Games Industry and General Business Misconceptions

GameOverThirty

Games industry discussion, especially on the large social forums such as Reddit and Twitter, is often boisterous, with competing opinions and thoughts. This is especially true when it comes to some of the more business-oriented subjects, such as development costs or how a publicly traded company operates. Unfortunately, much of that discussion is baked in misunderstandings & misnomers of how game development, or put more simply, a business, operates.

The internet – Everyone has an MBA. Source: https://weird5cience.tumblr.com/post/6723904145

Why go to all the trouble to write all this out? My original intention was to provide a library of rebuttals to common misunderstandings. While that is still the core intention, it has expanded into something much larger than I originally intended. I have no desire to squelch conversation, or make people feel “bad” about believing something. I view education (and experience) as the key to understanding, basically, anything. The reality of life is often far more complex, and nuanced, than some would have you believe. Many of the topics I will cover here (and later) have a much more complex conversation behind them, but for now, let’s hit the basics.

Misconception #1 – “Lowering executive compensation (at publicly traded AAA game companies) will save jobs during layoffs, or provide more funds for development.”

This misconception comes in many varieties but it’s usually stated as, “Why don’t they lower person X’s salary so they can <insert something here>.” On the surface this makes some kind of sense. Lower a person’s salary and the money can be used elsewhere? Right? The truth is, at a publicly traded company such as Take-Two or EA, reducing executive compensation would do little to nothing in terms of the capital (cash) used to pay employees or fund development. Notice how I used the term compensation? Most executives of public companies are paid with compensation packages that consist mostly of stock value rather than a cash salary. If you look up the data, you’ll find some executives have rather odd salaries (e.g. $1.00). Why is this important? It’s important because awarding someone (or another holding firm) with shares of company stock does not cost the company a direct expense. The person, or holding firm, is being paid in future value rather than cash.

We can use EA’s Andrew Wilson as an example. Wilson does have a base salary around two million per year (approximately), but like most execs of publicly traded companies, the majority of his compensation comes in the form of restricted stock units. Not only does Wilson have to meet certain performance metrics to be awarded those restricted stock units, but how & when he can turn them into cash is regulated as to ensure he isn’t involved with any inside trading. Do I feel “sorry” for Wilson, having to deal with all these restrictions? No, the man is wealthy beyond my dreams. The point I’m making is that reducing his salary to zero and trying to use it to save jobs (or fund development) is a non-starter in an industry where expenses can run between 300 and 700 million per quarter. Two million dollars divided within the entirety of the company amounts to completely inconsequential results . (Speaking of Wilson, he gave up his FY 2018 bonus and had it added to the employee bonus pool specifically, distributed in 2019.) Stepping back to think about it, it makes sense to pay CEOs of publicly traded company in stock rather than company cash. It avoids the exact scenario we are discussing and forces executives to think about the long term health of the company. If they fail to consider the long term health/growth of the company, their stock holdings drop in value.

I am NOT trying to convince anyone that executive compensation packages are “fine”. There is a serious debate to be had, especially in the United States, regarding how much an executive is compensated versus an employee. My summary here is meant to explain how reducing executive compensation will not directly benefit jobs or R&D (in public companies). The debate about comparative compensation is a different topic entirely, one we should continue to pursue. Additionally, there are exceptions to everything. Look hard enough and you will find execs that are over compensated with direct salary. This conversation is not about the exceptions, but instead the norms. If you want to read more on the topic, here are some links that explain the how & why of executive compensation:
A Guide to CEO Compensation
Evaluating Compensation
How Take-Two Awards their Executive Management Group

Misconception #2 – “AAA gaming companies must pursue short term priorities, and mythical infinite growth, at the expense of long term health.”

This “idea” has been prevalent lately. A lot of the YouTube outrage merchants have been pushing the idea that: Publicly traded AAA game companies only have one impossible trajectory – maximizing short term profit until it all comes crashing down…because capitalism. And because of that ideal (short term profit or die), games have slowly been picked apart and resold as micro-transactions because it’s the only way to show growth to investors (since they can’t grow their customer base). Unfortunately, the entire crux of the idea rests on “because capitalism”. I don’t believe YouTubers (and like minded critics) have ill intent, but it does showcase a blatant disregard for how the free market functions, dare I say “capitalism”.

Let’s get this out of the way first: Publicly traded companies are legally bound to act as fiduciaries to their investors. In other words, a company must act with their shareholders in mind but are also given broad authority in how they do that. With that out of the way, let’s talk about investing and what shareholders expect.

A company’s stock can change market value for many reasons but generally speaking, revenue (and thus profit) growth is a primary driver of stock value over time. When I say growth, I am referring to year over year, or quarter over quarter growth. It makes sense that shareholders want to see the value of a stock go up so they can A) sell it for short term profit, B) sell it for long term profit, or C) hold it for influence later. Obviously investors of all types (401k, small value buyers, major owners) want to see the value of their stock rise, thus they choose stocks that they expect will go up in value over some time frame. Some economists even argue that infinite growth is technically feasible! But for today, let’s concentrate on how a game company demonstrates growth.

They can: 1) produce & sell more games, 2) monetize a game or service, 3) reduce costs (reduce wages, reduce R&D, shrink employee base). Therein lies the rub – every single one of those revenue growth options has budgetary AND market risks associated to it. They are not “free growth” and could very well backfire if handled poorly.

Second, to pretend that publicly traded game companies are doing everything in their power to divide games into smaller & “grindier” chunks, and force consumers to pay for it (hooray infinite growth for investors), is to pretend the free market doesn’t exist. The point might hold some water if the game market was a closed system, with only a handful of companies supplying the product, but it clearly isn’t. Developers can only monetize to the point where the market accepts the value proposition (and that’s considering they even want to monetize the product). Deliver a sub-par value proposition and players exit the experience. Look no further than Ubisoft to see a game company that took a risk on expanding their revenue potential in the Ghost Recon franchise. They were too aggressive, created an arguably “bad” product, and the consumer base rejected it. What happened to infinite free growth? It doesn’t exist.

Want to know how hard it is to simply grow in this business? Some of the more vocal “influencers” will tell you that game companies are simply chasing infinite growth, quarter over quarter, and it’s working because…reasons. Here’s the reality of that supposed infinite growth:

Exhibit A – EA Revenue Trend (normal) Over Three Years (in hundreds of thousands ~ 300 = 300,000,000)
EA Revenue Trend Slightly Negative
Source: EA Financial Statements
As you can see, EA’s overall revenue trend for the past three years has been an interesting story. For a company that (apparently) monetizes everything, you would expect their revenue to grow, except that isn’t the reality of the situation. EA is certainly in a sustain phase, even with hits such as Apex Legends & FIFA. (It’s important to note that companies sustaining will still experience stock value fluctuations.) In fact, if you map out the revenue over three years for many of the major publicly traded publishers, they certainly aren’t growing rapidly in terms of revenue (perhaps overall value is a different story).

Simply looking (no advanced degree required) at how publishers have reacted to consumer expectations provides us with clues that the industry is recalculating a lot of strategies in favor of long term growth. With the exception of Ubisoft making a rather big miscalculation with Ghost Recon Breakpoint, all the major publishers have been doubling down on efforts to change how consumers view their products, with monetization strategies clearly undergoing a paradigm shift. When market juggernauts, such as Call of Duty, choose to go with the hidden subscription (aka “battle pass”), and companies start packaging up game services (e.g. Origin Premier), it demonstrates a shift to longer term growth considerations. Read investor transcripts and you might find CEOs are pushing back on investors who are asking for short term growth. EA’s Andrew Wilson was asked (essentially) why another Battlefield game wasn’t being set for release soon. He responded:

Source: EA Investor Transcript
Wilson: “…launching Battlefield in FY ’22 is really strong move for us and presents us with an opportunity for a strong two years of growth.”

I highly recommend taking caution when listening to YouTube “influencer” talking points, and instead examine the reality of growing (or simply sustaining) a business, it becomes a lot more apparent that the video games industry does not simply chase short term growth. Chasing short term growth obviously occurs, but it has to be balanced against long term growth considerations, not only for the CEO, but for the health of the company (and all the jobs that come with that). The best way to understand the industry in general is to always go to the source. When someone makes a claim about something, go bounce that idea off the available information that publicly traded companies provide (by law). You might be surprised what you find.

Misconception #3 – “Building games isn’t more expensive than it used to be! That’s just an excuse used by big corporations to charge more for the same experience. I watched a video on YouTube that told me game expenses aren’t going up.”

I do my best to avoid calling out other creators, or distract from the main point by sending my readers other places, but in this case I have to make an exception because it makes my point clear. SkillUp, a relatively large & popular gaming YouTuber, has done some excellent work over the last few years and his rise to fame is a product of his own hard work & success. That said, he’s also responsible for helping to spread this misconception as one his most popular videos, a deep exploration of EA’s pivot to loot boxes as a monetization method, makes the claim that development costs have technically been falling and that, essentially, games are not more expensive to produce.

Since you’re here reading this you can probably guess where I’m going: SkillUp, and other people spreading the mantra that “games are not more expensive to make“, are flat out wrong. Why? It appears much of their reasoning stems from the fact that they looked at one aspect of the financial statement and didn’t examine the underlying data (the why and the how).

In SkillUp’s video, he looks at a time slice from FY 2009 to FY 2017 and points out that Research & Development costs (specifically) fell by about $300 million (2009 to 2016). There are two significant problems with his analysis: The “window” of analysis is too small and more importantly, he failed to account for number of games in development. Lets start with the latter – the critical failure to account for number of games in development. It is true that EA’s R&D expenses have stayed relatively flat since 2009. In FY 2009, EA applied approximately $1.3 billion to R&D. Compare that to FY 2019 where EA spent approximately $1.4 billion on the same:

EA financial R&D FY 2019
Exhibit 1: EA R&D Expense FY 2019 – Approx. 1.4 Billion

A difference of one hundred million? Big deal! Case closed, right? Not exactly. The most cursory glance at an EA games list demonstrates that ten years ago, EA published approximately 3-5 times more games per year than they do now. It’s not an exact science, since a person has to account for game versions, time spent in development, and third party developers, but the trend is obvious to even the most basic of analysis: EA develops & publishes drastically less games today (in 2019) than they did just ten years ago. Basic math dictates that if EA has consistently less games in development, but is spending approximately the same on R&D, then game costs have risen per unit, not fallen.

The other “mistake” that I want to circle back on is the time window chosen by the argument that “games are not more expensive to make“. In SkillUp’s rebuttal to rising game costs, he willfully ignores the reality that many developers & publishers experienced from 2005 to 2009: net revenue growth was met with rapidly rising costs.

EA rising costs
Exhibit 2: EA grew net revenue from 2005 to 2009, but also experienced rapidly rising costs.

In exhibit 2 take note that EA experienced healthy increases in net revenue, but they were unable to take advantage of it due to the growing expense of COGS (cost of goods sold) & development. In fact, when accounting for marketing and other expenses, total operating expenses almost tripled from 2005 to 2009. Even accounting for the financial crisis of 2008, this is a massive cost increase for a company to absorb and upon reflection, it makes sense that EA shifted some of their business to focus on high margin strategies (digital goods, service based games, micro-transactions). Don’t believe me? Click here to see the same answer right from a game developer.

I’m only picking on SkillUp because his analysis is emblematic of a bigger problem when dealing with gaming discussion & commentary (including those that are considered games media) – surface level analysis isn’t enough to draw a conclusion. EA is a good example of a developer/publisher that experienced a sharp cost increase over a short period (still slowly rising today), but the story is very similar across much of the industry. Making games is, for many, a professional job that pays professional salaries. Those jobs are supported by professional degrees that obviously have costs associated with them as well. Experienced developers/engineers/artists expect to paid roughly the same as other experienced software engineers. A company can’t sustain itself on entry level employees (and even those demand competitive salaries). Even indie developers will tell you how expensive it can be to create a game with just a few people.

None of the above is trying to make public game companies out to be “fine”, or to excuse all of their actions & behavior. That’s not the intention at all. As I stated at the beginning, reality is often situational and misunderstood. What may look like one thing (e.g. costs went down) may in reality be the opposite (e.g. costs went up). I encourage you, the reader, to always go to the source when you hear something broad & non-specific – see if what you’re being told matches the reality of the data. If you don’t have the time to do that, do the next best thing: Talk to someone who work in the industry.

If you enjoyed what you read here today, or perhaps have a disagreement, please leave a comment here or on Twitter. Thanks for stopping by. Please feel free to link and share.

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