The Economics of Game Pass Demand a Playstation Launch

The supply-side economics of subscriptions are fairly straightforward: get massive scale and distribute costs. Netflix has over 160M subscribers meaning a $100M production only costs each user $0.63. There’s zero marginal cost (unlike Spotify), so the more subscribers Netflix has the less a piece of content costs on a per user basis. At $11 per user per month, Netflix can spend over $1.7B on content each month and break even. In fact, as recently as 2019, Netflix does spend close to break even. In the long-run, Netflix has a incredible loop: content brings users, these users lower per user content costs, this accelerates more content spend, which brings more users. Rinse, wash, repeat until diminishing returns take hold.

But remember this wasn’t always the case. Content costs are fixed: the crew of Mindhunter doesn’t care how many subscribers Netflix has. They face costs unrelated to if 100M or 10M people watch the show. As early as 2010, Netflix only had 20M subscribers, suggesting a per user cost of $5 for a $100M production. There’s a gaping hole between $5 per user per $100M production and $0.96 per user per $100M production under their current 160M subscribers. This underscores the massive upfront investment needed for streaming to work on a supply-side basis.

It’s this exact reason Microsoft needs Playstation users for Game Pass to at least have a chance at buying down per user costs. It also explains their aggressive sub & console bundling as well as rock bottom introductory pricing.

Microsoft has disclosed Xbox Live has 90M MAU while Game Pass has 10M MAU. At $10 per user per month, Microsoft has can spend as much as $100M in content per month and break even. Development costs vary widely, but let’s start with assuming a conservative $70M per game. From a break even perspective, that’s around 17 games a year and consistent with Xbox Game Studios current production. That may sound like a lot, but the Xbox One has had over 2,500 games released in its lifecycle or about 350 games a year. Supporting this sort of volume is going to require a lot more users. A lot more.

Let’s have a little more fun with the cost side to get a better handle. Consider a simulation assuming anywhere from $30-$70M per game and anywhere from 100-350 games per year. We’ll randomly sample numbers in both ranges, multiplying them together to arrive at a per year content cost (ex: our simulation might pull $40M a game and 125 games for a yearly content cost of $5B. The density chart below represents 100,000 such pulls).

Simulating Content Costs of Game Pass

Based on this, Microsoft would most likely spend ~$7B per year to maintain similar volume. At $120 per user per year, this means 53M subscribers or about 5x the current amount to break even. At a 60% profit margin the number of subscribers jumps to 93M or more then the current Xbox Live MAU. Microsoft needs more users for this to work and they know it. Of course, perhaps this volume is insane and Microsoft wants much fewer but higher quality hits. In this case, however, the entire cost-savings model of subscriptions to the consumer declines. Our gaming subscription paradox re-emerges: subscriptions make increasing sense to the consumer wherein they would instead pay for many distinct pieces of content. Like music. Or T.V.

In many ways this explains the expansion of Game Pass to PC, Project xCloud, and the new Xbox console subscription bundle. Subscribers are capped by those with a console and Microsoft wants to start to unshackle that cap. Netflix recognized this long ago with Roku, Smart TVs, and apps on every platform or hardware they could find. The ability to sell Game Pass on iOS or Android explodes the addressable market, but is dependent on Azure wrangling the explosive unit costs of streaming. Hello Sony and the Playstation user base.

Microsoft clearly understands the supply-side economics of making streaming work, but over and over again misses the fundamental difference in how players consume a game as opposed to a T.V. show. I’m not quite ready to short Microsoft, but critical questions remain in executing on this strategy.

The Intellectual Poverty of Game Streaming & Subscriptions

Amazon has announced Luna, yet another stab at game streaming and subscriptions. It seems like the failures of Apple Arcade, Stadia, Gamefly, and our oft-forgotten OnLive have not been effective deterrents. Not to be outdone, Rovio’s Hatch continues to drain money every quarter. Perhaps this is what Bezos warned shareholders about when discussing new “multibillion-dollar failures.”

And despite overwhelming failures, media pundits like Matthew Ball prop up skin-deep arguments in favor of game streaming and subscriptions. Instead of discussing why game streaming and subs might work, let’s talk about why they haven’t worked.

It’s important to understand the brother/sister relationship between streaming and subs. Subscriptions unlock zero-marginal cost content consumption. Once you’ve paid Netflix or Spotify $10, there’s $0 additional explicit cost to consume another movie or song. However, there are transactions cost. In the “before times,” customers had to mail DVDs back to Netflix to receive the next DVD in their queue. This effectively limited how much content customers could consume in a given month. If mailing took 3 days in transit, on a 1 DVD at-a-time plan, a customer could only consume 10 DVDs in a 30 day month. This assumes the customer turned around DVDs instantly. Furthermore, the “queue” forced customers to plan consumption habits rather than at the point of consumption. If you wanted Love Actually on Friday, but by Monday, you were in more of a Pretty Woman mood, then you’re shit out of luck. Let’s not forget that new releases were in strong demand, meaning it could be weeks before Transformers 3 lands in your mailbox. Steaming solved all this.

Non-steaming subs like Game Pass and EA Play exist in a weird middle, solving some but not all of these issues. Games are distributed digitally, but not instantly. A game like Call of Duty: Modern Warfare can take 3-4 hours to download on a 135 Mbps connection. SSD’s aren’t cheering at the prospect of 200GB games either. But once streaming takes off for games, these problems are solved. No storage is needed!

The incredible rise of free-to-play and GaaS (Games as a Service) render subs and streaming largely valueless to the player. Players do not consume games like TV or music, which should have been made obvious in the last decade. Players are playing fewer titles in a given year but are playing fewer titles for longer periods of time. Games solve the content problem in a way that other mediums simply can’t.

The content consumed in a game like Overwatch or Clash Royale is the pursuit of strategy equilibrium and/or mastery of mechanics. A new unit in Clash Royale, for instance, can change how players organize their decks, even if they don’t use the unit directly (they must counter it). This can provide hundreds of new hours of content to consume relative to the near 1 man-week of labor to produce a new unit. Therefore, the content output of a given member of the 16 person (!) Clash Royale team is astronomical. Compare this to the thousands of crew members and weeks necessary to produce even a single one-hour episode of Game of Thrones. Supply can’t keep pace with demand in the world of TV and movies. Netflix makes sense in this view because after binging 9 seasons of The Office, customers can immediately rip into 7 seasons of Star Trek: The Next Generation. It’s another reason why back catalogs are so much more important to Netflix than they are to something like Game Pass. If players are only investing in 3-4 new games a year, then the transactions cost reduction streaming is extremely minimal the benefit it provides in high unit consumption TV and music.

It’s a similar story for the failure of gaming subs. If players consume only 3-4 titles a year, subscriptions don’t make economic sense. Not to mention these 3-4 new titles are increasingly becoming free. In the West alone, League of Legends, Fortnite, Apex, Warzone, and Rocket League dominate playtime. And let’s not forget the entirely F2P ecosystem of mobile. The march to F2P in the West will continue as long as MTX revenues grow and box revenues shrink. There isn’t a whole lot to save by signing up for a $100 a year sub and streaming service when Fortnite doesn’t cost a dime.

Game streaming and subs don’t solve billion-dollar problems for the player. In the absence of doing so, subs and steaming will continue to flounder.

The LTV-UA Rebate from Platform Fees

Apple is increasingly under fire what’s claimed to be unfair practices in the App Store. The criticism takes three forms: (a) Apple’s 30% fee is much too high relative to cost (b) the rules are arbitrary and stifle competition and (c) the App Store as the exclusive avenue to install apps on iOS is unjust. That’s a lot to chew, so let’s focus on (a) for this post.

Eric Seufert’s criminally underrated podcast talks about this very topic but phrases the question as “Does Apple earn it’s 30%?” Various App Store benefits like payment handling and preventing fraud are discussed, but I wanted to scream by far and away the biggest way Apple “earns” it’s 30%: acquiring a mega fuck-ton users to iOS. Nearly the entire value of a platform to a developer is how many people it can reach. No one is rushing to get on Epic Game Store (EGS) or develop for Stadia because there are so few users. 12% or even a 0% fee is irrelevant: [88% * 0 users] = $0 versus [70% * more then zero users] = more then zero. This is an extreme example, but users are by far and away the most important ingredient of any platform. After all, developers can list in multiple stores with maintaining the listing or code for the particular platform as the only cost to do so. The fact that so few are willing to take on these small costs tells us a great deal about the user bases of Stadia and EGS.

But platforms fees also increase the LTV of the devices who run on the platform, if and only if, the firm internalizes those platform fees. For instance, the added platform LTV of an Android phone in China is less than in the United States because Chinese users install non-Google owned stores. In this case, platform fee revenue doesn’t accrue to Google.

If LTV of the iPhone X is say $1000, Apple should spend up to $1000 in UA to acquire a user. However, with platform fees the LTV grows. Sensor Tower estimates that iPhone users spend over $79 per year on apps. On a lifetime basis, that’s probably north of $250 (3+ years of ownership). That ups the iPhone’s LTV to $1250 and unlocks more UA budget for Apple to acquire more users. These marginal users benefit all developers. This is how Apple (or almost any platform holder) gives developers a rebate on the 30%. I’m not sure what the true fee is but it must be lower than 30%.

Why Aren’t You Doing Analysis on Your Impact?

Performance based marketing makes intuitive sense; of course you want to optimize ROI on spend that compose 30% or more of a your firm’s expenditures. But here’s the kicker: if it makes sense for firms why not individuals? Shouldn’t we be tracking the impact of our output?

Are co-workers actually reading your analysis, concept art or brand pitches? Imagine if you knew how long internal onlookers spent reading or viewing: how might that change future output? For instance, we might be able to find the optimal length of a memo or detail of a UX mock-up. With more widespread read receipts (on email, calendar invites, PowerPoints) I’d think we’d learn discovery of information within firms is rather low because search costs are so high. I’m routinely shocked by low view counts on important internal Google docs while on the other hand observing the willingness of participants to take a firm stance on the conclusions. Many firms haven’t invested in strong intrawebs to create easy ways to access content or for creators to push them to relevant parties.

This means information travels via internal networks via word of mouth. With a given game publisher distributed over many countries and time zones, this simply doesn’t scale well. Easy consumer discovery, regular “pushing” of content, and tools assist rather than inhibit creation are paramount to spreading the gains from Haykiean localised knowledge.