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#1: Sony’s Console Dominance Over Microsoft Grows Further

Sony reported FY 2022 and Q4 earnings On April 28th showing the Japanese technology conglomerate furthering its lead in the gaming business. Revenue and operating profit beat both the company’s guidance and analyst expectations, in part fueled by a surge in PlayStation 5 sales. Quarterly revenue of ¥3.06 trillion ($22.7 billion) exceeded analyst consensus by 3%, while operating profit of ¥128.5 billion ($950 million) also beat by 3%. Revenue grew by 35% from a year prior, hitting an all-time quarterly record, while operating profit for the year was also a record. 

In terms of FY 2023, which ends March 31st, 2024, Sony issued an outlook that was below estimates. The company projected a 3.2% decline in profits, which it attributed to a slower recovery than projected in console sales. But Jefferies TMT analyst Atul Goyal called this guidance “overly conservative,” as Sony has shown little weakness in this business since the supply shortage abated. In a press briefing issued along with the results, Sony President Hiroki Totoki stated that the console could be delivered “anywhere in the world without keeping [Sony] customers waiting.”

In addition, the supplemental information for 4Q disclosed the breakdown for various metrics in the gaming unit. PlayStation Plus subscribers have remained flat for eight quarters in a row, despite the surge in hardware sales. In FY21 Q1, the service had 46.3 million subscribers, while in the latest quarter FY22 Q4, it had 47.4 million. The subscriber count has remained rangebound over this period, peaking at 48.0 million in FY21 Q3 and troughing at 45.4 million in FY22 Q2. Monthly active users have followed a similar trend, growing from 105 million to 108 million over this two-year period. 

Revenue from consoles grew 91% year-over-year, while game software, which includes physical software, digital software, and add-on content, only grew by 10%. Sony has been successful in satisfying PS5 demand and nearly doubling console revenue in one year, but has lagged badly on the software side, as users find its offerings less captivating than Xbox and Switch.

The impact of foreign exchange continued to be a tailwind for Sony, which has benefited from a historically weak yen. For the entire fiscal year, sales increased by 16% to ¥11.5 trillion, but only 4% on a constant currency basis. In addition to gaming, the company benefited from strong sales in its Imaging & Sensing Solutions segment, which provides a range of image sensors for various optical technologies. The Music and Pictures segments also grew, as the industries continued their post-Covid rebound. 

The company expects to sell 25 million PS5s in this fiscal year, up 5.9 million units from FY 2023 and more than double the 11.5 million units it sold during FY 2021. Regardless of how conservative Sony’s outlook is going forward, it is clear that the PlayStation 5 has trounced the Xbox Series X/S in global sales since the consoles were released in November 2020. This is a continuation of Sony’s dominance during the eighth generation of consoles, which it entered in 2013 with the critically acclaimed PS4, the second best-selling home console of all time (behind Sony’s own PS2).

Microsoft doesn’t report hardware sales for its Xbox line, making an exact comparison impossible. Japanese companies like Sony tend to be more granular in their disclosures. Regardless, it is not much of an “open secret” that Sony enjoys a massive lead over Microsoft. According to market research firm Ampere Analysis, the PS5 install base at the end of 2022 was 30 million, versus Series X/S installs of 18.5 million. 

Sony’s market share between 2021 and 2022 contracted by 130 bps, most likely owing to the supply shortage situation. While both console families were constrained in 2021, the PS5 was in even shorter supply, and scalpers were asking close to $2,000 for the console. Almost all of its “contraction” in share is likely due to Xbox fans finally getting their hands on their device in 2022, as additional supply came online at an earlier date.

Sony’s massive lead in market share is not a new phenomenon. In a recent interview with the Kinda Funny podcast, Xbox Games Studios CEO Phil Spencer reflected on his company’s underperformance with the Xbox One, stating that it was the “worst generation to lose.” Microsoft admitted last year that the PS4 outsold the Xbox One by more than double, another “open secret” that didn’t require unit sales disclosures to figure out.

Why was the last generation so crucial in the console wars? It sounds puzzling, given that Sony and Microsoft have been at it since the launch of the original Xbox in 2001. But the eighth generation was the first to be internet enabled from the onset, not requiring a $100 wireless adapter like the Xbox 360. Bandwidth speeds were also significantly improved between 2005 and 2013, and latency went from a serious problem to an afterthought. This ushered in the disc-less era of digital distribution, and allowed for video games to adopt live service models via regular updates pushed out over the internet.

This period led to a buildup in gamer’s libraries across their console of choice. It even led to a resurgence in PC gaming, as digital distribution services like Steam garnered loyalty. Gamers stuck with their chosen platform in the eighth generation as they built their friends lists, gained achievements/trophies, and generally became entrenched in the ecosystem. It would be rare for a PS4 loyalist to then opt not to buy the new PS5 and instead purchase a Series X a decade later, and lose out on all of his or her accrued progress. This network effect carried forward to the ninth generation and will almost certainly persist in the console-less future where gaming services are paramount.

None of this is news to Microsoft — these points were all noted by Spencer in the 41-minute-long podcast. He went on to say that Xbox could lose out on the unit sale race but still come ahead due to software offerings. This is precisely why the Activision Blizzard acquisition is so important to Microsoft’s product strategy. Adding hundreds of exclusive titles across several fan favorite franchises would make the Xbox first-party lineup more desirable than Sony’s overnight. Up until this point, Microsoft has also come in second place in the gaming race.

During Sony’s petition in front of the U.K.’s CMA last November, the company pointed to the below statistics showcasing Xbox Game Pass’ 60% share of Western games content consumer spend. On paper it looks like Game Pass has a massive lead over not just PlayStation Now, but every other service it competes against. But this is due to the different models that Sony and Microsoft employ as it relates to services. PlayStation Now was more similar to Xbox Live Gold, in that it gave gamers access to the online service with a nominal amount of games. PlayStation Plus, which was launched in 2010, only began to resemble Games Pass in June 2022, when Sony merged all of its live services under the Plus moniker. 

The modern inception of Xbox Game Pass on the other hand was in June 2019, three years before PlayStation, when Game Pass and Xbox Live Gold merged into a single service. With Sony’s formidable catalog of exclusives that includes franchises like God of War, Horizon, and Uncharted, to name a few, and a pricing model rivaling its competitor, PlayStation Plus should rapidly begin to gain share. 

A Sony that is successfully executing on both the hardware and software fronts would be a huge blow to Microsoft’s fast-growing $16.2 billion gaming segment (based on FY 2022 revenue). Gaming only grew by 6% in FY 2022 due to challenging comparables, but has grown a staggering 40% since 2020. Microsoft is incentivized to keep fighting for Activision Blizzard, even if it is overpaying relative to January 2022 valuations, while Sony is battling for dominance in gaming against Microsoft.

Sony’s thus far successful challenge of the Activision Blizzard acquisition is not about giving Sony a “fighting chance” in gaming, but rather having it maintain its lead. Its retaliatory purchase of Bungie weeks after Microsoft’s announcement last January was geared at getting more first-party exclusives while not being subject to intense regulatory scrutiny due to the smaller nature of the deal. Regardless of whether Activision Blizzard becomes a part of Microsoft or not, we can expect smaller publishers and developers to remain targets for the largest video game companies. Regulators would have a difficult time claiming acquisitions in the sub-$5 billion range are anticompetitive, given the countless names that have been scooped up in the industry since 2015. 

#2: Kakao Prepares to Bolster its Mobile Business

Kakao Games, the gaming unit of South Korean internet company Kakao, reported FY Q1 2023 on May 3rd. Revenue increased 6% sequentially to ₩249.2 billion ($190 million) but decreased 6% year-over-year, driven by underperformance of legacy mobile titles. Operating profit was ₩11.3 billion, up 26% sequentially but down 73% from a year prior. This decline was due to a handful of factors, including increased marketing costs for new titles on the expenses side, and a sharp fall in mobile performance on the revenue side.

The non-mobile and PC business (labeled as Others) includes two primary ventures. The first is Kakao VX, a subsidiary that provides a host of golf services integrated with technology. This unit was created in 2017 when Kakao purchased Maum Golf, South Korea’s second largest supplier of golf simulators and sensors. Sales growth for Kakao VX was “muted” in the quarter. Note that Korean regulators began a probe into the business in April, claiming that its golf record management program that it launched in 2021 infringes on a patent from a smaller business.

The other part of this segment is Sena Technology, a wireless communication equipment company. Kakao acquired a majority stake in this business in 2021 for ₩95.2 billion. Sena manufactures peripherals, helmets, and other devices integrated with Bluetooth for motorcyclists and cyclists. In the near future, Kakao plans on having Sena create devices for golfers to cross over with Kakao VX. The earnings release stated that Sena’s overseas revenue expanded this quarter, but like with the other unit, a more detailed breakdown was not furnished.

Gaming is Kakao’s core business, comprising 67% of the overall top line in Q1 2023. Almost all of this is from mobile, with a single digit percentage of revenue coming from PC. Prior to 2021, Kakao Games had the publishing rights to Black Desert Online (BDO), a popular fantasy MMORPG developed by Pearl Abyss with a large PC following. The expiry of the publishing license led to Pearl Abyss retaking publishing rights, an event that was well telegraphed but still represented a blow to Kakao’s earnings.

Kakao tried to recapture this loss by inking a publishing deal in December 2021 for ArcheAge, a sandbox MMORPG developed by XL Games. This deal includes publishing rights in the NA and EU regions, with the developer retaining the rights in its native South Korea. Since its launch in 2014 the game has not been particularly well received, holding a 3.7 user score on Metacritic and 52% positive on Steam. BDO’s popularity has waned in recent years, but the game still has around 380,000 daily active players, according to MMO Stats. On the other hand, the player base for ArcheAge has plunged, with just 8,400 daily players among the game’s 2 million registered users.

Now onto mobile, which is responsible for nearly two thirds of the publisher’s revenue. Kakao has published dozens of games, primarily focusing on Android and almost exclusively on the domestic market. Odin: Valhalla Rising is the company’s primary breadwinner, responsible for approximately 62% of Kakao’s worldwide in-app purchase revenue over the last two years. The game is an open world MMORPG set in Nordic mythology. Players can choose between eight customizable different classes, and can participate in co-op and PvP like a traditional MMO. In recent months Odin has brought in about $20 - 30 million in monthly revenue, down from its launch months from July to October 2021 where it consistently netted over $50 million. 

The game’s success in recent times has moderated, but has remained remarkably consistent since its peak in late 2021. Odin’s performance is still enough to move the needle for Kakao’s overall revenue, as was the case this quarter after Kakao delayed the game’s launch in Japan from Q1 2023 to June. The game is also slated to launch in North America and Europe in Q4 this year, which should provide a tailwind to revenue, especially if its frontloaded launch in Korea two years ago is any guide. This should set up Kakao for a favorable FY 2023 as mobile laps its comparison from 2022.

Newer mobile games such as Eversoul and ArcheAge War (mobile spin-off of ArcheAge) continue to scale, and it is too early to gauge their success. But Kakao is mindful of its reliance on a hit title, and has a robust pipeline of new releases through 2023, and numerous unannounced ones in 2024 and beyond. These span multiple genres and also include the company’s first blockchain games. 

The stock of Kakao Games has fluctuated along with its plans for Odin developer Lionheart Studio, which is majority owned by Kakao. The company kept accumulating shares through 2022 in preparation for a Lionheart IPO, amassing a roughly 55% stake while CEO Kim Jae-young owns about 35%. Reports indicated that Lionheart’s valuation could exceed ₩4 trillion ($3.1 billion), but in October 2022, Kakao pulled the plug on the IPO and in turn caused shares to surge. Investors were concerned that Kakao would not be able to operate without Lionheart, given just how much revenue Odin still comprises. 

The overhang over Lionheart’s future continues to weigh on shares. While diversifying revenue is important for the sustainability of the business, it may also lead investors to think an IPO is on the cards again. The best bet for Kakao at this point is to utilize the recurring revenue from Odin to fund its other projects, while allowing the game’s sales to naturally tail off. A one-time windfall from an IPO may appeal to executives but does not appear to be the right outcome for shareholders. 

Top Movers

• For the week ending May 5th, 2023: the average return for gaming companies tracked by Naavik with a market capitalization exceeding $500 million was flat. The S&P 500 returned -0.8% and the Nasdaq-100 returned 0.1%.
• Markets ended the week more or less flat, after falling Wednesday during Chairman Powell’s hawkish press conference following the FOMC’s anticipated 25 bp rate hike. This was paired by a late week rally driven by positive earnings for Apple and robust labor market statistics. 
• Keywords Studios was the only notable performer of the week, falling -18.5% after reporting FY 2022 results. Revenue for the year grew 35% as reported and 22% organically, accelerating from 2021’s 19% organic growth. Investors may be concerned with the company’s operating margin compression from 16.8% to 16.2%, which includes a ~2.5% FX headwind that would have depressed margins even further. This was due to the closing of operations in Russia as well as a “post-COVID” impact. Capex rose by 39%, outpacing revenue growth as Keywords invested heavily in PP&E.

Most Notable Strategic Investments

• Astragon Entertainment, a division of British video game developer Team17, acquired development studio Independent Arts Software for an undisclosed sum. The studio was founded in Germany in 1990 and has helped produce over 250 titles across PC, iOS, and Android. Independent Arts is active in developing ports and will help Astragon bring current owned IP to new platforms while accelerating future new IP. The acquisition will be funded by cash and is not expected to impact Team 17’s revenue or adjusted EBITDA in the current fiscal year. The deal is a milestone for Astragon, as it is the division’s first wholly owned studio subsidiary. (Link)

Most Notable Venture Financings

• Turkish mobile gaming studio Frantic Games raised $2.4 million in pre-seed funding. The studio, which was founded just six months ago last November, will specialize in hybrid casual titles, starting with an action shooter featuring driving mechanics. Frantic currently has six employees, all with seven or more years of experience in the sector, and plans on doubling the team’s size to twelve. This funding round is the latest in a series of investments into Turkish mobile gaming startups this year. According to VentureBeat, there are currently more than 520 game studios in the country. (Link)
• WePlay Ventures launched a new accelerator program for European gaming companies called WePlay Hub. The Turkish gaming VC claims that the accelerator is the largest of its kind in Europe. During the three-month program, accepted studios will be trained on disciplines like finance and business development, and technical areas such as game design, development, and art. WePlay will also make physical workplaces available in 13 countries across Europe and Central Asia. The VC started its investment activities in 2020 as Turkey’s first gaming industry-focused investment fund. (Link)

Other News

• Two highly anticipated video games — Star Wars Jedi: Survivor and Redfall — had issues at launch.

• Star Wars Jedi: Survivor released on April 28th on PS5, Xbox Series X/S, and Microsoft Windows. The game is developed by Respawn Entertainment and published by EA. While the console version of the game received favorable reviews, the PC port had severe performance problems. Many players, even those on the highest end machines, are running the game at less than 30 frames per second, and are met with frequent crashes. Some are also unable to launch the game past the EA launcher. (Link)
• Microsoft exclusive Redfall launched on Xbox and Windows on May 2nd. The game was developed by Arkane Austin and published by Bethesda Softworks, both subsidiaries of Zenimax and ultimately Microsoft. All versions of the game were met with mixed to negative reviews, as gamers criticized everything from the story to game mechanics like pathing and gunplay. Many also experience performance issues for the PC version. Phil Spencer personally apologized for the launch, saying that they “let a lot of people down.” (Link)
• The Super Mario Bros. Movie crossed $1 billion worldwide at the box office and $500 million domestically. This puts the film ahead of Toy Story 4 as the fifth highest grossing animated movie of all time. After a successful theatrical run, the movie will be available on VOD streaming beginning on May 16th, starting with Optimum On Demand. (Link)
• Meta is hosting their third annual Quest Gaming Showcase on June 1st. According to the company, the event will feature a new pre-show of “games updates and debut trailers,” as well as a post-show developer roundtable. In the press release, the company claims that 2023  will be a “banner year for VR.” (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.