Major Players and Trends to Watch in the World of Video Games

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by contributor Seth McNew as they discuss some of the major trends and developments in gaming. From the biggest pure-play game developers to eSports, virtual reality, and the next generation of major consoles, tune in to find out what you should be keeping an eye on.

A full transcript follows the video.

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This video was recorded on March 23, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen,and it's Thursday, March 23rd. We are pre-recordingnext week's March 28th episode as Fool.comcontributor Seth McNew happened to be in town this week,and I couldn't resist inviting him, of course, to Foolheadquarters so we can spend some time in the studio together. Seth,welcome back, man!

Seth McNew: Thanks! It's great to be back!

Shen: I understand that you flew infrom San Francisco this weekto rubelbows with some power playersin Washington D.C. What's the story there?

McNew: Youcould say that. I got to write an article last week about this new billthat was introduced to Congress called the PHIT Act,which is for "Personal Health Investments Today". The idea of the PHIT Act is they're trying to make it so that fitness gear orpreventative sports gear would be a tax write-off through an HSA. What this event was in Congress, theassociation that put this forward is called the Sports and Fitness Industry Association, they had broughtsome athletes and other business people as lobbyists. So,we were sitting in these meetings with senators,telling them why the bill should be passed. Of course,I was just a fly on the wall in the back as these different people were lobbying.

Shen: So, the core idea here is, you can get a health monitoring band, for example, and pay for that through an HSA, andas a result of the pre-tax savings, you maybe save 25% to 30%, whatever your rate is.

McNew: Exactly. Andof course you can see there are some fine lines, like, running shoes? No,because they could be worn at work. But aFitbitwould be. Or,it's other things like personal training sessions, or a gym membership. Andthere's a limit, $1,000 a year through your HSA,so it's not too big of a change there.

Shen: So, overall,I'm guessing, do you have a stance on this bill? Do yousupport it? Do you think it's a good idea?

McNew: Itsounds pretty interesting, especially if your company like Fitbit orNike,you're obviously really interested in the fact thatthere will be more accessibility to buy fitness gear, andthe changing culture. The numbers they had put up about rates ofobesity, especially among children, you can see whysome of this would be attractive,especially in the current situation wherethere's a chance where the healthcare system will be changed, this sounds like an easy split in their bipartisan -- it seemed to be very bipartisan focused. There were senators from both sides that were supporting it.

Shen: Sure. And you mentioned, too, while you were there, you heard someconversations about the big healthcare bill going through.

McNew: Yeah,absolutely. This is the mostinteresting time to be on the hill right now, there are conversations all over the place, there's a buzz,it was really interesting.

Shen: Very cool. Moving on,we have to get to our main topic for the show today. We're talking aboutsome of the latest developments, news, and innovation that'scoming through in the gaming industry. Though, Seth,you have filled kind of the role offoreign correspondent sometimesfrom Macau and Japan,visiting the newest casinos and resorts,in this case, we're actually talking about video games.

Toopen the discussion,it's important to give an overview of how the video gameindustry is in a really interesting place right now due to a transition, asI'm sure you'll discuss, from disc-based games and the storesI remember seeing in the mall as a kid likeGameStop,Electronics Boutique, those aregenerally going by the wayside. GameStop reported down results and they'retrying to pivot their businessbecause ultimately, you can download your gameright to your Xbox or PlayStation. So, what are the bigtakeaways or trends right now that you're noticing,things that are driving the industry?

McNew: Likewe have seen with every industry,the internet has completely changed things, with e-commerce,and the same is true with the gaming industry. Internet-enabled consoles, more gaming through computers, especially mobile, has made it easier for these game developers to deliver their content digitally. So,you don't really need that hard plastic game anymore, you don'tneed to go to a GameStop and buy a physical gameif you can just download it right away. This is great for the developers,because they are having higher margins. They don't have to make the physical product, they can just create the game and send it out digitally. They're getting so much more on those margins. They're also able to upsell,during the game, these in-game sales have become a huge part of their business.

Shen: Yeah,absolutely. You mentioned developers. Who are some of the big names? Generally, I think of two guys. Who are the two big names,for anybody who isn't as familiar with this industry, in terms of leading with the most popular game titles, best sellers?

McNew: The big behemoths, as it's been for a long time isElectronic ArtsandActivision Blizzard. Those are two of the companies that are reallyfocused on gaming. You have other companies that maybe have gaming as a part of their company. These companies are all gaming, and they're the two biggest players in the industry. So, you haveActivision Blizzard, they're themaker ofgames like Overwatch,World of Warcraft, some of these really big names.

Shen: Yeah,really big franchises. I will add,for Activision,I always like to give people some scalein terms of the video game industry. I found, before we started filming the show,the number of video game playersglobally is estimated at about 1.8 billion,approaching 2 billion. That's incredible. I think that number isat least half now, or maybe even more than half, ofthe entire population that hasregular internet access. So,it gives you an idea of the share ofentertainment that video games can hold.

But ultimately, for Activision,being the biggest player in the latest quarter,for example, they reported over $1.5 billion of revenue witheach of their major gaming platforms. Now,if you think about gaming,traditionally, it may have beenconsoles and PCs, now mobile gaming. All three of those platforms, over $1.5 billion in revenue. Asyou mentioned, with those in-game purchases,those are so vital because itextends that revenue tail for a lot of these titles. They're in-game purchases hit a record $3.8 billion,and that's growing at incredible rates. This is part of that entertainment share idea, which I really like. In 2016, the company boasted 43 billion hours of engagement with customers, which approximately matchesNetflix. So,I don't know about you, but I don't play video gamesas often as I used to anymore,but I know that myself, a lot of people in my family are big Netflix watchers. So,the idea that you have that as an option,all of its competitors, and of course,you have this entire other medium as well. It's very interesting.

McNew: Thismust be what the fitness people are talking about, as to why they need this bill passed.

Shen: [laughs] And then, forActivision, across its entire portfolio of games,across the platforms, 450 million active users, huge base. ThenElectronic Arts, they have recently,in terms of big franchises that you might recognize,Battlefield 1,FIFA '17 was the best selling title of last year,and they're making a lot of similar progress as their rival. Digital sales now count for60% of total revenue,enjoying a very high rate of growth. They have something thatwe will talk about more, which I think is really interesting,which is their Competitive Gaming division, which istargeting eSports. That's something that we can get to when we get to the future of what the spacein this industry will look like.

McNew: And,of course, talking about EA, we can't forget Star Wars, of course.

Shen: Yes,course. They have had a lot of success in their mobile space, too, with that Star Wars title. But,beyond the two behemoths,like you said, who are some other names,potentially, that investors can follow that they might not recognize?

McNew: There certainly are some other players in the space, other thanNintendoand some of those other bigger names. There's a company,Take-Two Interactive,a little bit younger company than these big ones, butgrowing fast, especially recently. They've had a lot of growth. This is the maker of games like Grand Theft Auto andsome other big titles that people would recognize. Another good company isNetEase,this is a Chinese media company. This is much more than gaming. They have email platforms, e-commerce sites, but theirmain revenue comes from gaming. They make their own games, but they also distribute games, they have an agreement with Activision Blizzard todistribute some of their games. That's growing a ton because of theinternet penetration rate in China. Most recently, you have over 700 million people thereaccessing the internet. Much of that is through mobile. It's a great opportunity for NetEase.

Shen: Absolutely, huge market. And you mentioned Nintendo,beyond the developers making the titles that we're thinking,on the console side, there's been a lot of news -- now we'rediving a little into things that might be driving the industry. I saw some rumors aroundnew console generations.Since the last big release of theXbox and PlayStation, around 2013, approaching that time when we usuallyget a refresh.

But I want to talk first about something that is out now, which is the Switch fromNintendo. This latest device so far,from what I've heard from some friends and also for the inability forpeople to find these in stores because they're selling out so quickly,it's doing quite well. Keep in mind that Nintendo, right now, is in a position where they really want the Switch to succeed,especially after the struggle they had with the Wii U. To give you some perspective, the Wii U only sold about 13.5 million units in its entire four years on the market. A strong year for a morepopular console like the PlayStation,that might be one year or 1.5 years of sales for them. So,in terms of lifetime volume, that's quite low. Andcompared to the original Wii --even my wife, who is not a video gamer at all, she has one --it was the kind of console that really brought in a lot of new gamers,or people who hadn't played video games since they were much younger. The original Wii sold 17 million units in its first calendar year. Eventually, it topped 100 million units in its lifetime. PlayStation 4right now has an installed base of around 50 million. The numbers thatNintendo is hoping to put up for the Switch,management expects it to move about 2 million units by the end of March,some estimates say that 1.5 millionunits were sold in just the first week of its release. Have you followed this at all? Seen anydemonstrations of it? What do you think,in terms of how this can drivecompetition with the other major consoles?

McNew: Yeah,at the beginning, you couldn't find a Switch in any stores,they were sold out right away. I wasn't quite sure, maybe that created some scarcity there,they were trying to drive up some of the interest. But so far, it seems like it has been selling really well, somaybe it's just beating their own expectations there.

Shen: A report recently --I forgot to add this --from The Wall Street Journal said thatmanagement planned to double its production. For the fiscal year endingMarch 2018, theirproduction would jump from 8 million to 16 million,indicating potential first year sales of over 10 million units. This is outperforming a lot ofanalyst estimates. I think initially, for that first year of the release of this device, some analysts were puttingtotal sales at just in the 4 to 5 million range. So,really blowing that out of the water.Fromwhat I've seen, the only thing that is holding this back from hitting thatthreshold and taking off andbeing a huge success for the company is titles. This is where, I think, the more well-knownPlayStation and Xbox have that advantage. Right now, with the Switch,the only game that I know of that's really drawing in people,it's called Legend of Zelda: Breath of the Wild. The reviews for this are fantastic. I think theSwitchconsole actually sellswith this game to 90% of customers.

McNew: Yeah. This was the game that they really marketedas they were talking about the device, this is the onethey were saying was going to be the big game.

Shen: So,right now, otherwise, from Nintendo,a lot of their other major releases,in terms of those most famous franchisecharacters they have, which, people have pushed them in the past tomove away from producing consoles andjust try to monetize their very rich library of IP. But,they're not expected to release more games for Mario, for example,until later in the year,hitting the holiday season a little bit better, and also just trying to give a little bit of runway so they can slowly build up steam. But,I'm interested to see if that holds them back at all, because even the best game, if you have only one title to really hold on to people at first, we'll have to see how their momentum builds over time.

McNew: Of course. And they do have a really rich library,like you were saying. But I think there's also the risk -- I mean, look atSuper Mario Runthat they released for mobile earlier this yearor last year, it didn't perform nearly as well as they thought it would. So,I think there is that risk, you can't just say just because those are iconic names that the games themselves will perform well. But I hope they do, because I think this could be a really interesting change to the gaming industry.

Shen: Sure. Moving on to the next big console player, this isSony.ThePlayStation 4 Pro is already available to gamers. While the PlayStation VR introduced a bit of that technology to the platform, I think the Pro ultimately adds some beefier specs, and it also enables some 4K capabilities, right? The next step for Sony that a lot of people are wondering about is based on historical intervals between generations, we touched on this, the PlayStation 5, potentially on store shelves by 2019. I thought it was really interesting, an analyst atMacquarieResearchactually believes thatthe release date might be even sooner,and this has to do with competition fromMicrosoft,who we will talk about soon.

For Sony,just to give you a little bit of perspective in term of how thePlayStation business folds into their overall company, the Game and Network Services segment, which includes the PlayStation business, $5.3 billion reported most recently. That's about one quarter of total sales. That potential PlayStation 5 --which is not confirmed, by the way. This is justrumors and speculation. But,if it does come out earlier if,they believe it will be because of Project Scorpio, which isthe project name at Microsoft. Can you tell us a little bit about that?

McNew: Yeah. We'restill waiting to learn more about what Project Scorpio actually is. Is it an Xbox 2? Or a next generation? Wealready had the Xbox One S. So we'll see what that looks like. But,similar, we're seeing it's going to have the 4K gaming and the VR,certainly, Microsoft and Oculus announcing their partnership. We'll seewhat the technology looks like that really sets it apart.

Shen: Yeah. The release date is expectedpotentially later this year in 2017.I didn't realize it was going to be coming up that soon. Poised,of course, for the holiday shopping season,always important for these guys. In the latest quarter, again, for Microsoft, it's a little tougher, because it's such a big business, and obviously, you're thinking about all these other opportunities they have, their classic OS. But,Microsoft reported gaming revenue of about $3.5 billion, total top line of $24 billion for its latest quarter. Again, it's smaller, but it's not a trivial part of thebusiness, either. Ultimately, if you're looking for something in terms of exposure for gaming, I typically think, and I think a lot of investors, typically think of those major names we talked aboutActivision and Electronic Arts and Take-Two Interactive. But it's definitely an interesting approach that they have. They have flexibility, too.

McNew: Yeah. You wonder if this is similar to companies likeApplewith the iPhone, how long can they just keep going to the next console, and are theyputting them out because there's new technology to support a new release,or just because they're trying to breakinto that cycle of having a new one every couple years. So,hopefully, these new ones that come out,there really is some game-changing technology.

Shen: Andthe thing that's really starting to change is,traditionally, the PlayStation 3 or PlayStation 4comes out, it might bebackwards compatible, but you can't use your PlayStation 2 or 3 to playgames released specifically for the 4th generation. Things like that arestarting to get warped. You hearsome of the management from these companies talk about howthat kind of paradigm is changingbecause of digital downloads. It can change capabilities, and change what a game release means, the idea that you don't leaveany of your previous players behind by releasing a title,and it can be played across all these different consoles. So, it's an interesting idea, andit's definitely changing.

Moving on totwo more things I want to touch on that are driving growth here in theindustry. You mentioned Oculus. I want to get the virtual reality, we'll save some time for that. But eSports is what really blew me away. It's March,we're in the thick of March Madness. My teammight be out as a UVA alum. But, while watching that game,I could not believe it, I saw commercials for aStreet Fighter 5 championship eSport event being aired onESPN. The first time I've seen --maybe I don't watch enough networkcable television with commercials,because I'm usually on Netflix. ButI was blown away by this. It made me realizethat a lot of companiespoint to eSports as a big opportunity, but thelegitimacy there, I feel like anybody that's watching these games and sees that is like, "What is this doing on ESPN?" And now, you get an idea ofhow big this opportunity is. What do you think about this?

McNew: Yeah,certainly, seeing it on TV, there's a lot of companiesthat are trying to play in the space right now,not just the players we've mentioned so far, but ESPN,YouTube,recentlyAmazonbought Twitch, which is known for its eSports. But,what I think is interesting here is,first of all, we should just talk about what eSports is. It'selectronic sports. Essentially, there's pro gamersplaying against each other, usually for a cash prize. As you would imagine, there are people watching this. There is a fan base whichleaves open the door for advertisements and other revenue.

Shen: You brought this to me,and I think I've touched on this in a previous episode before,but some of these tournaments, the prize pools are not trivial at all.

McNew: Yeah,you're talking about prize pools of tens of millions of dollars. The most recent one was over $20 million. That'sincredible.

Shen: Yes. So,as you can imagine, with that kind of money on the line,you're going to start really attracting abigger and bigger pool of peoplewanting to get into this in a professional manner. But the thing is, I was trying to get a sense of the scale for this, 385 million people globally in terms of audience size for eSports. Huge, right?

McNew: Haveyou ever watch eSports, or any gaming?

Shen: I have, through YouTube.I haven't seen it on television,I haven't taken that step yet. Funny enough,I have been to a live event beforeat the conference center here in D.C.,just out of curiosity, to get a lay of the land. Andit was for Pokemon.

McNew: Doesit feel like a sporting event,with all the fanfare?

Shen: You haveeverybody seated. There wasn't tens of thousands of people, of course. Butseeing people playing with the big screens,I saw a lot of potential. And I can imagine that going to a full event with tons of fans in an arena --because this was more of just a conference for Pokemon --I could see that having an energy level thatpeople might typically associated withprofessional sports.

385 millionglobally in terms of audiences for eSports. And the thing is,this is really in its infancy, reallyearly stages. I found ananalysis that said the revenue for this market is not expected to break $1 billion until next year. So,the companies that are investing heavily in this,including Electronic Arts andActivision, they're really not making that much money on this, if any at all. But the idea is, you could attract more gamers, you could build more buzz and publicity for various titles, and ultimately,people are starting to say,385 million viewers, some of these audiences are bigger than major professional sports leagues like the NBA,does that mean they can make more money?

The issue right now is, by comparison, the NFL generated $11 billion in 2015 from ticket sales, TV rights, andsponsorships. eSports hasn't even broken that $1 billion marker. The problem is, I think, ultimately, the number of events you can have between NFL games and different franchises, the number of games played in the season, you have a lot of events generating those ticket sales,and a lot of money from those TV deals. You've heard about these billion-dollar deals signed to air football games, for example. Whether we reach that threshold, that point for eSportsremains to be seen. But ultimately, it'sdefinitely an exciting avenue. Anything else you've seen with eSports that you want to leave listeners with?

McNew: That's a good point, howsmall it is right now comparative. But I think it's interesting that there can be new content that drives its own leagues. It might be a placewhere there's just as many opportunitiesto have these kinds of competitions,as you have different leagues that are devoted toa specific game, more games have more leagues,and also the ability to have these in house ones in any arena, youdon't have to have them in an arena that's specific for gaming,you just need to have a TV there. So I think it's possible that this could grow much more regionally.

Shen: OK. Something else I've also kept in mind, and people stress with eSports, is that it can change as the technology we haveavailable to us,in terms of how we consume our media, it changes. Virtual reality, some of the first majorheadsets or devices for that, the hardware for that,went on sale last year. That could potentiallychange how we view an eSports tournament. Let's move on to that.

A lot of the big players have been putting money into this, and also,people not typically into thevideo game industry. Sony has the PlayStation VR. This offering issupposed to be meeting at management expectations. This is a headset, sells for about $400for most of the retailers that I checked before the show. It was released late last fall. So far, they've sold about 1 million units. Management seemsvery happy with the progress they've seen with this. What do you think?

McNew: I think they had a great advantage ofhaving the first console to make this a real part of the console. I think it works great. I love being able to play on it. And there's a lot of upsells they have with that, different kinds of controllers, the games that go along with it. It seems like it's agreat opportunity for them to continue getting revenueoff of that release. And obviously,other companies are following along.

Shen: Yeah. In terms of that dedicated headset, two other main competitors are the -- OK, thepronunciation on this, I've heard two differentthoughts --HTCVive. I don't mind either one,we'll just call it HTC. Theirheadset is being compared a lot to the FacebookOculus Rift. These companies have not offered nearly that level of detail that Sony has in terms of their PlayStation VR, but some people say the VR is outselling the Rift three to one,in terms of some analyst estimates. But ultimately, bringing this back,what kind of impact is this going to have for these companies, their bottom lines, and their overall revenue? A research group called CCS Insight, they put virtual and augmented reality device sales at 11 million last year, which is actually way more than you would think. We talk about console sales. Nintendo, with the Switch, is hoping that,if they can hit 10 million,that's really a good threshold for them to attractdeveloper attention. They would be very happy with that. But, while that seems really great, and the forecasted device sales might top 60 million by 2020, there is a caveat to all of that:most of this volume comes from low-cost solutions, likeGoogle Cardboard.

McNew: Sure, or even ones like theGoogle Daydreamthat they released for the Pixel, that'ssomething like $80, but that has to be used with the phone. There'snot a lot of technology thereother than the screen that views the phone. Here, you'retalking about real headsets that have the technology to be a serious gaming solution. And you have the early adopters thathave used that so far. But,here in the next couple of years,you'll see the prices start to decrease a little bit,and they could be a little bit more mass market.

Shen: And that's the big challenge, I think, with this technology in general. A lot of people have said that 2016deflated a lot of expectations for virtual reality. Not that there isn't a lot of optimism behind it, but a reality check, in a sense. When it comes down to it, if you want something like what the Oculus Rift offers, you need not just the headset itself, which costs anywhere from $500, for Facebook's offering, to $800 for HTC's offering,at least according to Amazon. Inaddition to that, you need a PC with some really strong specs, and a high quality GPU video card to be able to even run these games. So, at the moment,like you mentioned, early adopters --although, you're going to get early adopters, but otherwise,people are going to be very reluctant to shell out over $1,000 for a dedicated system when the titles themselves arelimited in the virtual reality space.

McNew: Andas we talked about earlier in this podcast, that's going to be a holdback. When you have the content that makes people want to pay that much money, then people will. But, of course, the other thing about the virtual reality is that you're still waiting to see what other industries it can be used for. People arealready going to have one at home for gaming,and it also works for something else. Might be moreimpetus to buy something, if it works for something more than just the game.

Shen: Thevalue proposition,it's easier to shell out that kind of money. And the thing is, over time, likeanything with technology, it will get cheaper.Going back to that original number I mentioned, 11 millionvirtual and augmented reality devices sold in 2016. If yougo to those dedicated headsets, the ones that are hundreds of dollars, muchmore sophisticated than, for example, theGoogle Cardboard, sales at just over 1 million. Still really early, butdefinitely something that I personally am very excited personally to see develop. Anything else from you, Seth, in terms of takeaways forpeople who are thinking big picture about video games, be it eSports, virtual reality, digital downloads? Anything else?

McNew: Yeah,especially, we were talking about the chips that go in your computer that are going to power all this stuff,that leads into a whole other discussion of companies likeNVIDIA,for example, that's making that technology that'sdriving the technology behind the gaming industry. That's for a whole other podcast, but it's something to look at.

Shen: OK. It's greathaving you back in the studio, Seth!Thank you for joining me!

McNew: Thanks a lot.

Shen: That'sall for us today. You can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus,or send any questions to Don'tforget to check out for more Foolish content. People on the program may owncompanies discussed on the show, andThe Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fools board of directors. LinkedIn is owned by Microsoft.Seth McNewowns shares of Apple and Nike.Vincent Shenhas no position in any stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard, Amazon, Apple, Fitbit, Netflix, Nike, NVIDIA, and Take-Two Interactive. The Motley Fool has the following options: long January 2018 $90 calls on Apple, short January 2018 $95 calls on Apple, and short April 2017 $28 puts on GameStop. The Motley Fool recommends Electronic Arts and NetEase. The Motley Fool has adisclosure policy.