[EXCERPT] Early Days: The Social Gaming Market and Facebook’s Achilles’ Heel

Chapter 17

Facebook’s Achilles’ Heel

It is clear from the console wars that being the market leader is a great position to be in for a five-year period. It is also clear that new entrants to the space can differentiate on service, pricing or content.

In the console wars, new entrants were able to gain market share because of inherent strengths, such as Microsoft with Xbox Live. With the Wii, Nintendo gained the top spot after two down cycles because it made gaming fun, family friendly, and accessible (meaning a lower price than the more expensive Xbox 360 or the PlayStation 3).

From the perspective of game developers, console wars have consistently provided a challenge: Which console should they develop a game for first, and then “port” or move to another console? In past cycles, Nintendo’s hardware was typically the first choice (such as in the NES and Super NES cycles), followed by others. In the 64-bit era, the Nintendo N64 console was supplanted by a newcomer, the Sony PlayStation. To take this out one more cycle, the Sony PS2 crushed the Nintendo GameCube and the newcomer, the Microsoft Xbox. In the current generation, the Nintendo Wii has been the top gainer, followed by Microsoft’s Xbox 360, then the Sony PlayStation 3.

Companies making software have had to make highly strategic production decisions based on platforms. For example:

• In the N64 era, most developers were making games for the N64 first, then “porting” or moving a game to consoles such as the PlayStation. However, Sony gained an early advantage getting developers to make games for the original PlayStation because a) it was a year ahead of the N64, and b) Sony was offering support in terms of development help or, more importantly, writing checks to developers to make games for Sony.
• In the PS2/GameCube/Xbox era, Sony was boss, and rarely wrote any checks to publishers to fund development of games for the PS2. Sony’s hubris got the best of it, communicating that companies should be paying us money to make games on the PS2.

The lesson here is clear: Hubris opens the door for competitors. Microsoft stepped up with its significant cash balance and started writing checks to developers to make a) content exclusively for the Xbox, b) content for release in an exclusive Xbox launch window, or c) post-launch content for release in an exclusive window through the Xbox Live service.

Part of the underlying issue here for developers was “how do we make a game” in this era? Most developers wound up targeting the largest platform — Sony’s PS2 — then porting a game to the Xbox, and then to the GameCube. Rarely, if ever, did a company develop a game in tandem for both the Xbox and the PS2 because of inefficiencies and cost implications. Developers were able to share art assets for the PS2 and Xbox, but rarely much code due to the architectural differences between the two consoles. Further, most of the art assets couldn’t be utilized for the GameCube due to resolution incompatibility.

In the Xbox 360/Wii/PS3 era, most developers made an Xbox 360 version first (the Xbox 360 launched ahead of the PS3), then a PS3 version, and eventually a Wii version. While the Wii was the runaway winner in this cycle, publisher company management typically adopted a wait-and-see attitude, concerned that the Wii could be more of a social fad than a market trend.

After three consecutive holidays of Wii hardware sell-outs in the U.S., publishers were forced to acknowledge the Wii’s market share gains, but still hesitated to make a Wii-first game. In the meantime, Microsoft continued writing checks and positioned itself against the PS3, with exclusive launch periods and titles against the PS3.

This underscores the challenges developers face making games in the social gaming era. The questions abound:

• Do I make a game first for the iOS operating system?
• Do I make an Android game first since that platform is gaining users?
• Do I make a game first for Facebook since it has such a massive global reach?
• Do I focus my efforts on tablets such as Android-based and iOS (iPad) platforms?
• Do I focus on mobile platform, such as a smartphone OS?
• Do I pick an emerging platform, such as the Amazon Kindle Fire and target it to be an early mover?

Game developers are forced to choose a development path. Some platform companies are writing checks for exclusive content, or an exclusive launch window.

Other companies aren’t offering checks, but equivalent metrics in “free” daily advertising in exchange for exclusive content or launch windows. Additional perks being offered include strategic placement for a title in banner ads. The competition for Facebook is growing, and the other platform holders are being aggressive.

So why could Facebook be in trouble? Hubris, led by social gaming and its deal with Zynga. Gaming is currently 11%-12% of Facebook’s revenues, and likely a higher percentage of profit.

Further, Facebook has become filled with hubris toward game developers, and challenges are emerging for Facebook to maintain its position.

While gaming provides 12% of revenue, Facebook allocates significantly less than 12% of its resources toward gaming. Facebook’s gaming division is understaffed. As a result, developers are reporting that getting results or communications from Facebook’s staff are hampered and a source of frustration.

The biggest issue for developers is that Facebook is ratcheting viral marketing efforts up and down depending on the partner. This is not an issue for just gaming companies, as other media companies have experience similar issues with Facebook.

In gaming, for example, if a Facebook user has 30 friends on their friends list, they will receive updates on the activities of those 30 friends. If one of their friends is playing a Zynga game such as Castleville, they will likely receive update status notification that the friend is playing Castleville. However, if the friend is playing a non-Zynga game, the non-Zynga status update typically won’t show up.

The implications for Facebook’s care and nurturing of gaming companies outside of Zynga are significant given Facebook’s market position and reach. The main implication will become more obvious over the next six months: game publishers not named Zynga will migrate away from making games for the Facebook platform, lowering Facebook revenue and advertising dollars.

The movement has already begun: the first company to acknowledge it publicly was CrowdStar (http://dthin.gs/M7Uxlt).

Further, Facebook admitted while on its IPO roadshow that advertising dollars were weaker than expected (http://bit.ly/M7UMwR). While we don’t believe this is completely attributed to gaming, it raises a red flag.

In discussions over the past six months with private gaming companies, more are moving game development off of Facebook to other platforms but haven’t publicly disclosed it.

This issue of lost publisher revenue and associated advertising revenue for social games will become a bigger issue for Facebook if Zynga doesn’t successfully launch more games on Facebook instead of www.zynga.com.

Do Facebook Math

While Facebook has great reach, reasons cited by developers for moving development and ad dollars away from Facebook include:

• Publishers are required to use Facebook credits as the game payment system. This means 30% of revenues from game sales go to Facebook.
• Advertising for a game to be sold through Facebook means the majority of advertising revenues will be spent on Facebook. This means another 20%-40% of revenues then goes to Facebook, bringing the total up to 50%-70% of revenues from a game going to Facebook.
• If a game is sold through Facebook in Europe, some developers have discussed challenges recouping the full VAT of 15%-20% from Facebook, which means 70+% of revenues aren’t going to the developer. Even with a full VAT refund, it continues to be a 50%-70% split in favor of Facebook, which is significantly higher than any split toward a platform company in the console eras.
• Facebook has been slow to help turn on viral marketing efforts for publishers not named Zynga, and such efforts lower cost-per-user metrics for the publishers. In turn, the publishers have to spend more on the marketing campaign, thus benefiting Facebook again.

Market leaders in the console hardware cycles have historically grabbed market share and been able to hold on to that position for five-plus years per cycle. The market for social gaming is not running on a traditional five-year console hardware cycle.

While there are mini-hardware cycles today — including iPhone 3, 3S, 4, iPad 1, iPad 2, and iPad 3 — they are incremental changes. They are not architecturally different platforms, such as the PS2 to the PS3, or the GameCube to the Wii. The change in technology over a five-year cycle is significantly different than a year upgrade cycle.

As a result, new platforms are regularly springing up and the market is in Early Days. For example, while the tablet market is currently dominated by Apple’s iPad products, there is not a clear No. 2 player in that market today. However, in 12 to 18 months, it is highly likely that the competition will heat up for tablets as a) the Kindle Fire continues to gain share as a low-cost alternative to the iPad and b) Microsoft throws its considerable weight and cash balance behind support for Windows 8 mobile devices (and the Windows 7 and 8 phone devices with partners such as Nokia) and its hardware partners.

Therefore, while we saw market share shifts in the console era on a five-year basis, today’s market share shifts are noticeable on a 12-month, or even a six-month basis. Further, it means the landscape for tablets and social gaming could be markedly different in 12 to 18 months from today, where Facebook stands as the market leader for social gaming.

What does Facebook have to do to maintain its lead? It can be argued that Facebook should do nothing, and simply enable any Facebook user to continue to access its service on any platform, current or future. However, just as consumers vote on retail stores by their feet, game developers are already following the new path away from Facebook, and some of the emerging platforms could shift market share positions in a surprisingly short time frame.

In the next few years, as Zynga’s private deal with Facebook continues through at least 2015, Zynga will be the anchor for Facebook’s gaming revenues, corresponding advertising revenues, and a meaningful percentage of its profit margin.

However, this won’t address any lost revenue through Facebook credits and advertising as other social gaming companies leave for other platforms. This will mean Facebook will miss opportunities, and will become increasingly reliant on Zynga.

Zynga now faces a practical and difficult decision: When should it start to drive consumers to its own platform, www.Zynga.com, instead of Facebook?

In essence, Zynga winds up competing against itself, and ultimately, Facebook, as it wants gamers to play games on www.Zynga.com instead of Facebook.

Where are better economics for Zynga? Revenue generated through www.zynga.com is more profitable revenue for Zynga, but until that website platform ramps up, the bulk of revenues for Zynga will continue to come from Facebook.

And the danger for Zynga? Facebook could shut down viral marketing opportunities for Zynga, driving up its partner costs once again after imposing the 30% Facebook credits fee last year.

What could Facebook do to help retain developers to focus on Facebook? It could welcome game developers once again by turning on more viral marketing opportunities such as enabling friends lists status updates to include gaming activities. This does not mean Facebook would have to turn push marketing (e.g., Facebook users were getting messages about friends playing Mafia Wars and needing helping taking down a drug cartel) back on. Viral marketing being enabled again would be a direct and clear response by Facebook, but increased competition for Zynga.

Facebook could also be more accommodating to partners when there are issues, such as any network problems. This is a concern of several developers working with Facebook today.

Partners are typically called partners because they work with them, and it is a symbiotic, not a parasitic relationship. The discussions we have had with publishers have had a common and resounding message: They want more help and less hostility from Facebook.

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