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What it takes to win in China's gaming market (1/2)

Characteristics of the world’s largest market

· gaming

{{{Daniel Concha Zegarra and Alexander Kremer}}}

Gaming is one of the largest sectors in Digital China. In just a decade, the industry grew 10x in scale and there are now around 600 mn active gamers (twice the US population) in China. After all, some of its biggest internet companies have large shares of revenues from gaming. That is certainly true for the giants Tencent and NetEase. Part one this series focuses on major characteristics in the Chinese market and introduces major players.

June 13, time for the final of the Tencent King of Honor Pro League Spring 2020, the largest league for one of the biggest mobile games. AG Super Play (AG.SP) is facing Turnso Gaming (TS). AG.SP had made its way through the winner´s bracket, while TS had to advance to the grand final via the loser´s bracket, following earlier defeats by AG and Dynamite Gaming (DYG) in the group stage (both 1-3). The final game is tied 3-3 as the last map comes up. Eventually, TS emerges with a 50:18 victory for an overall 4:3 score, taking revenge. The 5-player roster wins USD 430 k. The hero of the night is Lin Huang, who also goes by the name of NuanYang. Lin is only 20 years old. He joined TS in the summer of 2018, when he was just 18. In the last two years or so, he made an estimated USD 500 k – only from price money earnings.

Two months later, August 16, Beijing Cadillac Center, a venue previously used for the 2008 Olympic Games. TS is here to take another revenge, in front of 20k fans. Facing DYG in the grand finals of the King of Honor World Champion Cup, TS is behind 0-3. Following an epic comeback, eventually TS wins the last map 57:22 and thus turns the match into a 4-3 victory. This time the team banks an epic USD 1.9 mn check. The MVP? NuanYang.

Figure 1: Honour of Kings World Champions Turnso Gaming (Source: CGTN)

Much like NuanYang´s story, China´s gaming sector is remarkable and unique in many ways. Indeed, neither King of Honor nor TS or NuanYang are popular outside of China. Moreover, the last 3 years also brought massive changes to the industry. Over the course of 2018, China’s new gaming regulator, the State Administration of Press and Publication (SAPP), released new guidelines concerning the approval of new game titles, leading to a drop of approvals of almost 80% in comparison to 2017. That led to a highly distressed year for the majority of companies. Then, after a rather successful 2019, in 2020 Covid-19 struck and the industry saw growth unseen for years.

More fundamentally, secular trends such as technology (e.g., AI, AR/VR, Cloud games) are reshaping the industry.

Considering the fact that, to many observers outside of China, the Chinese gaming industry with its localized requirements and major trends remains more or less a black box , we decided to interview a number of gaming experts and gather results in this article.

China's gaming market requires a highly localized approach

Like every market, the Chinese gaming market requires a localized approach in both game design and operations.

Game design

In terms of platform, it is worth noting that the Chinese gaming market is primarily a mobile gaming market. While China accounts for roughly 1/3 of the global gaming industry, it accounts for around 50% of the global mobile gaming revenues. More than 65% of local video games revenues come from mobile (vs. 45% global). Indeed, the trend is actually accelerating. According to our analysis of game approvals in September 2020 by the leading regulatory body, SAPP, 95% of newly granted gaming licenses were for mobile games. This also shows that the pipeline for future revenues is dependent on mobile gaming.

Figure 2: SAPP September 2020 approvals of local new games by platform as of Sep 25 (Source: SAPP)

Playing games on a mobile phone / tablet instead of PC or console, though, comes with a number of challenges. For one, the hardware in terms of CPU, memory and GPU power of a smartphone is relatively weak. Even more so when considering that Chinese consumers often use lower-end Android smartphones. Additionally, a smartphone comes with limited battery power and a smaller display that also has to provide buttons on the screen. However, developing mobile games also comes with some advantages for game studios. For one, there are more daily mobile internet users than laptop users. In fact, China is one of the countries with the highest smartphone penetration overall. Furthermore, mobile gamers are “always-on” and can easily be drawn into a game at any time of the day via, for example, a push notification. Overall, playing on a phone is easier and thus creates lower entry barriers for new gamers. Lastly, the overall user experience can be highly integrated with existing accounts (e.g., sign-up by Wechat/QQ ID), social features (e.g., streaming) and mobile payments.

In terms of game types, multiplayer online battle arena (MOBAs), massively multiplayer online role-playing game (MMORPGs) and battle royale (BR) games enjoy a lot of popularity with Chinese consumers.A famous Mobile MOBA is Tencent´s Honor Of Kings, a game comparable to the internationally renowned Defense of the Ancients (DotA). Honor of Kings has more than 200 mn MAUs. Since released in late 2015, it made a huge impact on the gaming scene in China and accelerated the popularity of mobile games massively. Never before was a competitive mobile MOBA game that fun and smooth when competing in multiplayer mode. League of Legends, another MOBA distributed by Tencent, remains one of the most successful titles of PC gaming in China and has a significant followership of e-sports fans. A strong popular example for a MMORPG is NetEase´s Fantasy Westward Journey, somehow comparable to World of Warcraft (WoW). In terms of lifetime grossing, it is considered one of the most successful games ever in the Chinese market. PUBG Mobile, a BR game developed by Tencent, continues to be one of the highest grossing games throughout 2020. Other game types such as card games (e.g., Onmyoji) or casual racing (e.g., QQ Speed) can also achieve double-digit million MAUs.

Concerning monetization, the vast majority of games are designed as free-to-play (F2P) and monetize through in-app purchases (IAP) such as play-to-win (e.g., skins) and pay-to-win (e.g., faster cars or better weapons, battle pass), or in-game ads, instead of game purchases (upfront) or multi-game subscriptions.

Operations

In terms of operations, the Chinese gaming market faces more challenges than other markets. One important aspect is regulation. It is important to note that game titles in China require approval prior to launch. For many games, Chinese players can only compete among each other and not against players from other parts of the world, i.e., players in China will share a local server, making the online multiplayer option only available to those in the same geography. However, since Chinese players also like competing against others (e.g., Koreans), shared servers (sometimes called “gaming VPNs”) are popular and common among more competitive players. Another regulatory aspect is the daily upper limit of playing video games for minors (i.e., 1.5h during normal days and 3h during holidays). This policy is implemented by the need to register with the real name and facial scan, which is validated against a database containing government ID information.

Another aspect is related to the distribution via apps stores. While there is an iOS app store, the situation for Android is very different. To be specific, there is no one Android app store (like Google Play Store) but several ones (e.g., Tencent, OPPO, Huawei) with varying service fees.

The last operational aspect worth mentioning is the seasonality of mobile gaming practices. China has two large national holidays, one in Q1 (Chinese New Year) and one in Q4 (National Day). Those days usually mark the highest activity (and revenue) of gaming across the year and frequently lead to servers of popular games crashing.

The industry is big, keeps growing and is incredibly profitable

Size

The overall Chinese gaming market is well ahead of the market in the US in terms of revenues, a gap that is expected to further widen in the coming years.

Figure 3: Global gaming revenues 2019 by region in billion USD (Source: Newzoo)

Japan and South Korea are traditionally markets with an incredible high average spending per user but come in third and fourth overall given the small population size, whereas Germany is the fifth biggest market. When looking at the numbers from an internet user per capita spending, Japan leads the ranking with USD 183 p.a. ahead of Korea with USD 143 and the US with USD 127. Within the Chinese internet population, the per capita spending is only USD 44 at the moment which points at future potential to grow.

Figure 4: Gaming revenues per internet user 2019 by region in USD (Source: Newzoo)

Tencent - a global Top-10 company for three years by now - is China´s second-largest internet company with a market cap of USD 650 bn and perhaps the world´s most successful corporate venture capitalist. It makes around 35% of its USD 65 bn revenues from gaming (but that number used to be closer to 75% in earlier years). It is a clear leader in the market with around 50% market share.

Tencent Games maintains multiple revenue streams. First, it develops, publishes and distributes games in-house or through majority-owned subsidiaries, such as League of Legends (China), PUBG Mobile, Honour of Kings, Clash Royale and Peacekeeper Elite. Second, it maintains minority stakes in large studios through which it obtains games for distribution, such as Epic (40%), Ubisoft (5%) or Activision Blizzard (5%). Third, it also operates a Steam-alike gaming portal called WeGame for distribution in China. Moreover, it maintains QQ Game Hall, a chat-based application where players can compete in casual games, such as Mahjong. Lastly, Tencent also manages the largest Android app store in China. All three allow for charging service fees. Fourth, it organizes leagues and events (e.g., League of Legends Pro League, King of Honors Pro League), for which it monetizes content (media rights, ticket sales, merchandising) and achieves sponsorships.

Figure 5: The Tencent 2020 League of Legends Pro League attracts major sponsorship (Source: Invenglobal)

All combined makes Tencent the largest gaming company in the world, ahead of Sony Interactive Entertainment (PlayStation) at around USD bn 20, Nintendo (Switch, Super Mario, Pokemon) with USD 11 bn and Microsoft (e.g., Xbox HW, Xbox Live, Halo, Minecraft) with USD 11 bn in revenues respectively, for reference.

For NetEase (e.g., Fantasy Westward Journey, Shido Beach, Onmyoji: Monster House), China´s no. 2 gaming (15% market share) and no. 7 internet company with a market cap of around USD 60 bn, the share of gaming stands at 70% on circa USD 9 bn revenues.

Perfect World is another major company worth mentioning, achieving around USD 1 bn in gaming revenues in 2019 and 2% market share through in-house developed games such as Perfect World, Jade Dynasty or as the distributor of Valve games such as Dota 2 and CS:GO in China Mainland. Large groups like Tencent, NetEase and also Perfect World have a wide portfolio of titles and can hedge among different bets.

Then there are many much smaller gaming publishing companies where the revenue largely fluctuates with single title success/failure. Changyou used to be a big company in China´s gaming sector with USD 0.7 bn revenues back in 2014. However, it has lost around half of its revenue since then, and eventually got acquired by Sohu, before delisting from public markets. A recently uprising company is 37 Games (e.g., Blade and Rings, Soul Land H5, New Romance of the Three Kingdoms). After rapid growth, it achieved revenues of USD 0.2 bn in 2019 (less than 1% market share). miHoYo, founded by three Shanghai Jiaotong University graduates, was a rising force for years with its Honkai Impact game series. It had revenues of around USD 0.15 bn in 2017, then entered a quiet period but this year just entered the world stage after launching the title Genshin Impact. Alibaba through AliSports and Lingxi used to be a rising force in the industry as well but recently lost traction and talent. However, its 2019 title Three Kingdoms eventually turned out as a hit. Last, ByteDance is a rising force in China´s gaming sector but still comparably small as for 2019.

Figure 6: Gaming revenues of major companies 2019 in billion USD (Source: Company fillings)

With that, it becomes clear just how much of a dominating force Tencent is, as Figure 7 shows:

Figure 7: Market shares of Chinese major gaming companies 2019 in % (Source: own calculation)

Growth

In the US, Microsoft experienced growth of around 10% last year. Meanwhile, revenues for 37 Games grew in excess of 70%, from Perfect World´s gaming group revenues grew 26%, NetEase grew 16% while Tencent´s Gaming division grew more than 10% in 2019.

Figure 8: Revenues growth rate 2019 of selected Gaming companies in % (Source: Company fillings)

Profitability

But gaming in China is not only big but also incredibly profitable. Tencent's Value Added Services revenue stream, combining social networks such as digital content subscriptions (e.g., Huya video) and gaming, boasts an impressive gross margin of almost 55%, even ahead of 50% for the online advertising and 30% of FinTech/Business Services revenue streams.

Adjacent industries grow as the industry keeps emerging

The growth of the gaming industry in size continues to be supported by the growth of related industries. This phenomenon is now ubiquitous, as it is revealing itself in many other internet verticals, e.g. e-commerce. For example, the rise of Taobao led to the emergence of Ant Group, on track for the largest IPO ever. Another example is that the growth of JD.com spawned the emergence of JD Logistics, a company with more than 100k employees by now and about to launch an IPO separately sometime in the future. In gaming, related industries around education, equipment, virtual currencies, marketplaces, players, events, and content streaming continue to emerge.

In terms of education, many universities now offer majors to prepare people interested in this career track. One example is game design degrees where the Beijing-based Communication University of China has produced graduates going into major studios. Another example is the Tsinghua University/Tencent-partnership for the Shenzhen campus.

A gamer needs good equipment to compete with peers. As a result, major Chinese hardware producers have produced specialized PCs (e.g, Lenovo and Machenike) or even phones (e.g., Vivo iQOO series, Tencent Games ROG phone) but likewise equipment around specialized chairs, headsets and smartphone holders continues to sell very well.

Figure 9: The Vivo iQOO 5 Pro high-end gaming phone, worth USD 800 (Source: JD.com)

In China, Q coins (Q币) have been around for some 15 years. They play an integral part in Tencent´s gaming universe, as they are the virtual currency used to pay for IAP. Gamers have to exchange RMB to Q coins and usually get certain discounts, depending on the amount they exchange. It is worth noting that all of this happened at scale way before digital currencies such as Bitcoin, Ethereum and Lira entered the world stage and struggled to find meaningful and legal real world applications. While trading in virtual items reached beyond USD 1 bn in China already in 2008, it is now used for transactions accounting for tens of billions of USD every year.

Given the F2P monetization model of Chinese games, players tend to spend a lot on IAP such as virtual goods. They are then traded in major marketplaces. The largest of these is Webgame 5173, which exceeds USD 1.5 bn USD GMV in 2019. Other large ones are 7881.com and Taobao Gaming.

While many players play for fun with a bit of competitive spirit, a whole industry of clans, players and KOLs has emerged along the ever-larger gaming industry. Some popular clans/teams include LoL teams Edward Gaming, Royal Never Give-Up or JD Gaming (JD.com team) or KoH teams such as Turnso Gaming (see above), AG Super Play and Dynamite Gaming. Their players –like NuanYing – are often considered celebrities. Famous KOLs such as 老番茄 attract 13 mn fans on Bilibili, 8 mn follower on Weibo in case of pdd_liumo and 5 mn follower on Weibo in terms of Uzi. In fact, many formerly professional players later “retire” as semi-professional streamers.

Figure 10: NuanYing, Logo Weibo Turnso Gaming, the leading KoH player and team (Source: Liquipedia, Company Weibo)

While many play for themselves, they also like to see their role models compete and learn from them. As a result, Tencent has done an excellent job at creating a number of professional gaming leagues such as the China League of Legends Pro League (LPL), jointly with Riot Games, or the Tencent Games King Pro League (KPL) for Honor of Kings, where teams often represent certain cities to increase affiliation further. These leagues host large events where they sell tickets and merchandising, attract major sponsorship (including Nike, Vivo, Volkswagen), and sell media rights to other platforms such as Bilibili for hundreds of millions of USD.

Figure 11: 16 pro-teams, including TS, competed in the 2020 KPL spring season (Source: Baijiahao)

Another adjunct major industry that keeps experiencing rapid growth is content streaming by casual players, pro-players or of bespoke major events. Much like Twitch in the West, there are platforms such as Douyu, Huya, and Bilibili, often attracting tens of millions of viewers.

Figure 12: Douyu main page, app-version (Source: own image)

The rise of China´s video gaming industry to become the largest in the world remains a topic little understood by many. In fact, the size and influence of companies like Tencent or even NetEase does not find proper counterparts in the West. Based on our analysis, it becomes clear that at least in China, success of games does not depend on the game itself only, but rather on the distribution, operations, and the ecosystem aspects, including leagues, created around it. And that is what the large gaming companies really excel in. We find that the latest since the launch of KoH, China´s mobile gaming universe no longer is a virtual reality. In part two of this series, we will further dive into emerging technology trends.

All opinions expressed in this essay represent our personal views only.

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