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Is in-game advertising really the great white hope for subsidizing games development? In the latest report from DFC Intelligence, the analysts address underlying problems of mass market versus enthusiast audiences, professing cautious optimism on advertising's impact as the industry moves forward.

The full text of the report, released on the analyst firm's website, follows below:

"DFC Intelligence has been known for being conservative when it comes to forecasting industry growth. One compliant we hear is that we are not bullish enough on our forecasts. Our philosophy is that when making a business plan it is easy to run-off of hockey stick growth numbers. However, prudent investing should entail realistic forecasting that leans on the cautious side. Furthermore, our experience has shown that when DFC and others have been aggressive about forecasting rapid growth for a market is has inevitably lead to over speculation and disappointment.

Considering our forecasting philosophy, it was difficult last fall when we released our forecasts for the video game market in 2007. Last fall we forecasted that in 2007 the video game market would experience over 30% growth and could reach record worldwide revenues of $42 billion. From our standpoint, we were concerned that DFC Intelligence was becoming another reckless market promoter leading potential investors onto the hype bandwagon.

It is still too early in the year to say how things will turn out for 2007. October, November and December generally see progressively higher sales and historically it is unreliable to try and project fourth quarter sales based on the first six or even nine months of the year. However, we can say that going into the fourth quarter of 2007 we feel a whole lot more confident about our $42 billion forecast.

In January 2008, it looks like there will be all kinds of big numbers from 2007 for companies to throw in press releases. Of course, this is exactly the time that our cautionary side comes into play. Big numbers are meaningless unless you take a close look at where growth is occurring. In 2007, a huge chunk of revenue is coming from hardware sales. That means some of the growth is deceiving. Yes, hardware sales mean future software sales to the installed base. However, for software developers, hardware sales revenue is not he most important metric, instead it is unit sales and installed base. A game system that sells 1 million units at $100 can be just as strong a platform for software as a system that sells 1 million units at $500. However, the $500 system will add five times as much revenue to the overall industry figures.

The other big issue in the game market is the continued strength of portable platforms and online games. In many cases, this growth represents potential new revenue and business model opportunities for developers. However, in these cases it is very important to have a detailed understanding of these opportunities. One big example is the potential revenue growth from the increasing number of console systems that are going online.

DFC Intelligence recently released its latest detailed forecasts for console online game revenue. We broke our forecasts down by region of the world (North America, Europe, Japan and East Asia), game genre (MMOG, casual, FPS etc), consumer type and business model of which the primary ones were digital distribution, subscriptions and advertising. When it comes to console online game revenue we feel we were fairly bullish about growth on all fronts. However, one area where we got complaints about being overly cautious was on advertising on console game systems.

For the record we forecasted that console game advertising would grow 250% from 2007 to 2012. This would seem like strong growth, but it is an order of magnitude lower than what some people are expecting (?praying for?). However, we have several reasons for being on the cautious side in our forecasts.

The first issue to note is that consoles are just starting to get connected online. In today's market it is often assumed that anyone buying a PC will have an online connection. In fact, without an online connection, many consumers would be reduced to using their PC as a paperweight. This is clearly not the case with console systems. An online connection is not necessary to enjoy the bulk of what a video game platform can offer. Furthermore, the ideal setup for connecting a game system is to have a home PC network, preferably with Wi-Fi access. This is becoming increasingly common, but still only reaches a subset of console owners.

Of course, more consumers are connecting their consoles online and this is why DFC Intelligence feels online game revenue is going to experience strong growth. However, it is important to understand that this is more of a steady increase, not an overnight revolution. For the early lifespan of the Xbox 360, Microsoft reported that over 50% of initial purchasers connected online to Xbox Live. That sounds pretty impressive considering that the original Xbox system only had about 10% of members subscribing to Xbox Live.

However, looking in detail at the numbers raises some issues. For one, with the original Xbox, going online required buying a subscription. Going online with the Xbox 360 is free with the Silver level. The other thing to consider is that Microsoft specifically targeted the heavy online user and promoted Xbox Live as a key feature of the Xbox 360. Considering these factors, having 50% of the bleeding edge early adopter consumer go online is not that impressive. Furthermore, it is not really a figure that can be extrapolated out into the world at large.

DFC Intelligence also tries to account for game genres and consumer type in its forecast. Under this analysis we argue that subscription and digital distribution business models provide some of the biggest benefits for the consumers and games that are going online via console systems. The benefit of advertising is still somewhat unclear in our mind.

The console gamers that are going online in these still relatively early days tend to be significantly more weighted towards what we call "hard-core gamers." These are gamers that spend much more time and money on games than the average user. Advertising is all about collecting a whole bunch of eyeballs in a certain demographic and being able to target them with the appropriate message. Much of the focus on future advertising in video games is clearly looking at the mass market video game consumer. However, the reality of who will be online to receive advertising in the near term is much different. The opportunity in the next few years for console systems is more likely to be the hard-core or enthusiast gamer that has a very different profile than the market as a whole.

Of course, advertising to an enthusiast audience can be very profitable. This is especially true when you have an enthusiast audience as large as the hard-core video game population. However, there are some issues specific to advertising in games that will need to be addressed. First and foremost is that, for a hard-core gamer, advertising can be very intrusive. As famed industry game developer David Perry said in a recent interview in the DFC Dossier, when his company did a survey of gamers to ask if there was a way they could turn off advertising in games would they do so, the answer was 100% yes.

The big concern is that advertising is generally a way to subsidize a product for consumers. Television and radio are obviously the best examples. The game industry has been one of the few products to not be supported by advertising. However, the general media trend is having advertising support the mass market while the enthusiast user pays to avoid advertising. A big attraction of pay cable and satellite radio services like XM is, by paying a subscription, users can avoid advertising. Among the PC game services there is a similar trend where heavy users can pay a monthly subscription fee and play their games free of advertising.

That brings us to our final point. When looking at the opportunity for console online game advertising it is critical to look at the already established advertising business model for PC games. Advertising has supposed many free PC games. However, most of these have tended to be casual games, not the expensive massively multiplayer and first-person shooter games that attract an enthusiast user. Sites like Electronic Arts' Pogo.com have established user bases numbering in the tens of millions. This is more than the entire universe of video game systems connected online. However, in recent years, EA has talked less about the growth of advertising revenue. In terms of online growth opportunities, EA's fiscal 2007 10k talks mainly about MMOGs, subscriptions to online casual games, micro-transactions and the ability to sell digital content online. When it comes to advertising the statement in the 10k is limited to "we derive revenue from advertising in our games and on our websites."

Online advertising revenue from Pogo.com and other EA sites is no longer reported separately, but instead included as a line item as part of "Licensing, Advertising and Other" in EA's financials. For fiscal 2007, Electronic Arts reported that revenue from Licensing, Advertising and Other was down 6% to $57 million.

These are some of the reasons that DFC Intelligence has been much more bullish on the growth for subscription revenue and digital distribution revenue than we have on advertising revenue. However, we also stress that we do think advertising revenue will grow. Products like PlayStation Home provide a potentially attractive environment for advertising. It is just that many of these products are simply what the PC business has been doing for years. Advertising is in large part a numbers game and there seems to be no way that console systems will have the aggregate numbers of the PC in the next five years."

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