The gaming sector (GAMR) has been one of the hottest sectors in the market in the last few years. As game companies continue to find new ways to monetize users, revenues and profits have exploded, causing a large rise in the share price of game companies.
In recent times, however, a host of negative developments has appeared, causing the share prices of many game companies to fall significantly. However, these companies are still not cheap, and we believe further decline is possible, therefore we think investors should avoid the space for now.
Modern gaming is still a relatively new phenomenon. Many of the aspects of modern gaming, both good and bad, weren't discovered until after 2010. This immaturity means that game developers had the freedom to literally do whatever they want. From lootboxes to pay-2-win, the industry developed clever techniques to suck every last dollar from the consumer. This went unnoticed until the launch of EA's (EA) Star Wars Battlefront II, which had such terrible monetization techniques that lawmakers started to notice.
Recently, a bill was proposed by Senator Josh Hawley, the "Protect Children From Abusive Games Act", that would ban exploitative elements like pay-2-win mechanics or paid lootboxes. There's no guarantee that this bill would pass, but this bill not the first time regulation of games has been proposed, even in the US. In February, lawmakers in Hawaii proposed 4 new bills to regulate lootboxes. Other countries like Belgium and Netherlands have outright banned lootboxes, while larger countries like China and Japan have started regulating them. A petition in the UK asking for lootbox regulation has received nearly 17000 signatures. It seems that exploitative mechanics like lootboxes are despised throughout the world.
The impacts of this legislation can already be felt. EA was forced to stop selling extremely profitable FIFA Ultimate Team card packs in Belgium after trying to evade legislation. Other publishers removed their lootboxes much earlier.
Regulation of lootboxes and predatory purchases can have a significant impact on the profits of the largest game companies. EA is estimated to earn over $800mil from Fifa Ultimate Team revenues yearly. Activision (ATVI), though, may be the worst hit. Not only does Activision have lootboxes in most of its major releases - Overwatch, Destiny 2, etc, but the bill proposed recently specifically calls out Candy Crush's Luscious bundle, which is sold for $150. Candy Crush makes up more than 1/2 of Activision Blizzard's operating income.
Legislation is also terrible for the stock prices of these companies. EA, after hitting $100 from its earnings, fell 7% as after the bill was proposed. Activision has fallen a similar amount.
Gamers are asking for more
As computers become more powerful, gamers are becoming much more demanding. Modern gamers have many demands, they want better graphics, more content, multiplayer gamemodes, etc., all for $60. This is a big problem for game companies, especially as competition in this industry gets fiercer. Game companies today need to cover high upfront costs to develop a project that may or may not be successful. This has led to large game companies taking less risks, like implementing GaaS or relying on their brand name to sell pretty much the same game every year.
This isn't a viable strategy in the long run. Gamers will get disinterested in a once vibrant franchise. Just look at FIFA, EA's most successful game. (The last FIFA world cup was held in 2018)
Major publishers have now made themselves pretty much dependent on live service revenues, which are vulnerable to regulation and player decisions. To create a successful live service game, the game needs to have an active playerbase. Unfortunately, this isn't true for some of today's largest games, like Anthem or games from Blizzard. As players realise that EA and Activision aren't putting in enough effort to justify the price of their games, more and more players have been quitting.
Saturation in most major markets
After seeing the profits that game companies are making, independent studios and large game companies alike have begun churning out games with greater frequency. Dozens of games a day now hit mobile app stores and online games stores.
For example, Steam, the largest gaming marketplace in the world, had more than half of its games uploaded from 2017-2019, even though the platform has been around since 2003. IOS meanwhile, has 46 games uploaded every single day.
While AAA studios have managed to capture the majority of consumer attention for now, competition, especially desperate competition, will eventually create games that will start eating into the market share of AAA companies. Fortnite is one example of this - despite Epic games being a tiny studio in 2016, in 3 years it has become a multibillion dollar business.
Despite deteriorating fundamentals, most investors still think gaming is a secular industry that will continue to grow for many years. Gaming stocks therefore have somewhat high multiples, with the largest - EA and Activision, having earnings multiples in the low 20s. We believe this is much too high a multiple for companies that will most likely have their earnings eroded from regulation or increased competition.
Game companies are facing ever harsher regulation from lawmakers around the world, which will likely cut into their profits significantly. At the same time, gamers are becoming more and more demanding, wanting fresh content and better and better graphics, which increases the cost of producing a game significantly. Lastly, the market is extremely saturated, with a giant oversupply of games, all of which are begging for user attention. In the end, all these factors mean that the gaming industry is likely to enter a large downtrend. Investors should avoid this industry until valuations correct.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.