A Wealth Creation Journal

Author: XC (Page 3 of 5)

Investment Memo – CD Projekt

I bought some CD Projekt shares in my previous portfolio update here. I am very excited to finally become a partner in this wonderful business after following it for 3 years.

I will first discuss CD Projekt’s business at a high level and then go into the recent debacle with Cyberpunk 2077.

As I wrote in my previous blog post – Thoughts on video games:

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

CD Projekt has one strong game franchise – Witcher and in the process of building out a second franchise – Cyberpunk. Despite the launch drama, I think CD Projekt has a reasonable track record as a game developer. So CD Projekt does not fulfil those two criteria – owning strong game franchises and proven game development capabilities – very convincingly.

But I think there is sufficient evidence that CD Projekt can continue to develop its capabilities and strategically build out future game franchise. So there is not really a lot of margin of safety here and hence this is a 2% position.

I always prefer game companies that own and operate persistent game worlds which provide game-as-a-service revenue model rather than game-as-a-product revenue model. Unfortunately, CD Projekt adopts the game-as-a-product revenue model which means its cashflow is very tied to game releases and very dependent on the success of each game release. This has historically lead to a hit-driven business model which many investors hate because it is impossible to predict the sustainability of the company’s earnings.

This has been my biggest reservation about CD Projekt. But a few things changed my mind – 1) the launch Witcher mobile game; 2) the launch of Witcher Gwent card game, 3) the planned launch of Cyberpunk multiplayer online game and the 4) the release of Witcher series on Netflix

In some sense, CD Projekt has a very similar business model to Disney. Disney use movies to anchor its IP franchise which can then be further monetised through theme parks, merchandises and video games. For CD Projekt, it anchors its game franchise with flagship AAA games such as Witcher 3 and Cyberpunk 2077 and then develops spin-off games based on these core game franchises. It also produces TV series to further expand the influence of its game franchise.

CD Projekt’s real upside comes from 2 sources – 1) it builds out new game franchises and 2) transition one or more of its game franchise into persistent game worlds which can build strong customer loyalty and generate stable cash flow. With Witcher mobile game and the planned release of Cyberpunk multiplayer game, we are already seeing some signs that it is happening.

On valuation – it is very hard to value CD Projekt. As part of the company’s incentive program, it announced a goal of generating an average net profit of PLN 1.5-2bn for the period between 2020 – 2025. Assuming that they hit this goal, then I paid 15x multiple based on earning base of PLN 1.5-2bn net profit. Not too ridiculous but also not very cheap.


CD Projekt share price plunged after the disastrous launch of one of the most anticipated game in 2020 – Cyberpunk 2077. Here is a good Bloomberg article that documented the events that lead up to the game’s launch. In short, Cyberpunk 2077 built up an incredible hype but ultimately disappointed gamers as the game was full of bugs and glitches. It was so bad that Sony had to take the game off the shelves because it was almost unplayable on consoles.

Marcin, the co-founder of CD Projekt, posted a video to apologise for disappointing gamers and explain what happened.

He cited the technical challenges of making the game work with the next-gen and current-gen console & COVID-19 restrictions leading collaboration challenges as reasons for the failed launch.

From the outside, it is absolutely clear that the management team had huge pressure to get the game released before Christmas 2020 and that pressure led to the bad decision of launching before the game is ready. I am sympathetic to the challenge of COVID-19 situation which would have really complicated the entire development process.

The legendary game developer, Shigeru Miyamoto, once quipped that “a delayed game is eventually good, but a rushed game is forever bad”. This comment was made when games are primarily sold on physical copies and played with consoles that had no Internet connection. So there was no way to update the game after launch.

Fortunately, CD Projekt (CP) lives in the Internet era where it is possible to continuously update and improve the game once launched. In fact, Witcher 3’s launch was very problematic too. See this Eurogamer article written in 2015 to recount the disaster! And it feels eerily similar to Cyberpunk 2077 – last-minute crunch, graphic downgrade issues and the 2000 game bugs. Post-launch, CD Projekt continued to support Witcher 3, patched the bugs, launched DLC and won universal praise for the game. I believed something similar is going to happen here and that Cyberpunk has the potential to become another great franchise.

Ever since CP transitioned from a regional game distributor to a game developer in the mid-2000s, CP has been pushing its technical and game-making competence with every game. With Witcher 3, CP had to make a game engine that worked in an open-world while developing the game at the same time. CP has insane ambitions to grow as a world-class game developer.

I think with Cyberpunk, CP was trying to push the limits of what they can accomplish again. For example, they had to upgrade the game engine for FPS and driving. The Cyberpunk world was bigger and more complex. Except for this time, they had the complication of COVID, higher expectations, bigger gamer base and co-existence of two generations of consoles.

CD Projekt clearly screwed up this time. But from an investment perspective, I focus on three things – 1) what does this incident show about the company’s game development capabilities, 2) what does it reflect about the company culture and 3) the long-term potential of Cyberpunk 2077 franchise.

For me, it seems like CD Projekt’s ambitions might be ahead of its game development capabilities this time. But it is also clear that CD Projekt is improving as a game developer and based on the company’s historical track record of learning from mistakes, this could be another learning opportunity for CD Projekt albeit an expensive one. I am more concerned about how this incident could crash their ambition and kill the operational momentum that they have been on.

Few game companies have developed such a strong brand within the gamer community. CD Projekt always believed in treating gamer well which is exemplified by their ethos of providing good value for money – free DLCs and DRM-free games. I personally don’t believe there is anything sinister going on here except for the fact that there is immense pressure to release before Christmas 2020. During game development, there are constant trade-offs to be made and we could argue whether CD Projekt has made all the right trade-offs. But I don’t think there are any bad intentions here. I guess we will see how CD Projekt make up to the gamers in the months ahead.

After reading through many reviews and playing it myself, I think it is a good game and has the potential to become another long-running franchise for CD Projekt in the same way as the Witcher franchise.

Ultimately, I think there is a pretty good chance that CD Projekt can bounce back from this fiasco and become a better game company in the process.

Live Portfolio Update – 2021 – #3 (Tencent)

Buy Tencent as a 8% position @ HKD 645 per share.

Tencent is a company that I have actually spent the most time researching for the past 3 years because of work. While I cannot invest it in personally due to compliance reasons, I want to include it in the portfolio here.

Expect a full blog on Tencent soon!

Games Workshop – 1H 2021 Results Update

What a joy it is to be a business owner of Games Workshop!

Despite the closure of retail stores, GW reported excellent 1H 2021 results with revenue up 26% and gross margin expanding to 75% on the back of the higher volume. Net income reached an all-time high of GBP 73.9m and net margin improved from 39.5% to 49%.

The margin expansion has driven by operating leverage.

GW CEO, Kevin, reported that “operating profit – pre-royalties receivable – both value (up £35 million to £83 million) and profit to sales ratio (up 12% to 45%) have improved in the period. Our high margins are delivering incremental profit compared to last year at 91% (2019: 55%).

91% incremental margin!

In the long run, the margin should shrink a little as they reinvest into their business given the many avenues of reinvestment opportunities to drive future growth. It is not reasonable to expect GW’s margin to expand at its current rate, and I would rather them aggressively reinvest back into its core businesses.

China got a special mention from Kevin:

“An extended range of core products have now been certified for China Compulsory Certification (CCC) and have been available in the country. With Space Marines proving to be more popular than ever, we have enjoyed success in stocking and selling selected complementary licensed products within our own sales channels, key amongst which have been some action figures. These are also stocked in mass-market locations, helping us with brand awareness. We are expanding our translation team to ensure our customers in China and other overseas countries can enjoy the official Warhammer experience.”

I have been in close contact with the Chinese Warhammer community and translation quality is atrociously bad! I have no doubt that when they finally fix their China operations, it will provide the next leg of revenue growth. China is a huge market and I know Warhammer IP appeals to Chinese fans as much as it does in the UK and US.

A slight disappointment is to see the royalty income decline from GBP 10.7m to GBP 8.7m. But royalty income is going to be chunky. With the Warhammer IP going from strength to strength (TV series, animation and comic), it would ultimately be reflected in the royalty income at some point. Not to mention a strong pipeline of Warhammer game in 2021 and going forward.

In the long run, GW’s intrinsic value is driven by 1) the number of fans and 2) revenue per fan.

GW is a vertically integrated entertainment franchise that has historically monetised through miniatures. In the last few years, it expanded its fan base through better marketing on social media and better product campaign. Going forward, it is also exploring new ways to grow fan base through TV series, animation and comic. Not only is the fan base growing, it is also increasingly able to sell its fans more products such as mobile games.

So we are seeing both the fan base and revenue per fan growing for GW. In the next few years, this will prove to be a very potent combination!

Investment action: Adding 1% @ current market price

Jet2 (previously Dart Group) – a mistake of inaction!

After evaluating the financial resulting ending Sep 2020, it seems clear that I was probably being too conservative for not adding to Jet2 during the period of time where they raised new equity and sold logistics business. At that point, the risk of ruin is extremely remote and I have always believed in the normalised earnings of GBP 150m which means I could easily justify a market cap of GBP 1.5bn.

So I could have made a purchase around GBP 1bn market knowing full well that the risk of ruin is minimal. But I didn’t. And I don’t really have any good justification. So this is a mistake of inaction.

However, we are where we are now at a market cap of GBP 2bn. What to do next?

Jet2’s lack of a long growth runway concerns me quite a bit as it already commands a 40-50% market share within the UK’s package holiday sector. Hence Jet2 is unlikely to be a multi-bagger from here. But it could grow its market share to 60-70% as it comes out of this pandemic. I estimate its package holiday business could grow to 5 million customers within the next 3-5 years up from its current 3.2 million customers (pre-pandemic).

On the pricing side, I continue to be worried about ticket pricing due to a glut of plane capacity. But Jet2’s route network overlap with the major airlines is minimal and expect to shrink coming out this pandemic as Ryanair and easyJet retreat from the regional airports.

Finally, Jet2 gained incredible customer goodwill which could improve the sustainability of its franchise.

So on balance, it is a better business now versus 9 months ago. It is set to recover in 2021 and beyond.

I think I am in a better position to take advantage of any price correction now!

Nintendo entering the Cloud Gaming era

I played Control on Nintendo Switch today and it felt surprisingly good. Control was first released on PS4 and was previously thought impossible to port to the lower-powered Switch. But game streaming technology makes it possible.

The unique thing about a cloud game is that it requires an Internet connection to play and the gamer doesn’t own the game outright. Similar to the way that Spotify subscription users don’t own the music on Spotify.

Currently, Nintendo is working with a third-party company – Ubitus, a Taiwan cloud technology company to provide the cloud gaming solution. This is very different to Playstation and Xbox which both have gone down the path of developing their 1P cloud solution.

This could be a good thing for Nintendo as it allows Switch players to access AAA games which were previously unavailable on Switch. I wonder if the next Switch upgrade will come with 5G and introduce the possibilities of cloud gaming anywhere!

On the other hand, it also revealed the weakness in Nintendo’s cloud gaming strategy. They need to develop a proper company-wide strategy to adapt to the gaming era. I suspect at some point, they need to decide if they want to develop a cloud solution for Switch platform. The risk with a third party solution is that gamers would lose access to Control if Ubitus for whatever reason decide not to stream it any more.

With Xbox fully embracing the clouding game and cross-device future, the competitive pressure is heating up. It is possible that 5G smartphones + streaming could commoditise Switch’s superior gaming experience.

My next research project is to closely follow the technological evolution of cloud gaming.

Live Portfolio Update – 2020 #13

Bought 10% position in 51jobs @ 70USD per share.

This is a classic Chinese ADR privatisation deal with a PE sponsor. DCP Capital is currently offering to take 51jobs private. My guess is that mgmt team will join them in the privatisation deal at some point and hence they only have to buy 50% of the shares outstanding.

I should note that as compared to other Chinese ADR privatisation deal, the valuation sounds fair. So I believe there is very little chance of price improvement from here. Overall, I think the deal is very likely to pass within 3-6 months.

I see this deal as a way to earn a higher return on cash with a good risk-adjusted return.  I would not want to participate in merger arb if I can find high quality companies to own for the long term.

Live Portfolio Update – 2020 #12

Sold 4.2% of Avanza @ SEK185 per share.

It pains me to sell Avanza. But I cannot justify its valuation at this level. The trading intensity of Avanza customer base is so abnormally high (+50% versus an average of last 5 years) that it is only a matter of time before trading activity normalises. Hence current Avanza’s earning is materially overstated and putting a peak multiple (26x) on a materially overstated earning base is not good for prospective returns.

On the other hand, Avanza’s intrinsic value has benefitted from customer growth. I still have a 2% position in Avanza and I look forward to buying Avanza back at a lower valuation.

Generally, I do not try to trade around investments as I usually don’t make money out of it. Especially for a very high-quality franchise like Avanza. But when the valuation is so out of whack, I have to act.

Why I own Nintendo

After a lot of “backbreaking” research work, I am finally a proud shareholder of Nintendo!

Nintendo is a legendary Japanese video game company that has remained a mainstay in the industry for over 35 years, mostly because of its competence as a world-class game content creator. Nintendo owns the top 2 highest-grossing video game franchise of all time – Pokemon and Mario. Unlike most games that only last for less than 1 year, Nintendo’s most popular game franchises have exceptional longevity. For example, Nintendo’s current top 5 grossing games have been around for more than 10 years. I believe that Nintendo’s best days are ahead of it because its genius as a game maker will be amplified as Nintendo builds a direct and deep relationship with its gamer base. This new relationship with its gamer base will transform Nintendo’s cyclical revenue into a recurring one.

Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a cheap and effective medium to create all kind of problems for humans to solve. Nintendo’s genius lies in its ability to create problems (game contents) that are fun for the gamers to solve and to find the subtle balance between been too difficult and too easy. In short, Nintendo knows how to make games fun to play; or in Nintendo parlance, it “creates unique forms of play”.

Nintendo’s adopts the classic razor and razor blade business model. Gamers first purchase the Nintendo console, or more specifically Nintendo Switch which is the latest generation of Nintendo consoles, and separately buy the games to play on the console. Nintendo’s business model is to sell consoles at cost and make majority of the profit on the high gross margin game sales.

Traditionally, Nintendo is seen as a cyclical business because it is more reliant on the success of its console (hardware) rather than its true strength – games (software). Since new games released on the latest generation of console cannot be played on the previous generation of consoles (no backward compatibility), gamers might not upgrade to the latest generation of console which lead to limited incentives for game developers to develop new games for a console with small install base. This dynamic led to either huge successes or devastating failures. For Nintendo, Wii was a huge success but followed by Wii U which was a total commercial failure. But I believe this is changing as Nintendo’s relationship with its gamer is evolving to a more direct and continuous one which eventually lead to an almost recurring revenue stream.

Console games are evolving from distinct game worlds where gamers buy the game upfront with no further cost to persistent game worlds that gamers make ongoing payments. Many examples of very success persistent game worlds, such as World of Warcraft and League of Legends, have demonstrated incredible longevity and significantly higher revenue potential relative to distinct game worlds. As more gamers play more games with persistent game worlds, they are likely to play the console longer and more likely to upgrade to the new generation of console to enjoy better graphics.

Going forward, games’ backward compatibility is going to be a standard feature for the next-generation consoles. Without backward compatibility, each new generation of console resets the install base to zero, and the introduction of backward compatibility means that new console adds to the current generation console’s install base rather than a reset.

Nintendo builds a direct relationship with its gamer base through Nintendo Account which holds the entire library of games ever purchased by the gamers. This is a very powerful relationship as gamers could bring their games seamlessly onto the latest generation of console. Nintendo can also create new subscription products such as Online Membership which further improves revenue visibility.

Previously game developers found it very costly to develop for multiple gaming platforms (Nintendo, Sony, Xbox) as the underlying hardware architectures are different. Game engines such as Unreal and Unity provide a standard software development environment such that it is much easier for game developers to launch their games on multiple platforms. This dynamic amplifies Nintendo’s strength as a superior game developer relative to its competitors, who are primarily platform businesses with limited game development DNA, as gamers who previously buy Nintendo consoles just for the exclusive Nintendo games can now also get the games that are otherwise available on Sony and Xbox.

All of the four factors above – console games evolving from discreet to persistent game worlds, game’s backward compatibility, direct to gamer relationships and interoperability of gaming platforms – means that Nintendo’s strength as a world-class game maker is going to be the key driver for success going forward and the console’s cyclical risk is more muted.

Every time a big technology paradigm shift appears, there is always a risk that incumbents could somehow be disrupted. Cloud gaming is the latest technology paradigm shift. While it is still not clear to me how cloud gaming is going to change the industry, I am confident that Nintendo can thrive as long as they are able to apply their game development DNA to the cloud gaming environment. However, Nintendo might not be able to adapt to the cloud gaming world just as they still struggle to adapt to the mobile gaming environment.

Nintendo has failed to adapt to the mobile game environment because they do not have the operational capability to operate persistent game worlds that are live and requires a continuous content upgrade. Nintendo’s game production is more akin to making a movie rather than a talk show that requires new episodes every day.

I view Nintendo’s lack of game operation competence as the single biggest concern now. If I see evidence that Nintendo has developed a strong game operation competence, then I will increase our investment in Nintendo meaningfully.

I believe that Nintendo can easily have 100m of gamers who would consistently spend USD 100 per year on Nintendo games almost on a recurring basis within 1-2 years. This translates into a USD 10bn revenue base. Assume they breakeven on hardware, Nintendo could generate USD 4bn of net profit. This implies 15x P/E which is very reasonable valuation for such a high-quality company.

By the way, I have never had so fun researching a company!

Live Portfolio Update – 2020 #11

Sold out of Eslite Spectrum @ an average price of TWD 75 per share. Generally speaking a very disappointing investment because of my mistake in judgement.

In Jun 2020, Eslite announced the closure of Shenzhen mall due to an inability to reach a rental agreement with CR Land. COVID-19 probably accelerated the already sub-par performance of SZ Eslite.

The further deterioration of the HK business also compounded Eslite’s problems both due to social unrest and COVID-19.

TW business continues to have limited LfL growth.

I believe the key underlying issue is due to the core Eslite business model of bookstore + shopping is just not that strong. My mistake has been to overestimate the strength of this business model.

My original hypothesis depends on Eslite bookstore ability to continuously generate traffic which can be monetised through other merchants. However, traffic generated by the bookstore is neither high in volume nor valuable enough.

I hope Eslite would continue to do well as it plays an important role in spreading art and culture in Taiwan.

Live Portfolio – 1H 2020 Review

The portfolio delivered a net return of 7.9%[1] for first half of 2020 while FTSE Global All Cap index’s return is -6.7% during the same period. Our portfolio’s cumulative return since 2016 is 86.6% while the above-mentioned index’s cumulative return is 45.3%. Cash is 48% of the portfolio.

In the past six months, COVID-19 introduced unprecedented level of uncertainties and challenges for businesses. Most of the businesses in our portfolio performed exceptionally well given the tough circumstances. Below are some operational highlights:

Games Workshop reported revenue growth and profit growth of 4.6% and 8.3% for the 12 months ending 31 May 2020 despite having no revenue for 6 weeks. Fans are escaping to Warhammer to seek temporary respite from the stressful lockdown environment. On 25th July 2020, Games Workshop successfully launched the latest edition of Warhammer 40K with improved game play, new story lines and miniatures; and fans responded enthusiastically. The Warhammer IP continues to grow from strength to strength with a record pipeline of video games and an upcoming mass-market TV show. Warhammer is truly a global franchise which is still in the early innings of its growth trajectory. I am thrilled to be part of this journey. Games Workshop is our largest investment and constitutes ~15% of our portfolio.

As a travel company, Dart Group is disproportionately impacted as customers cancelled their holidays due to CVOID. They took this opportunity to build enormous customer goodwill by refunding its customers quickly. The management team also quickly sold assets and raised new capital to ensure they can survive under any conditions.

Avanza has benefitted from the global tailwind of increased participation from retail investors with the growth of new customers accelerating. 139,100 new customers joined Avanza during the 6 months ending June 2020 – an incredible 100% growth versus same period in 2019. Consistent many other retail brokerage platforms globally, the average trading volume per customer increased by 50%. With a largely fixed cost base, Avanza’s net profit grew 211%. Avanza’s short-term operational performance is driven by a myriad of market factors such as market volatility and prevailing interest rate level. However, in the longer term, the most important driver for Avanza’s intrinsic value is the growth of its customer base. Avanza’s current market value is probably ahead of its intrinsic value. I have resisted the temptation to sell Avanza shares as there is still an exceptionally long growth runway for Avanza. Avanza’s customer base is 10% of Sweden population but its share of savings capital is only 5%. Our long-term return should be slightly above Avanza’s long-term customer growth rate of 15% due to operational leverage.

Eslite Spectrum is a physical retailer from Taiwan. While its Taiwan operation is relatively well insulated from the impact of COVID-19, its mainland China operation took a big hit. Due to the pandemic, it closed the Shenzhen store. I believe the pandemic is simply a catalyst to reveal the inherent weakness of Eslite’s retail model of using Eslite bookstore as a traffic generator and monetised through carefully selected third-party vendors. My mistake is to over-estimate the brand reputation of the Eslite bookstore as a traffic generator and its merchandising capability. Hence, I will be exiting this investment.

When I consider my performance in this period, I give myself a B minus – reasonable but not stellar performance. It was not stellar because I was too conservative in deploying capital due to my hesitation to take advantage of investments opportunities that were offering attractive absolute long-term return. Overall, it is a reasonable performance as I have the conviction to hold onto existing investment and added two news investments – Nintendo and Ryman Healthcare.

I am increasingly convinced that partnering with great businesses is the most reliable strategy to grow wealth over a long period of time. Accordingly, the highest priority is to increase the weighting of great businesses within our portfolio. While I will always be open to the generally undervalued and special situation investments, the relative opportunity cost of owning them will increase as I find more great businesses to own.

I am glad to report that Compounders currently make up 36% of our portfolio up from 3% in 2017. As a reminder, I define Compounders as great businesses with durable business moats and an exceptionally long growth runway. I intend to hold our Compounders for as long as possible unless 1) there is a mistake in my judgement, 2) the valuation is so ridiculous that prospective long-term return is below risk-free rate, 3) there is better investment opportunities. In the last six months, we became business partners to two great businesses – Nintendo and Ryman Healthcare – which I will explain in detail later. I believe that our Compounders as a group can sustain ~10% return for a long period of time.

The high cash level is due to the successful closure of Yixin investment in June 2020. While no one can grow rich sitting on cash, I am willing to be patient and wait for great opportunities to present itself. After all, one must not lose money to make money.

[1] Assuming a fee structure of 1) no management fee, and 2) a 20% performance fee above 5% threshold i.e. 8.6% – (8.6%-5%)*(20%) = 7.9%

Live Portfolio Update – 2020 #10

Added 3% to Ryman Healthcare @ NZD 13.

Increased conviction in their Australia growth prospects where they literally don’t have any serious competition because a lot of the Australian retirement village operators are really property developers who are hesitant to take on age care operational risk in the scandal-prone Australia age care sector.

Ryman is hence very uniquely positioned to grow in a huge market for a long period of time. And Ryman charges 20% deferred management fee while competitors charge north of 30%.

How often do you find the lowest cost operator who is also the highest quality operator in a sector with VERY VERY long growth runways.

Live Portfolio Update – 2020 #9

Ryman Healthcare reported its annual results ending Mar 2020. Overall they have done a fantastic job taking care of the residents and NZ as a country also did a great job containing COVID. The likelihood of a liquidity crisis at Ryman has reduced significantly as the sales process has resumed and the care business generated strong cash flow even at the peak of COVID-19 crisis. Nonetheless, the near term financial performance is likely to be negatively impacted as the sales momentum takes time to resume. However, Ryman’s long term prospects are intact and, if anything, Ryman is likely to emerge as a stronger company.

Added another 4% to Ryman Healthcare @ NZD 13 per share

My conviction in Nintendo grows as I learn more about the company. Recently, there was a Bloomberg article that claimed Nintendo has reduced ambitions in mobile games due to its success with Switch. And a few days later, Nintendo announced a new cross-platform (mobile + Switch) Pokemon game called Pokemon Unite which is a joint development with Tencent. Despite the deluge of criticism by Pokemon hardcore fans, I am very excited about this game. I think Pokemon IP has incredible adaptability and this is just the beginning.

More importantly, this signals another attempt by Nintendo to transition from Game as a Product (GAAP) to Game as a Service (GAAS) over time. (For more details on GAAP vs GAAS see this post ) While it is hard to predict exactly how this transition will happen, I am confident that it will happen. My best guess is that Nintendo will use mobile games as a way to funnel gamers to their own game system and they will adapt more service capability to their game system over time. Pokemon Unite is one such example.

Added another 2.5% to Nintendo @ JPY 50700 per share

Thoughts on the video game business

I am a gamer myself and I am very excited about the future of video game as a great entertainment medium and a “subset of reality”. But I am even more excited about the lucrative prospects of video game businesses as an investor!  I have learnt so much from the great thinkers in this industry – Chris Crawford, Nicole Lazzaro, Satoshi Iwata, Gavin Baker, Shigeru Miyamoto, Matthew Ball and many more. And I have taken their work and organized it in a way that is useful to me as an investor.

Note: While I will use game and video game interchangeably here, I recognise that many great games, such as Magic: the Gathering and Warhammer, share many common features with the video game as described below. For this discussion, I mostly focus on video games

1. Unlike traditional media of TV, books and music, video game is an interactive entertainment media. This is a highly immersive environment where the gamer can interact with the game environment and change the course of events in the game world. Video games, because of this interactivity, are in essence problems for gamers to solve. For example, puzzles in Legend of Zelda, defeat enemies with finite resources in a real-time strategy game, opponents to be killed in a first-person shooting (FPS) game. It is believed that human instinctively derives happiness from solving problems and the harder the problem, the more intense the feeling of happiness when the problem is solved. Using this perspective, a video game is a very cheap and effective medium to create all kind of problems for humans to solve. It would be stupendously expensive to recreate a typical role-playing game that involves 100 characters to act out 100 hours of game-play content in real life! So game worlds simulate problems for gamers to solve and gamers derive happiness from solving the problems. 

2. In this context, the video game industry has tremendous future ahead of it! Beyond its current incarnation as an entertainment media, video games can be used to solve real-world problems such as education and politics. Imagine the value that could be created if job interviews involve the candidate playing a game which simulates the work environment with high fidelity or two countries before engaging in a trade war is required to play a game that simulates the economic consequences of their trade policies in a game! Humans can sometimes only learn from things that they have experienced and games are an efficient way for human to learn from experience albeit in a virtual environment. This is very far into the future but I believe this is the direction that we are heading towards.

3. The most important difference, from a business model perspective, between video games and traditional media is that video games’ interactive nature creates a feedback loop of inputs and rewards. Gamers give up time and effort to create inputs into a game and the game rewards the gamer with some kind of positive emotions. If the gamers feel that they receive more reward from the game than the effort they put in, the gamer is said to be in a positive feedback loop where his/her emotional attachment to the game grows with time. Some game companies exploit this feedback loop (through mechanisms such as loot boxes) in a way similar to gambling. Other game companies create truly beautiful games where the gamers are treated to a rewarding emotional journey similar to watching a well-made movie.

4. There are three main roles in the video game value chain – 1) Game developers (Nintendo / Blizzard) who made the game, 2) Game publishers help to market and distribute the game. Game publishers can either buy the game content from game developers outright and take on the marketing cost to sell the game or more commonly finance part of the game development cost and strike a profit share agreement with the game developers. It is common to see big game developers such as Activision develop and publish their own games, 3) Game distribution platforms. Apple / Google for mobile games. Steam / Epic for PC games. Sony / Xbox / Nintendo for console games. Most game companies are involved in multiple roles across the value chain. E.g. Tencent takes on all three roles – game developer, game publisher and a distribution platform 

5. Game developers and distribution platforms capture the majority of the profit pool in the value chain while the game publishers are increasingly squeezed in the middle. Game publishers’ service, relatively speaking, add less value and least differentiated and hence they take the smallest slice of the cake on thin margins. Tencent is a unique case where it began as a game distribution platform and game publisher and grew to become a very successful game developer. As a content creator, the game developers differentiate themselves through game content. Fans are extremely loyal to great games but the challenge for the game developer is to consistently produce great games.  Game distribution platforms such as Apple App Store through their control of users are extremely profitable. For a typical mobile game on iPhone, the Apple app store clips 40-50% of the total revenue and the game publisher takes 10-20% and the game developer accounts for the rest

6. Why do people pay for virtual items in games? Gamers pay because they receive an emotional reward in exchange for time and money spent on the game. Ultimately, the maximum amount of money people is willing to pay depends on the quantum of emotional reward they receive. There are a couple of ways for people to get an emotional reward – not a comprehensive list. 1) enjoy a good the storytelling (similar to emotional reward from movies) 2) sense of competence as one becomes good at the game 3) social interactions – critical for many online games. E.g. gamer pay for cosmetic appearances for their in-game avatar. When my 15-year-old cousin was asked why she pays for virtual clothes in-game, she said “you don’t walk around naked nor wear the same cloth every day so why shouldn’t I behave any different in-game”.

7. Traditionally (let’s say before the 2000s), in the Game as a Product (GAAP) revenue model, gamers pay a fixed sum in exchange for unlimited gameplay time to get an unknown amount of emotional reward. The traditional distribution model of games is in essence very similar to books. A gamer walks into a physical game store to check out the latest games available and make a purchase decision based on very limited information. Pretty much judging a game by its cover. It is impossible to charge each gamer a different price based on how much each gamer liked the game. For the most part, the gamer cannot try the game before deciding on the purchase. Furthermore, the gamer’s relationship with the game developer is indirect because the game developer does not know who plays the game nor how the game is played. Feedback collection mechanism is chunky and ineffective. The entire experience is sub-par for gamer and game developer.

8. Internet and smartphones herald a new revenue model – Game-as-a-Service (GAAS). GAAS employs a continuous revenue model with free-to-play being the most dominant GAAS model for mobile games. GAAS spreads the revenue across the entire lifecycle of a gamer while GAAP is 100% upfront payment. There are many different manifestations of GAAS such as a game subscription, in-game transactions, in-game economy tax. I am excluding the discussion of cloud gaming here because cloud gaming is more about computation and I want to focus on game monetisation method here. Conceptually, GAAS is a superior revenue model to Game-as-a-Product because 1) game developers can build direct relationships with its gamers and own that relationship; 2) price discrimination of gamers; 3) maximise gamers’ lifetime value. Said in another way, for great games that use the GAAS model as opposed to GAAP model, the gamer’s loyalty is higher, generate higher revenue and play longer while also getting more emotional rewards from the game.

9. We are still exploring what is considered fair and ethical in the GAAS model. Some game developers design GAAS games with feedback loops similar to those that cause gambling addiction or create an unfair advantage to paying gamers.  Other GAAS games, such as League of Legends, sell virtual costumes for purely cosmetic purposes and does not impact the competitive gameplay at all. I believe that GAAS is especially powerful for great games with a fair monetisation mechanism.  Because great games are by definition offering tons of emotional reward, and it is likely to be under-monetised in the GAAP model because great games’ sale price is not too different from the average game price. On a price per unit of emotional reward basis, the great games are arguable under-monetised as a GAAP game. Using a GAAS model, gamers who otherwise cannot afford the game could play the game for free and the most passionate fans can be monetised based on the different amounts of emotional reward they each individually receive.

10. A great example is a Chinese online MMORPG game created by Netease called Fantasy Westward Journey. This game has two monetisation methods – 1) gamers pay an hourly rate of USD 1 to play the game and, 2) Netease charges a 1% commission rate for transactions between gamers. Most passionate fans are willing to spend thousands of US dollar to buy powerful characters from players who committed incredible time and effort to train up the character. Netease charges a 1% commission rate for this kind of transactions. The commission dollars help to keep the hourly rate low which then keeps the players with a lot of time and less money in the game to train up their characters which they can sell to players with more money but less time. Such an in-game economy structure improves the game experience, increase gamer loyalty and maximise gamers’ lifetime value in a continuous game world using a GAAS revenue model

11. Gamers can become incredibly loyal to one game over a long period of time once they become invested in the game. I started playing DOTA when it was just a customized game within Warcraft in 2007. DOTA has inspired League of Legends and the entire MOBA genre. DOTA has a reasonably high barrier to entry because the gamers need to develop a base level of game knowledge and skill to start enjoying the game meaningfully. Given that I have already become a reasonably good DOTA player, I don’t want to commit to another game where I need to build up a base level of competence to play that game. Instead, I prefer to enjoy the joys of playing a game that I am already pretty good at. And DOTA, which is now hosted on Steam, continues to release new game content to enrich the game experience which means it is never boring for me. The point here is gamers become loyal to a game when they become highly invested in the game world and the challenge is for game developers to provide new content to continue to enrich the game experience. Again this is only possible in a continuous game world

12. Finally, let’s think about how to value a game developer. There are two components to the value of a game developers 1) the present value of all free cash flow generated by the existing game franchise and 2) the present value of all free cash flow generated by future game franchises. The total profit generated by the existing game franchise requires one to estimate A) longevity of the game, B) revenue per gamer and C) the ongoing operating cost of the game. A game company’s development capabilities determine the probability of producing successful games in the future. It is much harder to assess the value created by futures games but it can have very real value

13. To assess the existing game franchise, one must understand the drivers for gamer loyalty to a specific game (longevity) and the quantum of emotional reward (revenue per gamer) received by the gamers. One can investigate the strength of the game community to get some sense of the social bond between gamers. The social bond formed through the game can be one of the most powerful retention mechanism. Another neat trick to assess gamer loyalty to the game is to investigate the behaviour of returning players. For example, Warhammer 40K has many gamers who played as a teenager but stopped playing as they got older. However, given a chance, many old Warhammer 40k players readily come back into the game. The “relapse rate” for Warhammer is very high. The revenue per gamer should be proportional to the emotional reward per gamer. However, if the game is fun for a sub-group of gamers at the expense of another group of gamers then the game might not be sustainable. Hence the pay-to-win model is inherently quite risky. Sometimes it is clear that the game is under-monetised. For example, Nintendo’s Animal Crossing is a great example. Many gamers are paying hundreds of dollars to acquire certain items from other gamers which Nintendo is not capturing. Finally, for any game franchise to attain super long longevity, the game developers must continuously innovate and create new game experiences in the game world.

14. There are a few exceptional game franchises that have proven their capacity to sustain themselves for a very long time into the future. Pokemon, League of Legends, Magic the Gathering, Legend of Zelda and the sports franchises are such examples. Pokemon is able to build an incredible IP and continue to generate high-quality game content. While Pokemon has sustained its longevity under the GAAP model, its transition to a GAAS model through Pokemon Go is going to make Pokemon a much more valuable franchise!

15. To assess the game development capabilities of a company, one must understand the game company’s culture, its development process and historical success rate. It is hard to define the commercial success of a game on an absolute basis. Typically, the game industry, just like any other creative industry, is defined by huge but few successes. So it is better to define success through return on investment. For the sake of this discussion, I define a 10x return on investment as a successful game. A great game company tend to have a very strong and unique culture. Some game company care more about making really great games than others who are more concerned about short term commercial success. Some great game companies have well-defined game philosophy, for example, Nintendo is a big believer in hardware and software integration as a source of differentiated game experience. One needs to assess if the game development team’s organizational structure makes sense for the games that they are trying to build. From an investor perspective, the most important method is to study the game development track record. CD Projekt Red is developing a very impressive track record and its future game franchise value makes up the majority of its market value. Nintendo maintains a very impressive game development track record over a long period of time though it is not proven in the mobile game space. Blizzard has a great track record but they are struggling in the mobile era. Netease and Tencent both have impeccable game development track records!

16. Scale matters a lot for game developers. Luck plays an important role in the outcome of any one particular game. Assume a good game developer can expect a 5% success rate and each successful game yield 10x return, then the game developer’s expected return is 50%. However, the game developers need many tries before the expected value can be achieved. Hence the two gamers with the same expected return, the larger of the two is much more likely to realise the expected return. But as game companies grow larger, they tend to become more bureaucratic and hinders the creative process and reduce the expected return. So scale matters only to the degree that the expected return doesn’t decline with scale.

17. GAAP vs GAAS involves very different game development process. Chinese game companies are generally leading in this regard. GAAS requires a game development team that continuously create and improve game experience after the game is launched. However, GAAP game development process pretty much ends after the game is launched. This difference to game development approach is, I think, one of the main reason why traditional console game companies, such as Nintendo and Activision, are not able to be very successful in the mobile game era.  Mobile games almost exclusively adopt GAAS model while console games are still very reliant on GAAP revenue model.

As an investor, I prefer game companies with incredibly strong game franchises and a proven game development track record. There are very few game companies that fulfil both criteria. Netease, Tencent and Nintendo are some examples. Please let me know if you know of any! The goal is to buy such game companies at a discount to its existing game franchise value and future game value is margin of safety.

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