One of the businesses you learn very quickly are the best compounders to own and pass on to ones children historically have been liquor distributors and cigarette producers. There is something to the low price inelastic segment coupled with an addictive product that produces natural scaled monopolies either on the product or the distribution side that simply allows for high ROE over extended periods of time. I believe this was the genius of Buffett’s investment in Coca Cola. Coca Cola’s business model was about creating distribution across the globe, to the point where it was easier to find a bottle of Coca Cola than a bottle of water in far flung places. With this massive distribution network, it was easy to simply acquire new brands or create new products and gain impressive topline and margin growth from pushing various products through your large horizontal channel.
One of the challenges with this horizontal distribution model is that it does not enable the capture of consumer surplus. Take Coca Cola for example, it already has deep reaches throughout emerging markets, it is hard to see how it can replicate its growth to the same extend going forward, as there simply aren’t another two billion people in China and India to introduce to the brand. Another potential source for growth is capturing a greater share of the consumer wallet share. Here again, you run into certain problems with certain product categories, such as Coca Cola. Even if the consumer was in love with your product and was willing to drink 10 sugary drinks a day, you are at most capturing a few dollar in daily value despite the potentially high utility. This may not be a problem today, but 20 years from now, when your average consumer doubles or triples in income, it is highly unlikely their spending per product will scale relative to their income going forward. This has been the reason as to why Alchohol has been a better play than products like Coca Cola for this very reason, in that you are more easily able to price segregate by consumer and as a result be able to capture more of the consumer surplus.
The gaming sector is THE most attractive industry I see today due to:
– Relative low price point and inelasticity
– Highly addictive products
– Cyclical defensive
– Ability for some to capture consumer surplus
– Consistent high margins and ROE
The downsides are:
– Difficulty in developing new IP
– high rate of reinvestment
In many ways, gaming has many of the same characteristics as the other addictive sin products. The products have high utility function relative to the price paid. Prices are generally low and relatively inelastic for the average gamer. Games could be made to be highly addictive due to structured progression relative to the chaotic world people operate in. Throughout the GFC, video game company revenues shared the same robustness as tobacco and alcohol to the economic cycle. The sector seem poised to perform well regardless of future outcomes. Whether the world becomes a post-scarcity world in which 90% of the people will spend their time writing holodeck programs or experiencing holodecks or whether we live in a world where 80% of the population are living on universal income because of automation, escapism will be in ever increasing demand. What I do know is that we are unlikely uninvent mass media and information technology, which continues to create winner take all market in what Nassim Taleb calls extremistan from mediocrestan, resulting in greater search from forms of alternate escapism and achievements.
However, this is where the similarity ends. Unlike tobacco and alcohol, which have had the same recipe for hundreds if not thousands of years, video games must innovate in a timely matter less it becomes stale and monotonous, requiring large amounts of re-investments. In addition, building a new IP is incredibly hard, as per my previous discussions on Nintendo. In many ways, the prevailing view on the sector is to look at it in the same way as the Movie industry. Traditional PC and console gaming, just like in movies, have largely relied on fixed pricing per consumer. Consumers are expected to pay largely the same amount regardless of how much utility he/she can derive from the product. This dynamic results in an inability to capture consumer surplus and forces the producer to grow sales by focusing on expanding horizontal distribution, which is often times very expensive, leading to a strong focus on reusing IP instead of creating new ones.
The Mobile Gaming Model
Something changed in the business of gaming with the advent of mobile gaming. In order to attract a large base of customers early, developers largely started with a premium model and quickly realized that the 80:20 rules applied when it comes to capturing consumer surplus. It turns out only a small portion of the gaming population of a product or service generates an outsized portion of revenues. This discovery is now being replicated by PC and console games, with most PC and console companies looking for ways to introduce micro-transactions and aspects of gambling into their latest offerings. This model is incredibly powerful from a investment perspective and the trade off to high reinvestment cost and IP risk is worth the risk. Imagine being able to sell $5 worth of coca cola to someone and $5000 worth to someone else, suddenly the need to build a massive horizontal distribution platform is terribly wasteful and your efforts are better spent capturing a smaller share of premium clients, which is made possible by the internet and ubiquitous mobile phones. To some extent, I think this is also the beauty of companies like Amazon and Facebook, in that they are enablers of businesses to capture specific consumer surpluses in a focused way while the incumbents CPG companies are locked into a horizontal distribution model which are ripe for disruption.
Today, China is the largest gaming market in the world, and it is largely dominated by mobile, unlike the US and Europe, which is spread evenly between Console, PC and Mobile. As I mentioned earlier, the best play for the west is really on IP as a result of the fragmented distribution channels, which narrows down the number of potential investments. As a result, I have made my bet on Nintendo and will divert my focus onto the China market.
In many ways, being the last mover has tremendous advantages for emerging markets such as China in that they can more readily leapfrog inefficient business models, whether it is land lines being replaced by mobile or brick and mortar being replaced by Tmall and JD. Today the gaming sector in China is dominated by mobile due to the ubiquitous nature of phones compared to the lack of platform penetration of console and to a lesser extent PC games. As a result, the two Chinese companies which dominate the gaming space, Tencent and Netease, which together control arond 80% market share, were able to leapfrog the traditional console/pc game market and focus largely on mobile and are in my opinion global leaders at the art of capturing consumer surpluses.
In my next couple of articles, I will take a deep dive into Netease and Tencent.