May 26, 2022
After growing at 9% compound annual growth rate (CAGR) for the last decade, there is still much to get excited about regarding the long-term prospects of the video game industry. New marketable technologies, streaming that provides exposure to lesser-known games, and new phone owners becoming potential gamers, are only a few of the reasons to believe that the industry will be able to maintain this growth over the next decade.
Despite these positive secular trends, video game developers and publishers have been facing a difficult start to the year. Two years of COVID has brought production delays that had initially been offset by significantly increased consumer engagement from various lockdowns across the world. With the reopening now well underway, these “non-core” consumers are going back to their pre-COVID lifestyle. This obviously creates difficult comps for companies that saw record growth for the last two years and are still often facing production delays, with many big names, such as Activision, Nintendo and Ubisoft posting negative year-over-year (YoY) revenue growth in 2022. Although, the delays were initially blamed on the work from home situation, where collaboration was more difficult and productivity was inconsistent. It is now the talent retention that seems to be at fault.
Indeed, game designers and engineers have a long history of being underpaid, compared to their peers in other fields, often trading higher salaries in exchange for working for companies that create games they are passionate about. Payscale.com listed the median video game designer salary at $66,452 versus software developers at $73,177 for 2021. Wage inflation is now rampant across virtually the entire economy. Additionally, many employees are reluctant to go back to the office, meaning that designers, developers, and game engineers are receiving multiple offers from competitors from within but also outside the video game industry. Video game development requires substantially more collaboration than many other software developer jobs. Management teams face a difficult choice between maintaining the perks of working from home to retain talent and bringing everyone back to the office to meet production timelines without requiring more resources.
It is not all negative for game developers and publishers though; 2022 is already the biggest year on record for mergers and acquisitions (M&A) in the video game industry. Microsoft acquiring Activision Blizzard for $68 billion is on its own the biggest video game company acquisition of all time. Other recent deal announcements, such as Sony acquiring Bungie and Take-Two Interactive acquiring Zynga, have shown that there is still demand for Intellectual Property (IP) and that the studio consolidation trend is well and alive. The top 10 gaming companies already represent over 65% of the market and that share is set to grow over the next decade. Increased M&A also tend to be beneficial for small-cap as their acquisitions are usually at a premium to their market value.
So how is Global Alpha positioning itself? We currently own Sega Sammy Holdings.
Sega Sammy Holdings (6460 JP)
Established through the integration of game publisher SEGA Corporation and pachinko machine manufacturer Sammy Corporation in 2004, it has historically also been involved in amusement centres and theme parks. A defensive name in our portfolio, the company owns strong and long-lasting franchises, such as Total War and Sonic, which they have a solid history of monetizing. The company has been divesting from its arcade business in recent years to reinvest in its gaming segment, which will allow them to more aggressively acquire studios and IPs, as well as facilitate the distribution of games worldwide.
The company differentiates itself from western game publishers through its diversification in the pachinko and pachislot business, which provides them with a more consistent cash flow than its video game business. Furthermore, their Pachinko and Pachislot business benefits from the economic reopening play where the video game segment would usually suffer. Another differentiator is the labour market in Japan, which is not facing the same wage pressure as seen in the west and therefore did not see the same challenges in retaining talent.
- Owns popular IPs and strong brand moat
- Diversified complementary revenue stream
- Margins weaker than peers as it is not a pure play
- Margin expansion from divestment
- Deployment of cash for acquisition
- Regulatory risk in their Pachinko business
- Fail to produce or obtain exciting new titles/IP
Global Alpha is excited about the long-term growth prospects of the video game industry, and we believe the recent negative sentiment seen in markets worldwide offers good investment opportunities to stock pickers.