The Finance of Epic Games – Fortnite Subsidises All?

This is not investment advice. The author has no position in any of the stocks mentioned. WCCF TECH INC has a disclosure and ethics policy.

Epic Games (no stock ticker here!) The name conjures up different things for different gamers. Lust from Fortnite fans, bile from people who wanted to buy Control or Metro Exodus at launch on Steam, and free PC games for a lot of us courtesy of the Epic Games Store. Like a lot of people, I was never into Fortnite and broadly indifferent to the Epic Games Store as I had basically never used it other than to sign up for an account and get free games whenever they are offered. As with a lot of other people, the number of games I’ve got tied to my various accounts through various bundle purchases etc over the years is excessive and I long ago gave up any hope of getting to most of the stuff in my various libraries. Even so, free is free and I’ll take it.

Fast forward a bit however and a game I was looking forward to coming out was going to be an Epic Games Store exclusive. John Wick Hex (FYI, it’s a great game!). I didn’t particularly get all the gamer ranting about the store, content fragmentation is part and parcel of being a PC gamer these days what with Steam, Origin, UPlay, GOG and I’m sure others. Adding one more to the mix seems insignificant at this stage.

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So John Wick Hex launches and I’m using the Epic Games Store. In general I have no issue with it, right up until the first time I try to fire it up on the laptop and discover that cloud saves aren’t a thing. What?! Yep that’s right. A bit of googling reveals that Epic is rolling it out slowly across its library. It seems relatively basic functionality that if you want to have a PC game store and launcher, you should really be building in for launch day but there we are.

This gets me thinking a bit. I’ve gotten quite a few free games from Epic over time and seen some rumours around what it’s doing with all its money but it’s probably worth digging a bit more in to some of the activities of this private company.

Epic Games – A Financial Behemoth of Gaming

While still having a way to go to be number one from a financial metric perspective, Epic is still huge. A funding round about a year ago brought in an additional $1.25 billion from a variety of firms and apparently valued the company at about $15 billion. Chinese games, AI and general entertainment goliath Tencent (HKG:0700) remains the largest shareholder after a shrewd pre-Fortnite success investment in Epic when it put $330 million into the firm back in 2012 and took a 40% stake. A deal which (not including any subsequent dilution) puts its holding at about $6 billion, an 18x return in 6 years isn’t bad.

Epic still is something of a one trick pony though in the financial stakes. Fortnite propelled it to big financial success but it’s still got a way to go to catch up with the big boys. Activision Blizzard (NASDAQ:ATVI) is over $40 billion, Electronic Arts (NASDAQ:EA) is almost $29 billion and Tencent (often classified as the biggest gaming company in the world although that is something of a misnomer given its other interests) is about $400 billion. Still, other publicly listed games companies are smaller with Ubisoft (EPA:UBI) and CD Projekt Red (WSE:CDR) both coming in at a relatively paltry $6 billion apiece.

Remarkably, despite all of this dilution of his holding, founder Tim Sweeney still reportedly retains overall control of the firm, although as part of its deal, Tencent does get board level representation. Sweeney has famously commented that Tencent has basically no control over the company, particularly as trade tensions between the US and China have ratcheted up. It’s important to understand that while day to day operations and strategic decision making often rest with a company’s executives, boards do wield a kind of soft power over companies and can set the tone for the operation of a company.

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Additionally, people will no doubt be familiar with Tencent’s approach when it came to one of its portfolio companies, Riot Games (which Tencent now owns entirely) and the debate over a mobile version of League of Legends. When Riot seemingly refused to develop a mobile version in the past, Tencent went ahead and created a similar mobile game called “Honour of Kings” for Chinese audiences which has proven somewhat successful. Perhaps unsurprisingly, since then Riot has agreed to make a mobile version of League of Legends.

So yes, while it may be true that for the time being, Tencent has “zero input” into the Epic business, this is at least in part due to the fact that Tencent's ambitions for its company are likely aligned with the plans it has at the moment, however this is unlikely to last forever. At the moment, Epic is doing what it should be and monetising its best IP to good effect, but Fortnite will eventually wane and when it does it will be interesting to see what happens if Epic’s decisions don’t align with those of its largest shareholder.

Epic is Trying to Creating a Platform Economy of Gaming

So with its huge cash pile, Epic feels like it is still at least somewhat spiritually aligned with the world of the AAA desktop game. Despite having a huge success in the free to play and microtransaction world of Fortnite which many gamers loathe, despite losing some notable talent over the years to other companies, particularly after the Tencent investment and the clear direction of moving away from big, single player titles to F2P (Rod Ferguson, the lead developer of Gears of War for example), Epic has effectively been subsidising a lot of other companies.

Recent figures which came to light show that Control publisher 505 received $10.5 million which looks to be for the Epic Games Store exclusive rights to Control, while 505 apparently provided about $8 million in development funding to Remedy to make the game. Additionally, Unreal Engine (which Epic owns) has effectively been made free to developers who will sell their game through the EGS, effectively saving companies the usual 5% fee for the engine (which is still payable for games sold through other storefronts). Couple this with the lower fees for selling via the EGS (12% rather than Steam’s traditional 30%) and it’s clear that game developers are getting a bigger share of the pie from their games.

This has seemingly pushed Steam to change its fee structure and the storefront now has tiered fees starting at 30% and dropping to 25% and 20% as a game sells more, so in this sense, the competition is good for developers, which in turn should be good for gamers. In this sense, competition is good and it is generally helping things. Even so, it is clear that Epic saw the writing on the wall and comments from Sweeney have shown that he views the big money as being associated with the online, F2P model.

Epic continues to pursue paid exclusives for its store aggressively with whispers of one game even receiving a 100% subsidisation of development costs by Epic until said game earns back their dev costs via Epic Games Store sales. Is this genuinely a business model that the firm should be pursuing though?

Wrapping Up – Investors Eventually Want Return…

…but can Epic give them one? Thus far the answer has obviously been yes to its earlier investors (notably Tencent, to a lesser extent Disney NYSE:DIS). But we’ve seen this year that public markets have started to reach a turning point with the once reliable tech IPO seemingly floundering this year with a number of high profile companies trading below their placing price. Big investment on the expectation of future returns from a hit game maker that is raking in piles of cash from Fortnite may be possible but if indeed the economic cycle is approaching a peak for this iteration, throwing precious Fortnite cash at free games to attract gamers to its storefront, exclusives and giveaways like the Unreal Engine may be short lived.

Private equity is a very different game to public markets and it may be that Epic was able to convince a select group of investors of the benefits of its strategic vision which may not have held water had the firm attempted to access publicly traded status via an IPO like we saw with the WeWork debacle.

Platform economies can be powerful drivers of businesses but Epic doesn’t particularly feel like it’s doing anything innovative with its Fortnite cash at the moment. Trying to gain traction in terms of market share of PC game purchases is undoubtedly a big pie that it may want to pursue but it feels like it’s simply throwing cash around while looking for the next big thing to eventually replace Fortnite cash as the game’s revenue profile dips. Is a game store with Unreal Engine exclusives really enough to replace what last year amounted to $2.4 billion in revenue? Possibly, but it seems unlikely.

Fortnite spending is (according to research by Edison Trends) down about 52% from Q2 2018 to Q2 2019 so the decline has already clearly begun. It may be that Epic Games has another hit up its sleeve to come once Fortnite’s revenue has dipped sufficiently and it feels it has milked that particular cow as much as it can. Exactly what would’ve been revealed to the recent investors regarding roadmap was likely important and part of what convinced them to invest in Epic at what could be the peak if no further hits materialise. It seems unlikely that the pitch:

“Hey guys, we’re gonna make the best PC gaming storefront the world has ever seen and Steam, Origin, Uplay and all the others will have to close up shop giving us all PC gaming sales commission revenue and then jacking up our fees”

Would’ve been enough to convince investors to pony up, so there must be something else to come. A swathe of as yet unannounced exclusives due to the Unreal Engine licensing would help one assumes but there must be other plans. In the event of an economic downturn, discretionary spending (as everyone knows) is the first thing to go out of the window. Epic is undoubtedly helping the single player AAA industry at the moment with the kinds of terms it’s offering for game engines, store fees and exclusives but that can’t last forever. With Fortnite cash drying up and the amount of time it takes to develop games being measured in years, it must have something else up its sleeve.

PC gaming worldwide reportedly brought in about $30 billion in 2018. Even if there were no other stores and all of that was sold through the Epic Games Store (never going to happen of course), it would only have amounted to $3.6 billion in fees. Growth in the PC gaming market and games store domination can't be the only prong in its strategy.

We’ve reached out to Epic Games for comment on this piece and will update with any reply.