An attendee plays a game on a smartphone. (Photographer: Kiyoshi Ota/Bloomberg)

Darth Vader Choke Hold Fuels Fear Over $370 Billion Rally

(Bloomberg) -- Free, it turns out, can be a great business. 

When Shigenori Suzuki played video games in high school, he spent a few hundred dollars a year on titles like Final Fantasy. Now the 42-year-old Tokyoite plays free games including Sony Corp.’s Fate/Grand Order -- but spends more overall: He forks over thousands of dollars a year for in-game extras like rare characters and special outfits.

Players like Suzuki have transformed the video game industry in recent years, giving companies from Sony to Electronic Arts Inc. new ways to profit without charging upfront. Companies give away games, then sell digital goods and services through so-called microtransactions. After smartphone game developers demonstrated the technique’s profitability, publishers are applying similar approaches to console and PC titles like FIFA and Grand Theft Auto.

Developers earn billions more than the old-fashioned approach of selling a one-time, $60 CD-in-a-box. Game stocks have rallied $110 billion this year, as investors eye the prospect of higher and recurring profits. Add in gains from China’s Tencent Holdings Ltd., whose main business is games with microtransactions, and the figure climbs to about $370 billion.

“The model allows players to spend as much as they want and keep spending as long as they like,” says Michael Pachter, an analyst with Wedbush Securities Inc.

Not everyone is celebrating. Gamers have begun to gripe about the constant pressure to pay more. Electronic Arts came under fire for its Star Wars: Battlefront II, which debuts Friday and originally gave substantial advantage to players who paid to improve powers like Darth Vader’s choke hold. There are fears the industry is repeating mistakes of the past, when companies like Zynga Inc. lost millions of users by putting profit first.

“That is a danger,” says Owen Mahoney, chief executive officer of Nexon Co., which pioneered microtransactions in South Korea two decades ago. “The growth rate is unsustainable. Why? Because at the same time you’re monetizing, you’re driving users away -- and then you have to monetize the remaining ones even harder.”

The backlash intensified this week with Battlefront II, EA’s flagship for the holiday season. Despite receiving some acclaim, fans rated it 0.9 out of 10 on the site Metacritic, largely due to what are seen as unfair payment practices. On the eve of the launch, EA pulled all microtransactions from the game.

“We have heard the concerns about potentially giving players unfair advantages,” said Oskar Gabrielson, a general manager wrote on Twitter. “We hear you loud and clear, so we’re turning off all in-game purchases. We will now spend more time listening, adjusting, balancing and tuning.”

Shares of EA dropped as much as 3.6 percent in New York on concern the change would hurt sales. In a filing Friday, the company said it didn’t expect a material effect on its forecasts from the move.

EA isn’t alone. In October, Microsoft Corp. was forced to change in-game rewards after fans complained they were being shortchanged in racing game Forza Motorsport 7, while Time Warner Inc.’s Shadow of War drew scorn for making it too difficult to see the game’s true ending without paying.

Mahoney and Nexon have an unusual perspective on the controversy. The publisher stumbled on the business model in 1998, when it decided to give away one of its failing puzzle games. “Then someone said, ‘Let’s sell some hairstyles or some cool shoes as a way to make the game a little better.’ And that started to do really well,” says Mahoney, who joined Nexon in 2010 after a decade at EA.

The company applied the model more broadly, including to the online role-playing game MapleStory, a free title that’s been profitable for 14 straight years. That kind of longevity is lucrative. Nexon just forecast operating profit will double this year and its shares have almost doubled this year, giving it a market value of about $13 billion. The stock rose as much as 2.1 percent in Tokyo trading.

Asian rivals like Tencent began adopting the approach in the 2000s. In the West, Zynga popularized the technique in Facebook games like FarmVille, while Candy Crush-maker King Digital Entertainment Plc brought it to smartphones. In free-to-play games, 2 percent of players typically generate around 50 percent of revenue, according to consultancy Yokozuna Data. High-rollers often spend at least $500 per month.

With such a huge disparity, Mahoney says the secret to keeping everyone happy comes down to balancing three things: keeping it affordable, fair, and tuned to the culture of each country. That means in-game items must be within reach of students and businessmen. It also means purchased items can’t be so advantageous that paying customers always win. “Pay-to-win” strategies infuriate gamers.

“If you get that wrong, they all leave at the same time,” says Mahoney.

That’s what happened at Zynga. The company “did every horrible thing in the book,” founder Mark Pincus conceded in one speech. About 200 million players fled the platform in 2013 alone, crippling the company. In Japan, Gree Inc. and DeNA Co. faced similar troubles.

In the aftermath, the industry began expanding microtransactions to console and PC games. EA overhauled its popular FIFA soccer game, allowing users to buy items instead of earning them through matches. More recently, PC gaming sensation Playerunknown’s Battlegrounds encourages players to buy in-game outfits, which can go for hundreds of dollars on the secondary market. Today, the industry generates $100 billion in revenue with about 70 percent coming from in-game goods and services, according to Goldman Sachs Group Inc.

Some question whether that balance is sustainable.

“The more that games get into nickel-and-diming their players at every turn, the higher the chance of player burnout,” said Jeff Gerstmann, editor-in-chief of gaming publication Giant Bomb. “It cheapens the entire experience.”

Gerstmann says one problem is that publishers are adding microtransactions to console and PC games -- while charging $60 upfront. Last week, EA’s Chief Executive Officer Andrew Wilson suggested his company may apply the free model to its core lineup, including FIFA and Madden NFL games.

The industry is exploring dark territory. Last month, an Activision Blizzard Inc. patent surfaced which described how machine learning could be used to entice players to spend more. For example, a player could be paired with a teammate who owns a special paid item, and then encourage the player to buy it too.

Despite the controversy, Mahoney is optimistic about free-to-play in the long run. The model means anyone can try a game, raising standards for developers.

“You have to be focused on quality,” says Mahoney. “People are starting to finally realize the importance of longevity and bringing your customer back over time.”

©2017 Bloomberg L.P.

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