Gaming Consoles Part 1: The Thesis - [Business Breakdowns, EP.201]

27:56Well, remember, I already bought this game. I paid 70 bucks to buy the game. I'm also doing in -game purchases and I'm seeing ads. I think there's a long room for console, but they also have a lot of space. and in -game ads is something that's really nascent for consoles in general. Yeah, well, it's interesting to see how many levers there are to pull to get that customer value up. If we just go back to that one more time, breaking out the 600 to the 2000, do you have, it doesn't have to be super precise measurement in terms of what drives the majority of that, but any loose math on where you expect that to be just in terms of whether it is the upfront purchases versus the subscriptions versus anything else?

28:43So let's look at Nintendo for a moment. Nintendo is not as far along as PlayStation. Back in 2015, we estimate the lifetime value was $90. 2020, 3X to $260. Now, for both Nintendo and Sony, you can see that it is growing. But if you just actually overlay the stock price and said, I bought and hold from 2015 to 2020, both of them, their stock price nearly tripled for both on the back of this becoming a much more stickier, higher quality user. Now let's get to our bold predictions. So we think Nintendo today, the lifetime value is gonna go 5X, grow from $300 to $1 ,400, broad stroke. Let's look at the math of what's driving it.

29:29Well, what we're looking at when we say revenue per user, we're not looking at hardware for both sides. We're actually leaving the hardware out of it. We want to keep it apples for apples. We're just looking at the software side of spin for the users. And we know from the math is it's roughly a little under $100 for Nintendo users today. Now, what's interesting is because this is the first time Nintendo will go to an iterative cycle, meaning Switch 1, Switch 2, Switch 3, we're taking our lifetime value, the churn part, And we're saying instead of users churning every five, six years, the churn is now only 10 years or 11 years.

30:08And the further you go out, that means the lifetime value of that user is, of course, worth more and more and more. Now, this is a pretty monumental moment for a company like Nintendo, who has never done an iterative cycle. And every set we set the player base, it was always hard for the market to say your lifetime value is high because I don't know if people will continue to the next device you bring out. that risk is off the table. And I think that is what gives us so much excitement around this generational console thesis. Let's now look at Sony for a moment. Sony obviously is further along in this process.

30:43We shared that the lifetime value is around 600 bucks today. We think this gets to almost 2000. But if we look at the spin power, it's around $180 per user today. And we think this is only going to grow to maybe 280 to 70 but similarly the user is instead of being around for seven eight years is going to stay around for 11 12 13 years because one of the things that sony's working on and we know is that there is less and less gaps between consoles and the titles because of live service games if you're playing a ps5 today let's say the next iteration of PS6, it's going to continue on. You'll go from Fortnite here to Fortnite there.

31:27You didn't have that in the last cycle. And I think this is that broad stroke of what we're saying is that really the console cycle, this cyclicality that you saw in the past, really it's gone. And in that, the turn rates are going to come down lower on that front. Yeah, there's a certain stickiness there. And seeing how they evolve that stickiness and what leads to stickiness will be interesting as well. On the point of profitability, so to speak, margin profile of these businesses, just the shift away from hardware makes a material difference. The cost of selling something through a retail location, having to ship all those titles, having to produce all the boxes and whatnot looks drastically different than just granting through a couple of clicks access to these games.

32:17What does that show up in the numbers themselves for these businesses? And you could walk through to the extent that it's available for Nintendo and Sony, but just some snapshot of how much of a difference it makes. Yeah, no. So if you looked at Nintendo today, it's almost a 50 -50 % split between hardware and software. But if you really get down to the bottom line and earnings, it's majority software driven. Now, Nintendo and the Switch, they were never devices that they stole at losses. There was always small margin in it. But obviously the software margin is where you want to be. For PlayStation, very different.

32:55So margins have oscillated quite a bit between, let's say, low single digits to as high as 20%. We're at that point where right now the margins are around 10 % and should be much higher. One of the things that we're looking forward to is a margin expansion story at the PlayStation ecosystem level. But with each of these businesses, I think the hardware is part of this, if you take a step back and you say, the hardware is part of this vertically integrated mode that I have, and then how these devices evolve and behavior of gamers, it will be interesting because, not to get too out there, but is there a scenario where in the next generation of Switch, it becomes a phone because it's quite a big phone.

33:40But these things are all quite feasible to do and cost effectively. And then we look at the PlayStation ecosystem. Obviously, one of the risks to the thesis could be around people streaming games and playing from their TV. But then you think about part of this moat of why you play the Switch is you want to play the IP. And so Sony's got a treasure trove of IPs and they're acquiring more. there's a lot going on around kind of the makeup of these businesses where hardware isn't necessarily a bad thing it's part of that moat and the part that i think people are when we look at the numbers the next four five years is we think people or markets when i say people is they're sleeping on the fact that the bottom line could accelerate because of third party and software sales and we think that's going to be showing up in the numbers the next few quarters but also really a question of like, hey, I have a business that historically, and if I take a step back, what did the PlayStation ecosystem do from a recurring operating profit perspective?

34:43So prior to PS4, PlayStation's operating profit was very volatile. It was all over the place. And hence, yeah, this is not a great business because no one likes cyclicalness. But since PS4 to today, you've had a new norm where the PlayStation ecosystem has been churning out a couple billion dollars in profit annually. And we think this is going to accelerate and double from here, basically. When you look at Switch, same concept. So just looking at operating profits. They've always been okay, but they had that one little blip called the Wii, where they, for four or five years, operating profit went negative.

35:19And I think markets, they look at that and say, okay, what if this happens again? And our whole argument is that that's not going to happen again because you're building off the success of the most successful device that Nintendo did in Switch, going to Switch 2. And then with that, you're also saying, look, this is a whole different market where you're making money in live service and software. So yeah, I think that touched on many points there, but I think that's the right way to look at it is this recurring nature of an operating profit for both companies is going to be higher and then really less cyclical is the way that I would think about it.

35:55It was just an interesting market to think about prior to the shift. You had essentially five -year DCFs for whatever the new console was and all the games associated with it. But you were going to see some cyclicality in there and then from one to the next. So it's interesting to see how it shifted. And I think that just the point on the $2 billion of operating profit from PlayStation and then the change for Nintendo makes a lot of sense. Getting back to the hardware point that you were referencing, when you think about an alternative risk just being mobile, what are the hurdles from a technology perspective for mobile to capture more of this opportunity?

36:35And what I'm basically getting at is, are there just graphical constraints that will never be reached? What are the other things that stop an iPhone or an Android from being able to carry these titles? When you look at some of the best IPs out there, some of them are on mobile, some of them are on console, and it's split between these experiences. But there'll always be titles that you're not going to be able to play on your phone because of just how you would use the controller. And those titles don't make sense to be on a mobile device that's super tiny. I think it's going to come down to really the type of game you want to play and type of session you want to play.

37:13So I'm speaking out loud for a moment here, but if I were looking at Fortnite, I'm pretty sure my engagement sessions on console versus mobile are very different. Each IP will do what it makes sense because you'll have some IPs that are crossover and some that won't. But it's not a big factor in my mind in terms of how the future evolves against mobile versus console. I don't think of them as fighting each other. If you wanted to get into kind of, okay, what are the things that are potentially battling each other? I would say it's console versus PC. Yeah, I wanted to get into the PC market. It's a very interesting one.

37:50And I've probably referenced the making of Prince of Persia book on this podcast several times, but it really is fascinating. It gets you into the earlier days of this market, specifically around PCs and just how unique it was at that moment in time. But after the days of doom in the late 90s, early 2000s, when my dad brought home a copy, it felt like PC just fell off and to the benefit of the console market where all the games shifted that way. I could be just not the right person, the end of one anecdote. But what happened to the PC market? Where does it stand today? And it sounds like there's a risk of it regaining life or being stiffer competition.

38:31So where do we stand there with that market? So the PC market, called the ballpark, it's around $40 billion. So it's slightly smaller than console in terms of spend. Still very respectable though, in terms of relative size. But in terms of reach and user base, so it's hard to come up with monthly active user numbers. But I think if we looked at the top platform for digital spend, it's a platform called Steam. Steam has 130 million monthly active users. So it's bigger than PlayStation, bigger than Switch, bigger than Xbox. and we know for at least what's been out there is that it's about $9 billion in sales.

39:10Now, what I think is interesting about the PC market is that of that 130 million users, about 50 million of them will get a controller and plug it into their PC to play. Now, let's unpack that a little bit further. One of that behaviors is because if I'm playing an online game on PC, I don't have to pay the subscription versus when you look at console to play online, you need a subscription. You have to pay that additional five, 10 bucks a month. So if in a scenario where console says, we'll get rid of the subscription online play, then I think PC is going to have a hard time. There's 50 million users who want to come over.

39:52Then when you unpack and you go back to the titles part, because the PC market, there's 14 ,000 games annually that get released on there versus Consless Cup 100, 300 games. So you're looking at AAA games versus the single A, double A indie games, very different markets. In that sense, there's just a lot of IPs that are not on PC that are console exclusives. So myself as a gamer, I have a Switch, I have an Xbox, I have a PlayStation, I have a gaming PC. And if I'm being honest, I play my PlayStation the most and my Switch the second and the gaming PC and Xbox are the number three and four. But it's very much title driven for me.

40:35And does PC have, obviously, just given by the number of titles released each year, there are going to be some that are released only on PC, but does it have major titles, major IP that are only released on PC? They do. But I think one of the more interesting things about PC is that there's a lot of innovative titles that come out of PC because the budgets are a lot less than console. So let me give you an example. One of our most noble investments that we were successful with is a Korean company called Crafton. Crafton created the battle royal genre with a game called Players on Battleground.

41:14They were the first to really invent this. And then later on, Fortnite and Free Fire came and mimicked their gameplay. But what's interesting about this game, Players on Battleground or PUBG, is that it was built with a budget of less than $10 million and ended up being a massive hit because it expanded the shooter genre in a way that shooter genre hadn't before because it introduced a new win condition. And so when you think about PC IPs, there's a lot of innovative stuff that comes there. And since of PUBG, it came out from PC, but then once successful, they immediately go into mobile. They immediately go into console because they know the bigger markets are there in terms of profit pool on that side.

41:59And when you think about the third -party market, just game developers, new games, where they're coming from, are there any new entrants or interesting catalysts for that market to potentially grow on console? Absolutely. In fact, I think one of the most interesting things that we've seen since we've been investing in video games going back to 2017 was the flood of venture capital that went into the space on this metaverse thesis and COVID hype. And so on the back of that, you've just seen a bunch of venture funding that before COVID never really happened. And so we think there's already a handful of venture game studios that have looked at console as a way to explore that before would never look at it.

42:49Do you remember console? there's only a couple hundred games that launch each year. And then the second piece is, how do we reach this audience to the store in terms of advertising on there? And because we know that the console gamer is a high value customer. That's one that's much more valuable than just the mobile gaming user. It's a market where I'm always impressed. Reference the leaks earlier. There's something to be said for how big an industry is and how niche and obsessive the customers are based on the number of leaks that come out. You can have industries where nobody cares if there's a leak about the next apparel line from the GAC.

43:25But if there's a leak about a video game, people are lined up at their computers looking at every pixel. So there's something very interesting about the customer base and the obsessiveness of it. One of the things that we've never talked about in our conversations has been eSports, which was a very popular theme. And there's the whole idea of streaming and that being something that's major. Does that play any role in the economy of these games, these consoles in the future? Just what's your thought process around esports? Because it felt so thematic in the moment, say five years ago, and I just haven't followed it nearly as much recently.

44:03So esports, when it first got a bunch of momentum, people were investing in teams and it was really wild back then. But I think when you take a step back and you look at really what it is, it's a marketing function and the value is really accumulating to the game itself because people are playing your game all over and they're playing it competitively. But we're potentially maybe getting into an area where esports might be something more than just marketing. And why I say that is because up until this year, esports has been run in Asia that's run by different channels. And now we have the first Olympic sport event happening next year in Saudi.

44:47And I think that's a big deal because now countries are going to win Olympic medals in esports in a situation that never happened before. And you have countries like Japan that have come out and said we're building teams and Korea is a powerhouse in this category. So I think the esport category, if I look at it, I think it's a soft power aspect. From a business model perspective, it's a media company. You're trying to get eyeballs and you're getting to an audience that is the next generation of consumers. You're building brand awareness from that front. But it definitely has its own challenges when you look at what's the lifetime of an A -sport player.

45:28It's only a couple of years. Is your brand the player? Is it the team? They're global. They're not really city -based. It's a very fascinating case study, I think, of just real. But also, you think about how many people want to make this work and think about where the consumer is today. So I mentioned to you earlier, I play a lot of FC25. every footballer today looks at their FC25 rating and complains about it. And they care a lot because they're the first generation of footballers who are probably playing a lot of games themselves too when not on the pitch training. So discoverability, brand awareness, esports is, I think, a channel for creating that awareness.

46:12And then thinking about generational dynamics and consumer preferences, How does that play into this? I am certainly of a generation where consoles were a major theme, but as you think about different generations, their preferences, are there any unique dynamics there that play a role in this thesis? In fact, one of the most exciting parts to the thesis is that there is this massive sector growth in what is known as Gen Z. And so myself, I'm a millennial, but when I think about investing, I think about investing into what Gen Z wants to do. And the reason is simple. They are the most important incremental spender in a decade ahead.

46:54And if you think about markets, pricing change is very hard. And I'm always thinking about where does incremental spend happen? So back to Gen Z. So the oldest Gen Z -er is around 25, 26 years old. They're just starting into the workforce. In terms of the estimates, the spin power today is roughly $400 billion, and it's expected to grow to $2 trillion. And so when you think about that kind of spin at a global level, that is what gets me really excited about the video game industry on a whole. But then specifically, when I think about the mid to hardcore gaming of console, where you're spending hours on your couch, playing with your friends.

47:33And now let's get into the social aspects of Gen Z. This is really the first generation that grew up playing games with both guys and girls. And that has led to huge implications of why microtransactions are working versus in my generation, you didn't have that dynamic and microtransactions really didn't exist as a concept. So there is essentially a snare year where I think in the next 10, 15 years, gaming surprises a lot of people and goes from an overall $200 billion to a trillion dollar industry. But it's because the paying ratios are going up, not just in mobile, but people are going to spend money in games overall because this is now the activity to hang out.

48:17And now that you have both genders playing games, it introduces all the social dynamics of why we spin mind in the real world. So that is truly what makes this next decade unique and what makes us so excited to be going all in into this thesis. When I put this all together and just think about the signposts or the milestones to watch for for the thesis to play out, I think you outlined Switch 2 being a major one and then on the PlayStation side, the next Grand Theft Auto release. Obviously, if there's delays around those, that moves things around a little bit. But is the main thing that you're watching for just the adoption and the sale of those titles?

49:02What else are you monitoring the most to maintain confidence in this thesis playing out? Yeah, so let's first touch on Nintendo first. Nintendo historically has been viewed through this lens of how many units you sell this year. And the most they ever sold was 21 million units. That was the first with the Switch 1. And that was in year three. And Wall Street will continue to focus on that, a number of units sold, number of units sold. But remember, there was a time when everyone looked at Apple the same way, how many units you sell. Nintendo, in the last few years, has been disclosing active annual players.

49:38And they're going to continue to reinforce disclosing KPIs as they stop focusing on how many units we sell, How many active players in our ecosystem is that number growing? So to me, that's the key KPI from that front. PlayStation, much further along in that sense. But I think for us, what we're going to spend more time thinking about is how much is around the subscription side? Can you grow from the 50? Can you grow that to 60, 70, 80 million on that front? And then when you think about the console market overall, something that kind of doesn't get discussed enough that I think really deserves a flashlight because it's the 10 -year vision of how big consoles can get is we're not seeing huge player -based growth in these markets in terms of Western.

50:25But think about a market like India, think about a market like China. Console gaming is actually growing. So I'll give you a fun fact. in India, PlayStation is dominating, but it's dominating with maybe $200 million in revenue. But this grew 50 % last year. Now, obviously, you're thinking about a PlayStation device and the price point and the TV. But if you want to play the middle class of India, that is a 10 -year vision. And the console gaming markets for it to grow will have to go in a market like India. Now, it was interesting, early this year in August, there was an IP called Black Myth Wukong that came from China, six years in development, used Chinese historical IP, and that caused PS5s to sell out in China.

51:10And today the console gaming market in China is called 20 million people. And this is out of a market at 600 million people. So China's the biggest single gaming market in the world, but console gaming has really got a long way to go to catch up. But again, it goes back to what's going to pull a lot of people to consoles. I think it's going to be the IPs itself, the titles. if you want to play it. So that was a really good example of I think people potentially sleeping on the fact that you have China and its rules of regulation, but console gaming is growing market there. Then you have India, which is super early.

51:46It's less than a million users, a couple hundred million in sales. But this last year we saw 50 % growth and PlayStation and Sony has come out and said, we're going to really focus on India. So they've actually recently set up a division to go and invest in Indian content and help support building that on that front. So that's, I think, about 10 years from now, I'm thinking about emerging markets and I'm thinking about their adoption of consoles on that front, which I'm just new users coming in. And then just to bring this to a wrap, when you think about the market's appreciation for this, what's reflected in the businesses themselves, the stocks themselves, how do you go about approaching that, whether it's just the growth potential from the actual earnings or the multiple itself and a potential re -rating based on the back of a business model shift?

52:39How would you even begin to frame that and think through it? So let's break this down one by one. Nintendo first. If you think about where Nintendo is going and its operating profit, it has margins of 35 plus percent. It's been doing that for many years. It's highly profitable. 12 billion plus in cash. It's in a great place. And I think the next step is saying, well, why do you trade at this multiple of 13, 14 times EBITDA? Why can't this be much higher? Why can't this be maybe more like a Netflix? And I say Netflix because when I think about Netflix close to $300 billion and Nintendo at 60 billion market cap, Nintendo could be at Netflix's earnings power today in the next few years.

53:26But that's going to take some time. It's going to take not just having first party, but really having third party titles come in and say, let's leverage the in -game purchases that create these massive economies. So one thing that gets us excited is you think about there's titles that never before have been on the Switch. So the Call of Duty title from Microsoft, that's coming on the Switch, that's announced. And I think there's more of that title on that front. So I always think about when it comes to valuation, both these companies, both Nintendo and Sony, they're going to have strong earnings throughout the next few years, but what multiple will you pay?

54:03And to me, in the case of Nintendo, it just has to keep doing what it's doing. Margins could expand, but I think it warrants higher multiple because of it's just quality of the business. Now let's take a look at Sony. Sony, I think, will be a lot clearer story of this evolution because margins are lower than they need to be. They should be much higher at both the PlayStation level and at the group level. And I think if we see that really materialize, margin expansion stories are well received by the market because bear in mind, Sony trades at eight times EBITDA. Should this be at 15 times or 20 times?

54:41Honestly, I would say yes for a company that is a global leader in entertainment and both video games, but we can talk about music and anime and other categories. So the margin expansion story is a tried and true approach to multiple expansion. And I think for Sony, that would be the next step for it. Excellent. Well, this has been a fun kickoff to the rest of these conversations, where we'll dive deeper into the individual businesses, but appreciate you sharing the knowledge. My pleasure. Thank you for the time. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary check out JoinColossus .com That's J -O -I -N -C -O -L -O -S -S -U -S dot com