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Top Trends in Video Games For 2023 and Beyond

What trends have you seen in the video game market over the past few years?

The video game software market grew at a strong clip during the pandemic due to an abundance of free time and disposable income (via stimulus checks) for consumers. But as lockdowns and stimulus ended, growth slowed dramatically. Taking a closer look, we believe stagnating demand alone does not explain recent declines. Apple’s privacy policy changes weighed on mobile publishers’ ability to acquire users profitably and were a significant headwind to the mobile market. Major market players Sony and Microsoft recently released new consoles and supply chain issues made it difficult for consumers to purchase them, and new premium game releases have been limited with many publishers delaying or canceling new games. The bar for launching games is high especially when developing for next-generation consoles and the work is collaborative, so lockdowns were not favorable for premium game development. We are optimistic this situation will improve as they return to the office.

Has inflation and the current macro environment impacted consumers’ willingness to spend on video games?

Video games have historically been resilient during recessions due to their low cost per hour of entertainment, but now a significant portion of games are free to play. This allows users to continue playing their favorite games and delay spending during times of economic uncertainty. We believe franchises that maintain engagement during this period will be rewarded when consumers’ willingness to spend returns. To that end, it’s encouraging to see several publishers highlighting strong engagement for their top games.

On the premium (console/PC) side, niche games with strong reviews were squeezed out by blockbusters, both new and old (at discounts), during the 2022 holiday season. This indicates that inflation and a weaker economy are influencing gamers’ willingness to spend, but truly great content with mass appeal will be rewarded even in difficult economic times.

Shifting gears to the publishing side — what makes a company successful in this industry?

The simple answer is creating great games that generate strong returns on investment. Like the rest of media, content is king, but that's easier said than done. It takes years to develop hit games, significant marketing budgets to launch them and an ongoing stream of new content to keep players engaged post-release. This requires top-tier creative teams, existing franchises with strong brand awareness and robust marketing capabilities. Flops are an inevitable part of the business and strong balance sheets and diversified content portfolios enable studios to take the necessary creative risk to produce hits. A management team with expertise in managing creative talent, a long-term time horizon and vision for the industry is important as well.

Current holding Take-Two Interactive is a business we believe possesses many of these qualities. They have the necessary franchise content, including Grand Theft Auto, Red Dead Redemption and NBA 2K, to be successful long term, a strong management team and added industry-leading mobile capabilities and significant scale with their acquisition of Zynga. We think they may have overpaid in the transaction, but the premium will be worthwhile if Take Two can successfully leverage Zynga’s creative talent and marketing capabilities to grow the reach and engagement of its premium franchises via the mobile market — the largest and fastest growing segment of video games.

Looking ahead, what trends are you seeing in the video game industry?

We’ve seen a lot of headlines and hype around metaverses, AI and subscriptions lately. The metaverse concept will likely gain traction in the future, but the technological capabilities and infrastructure needed to provide a sufficiently immersive experience are still far off. AI is also a meaningful development for the industry. We don't think it replaces game developers, but it should allow them to work more efficiently and spend more time on the more creative aspects of games, which should ultimately provide a richer experience for players. The success of Xbox’s Game Pass is encouraging for subscriptions, but we find the value proposition less compelling relative to video and music bundles. For example, the average Netflix user may watch five to 10 titles a month while the average gamer may not play that many titles in a year.

Finally, there is intense competition across the entertainment industry for consumers’ limited leisure time, and as the most immersive form of entertainment, video games are positioned favorably in this environment. We see a similar winner-take-most dynamic emerging within the segment as gamers play the same titles for longer. Switching costs have increased relative to video games’ analog days, driven by social connections, voluntary in-game spends to maximize experiences in free-to-play titles and an increased learning curve to master more complex games. As a result, blockbuster franchises are well-positioned to earn their fair share of players’ leisure time and grow intrinsic value long term.

As of 30 April 2023, Diamond Hill owned shares of Microsoft Corp and Take-Two Interactive Software Inc.

The views expressed are those of Diamond Hill as of June 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

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