The state of games: State of AAA

In part one of a five-part series, Polygon evaluates the state of the blockbuster "AAA" game development industry.
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This is the first part of a five-part series on the state of games, written by the editors of Polygon. Parts two through five will be published separately each day this week. The entire series will be re-published in total next Monday. - Ed.

We hear a lot of talk. At gaming events, at press conferences. At private functions or over dinner with well-connected friends in the industry. People talk, even when they shouldn't. And we listen, even when we can't quote them.

Here's what they're saying:

The state of AAA is chaos, bordering on impending doom.
AAA development is a high-risk, narrow margins game with only a very few winners, and too many players.
It's a mosh pit.
It's chaos.
It's falling apart.
No one is profitable.

The last is what we hear over and over. That no one is making money in AAA games. Costs are too high and the number of units that have to be sold in order to break even is in the mid-millions. Nobody is hitting those marks with any predictability, which means nobody is winning, or so they say.

Now let's look at the truth behind the rumor.

THAT'S A 3% PROFIT MARGIN — NOT GREAT
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By the Numbers

Industry sales data posted last month by Variety points to modest gains in the last fiscal year by all three of the major third-party publishers, Activision, EA and Ubisoft. Although in each case the gains were posted largely in the fourth quarter, bolstered by online sales and non-AAA revenue.

Ubisoft is the winner of the door prize, posting $48 million in profits versus a $67 million loss the previous year. Virtually all of that growth, however, came from its virtual game sales, which rose 111%, and games for the Wii, which comprise a third of their total revenue.

Also worth noting is that $48 million is the profit off of total revenues of $1.4 billion. That's a 3% profit margin, for those keeping score at home. Which is not great.

EA did slightly better for the year, posting total fiscal year profits of $76 million, versus a $276 million loss last year. But before we get all happy weepy over the turnaround, let's consider that $56 million of that profit came in the fourth quarter, and that EA's money-maker for that period was Mass Effect 3. That game's budget has been estimated at around $40 million, and it has sold over 3.5 million copies to date.

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Mass Effect 3 DEVELOPING A AAA GAME IS ONE OF THE MOST EXPENSIVE ENTERPRISES HUMANS CAN UNDERTAKE, OUTSIDE OF BUILDING BATTLESHIPS, LAUNCHING SPACE VEHICLES OR MAKING MOVIES

Look at those numbers closely. EA spent $40 million to make $56 million, and they had to ship more than 3 million copies to make a profit at all. That, my friends, is why people in the know are starting to panic. EA's $76 million in profits came in over $977 million in revenues, which is close enough to a round billion that it'd be exciting if it represented more than a 7% profit margin.

Now let's take a look at the 800 pound gorilla in the room: Activision. Activision posted a profit of $384 million in the first quarter of this fiscal year, down from $503 million last year. But hey, $384 million is still over $300 million more than anyone else, so what's to worry about? Plenty.

For one thing, that profit is driven largely by World of Warcraft, which posted flat subscriptions last year for the first time since it launched 8 years ago. Call of Duty continues to dominate AAA multiplayer gaming, but dominating that market will not yieldWoW numbers any time soon unless Activision finds a way to make subscriptions palatable to console gamers. Even then, it'll be a stretch. Even WoW fans are beginning to question the wisdom of paying a monthly subscription. Which means Acti has another year, maybe three of guaranteed crazy-insane profitability before it needs Plan B to start paying off.

Also worth worrying about, Activision's $384 million in profit comes off of $1.2 billion in total revenues. Not only is that revenue number down 19% from last year, but it represents a $200 million shortfall against Ubisoft's yearly revenues, putting Activision into second place, revenue-wise. Its massive 30% profit margin has to be some consolation, however.

So, those are the numbers, and by themselves they tell a pretty compelling story, but why is the industry in such peril? Why is only one of the major AAA studios earning a double-digit profit margin, and why are everyone's profits coming off lucky gambles or marginal models like virtual purchases and Wii games? Why aren't AAA games making money?

The expense of developing a AAA game is old news. With teams often starting at 100 people and budgets soaring to multiple hundreds of millions of dollars, developing a AAA game is rapidly becoming one of the most expensive enterprises humans can undertake, outside of building battleships, launching space vehicles or making movies.

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THE WOES

1. Outsourcing

The once controversial (and now traditional) primary means of offsetting this expense, i.e. outsourcing low-to-mid-level coding and graphic development, continues, but the pace of the savings have failed to keep up with the cost of remaining competitive.

For one thing, outsourcing is difficult to scale. Each externally-developed component requires mid-level management, straining the talent pool precisely where it is typically most vulnerable: the creative leadership. Video games are not automobiles. You can outsource production of level design or texture development, but in an artistic enterprise, that outsourcing comes at a cost to innovation and quality control. It requires much more finesse and attention to detail to successfully manage multiple, cross continental game design teams than to import ready-made bucket seats. And the publishers who are most successful at this tend to be those who already have an edge in the market, making it that much more of a losing proposition for studios "on the rise" to catch a break in AAA.

2. Extended console cycle

AAA game development requires a broad base of potential players. No one is going to sink millions of dollars into designing games for a platform for which no one is willing to buy games. Unless that developer is Sony and that platform is Vita, but I digress.

Historically, there have been two or three concurrent AAA platforms. In the United States, as of now (i.e. "current gen") that platform is the Xbox 360, and to a lesser extent the PlayStation 3. These are two platforms inching into their 8th and 7th years, respectively. By the time the next generation of consoles hits the market (experts agree this will happen either late in 2013 or in early 2014 for the new Microsoft console) the current gen will be a decade old. That's more than twice the usual lifespan for a home gaming console.

On the one hand, the longevity of the current generation is a sign of the popularity of the games for the generation. In theory, it makes developing AAA games for these consoles relatively low-risk and somewhat less expensive. In practice, however, these gains are marginal, and are offset by the reduction in "wow" factor of games that look so much similar to games released almost a decade ago.

Developing AAA games for a decade-old console is, by definition, devoid of innovation, and this innovation deficit is opening the door for the PC platform (which continually innovates) to steal market share from AAA consoles and siphon off the attention of the hardest of the core gamers. New technology like Intel's Ivy Bridge processors are providing a compelling excuse for hardcore influencers to spend their gaming dollars on PC platforms and games, instead of on far less graphically impressive console titles.

Not only does the widening technological gap between consoles and PCs siphon profit and attention from AAA games developed for the consoles, but it puts the major publishers into a double disadvantage considering the staggering losses they generally attribute to developing strictly for the PC. Multiple sources speaking anonymously have pegged the PC game piracy rate at close to 90%, meaning only 10% of the people playing AAA games in the PC platform have actually paid for it. A new generation of console tech would cut that source of attrition off at the knees.

3. Graphic reach

One of the biggest fears about the upcoming console generation is that in spite of nearly 10 years development over the last gen, the graphical improvements just won't be all that shiny.

Ever impressive graphics are to most AAA games what ever larger explosions are to Michael Bay films.

As the goal of producing photo-real graphics approaches, there is very little room left for practical innovation. It seems very unlikely that the next gen will represent as significant a graphical leap as the last gen, and it's entirely possible the advances will be so slight as to be unnoticeable to most consumers. What this means on the ground is that your average gamer (i.e. the "broad middle") will be unlikely to see the next gen as a significant enough advancement to warrant investment. Early adopters will be few, and some consumers may skip the generation entirely. Which means some publishers and developers may skip it entirely as well.

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THE CORE PROBLEM

Yet none of this really gets at the heart of what exactly is ailing AAA development. These are symptoms, and serious ones, but not the disease.

The disease is how games are developed in the first place, and, in some part, how consumers judge them.

The reason so many studios are willing to take a gamble on multi-million-dollar AAA development cycles, even knowing the odds of commercial success are slim, is that there really aren't that many other options. You can make a living making indie games, or making social and mobile games, but between that tier and AAA is a wide swath of budget and team sizes at which it is practically impossible to survive.

PUBLISHERS HAVE TRADITIONALLY EATEN THE MARGIN. THOSE DAYS ARE OVER. GET READY
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AAA CASE STUDY: EPIC GAMES


Epic Games, based in the unlikely city of Raleigh, North Carolina, is rapidly emerging as the poster child for survival in a post-AAA game industry landscape. Their secret: diversification. It also doesn't hurt that they own the engine powering many other companies' AAA games.

Epic began accumulating fame in the late 90s and early Aughts as a serious contender in the nascent first-person shooter arena. Their Unreal steadily took second place to shooters from competitor id Software, but behind the scenes, Epic was selling the game's engine - the program powering the game - to those developers without the funds to create their own technology. Epic continued to iterate on its FPS game designs and engine technology in the following years, steadily consuming a larger share of both markets.

By the second decade of the new millennium, Epic had parlayed their dogged perseverance and traded on a close relationship with Microsoft to become both one of the most successful shooter developers and best-selling engine makers. Epic's Gears of War Franchise dominates the Xbox sales charts, and the Unreal engine powers more successful AAA games than any other engine.

The company has begun a series of expansions and acquisitions aimed at diversifying their offerings across multiple gaming platforms and allowing the company to publish multiple installations of current and future franchises. Epic has already or is in the process of building up studios in Shanghai, Korea, Tokyo and Baltimore, and has acquired Chair Entertainment (Infinity Blade, iOS) and People Can Fly (Bulletstorm, Xbox).

Chair is currently iterating on the Infinity Blade franchise for iOS devices. The move, while somewhat of a shock at the time, would seem to make perfect sense considering that iOS devices make up the single largest gaming platform on the market. While other AAA developers struggle to find their footing on mobile platforms, Epic is literally on stage with Steve Jobs, touting their engine's grace and utility on the latest devices from Apple.

Meanwhile People Can Fly has stepped in as a secondary developer on Epic's own Gears of War franchise. This latter move may signal that Epic is ready to begin "yearly" updates to their mega-selling super hit franchise.

Perhaps the single biggest reason Epic has remained competitive and now stands to dominate AAA development, however, is that it makes and markets technology better than any other player in AAA. Epic has the privilege of being able to lay partial claim to a startlingly high percentage of the best-selling games each year simply by virtue of having sold those games' developers an engine. With recent licensees including mega-sellers Mass Effect 3 and Batman: Arkham City, the power of this positioning is hard to overstate.

While it may not be accurate to call Epic an engine company first, game developer second, it is nevertheless appropriate to consider that Epic, as a game designer and publisher, can afford to take risks other companies can't. For one thing, the company can provide subsidiary studios with out-of-the-box game design solutions, giving them a rapid, stable foundation for their nascent game designs. For another thing, through those subsidiary studios, and on the back of the magic carpet of money that is the Unreal Engine, Epic, unlike most other AAA developers, can afford to fail. In the high-stakes game of narrow-margin risk-taking that is AAA development, Epic is holding a lot more cards than anyone else.

To explain why, let's compare games to film once again. In the film industry, the craft of filmmaking is relatively well-established, and costs a certain amount in terms of crew and equipment. Filmmakers can save money by cutting scenes and getting creative with locations, but by-and-large, the cost of making of a movie is relatively fixed. Yet the visual quality of the film being made does not change by a wide margin from film to film. Woody Harrelson looks like Woody Harrelson, whether he's in The Messenger or The Hunger Games.

In film, the difference between AAA and everything else is largely in the abundance or lack of computer graphics, explosions and other graphical effects that cost a great deal of money to create. So-called "B" movies may have fewer well-known stars, but are typically just as well produced and look similar to AAA films, minus the dinosaurs and rocket ships. In games, it's all computer graphics. The general consumer metric of quality is the pinnacle of graphical technology, which in games represents 100% of what is seen on the screen, as opposed to film, in which that percentage is much, much smaller.

The rising competition to mainstream, AAA games from the mobile and social sectors is creating a market for "B" level games entirely outside of the scope of traditional development. EA and Ubisoft are investing heavily in this sector for the express purpose of getting a foot in the door of what they believe will be the next big audience, but for core gamers un-interested in this market, the choices are slim. In video game development, there is nowhere to save money without sacrificing quality. "B" games look, to the consumer, like bad games. There is no market for "straight to DVD" or "second run theater" titles. There is no "made for TV." In games, If it isn't AAA, it's bargain bin. There is no middle ground.

This is why Ubisoft, which is concentrating heavily on the low-end market with Wii games and games designed for children and families, is pulling in revenues higher than Activision, which is focused almost exclusively on AAA development. This is why the iPhone, for which games are sold for under $10 and cost merely hundreds of thousands to develop, is currently the most popular gaming platform. This is why the MMO industry, which a half-decade ago employed close to a million game developers, is now shifting to a "free-to-play" model, where consumers pay only for premium extras, at a few dollars a piece.

This is also why the AAA developers are also looking at premium or "freemium" models, in which consumers may still pay for a game off the shelf, but will also continue to pay the more they play. If you think Call of Duty Elite and EA's online pass programs are a flash in the pan, think again. The next generation of consoles (and the one after that) will rely heavily on online distribution, and once that happens, the control of the market will shift from retailers to console makers, and then directly to publishers.

Having learned (through experiments with DLC and MMO subscriptions) that the broad middle will pay continuously to prolong an enjoyable experience, publishers are shifting to extend the process of paying for games into well after their release. The initial cost of a AAA will most likely not decrease, but it will also not go up. How you pay for the increased cost of the game’s production will depend on how you want to play it.

If you are a fan of single-player experiences and deep narratives, expect to get a short, open-ended experience for your initial $60 investment, and then pay for successive installments down the road. If you are a multiplayer fan, expect to get a very basic, no-frills multiplayer shell for your $60, and then pay a subscription for map support, and additional hard money for skins and other extras.

This is not supposition; this is happening. Right now. I predict that this will ultimately become a failed experiment and that the industry will have to take a hard step back to limited experiences with limited price tags (for developers and consumers), but the next 3 to 5 years of AAA development will look a lot like the airline industry; where you pay a little for a seat, then a little bit more for the peanuts.

In an industry where consumers have traditionally paid the same price for a product no matter how much that product cost to create, the publishers have traditionally eaten the margin. Those days are over. The bottom line of the state of AAA is that the cost to produce AAA content is soon to be coming out of your pocket. Get ready.

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