Pachter compared social/core games to McDonalds/a steakhouse. It’s nonsense

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I was recently interviewed for a Eurogamer article entitled “Are console games dying?”

It was triggered by a quote from Peter Vesterbacka of Rovio saying console games are dying at SXSW.

It probably won’t surprise regular readers that I am more in the Yes camp than the No camp, although what I really I believe is that the games industry is fragmenting into three, leaving little room for the middle-tier of console games makers.

But surprisingly in the No camp was Michael Pachter of Wedbush Morgan with this choice quote:

“It’s like McDonald’s saying nobody will ever eat at a steakhouse again because McDonald’s cheeseburgers are so successful. McDonald’s and Rovio provide phenomenal value for the money, but fast food is fast food, whether real food or a video game.”

Coming from a financial analyst, I find this baffling.

The fundamental economics of a McDonalds and a steakhouse are the same. They each need to pay rent for a good location, hire cooking and waiting staff and buy ingredients.

Sure, the amount McDonalds pays is much less, and the amount it charges is much less. But the cashflow statements and working capital requirements will look reasonably similar.

The economics of digital games are fundamentally different from those of physical games

Actually, it’s less about economics and more about risk/reward profile.

For a physical console game, the bet that you need to take is humungous. You need to develop a good AAA console game (minimum $5 million, $50 million for Modern Warfare 2, with higher budgets rumoured for some forthcoming games). You need to pay Sony or Microsoft a royalty to put a couple of million units into retail in the first month ($7 per unit x 2 million units = $14 million). You need to pay for manufacturing, warehousing and distribution. Having stumped up tens of millions of dollars, you get one shot at getting people to buy the game.

So you spend the same amount again on marketing.

So now you’re probably into triple-digit millions spent on your game. And the opening weekend (the opening month if we’re being generous) will make or break your game. A poor showing will mean no re-orders, retailers pulling your games off the shelf, and rapid price falls. Worse, you may have to buy back stock that hasn’t sold to keep your retailing partners sweet.

For a digital distribution product, the maths is very different.

If it’s still a product, rather than a service, like a PSN, Xbox Live or paid-for iOS title, there is some similarity. You still need to finish the game entirely before you launch it. You still need to spend marketing money. Chart position is key. You don’t have to pay for manufacturing, distribution, warehousing, which is a massive improvement to cashflow. You only pay platform royalties on games you sell, not stock you hope to sell, and you have no risk of unsold returns.

For service-based games it gets even better. You don’t need to complete 100% of development. Less than half is normal. You don’t need massive launch marketing. (I think it’s better to keep initial marketing spend low, so you don’t have a leaky bucket problem). You can test the water for your great new idea with much less working capital and much less fear of failure. (Not because failure is less likely, but because the consequences are less severe).

Why core games are not a steakhouse

The analogy breaks down because core games are not a single steakhouse. They are humongous, capital-intensive monsters. It’s like trying to compete with McDonalds by building a global network of thousands of steakhouse franchises before you even know if customers like your format.

No sensible investor would take that bet. They’d want to wait until a single steakhouse, in a single city, was successful and then roll it out globally.

The reason why console games are in so much trouble is not because the audience has disappeared, but that capital intensity is rising while audience numbers are barely growing, if not shrinking. The risk/reward calculation is getting worse and worse.

For some publishers and developers, it will go so badly wrong that they will go bust. For others, it will be fine for a while, although every time a core gamer decides to spend some time or money on a mobile, social or browser-based game, he or she is shrinking the market for core games.

But will it be good enough to justify Microsoft, Sony or some other corporation to invest $5 billion in a new AAA console platform?

Maybe one more. After that, I’m not so sure.