Why did Fortnite maker Epic Games need to raise $1.3b? - The first knowledge sharing application in Vietnam

Compare Fortnite with my favourite game Red Dead Redemption 2 (RDR2), a Triple-A from the $27 billion Nasdaq-listed company Take 2 Interactive. Two thousand people worked for seven years to develop RDR2 at a cost of perhaps $600 million. Launched with a single-player story and a price exceeding $100, it grossed almost $1 billion in its first weekend – that’s 25 per cent more than blockbuster movie Avengers: Infinity War.

It’s numbers like these that drive valuations into the tens of billions.

Yet Fortnite is perhaps the least interesting part of Epic Games, which this year celebrates its 30th birthday. Remarkably, it is still run by its founder and controlling shareholder, 51-year-old American Tim Sweeney.

Epic probably earned $US6.5 billion of revenue and $US1.3 billion EBITDA in 2020 so it’s much more than just Fortnite (as a private company CY20 results are not yet available).

Epic’s most-impressive and industry-leading product is the Unreal Engine. To understand the magic of Unreal, imagine a Fortnite player firing their sniper rifle. First, the laws of physics need to be painstakingly coded so that bullet velocity, gun recoil, damage mechanics, and so on can be calculated and animated.

Unreal Engine offers a pre-cut flexible software environment so developers can avoid this coding grunt work and focus instead on gameplay. Not only is Fortnite built on Unreal, but so are titles from other developers including Triple-A game Borderlands 3 and Nintendo’s Yoshi’s Crafted World.

Unreal charges a 5 per cent royalty on sales over $US1 million, delivering predictable subscription-like revenue that augments lumpier hit-based games development.

This combination means Epic isn’t merely a successful games shop but also a platform play, which has proven highly attractive to investors including PlayStation 5-maker Sony.

Given its profitability, why does Epic need the big lump of investor cash it has just raised? The answer may lie with two problems that share a common theme: revenue leakage.

Goldman Sachs estimates that by 2025 digital downloads will account for 80 per cent of total game sales. For PC games the ubiquitous marketplace is Steam, owned by privately held Valve Software and valued at $13 billion by Bloomberg in 2019.

Developers pay Steam a commission of 20-30 per cent of every download and subsequent in-game “micro-transaction”, which creates a big ongoing revenue leakage problem for Epic.

In response, it created its own competing marketplace, but the Epic Games Store has recorded staggering losses of $400 million so far, with big losses forecast to continue.

These figures were revealed during Epic’s response to its second big revenue leakage problem, mobile gaming.

Like Steam, Apple also charges an ongoing commission of 30 per cent on in-game purchases when an iOS app is downloaded from its App Store. Last year, Epic and Apple had a brief but brutal public altercation over commissions. The result was Fortnite’s removal from the platform and a lawsuit against Apple.

In a local twist, late last year Epic filed a second lawsuit against Apple under Australian consumer law. It also filed a similar claim against Google last month, indicating that our Consumer Protection Act is viewed globally as a framework with sharp legal teeth.

Epic is appealing the Federal Court’s decision to temporarily stay the local Apple proceeding and the US case is scheduled to commence in May.

Regardless of the outcome, the financial cost of litigation will be enormous. When added to Epic’s Games Store losses these anti-leakage actions could partly explain the capital raise. Epic may have no other choice given that on $5 billion of revenue every 1 per cent of extra commission costs $50 million.

As for Epic’s valuation, at 5.6x revenue and 28x EBITDA, it doesn’t come cheap. However, the company is a well-established and diversified market leader that likely grew strongly in 2020.

A valuation of $US37 billion for pretend outfits and Unreal Engine? What an epic time to be alive.