MARCH 26, 2010 • At the VCON event during the 2010 Game Developer’s conference, DFC Intelligence analyst David Cole gave a presentation entitled “Eating An Elephant One Bite at a Time: How buying online in small increments is likely to cause consumer spending to soar.” The full presentation is available here. In this issue we thought we would highlight some key points from the talk.

The concept behind the title “ Eating An Elephant One Bite at a Time” is that games like Call of Duty: Modern Warfare 2, World of Warcraft, and others have become these huge elephants that are simply not consumable in one $60 or $15 a month chunk. In fact, charging only $60 or $15 a month to a core consumer of these products is actually leaving money on the table. The idea of being able to charge consumers in small increments ON TOP of the one-time purchase is really only now coming into place with improvements in technology. DFC has long believed that the ability to offer users more flexible payment options will eventually result in a significant increase in overall spending and eventually greater profitability for smart game companies.

For 16 years DFC Intelligence has argued that the consumer game model is whacked and not sustainable. By that we mean the $50 to $60 packaged good business that has driven the games industry to $60-plus billion in annual revenue.

The problem we had with the game industry price model was its lack of flexibility. The idea that Game A might provide two hours of entertainment while Game B provided 200 hours of entertainment, yet both are priced the same, has always gone against all basic laws of economics. In our view, the bulk of games have always been too expensive, while a popular minority of products is actually underpriced at $50 and even $100.

The fact that prices remained so high for so long is a testament to how popular games are in modern society. When Sony brought prices down towards $40 with the first two PlayStations, we thought this was part of a long-term trend towards lower prices. However the launch of the Xbox 360 and PlayStation 3 saw an lower rise in prices toward $60. Unfortunately, as became painfully clear in 2009, consumers are fine with $60 price points for games like Call of Duty: Modern Warfare 2. However, most products are not in that boat and must compete with the growing library of older titles, used games and a growing base of free-to-play games.

The good news is that finally technology is opening up new pricing models across all game platforms. Instead of having to buy a game whole, we have reached the point where we are seeing a massive variation in game prices based mainly around usage – from bite-sized to large chunks.

So where technology once limited home delivery options and forced artificially high game prices, technology has now improved sufficiently to allow for more flexible content delivery models to the home. Economics 101 says that if you offer people more efficient purchase and delivery options and they will take them.

Recent research shows that in North America and Europe core game consumers are rapidly adapting to this change. We are quickly learning that the core game consumer age 13-24 is now comfortable buying digital content. This shift towards digital purchases is likely to cause short term disruptions but in the long-term is expected to drive significant industry growth.

Today the ascendant model is to separate consumers from their money in small amounts over many months of continuous online gameplay. Moving PC games from a retail box commodity to an online game service was the brainchild of South Korean companies such as Nexon. Given the propensity for digital piracy in emerging markets, the micro-transaction model not only proved sensible, but also wildly profitable in Asia.

This free-to-play business model assumes the publisher can recoup investment over time by charging users small amounts for special items to use with in-game characters, or for access to special areas in the game. These micro-transactions can be paid for via credit card, or branded game cards that can be purchased at retail like the time cards for mobile phones that many consumers in emerging markets are familiar with.

Micro-transactions are quickly becoming established with video game consoles such as the Xbox 360 where gamers can purchase all kinds of enhancements at various prices using Microsoft Points that can be purchased or awarded as part of promotions. Micro-transactions are also an integral part of staying hip while playing PlayStation Home. There’s also the Wii Internet Channel where Wii points can be used to purchase items for the Nintendo platform.

Many consumers will pay a small amount for special items and in-game currency, and a lot of people are increasingly spending money based on product usage. Some will play for free and never buy an add-on item. Others start off playing for free until they decide they like the experience enough to augment their characters with special items. Some gamers are happy to take advantage of lifetime subscriptions to new MMOs that won’t start saving them money until after two years of play time.

The key is that consumers are still learning how to place value on games using these new business models. These new methods of charging based on usage are just being introduced and both consumers and game providers are in the stage of trying to figure out what works best. One thing that is very clear, however, is we know consumers increasingly have more choices and they are starting to make more efficient decisions.

Moving forward most products will not have the luxury of getting consumers to make a major commitment up front and will need to rely on getting consumer payments in smaller increments. But after the consumer is hooked on these products there is a growing ability to upsell digital content to heavy users. The quality of the user experience is becoming the most important factor. Which means a high profile license can bring consumers in, but it can’t get them to stay around.

It is obvious that many consumers worldwide are flocking to free-to-play options.  Online game portals like Pogo and Bigpoint have been building huge user bases – with the latter claiming more than 100 million registered users, with over 30 million of those users registering in the last six months of 2009. Bigpoint titles such as Seafight and DarkOrbit draw 25 million registered user each. And Sony Online Entertainment’s Free Realms MMO drew in 10 million registered users between April 2009 and March 2010. However, one big change for 2009 was the growth of social networks as launching pads for playing free-to-play games. Social networks like Facebook exploded in 2009. Using Zynga games on Facebook as an example gives a snapshot of how much potential there is in the free-to-play busines

If only 1% of those monthly FarmVille players spend $5 a month on related microtransactions, that’s $3.75 million in revenue. On an annual basis that adds up to $45 million, for just one simple game. In the casual game market, normally it has taken aggregating dozens of games to generate that type of revenue.

Not only is the free-to-play model tailormade for cash-strapped consumers in the U.S. and Europe, it is the main entry point into games for consumers in emerging markets. As of November 2009, Facebook reported 2.2 million users in Brazil, adding 558,000 users over October. According to a survey of 250 Brazilian Internet users 18 to 35 years old undertaken by the Universidade Católica de Pelotas (UCPel), Brazil, nearly nine out of 10 users (86%) indicated that games are their favorite thing to do on Facebook, and a strong motivation to keep coming back.

What’s more, these accessible and fun titles are attracting demographics that don’t normally play games. Of the five Zynga games listed above, three have majority female player bases.

It’s growth potential such as this that led Electronic Arts to acquire social game creator Playfish in November 2009 for $275 million. Playfish has more than 60 million active users per month playing its 10 games. DFC projects online subscription and online usage revenue to nearly double during the next five years.

However, it is important to note that most free-to-play and virtual item models are simply tweaks on the subscription model.  The free-to-play model allows consumers to pay usage fees in small increments as opposed to committing to a high monthly or annual subscription/usage fee.  Much of the growth in subscription/online usage will be via payment mechanisms that charge for usage in small increments of under $10.

More telling is that the growth in virtual item transactions in online games has not been lost on traditional subscription-based MMO publishers. Turbine Inc. launched Dungeons & Dragons Online: Eberron Unlimited in June as free-to-play with adventure packs, items, and account services purchasable online. The MMO is based on its subscription Dungeons & Dragons Online: Stormreach. In consumer surveys DFC Intelligence conducted in late 2009, consumers showed a positive reaction and Dungeons and Dragons usage showed strong pick-up. Blizzard Entertainment also added sales of virtual pets priced at $10 each for players of World of Warcraft.

Although monetizing games into bite-sized chunks may seem like a long road to profitability, the opposite is proving to be true. The top global markets for PC games are those that have adopted free-to-play and online usage models. In 2008, China passed the U.S. as the number one market for PC games. While the U.S. market experienced a slight decline in 2009, the China market continued to expand with growth of about 36%. Meanwhile, Korea, the pioneer in free-to-play games, continues to be the leading market in spending with average per capita spending on PC games of $28.6 versus only $7.6 for the U.S. More importantly, these new models are proving to be sustainable in ways that the traditional retail model is not.