“Choose the real world, or be immersed in a simulated digital reality”
Cinematic, immersive environments - digital worlds with open ended narratives are the signature characteristics of the video games produced by Frontier Developments (FDEV).
Frontier’s niche in the multi-billion dollar global video games market may just be the starting point in its evolution towards founder David Braben’s vision of becoming one of the world’s most respected entertainment companies. Braben has often noted in Frontier’s Annual Reports that the video games sector is:
the largest sector within the $300+ billion entertainment industry, which includes games, film, TV and music
And the sectors are beginning to converge.
The high production quality and cinematic style of Frontier’s games enable them to be promoted and released in a similar way to movies with pre-release trailers containing a mix of original video content and in-game footage.
The way that video games are consumed is also changing. Almost all of Frontier’s sales now come from digital downloads rather than physical discs, and subscription and streaming services are beginning to emerge.
“How would you know the difference between the dream world and the real world?”
Frontier’s immersive environments keep players engaged on timescales that extend over weeks, months, and even years.
The open ended narratives enable the games to be continually expanded with new features and storylines which are added in the form of expansion packs, also known as Paid Downloadable Content (PDLC).
Like the original games, expansions are promoted with movie style trailers, tapping into powerful community network effects. The pre-release anticipation, and subsequent launch, of a new game expansion generates an increase in community activity on YouTube and other social media platforms. This in turn generates additional interest in the original game, attracting new players, and increasing the market demand for future game expansions. A virtuous circle.
Frontier calls this strategy ‘Launch and Nurture’. It’s success can be illustrated by the cumulative sales figures for the flagship Elite Dangerous game, launched in late 2014, and now approaching sales of some 5 million units:
The ‘Launch and Nurture’ strategy can be further illustrated by looking at annual sales as a percentage of total sales to date, shown below. Following its launch, Elite Dangerous sales have been supported by several paid for game expansions (Horizons, Beyond, Fleet Carriers, and Odyssey) and by the release on PlayStation 4 in 2017.
Now, compare the profile above to the expected sales profile of just 2 years for a typical Team17 (TM17) video game (based on Team17’s amortisation policy for capitalised development costs).
It might be argued that Elite Dangerous is a special case. After all, this is the flagship game on which Frontier (as it is now) was built. The reboot of the 1980’s space exploration game, Elite, (co-authored by Braben), was funded by a massively successful Kickstarter campaign in 2012, enabling Frontier’s transition to independent publishing.
Frontier has since released 5 additional titles. Planet Coaster, launched in late 2016 has the longest comparative sales history. The sales profile below displays a similarly extended game lifespan supported by game expansions and releases on additional platforms.
“Maybe We Did Something Wrong. Or Didn’t Do Something”
So, Frontier’s games have longevity, but a reliance on just a few games titles carries significant risk. This year we have seen less successful examples of both the Launch and Nurture parts of Frontier’s strategy, and a revenue guidance downgrade.
The first example was the launch of Jurassic World Evolution 2, the sequel to the very successful Jurassic World Evolution game. The sales profiles above show the importance of the initial sales when a game launches as this period generates the largest proportion of total revenue. In fact the vast majority of a game’s initial year’s sales occur within the critical first few weeks.
The original Jurassic World Evolution game launched in 2018, coinciding with the movie Jurassic World: Fallen Kingdom. Sales of 1 million units were generated in the first 5 weeks, and 2 million units after 7 months (blue bars in the charts below) .
The sequel, Jurassic World Evolution 2 (gold bars below), launched in late 2021 six months before the (delayed) corresponding movie Jurassic World Dominion. Sales took almost twice as long as the original game to reach 1 million units, and after 7 months had reached only 1.3 million units.
The second example of strategy execution failure was the disastrous release of the latest expansion to the Elite Dangerous franchise, Elite Dangerous: Odyssey.
Odyssey had been described by the company as “a huge investment in the future of Elite Dangerous”. Stability and performance issues (which Frontier partly blamed on the inability to meet in person during lockdown) resulted in negative sentiment among players, and sales fell “below expectations“. The impact on reported operating profit for the current year, which fell by 92%, was striking and is a consequence of Frontier’s somewhat aggressive accounting policy.
“Remember... all I'm offering is the truth. Nothing more.”
Frontier chooses to capitalise it's game development costs, and amortise them over the expected life of a game (or expansion pack). This is not unusual for software companies but the problem with this kind of accounting is that it front loads profits and game lifespans (sales) are not guaranteed.
Capitalised costs eventually have to unwind as amortisation and impairment costs reported on the income statement. Frontier’s capitalised development costs have been steadily increasing for several years at a level much higher than that being amortised (shown below). The current year is an exception, which brings us back to the failure of Odyssey.
Poor sales and technical issues have prompted Frontier to cancel further development of Odyssey for games consoles and focus solely on the PC format. Consequently the company chose to fully amortise Odyssey’s capitalised development costs, resulting in a significant “non cash“ charge on the 2022 income statement and that big fall in operating profit.
But the phrase “non cash“ does not mean that the charge should be glossed over, because really it is cash - spent in previous years, capitalised as intangible assets, and not reported on the income statement, until now.
“What’s He Doing?”…“He’s Beginning To Believe”
Frontier’s capitalisation policy currently obscures its real profit margin and, as demonstrated above, Frontier remains significantly exposed to the risk of individual games under-performing. The low frequency of new game releases has also meant that revenue has historically been inconsistent.
The ‘Launch and Nurture’ strategy has however produced several successful video game franchises. The strategy is also evolving. Frontier now has a third party publishing label, Frontier Foundry, providing an additional revenue stream. The company says it expects Frontier Foundry to “become a material part of the overall business over time”.
Revenue generation should become smoother as Frontier grows its development team, enabling it to increase the frequency of new game releases. The growing portfolio of titles will also reduce the risk of single game failure.
Development costs will not need to scale linearly with the number of games, since existing games (in the Nurture phase) require less manpower than is required for new games. That could lead to more efficient revenue generation, and the chart below indicates that revenue per employee is indeed increasing as the company scales.
There may be some early signs that revenue is becoming more consistent. Revenue grew by 19% in FY21 without the benefit of a major new game release, and grew by 26% in FY22 despite guidance being downgraded due to the lower than expected sales of Jurassic World Evolution 2 and Odyssey.
Is this a story to believe in? Perhaps, but if we choose to believe, we must also accept that the future is uncertain. Even the precognitive powers of the Oracle were shown not to have been real. When asked, “Did you always know?“, she replied “Oh, No. No, I Didn't... But I Believed. I Believed!“
This article is intended for informational purposes only. It is not a recommendation to buy or sell shares or other investments. Always do your own research before buying or selling any investment or seek professional financial advice.