There were 3.2 billion gamers across the world in 2022, and that number continues to grow. The COVID-19 pandemic supercharged the gaming industry, with 82% of global consumers playing video games or watching video game content during the height of lockdowns. Although this acceleration has slowed since the pandemic, with a slight decline in global gaming revenue reported in 2022 (down to $184.4 billion from a peak of $192.7 billion in 2021), more people played games in 2022 than ever before, and a return to growth is expected following the pull-ahead caused by the COVID-19 lockdown period.

In the long term, gaming seems set for continued growth. As of 2023, two-thirds of all Americans under 18 played video games online. Mobile is the largest segment of gamers with 48.3% of the US population playing games on their smartphones in 2022. The acceleration in VR, with milestones like the June 2023 release of the Apple Vision Pro, may herald the emergence of a new era of immersive spatial computing experiences which may unlock even more potential for the growth of gaming. The emergence of persistent virtual worlds, often referred to as the metaverse, may also become a major trend in the next era of gaming.

Epic Games is a prominent gaming platform company. In addition to having produced flagship titles like Fortnite (released in 2017), Epic Games provides an end-to-end digital ecosystem for developers and creators to build, distribute, and operate video games through the Unreal Engine, Epic Games Store, and Epic Online Services. In a way, Epic’s business model is analogous to Amazon’s consumer business and AWS. Not only does Epic develop games, but it also builds game engines, which serve as the core infrastructure powering large parts of the gaming and 3D graphics industry.

Epic Games founder and CEO Tim Sweeney started the company in 1991 as a college student under the name “Potomac Computer Systems.”

Sweeney, a mechanical engineer by training, was fascinated by gaming, but more as a programmer than as a player. He moonlighted as a programmer to develop games that he could one day sell. His first game ZZT (1991), an adventure game, was a local success, giving Sweeney the conviction to make game development a career. Potomac Computer Systems was quickly rebranded with the catchier name “Epic MegaGames” (1992-1999) and brought on Mark Rein as co-founder, before settling on the simpler “Epic Games” (1999-present).

Epic Games quickly hired a small team and began producing new titles. In 1995, Sweeney developed the Unreal Engine (“UE”), a 3D computer graphics game engine, which laid the groundwork for Epic Games’s first-person shooter Unreal (1998). Not only was the game engine a substantial technical achievement, but Unreal also achieved commercial success, reaching sales of 1.5 million units by 2002. Epic Games also started licensing out the first version of Unreal Engine to other game developers.

ZZT and Unreal Engine were the foundational pillars of Epic Games. In both cases, Sweeney developed the game engine first and then used the engine to produce a game. In recent decades, Unreal Engine was used to create the popular game Fortnite, and many other titles from a diverse range of developers.

By the early 2010s, it was clear that the industry was shifting towards a games-as-a-service (“GaaS”) and free-to-play (“FTP“) model. Epic sold a 40% stake to Tencent in exchange for their expertise on this transition. With the new capital injection, Epic embarked on a series of strategic changes: it made Unreal Engine 4 free, moved a few of its titles to an FTP model, launched the Unreal Marketplace, and cut its dependency on other publishers.

In addition to flagship games like Fortnite, Epic provides an end-to-end digital ecosystem for developers and creators to build, distribute, and operate video games through the Unreal Engine, Epic Games Store, and Epic Online Services. Using a GaaS and FTP model for its products, Epic Games lowered the barrier to entry for creating and playing games. As more games are built with Unreal Engine and distributed through the Epic Games Store, developers, and gamers become further entrenched in Epic Games’ ecosystem.

Gaming: Fortnite (Flagship)

Fortnite is one of the world’s largest games with over 500 million accounts and 70 million monthly active users (”MAUs”) as of March 2023. It ranked third among non-mobile games compared to Roblox and Minecraft, which had roughly 220 million and 140 million MAUs respectively, as of March 2023. Fortnite has more total playtime compared to Roblox and Minecraft. In April 2020, it amassed more than 3.2 billion hours of playtime compared to 2 billion hours each from Roblox and Minecraft. Additionally, users spend 3x more time playing Fortnite than on social media apps such as Facebook and Snapchat. Netflix even cited Fortnite as a competitor in its Q4 2018 shareholder letter.

Fortnite has 3 main modes of gameplay:

• Battle Royale: Up to 100 players land on an island and fight other players until no opponents remain.

• Party Island: A social hang-out space where players can dance, fish, race, and attend live virtual concerts by celebrity DJs and musicians. Users portray their identities via skins and avatars.

• Creative Mode: Players can create digital worlds, games, and stories using the assets and mechanics of Fortnite in a Minecraft-like experience. Additionally, users can play games made by other players. In March 2023, Epic Games launched the public beta of the Unreal Editor for Fortnite (UEFN) to improve the creative options for creating and publishing games within Fortnite.

In the long term, Fortnite is a testbed for Epic’s version of the metaverse — persistent virtual worlds continuing to exist even when people are not playing. Epic brought real-world experiences to Fortnite through partnerships with brands (Disney and the NFL) and celebrity musicians (Deadmau5 and Ariana Grande). Epic continues to test new experiences in Fortnite, blurring the line between the real and virtual worlds.

Source: Epic Games

Unreal Engine

Unreal Engine is one of the most popular 3D game engines in the world, holding a 10-20% market share in the industry. Game engines are software development programs originally used to develop video games. Over time, these powerful rendering and visualization tools also expanded to support other industries, including architecture and manufacturing. Today, Unreal Engine is used in not only video games (Fortnite, Arkham Knight, Mortal Kombat X) but also film and television (The Mandalorian), automotive (Nascar, Ferrari), and fashion (Balenciaga).

Over time, Epic built or integrated additional developer tools into the Unreal Engine making developing 3D digital content more efficient. Examples include Metahumans, a framework for creating high-fidelity digital humans, and Twinmotion, a real-time immersive 3D architectural visualization platform. First launched in 1998, Unreal Engine is now in its fifth generation, which was announced in 2020 and released to developers in 2022.

Source: Epic Games

Epic Games Store

Launched in 2018, Epic Games Store (”EGS”) is a digital video game storefront, providing a game catalog, friends list management, player matchmaking, and other features. After the success of Fortnite, Epic used the profits to enter the gaming distribution market and to break its reliance on Steam, whose revenue cut could be as high as 30%. EGS’s revenue cut, at 12%, is more developer-friendly and constitutes a direct effort to tackle Steam’s dominance.

EGS rapidly gained popularity by offering developers and publishers time-exclusivity agreements, which stipulate that games cannot be released on other storefronts for a defined period of time in exchange for minimum revenue guarantees. This strategy has been effective but also controversial, as gamers expressed frustration over games constantly moving storefronts due to EGS exclusivity contracts. Prior to EGS, timed storefront exclusivity was rare in PC gaming.

Source: Epic Games

Epic Online Services

Epic Online Services (”EOS”) is set of cross-platform gaming services which help developers to launch, operate, and scale cross-platform games. EOS is roughly divided across 3 categories: account services, game services, and store services. Functionalities include authentication, player progression tracking, matchmaking, voice chat and more.

Epic offers EOS to developers for free with the goal of “encouraging wider adoption of all of Epic’s offerings, and of making cross-play, cross-progression, and other open and interconnected, online features more accessible to everyone.”

Source: Epic Games

Customer

Epic Games serves 3 customer bases: gamers, developers, and publishers.

• Fortnite: Roughly 60% of Fortnite gamers are between the ages of 18 and 24, and skew male (roughly 70% male vs. 30% women). Most of its users come from the U.S. (~30%), followed by Brazil (8%) and Russia (6%). Fortnite has over 500 million registered users and 70 million MAUs as of March 2023.

• Unreal Engine: Developers who require 3D computer graphics and advanced rendering are all potential customers for the Unreal Engine. UE’s use cases go beyond the gaming industry to TV and film, architecture, automotive and more. Compared to Unity (another popular game engine), UE is better for producing high-fidelity 3D content, which makes it suitable for PCs and console gaming.

• Epic Games Store: Publishers are incentivized to distribute their games on EGS for its favorable platform royalty of 12% versus Steam’s 30%. Epic also provides additional benefits to publishers, such as timed exclusivity and minimum guarantees. In 2022, the Epic Games Store recorded 34.3 million daily active users (”DAUs”), roughly 50% of its 68 million MAUs.

Market Size

Epic Games competes in two markets: video games (Fortnite and Epic Games Store) and game engines (Unreal Engine).

The global video games market was estimated at $235 billion in 2022 and is projected to grow to $321 billion by 2026. Globally, the video game industry boomed during the pandemic, with 82% of global consumers playing video games or watching video game content during the height of lockdowns. Industry growth was also fueled by improved internet access and lower smartphone and PC prices. Twitch streaming and esports leagues are now recognized professions, with some star gamers earning over $5 million annually.

The global game engine market was estimated at $2.4 billion in 2022 and is expected to grow to $8.3 billion in 2030. Unity is much more bullish on the total addressable market, citing $29 billion across games and entertainment in their S-1. Gaming is leading industry growth, with the world quickly moving towards content that is interactive, real-time, and 3D.

Epic Games's gaming unit and Unreal Engine are among the most popular players in their categories, but even at scale, it has only scraped the tip of the iceberg. Fortnite at its peak represented only ~2%of game industry revenue. Epic will need to continue strengthening its value proposition to the developer community while delivering more gaming titles to the gamer community.

Fortnite

Fortnite competes against other games within two categories: consumer gaming (Roblox, Minecraft, and Apex Legends) and esports professional gaming (League of Legends, Counterstrike, Call of Duty).

Consumer Gaming: At any point in time, each game’s MAUs can skew towards one direction over another. A game ranking can look different every month.

eSports Professional Gaming: Game popularity is judged on a variety of factors, including MAUs, prize earnings, number of tournaments, game hours watched, and more.

Source: NewZoo

Unreal Engine

Unreal Engine competes against standalone game engine companies (Unity) and in-house game engines (Activision Blizzard, EA’s Frostbite).

Unity: Unity’s game engine is the most widely used in the game development industry, holding 48% global market share versus Unreal Engine at 13%. In Q4 2020, games made with Unity accounted for 71% of the top 1,000 mobile games, including Pokémon Go and Temple Run. However, Unity and UE serve distinctly different developer needs and project goals. Unity is a better fit for developers who have little to no experience in game development and 3D graphics, whereas Unreal is built for seasoned developers. Unity is generally used for 2D or simple mobile games, whereas Unreal is used for more advanced games with sophisticated graphics. Unity’s learning curve is much lower than Unreal, appealing to the long tail of game developers, and it charges only a small subscription fee instead of revenue share. Both game engines have their own advantages and limitations. Selection depends on the developer’s experience, project type, and overall budget.

In-House Game Engines: Major game publishers typically use proprietary engines. Since many top games generate more than hundreds of millions in revenue, UE’s royalty structure (5% for revenue over $1 million) quickly becomes costly. Typically, in-house engines are not as feature-rich as Unreal or Unity and take time to build and significant engineering resources to develop and maintain. As a result, some publishers have shifted to using Unreal or Unity instead of their proprietary engines.

Epic Games Store

Epic Games Store (EGS) primarily competes with Valve’s Steam.

Steam: In 2021, Steam recorded 132 million MAUs. Prior to that, in 2020, Steam recorded 120 million MAUs, more than double that of EGS’s 56 million MAUs. Many gamers prefer Steam’s UI and find Steam to be faster and less buggy than EGS, EA’s Origin, and other storefronts. Steam also boasts a larger game library than EGS, with over 50K titles compared to EGS’s 1.6K games Although Steam charges a much higher revenue share (30%) than EGS (12%), developers are willing to sell their games to Steam since so many people use it. If a developer sells to EGS under a timed-exclusivity contract, they risk restricting themselves to a smaller audience during that time window. Founded in 2003, Steam is undoubtedly the game distribution market leader; however, EGS has also grown at an impressive rate, considering it was only founded in 2018. EGS will need to level up its platform features and functionality before it can reach Steam’s scale.

During the Epic Games v. Apple lawsuit, a January 2020 financial presentation from Epic was made public. In it, the company revealed how it had declined from $5.6 billion in 2018 revenue to $4.2 billion in 2019 revenue. That same presentation forecasted the company’s 2020 revenue would decline further to $3.6 billion. However, in May 2021 Sweeney indicated that Epic Games earned roughly $5.1 billion in 2020 revenue. In previous years, you can see the breakdown of revenue for Epic Games, and how Fortnite has continued to make up the vast majority of its revenue.

Source: Variety

Gaming: Fortnite

Fortnite is free to play. The majority of Fortnite’s revenue comes from sales of cosmetic items, such as avatars or costumes, and Battle Passes, which unlocks rewards, new accessories, and items each season. In-app purchases can only be bought through Fortnite’s in-game currency, which is named “V-bucks.”

To encourage more players to buy, Fortnite creates a sense of urgency by extending access to in-app purchases for a limited window of time.

Unreal Engine

Unreal Engine makes money from both royalties and licensing:

• Royalty: UE’s source code is available on GitHub and free to use until developers earn $1 million in gross revenue. After that threshold, Epic collects a 5% royalty (”engine royalty”) on any product that incorporates Unreal Engine code. Epic also waves royalties if Unreal Engine games are sold on the Epic Games Store, where it collects a higher royalty.

• Licensing: UE has three license options including Standard, Enterprise, and Custom. Enterprise and Custom licenses offer more bespoke support, private training, and more. Standard licenses are free but uphold the 5% royalty. Enterprise licenses charge $1,500/seat per year.

Unreal Engine is free for personal use, projects, and linear content creation.

Epic Games Store

Epic Games Store takes a 12% commission (”platform royalty”) on game sales. The business is a loss leader, generating losses of $273 million in 2020 and $139 million in 2021. The key drivers of EGS’s losses are Epic’s generous “minimum guarantee” program and the weekly free games. Epic fronts payments for timed exclusivity contracts in order to attract developers and publishers, even if the game is performing at a loss. EGS also fully subsidizes free games. In 2021, some estimate that Epic gave away roughly $18 billion worth of games from 765 million free games.

Source: FourWeekMBA

According to Epic Games, in 2022 there were 230 million Epic Games Store PC users, representing an increase of 36 million users from 2021. This brought the total number of cross-platform Epic Games accounts to 723 million by the end of 2022. Daily active users grew to 34.3 million and monthly active users hit 68 million in 2022, up from 62 million in 2021.

Epic Games offered 1.5K+ game titles in its store after releasing 626 new PC titles in 2022, more than any previous year. PC players spent $820 million on the Epic Games Store in 2022 (-2% YoY), and $355 million was spent by players on 3rd-party PC games in Epic Games Store (+18% YoY) according to the company. The slight decrease in spend despite user growth likely represents the higher relative amount of time users spent gaming during the COVID-19 pandemic lockdown and subsequent period, versus the post-pandemic reversion to the mean.

As of April 2022, Epic Games held a valuation of $31.5 billion after raising a $2 billion round of funding from Sony Group Corp and KIRKBI, the family-owned holding company behind the Lego Group. The valuation implied a 6-7x revenue multiple based on publicly disclosed 2020 revenue. The round was raised on the back of Epic’s promises to build the metaverse, almost doubling Epic’s valuation within two years.

In 2022, M&A and private investments in gaming soared to $127 billion as publishers made a bigger push towards game development. On top of Epic’s raise, transactions include Microsoft’s acquisition of Activision for $68.7 billion, Embracer’s acquisition of Tomb Raider and the franchise’s development studio for $300 million, and Tencent’s acquisition of Subway Surfers maker Sybo.

Publicly traded gaming companies have traded down in comparison to other industries since reaching all-time highs in late 2021. As of April 2023, the NASDAQ was down ~25% from its November 2021 peak, but companies like Roblox and Unity were down ~70% and ~80% respectively. Investors are primarily concerned with declining user engagement compared to peak levels during the pandemic. However, even with the public market decline, each company still trades at roughly 10-12x 2021 revenue, a premium to Epic Games’ latest estimated revenue multiple of 6-7x.

Investing in Emerging Technologies

Epic Games’ toolkit is well-suited for the emerging technologies in the virtual era, including AR/VR devices, simulations, "digital twins", and the Metaverse more broadly. However, its investments in and adoption of emerging technologies have lagged behind Unity. Apple and Microsoft’s development of AR/VR devices created new platforms for gaming and immersive media. NVIDIA and Unity also increased investment in digital twins, or large-scale, physically accurate simulations of industrial assets or environments based on real-world data. Unity worked with Hyundai Motors to connect a physical factory with its digital twin to enhance plant management and drive productivity and innovation during manufacturing.

As gaming becomes increasingly interconnected with technology, Epic Games now finds itself in the same playing field as larger tech companies. If it wants to compete, Epic Games will need to find ways to elevate its gaming and gaming engine technology to meet the demands of new trends.

Deepening Player Value Proposition

Many gamers are not sure how they feel about the Epic Games Store. On the one hand, the weekly free games are a huge bonus. On the other hand, EGS’s features are limited, exclusivity deals can be frustrating for consumers, and the game library is much smaller than Steam’s.

Source: Steam

EGS has a significant opportunity to improve its value proposition to gamers. EGS can level up features to match that of Unity, building community channels, player matching, and more. To encourage gamer engagement, EGS could add loyalty incentives after a gamer engages with the platform for certain milestones. Finally, EGS could consider deleveraging the minimum agreement thresholds in exclusivity agreements, or only sign tentpole titles that will move the needle on player acquisition and engagement.

Deepening Developer Value Proposition

Today, Epic’s Online Services serve as a toolkit, helping developers launch, operate, and scale games. However, EOS could also offer more analytics, ad tracking, and infrastructure support to help developers monetize and maintain increasingly complex systems. Today, Epic’s Online Services are free, offered to entice developers to stay in Epic Games' ecosystem. By contrast, Unity generates most of its revenue from Unity Operate Solutions, various cloud-based products help provide analytics, ad distributions, and other infrastructure services for game developers. Epic Online Services could offer similar support for its developer community.

Fortnite Revenue Concentration

In 2020, Fortnite constituted roughly 77% of Epic Games’ revenue, down from 97% in 2018 when Fortnite’s MAUs peaked. Like all games, Fortnite’s popularity rose and fall thereafter, causing revenues to be less predictable. Epic Games recognizes this issue, and the company has spent the past few years diversifying its revenue streams across the Unreal Engine, Epic Games Store, and third-party game titles. These efforts are gaining traction, but if Fortnite’s popularity falls faster than the growth in other businesses, Epic will have a significant problem on its hands. Fortnite’s profits heavily subsidize other unprofitable lines of business. Epic will need to release another blockbuster hit or expand Fortnite’s offerings to de-risk its revenue concentration.

Defensibility of Epic Games Store

Epic Games Store deliberately undercut Steam, debuting at a 12% revenue share model vs. Steam’s 30%. Many developers and gamers are attracted to EGS largely for its heavily subsidized perks, including low royalties, minimum guarantees, and weekly free games. While these offerings are intended to serve as a loss leader for Epic to amass a developer base, it is also unsustainable in the longer term. Some project EGS’s losses might reach $1 billion by 2027 under the status quo.

Valve Software stands by Steam's 30% revenue cut, but it could slash that if it decided to. Sweeney conceded that if Steam were to cut prices, EGS would retreat. However, deprecating EGS could cause repercussions in the broader Epic Games ecosystem. Without a distribution channel, Epic Games' value proposition goes from a one-stop shop to an à la carte offering.

Source: Twitter

Distributor Terms of Service

The lengthy lawsuit between Apple and Epic Games from 2020-2021 was widely covered by the media and ignited a wider industry debate. In line with Epic Games' battle with Steam, Sweeney believed that storefronts like Apple’s App Store do not earn a substantial cut of revenue. However, the court ultimately ruled in favor of Apple on 9 of 10 counts, largely due to Epic’s circumvention of Apple’s terms of service. Apple subsequently removed Fortnite from Apple’s App Store.

Epic rebuilt its own Steam, but replicating Apple’s App Store is not trivial. Fortnite is now available on Android and Samsung Galaxy devices, but tensions remain as Epic’s lawsuit against Google will go to trial in November 2023. Storefronts like Google and Apple are critical for user reach, but they limit Epic’s control over the destiny of its own games.

Epic Games has a track record of reinventing its business model in response to changing consumer sentiment. However, there are still many risks that need solutions: how does it keep Fortnite relevant? How does it run EGS sustainably? How does it keep developers and gamers loyal to the platform? And how does it stay ahead of new competitors as gaming companies enter the world of tech — competing with the likes of Meta, Apple, and NVIDIA?

These are tough problems to tackle all at once. The company's gaming unit and its Unreal Engine are the culmination of decades of work, and yet it has only scraped the tip of a deeper addressable market. Epic Games planted a stake with Fortnite, but the gaming and technology market is now reaching an even bigger inflection point as developers race to define the Internet's future.