[MoMoBangalore] DFC Brief Article: What Role Will Advertising Play in the $40 Billion Video Game Industry?

Wed Aug 29 08:42:46 IST 2007

What Role Will Advertising Play in the $40 Billion Video Game Industry?

August 28, 2007

DFC Intelligence has been known for being conservative when it comes to
forecasting industry growth.  One compliant we hear is that we are not
bullish enough on our forecasts.  Our philosophy is that when making a
business plan it is easy to run-off of hockey stick growth numbers.
However, prudent investing should entail realistic forecasting that
leans on the cautious side.  Furthermore, our experience has shown that
when DFC and others have been aggressive about forecasting rapid growth
for a market is has inevitably lead to over speculation and
disappointment.

Considering our forecasting philosophy, it was difficult last fall when
we released our forecasts for the video game market in 2007.  Last fall
we forecasted that in 2007 the video game market would experience over
30% growth and could reach record worldwide revenues of $42 billion.
>From our standpoint, we were concerned that DFC Intelligence was
becoming another reckless market promoter leading potential investors
onto the hype bandwagon.

It is still too early in the year to say how things will turn out for
2007. October, November and December generally see progressively higher
sales and historically it is unreliable to try and project fourth
quarter sales based on the first six or even nine months of the year.
However, we can say that going into the fourth quarter of 2007 we feel a
whole lot more confident about our $42 billion forecast.

In January 2008, it looks like there will be all kinds of big numbers
from 2007 for companies to throw in press releases.  Of course, this is
exactly the time that our cautionary side comes into play.  Big numbers
are meaningless unless you take a close look at where growth is
occurring.  In 2007, a huge chunk of revenue is coming from hardware
sales.  That means some of the growth is deceiving.  Yes, hardware sales
mean future software sales to the installed base.  However, for software
developers, hardware sales revenue is not he most important metric,
instead it is unit sales and installed base.  A game system that sells 1
million units at $100 can be just as strong a platform for software as a
system that sells 1 million units at $500.  However, the $500 system
will add five times as much revenue to the overall industry figures.  

The other big issue in the game market is the continued strength of
portable platforms and online games.  In many cases, this growth
represents potential new revenue and business model opportunities for
developers.  However, in these cases it is very important to have a
detailed understanding of these opportunities.  One big example is the
potential revenue growth from the increasing number of console systems
that are going online.

DFC Intelligence recently released its latest detailed forecasts
http://www.icebase.com/go.shtml?20070828072655287432&m10610&http://www.
dfcint.com/game_article/../game_report/online_game_forecasts_toc.html>
for console online game revenue.  We broke our forecasts down by region
of the world (North America, Europe, Japan and East Asia), game genre
(MMOG, casual, FPS etc), consumer type and business model of which the
primary ones were digital distribution, subscriptions and advertising.
When it comes to console online game revenue we feel we were fairly
bullish about growth on all fronts.  However, one area where we got
complaints about being overly cautious was on advertising on console
game systems.

For the record we forecasted that console game advertising would grow
250% from 2007 to 2012.  This would seem like strong growth, but it is
an order of magnitude lower than what some people are expecting
(?praying for?).  However, we have several reasons for being on the
cautious side in our forecasts.

The first issue to note is that consoles are just starting to  get
connected online.  In today's market it is often assumed that anyone
buying a PC will have an online connection.  In fact, without an online
connection, many consumers would be reduced to using their PC as a
paperweight.  This is clearly not the case with console systems.  An
online connection is not necessary to enjoy the bulk of what a video
game platform can offer.  Furthermore, the ideal setup for connecting a
game system is to have a home PC network, preferably with Wi-Fi access.
This is becoming increasingly common, but still only reaches a subset of
console owners.

Of course, more consumers are connecting their consoles online and this
is why DFC Intelligence feels online game revenue is going to experience
strong growth.  However, it is important to understand that this is more
of a steady increase, not an overnight revolution.  For the early
lifespan of the Xbox 360, Microsoft reported that over 50% of initial
purchasers connected online to Xbox Live.  That sounds pretty impressive
considering that the original Xbox system only had about 10% of members
subscribing to Xbox Live.  

However, looking in detail at the numbers raises some issues.  For one,
with the original Xbox, going online required buying a subscription.
Going online with the Xbox 360 is free with the Silver level.  The other
thing to consider is that Microsoft specifically targeted the heavy
online user and promoted Xbox Live as a key feature of the Xbox 360.
Considering these factors, having 50% of the bleeding edge early adopter
consumer go online is not that impressive.  Furthermore, it is not
really a figure that can be extrapolated out into the world at large.

DFC Intelligence also tries to account for game genres and consumer type
in its forecast.  Under this analysis we argue that subscription and
digital distribution business models provide some of the biggest
benefits for the consumers and games that are going online via console
systems. The benefit of advertising is still somewhat unclear in our
mind.

The console gamers that are going online in these still relatively early
days tend to be significantly more weighted towards what we call
"hard-core gamers."  These are gamers that spend much more time and
money on games than the average user.  Advertising is all about
collecting a whole bunch of eyeballs in a certain demographic and being
able to target them with the appropriate message.  Much of the focus on
future advertising in video games is clearly looking at the mass market
video game consumer.  However, the reality of who will be online to
receive advertising in the near term is much different.  The opportunity
in the next few years for console systems is more likely to be the
hard-core or enthusiast gamer that has a very different profile than the
market as a whole.

Of course, advertising to an enthusiast audience can be very profitable.
This is especially true when you have an enthusiast audience as large as
the hard-core video game population.  However, there are some issues
specific to advertising in games that will need to be addressed.  First
and foremost is that, for a hard-core gamer, advertising can be very
intrusive.  As famed industry game developer David Perry said in a
recent interview in the DFC Dossier, when his company did a survey of
gamers to ask if there was a way they could turn off advertising in
games would they do so, the answer was 100% yes.

The big concern is that advertising is generally a way to subsidize a
product for consumers.  Television and radio are obviously the best
examples.  The game industry has been one of the few products to not be
supported by advertising.  However, the general media trend is having
advertising support the mass market while the enthusiast user pays to
avoid advertising.  A big attraction of pay cable and satellite radio
services like XM is, by paying a subscription, users can avoid
advertising.  Among the PC game services there is a similar trend where
heavy users can pay a monthly subscription fee and play their games free
of advertising.

That brings us to our final point.  When looking at the opportunity for
console online game advertising it is critical to look at the already
established advertising business model for PC games.  Advertising has
supposed many free PC games.  However, most of these have tended to be
casual games, not the expensive massively multiplayer and first-person
shooter games that attract an enthusiast user.  Sites like Electronic
Arts' Pogo.com have established user bases numbering in the tens of
millions.  This is more than the entire universe of video game systems
connected online.  However, in recent years, EA has talked less about
the growth of advertising revenue.  In terms of online growth
opportunities, EA's fiscal 2007 10k talks mainly about MMOGs,
subscriptions to online casual games, micro-transactions and the ability
to sell digital content online.  When it comes to advertising the
statement in the 10k is limited to "we derive revenue from advertising
in our games and on our websites."

Online advertising revenue from Pogo.com and other EA sites is no longer
reported separately, but instead included as a line item as part of
"Licensing, Advertising and Other" in EA's financials.  For fiscal 2007,
Electronic Arts reported that revenue from Licensing, Advertising and
Other was down 6% to $57 million.

These are some of the reasons that DFC Intelligence has been much more
bullish on the growth for subscription revenue and digital distribution
revenue than we have on advertising revenue.  However, we also stress
that we do think advertising revenue will grow.  Products like
PlayStation Home provide a potentially attractive environment for
advertising.  It is just that many of these products are simply what the
PC business has been doing for years.  Advertising is in large part a
numbers game and there seems to be no way that console systems will have
the aggregate numbers of the PC in the next five years.

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