In a report titled “Rethinking Next-Gen Assumptions” released today by the Susquehanna Financial Group, analysts Jason Kraft and Chris Kwak look at attach rates and discuss why recent comments by publishers imply a lower attach rate in the coming hardware cycle. The report starts as follows: “Executives at major game publishers have been saying they want to extend the game experience for their marquee franchises. An extra hour of GRAW for the consumer is an extra hour to generate revenue for the publisher. One way to enable longer play is through online play via downloadable extensions (e.g., map packs). Call of Duty 2 (CoD2) remains one of the most popular 360 titles on the market, precisely because of its online multiplayer maps. At this point – seven months after CoD2 launched on 360 – if Corporal Taylor hasn’t crossed the Rhine, you might as well hang it up. Even the original multiplayer maps for Xbox Live (XBL) have fatigue; we are tired of Brecourt, Stalingrad, and Toujane. We know the optimal positions and when to favor the Springfield over the Thompson. Thank goodness for the new maps of Vossenack and Wallendar, Germany. (Please, less France, more Africa)." Designing With Add-Ons In Mind It then notes: "With Microsoft’s urging, publishers are designing games with expansions and add-ons in mind. This will make more games like CoD2 – longer play, greater brand loyalty, and bigger community. As we will argue, there may be an unfortunate consequence to making video games play longer. Because the video game industry is cyclical, many investors look at earnings potential through the cycle. Figuring this out is no easy matter. Some investors inductively reason that the next-gen cycle will deliver higher revenue and margin. In the absence of definitive evidence to the contrary, it is not unreasonable to assume the future will resemble the past. That is what investors have come to expect of the video game industry. Naturally, such inductive logic is oversimplification. There are many variables in the equation, including installed base projections, average selling price (ASP) expansion, attach rate factors, and numerous new revenue growth opportunities. We will touch briefly on the installed base and ASP. We intend to delve into installed base and pricing assumptions in a later issue of the Video Game Journal. We have written about some of the new revenue opportunities – in-game advertising and episodic content via digital distribution. Many factors drive video game publishers’ stocks. On a macro level, disposable income and time-share drive demand for forms of entertainment. Specifically, console hardware adoption and share shifts impact publisher fundamentals. A third-party publisher’s ideal scenario is the dominance of a third-party friendly console (Sony PS and PS2). By “third-party friendly” we mean a console advantageous to third-party (e.g., Take-Two) attach rate. A third-party publisher’s worst-case scenario is Nintendo capturing dominant share, as Nintendo publishes the lion’s share of games on its console (Mario, Zelda, Metroid, Pokémon, Nintendogs, and the list goes on). With its growing Game Studios assets, Microsoft – while not as friendly as Sony – is substantially more third-party friendly than Nintendo.” A Formula For Sales? The report sums up the value of the game industry with the following formula: E = B(1+b) * P(1+p) * A(1+a) + v The report explains this formula in the following way: “1. Installed Base (B). People have already concluded the installed base will expand over the next five years. Why? Simply because this has been the trend over the past few cycles. Where will the installed base growth come from? Japan? There is probably no market more mature and where American consoles (no less publishers) have the toughest time cracking. China? Korea? These are PC-centric gaming markets. It doesn’t help that game piracy is rampant here. Emerging markets? Where? That leaves us with North America and Europe. 2. Average Selling Price (P). It would be reckless optimism to believe all frontline games will launch at $60 on next-gen consoles (vs. $50 on current gen). To date, nearly all titles have launched at $60. After nearly seven months, Need For Speed, GUN, Call of Duty 2, and Tony Hawk American Wasteland are still priced at $60. Some titles (Table Tennis and Topspin 2) are beginning to debut at lower price points. Many games will continue to debut at $60; however, we expect publishers will experiment with pricing for lesser franchises. 3. Attach Rate (A). We define attach rate as the number of games (units) per unit console installed base. The attach rate rises through the cycle. The early 360 exit polls suggest the attach rate may rise over the next-gen cycle. This has led some managements to proclaim publicly and privately the attach rate should rise cycle-over-cycle. 4 New Revenue Streams (v). In prior issues of the Video Game Journal, we have written about some new revenue sources in the coming cycle – namely, in-game advertising, micro- transactions and downloadable content, and the PSP. Of these, we believe downloadable content (map packs and expansion packs, in particular) and the PSP will be the most significant new revenue opportunities over the next five years.” Smaller Games, Lower Prices? The report identifies the ideal scenario for game publishers as one with “smaller games with lots of churn at good price points.” It continues: “Imagine a world in which four hours of gameplay cost $40, and unit sales of the best of them rivaled current-gen best sellers like GTA and Halo. Now, imagine exceptionally high turnover. Given a fixed number of hours dedicated to playing games, the attach rate would be astronomical. If the relative attach per game were similar, the game publishing industry would be able to extract more revenue per hour of gaming. Imagine Bungie releasing Halo 3 in spring 2007 with 1,000 hours of gameplay, and Rockstar releasing GTA IV in fall 2007 with 1,000 hours of gameplay. Talk about crippling the industry. Many of us would not buy another game in 2007. We wouldn’t have time to play anything else. This isn’t even the worst-case scenario. Imagine a shift in share to PC where everyone played World of Warcraft. That would be catastrophic for everyone, except VU Games. No matter how many people are playing Halo, the Nintendo and PlayStation guys are playing something different. (We used to say that about GTA, but not anymore. When GTA IV comes out, it’ll be on 360 and PS3.) If timeshare of video games stays constant, a longer average game experience will necessarily mean fewer games purchased through the cycle. (We acknowledge that a few longer games do not necessarily imply fewer games in aggregate. If consumers are willing to commit less time on average to the remaining games, the attach rate could remain constant.) Why would consumers play games longer? Games will be longer on the DVD and made longer (extended) via downloaded content on the console. To borrow a phrase from the movie, Antitrust (2001), if the additional content is “in the box”, that’s not good. If the additional content is downloaded “in the band” to the console, that’s good. That is, if the additional hours of gameplay are a function of publishers providing more hours of gameplay on the disc (in the box), that’s not good. If the additional hours of gameplay come from downloadable content (in the band), that’s good. In either case, consumers will purchase fewer games if the average number of hours per game rises.” Making Up For A Lower Attach Rate Citing examples by SFG Research, the report writes: “We hold price constant at $50 for the purpose of the exercise, as the increase in game price from current-gen to next-gen is captured by the ASP, a variable we intend to cover in upcoming issues of the Video Game Journal. The increase in frontline ASP to $60 is a fortune for publishers in the upcoming cycle. Scenario 1 represents a hypothetical current-gen cycle attach rate model. In Scenario 2, we increase the average hours consumers play per game. Given that we assume a fixed timeshare of entertainment consumption for video games, it follows the attach rate must decline. This delta in revenue ($100) is the natural result of a lower attach rate. Publishers could make up this lost revenue resulting from a lower attach rate if two things happen. If consumers are willing to play fewer hours of some games, publishers will generate greater dollars per hour on those games. Scenario 3 outlines this behavior. It is hard to conceive that consumers would buy games knowing they will play fewer hours. Consumer appetite to try games must remain high. Given the number of playable demos on XBL, we wonder if consumers aren’t more careful with their dollars this time around. If consumers’ appetite for downloadable content grows, this trend will help generate revenue above the retail price. Holding the price per game constant, if we assume downloadable content has a blended ASP of $5 ($2 per map or object and $20 per “level” in a 5-to-1 ratio), you would need the remaining eight games to attach 2.5 downloads per game to make up the lost revenue. Again, if people are spending more time per game, it means people are consuming more. If consumers are playing longer in the box, revenue will be negatively impacted by the lower attach rate. If consumers play longer in the band, revenue will be positively impacted by the paid-for downloaded content.” Why Online Stops New Purchases Turning attention to how these scenarios play out in the real world, the report writes: “Online makes games play longer. CoD2 is a case in point. Multiplayer maps for XBL have extended CoD2 gameplay. Up to May 2006 (six months after its debut with the 360 in November 2005), Activision generated no revenue from those online hours of gameplay. Here then is an example of a game with more hours of gameplay (online via multiplayer maps) in the box which does not generate revenue. With the release of new multiplayer maps on XBL in May 2006, Activision is at last generating new revenue from the nearly 1 million CoD2 units sold in the U.S. If the hypothesis that the attach rate may fall turns out to be true, and downloadable content is required to offset this decline, exactly how many pieces of content would a game need to sell to make up the loss? That is, what must the attach rate of downloadable content be to help recover lost revenue from potentially lower attach rate of games?” Concerning the idea extending the blackout period surrounding game releases, the report writes: “As with the movie industry, timing of release is critical to game publishers. If Activision were ever to develop a sequel to True Crime on console, it would behoove the company not to launch the game the season in which GTA is released. If Call of Duty 3 (CoD3) hits retail shelves this fall, WWII FPS’s would do well not to get caught in CoD3’s line of fire. It shouldn’t surprise us that EA is pushing out Medal of Honor: Airborne to January-March 2007. Medal of Honor’s survival as a franchise may depend on scheduling flexibility. If CoD3 comes out November 2006 and Airborne comes out, let’s say, January 2007, surely this distance between launches will minimize Airborne’s exposure to CoD3. If Activision does what management says it will, we have a sneaking suspicion CoD3 will release new multiplayer maps (and potentially more levels) to coincide with Airborne’s release. Tactically, this would make good sense. This is no different than Microsoft releasing the much anticipated Gears of War to coincide probably with the PS3 launch. (Although, in this case, Gears will help 360 more than it hurts PS3.)” Franchises Negatively Affecting Game Sales? The report then asks: “Might extensible franchises have a further negative impact on the supply of and demand for games? Specifically, if publishers extend franchises with additional content, won’t the blackout period before a similar game launches increase? It would be a strategic disaster if Airborne hit shelves the same day as CoD3. Even the same month is risky. EA would like to put as much distance as possible between Airborne and CoD3. But what if CoD3 grabs consumers for three months instead of two? If Activision increases the window of interest for CoD3 with additional content, it will decrease the window of opportunity for Airborne. Publishers understand this already. While difficult to determine conclusively publishers’ motives, we believe the fall 2004 launches of GTA: San Andreas and Halo 2 suggest publishers work around franchise titles. What the industry refers to as the GTA and Halo effect is merely the materialization of increasing the theoretical blackout period before the market is freed up for new games. There was a surge in the number of titles launched in September 2004. It is possible the year-over-year growth would have continued were it not for GTA: SA and Halo 2 launches in October and November, respectively. Not only did the number of titles launched decline year-over-year in October 2004 (GTA: SA), they declined in November 2004 (Halo 2). Furthermore, there appears to have been something of a hangover in December 2004. Again, this is in no way conclusive. Our position is merely that in what otherwise should have been a solid 2004 holiday, publishers chose to release fewer titles in October, November, and December 2004 versus the year-ago months. The dollar volume of the industry (including GTA: SA and Halo 2) was very strong. In fact, each month in the study below exhibits year-over-year growth. It makes sense that consumers shifted dollars to GTA: SA and Halo 2. The bigger question is (again, it’s not 100% clear), “Did consumers spend less in December 2004 than they would have because they were playing GTA: SA or Halo 2?” Freeing up dollars is one thing – it is hard to know if GTA: SA or Halo 2 locks people out of buying another game. Freeing up time, however, is altogether different. If you’re playing GTA: SA or Halo 2, you are certainly not playing something else. Again, while the data is not conclusive, we believe the rest of the video game industry would have had a better 2004 holiday without GTA: SA and Halo 2. We doubt the dollars diverted to GTA: SA and Halo 2 during holiday 2004 would have transferred fully to other games if these two big franchises had not been available; although, we cannot underestimate the positive impact these two games had on foot traffic at retailers. However, even if the pie were smaller without these two games, the others publishers would have had a larger share.” How Publishers Should React To This Turning to what the report calls a different kind of consolidation, it writes: “What does this mean for the publishers? Simply, if you’ve got a lineup of marquee extensible franchises, you’re probably in good shape. We are likely to see consumers circle around fewer franchises, but for a longer time per franchise. In other words, we may be witnessing a consolidation in consumer dollars for video games around the most easily extensible franchises. If every publisher had one World of Warcraft on console, even if the overall market size expanded, the number of titles – and hence, attach rate – would not. If the idea then is that extensible franchises are ideal for longer gameplay, what makes a game extensible? We posit that games are extensible if new content can be downloaded to extend the gameplay. As we have noted, Call of Duty 2 is a good example. As a FPS, CoD2 can deliver map packs for multiplayer online play. A FPS with a sufficiently interesting story arc can also provide new levels/missions. Half-Life 2: Episode 1, recently launched, is another example. Games that are divisible are suited for episodic delivery. We are principally interested in games with roles, narratives, and story lines. Which genres are less ideal for increasing gameplay? Games lacking interesting narratives and those released annually are limited by nature. Concluding, report offers a final thought: “The downside to longer games is potentially a lower attach rate. However, the push for longer games, which yields a lower attach rate, is driving publishers to the endgame – digital distribution of (portions of) video games. While a decrease in attach rates of next-gen games could hurt near term, it may be a necessary transformation to make the business of video games more attractive longer term. In essence then, the new revenue sources (in-game advertising, expansion packs, etc.) may merely offset lower attach rates. At what point do the new revenue sources more than make up for potentially fewer games? This is a question we will have to wait to answer.” [Thanks again to Susquehanna Financial Group analysts Jason Kraft and Chris Kwak for their work reprinted here.]