OVERVIEW: Virtual Reality (VR) is about to become mainstream and could be a $7 billion market by 2018.

Numerous head-mounted displays are in development (but not commercially available) with Facebook’s Oculus, Samsung, and Sony leading the pack, and Nintendo not far behind.

If Samsung’s Gear VR remains wireless, it could dominate the mobile gaming space since 78% of the world’s 1.2 billion gamers are mobile. Oculus could evolve into Facebook’s next generation social networking platform in addition to providing interactive immersive play for Facebook’s 1.3 billion subscribers.

Augmented Reality (AR) is already here, with numerous companies servicing the retailing and engineering sectors not to mention Google, which led a $542 million funding round for Magic Leap, an AR startup whose product hasn’t even been announced.

We detail some of the more interesting technologies in this report and highlight several companies participating in the market including Sophic Capital client Spectra7 Microsystems (Spectra Microsystems Stock Quote, Chart, News: TSXV:SEV).

For decades, aviation simulation companies and the military have used virtual reality (VR) for training. This included VR “rooms” with floor to ceiling display panels that created ‘virtual worlds” (although the latency of the motion to image change time was prohibitive.) Although many articles have appeared concerning VR’s potential usage in the medical, educational, and military sectors, we believe that VR’s initial potential lies in the gaming and social media industries.

With the emergence of major VR gaming hardware innovators such as Samsung, Sony, and Oculus (purchased by Facebook in 2014 for $2 billion), we believe that VR gaming is real. Investors have the opportunity to invest in the early stages of a disruptive gaming technology that people have talked about for decades. VR gaming is here and could make its way to retailers’ shelves as early as December of this year, with 2015 expected to be the real breakout year where several platforms are anticipated to be released.

Using consulting firm KZero’s forecasts, the VR market could reach $7 billion by 2018, with room to grow. In arriving at this forecast, KZero estimates VR hardware revenues to be worth $2.3 billion by 2018. The firm also predicts about $4.7 billion of VR software (games and apps) revenues by the same time. Summing the two KZero forecasts, we arrive at the $7 billion estimate. We remind investors that VR gaming is in its infancy; as of 2013, there were 1.2 billion gamers in the world and none of them had head-mounted displays (HMDs), input systems, and software needed to play VR games.

Yes, people love their mobile games. They’re fanatical (maybe even addicted), with 10% of 602 gamers surveyed saying that they have played a mobile game while driving a car, at a movie theater, and even at a place of worship. VR is the next big thing for all gaming, and devices like Samsung’s Gear VR will immerse mobile gamers in new worlds for their next great adventure – but not while they’re driving, we hope.

Haven’t We Talked about VR Forever?

Not “forever” but close to it. VR is the immersion of an individual into a computer-generated world. Science fiction has been littered with VR references, ranging from the robots in the Matrix who plugged humans into a computer to keep them mentally stimulated, to Captain Kirk’s holodecks. But real VR systems preceded the gaming industry’s interest. In 1962, Morton Heilig was granted a patent for his Sensorama Simulator, a machine that played 3D film, stereo audio, implemented wind generators, and exhaled an array of aromas for what many consider history’s first VR experience. From there, the U.S. military experimented with VR, trying to incorporate a display into pilot helmets.

Then came the birth of modern HMDs. In 1968, Ivan Sutherland created a 3D stereoscopic HMD, which he called the “Sword of Damocles”, to improve flight trainers . It was this idea of using a visual display to merge the human and artificial worlds which led to the HMDs in development today for the next stage of the gaming industry.

The unit was suspended from the ceiling from a metal rod, much like how King Dionysius had suspended a sword by a horsehair above one of his court’s flatterers, Damocles, so that the latter could experience what it felt like to be a King.

Gaming Trends – Give us More VR Please

VR is a gaming trend that is only going to get bigger. E3 2013 was abuzz with a VR prototype game developed by CCP called EVE Valkyrie that won several awards at the show. The game utilized a VR headset from Oculus, which debuted at CES 2013 and attracted a lot of attention and sales – Oculus quickly sold 60,000 of its Oculus Rift DK1, and 20,000 of the 60,000 second generation development kits (DK2) have shipped. Facebook noticed and bought Oculus for $2 billion on March 25, 2014, potentially giving the VR platform a 1.3 billion person audience.

Fast forward to September 2014, to when Oculus held its first developers’ conference, Oculus Connect, attended by 800 developers. CTO John Carmack presented a speech outlining Rift’s technological challenges and where the technology is heading. But in spite of the gamer hype and the developer enthusiasm, commercial Oculus headsets still aren’t available. However, at Dublin’s Web Summit in November 2014, CEO Brendan Iribe stated, “We are still working on a number of aspects, but the hardware is almost there for the consumer product. The headset is largely finalized at this point. Although he would not commit to a release date, Mr. Iribe further said that the consumer version is “months, not years away, but many months.” VR may no longer be a “virtual” reality – it’s closer than we think.

During Facebook’s third quarter 2014 conference call on October, 28, 2014, CEO Mark Zuckerberg reiterated that Oculus was a long-term bet on the future of computing. He noted that it will “take a bunch of years to get there” and that he didn’t think it would “get to 50 million or 100 million units in the next few years.” This suggests to us that Facebook could not only see VR as the future of gaming and social networking, but as an actual computing platform, perhaps with VR as an interface. Why scroll a mouse when your eyes could tell your computer where to navigate? Why type when subtle head movements could point to letters or words?

Sony Computer Entertainment has jumped on the VR bandwagon with “Project Morpheus.” Designed to integrate with Sony’s PS4 gaming system, the company views Morpheus as an opportunity to push the boundaries of play. However, Shuhei Yoshida, the President of Sony’s Worldwide Studios, recently said that beyond gaming there are other applications. He described VR as “the feeling, the belief that all your senses believe that you are in a different place.” He then shared the ideas of traveling to Barcelona virtually or being on the moon.

For now, Morpheus will not compete directly against Oculus since Oculus is focused on the PC gaming market and Morpheus is meant for the PS4. Mr. Yoshida has conceded that Sony has finished 85% of Morpheus’ development. And although he would not divulge a release date or pricing, Mr. Yoshida stated that Morpheus won’t be available in 2014. He further offered that when Sony does release Morpheus, the public should not expect a $1,000 price point.

Samsung won’t be left behind. On September 3, 2014, during Samsung’s Unpacked 2014 event, the company unveiled its Gear VR platform. Developed in conjunction with Oculus, the Gear VR headset is a shell that slips over a Samsung Galaxy Note 4 for its video screen. It’s quite clever since one connects Gear VR to a wireless device rather than a PC or gaming console.

Speculation exists that Samsung’s Gear VR will be the first to market, possibly as soon as December 1, 2014 in South Korea and at a cost of about $187 (Galaxy Note 4 not included, but currently priced at $825.99 at AT&T or $299.99 with a 2-year contract). Given the need to have a Galaxy Note 4 for Gear VR to work and assuming that the Note 4 is bought on contract, the true cost is similar to the $350 Oculus’ Rift development kit. We believe Samsung could also announce a VR product similar to Oculus that could be plugged into its large TV install base.

Even if the speculative pricing for Samsung’s Gear VR is true, Oculus still looks like the leader in the market. Oculus is at the forefront of modern HMD and VR development. When Facebook announced its $2 billion purchase of the company, CEO Mark Zuckerberg posted that gaming will be the first experience for customers, and Facebook hopes to accelerate Oculus’ plans. Zuckerberg also detailed future plans for Oculus; plans where Oculus’ VR technology could allow users to “share unbounded spaces and experiences with the people in your life.” To us, this hints that Oculus VR could power a new social networking platform for Facebook. To scientists at Carnegie Mellon University, this means landing a robot on the moon that will allow Earthlings to view the moon’s surface with Oculus Rift HMDs.

Google is also targeting VR, not with Glass but with Cardboard. At this time, Google Glass is more of a hands-free information system that can do things like measure your golf swing, navigate the Earth, and record and send video messages. Cardboard, on the other hand, is literally a cardboard box designed to pair with a mobile phone (similar to Samsung’s Gear VR platform). Cardboard uses the phone to track head movement thereby allowing users to interact with the environment.

Amazon retailers sell Google’s Cardboard at prices starting at $2.39. What you’ll receive is a cardboard box embedded with lenses and a near-field communication chip to launch an app that users must download. Google also provides Cardboard plans for users to make their own, the same plan many of the Amazon retailers use for their kits. Some may view Cardboard as gimmicky, but we will have to see how successful this product is. Who knows? If nothing else, it could bring VR to the masses and spur VR app development.

Consumer VR Market Could be Worth $7 Billion by 2018

In 2013, research firm Gartner estimated that the 2013 global gaming market could reach $93 billion (from $79 billion in 2012) and grow to $111 billion by 2015. IDATE predicts that the current global video game market will grow from about €54 billion in 2013 to €82 billion in 2017. DFC forecasts that gaming software alone could grow from $64 billion in 2014 to $100 billion by 2018.

Our question is: How big could VR gaming become? Summing KZero’s predictions of $2.3 billion in VR hardware sales in 2018 and about $4.7 billion in VR gaming software and apps by the same timeframe, we arrive at the $7 billion estimate for the entire market. Although the market value is small, we remind investors that commercial VR gaming is still in its infancy, targeting only 39 million gamers in 2018. This equates to only 3% of the estimate 1.2 billion gamers in 2013.

MarketsandMarkets forecasts the global HMD market to reach approximately $12.3 billion by 2020. We note that this forecast considers non-immersive (systems using a workstation) HMD as well. Consulting firm KZero anticipates HMD sales to grow from 200,000 units to 39 million by 2018 (Exhibit 2).

KZero projects VR input systems growing from about 2,000 units in 2014 to about 10 million in 2018. Input systems are accessories such as suits and gloves that interact with VR systems, and the growth of this market sector should straddle HMD purchases. We anticipate that many input systems will cost more than HMDs because gamers will wear them, thus necessitating different manufacturing processes (fabrics and electronics) which command a new set of design challenges beyond steam-injected plastic modules for console platforms. KZero also forecasts the VR software market to grow to almost $4.7 billion market by 2018 (Exhibit 4) from about $1 million in 2014.