The Invisible Arcade

A few weeks ago, we wrote a newsletter on the CMA’s (UK regulator) decision to block Microsoft’s $68.7b acquisition of Activision Blizzard due to concerns about anti-competitive behavior in the cloud gaming market. While we have already outlined our perspective on why we believe this is a misguided opinion, the underlying topic of cloud gaming remains an interesting (and often overlooked) channel for video games.

A Brief History of Cloud Gaming

Cloud gaming has recently attracted a growing level of attention, especially as it relates to Microsoft’s ambitions in the space. In reality, the technology has been a work-in-progress for over two decades. For a sense of how this space has evolved, here is a high-level timeline:

• 2001: G-cluster launches a novel technology that allows for playing PC games on wireless handheld devices over selected “hotspots”.
• 2005: Crytek begins research into cloud gaming before stopping efforts in 2007 due to doubts around viable economies of scale given bandwidth costs and constraints.
• 2010: OnLive launches their cloud product with immediate access to premium video game content on a PC or Mac via a broadband connection through a web browser.
• 2011: Gaikai launches a Beta of its game streaming service that allows users to play high-quality games in a web browser.
• 2012: G-Cluster announces the debut of its Game Machine platform to bring premium games to TVs without needing a console, Nvidia announces their GeForce Grid streaming service in partnership with Gaikai to provide a lower latency game streaming service, Sony acquires Gaikai.
• 2014: Sony announces the PlayStation Now cloud gaming service based on the acquired technology from Gaikai.
• 2015: Sony acquires OnLive and promptly shuts it down.
• 2016: Shadow releases their first offering to unlock the power of a high-end PC in the cloud.
• 2019: Google launches Stadia, EA launches a cloud gaming technical trial after acquiring GameFly’s cloud-streaming technology the prior year.
• 2020: Microsoft launches xCloud game streaming product.
• 2022: Amazon releases their Luna cloud gaming service with free games for Prime members.
• 2023: Google shuts down Stadia after failing to attract a sufficient user base.

Where Are We Now?

Despite the time, effort, and capital that has gone into cloud gaming since 2001, Newzoo estimated that only 31.7m paying cloud gamers would spend $2.4b on cloud gaming services and software in 2022. Without context, these sound like impressive adoption numbers, but cloud gaming has only captured ~1% of the 3.1b global gamers and only 1.3% of $184.4b in total global gaming revenue in 2022. By comparison, there are 1.1b PC gamers and 611m console gamers that collectively generated $92.3b last year.

The following chart indicates that cloud gaming was roughly the same size as the Browser PC Games market in 2022. For now, user experience challenges such as latency and input lag are preventing the cloud gaming category from being a viable alternative to other gaming experiences across mobile, PC, and console.

That being said, the excitement around cloud gaming remains warranted given its potential. Cloud gaming’s core value proposition is unparalleled access to content across virtually any device. There are a couple of key benefits that apply to gamers, IP owners, and distributors:

1. New Audience: Cloud gaming can unlock access to a new category of gamers that could not previously access content due to restrictions such as hardware limitations (more on this later). This is effectively expanding the gaming market size by reaching an audience that was previously excluded due to technological barriers (as long as they have sufficiently strong internet connection, a significant barrier for many).
2. Deeper Engagement: The technology can also enable increased engagement from the existing gaming audience by providing content anytime and anywhere. In this case, cloud gaming might effectively become the distribution channel for all devices, which would take market share from all of the categories in the chart above.

Additionally, an effective cloud gaming solution alleviates the need for designing, building, selling, and updating physical hardware. This is particularly compelling for console providers that are generally selling these devices at a loss in order to unlock software and subscription purchases. As an example of this, Xbox has famously never turned a profit on any of its gaming hardware devices.

It is important to note that cloud gaming does not eliminate the hardware requirements for gaming, it simply shifts the burden away from the consumer. For a game subscription service like Xbox Game Pass, Microsoft only covers the cost of games bundled in the offering; however, with cloud gaming subscriptions like xCloud, Microsoft must cover both the games bundled as well as the infrastructure costs to run those games. This is a particularly expensive undertaking because the cost scales one-to-one with the number of users supported - every player needs their own instance of the game running in the cloud, with GPU support, to render their specific view of the game. The network infrastructure load for cloud gaming is also drastically increased because hyper real-time video streaming is introduced (i.e. fast paced shooters or action games), whereas traditional multiplayer gaming relies on very small scale game state updates, such as positional movements, between players. 

Given the burden now falls on the cloud providers themselves, it makes sense that the most prominent players in this space all have their own first-party cloud infrastructure offerings.

• Microsoft xCloud - Azure
• Nvidia GeForce Now - Graphics Cards and Data Center
• Amazon Luna - Amazon Web Services (AWS)
• Google Stadia (defunct) - Google Cloud Platform (GCP)

However, this is not the only requirement for building out a cloud gaming service. There are three key layers: 1) distribution interface, 2) cloud infrastructure, and 3) game content. There is significant value in owning each incremental layer of the stack, so the following strategies are ranked from least to most ideal.

1) Distribution Interface: This is effectively the client or web page where users discover and launch game content. In general, most of the startups we see trying to compete in this space come to fundraise with a core stack that leverages third-party hardware (typically from one of the four groups mentioned above) and tries to create partnerships with content owners. Sometimes offerings in this category will provide infrastructure without the bundled content, such as Shadow; this works for some audiences, however most consumers have been conditioned, through their experience with streaming and music services, to expect bundled content with their subscriptions.

2) Distribution Interface + Cloud Infrastructure: By owning the hardware resources that stream content to the end-user, cloud services from companies like Nvidia, Amazon, and Google are effectively able to cross-sell their cloud offerings with game distribution. The risk is that usage costs outpace the gaming subscription fees, but ownership of the infrastructure enables these parties to treat compute as a loss-leader (at cost versus paying margin on another company’s resources) in order to win over a user base of early cloud gaming adopters. 

3) Distribution Interface + Content: The primary player in this category is Sony, as they have a strong existing distribution channel through the PlayStation ecosystem alongside a robust library of game content. The piece that is missing for them is cloud infrastructure. Back in 2019, Sony and Microsoft entered into an agreement to collaborate on joint development of cloud solutions under Azure. Given the two parties have become increasingly competitive (and even combative in the context of the Activision deal), it appears Sony may be shifting their third-party infrastructure partner to AWS.

4) Distribution Interface + Cloud Infrastructure + Content: Microsoft is the clear leader in the field, and the only one to truly own all three pillars of the cloud gaming ecosystem. As stated in the CMA’s press release that announced their decision to block the acquisition, they estimated that Microsoft already owns 60% to 70% of the cloud gaming market. A key driver of this early lead is the fact that Microsoft has effectively bundled their existing game subscription service (content + distribution) with internally owned cloud infrastructure. As a result, they are particularly well positioned to create the cloud gaming market.

Takeaway: Cloud gaming continues to attract attention as it provides unparalleled access to video game content. There are still a number of technical challenges around user experience (particularly latency and input lag); however, over 20 years of work has gone into solving these issues given how substantial the opportunity is to expand gaming’s reach. We expect the winners in this space will own the entire stack of distribution, cloud infrastructure, and content. At the moment, Microsoft is actively taking the early lead and remains the most likely winner if the technical barriers are overcome.