The video game industry is thriving, and most major publishers have been delivering great returns for shareholders. More people are playing games than ever before, titles are being purchased directly from publishers through digital downloads, and players are increasingly spending money on in-game items that are hugely profitable. That last performance catalyst has become particularly important.
Growth for in-game purchases is central to bullish sentiment for most video game companies, but the sale of these digital goods is also coming under increased scrutiny at both the consumer and government levels. With that in mind, it's a good idea to take a deeper look at the climate for microtransactional business models in games, some potential threats on the horizon, and whether these factors make game companies like Activision Blizzard (NASDAQ: ATVI), Electronic Arts (NASDAQ: EA), Tencent Holdings (NASDAQOTH: TCEHY), and Take-Two Intaractive (NASDAQ: TTWO) too risky as investments.
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Why microtransactions matter
The general trend has been that in-game purchases have made these companies more profitable and more predictable. The video game industry is still driven by hits, but the rise of in-game purchases means that revenue continues to be generated after the initial sale -- making earnings more dependable and reducing risk profiles for businesses. The trend is undeniably beneficial, but given how crucial these sales streams have become, it's important not to treat them as a given.
The quarter ending in December actually saw Activision Blizzard generate more money from in-game purchases than it did from full-game downloads. That's a notable statistic given that the company released a well-received installment in its Call of Duty franchise in the period and benefited from ongoing sales from recent releases Destiny 2 and Crash Bandicoot N. Sane Trilogy. Activision Blizzard generated roughly $4 billion in revenue from microtransactions in 2017, good for 57% of sales for the year, and it's hardly alone in its dependence on in-game purchases.
Microtransactional revenue grew 64% year over year to account for 32% of overall sales in Take-Two Interactive's December-ended quarter. Nearly all of the revenue for Tencent Holdings' online games segment comes from microtransactions, a product of the fact that its biggest franchises are in the free-to-play category. These revenue streams are becoming increasingly important to companies, and as that's happened, game design has shifted to encourage microtransactional spending.
How sturdy is this sales base?
A large portion of in-game purchases are derived from a small group of users. Spending trends vary across games and platforms, but the general dynamic of counting on a small pool of big spenders presents a risk factor. A study from Tapjoy showed that 70% of total microtransactional revenue comes from 10% of the player base, while a study from Swrve found that 0.19% of users account for 48% of in-game purchases on mobile. Developers of free-to-play games are increasingly looking to in-game advertising as a new revenue stream and way to offset this reliance, but for now, free-to-play titles live and die based on their ability to court a small selection of big spenders from their player bases.
We've already seen that poor implementation of in-game spending models can irritate consumers and have material impacts on a company's performance. Electronic Arts' Star Wars Battlefront II was hamstrung by consumer rejection of the game's implementation of microtransactions, causing the company's share price to drop 7% in the month of the game's release. The publisher's valuation has since bounced back, but the Battlefront II microtransactions controversy remains an interesting instance of pushback against one of the industry's most important monetization methods.
No form of microtransactions has generated more controversy and piqued government interest to a greater extent than the "loot box." This element of game design presents players with the option to purchase a digital package of in-game items using real money. The contents of these boxes are typically randomized and can usually be earned through playing the game, but purchasing them directly offers a way to expedite the process.
If you were to tell a game developer that his latest hit project is addictive, he or she would rightly take it as a compliment. Engineering an experience that encourages users to continue playing is the fundamental goal of game design. However, with the introduction of randomized item packs that can be purchased as part of the experience, some government figures are raising concerns that loot boxes are gambling or simply a manifestation of predatory business practices.
American lawmakers have put forth legislation to regulate microtransactions at the national and state levels. Belgium's Gaming Commission has called for an investigation into regulating or banning the sale of loot boxes in Europe, and the German Commission for the Protection of Youth in the Media has indicated it could take a deeper look at banning loot boxes if it receives additional consumer complaints. The good news for video game companies is that there's some plausible deniability against the charge that they've moved into the gambling space.
If loot boxes are gambling, the case might also be made that collectible cards are. Some loot box-style microtransactions actually take the form of digital cards. Activision's Hearthstone and the Ultimate Team modes featured in EA's sports titles both involve purchasing in-game card packs. Other than the fact that these goods are digital, it's unclear how these packs differ from Pokemon, Magic the Gathering, or collectible sports cards. EA saw roughly $800 million in sales from Ultimate Team microtransactions in its 2017 fiscal year, representing roughly 16.5% of sales over the period, so the defense that other types of collectible products have had elements of randomly distributed value is significant.
It's unclear how much of an effect legislation around addictive gameplay and payment mechanics could have on publishers. One study showed that the average microtransaction customer on console platforms is 32 years old with an above-average income. That suggests that regulations to prevent children from buying digital items might not have a crippling effect on games companies. However, without exact data from companies on who's spending on microtransactions, visibility remains somewhat limited.
The risk is real but not overpowering
Growth for in-game purchases is on track to continue, but those who are invested in video game companies should be cognizant of the risk that shake-ups might occur. Compared to other entertainment mediums, video games are still relatively young, and microtransactional revenue as a core part of the industry is even younger.
Overall, the growth outlook remains promising, but it's important to have some understanding that disruption of this model represents a potential fault line. Just as Facebook and other leading tech companies have recently been dinged by the prospect of increased regulation, the gaming industry is likely to bump up against similar challenges as it increases in size and importance.
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Keith Noonan owns shares of Activision Blizzard and Take-Two Interactive. The Motley Fool owns shares of and recommends Activision Blizzard, FB, Take-Two Interactive, and Tencent Holdings. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.