Chinese video game firms will vie for World dominance

The global video games market is growing rapidly, driven by online/mobile games. China has produced some of the world's best games companies, which are now looking to international markets for additional growth. This offers a significant opportunity, but investing internationally isn't as simple as they might hope. To explain why, let's start by looking at the global market.

Asia is the place to be

The video games industry is big, getting bigger and changing, rivaling Hollywood in 2009 - $77 billion (58 billion euros) video games versus $85 billion film global revenue. Online and mobile games should grow total video games market size to $87 billion in the next five years, and take 50 percent revenue share at $44 billion. The historically strong pure console sector will be flat to down.

The Asia-Pacific and Europe should take 90 percent revenue share for online and mobile games (with China 49 percent, Europe 17 percent, Japan 14 percent and South Korea 11 percent). While North America remains important, the dominant market for online and mobile games is and will be China. If you want to be in online and mobile games and if you aren't in China, then you aren't anywhere.

Complex and fragmented market

There are different sub-sectors within the video games market. These include casual online (simple single player online games on online casual games platforms, for example Spil Games), browser-based Massively Multiplayer Online or "MMO" (thousands of simultaneous online player games on browser-based online MMO platforms, for example Bigpoint), social online (multiplayer online games on social platforms like Facebook, for example Zynga), iPhone/iPad and other smartphones/tablets (mobile casual, social and web-based MMO games on smartphones/tablets, for example Rovio), online/smartphone/tablet middleware (technology for online/smartphone/tablet games using a Software as a Service or "SaaS" B2B business model, for example Live Gamer), online skill-based gaming (online gambling based on skill, not chance, with thousands of simultaneous online players, for example King.com), pure console (retail/digital download console games on PS3, XBox360 or Wii, for example Electronic Arts), retail MMO (thousands of simultaneous online player games on PC/Console via retail or digital download, for example Activision Blizzard) and online gambling (online versions of offline gambling on PCs or smartphones, for example Betfair).

Video game consumer markets are also becoming increasingly fragmented. For example, Wii grew the Casual Console market (more than 60 million Wii units sold), Apple grew the Casual/Social Mobile market (more than 3 billion Apps sold), World of Warcraft grew the Hardcore Online market (more than 12 million subscribers), Zynga, Spil, Playfish and Yahoo! grew the Casual/Social Web market (more than 200 million players), King.com grew the Casual Skill Web market (more than 20 million players), Bigpoint bridged the Casual to Hardcore browser market (web delivery, PS2 quality, no downloads), and Onlive hopes to expand Casual to Hardcore markets across TV and web (digital delivery, no console, PS3 quality).

High revenue growth, high profit

While fragmented, these markets are delivering a rare combination of high revenue growth and profitability. The best online/mobile games companies are growing revenue of more than 100 percent annually while also generating 20-50 percent operating profit margins. They are using a combination of one-off purchases, subscriptions, in-game items (micro-transactions), rake of user bets and advertising, with prices for online/mobile games, in-game items and subscriptions range from 99 cents to $14.99.

Operating successfully in these markets requires specific skills and approaches: Multiple, parallel game development business platforms (not "one game" hit driven companies), multiple distributors (not just Facebook), rapid, low-cost game development and continuous daily redevelopment cycles for rapid market response, and fast failure (rapidly cut commercial losers and back commercial winners).

The Chinese advantage

Chinese companies have significant advantages in these markets. With 29 percent Internet penetration, but 382 million users, China is forecast to reach 56 percent Internet penetration (754 million users) by 2015. The scale, growth and profitability of Chinese games companies is something international firms can only dream about.

For example, Tencent is one of China's leading games companies. It holds dominant or leading stakes in many Chinese online/mobile markets (IM, games, eCommerce, search, mobile services). Tencent's Chinese games market share was 20 percent in 2009 with a forecast of 27 percent by 2012. Tencent's market cap was greater than Activision Blizzard, Electronic Arts, GamesStop, Take2, THQ, Atari, Game Group and Ubisoft combined.

Of particular importance, Tencent has an integrated business model with upgrades/privileges across online, mobile and offline (not just games), delivering a significant advantage for customer acquisition, development and retention. It capitalizes on enhanced capabilities to cross-promote, upsell and cross-sell. Facebook could learn a lot from Tencent about how to make even more money.

Gap in online/mobile market

Yet there is a gap in the online/mobile games investment market.

Major console publishers are struggling to invest in online/mobile games. They are focused on existing large console games franchises, as the console games market is flat to down, with declining profitability. Major publishers' core competencies focus on management of more than $20 million serial, high risk, complex developments, launches and commercialization, while online/mobile games require rapid, multiple, small-scale parallel development platform investments, completely different to major publishers' business cultures. So major publishers are not driving online/mobile games investment as they did in the console games sector. The CEOs of major global console publishers are wary of large-scale online/mobile video games M&A in early stage, fragmented markets where market dominance is not yet clear.

In parallel, generalist VC video games investment has also declined. Despite rapid market growth, VC investment across video games in 2009 had dropped by 60 percent from its high point in 2007 due to general VC market weakness and limited knowledge and relationships across complex, fast-moving online/mobile games sectors. VC investment is not maximizing growth during the critical stage before industry consolidation. Quality investment demand exceeds supply, with high-quality, high-growth online/mobile games companies struggling to find investment. This is happening despite major publisher/media online/mobile games consolidation deals.

Filling the online/mobile gap

I am currently looking at ways to fill the investment gap with an online/mobile games growth capital fund, investing in quality online/mobile video games companies that are already delivering 50-100 percent annual revenue growth, 20-30 percent operating margins or potential and more than $10 million revenue. The most interesting companies from an investment standpoint have domestic strength with East/West ambitions (China to Europe/US or Europe/US to China), strong management teams, intellectual property and commercial track records with clear exit strategies, and a specific sector focus on casual/social online, iPhone/iPad, other smartphone/tablet, browser-based MMO and online/smartphone/tablet middleware. My view is that you need a clear investment strategy to manage risk and optimize returns, so focusing on investing $10 million on average per investment with a focus on for growth capital investment returns.

There is significant demand from quality online/mobile games companies in both Chinese and international markets for growth capital investment in working capital (debt convertible into equity via convertible loan notes), pure equity capital and equity capital plus bank debt. However, you need the knowledge, relationships and ideas to focus on companies with clear exit paths via trade sale to strategic video game and media corporates as the market consolidates, or with IPO potential depending on market conditions.

International opportunities

I have also seen an almost universal desire to leverage Chinese strength into international markets. These are the broad themes for Chinese companies and investors to invest and grow internationally:

Major Chinese video games companies: (1) invest in online/mobile games fund (2) invest in, partner and acquire international online/mobile games companies, but (3) avoid large, value destroying acquisitions

Independent Chinese video games companies: (1) exit to major international games / media / private equity company (2) license successful Chinese IP internationally (3) license successful international IP for China domestically (4) invest organically, raise funding or partner with major video game/media company to build an international subsidiary or (5) provide high quality, efficient outsourcing services to international companies

Chinese institutional investors: invest in online/mobile games fund

Chinese venture capital/private equity firms: co-invest with online/mobile games fund for specialist knowledge, relationships and ideas

Chinese technology, media and telecommunications companies: (1) invest in online/mobile games fund (2) joint venture with international major/ independent video games companies for domestically licensed game marketing/ investment or (3) make strategic international investments to build capability and leverage domestic Chinese platforms.

The author is managing director of investment bank Digi-Capital.