Creatives often struggle to hide their disdain for the finance department. Designers, film directors, musicians, copywriters and artists rely on their intuition; they see creativity as a scarce resource and financial logic as lacking imagination. It’s not unusual for financial success to be deemed subordinate to great entertainment and artistic merit.
Some of this attitude pervades the computer games industry. Yet because game play involves completing levels to gain rewards, coders tend to think about strategy more deeply than other creatives. Trends in the videogames sector often prefigure developments in the wider economy.
Videogame executives have thought hard about how to benefit from the creation of platforms, network effects, digitisation, and the shift from a physical product sold once to recurring subscription revenue. A commercially successful game requires considerable creativity with business models and marketing nous.
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Videogames are a genuine UK success story
In the UK, videogame companies are a genuine success story. The UK videogame sector is the largest in Europe, contributing £1.8bn towards GDP. That is partly due to government policy, with the Video Games Tax Relief Act allowing companies to claim a tax break of up to 25% of their production costs.
Gaming is a global market, so overseas revenues are an important source of earnings. Unlike manufacturing, games are a knowledge industry, unaffected by supply-chain difficulties or border red tape.
The industry employs 50,000 highly skilled staff in the UK, mostly outside London. The associated spin-off benefits include the Raspberry Pi Foundation, a charity promoting the study of computer science in schools, and Deep Mind, an artificial intelligence (AI) company acquired by Google’s parent Alphabet for $500m. It was founded by Demis Hassabis, who in his gap year before going to Cambridge became a computer-game developer specialising in strategy games. Deep Mind is now solving important problems in areas such as nuclear fusion, but Hassabis first taught his neural network to think by playing videogames such as space invaders.
There have been missed opportunities, too. Edinburgh-based studio DMA Design was acquired by US company Take Two Interactive for just $11m in 1999. A decade later, its Grand Theft Auto V, released in 2013, earned $750m from players downloading the game and a further $2bn over five years from additional content.
Today there are four listed videogame companies on Aim, the London Stock exchange’s junior market, collectively worth just under £4bn: Devolver Digital, Frontier Developments, Keywords Studios and Team17 (more on these below).
The pandemic has benefited games companies, as people trapped at home had few other options. The global number of gamers is rocketing; there will be 3.3 billion in 2024, according to Devolver Digital, up from 1.3 billion in 2015. Historically, gamers have tended to be male, aged between 16 and 30, and single. This was partly because gaming industry executives lacked the imagination to see that they were missing an opportunity by defining their customers’ demographic so narrowly. More recently, women and other ages have joined the party in droves, particularly when it comes to games played on a mobile phone.
The basic business models of videogame companies
The three console makers, Microsoft (Xbox), Sony (Playstation) and Nintendo (Switch) are capital-intensive and have long release cycles. Consoles – computers specifically designed for playing videogames – are often sold at a loss; the hardware manufacturer makes profits from licensing a revenue share of games sold and played on the consoles. Aside from the consoles, gamers also play games on PCs, and more recently mobile-phone games have taken off.
Apple goes the opposite way. It makes a profit on hardware (Macs, iPhones and iPads) and encourages programmers to build apps as a complementary asset that increases the value of its devices. The majority of app-store downloads are games. Apple handles payments, promotion and distribution but charges a 30% cut of app developers’ sales in return. Alphabet, Google’s parent, which owns the Play store, has followed a similar strategy, despite not manufacturing the majority of Android phones.
Epic Games, maker of the popular free-to-play Fortnite, a multi-player ‘last-man-standing shoot-em-up’ game, has baulked at the 30% revenue share, last year filing lawsuits against Apple and Google claiming their behaviour is anti-competitive. Although Fortnite is free to play, it generated $4bn in revenues in the first two years across all platforms (including mobile) as players paid for premium features. Following the court battle, the judge ruled in favour of Apple, though Tim Sweeney of Epic Games has vowed not to bring Fortnite back to Apple until it has reduced its charge and passed the savings on to gamers.
Blockbusters compensate for losers
Fortnite is also an example of the sector’s ‘Hollywood Economics’. Gamers want to play the games that other gamers are playing, so successful titles enjoy a so-called positive-feedback loop. Yet most games barely break even; a few huge blockbusters make up for the losses on most other games.
Grand Theft Auto V, for instance, was several years in the making and cost $265m, split evenly between development of the game and marketing. At the time it was the most expensive game ever produced, but the faith of the publisher, Take Two Interactive, was rewarded when the title earned back multiples of its original cost.
Although there are hundreds of games released each year, the top ten titles in each genre account for roughly 90% of consumer spending. According to Joost van Dreunen of the New York University Stern School of Business, in 2018 the top-grossing sports game, FIFA 18, earned $723m, or 28% of the top-ten sports games’ joint revenue. In the fighter genre, Super Smash Bros dominated, earning $190m, or 57% of the top ten’s revenue. The number-ten game in each genre accounted for less than 2% of total sales.
Foreign rivals have been shopping on Aim
This ‘winner-takes-almost-all’ aspect means the industry has split into studios of developers and publishers. The studios are the creative heart of the industry, but are vulnerable if they can’t develop enough hits. Publishers, on the other hand, act like venture capitalists funding games, but they also provide services such as marketing. The Aim-listed companies have tended to pursue a mixed strategy, operating primarily as publishers, but more recently they have been acquiring studios of developers.
Two Aim-listed companies have already been acquired by overseas rivals. In December 2020 America’s Electronic Arts (EA), which is worth $36bn, outbid Take-Two Interactive, worth $21bn, to buy Codemasters, the car-racing games specialist with the Formula One licence agreement (giving it the exclusive right to produce games based on Formula One).
Codemasters had listed on Aim in 2018, valuing the company at £280m. EA’s bid valued the company at around £750m two years later: a 2.7-fold return in two years. Sumo Group, a Sheffield-based UK videogame company that listed on Aim in January 2018, rewarded investors with a fivefold return when it was acquired by China’s entertainment conglomerate Tencent for 513p a share in January this year. Tencent, which owns Fortnite, also holds 9% of Britain’s Frontier Developments – it is the company’s largest shareholder after CEO and co-founder David Braben.
Future videogame revenue streams
Where next for the sector? Virtual reality is likely to offer more immersive experiences, while there is always scope for new business strategies. One option is to invest in physical merchandising, in the same way football teams derive revenue from shirt sales. There’s already one e-sports business, Semper Fortis (listed in the UK on Aquis Exchange, a market for small growth stocks). The company has a business model based on videogames as a spectator sport.
Given that the best strategy games involve managing trade-offs and making creative use of scarce resources, it is perhaps unsurprising that we have seen these companies compete in imaginative ways. Indeed, perhaps the likes of FDEV, Team17 or Devolver ought to make a corporate-strategy game rather than another one involving football or building a farm, zoo, or city. The gamer could play the role of a CEO of an Aim-listed videogame company, looking to allocate capital wisely, outperform rivals and avoid being gobbled up by larger overseas consolidators.
The picks-and-shovels play
With that in mind, let’s take a closer look at the companies listed on Aim. The largest, and probably the easiest to understand, doesn’t design or publish computer games. Instead, it offers support services to the games industry, making it the equivalent of a supplier of picks and shovels to those who are hoping to strike gold with a blockbuster hit.
Keywords Studios (Aim: KWS), based in Dublin, was founded in 1998 by a couple of Italians to provide localisation services to games publishers. Localisation covers translation (finding the Italian equivalent of “WHAAM!”) and adapting the game to the local culture. Videogames now have actors speaking scripted lines, so localisation includes both translating the script and selecting suitable actors. Native-language testers play, test and report bugs before the game is released.
In recent years KWS has moved on to offer related services, such as quality assurance (establishing whether the game is as technologically as seamless as possible), marketing services and player support (ranging from basic customer service to interacting with the audience on social media). KWS works with all the large industry players: 23 of the top 25 games companies by revenue and ten of the top-ten publishers for mobile games.
This means its revenue growth is more stable than businesses that rely on releasing blockbuster hits. From 2017 the group’s organic revenue growth has averaged around 15% per annum. While organic growth has been impressive, KWS has also expanded through acquisitions, making about 70 since its flotation in 2013. KWS’s value has soared from £50m to £2bn since it floated. It is on a 2023 price/earnings (p/e) ratio of 29. That seems a lot for a company with a relatively low average return on capital employed (ROCE, a key gauge of profitability) of 9.7% over the past three years.
Dabbling in dinosaurs
Frontier Developments (Aim: FDEV), founded in 1994 by David Braben, who still owns 33% of the shares, is most famous for the Elite franchise, a series of games set in space. It also makes Jurassic World, which ties in with the Jurassic Park films and Planet Coaster, a rollercoaster-design game. FDEV owns its own ‘game engine’ – a software framework to develop games, essentially – called COBRA, which has powered the development of games for other publishers.
Although FDEV develops its own games internally and publishes them, it has also recently begun to operate a third-party publishing label, Frontier Foundry, which enables it to partner with independent developers. In the past revenue has been volatile, but the third-party business should mean sales are less dependent on the release cycle of Frontier’s own games. In May the group released Warhammer 40,000: Chaos Gate – Daemonhunters, a licensing partnership with Games Workshop. After one month of sales it had become their most successful Frontier Foundry game to date.
Since 2018, Frontier’s ROCE has swung between 6% and 29%. Last November it warned that sales of the latest Jurassic World game were lower than expected for PCs. The shares are selling for 32 times expected earnings in the year to 31 May 2023 and five times sales, which seems expensive given the historic volatility and price/earnings (p/e) ratios below 20 at Devolver Digital and Team 17. The shares are down 15% this year. Given that Tencent owns just under 10% of the company, the valuation may also reflect some hope that the Chinese company will make a bid for the rest of the company.
A videogames venture capitalist
The business model at Devolver Digital (Aim: DEVO) which listed on Aim last November, achieving a valuation of £694m, is different. Unlike Frontier, it doesn’t develop games itself. It works with developers or studios, receiving and vetting more than 2,000 unsolicited game title pitches each year at varying stages of completion (from initial concept to fully-formed games.) Devolver funds developers but does not require them to hand over the intellectual property (IP) or sequel rights to their games. It is essentially a venture-capitalist group investing in computer games.
Devolver had a huge hit in 2020 with Fall Guys, a game involving jellybean-like creatures racing each other through obstacle courses and performing other tasks. As a result, the group had net cash of $44m in December 2020, facilitating the purchase of CroTeam, a game developer based in Croatia, for $27m.
Last year it snapped up another four developers. In June Devolver released a profit warning saying that sales of new games had been disappointing. Rather than blame people going to the pub post-lockdown, it said the release window had been very competitive. The shares have slipped by 70% so far this year. Following the profit warning the shares are now trading on a 2023 p/e of 17.
The schoolboy game developer
Founded in 1990, Team 17’s (Aim: TM17) early history consisted of producing games for the Commodore Amiga PC. In 1995 it enjoyed major success with the release of Worms, a famous game initially designed on a Casio graph-plotting calculator by a schoolboy who was bored in a maths lesson. Once the game worked on the calculator, he transferred it to the school’s Amiga computer. The game was later banned by teachers because everyone was playing it so much.
Andy Davidson, the game’s creator, then approached Team17, who published it a couple of years later. TM17 was mainly a developer in the 1990s and 2000s before the current CEO repositioned the group as a publisher. In May 2018, TM17 listed on Aim, achieving a value of £217m. The group has grown by acquisition recently, buying StoryToys, which makes ‘edutainment’ apps for children, for $49m in July last year. Then this year it bought astragon, a leading German developer and publisher of ‘work’ simulation games (in which users drive a bus or operate construction equipment, for instance) and Australia’s The Label Group. The shares have slipped by 42% this year, suggesting that some shareholders didn’t like the flurry of recent acquisitions. It trades on a 2023 p/e of 18.
The upshot for investors is that none of the stocks appear to be immediate buys. Keywords looks pricey and would be more attractive after another bout of general market jitters. Frontier also seems expensive, while Devolver and TM17’s share-price recovery will depend, respectively, on whether the profit warning remains a one-off and how the flurry of acquisitions bed in. In six months or so these stocks may look more appealing to investors. Their long-term potential in a global growth industry, however, is clear.
Bruce is a self-invested, low-frequency, buy-and-hold investor focused on quality. A former equity analyst, specialising in UK banks, Bruce now writes for MoneyWeek and Sharepad. He also does his own investing, and enjoy beach volleyball in my spare time. Bruce co-hosts the Investors' Roundtable Podcast with Roland Head, Mark Simpson and Maynard Paton.
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