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written by: Eric Kress and David Sepetka
The Microsoft-Activision deal is back in the headlines with the UK Competition and Markets Authority’s latest report. While the regulatory maneuvering has received plenty of coverage, there is a story under the surface that deserves more attention: Xbox Game Pass.
We should take a very careful look at the state of bundling. What’s driving it? What are the consequences if it continues to take market share? The Activision deal puts a lot of firepower in the hands of the most aggressive bundler of video games. The deal could kick off an escalation in bundling that causes major damage to the industry and consumers alike.
What motivates a giant?
Activision’s motivation for the deal was straightforward. We’ve talked about the troubles in the ABK empire for years, even before the scandals broke. The future looked rough and this deal price delivers an exit close to the stock’s all-time high. Activision wanted to de-risk before that window slammed shut.
But Microsoft’s motivations deserve special attention because they will drive Microsoft’s behavior regardless of whether it aligns with the interests of gamers and game makers. While Microsoft has been in games for decades, it’s a conglomerate tech giant that ultimately cares about the valuation multiple of the overall company. To defend and grow its multiple, Microsoft needs credible growth narratives and this deal potentially offers two.
- The first is consumer growth. Microsoft’s enterprise and public sector business have long been extremely strong. Consumer, however, has been less consistent – including the painfully visible retreat from the mobile phone OS market amid the declining relative importance of PCs. Xbox may actually be its strongest and steadiest consumer business.
- The second growth narrative is a more straightforward appeal to something that Wall Street loves: annual recurring revenues. Recurring revenue is a trendy valuation driver that receives a premium from public market investors. Both growing topline recurring revenue and increasing the recurring share of their revenue mix would be wins for Microsoft.
The dangers of impossible economics
Because Microsoft derives less than 10% of its revenue from gaming, combined with the broader parent company motivations outlined above, it is willing and able to forgo maximizing the revenue potential of its gaming business. In theory, Microsoft doesn’t even need its gaming division to be profitable. This is obviously impossible for any pure gaming business! As a result, they are free to pursue impossible bundle economics by giving away an unprecedented amount of video game value. Game Pass is easily the most aggressive bundle in the business because it gives away top-tier premium content on launch day. There is no way that the cost of the subscription recoups the revenue that its component titles would have otherwise earned. This would be unthinkable for virtually any publisher.
Not only does this give Microsoft incredible competitive leverage, I believe it harms the video game format as a whole. It lowers consumer price expectations and drives the devaluation of gaming content in a cannibalistic race to the bottom. Frontline premium games will suffer as they begin to seem expensive in comparison to what is available in bundles. The sunk cost will weigh on every purchase decision outside of the ecosystem. Why pay an additional $70 to gamble on a new IP when you already have access to 3-5 new games in the same genre? For the same reasons, this will overload bundle subscribers with a ton of content and compete for attention with all other business models. Not even F2P will be safe from Game Pass stealing away attention and engagement, as consumers will view the incremental Game Pass title as functionally free. Content overload combined with ecosystem lock-in would have pernicious spillover effects on industry-wide engagement – less playtime per game, shrinking game communities and weaker attachments to IP.
Stage 2: Bundling the Industry
Everything outlined above is associated with aggressive bundling – I believe it is already taking place, albeit slowly. But the more Microsoft (and others) bundle, the likelier it becomes to reshape the industry at an accelerating pace. The more the strategy works, the more others will be inclined to follow. Tencent or Google could join in. Sony, Apple and Netflix are already operating less aggressive bundles which could expand in scope. As more follow in Microsoft’s footsteps, the devaluation problem will accelerate very quickly.
Likely, another round of massive consolidation would follow as the giants compete to snap up IP holders and development capacity. This would lower industry business diversity and leave employees more vulnerable to large layoffs down the line. Not to mention, tech giants have a shaky history with managing first-party studios, including Microsoft itself with Bungie, Rare, Lionhead, and 343 Industries.
Any platform run by a company that’s also aggressively bundling would have perverse incentives to let 3rd parties dwindle away. Currently, 3rd parties contribute too much revenue to neglect. But as the bundle itself becomes the strategic focus, what will motivate platform owners to provide robust discoverability or to actively promote 3rd party content that competes with the bundle? At best, those concerns would be put on the back burner and most platforms would increasingly exhibit the first-party dominance of Nintendo. This would be yet another blow to the industry, as independent devs would take on less risk on fewer platforms.
Finally, the strategic incentives of operating a bundle would elevate the importance of Quantity (deadlines, budgets, content cadence) over Quality (innovation, polish, fun). This seems almost inevitable once a bundle becomes successful. The lifecycle of this business would encourage bundlers to keep subscribers steady, not to rock the boat, and slowly lower costs over time. There would be very little incentive to create the very best games possible, save maybe one or two marquee titles per year. The end state of this market could consist of a handful of calcified giants jealously defending the turf that they won by economic attrition.
More Harm than Good
The most common pushback I hear about this view boils down to a few points. Netting everything out, Game Pass will cause more harm than good. Let’s look at the big ones:
- “Game Pass is good for consumers” – This is the most common one. While it’s true in the short term, I believe that it will harm product quality, product diversity and product discoverability for all the reasons outlined above. Even if gamers can get more content for less, the content and the experiences will suffer. There are already plenty of ways for gamers to play at deep discounts or for free. Rewiring and damaging the industry as a whole would cost players more in fun than it saves them in cash. And let’s be honest, monopolistic platform ecosystems will likely find a way to inflict economic harm on consumers in the long run, if they don’t drive them away from the format first.
- “Game Pass improves discoverability/increases engagement / expands the audience for games” – While that might have some truth to it at the margins or from the perspective of a given bundler, I don’t expect these effects to outweigh the broader damage done. The most enthusiastic adopters of Game Pass are core gamers who are outright saving money with it by not having to buy as many games. Casual players or non-gamers within the Microsoft ecosystem aren’t likely to start spending far and wide on gaming content outside of Game Pass. Mass market audience expansion strategies have usually been a bust throughout the history of the industry. And again, the harm to the industry will eventually be a headwind to audience expansion anyway.
- “Bundling was great for video” – This is an interesting point, citing the “golden age of television” brought on by Netflix. Video platforms like Netflix accrued large audiences and other providers began to compete, they funded more content, a wider range of content and more studios/actors needed to be employed, as the story goes. However, we shouldn’t want to emulate the value of video, which is now essentially zero on an individual product basis. Additionally, the correct analogy for Game Pass would be bundling launch day theatrical film releases into the subscription. Disney has been maintaining theatrical exclusivity for ~1-3 months and Paramount held the megahit Top Gun Maverick exclusive for 7 months. Broadly, I doubt the long tail of video projects (especially those produced directly for bundles) is a very lucrative business. Projects are greenlit to check various boxes but where’s the upside for creators?
We Have to Look Out for Ourselves
We have no right to a vibrant video game industry. Nobody will protect it on our behalf, so we have to be thoughtful about what business models we want to support. I’m not scared of gaming businesses getting too big and suppressing each other. But I’m terrified of conglomerates vampirically extracting value from an industry that they don’t have to care about at all.
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