Over the past decade or so, the video gaming industry has shifted to a digital purchase-based model. While this has stabilized cash flow for companies in the industry, it also presented them with plenty of new risks.
In this clip from from The Motley Fool's Industry Focus: Tech podcast, Dylan Lewis and David Kretzmann talk about a few of the biggest challenges that companies like Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) are now facing with their online and mobile segments and what they're doing to maintain their positions as the dominant players in the space.
This podcast was recorded on June 10, 2016.
Dylan Lewis: You mentioned in the first half the idea of this transition to digital, that there is not the physical case and disc that you're picking up at your GameStop (NYSE: GME), or something like that to be able to play these games. That leads this to being, in some ways, a very high-margin business to be in. You're eliminating all the physical stuff that goes into the product. I'm a little worried that that lowers the barrier to competition a little bit.
David Kretzmann: No, that's certainly right. I think that's a great way to put it. Another way to frame is that the switching costs for customers is much lower than it was 10 years ago when it comes to a game. Ten years ago, again, you go to the store. You pick it up off the shelf. You have the game on your shelf. You'll play it. You would have to go back out to get a game if you want to switch to a different game to play.
Especially with mobile and then this digital transformation in general, if you're on your phone, it takes you, what, 30 seconds to download a game. You can play it. You can fiddle around with it for maybe 20, 30 minutes if that. If you're not happy with it, worst-case scenario, you just leave it on your phone. You don't open it for six months. You forget, "Oh I downloaded Bejeweled a year ago."
It's painless to just uninstall that game and just install another game. Certainly, the switching costs are very low for customers. Especially on that mobile platform, you're seeing a trend where it's really a freemium experience. You're not even paying anything necessarily up front to play the game.
That mobile model is more challenging because you recognize that the majority of people who play a game on a mobile app are not going to pay anything. You're betting on that small fraction, maybe 1% or 2% of the really power users who are going to be spending half the day on the game. They're going to be buying different credits and stuff to progress through the game.
That's a more challenging model. There has certainly been a lot of risks that come with that. Yeah, that transition to mobile and digital, I agree. It does have more risks. It pressures the companies like Activision and Electronic Arts. They have to engage with their users much more regularly than launching a game every year or two, which is what they were doing maybe 10 years ago. Now, as I said, with Electronic Arts, it's not uncommon for them, with their popular games to be releasing daily, or weekly updates.
Companies that can make that transition, they should do well. It's on them to maintain that engagement with customers. Companies that don't do that are probably going to have a difficult time. Competition can swoop in much more easily now than 5 or 10 years ago.
Lewis: Yeah, and on the note of staying relevant, I think another one of the major risks with these types of businesses is that being a video game publisher is a lot like being a movie studio. You need to keep pumping out hits. Luckily, for both of these companies, they have very established, rooted franchises that they have been able to milk for quite some time. It's amazing the grapple that EA has had on sports games.
Kretzmann: Even so, obviously EA, they've done a great job, especially with their FIFA and Madden franchises. They have other sports franchises that have done really well, but then within the past five years or so, you have this smaller company, Take-Two Interactive (NASDAQ: TTWO), which comes out with a NBA 2K, which is now the dominant game for basketball video games, at least for the NBA.
Even in a case with EA, you have a dominant market position. They control the vast majority of that market share of sports video games. Even then, if they get complacent and they're not putting the energy into a game and making it player-friendly and making it what players want, that opens up the door for competitors. For EA and Activision, certainly they have these dominant franchises, so long as they can continue to update them and keep them relevant for people, they should do well.
Going back to mobile, and just an example of Electronic Arts, they've managed to do pretty well with some of their mobile games. They have Madden NFL mobile games. They also have a lot of the... Disney (NYSE: DIS) licensed their Star Wars games to Electronic Arts. The Star Wars mobile game that Electronic Arts has, in the most recent quarter, the average player of that Star Wars mobile game spent two hours a day on that game. That's the average player. That's not just the top tier. That's the average player. Electronic Arts, they have found different ways to really break into that market.
Monetizing it is another story, but at least having that engagement, that's the first step. Anytime you go to a new platform, you want to have that engagement. The monetization will come after that. The engagement is the first step, then monetization will come. It's an interesting space to watch. So far, both these companies, in their own ways, have found ways to transition nicely to that digital model. Anytime that your margins are ticking up, like both these companies, you're inevitably going to attract new competitors. That'll be the thing to watch in the coming years.
Lewis: Was it Jeff Bezos that said, "Your margins are my opportunity?"
Kretzmann: Exactly. There's a big, growing target on the backs of both these companies. It'll be interesting to see how they fend off competitors. Whether they acquire new games or acquire new companies to better reach customers on these platforms or license new games and franchises, they have different opportunities. Both these companies are flush with cash and producing a lot of free cash flow and their margins are very strong. They have the resources.
It's really just a matter of how effectively they allocate that capital to strengthen their competitive position, invest in the games, invest in that player engagement. If they can do that effectively, they should be able to grow for a long time, but if they get complacent and just sit on their cash and put their feet up on the table and sit back, they could lose that competitive position pretty quickly.
David Kretzmann owns shares of Activision Blizzard, Electronic Arts, Take-Two Interactive, and Walt Disney. Dylan Lewis owns shares of Walt Disney. The Motley Fool owns shares of and recommends Activision Blizzard, Take-Two Interactive, and Walt Disney. The Motley Fool has the following options: short July 2016 $28 puts on GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.