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While I've been a video game player all my life, I haven't always been a video game investor. My trepidation has always stemmed from the fact that to a large extent, the business dynamics in the video game industry are a lot like those in fashion retailing -- one day you've got the hottest thing around and you're the king of the world, but if you stop to celebrate for even half a second, you're already behind. In investing terminology, the best way to express it is that video game companies, on the whole, just don't build a lot of durable moats.
The winds of change
That, at least, was the traditional model. Toward the end of the '90s, a new breed of video games began to emerge called massively multiplayer online role-playing games. These MMORPGs plugged millions of basement-dwelling geeks into alternate realities where nerds like myself could battle each other for digital loot and glory. There, of course, had been multiplayer games before the dawn of the MMORPG, but no other genre connected so many gamers at once, and perhaps no other genre had as much of an influence on shifting the entire video gaming experience from being antisocial to becoming a social one.
The pinnacle of this metamorphosis is no doubt apparent in Activision-Blizzard's (Nasdaq: ATVI ) World of Warcraft, which as of the end of last year had more than 12 million gamers worldwide. Excuse me, I should say, 12 million subscription-paying gamers worldwide. Because not only has the MMORPG changed the social dynamics of video gaming, it also introduced a completely new business model. The MMORPG is hosted on the company's servers. Customers pay to access the digital game world on a usage-based or time-based system. Yes, that's right, if you're familiar with the latest and trendiest growth and tech buzzwords, then no doubt you are beginning to recognize that this business model is the same cloud-hosted, software-as-a-service model that has rocketed companies such as salesforce.com (NYSE: CRM ) into triple-digit valuation multiples territory -- as of the most recent market data, 170 times free cash flow. For comparison, Activision-Blizzard sits at a relatively modest nine times.
The power of the MMORPG business model
Despite the vast valuation differential, a lot of the same rules apply. Cloud hosting means more efficient allocation of assets and generally higher returns on capital. As an example, Activision-Blizzard's World of Warcraft subdivision generated an operating margin of about 51% last year, whereas its more traditional, flavor-of-the-month Activision division only pulled in an 18% operating margin. It's like this across the board. In fact, competitors such as Take-Two Interactive (Nasdaq: TTWO ) and Electronic Arts (Nasdaq: ERTS ) , both of whom depend on the traditional blockbuster business model, do even worse! Take-Two took in an operating margin of 9% last year and Electronic Arts was at -5%!
On the flipside, you look at some of the Chinese video game companies that specialize in MMORPGs like Perfect World (Nasdaq: PWRD ) , Shanda Games (Nasdaq: GAME ) , and NetEase.com (Nasdaq: NTES ) and you start to see more pleasant numbers: 36%, 30%, and 46%, respectively.
Time to re-evaluate nerdom?
Those are respectable figures any way you look at them -- respectable enough to almost make you feel proud for pulling an all-nighter raiding the night elf capital city, claiming that it's just "market research."