In place of this week’s newsletter, we wanted to take the opportunity to reflect. 2020 was unprecedented in so many respects. This was a profoundly challenging year but it also marked a step function change in the gaming market. It ended up being a productive year despite its many trials. We closed 8 advisory transactions in 2020, including Phoenix Lab’s sale to Garena, FoxNext’s sale to Scopely, AppLovin’s acquisition of Machine Zone, Skillz’s SPAC merger with Flying Eagle Acquisition Corp., TSG’s investment in Scopely, and Daybreak’s sale to EG7. We expect the frenzied pace of transaction activity to accelerate further from here.
We co-founded Griffin Gaming Partners with Phil Sanderson and Peter Levin and have some of the world’s largest strategic investors backing the fund. With ~$250 million in assets under management, Griffin is now among the largest venture vehicles focused on gaming and is proud to support some of the most promising companies in the sector. The first fund is over half deployed, having made investments in Skillz, Discord, AppLovin, Tactile Games, Wave, N3TWORK, Subspace, Funzy, SuperSocial, and Spyke, among others. Our objective is to be the definitive resource for companies raising capital at all stages and are excited about the progress we’ve made to that end.
Sitting at the intersection of so much movement, we wanted to share predictions for the coming year from our vantage point.
BROADER PERSPECTIVES: OBSERVATIONS FROM THE PAST DECADE
The last decade has proved a dramatic transformation for gaming companies. Electronic Arts, for example, traded at less than 1x its next year’s estimated revenue and less than 4x its anticipated EBITDA. The reasons were relatively straight forward: many investors believed its performance to be unpredictable and it depended on third-party licenses. Shipping packaged software was a hard business and even more so when one owed royalties for the use of third-party IP.
Margins for the largest Western gaming companies have naturally expanded over the past decade as consumers shifted from purchasing physical copies of software to digital. As EA has diversified, demonstrated a track record of relatively consistent execution in marquee titles like FIFA, and exploited new adjacent opportunities such as Ultimate Team, the market has come to ascribe very different multiples: 6x and 17x 2021 revenues and EBITDA, respectively. EA is not alone in this “re-rating”; Take-Two, Activision Blizzard, and Ubisoft have all grown revenue and earnings but not nearly enough to explain the ~1000% appreciation in their stock prices since 2011.
This has proven to be a wildly sentiment-driven sector. As Activision Blizzard was perceived to be driving a significant proportion of the emerging momentum around eSports, its trading multiples expanded significantly. When EA’s acquired studio Respawn launched Apex Legends, its market cap increased by $5 billion over the next two weeks without much visibility into users, revenues, or profits from the new free-to-play hit franchise. Similarly, Nintendo’s market cap was up 36% in the two days following its announced partnership with mobile game developer DeNA without providing much detail on the specifics of the business terms. These are just a few of countless examples.
IMPLICATIONS FOR MOBILE GAMING COMPANIES TODAY
Mobile games companies have long suffered public perception created by King’s trading post-IPO. King marketed an IPO story centered around its unique approach to game development that produced one of the largest entertainment franchises of all time: Candy Crush. Yet, despite this meteoric success, which pushed King to over 500 million monthly active users at its peak, King failed to produce similar successes outside of the Match-3 genre. Candy Crush and its progeny seemed at the time to many public investors to be on a “decay curve” given low switching cost for users on mobile and resulting churn, which many investors extrapolated asymptotically ad infinitum. As a consequence, King traded as low as 2-3x its EBITDA.
So how is King doing today? Activision Blizzard acquired King in 2015 for $5.9 billion, representing less than 6x its expected EBITDA. Candy Crush users did indeed decay to a nadir of just under 250 million but the user numbers stabilized there.
Let that sink in: King owns and operates an entertainment franchise that a quarter of a billion people interact with each month, generates $2 billion of revenue and approaching $1 billion of operating income annually based on its Q3 2020 run-rate. This dwarfs almost every traditional entertainment franchise on the planet and although buried within Activision Blizzard, we estimate King may account for as much as $20 billion of Activision Blizzard’s $73 billion market cap today. It seems that Activision Blizzard saw something in King others did not.
PUBLIC MARKETS ARE OPENING BACK UP FOR GAME COMPANIES
With King’s lackluster performance and Zynga also trading poorly in the years immediately following its IPO, Western public markets were generally regarded as inhospitable for game companies. In dozens of strategic assignments for clients in the sector, only a very small minority considered a public exit as a serious alternative.
Today, we see euphoric appetite among public investors for the “picks and shovels” of the gaming ecosystem. Unity, for example, offers the most prolific game development software and has 1.5 million developers using its tools on a monthly basis and 2.5 billion monthly active end users who consumed content that was created or operated with Unity solutions.
Unity went public in September at a $16 billion valuation, which represented a 15x multiple of its expected revenues but has traded up dramatically to as high as $55 billion. Unity is only expected to grow sales 26% next year and is unprofitable according to consensus analyst estimates.
Unity is, in our view, among the best positioned companies to execute against the opportunity to bring ad-based monetization to the billions of users that play mobile games but don’t spend on in-app purchases. While approximately a third of all mobile downloads are games, only $3 billion of the $133 billion mobile advertising market is accounted for by in-game advertising. This represents a staggering opportunity but it is also a testament to the market environment to witness the degree to which Unity is credited for its potential future execution against this opportunity (and others) by current trading levels.
Skillz is another extraordinary example of a recent enormously successful IPO. We helped broker a merger with a SPAC at a $3.5 billion valuation just months after it raised capital privately at a significantly lower valuation. Skillz trades today at an $8 billion market cap and commands a 21x multiple of its expected 2021 revenue. Skillz is notably expected to grow revenues next year by 63% and also has profitable unit economics.
While SPAC mergers are extremely complex and require significant negotiation with the nominal acquirer, in this case, we believe it produced a superior outcome relative to a traditional IPO and a much lower cost of capital for Skillz going forward than had it stayed private. It is a sharp example of why we believe SPACs are more than just a flash in the pan, especially for sectors like gaming where public investor sentiment is rapidly evolving.
One interesting note from the process: Skillz was marketed to public investors without reference to mobile gaming companies like Zynga, Glu, or SciPlay given Skillz’s position as a platform. Skillz enables casual eSports tournaments and head-to-head contests with prizes for millions of mobile game players. Only time will tell but this mechanism for monetizing game content may end up rivaling that of in-app purchases, which today represent over 80% of all mobile App Store revenues according to AppAnnie.
IN THIS GOLD RUSH, IT WILL BE GOOD TO BE LOOKING FOR GOLD TOO
There is something incongruous with how public markets require companies like Zynga, Glu, and SciPlay to “show me” before ascribing much credit for potential new games or more importantly, to acquire businesses that accelerate growth and add to scale in a business that will ultimately benefit immensely from it.
In 2021, expect that to fade as a host of both gaming infrastructure and content companies, including Roblox, Playtika, and others that have demonstrated an ability to sustain growth, tap public markets. Many of these businesses, with enhanced cash war chests and a public currency will aggressively pursue acquisitions to accelerate growth much the way Zynga, Stillfront, Embracer, MTGx, and EG7 have.
Mobile gaming has emerged over the past decade as one of the most significant developments in entertainment. A niche business a decade ago has transformed into an $86 billion global market and one of the fastest growing entertainment markets today. One-third of the world’s population plays mobile games according to TechCrunch. With such incredible reach, lightning-in-a-bottle moments like Niantic’s 2016 launch of Pokémon GO are possible and allow for a piece of software to reach a billion users. As mobile screen resolution and compute power increase, and broadband cellular networks proliferate, increasingly immersive and social experiences are being created “mobile-first” in gaming.
Against this incredibly constructive market backdrop, extraordinary competition has emerged. The stakes are so high — billions in revenues and profits for the market leaders — and the cost of entry so low, more than a million mobile games have been created. Predicting those explosive hits like Pokémon GO is possible, we believe, but difficult. At Griffin, we have already evaluated close to a thousand venture financing opportunities since launching the fund.
While the market leaders in China, such as Tencent and NetEase, moved aggressively against the market opportunity for mobile games, and now generate ~80% of their games revenue from mobile, Western leaders have been much slower to increase their exposure to mobile, with such revenues representing only 10% - 30% of their total games revenue with WB Games as a notable exception.
Producing mobile hits is tough business, even for seasoned AAA gaming companies, given how many companies there are launching new games each year. Switching costs for most users are low, producing, as Kevin Chou, formerly Kabam’s CEO, observed, “shark fin” patterns of early success but high churn and rapid decay of user bases. Many of the larger gaming companies have opted to buy instead of build, creating an increasingly constructive market for mobile games businesses to find buyers willing to pay premium multiples.
ACQUIRED GROWTH IS GROWTH -- AND, FOR MANY, SUSTAINABLE
In examining recent consolidation in mobile gaming, Zynga’s history is illuminating. Notwithstanding its choppy start to life as a public company, Zynga has been on a terrific trajectory since Frank Gibeau took the CEO mantle back in 2016. He brought on a seasoned team of operators and set a new strategic vision for the business to focus organic efforts on Zynga’s biggest franchises (i.e., a “fewer, bigger, better” strategy akin to what had worked at EA), reducing costs, and most importantly, with an explicit intention to grow through acquisitions.
If we take the beginning of 2017 as the line of demarcation, at which point, Frank’s credible and compelling strategy had been clearly articulated, there are a number of remarkable dynamics to the next four year’s trading. At that point in time, Zynga’s beta, which takes account of both volatility and the way Zynga’s returns vary with market returns, was 1.3, Today, Zynga’s unlevered beta is an incredibly low 0.19. To distill this down to practical implications: the less volatile the returns and the less those returns move in line with the market returns, the lower the required return should be for an investor to hold the security. An investor who bought Zynga at the beginning of 2017, is up 3.8x, having produced an IRR of 40%. If the expected returns needed only be low double digits and the multiples it trades at today are similar, Zynga must have performed unforeseeably well to explain these anomalously high returns?
Zynga has performed well but not that well. If you drill down into Zynga’s growth, it turns out that nearly the entirety of its tremendous growth has been driven by its acquisitions. It has embarked, just as Frank said he would, on an aggressive string of acquisitions. It bought Peak’s card game assets, Gram Games, Small Giant, the remainder of Peak Games, and Rollic. Each deal has its own nuances, of course, but notably missing is the analogue to Caesar’s acquisition of Playtika in 2011 for ~$100 million. It of course sold the business to a Chinese consortium in 2016 for $4.4 billion.
Zynga, by contrast, has paid relatively full prices for its acquisitions. In the case of Peak Games, Zynga paid $1.8 billion for a company whose two hit titles, Toy Blast and Toon Blast, had category-leading user retention statistics. The business had single digit top line growth and still garnered a reported 15x EBITDA multiple. While almost 3 times the multiple Activision Blizzard paid for King, the market responded quite positively to the deal, with Zynga’s market cap increasing $630 million on the day of announcement. While Zynga has paid up and derived little benefit from synergies thus far, they are, as a package, strong strategic moves. However, in a market so thoroughly fragmented, with so many opportunities to buy, it’s hard to resist concluding that Zynga was mis-priced and materially undervalued back in 2017.
MANY MOBILE FRANCHISES WILL HAVE LONG LIVES
The key risk factor for mobile game developers has always been sustainability of growth. In the lead up to the sale of Kabam, we highlighted to potential buyers an important dynamic among the millions of players in the hit Marvel Contest of Champions game. The metrics for the whole population of players masked what was going on with a subset of players, dubbed Regulars, or players that had played 7 of the past 7 days. Those were players, we argued, that had often formed a sustaining habit. For many, the game had become a way of life. Regular customers, it turned out, monetized more like a subscriber. Cohorts of these users paid a very consistent and high sum each month despite being under no obligation to do so. They also had almost no propensity to churn. In total, Regulars accounted for approximately 80% of the overall game’s revenue.
One runs the risk in data mining of confusing correlation with causation, but we’ve now had ample opportunity to test the hypothesis out of sample. After observing the subsequent performance of Marvel Contest of Champions and countless other games, we’ve found this to be a recurring dynamic.
Many games have huge subsets of their player populations that form daily habits. Their status in these games often matters. They have friends in the games. They sometimes have enemies. They engage for hours every day. They simply don’t churn like the average statistics would predict. In many cases, mobile game developers can come up with new virtual goods and services to offer them. Regulars represent a subset of overall users, but we believe valuing the business opportunity derived from those most highly engaged users should look more like a software-as-a-service company valuation than the historical approach to mobile game company valuations.
Moreover, mobile games are increasingly akin to living organisms which evolve continuously. Pokémon GO has transformed radically since it launched in the summer of 2016. It further altered gameplay specifically in response to the COVID-19 pandemic, which curbed some of its historical outdoor gameplay patterns. As a result, Niantic delivered record revenue and player engagement in 2020.
Just as the market came to appreciate that AAA gaming companies had competitive advantages that would sustain and allow for growth in core franchises, we believe markets will afford increasing credit to mobile gaming leaders. The best executing private mobile game companies have grown dramatically, not only by launching new, unforeseeable hits, but also by scaling existing titles through profitable spend on user acquisition and by acquiring complementary businesses. Market leaders like AppLovin, Jam City, Moon Active, Niantic, Playrix, PlayStudios, Playtika, Scopely, Wildlife, Zynga, and many others are larger (in some cases, dramatically) and more valuable today than they were in 2017.
SCALE WILL INCREASINGLY MATTER IN MOBILE GAMING
Mobile is a market where scale will ultimately matter. The paradox is that scale, at least thus far, has not demonstrated an ability to help companies discover the next big hit. If you look closely at the Among Us examples of explosive success, they are very rarely produced by the largest Western developers. We do expect some change to that dynamic over time. However, sustaining and growing a game is a business that already dramatically favors scaled operators. Most mobile games need to spend significantly to acquire users through paid marketing channels. They also benefit from scale in running in-game events, producing new content for hyper-engaged users, and managing complex virtual economies.
Mobile gaming gives the developer the benefit of the data from every player interaction with the software and ability to track and ultimately model the results. Did a particular game mechanic cause a player to engage more deeply? Did it cause the player to churn? Did it lead to increased monetization?
The very same stimulus may very likely lead to a different result for a different player. The largest mobile game companies are building sophisticated player segmentation tools, which we believe will ultimately allow for customized and nearly individualized player paths through games. This will be an incredible application of machine learning technology for companies to be able to ingest such enormous quantities of data and tune the player experience algorithmically in response. Given the near-infinite variability of virtual economies and that the marginal cost of the virtual goods is close to zero at scale, we expect some extraordinary business results as mobile game companies systematize and automate maximization of lifetime value of players.
MOBILE GAME ADVERTISING WILL PRODUCE BILLIONS IN NEW MARKET VALUE
The last and perhaps more immediate opportunity for mobile game developers is advertising. King is an example to illustrate the point. When King was sold, it received very little if any value for the untapped engagement of non-paying players. At the time of the acquisition, only 3% of King’s users paid for in-app purchases.
The aggregate engagement was astounding. Users played 1.4 billion games per day. As is very common in mobile gaming, which is almost entirely a market of products that are free-to-play, the vast majority of users were “free riders”. Introducing ads in a way that doesn’t cause future payers to churn or allow competitors to pick off your audience is a non-trivial exercise, but it is increasingly being done. As of its last public disclosure, King’s advertising business generated $150 million of incremental net bookings and is the fastest growing segment within King.
There is an astounding amount of un-monetized time spent in mobile games. Users don’t get to “free ride” in Facebook, YouTube, or Snapchat, nor would many expect to. In the next year and beyond, we expect game developers to increasingly avail themselves of this ancillary revenue stream. The mobile game advertising ecosystem is evolving rapidly and stands to benefit many mobile games developers significantly.
Although extremely difficult to forecast with precision, we expect public markets to increasingly “price in” the probability of growth in existing franchises, new games, successful acquisitions, and new monetization opportunities for games companies.
As games increasingly facilitate digital interactions, we believe we will see the creation of what pundits have coined the “metaverse”. One of the most reflective CEOs I know, Dave Baszucki, recently said quite artfully: “The Metaverse is arguably as big a shift in online communication as the telephone or the internet. Within the next few decades its applications will exceed our wildest imaginations. Perhaps the greatest opportunity it presents is to bring together people from all walks of life and foster a civil digital society. In 2021, that new society will begin to emerge for real.”
Whether Roblox or Epic will run one Metaverse or there will be a multitude of metaverses that emerge from the incredible engagement and immersion players have with their favorite games remains to be seen but it seems entirely likely that games will continue to consume more and more of our attention and facilitate an increasing proportion of social interactions.
Robert Putnam, in his seminal work Bowling Alone, decries the collapse of community engagement in modern society. We see gaming at the heart of a potential rebirth of social capital. Gaming, in many respects, has evolved in a way that facilitates social interaction, deepens relationships, and provides people around the world a new way to connect with one another. In games, we have the opportunity to “bowl together” at scale and perhaps build even deeper social roots than formed through community activities in the analogue world. For that potential, we are incredibly hopeful around the role gaming can play in bringing our world closer together.
Thanks to our clients and friends for all of your support. We hope to repay the kindness with creative ideas on how to support your growth. Feel free to reach out at any point if we can help provide advice or just to chat. Looking forward to the year ahead!
P.S. I’d like to thank everyone who contributed to this in one way or another and specifically, my team, Frankie Zhu, Jon Bikoff, and Seth Nutt, as well as Dean Takahashi, who kindly contributed to this directly with his suggested edits and whose work I hyperlink liberally 🙂