iDreamSky (DSKY) Strong Sell On Obsolescence, Game Failures And Accounting Issues -68% Downside by The Pump Stopper
- iDreamSky’s American SEC documents show curious differences with local Chinese SAIC filings, CFO associated with bankruptcy and failure, raising serious questions about cash balances, profit margins and accounting integrity.
- DSKY in terminal decline with past hit games rolling off while “real-time” data shows new games are failing while DSKY content partners experience rampant piracy and financial disappointment.
- DSKY is being inevitably disintermediated, Tencent excluding DSKY by buying up quality content while foreign game companies rapidly open local Chinese development offices of their own.
- China Mobile recently halted billing, which could not come at worse time as DSKY has limited time to milk final remaining dollars from declining past hit games.
- Wall Street DSKY revenue estimates are impossible as DSKY business continues to implode, DSKY investors are confused valuing DSKY on future earnings and are missing “melting ice cube” dynamic.
I believe iDreamSky is a “walking zombie” Chinese JOBS act IPO experiencing inevitable decline with serious accounting and financial statement integrity issues. Even if you trust DSKY’s financial statements, long term I believe it is fundamentally worthless and will become obsolete while “real time” data shows near term revenue estimates are impossible. Shockingly, DSKY Chinese SAIC filings show “curious” differences relative to US SEC filings, as Chinese tax filings show much lower past cash balances and margins than reported to American investors, raising serious questions about the integrity of DSKY’s SEC filings. Furthermore, DSKY’s CFO is associated with bankruptcy and failure while DSKY’s IR partner is a notorious Chinese IR firm known for touting Chinese stocks later facing fraud allegations.
US investors confuse iDreamSky with a China growth story, valuing it as if it were a going concern based on vague and unsubstantiated future “earnings” multiples, while missing the decline rates of its games. After IPO’ing on the back of an unusual, one-time game success, DSKY is now trapped with current games rolling off, new games failing, and their entire business model becoming obsolete at a rapid pace.
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(pic credit iDreamSky)
Even if you trust DSKY’s financial statements, DSKY is trapped in a fundamental “death spiral” while juggernaut competitors outbid them for content, forcing DSKY into swift obsolescence. As it continues to become increasingly obvious DSKY revenue estimates are impossible, I expect DSKY stock will continue to collapse and, after wasting it’s cash balances overpaying for “left over” content, DSKY will dwindle towards eventual irrelevance and failure.
DSKY Quick Fundamental Summary and Background
Originally a failed game developer (iGameDock) itself, DSKY is what is known in the gaming industry as a “publisher” or “distributor” meaning DSKY is a middle man for foreign game developers to distribute Android games in China. DSKY takes foreign games (like Gameloft’s), makes small changes for language and monetization, and then manages distribution and sales in China. For this task iDreamSky has historically collected a gross margin “publishing tax” of 35-40%. Since DSKY was one of the first players to take this niche seriously, DSKY initially had limited competition on choosing which games to distribute. Therefore, DSKY was able to take already successful games from other markets and get them to China while marketing them before pirate game cloning studios could steal the games and monetize their own distributed clones.
Historically, when mobile or social games initially take off in a region, distributors have played a temporary role. In the US for example, during the early days of Facebook (NASDAQ:FB) and Mobile similar distributors like 6wave and Chillingo thrived temporarily before essentially flaming out and failing.
The reason these distributors temporarily rise, only to later become epic fails, is because in the early days of gaming the fresh content providers are small and the ecosystem is evolving with lots of moving parts. However as the market evolves, the game developers themselves become large and more sophisticated while simultaneously the platforms consolidate, streamlining the ecosystem, and eventually leaves the distributors without a business.
(pic by me)
The problem for iDreamSky, which other game distributors before them also experienced, is that unfortunately now all of the factors which helped DSKY in the past are reversing into headwinds, swiftly rendering DSKY obsolete. DSKY founder Jeff Lyndon has said himself (at 15:40) that in 2011-2012 the Chinese market was dominated by American companies but in the future he expects the market to become essentially 100% Chinese game developer driven.
DSKY Old Games Rolling Off, New Games Failing
I will go through why iDreamSky is currently failing, but first let me prove to you the math of DSKY’s impossible future and show you what is going on here.
The first fact you need to understand is that it has been a LONG time since DSKY distributed a homerun hit game.
This temporary benefit was great for iDreamSky at the time, but the problem is DSKY is still expected to grow, and to grow from this would require keeping games in the top ten in China as mobile gaming is financially a “winner take all” arena. We can see below in early 2014 DSKY had 3 of the top ten titles, something I believe will never repeat.
(pic credit DSKY)
To see where iDreamSky is now, since DSKY is a customer focused company, we have all the data available to make a pretty good “real time” revenue model by using App Annie and taking snap shots of Android game download screens. I have “real time” Android download models but for presentation simplicity we’ll use App Annie as a proxy for now. For those of you who think App Annie is not a useful estimate, Chukong (DSKY’s largest distribution competitor)disagrees and publicly uses App Annie data as Chinese market proxy routinely. App Annie provides ranking data free for anyone to look at but I highly suggest you pay for AppAnnie revenue numbers as I’ve found them quite accurate historically.
We can see below all DSKY’s games still rank well out of the top games they used to be. Even the hyped Bruce Lee addition to Temple Run only generated one very small bump (right at the end of Q1) in usage before settling back down near irrelevance.
(pic credit App Annie)
And if we look at the current top games in China, we see now DSKY titles are absent with the top game titles now dominated by DSKY’s theoretical partner Tencent (OTCPK:TCEHY).
(pic credit App Annie)
and it seems iDreamSky’s partner Fruit Ninja is still experiencing widespread piracy??
(pic credit recent Chukong presentation)
From a revenue perspective, for DSKY to hold game revenue flat would need to keep distributing homerun, top 10 games because the “melt off” of Chinese mobile game users is extremely quick (and actually getting quicker). We can see below that in 14 days nearly 90% of players have fallen off and in 30 days 93% of total users have left. Here, DSKY founder Jeff Lyndon says China casual games are lucky to have a user life of 2 weeks.
(pic credit talking data)
iDreamSky has quoted numbers higher than this but no matter whose numbers you use, retention of Chinese mobile gamers is very short. We can also see that percent of users who end up paying (daily%p) and ARPU are also extremely low for Chinese gamers.
(pic credit talking data)
With the known lifespan of old gamers, the arpu, % of total users who ever pay and sequential downloads we can estimate DSKY revenue and see there is just no way DSKY can keep up past revenue levels for any sustained period of time. If DSKY wants future growth, they need to constantly put up hit top 10 games. However, DSKY’s new games are failing miserably and they appear to be getting desperate. Let me explain:
DSKY’s Cookie Run Disaster: Financial Failure and Rampant Piracy
One of the main excuses given for DSKY’s latest earnings call disaster was a delayed launch of Cookie Run. However, if we look to see how DSKY’s Cookie Run is doing now, it looks like a total disaster. Given the low amount of downloads we can see below, I estimate generated revenue is ~$0. Furthermore how is it possible DSKY had a “source code issue” when it appears iDreamSky already did a pilot launch last year? Is DSKY just making excuses for a very poor launch?
(pic credit Cookie Run)
Even more concerning, when we look this game up (see below) we find an overwhelming amount of Cookie Run counterfeits which have been available for a long time! (This is an unappreciated structural headwind iDreamSky faces – there are a lot of virtually instant and increasingly high quality counterfeit games in China.) Where is DSKY protecting their content provider and taking these down?!
(pic credit Cookie Run Clones)
Aside from the rampant piracy and failed launch, if we look at Cooke Run it becomes clear this is a “has been” game that was popular in Japan years ago but has been losing market share for a long time now.
(pic credit AppAnnie)
DSKY’s Other Hyped Game “Monument Valley” Also Failing with Minimal DSKY work and Piracy
As another example of iDreamSky’s desperation and failure, consider the game Monument Valley they hyped on the last call. This game is obviously a stretch to economically distribute in the Chinese market given the UsTwo founder’s preference for up front game payment (instead of F2P) and minimal financial success in developer markets.
However the issue is that this game has been cracked and available in China for many months for free while it’s “pay up front” model just doesn’t work in China. DSKY apparently offered to bring it to China but Chinese gamers have been complaining that DSKY FAILED as they apparently did essentially zero work on the art or gameplay?
If monument valley simply wanted their game reskinned in Chinese with virtually zero development work then they could have gone to any app competitor highlighted above who does this for <$1k and puts the app on top 20 stores (90%+ of the market). Even more absurd, China was already payingsmall amounts for Monument Valley apparently in a manner that didn’t require UsTwo to pay DSKY at all! If we attempt to lookup iDreamSky’s distributed Chinese version of Monument Valley it is basically nowhere to be found far as I can tell! What is going on here?!
It is clear to me there is no way either of these games, or any of the other games in DSKY’s portfolio, have any hope of upstaging Temple Run or Subway Surfer to become a top game.
Why is DSKY Failing Miserably To Launch New Hit “Top 10? Games?
There are many reasons for the eventual demise of iDreamSky but the primary issues are: DSKY getting squeezed out by consolidating mobile platforms (like Tencent) and the parabolic increase in Chinese mobile gaming competition while foreign game companies gain China sophistication and setup shop in China themselves. In other words, DSKY’s value proposition has eroded badly.
Chinese Android Market: Rapidly Consolidating and Squeezing DSKY Out.
In the early days of Chinese mobile gaming, the Android market wasextremely fragmented. This era is coming to an end as the Chinese app market is becoming quite consolidated. We see below that (even using a chart from 12m ago) the top 9 app stores alone have ~100% of market activity, compared to an estimated >800 total China Android App stores 6 years ago.
(pic credit TalkingData)
Much of China’s app stores consolidation has happened and billing/monetization is apparently next.
“From what App Annie knows about the Chinese market, we’re starting to see a consolidation of the top five or six app stores – the distribution platforms,” says Schmitt. Monetization is following suit. China’s three major carriers released a joint billing SDK for developers.”
Now with the China Android app platform market and monetization consolidating, the next step is for platforms [Qihu (NYSE:QIHU), Tencent, etc.] to go straight to content providers and remove distributors with excessive margins ((NASDAQ:DSKY)), and this is happening now in a big way.
Tencent especially has been aggressive in going straight to content providers and signing very rich deals. Most recently, Tencent bought a direct $126m stake in Gluu Mobile (NASDAQ:GLUU) after buying a $400m stake in Riot Games, a $330m 40% stake in Riot Games and a $500m stake in CJ games corp. Now 7 of 10 top grossing games are Tencent’s games on Tencent’s WeChat as Tencent takes over the market, and even worse for iDreamSky, Tencent plants to dramatically increase future volume of games published on WeChat!EVEN WORSE Tencent is aggressively working with foreign game developers to help them enter China!
(pic credit Tencent)
List of Tencent’s foreign gaming investments just from 2013 and older.
It’s not just Tencent though, as now Xiaomi is making and buying their owngames while China Mobile (CHM) doing the same and Alibaba (NYSE:BABA)also [with SkyMobi (NYSEMKT:SKY)] becoming increasingly active in Chinese mobile gaming. Qihoo also summarized its intention to compete directly with DSKY at recent development conference:
“We helped many western developer/publishers make a hit in China include: Disney, EA, Glu and Gameloft. 360 Store accounts for 40% of market share, we distribute mobile contents to our 400mn active users’ smart phones through 360 Mobile Assistant(our killer app). We are very interested in bringing Western Mobile Games to Chineseplayers. Please feel free to contact us if you are planning to enter China.”
Tencent even offering localization for King’s candy crush as early as last year and then Tencent also going directly to Japan and Korea to lockup the best content and most popular games there directly as well. This only ends one way for DSKY….
One reason Tencent and Qihu can pay more than iDreamSky, and still generate attractive returns on their game development deals is because the platform Channel and Billing/Monetization costs are as much as 60% of gross revenue!
(pic credit TalkingData)
As you see above, Tencent and Qihu collect at least 30% of gross revenue from Channel/Platform cost. As a result, they can expand their own margins while simultaneously giving much more of the total revenue to game developers by removing iDreamSky entirely.
The $100-500m+ checks Tencent and others are writing are checks DSKY simply can’t afford. Fortunately (for shorts) this will only get worse, as DSKY’s business dev head has stated he expects the upfront cash payments to content developers to move into the “eight figures” (!!!), effectively pricing DSKY out of the market in my view.
DSKY: Vulnerable To Tencent, Without A “Safe Word”
(pic credit Pulp Fiction)
Increasing Sophistication of Chinese and Foreign Mobile Game Companies = DSKY Obsolescence
“What I foresee in 12-24 months from this (2014) it will be all Chinese games in China”
-Jeff Lyndon, DSKY Founder
It seems we can expect iDreamSky’s current distributor business model to be disintermediated within the next 12-18 months. The problem is twofold, first Chinese (and other Asian) game developer quality is improving rapidly, which negates any reason to work with DSKY as they obviously don’t need help understanding their own culture. Back in 2012, 90% of top games in chinawere Western games but that has shifted rapidly and we can see at 15:45DSKY founder Jeff Lyndon knows Korea and Japan can produce the same quality of games as the US but with better natural culture for Asian customers. As these Asian game companies get increasingly comfortable in China, theKorean, Japanese, and Taiwanese game developers are also now opening theirown offices in China and working directly with Chinese platform companies, cutting DSKY out entirely. Even the US distributors are moving in with juggernaut Electronic Arts’ (NASDAQ:EA) mobile distribution division Chillingo,publisher of Cut the Rope, Angry Birds, and others will have an office of their own office direct in China.
Furthermore, iDreamSky states the larger game companies are not likely to need publishers in China long term. Example one is “Plants vs. Zombies”, who entered the China market on their own and kept DSKY’s margins for themselves. They had to pay to get up the learning curve but now even DSKYadmits “they’ve picked it up. They’re doing well now”.
Even other lesser issues for mobile games in China are rapidly being resolved. Compressing and “right sizing” games in China is largely not an issue anymore as WiFi has become increasingly ubiquitous, 3/4G data plans are getting cheaper and China local phones by Xiami and Huawei offer high performance cheaply. There are even marketing focused companies to help mobile game developers while of course partnering with a platform like Tencent or Qihu thoroughly addresses that.
As China has become a larger and more important market, foreign game companies inevitably setup their own development arms in China, staffed with Chinese employees, and are expected to begin producing China focused/dedicated games.
We are already seeing competition squeeze iDreamSky also, as their direct and large competitor Chukong, is working with many of DSKY’s claimed customers. If DSKY truly had a strong advantage as they claim, I don’t see why Gameloft, Ubisoft or Disney would need to work with other Chinese distributors who compete with DSKY such as Chukong.
[from Chukong (DSKY competitor) website]
(pic credit DSKY)
As a result of these simultaneous dynamics, the Chinese game company has become virtually impossible for anyone but Tencent and Qihu. Mobile game development in China is now so competitive there are apparently 15,000+ mobile game companies (double rest of the world!) in China with success rates of ~0.1%. The competition is so fierce, Baidu VP has stated >57% of new mobile games are lucky to live past 10 days! For the ones that live longer than a week, according to China Intl Digital Entertainment (China Joy) even back in Q2-2014 a full 95% of mobile games fail to generate any profit with only the top 1% of mobile games generating gross billings of more than 50m RMB per month.
Given all of the above, I am not surprised to see iDreamSky failing to create games with similar success as Temple Run, and I don’t see how they can compete long term.
If DSKY really plans to grow why are they apparently not hiring English speaking developers?
Most companies raising $100m from American investors do so in order to grow and iDreamSky’s current valuation certainly assumes future growth. With this in mind I am surprised to see DSKY shows just three openings (which have been there for months) for English speaking developers while the direct careers link on their page doesn’t even work?
DSKY’s American SEC Filings Don’t Match Their Chinese SAIC Filings??
If you go and pull DSKY’s historic Chinese SAIC filings you will find some interesting questions are raised. I am struggling to explain this and am concerned as the only explanations I have here are not good…..
In order to understand how iDreamSky cash flows work, below is my estimated DSKY VIE structure analysis. It is not clear to me why DSKY requires so many subsidiaries and strange looking shell structures.
(pic credit, built by me with publicly available information)
An interesting exercise to attempt with any Chinese company is to go track down the relevant local Chinese SAIC filings and legal docs for all the relevant subsidiaries, then add up all the financial statements from the Chinese SAIC filings and compare them to US SEC filings to see where they may match (or not). When I look at this for DSKY, some “interesting” questions arise for me.
The first thing I note below is the revenue numbers I come up with for 2013 from Chinese SAIC filings are approximately similar to DSKY’s reported SEC filings. This gives me some confidence that I have likely identified the relevant Chinese SAIC filings and am not missing anything.
The two other things I notice though are very confusing. First, is that iDreamSky’s reported cash balances in 2012-2013 seem strange. Chinese SAIC filings indicate 2013 cash balance of ~16.59m RMB while the US SEC filings show cash balance of ~179m RMB?!? The second question that pops out at me are the differences in earnings, as the US SEC filings appear to show materially higher profits?
(pic credit, built by me with publicly available information)
I honestly am not sure how to explain these apparent issues?? I tried to call DSKY repeatedly but it appears to be impossible to get someone from their internal IR on the phone so I was not able to answer this question. I look forward to iDreamSky providing whatever their explanation is so I can see if it is honest and credible.
DSKY Accounting Weaknesses and Deficiencies
During the IPO filing, iDreamSky highlighted two material weaknesses and other control deficiencies. Despite these significant control deficiencies, DSKY was able to go public in the US under the JOBS Act.
In the preparation of the consolidated financial statements as of and for the two years ended December 31, 2013, we identified two material weaknesses and other control deficiencies in our internal control over financial reporting. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control such that there is a reasonable possibility that a material misstatement of our company’s financial statements will not be prevented, or detected and corrected on a timely basis. A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. Effective internal control over financial reporting is necessary for us to provide reliable financial reports, effectively prevent fraud and operate as a public company.
One of the material weaknesses identified relates to our lack of sufficient accounting personnel with appropriate knowledge of U.S. GAAP and SEC reporting requirements to properly address complex U.S. GAAP technical accounting issues and prepare and review financial statements and related disclosures in accordance with U.S. GAAP and SEC reporting requirements. The other material weakness identified relates to our lack of effective control procedures, including the lack of a comprehensive accounting manual, to track, estimate and record the proceeds that we share with our game developer partners and to assess the completeness and accuracy of the related accruals on the proceeds sharing and withholding taxes.
Given the financial statement weaknesses and deficiencies, how can anyone trust their numbers?!?
DSKY CFO Jun Zou‘s Dubious Background
CFO Jun Zou was hired by the company prior to the iDreamSky going public in August 2014. However, Mr. Zou was also the Chief Financial Officer, Treasurer, Board Secretary and VP of Strategy of Chinese BAK Battery Inc (NASDAQ:CBAK) until 2010. In 2012, CBAK has teetered on the edge ofbankruptcy while facing serious allegations of problematic balance sheet issues and accounting practices (here, here and here).
After CBAK, Mr. Zou went to Xunlei XNET. Mr. Zou was the CFO of XNET from 2010 to 2012. XNET tried to go public in 2011, but was apparently not able to gather enough investor interest and so Mr. Zhou presumable left XNET after the failed IPO. XNET appears to be an enabler of illegal movie downloads and copyright infringement, which has been a disastrous investment.
When considering Mr. Zou’s background in leading a company to the edge of bankruptcy and then a company which allegedly facilitates illegal content, I am left feeling financially queasy.
DSKY’s Unfavorable Dual Class Share Structure: Removing Voting Control from Shareholders
US investors should note that of the shares offered to investors, they are receiving heavily disadvantage shares which seem to have close to zero voting rights with no real claim to the underlying assets. Public investors, who hold A-shares, received 1 vote per share versus 10 votes per share for insiders who hold the B-shares and, as a result, public investors will hold 25% of outstanding shares, but less than 10% of the voting rights, effectively giving public shareholders zero control or influence of their investment.
170,359,420 ordinary shares (or 174,979,420 ordinary shares if the underwriters exercise their option to purchase additional ADSs in full), comprised of (NYSE:I) 88,913,300 Class A ordinary shares (or 93,533,300 Class A ordinary shares if the underwriters exercise their option to purchase additional ADSs in full), assuming that we will issue and sell a total of 8,000,000 Class A ordinary shares through the Concurrent Private Placements, which number of shares has been calculated based on an initial public offering price of US$13.00 per ADS, the mid-point of the estimated initial public offering price range shown on the front cover page of this prospectus, and (ii) 81,446,120 Class B ordinary shares.
In respect of matters requiring shareholders’ vote, each Class A ordinary share is entitled to one vote and each Class B ordinary share is entitled to ten votes
DSKY’s IR Firm Known for Promoting Chinese Companies Which Wipe Investors Out
Christensen IR, who represented iDreamSky is an IR firm known for representing Chinese companies for the US market which later face fraud allegations and SEC investigations. One example is China Green Agriculture (NYSE:CGA), where shareholders experienced brutal losses and an SEC investigation
And Chaodao Modern Agriculture – Hong Kong government alleges fraud
(pic credits yahoo finance)
If DSKY is such an amazing opportunity where is the credible CFO? Why partner with an IR firm like this? And why such a rush to IPO in the first place? Why not fix the glaring financial control issues? I think these questions answer themselves.
DSKY: THE END IS HERE
As we can see below, iDreamSky business is already flattening out and about to enter sequential decline. Given the lifespan of a Chinese casual phone game customer, this reversal is likely to be fairly violent as this unfolds.
(pic credit charts from Piper Jaffray built with DSKY numbers)
The only hope of slowing down the decline I can see is for DSKY to quickly overpay for a game company (remember Tencent’s platform economics mean Tencent can economically pay more than DSKY) which will only slow the near term DSKY decline and postpone the inevitable, while leaving DSKY without whatever cash balance they actually have. Depending on how much DSKY’s overpays by, it may actually accelerate their demise.
I expect the Q2 numbers reported won’t be too horrendous given iDreamSky gave guidance deeply into the quarter already but there is just no hope for guidance (if DSKY is honest) and the 2015 Q3 & Q4 numbers seem impossible.
There have been many game publisher/distributors in the past from 6waves to Chillingo, and none of them have worked out well or lasted for any sustained period of time, I don’t see how DSKY will end up differently.
China Mobile DSKY Billing Disruption: Disastrous Timing for DSKY
Even worse for DSKY is China Mobile (the world’s largest mobile phone carrier) has been reported to have shut down billing in some provinces to crack down on illegal billing practices by mobile games. This could not come at a worse time for iDreamSky who must try to milk every last dollar they can from their remaining declining games before that revenue goes $0. I estimate this alone could hit DSKY and Sky-mobi (NASDAQ:MOBI) by as much as 10%+ of revenue in Q2/Q3 with spillover impact on partners Qihoo and Baidu (NASDAQ:BIDU). Gamelook report appears to show some casual mobile game companies experiencing daily revenue drops of 1/3.
DSKY Estimates Still Far Too High, DSKY In Terminal Decline
Given what we have seen above, it is clear DSKY is going to struggle in the near term and CapIQ shows investor estimates for future revenue.
(pic credit CapIQ)
Coupled with the very short life of paying Chinese mobile game users, we can see growth into 2016 will be essentially impossible and these estimates are clearly completely unrealistic. If DSKY is flat lining and the Chinese mobile phone market is growing, that means DSKY must be losing gobs of market share.
The estimates assume DSKY will constantly roll out hit games in China (which they have shown they cannot do) and take market share away from competitors (they are actually losing market share). With no hit games, I believe iDreamSky will consistently disappoint. Guidance for this upcoming quarter looks potentially reasonable but as we move into Q3 and Q4 of this year, I expect more downgrades and guidance reductions.
DSKY’s Dreams are Falling from the Sky
(pic credit me)
Conclusion: DSKY = Walking Zombie (At Best)
DSKY’s business model is malfunctioning and over time DSKY’s market opportunity and margins will contract as DSKY’s relevance in the market shrinks into nothing. As DSKY’s business continues to unravel I believe iDreamSky has no choices. If DSKY were to just lie about their financial results (I’m not saying they will), since all their products are customer facing and can be verified with industry data and data scrapes, that could easily be verified and presented to the SEC. This means DSKY has to report honest income statement metrics, assuring the accuracy of the pending implosion.
Unappreciated is the negative feedback loop built into DSKY. I estimate about 1/4 of DSKY current downloads are a product of DSKY’s internal marketing on their old hit games. As those games fall off, DSKY’s ability to market any new games also disappears and their whole business is likely to reverse in violent fashion.
I have been short iDreamSky for some time and SAIC filing discrepancies coupled with real-time China app store data showing new games failing with shrinking legacy games, I think the short thesis is timelier now than ever.