Alex Naffziger estimates that he has spent as much as $400 on character costumes and other digital tchotchkes while playing a video game that costs $60 at retail — Activision Blizzard‘s (ATVI) 2016 “Overwatch.”
With gamers like him spending freely to outfit characters with new “skins,” in-game purchases are booming and digital content now generates more revenue for Activision than physical games do.
“They had a lot of cool skins, and I wanted to make sure that I got them, so I probably spent a good $150” during the game’s most recent sale, he said while standing in line at Activision’s booth during the E3 gaming conference in June.
Back in the day, buying a new console game was a one-off transaction. That single shiny disc bought from the local game shop (or cartridge, depending on when you played your first title) contained everything needed to become immersed in a far-off digital realm. Now it could be just the start of a long-term relationship with so much profit potential that game publishers like Activision and Electronic Arts (EA) are transforming their businesses into a “games as a service” model that keeps players engaged with a title long after it hits shelves.
The video game industry’s revenue boom comes despite an aging demographic and niche user base, issues that might set off alarms for investors of other tech firms like Twitter (TWTR) or Snapchat-parent Snap (SNAP).
The soaring business in virtual goods via in-game “microtransactions” also contrasts with the troubles that have beset other industries shifting to a digital-first mindset (see: retail, entertainment). Gamers, it turns out, are happy to spend money online to extend the life of a game they love.
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“(There’s) clear evidence people are willing to spend vast sums of money when given the opportunity for the right experience,” Jefferies analyst Timothy O’Shea told Investor’s Business Daily.
And unlike an actual sword or machine gun, a digital version to arm a game character costs almost nothing to produce.
Microtransactions, Not So Micro Margins
Virtual goods vary from game to game. They can include anything from coins to weapons to trains to horse armor. The practice certainly isn’t new to PC gamers or enthusiasts of mobile addictions like “Candy Crush Saga.”
But for gamers who play on consoles like the Sony (SNE) PlayStation and Microsoft (MSFT) Xbox, the concept really only took off three or four years ago, spurring a massive growth-engine for publishers.
“The R&D costs are minimal; the economics on that sale are incredible,” said O’Shea.
Creating widgets out of pixels takes very little time. “Maybe for the developers it’s like 30 minutes at lunch,” he joked. But the profits are serious: Microtransaction margins can be a whopping 85%-90%.
On top of that, the add-ons can draw players deeper into a game, making it a “really, really intriguing model,” said O’Shea.
This model involves cultivating an overarching stream of “live services,” of which microtransactions of virtual goods are just a part. It also includes e-sports competitions as well as expansion packs or “map packs” that unlock new areas of an existing game — essentially, any content updates provided after a game’s initial launch.
Game publishers “don’t look at a game as a new release and then it’s done; they look at a game as something that consumers want to interact with for years rather than weeks,” said NPD Group’s Mat Piscatella. “And that’s leading to the success that’s going on in the market right now.”
“GTA Online,” the web extension of Rockstar Games’ “Grand Theft Auto V,” has reportedly raked in over half a billion dollars from microtransactions. That’s according to a legal complaint filed against Rockstar and parent company Take-Two Interactive (TTWO) by the game’s producer and former Rockstar North president, Leslie Benzies.
“These purchases have a nearly 100% profit margin, subject only to nominal development costs and app store commissions,” reads the document.
And “GTA Online” continues to chug along in popularity, despite being released in 2013 — a lifetime ago in gaming years.
“Plenty more content is coming” for that particular title, said Take-Two CEO Strauss Zelnick on the company’s May earnings call. “Consumers love it. It remains an enormous focus of everyone’s attention.”
Piper Jaffray analyst Michael Olson says the “bigger, better, fewer” approach has taken hold of video game publishers in the last five years, a safer alternative to trying their luck on untested new titles.
“A few weeks ago we set a new (daily active user) record on the back of these new content updates,” said Blizzard head Michael Morhaime in Activision’s Q1 call in May. “This reflects the evolution of our business from focusing primarily on full game releases to also providing a consistent stream of content for our players. Even without any full game launches this year, we’re continuing to add to the depths of our games to serve a very highly engaged community with more content across our portfolio than we ever have before.”
‘Gateway’ To More Business
In 2016, in-game revenue made up $3.6 billion of Activision Blizzard’s $6.6 billion in sales — more than half of the total pie and up 126% from the prior year, notably helped by the takeover of “Candy Crush Saga” maker King Digital.
And as more people bought entire console titles online and acquired more downloadable content, the overall digital-revenue segment shot up 94% to account for almost three-quarters of total revenue for the year.
At Electronic Arts, digital revenue accounted for 61% of the year’s nearly $4.9 billion in net sales, as it too embraced the industry’s shift.
Case in point: the online multiplayer fantasy-soccer mode in EA’s popular “FIFA” series sells 12-packs of virtual trading cards, which can include coveted star players that gamers can add to their teams. On its own, “Ultimate Team” accounted for $832 million in net sales for the year, or about 17% of EA’s 2016 revenue.
“EA’s games today are live services — amazing experiences that we update and evolve to deliver ongoing fun that keeps players engaged, connects them to their friends, brings them more content and grows our network,” said EA CEO Andrew Wilson on the company’s Q4 earnings call in May. “This strategy has been at the core of our digital transformation, and today our live services are some of the strongest and most vibrant in the industry.”
EA management pegged features like virtual cards as one of the key growth drivers for the current fiscal year, alongside its mobile business and “Star Wars Battlefront II.” Officials touted Ultimate Team as a “gateway” to e-sports competitions, another budding revenue stream.
“It’s like selling airline tickets; some people pay much more to fly first class and many opt for the coach experience,” Jefferies’ O’Shea wrote in a note. “Applied in the right way, the trading card business model results in larger audiences, deeper engagement and higher profits.”
Wider Gaming Audience
Still, even as the live-services model takes hold, some gamers complain about microtransactions and the industry’s efforts to make them shell out for more content after they’ve already bought a game. The idea of paying for more powerful weapons or more lives strikes some as unfair.
Another common complaint is that the microtransaction model promotes “pay to win” instead of “play to win.”
“I’m OK if it’s just an extra option,” said 27-year-old Joseph Vasquez at E3. “But they’ve kind of turned it into where, if you want to really unlock a lot of things, unless you’re willing to play months-on-end straight, then you’re going to want to spend some extra money on top of the $60 you’ve already spent, which is kind of a cheap tactic — a cheap business tactic, I think.”
But such opposition might not rattle the bottom lines of Activision and Electronic Arts.
In fact, Wall Street remains bullish on the video game sector.
“You don’t need huge growth among the player base to drive continued increase in revenue per player,” according to Piper Jaffray’s Mike Olson. He said solid sales of PlayStations, Xboxes and other consoles point to an expanded addressable market that is “hungry for new technology.”
Piper Jaffray’s biannual teen survey still shows great interest from Gen Z. So even though the average gamer is older, the overall age range of the video gaming community is actually widening, Olson says. That translates to more, not fewer, revenue opportunities.
Underscoring that cross-generational opportunity is 37-year-old Aurelio Rubio and his four kids: two daughters and two sons. Between the five of them, the family currently uses three PS4s, one Xbox One and one Nintendo Switch.
Since everyone has his or her own TV and console, Rubio is used to buying several copies of each game — and by extension, several copies of the same expansion packs and other digital content.
“For us, it’s the way we bond,” said Rubio, who estimates that he has spent thousands of dollars on video games in his lifetime. “As a family thing, we bond together. It adds that value.”[“Source-investors”]