The Online Games Market – Part 2

Despite the weakness of the aggregation service business model as it stood, the aggregators market was joined by two major new players, Microsoft and Segasoft with their Zone and Heat.net services. Whilst Microsoft relied to a great extent on its brand to grow, SegaSoft has secured some promising deals with cable companies @Home and RoadRunner which it is claimed gives it an addressable market of 85% of cable TV users. The Zone is now the most popular aggregation service with some 7m members and 500,000 daily users. Multiplayer games aggregation services remain a viable business model for now although the entry of the publishers themselves into the online games service market represents the beginnings of a trend that could seriously undermine this model.

Enter Stage Right: The Publishers

The expression “content is king” is nowhere more true than in the games market and, as the IPR owners of 90% of games developed (principally because they fund their development), the publishers are in a powerful position. With the rejection of pay per play and monthly subscriptions to aggregation services, the publishers (who received a proportion of the revenue generated) soon realised that these companies added little value to their titles and that they could easily provide the same sorts of services themselves. Thus Blizzard’s battle.net, CUC (now Havas)’s Won.net, Novalogic’s Novaworld and a number of other publisher services were created and many publishers decided to give these services exclusive use of their hit multiplayer titles. Battle.net has proven to be particularly successful following a string of best-selling PC games that has resulted in a subscriber base of over 2.1m active users and over 400,000 games played on the service every day. Indeed the success of Battle.net has proven that aggregators are not needed to generate traffic and enhance retail sales. Having control over how the service is run, and sole access to a substantial and loyal userbase, the advantages to Blizzard are obvious.

This exclusivity was taken a step further with the ground-breaking release of Ultima Online by Electronic Arts (EA). Distributed as a boxed retail product in 1997, Ultima Online has to date sold only 300,000 units (a moderate success, grossing around $15m). However, the game has established not only a new genre (the persistent environment game), but also a new business model, which has proven highly profitable for EA. As the name suggests, Ultima Online can only be played online. It is a role playing game (RPG) in which users create and nurture their own characters and develop them (by gaining items, wealth, property and abilities) within a preset game environment. What is different is the fact that the game environment is an ever-present world that continues to evolve even when users are logged off. It was massively multiplayer too supporting over 100,000 players, all of whom could interact with one another via trade, fights and conversation. The appeal of the game allowed EA to justify a $10 monthly charge and two years after its release the game still boasts some 135,000 monthly subscribers. Indeed, the dedication shown to the game by some players (some of whom were clocking up 48 hour continuous sessions) resulted in some interesting off-shoots, with in-game protests and riots, and with users’ characters changing hands on e-Bay for as much as $3600. With the title grossing some $1.35m dollars/month (as much as 30% of which goes to EA’s network providers for resilient 24/7 connections), Ultima Online, has set a precedent that many publishers intend to follow.

Exit Stage Left: The Retailers and Distributors?

The disintermediation of the aggregators will continue and is being joined by disintermediation of other elements of the games value chain. As homogenous products, games, like any commodity, are ideal for online retailing and although the games e-retail market is mature in the USA, it has only just started to mature in the UK with a number of new entrants such as simplygames.com and gameplay.com promising to substantially undercut retail prices. The short and medium term prospects for games e-retailers are substantial, but they too face an uncertain future as publishers begin selling and distributing direct to consumers. At present, the principal drawbacks to this are twofold: (1) lack of bandwidth needed to distribute the large quantity data most games comprise and (2) the unwillingness of publishers to undercut the retailers on whom they still rely for the vast majority of their sales. As a result, whilst most games companies sell their products online, they do so at retail-level prices (and so benefit from increased margins but not necessarily increased sales). We do not believe that any major publisher will decide to undercut retailers across the board. The disintermediation of the retailer will be more subtle, with publishers initially releasing individual titles, the bulk of whose revenue will be derived from monthly charges (as in Ultima Online). In future, when bandwidth allows, publishers will also start to distribute games online, thus disintermediating both the retailer and the distributor.

As games transition from being commodities to services, it is inevitable that traditional retailers and distributors will suffer. However, it is likely that the publishers will not seek to promote their titles alone and will use heavily trafficked sites for both games promotion and possibly games hosting. EA, the largest games publisher in the world have identified that their future lies in online revenue generation and have predicted that 20% of their total revenues (which last year were $1.2bn) will come from the internet within the next 3 years. EA have also tested the demand elasticity (although not the price elasticity) of online distribution of a full product by offering the most recent iteration of the popular Wing Commander series as a free download. Despite its 130Mbyte size, nearly 400,000 people downloaded the product, a considerable number when one considers that most will have used modems for the (6hr+) download.

A number of factors will facilitate the transition to online distribution:

  • The advent of broadband internet access via xDSL, cable modem and later 3G/UMTS (and possibly also satellite) will dramatically lower the technical barriers for online distribution allowing a CD’s worth of game data to be downloaded in minutes.
  • The decision to provide open connectivity (enabling devices to use any technology) by Sony, Sega and Nintendo for their next generation machines will likely be augmented by deals with telecoms and cable companies. Sega’s Dreamcast internet service has proven popular in Japan with some 250,000 regular users and Sony has indicated that it intends to provide online distribution within a year of its Playstation 2 launch.
  • Online distribution will allow publisher to set their own prices (which they are currently not able to do), take a higher margin whilst lowering end user prices and interact directly with their customers. It will also rid their balance sheets of the inventory risk associated with having to predict demand for manufacturing purposes. These advantages apply to the distribution of both single-player games and multiplayer games and it is likely that different pricing plans will emerge for both.
  • The increasing use of server-based games that require little (or no) client-side storage facilities. This will be particularly suitable for set-top box and hand-held games playing.

What Role The Developers?

As the originators of games ideas and the creators of games products, one would have thought that the developers would wrest control of IPR from the publishers. In theory this is correct. However, as mentioned before, in nine out of ten cases the developers are funded by the publishers and as a result are in the driving seat when it comes to royalty negotiation. We also believe that the financial and commercial relationship between developers and publishers will change.

As it stands, developers receive somewhere between 15%-40% of the net amount per unit received by the publishers. The breadth of the range is due to a number of factors:

  • The extent to which the game has been funded by the publisher/distributor. In general, the higher the proportion of the development funded by the publisher, the lower the royalty paid to the developer.
  • The saleability of the title. A well known development team with a track record of successful products can command considerably more favourable terms with publishers and distributors.
  • The role of the publisher/distributor. The extent to which the publisher or distributor take on responsibilities such as the game’s promotion, localisation, multiplayer server hosting, bandwidth costs etc. also affects the royalty rate.

We believe that this revenue sharing arrangement will remain true for boxed units but average royalties will increase considerably for recurring revenues from online games. However, the roles would be reversed should a developer find the means to fund a title’s development, as in this case it will be able to employ a publisher to market and sell the product online and will effectively be paying the publisher a royalty.