) — which means that adding another hit franchise (e.g. Project Hadar in 2030+) could theoretically grow their revenues by +50%, whereas adding one more franchise wouldn’t do much for its much larger sector peers due to higher base effects.
This leaves CDPR as one of the few Big Gaming companies with a US presence which can still 3x or 4x its current revenues over the next 10-20 years — truly qualifying it as a “forever” investment. Such a growth profile will likely be attractive to potential future Tech megacap acquirers (and uniquely so) in the aforementioned convergence scenario between the Big Tech + Big Media + Big Gaming sectors. And if MSFT was willing to pay 37x PE for the matured ATVI in 2023, it’s not out of the question that they might one day be willing to pay just as much for a CDPR with supercharged growth in 2033.
Thanks for your thoughts , divergent opinions are what makes a market and I think both of you make some fair points
It's trying to think which is more applicable to each situation I guess
Thanks so much for an awesome article. Quick edit:
The labels on the market cap chart are actually in units of billions but it's labeled as "units of millions".