Epic Games pushes out profitability

It has been another busy week of tech news, with more AI announcements, TikTok’s big moment in Washington, DC, the Game Developers Conference, and some notable people moves I’ve rounded up below.

I have a deep dive on the state of Epic Games, including some previously unreported financials, my thoughts on what comes next after the TikTok hearing, and more. Also, as I was reading Coinbase’s response to its Wells notice from the SEC, I couldn’t help but think about the fire-eaters performing at the Bored Ape Yacht Club party this week here in Los Angeles. What a time we live in.

A special programming note: next week’s edition of Command Line will be sent on Friday, March 31st, instead of Thursday like normal. I’m planning to go up to San Francisco next Thursday to attend the Cerebral Valley AI Summit and share my takeaways with you. I’m also taking part of next week off for some much-needed R&R and want to make sure the newsletter doesn’t suffer for it.

On to this week’s edition…

Yesterday, Tim Sweeney, the billionaire founder and CEO of Epic Games, spoke to a room full of game developers at the Yerba Buena Center in downtown San Francisco.

“We went from the pandemic to the tech downturn, the crypto implosion, and now banks are failing,” Sweeney said toward the end of his annual state of the union address at GDC. “It’s a really crazy time again. But we’re investing very heavily in the future with the belief that companies that invest now through these hard times are going to come out the strongest companies in the future.”

It turns out that, over the past several weeks, a similar message has been shared privately with Epic’s investors, who have collectively plowed about $7 billion into the Fortnite creator since 2018, making it one of the most highly valued private companies in the world. After posting another year of declines in gross revenue and adjusted earnings for 2022, I’ve learned that Epic doesn’t expect to grow profitability for at least the next couple of years. According to people who have seen the numbers, Epic’s top-line revenue for last year was about $4 billion, down from about $4.7 billion in 2021, and its adjusted EBITDA fell to around $340 million from about $750 million in 2021. The company burned through more than $1 billion last year. (A spokesperson declined to comment.)

In a way, Epic is a victim of its own success, though I doubt that provides much solace for its late-stage investors who were hoping for profits sooner rather than later. Fortnite quickly became one the most lucrative games of all time after it debuted in 2017, bringing in more than $9 billion in revenue during its first two years of existence. No one expected that growth to continue unabated, especially after Sweeney’s holy war against Apple and Google got Fortnite kicked off mobile phones and pandemic lockdowns were lifted. Still, it’s worth noting that Epic’s best financial year remains 2018, when Fortnite really took off and the company reported an astounding $3.7 billion in gross profit on $5.6 billion in revenue. At a high level, business has been mostly trending the wrong way since then.

Like the rest of the tech industry, Epic spent the past several years in expansion mode. It had 2,232 employees at the end of 2020 and is now getting close to 6,000, I’m told. It acquired a bevy of companies that have yet to really demonstrate their worth, including the social network Houseparty, the game studios Psyonix and Mediatonic, and the music service Bandcamp (whose staff is now attempting to unionize).

Epic is also continuing to spend millions on giving away free games through its store in an effort to unseat Valve. Its core Unreal Engine is a technical marvel with long-term, strategic significance. But it isn’t profitable for Epic. (That said, I have heard that non-Fortnite revenue is growing nicely these days at over 20 percent yearly growth.)

There are other costs to consider. Just last year, Epic reached a $520 million settlement with the FTC over child privacy violations. Then there was its $144 million donation to Ukraine relief efforts. A significant amount of the money it has raised in recent years has gone towards helping employees cash out of their stock options through secondary stock sales, though I’m told a tender offer didn’t happen last year. In 2021, it bought a 980,000-square-foot mall for $95 million to create a new global HQ.

Meanwhile, Fortnite now has 70 million monthly users, down from over 80 million in 2020. More importantly, people are spending less in the game than they did early on; talk to anyone who has played it for a while and they’ll tell you that the benefit of buying new skins goes down over time.

That brings me to Epic’s big bet of turning Fortnite into a full-fledged creator platform, putting it in more direct competition with the likes of Roblox, which boasts 250 million monthly users. Epic announced this week that it would begin distributing 40 percent of Fortnite’s net revenue to the most engaging worlds built in the game, a definition that my colleague Jay Peters astutely pointed out includes Epic itself. It’s a step in the right direction, but Roblox’s monetization for creators is much more direct and attributable to their individual work. And unlike Roblox, Fortnite creators still can’t make a digital item and sell it directly to others.

From the outside, Epic is also behind on an increasingly important wave of technology for 3D-world building: generative AI. This week, Roblox announced a handful of AI coding tools for creators that are truly impressive. From Ars Technica:

“The release of the Roblox Code Assist beta Monday morning certainly seems to have the potential to let users create simple code snippets with a minimum of effort. In an example [Roblox Studio head Stef] Corazza presented at the conference, a user could ask the system to ‘make orb turn red and destroy after 0.3 seconds when player touches it.’ The system then generates a seven-line Lua function that does just that, based on a coder-defined orb object provided earlier in the code.”

Unity CEO John Riccitiello also told Reuters this week that the company plans to debut its own generative AI marketplace to help developers create things like characters and sound effects. Meanwhile, Epic didn’t talk about anything similar to what Roblox and Unity are building at GDC this week. That seems like a missed opportunity.

To be clear, I’m not counting Epic out here. For one, its Unreal Engine holds a uniquely influential place in not just the gaming economy but the tech and media ecosystem more broadly. On a personal level, I find Sweeney’s vision for the metaverse to be more pragmatic than Mark Zuckerberg’s, and like Zuckerberg, Sweeney has a proven track record of success backed by long-term thinking. I also believe that he’ll be on the right side of history in his crusade against Apple and Google’s control over mobile app distribution.

Epic was also smart to raise more capital in April of last year when it announced a $2 billion round led by Sony and KIRKBI, the holding company behind Lego, that valued the business at $31.5 billion. Sweeney remains Epic’s controlling shareholder. I’m told the company had about $4 billion in cash on hand at the end of 2022. That’s plenty to weather an economic downturn. As Sweeney recently tweeted, shields up.

It’s only going to get worse from here.

That’s my main takeaway after watching most of the meandering, often painful congressional hearing with TikTok CEO Shou Zi Chew this morning in DC. Despite his comms department trying to quietly play up his preparedness in the press leading up to the hearing, it was clear he wasn’t prepared to actually answer questions about how TikTok can truly operate independently from ByteDance and its China ties. That’s because it can’t, as the Chinese government made clear right before the hearing started.

Part of me naively hoped that members of Congress would come armed with new evidence to back the animating fear that led to the hearing: that China has somehow used TikTok to spy on Americans or put its thumb on the scale of the algorithm. That didn’t happen, which suggests there still isn’t evidence. (Yes, the Forbes spying scandal involved Chinese ByteDance employees, but let’s not pretend that’s the same as government intervention in TikTok’s algorithm.)

What’s clear is that TikTok didn’t win any friends in Washington today, and the government will likely proceed to force some kind of spinoff or outright ban. According to my colleague Makena Kelly, the most likely policy outcome is the bipartisan “RESTRICT” Act passing in some form, which would give Congress the power to ban or put in place strict transparency requirements on foreign tech companies that pose a national security risk.

If a ban does happen without new legislation being passed, I expect TikTok to fight the order in the courts and probably win, just like it did during the Trump administration. At the end of the day, a bunch of money and time will have been wasted, and TikTok will still be as popular as ever.

Of course, there’s also the chance things go badly for TikTok like they did in India, and all this does result in an outright ban with no available recourse for ByteDance. If that happens, Oracle’s calculus to keep its head in the sand and not publically tout its Project Texas plan with TikTok will have been a smart one. Whatever happens, Larry Ellison gets paid.

That’s it for this week. Please don’t hesitate to forward this to a friend.

I’ll be back next Friday. In the meantime, if you have any feedback on this edition or tips on stories I should be looking into, let me know.