How Japan’s social game regulations will impact GREE, DeNA and the U.S.

Update: As of May 9, GREE, DeNA, Mixi, CyberAgent, Dwango and NHN Japan have announced they are removing kompu gacha from all their games by the end of May according to industry watcher Dr. Serkan Toto. Developers using the mechanic in their games include Konami, Zynga, GREE, Klab, Namco Bandai and Sega.

Shares in GREE, DeNA and other Japanese game developers plummeted this weekend on the news that kompu gacha, an extremely lucrative mechanic found in Japan’s highest grossing mobile-social games, violates Japanese law.

With Japanese news outlets reporting the Japanese Consumer Affairs Agency will soon ban the practice, analysts predict Japanese social gaming companies will see a dramatic impact on their revenues. While that alone could affect earnings of Japan’s mobile-social game companies, it could also pave the way for similar regulations in North America.

How the government got involved

One of the reasons Japan’s mobile-social games are so lucrative that is the games have something in them called gacha — a game mechanic where players can pay a small amount of money to get an in-game item at random. Some Japanese developers see half of their sales coming from gacha, and the Japanese game companies setting up shop in the U.S. are bringing gacha with them. Both GREE’s Zombie Jombie and DeNA’s top-grossing Android hit Rage of Bahamut make use of the mechanic.

The Yomiuri Shimbun’s explanation of kompu gacha.

Kompu gacha, or “complete” gacha in English, further incentivizes the practice — instead of just acting as a way to get extra items or goods, kompu gacha offers grand prizes to players that can amass a complete set of specific and usually rare items. According to a report in the Yomiuri Shimbun, collecting a complete set can take hundred of tries and hundreds of thousands of yen. Although it seems like a fairly benign motivation scheme, as Japan’s social game companies have focused more and more on kompu gacha to increase revenues, the Consumer Affairs Agency has seen the number of complaints about the tactic increase dramatically.

Between April 2011 and March 2012, parents submitted 688 complaints to the agency about children and gacha. In one case, a boy in middle school racked up more than $5,000 (400,000 yen) in charges in a single month. Another boy in elementary school was able to make $1,500 (120,000 yen) in purchases in just three days. Reports like these have turned press scrutiny against the Japanese social games industry.

In March, industry watcher Dr. Serkan Toto reported GREE, DeNA, Mixi, CyberAgent, NHN Japan and Dwango had formed a self-regulation council specifically to regulate monetization. Although both GREE and DeNA now restrict the amount of money minors can spend on their platforms, the way kompu gacha encourages players to pay lots of real money for random prizes still seems to be too close to gambling for the comfort of Japan’s regulators.

Although the Consumer Affairs Agency hasn’t released its official report yet, according to the Yomiuri Shimbun, the agency plans to ban the practice and impose fines on companies that continue to include kompu gacha in their games. According to Tech in Asia, the ruling will be based on the Japanese law that covers “unjustifiable premiums.” At this point regulation seems to be a question of when, not if.

Small regulation, big impact

Japan’s mobile-social game business routinely turns in profits that dwarf what North American developers earn. In its most recent earnings call, GREE reported third quarter net sales of $577.3 million (46.1 billion yen), and a net income of $167.8 million (13.4 billion yen). DeNA reported $1.7 billion in net sales in 2011. For both companies, tactics like kompu gacha that encourage users to buy lots and lots of virtual goods are a key profit generator.

That’s why even without a definite ruling from the Consumer Affairs Agency, the threat of regulation was enough to tank the stocks of Japan’s mobile-social game companies. GREE and DeNA stocks both lost more than 20 percent of their value after the news broke, hitting their daily loss limits and their lowest prices in a year. The stocks of other Japanese companies with significant mobile-social businesses like Capcom, Konami and CyberAgent took similar beatings.

Was the drop justified? According to Credit Suisse analysts, eliminating kompu gacha from Japanese mobile-social games could result in a 20 to 30 percent decrease in sales and an drop of between 40 to 50 percent in operating earnings. Other analysts are being more optimistic, estimating GREE and DeNA will see a drop in net income of about 18 and 6 percent, respectively. Even by conservative estimates, both companies will lose millions of dollars if the Consumer Affairs Agency goes ahead with the widely anticipated ban.

Ripples felt in North America

Both DeNA and GREE have made it clear they’re looking to become global players, and so far both companies have financed their top-dollar acquisitions with cash from home. Regulations that effect earnings in the Japanese market affect acquisition prices in the long term, even if Japanese companies aren’t the ones who are buying. Part of the reason Zynga paid $210 million dollars for OMGPOP was because it was bidding against GREE. Smaller Japanese companies looking to make plays in the U.S., like Gloops and Gumi, could also be affected.

International companies with significant businesses in Japan like EA, Game Insight, Zynga and Com2uS might also see impacts on their earnings if kompu gacha is banned. Investors are already wondering if North American game companies will be affected by the regulations — one asked if Japanese social gaming regulations would effect EA’s bottom line during the company’s fourth quarter earnings call on May 7.

The future of gambling and mobile-social games

While its similar to a lottery, kompu gacha is fundamentally different from the type of real money games that prompt government regulation, like poker or virtual slots where money goes back and forth from player to game operator. Japan might pass legislation that restricts or bans some variations of the practice, but the likelihood that similar legislation would be passed in the U.S. is fairly low. As it stands, the U.S. federal government has left it to individual states to define for themselves what constitutes lawful Internet gambling and these regulations are most often aimed at Internet poker or slots — so any actual regulation as applied to mobile games could vary by state and game type.

However, with both GREE and DeNA already bringing games that use Japanese-style monetization mechanics to the North American market, even U.S. developers without games in Japan should be watching the situation in Japan closely.

Despite the initial media flurry, Japan’s Consumer Affairs Agency hasn’t made its ruling on kompu gacha public yet. Games that use the kompu gacha mechanic are still widely available on GREE and DeNA’s mobile-social gaming platforms.

With additional reporting from AJ Glasser.