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#1: The Rise and Fall of Esports as a Business

The esports industry is stuck between a rock and a hard place. Last week alone saw the shuttering of Newzoo’s esports division, layoffs hitting the entire staff of esports production company Beyond the Summit, and Saudi-led ESL FACEIT Group’s acquisition of esports analytics firm Vindex. Instead of entering a period of expansion like so many industry pundits believed would happen, esports instead is in a state of contraction and consolidation. Some are calling it “esports winter.” 

In the meantime, more people are watching video game competitions on streaming sites than ever, and the rise of YouTube Gaming has expanded the TAM of the ecosystem. This has contributed to the growth of PC gaming, as Steam continuously logs record concurrent players, many of whom are playing esport favorites like CS:GO, Dota 2, and FIFA. This is a profound disconnect that has to be analyzed through both an industry-specific lens, but also in a broader economic one. 

The COVID-19 pandemic supercharged esports viewership. As traditional sports leagues came to a halt, many occasional esports viewers turned into ardent followers of games that they only used to watch casually. Even when leagues like the MLB and NBA returned to competitive play, seasons were truncated and fans were absent from the stands. While in-person esports tournaments also shuttered, these only make up a fraction of esports revenue, as most of the money is concentrated in sponsorships, media rights, and streaming.

New esports releases heightened the excitement during this early pandemic period. Call of Duty: Warzone launched in March 2020 to critical acclaim and started topping the Twitch viewership charts immediately. This was followed by Riot Games’ first-person shooter Valorant in June, a title which also earned rave reviews from critics and players and began participating actively in the esports scene in September. During this period of euphoria, the Call of Duty League had its inaugural season, as 12 teams bought franchise spots worth a purported $25 million (though this sum has since been called into question).

Money also came easy during this time. The Fed quickly slashed interest rates to ~0% in March through a series of emergency unscheduled actions. With bonds across the world yielding record low rates, investors turned to public equity markets to reallocate their investments and spend their numerous stimulus checks. From this environment was born the FaZe SPAC, or the first major public offering for an esports company. While there are other publicly traded esports teams like Denmark’s Astralis or the UK’s Guild, their valuations are a fraction of what FaZe was trying to garner: $1 billion. 

For readers who aren’t familiar with the structure, SPAC stands for Special Purpose Acquisition Company. These entities raise money from investors through an IPO, and the funds are held in a trust until the SPAC finds a suitable target to acquire. For these reasons they are also known as “blank-check companies.” Many SPACs are set up with the target company already in mind, as was the case with FaZe’s SPAC, which traded with the ticker BRPM before the “merger.” SPACs have gained popularity in recent years, because the structure provides an alternative route for companies to go public. This process can be faster and less expensive than a traditional IPO. Additionally, SPACs can provide an opportunity for retail investors to participate in investing in private companies that they may not have access to otherwise due to a lack of accreditation status. 

The downside for investors however is that SPAC’s disclosures have historically been less than robust, to put it kindly. In its official investment presentation dated October 2021, FaZe was permitted to claim it would grow revenue at a 90% CAGR over five years, gross profits at a 114% CAGR, and be profitable on an EBITDA basis by 2023. The company claimed its social media following, which admittedly is impressive with nearly 400 million followers across the organization and signed talent, would allow it to monetize its audience at a rate comparable to traditional media or sports. FaZe also touted vague opportunities related to real-money gambling, subscription offerings, and even the metaverse. Of course, none of these ever came to pass, with the exception of a “strategic partnership” with The Sandbox in which FaZe bought a plot of virtual land. 

FaZe finally went public in July 2022 at $10 a share and a valuation of $725 million, shy of the $1 billion it had hoped to achieve. But this valuation proved to be too high as well. As the lock-up period for insiders ended and they sold their shares, coupled with surging interest rates and the worst environment for growth stocks since the dot-com bubble, FaZe sunk into penny stock status. 

As of March 3rd, the stock trades at $0.61 with a market capitalization of $44 million. As for its projections, FaZe hasn’t even reported fourth quarter and full year earnings for 2022 yet, despite it being nearly four months since Q3 earnings were released on November 14th. But on a TTM basis as of the end of Q3, revenue was $48.6 million, up just 29% from a year ago. EBITDA losses in the third quarter were $12 million alone — almost the total losses the company projected for the entire year. 

The SEC proposed rules last year to end the loose disclosures that allowed companies like FaZe to make claims it knew it could never achieve. Coupled with the severe losses investors have incurred on many other SPACs (such as those spearheaded by Chamath Palihapitiya), the structure is all but dead. 

This flash in the pan is synonymous with esports’ time in the limelight as a potentially viable business. Even the lucrative deals inked in the last three years are illusory, as is the case with TSM’s $210 million, 10-year naming rights deal with FTX. This partnership only lasted from June 2021 to November 2022, when FTX declared bankruptcy as a result of massive fraud. 

As for media rights deals, which are the bread and butter of traditional sports franchises, they have been few and far between. The most touted example of a “successful” rights deal was Activision Blizzard’s $160 million exclusivity agreement with YouTube over three years, which covered Call of Duty, Overwatch, and Hearthstone esports streaming rights. Note, however, that this is across three games, amounting to three distinct leagues when compared with traditional sports. Taken individually, this is about $18 million per game per year. Compare that to media rights deals for a league like the NFL in the table below, which renewed its rights with its partners at well north of $1 billion annually. 

Activision Blizzard is also not an esports company per se. Like with many other publishing giants, esports are used as a mechanism to increase traction of the underlying game for more casual gamers, who comprise the wide majority of the audience. Esports are likely a loss leader for many companies hosting high-profile tournaments like Riot and Valve, whose popular MOBAs are played by casual gamers at a rate magnitudes higher than by professionals. Companies like Activision, EA, and Epic are able to run loss-generating tournaments if it means boosting the long term success of their catalog. Attracting lucrative sponsors for the event is secondary to this goal, but unfortunately, other smaller players in the industry do not have pockets as deep. 

Consolidation has also made it hard for smaller teams and pure-play esports production companies to compete. In early 2022, Modern Times Group sold its esports organization division ESL to Savvy Games Group, an entity wholly backed by Saudi Arabia’s sovereign wealth fund. In the same breath, Savvy also acquired FACEIT, which was arguably the second largest esports platform at the time. This new entity was renamed ESL FACEIT Group, in a combined deal worth $1.5 billion. The terms of the recent Vindex acquisition were undisclosed, but given the company had $110 million in funding to date, it likely was north of $200 million. Vindex will provide the ESL FACEIT Group with in-house operations and analytics, complementing the front-of-house production capabilities with infrastructure rails.

Perhaps the most striking aspect of this doldrum period for esports is just how much private estimates for team valuations were wrong. Forbes’ list was the most circulated in the gaming world, and its May 2022 valuation list had FaZe as the fourth most valuable esports team with a valuation of $400 million. Note that this is after FaZe disclosed revenue in its S-4 SEC filing of $52.9 million. An 8x revenue multiple is rich and one reserved today for only the fastest growing companies, as the average multiple today even for tech is just over 2x. FaZe’s valuation is 89% lower than what the list below indicates, and if applied to all 10 “most valuable esports companies,” drops their collective value from Forbes’ $3.5 billion to $385 million, or less than FaZe itself. 

Ultimately, it would be near-suicidal for any of the teams on this list to go public currently, given the immediate hit they would take to their valuations. But these private valuations were never sustainable to begin with, as the market is the most efficient discounting mechanism out there. Given the lack of additional equity fundraising, and the double digit coupon such companies would need to issue debt, positive cash flow from operations seem like the only solution to prevent insolvency. And with revenue opportunities drying up, the next best thing is to cut costs, resulting in the layoffs which have stricken all corners of the esports world.

#2: Competition Heats Up in VR Landscape

Sony’s recent State of Play announcement generated buzz for VR after the company debuted five new titles for PSVR2, the company’s new flagship headset now retailing for $550. These games are all slated to release this year and span a mix of ports, from existing PC games to original IP designed just for the system. Earlier in February, Sony confirmed there were “more than 100” titles currently in development for the headset, as well in an online FAQ. Some of these will be cross-gen and playable on the PS5 as well. The PSVR2’s robust catalog should make it a formidable player in the industry, as Sony vies for market share in the growing market.

In response to increasing competition, industry leader Meta slashed prices for its consumer-grade Quest headsets, an about face from recent price increases. The Quest 2 used to retail for $300 for the 128GB version and $400 for the 256GB one, before prices were increased by $100 last August. This was done not only to combat surging inflation, but also to steer Meta’s VR and AR division toward a profitable path. Last week, the higher storage Quest 2 saw its price tag cut from $500 to $430, while the other model will stay at $400. Furthermore, the flagship Quest Pro device had a more dramatic price cut, from $1,500 all the way down to $1,000. 

This puts the Quest Pro in line with other top-end devices like the upcoming VIVE XR Elite, which is scheduled to launch in the coming weeks. The Valve Index also costs $1,000 and continues to rank among the highest-grossing products on Steam. Meta is also preparing for Apple’s premium VR headset, rumored to launch later this year under the name “Reality Pro.” Information is still scant, but Apple Insider reports it will be priced “above the $300 to $900 of its rivals,” which would likely put it above comparable premium headsets.

According to IDC, Meta dominated the market in 2022, as the Quest 2 enjoyed 84.6% market share in the global VR/AR market during the first three quarters of the year. With such a dominant position, the recent price cuts underscore how competitive Meta foresees VR becoming in 2023 and beyond. And with the company’s name change and pivot to go “all-in” on the metaverse, it is important for this share to remain high. Meta has never disclosed VR unit sales to investors, but recent leaks revealed that nearly 20 million Quest headsets have been sold. Assuming an average price per headset of $400 over the life of the product, this amounts to “just” $8 billion in sales. Compare this to Meta’s market capitalization of around $500 billion, and it’s clear the company has a long way to go to become a champion of VR. 

The VR gaming industry has evolved considerably since the Oculus Rift was introduced in 2012, with new games and platforms being released regularly. Some of the latest advancements in VR include improved graphics, haptic feedback, and more sophisticated tracking systems, which allow for more realistic and immersive gameplay. 

Maintaining profitability with increasingly sophisticated components while cutting costs to compete effectively will be a challenging, but necessary, endeavor. And, of course, breaking out of gaming will be critical for the industry to succeed, too, but there’s little sign of that happening yet. It’s also rumored that Apple will come to market with a headset relatively soon, which will undoubtedly be uniquely Apple and come at a premium price tag. While we think it’ll take a reasonably long time for VR sales to go to the next level — after all, the challenge of packing a powerful computer into a small headset is enormous — we’re excited to see the ongoing investment (even if it’s not all high ROI yet). 

Top Movers

• For the week ending March 3rd, 2023: the average return for gaming companies tracked by Naavik with a market capitalization exceeding $500 million was +1.78%. The S&P 500 returned +1.59% and the Nasdaq-100 returned +1.93%.
• Paradox Interactive enjoyed the biggest gain for the week, as the stock increased by 12.9%. On February 27th, the company announced it would host its first dedicated announcement show, where it will debut new content across its network of studios. Hosted by CEO Frederik Wester, the show will feature reveals for announcements for Crusader Kings and Europa Universalis, along with a few new games as well. The show premiered on YouTube and Twitch on March 6th, and the company also announced a large slew of games coming to Xbox Game Pass. (Link)
• NetEase rose by 9.2% after reports that video game developers in China were considering incorporating AI chatbots into their games. An SCMP article on February 27th reported that NetEase plans on “allowing players to converse with in-game characters” in its game Nishuihan using a built-in chatbot. The company’s education technology subsidiary Youdao may also use AI to grade student’s papers. (Link)
• South Korean stocks including Wemade, Pearl Abyss, Netmarble, and NCSoft were notable losers for the week. The Korean benchmark increased marginally and there were no notable earnings releases for gaming companies in the region. 

Most Notable Strategic Investments

• Vindex was acquired by Savvy Games Group (SGG) subsidiary ESL FACEIT Group for an undisclosed sum. SGG is owned by Saudi Arabia’s Public Investment Fund, which has over $600 billion in assets. This deal is part of SGG’s updated investment strategy, which involves allocating $38 billion for a number of investments across gaming and esports. This deal adds esports infrastructure to ESL FACEIT’s tournament production capabilities, as the entity is by far the largest esports company in the world. (Link)
• Microsoft’s $68.7 billion purchase of Activision Blizzard is likely to win EU approval. According to Reuters and citing people familiar with the matter, the European Commission may not even require concessions from Microsoft, after it inked licensing deals with Nintendo and Nvidia to bring Call of Duty to Switch and GeForce Now. The Commission is scheduled to issue its ruling by April 25th. Approval in the U.S. will have to wait until August at the earliest, which is when the FTC has its evidentiary hearing scheduled. Shares of ATVI rose by 3.4% on the week to $79.39, their highest level since last August, but still 16% shy of the $95 per-share acquisition price. Winning over the U.K.’s CMA should be the final major hurdle. (Link)
• Decentralized virtual worlds platform The Sandbox acquired German game developer Sviper, as part of the company’s expansion into Germany. Sviper specializes in free-to-play mobile games and currently has one active title, a real-time strategy game called Super Spell Heroes on Android and iOS. The terms of the deal were kept private. (Link)

Most Notable Venture Financings

• Avalon raised $13 million in seed funding to build a platform to foster interoperability between gaming worlds. The company was founded by veteran game developers who worked on World of Warcraft, Call of Duty, and Assassins Creed. CEO Sean Pinnock said in an interview with GamesBeat that Avalon would build worlds of its own while enabling other creators to “build worlds in its universe.” According to the company’s website, the studio has 25 employees with headquarters in Orlando, Florida. (Link)
• 3D asset visualization firm Hexa closed a $20.5 million Series A funding round led by Point72 Ventures, Samurai Incubate, Sarona Partners, and HTC. Hexa’s technology is used to create 3D models from 2D images that users upload to the platform. These models can then be interacted with and viewed from multiple angles. Hexa’s primary business is 3D commerce, and the company aims to become the leader in both the online and offline retail experience. (Link)
• Sequoia India invested in 12 startups in the region, as part of the eighth cohort of its accelerator program Surge. One of these startups was Altword, an Indian gaming platform where users create and participate in 3D multiplayer experiences. Another was Bifrost, a platform that uses generative AI to create 3D environments for gaming and simulation purposes. (Link)

Other News

• Yosuke Matsuda stepped down as president and CEO of Japanese gaming giant Square Enix after 10 years in the role. This move follows another tough quarter for the company, which sold off all its Western studios last year to focus on blockchain gaming and NFTs. This move was not seen favorably by many gamers, who lamented the lack of focus on core franchises like Final Fantasy and Kingdom Hearts. Square Enix’s Chief Strategy Officer, Takashi Kiryu, will replace Matsuda starting this June. (Link)
• Axie Infinity developer Sky Mavis aims to be “more aggressive” this year despite a challenging 2022. In a panel with Bloomberg, co-founder Aleksander Larsen said he wanted to create more tokens while grappling with Apple’s restrictions on crypto assets. For reference, Axie currently has two tokens, AXS and SLP, each of which fell 82% in price in 2022. (Link)
• According to Ampere, global console spending fell by 7.8% year over year to $56.2 billion. This was driven by a 9.3% decline in console game revenue, which was pared by a 5.6% increase in games services spending. In terms of individual console manufacturers, Sony led the pack with 45% market share, while Nintendo and Microsoft were roughly tied with 27.7% and 27.3%,  respectively. The gap between Sony and Microsoft is slated to grow during the first six months of 2023. (Link)
• Meta’s VR battle royale shooter Population: One is going free-to-play starting March 9th. Meta acquired the title in June 2021, and it currently retails for $30 on the Quest Store. Owners of Population: One who purchased the game will be compensated with a handful of cosmetic items. (Link)

A big thanks to Mario Stefanidis, CFA for writing this update! If Naavik can be of help as you build or fund games, please reach out.