What Will Stop This Game Maker From Hitting a New High Score

Rob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Activision Blizzard (NASDAQ: ATVI) hit a new 52 week low after announcing third quarter earnings after the bell last Wednesday. Despite the drop in price, Activision actually beat earnings estimates by 7 cents per share and revenue estimates by $41 million. Activision even raised full year revenue guidance by $180 million and EPS guidance by 11 cents. Although Activision blew past analysts’ expectations both for this quarter and next, they were several reasons for concern.

Third Quarter Highlights

Activision’s third quarter sales were driven by brisk sales of Blizzard titles Diablo III and World of Warcraft’s latest expansion, Mists of Pandaria. World of Warcraft subscribers even rose in the past quarter after declining steadily since hitting a high of 12 million users back in 2010. Blizzard produces #1 hits with every release, and they hope to keep that up with StarCraft II: Heart of the Swarm in March of 2013. Also on the horizon for Blizzard are Blizzard All-Stars, a Diablo III expansion, and a new MMO, code named Titan, although all three are likely to be released 2014 or later.

Call of Duty also continues to sell well, but the real star of Activision’s earnings was their newest hit, Skylanders. Skylanders was not only the #1 selling console game so far this year (including accessory packs and figures,) but also the #1 selling action figure line. Just 1 year after launch, Skylanders is a top kids brand with over 100 licensing partnerships and a sequel, Skylanders: Giants, that was just released in October. Skylanders is on its way to becoming Activision’s next $1 billion franchise. 

Reasons for Concern

Activision forecasts that the fourth quarter will be another record quarter, although management does not seem confident in replicating these results next year. CEO Bobby Kotick cited a difficult macro environment and the ongoing console transition as headwinds the company will face next year. Nintendo is launching their newest console, the WiiU, on November 19 and even though Kotick specifically said on the conference call he could not talk about the transition to next generation systems from Sony (NYSE: SNE) or Microsoft (NASDAQ: MSFT) new consoles from both companies are expected within the next 2 years. The Playstation 3 and the Xbox 360 have been on the market for 6 and 7 years respectively, longer than the typical 5-6 year life cycle for consoles. Microsoft and Sony may be trying to delay the release of new consoles as they would be sold below cost, as opposed to their current profitable systems. The main concern with the release of the next generation of consoles is the rise in development cost for games. Tim Sweeney, CEO of Epic Games, expects development costs to double or triple and the price of games to increase as a result. AAA title games, such as Call of Duty, already costs upwards of $20-$60 million to develop and require game makers to sell nearly 2 million copies of a game just to break even. Increasing cost for Activision would cut into the companies’ margins unless they raise the price of their games. 

Another reason for concern is the lack of insight Activision gave to next year’s release slate. So far the StarCraft II: Heart of the Swarm is the only Blizzard title with a release window.  On the Activision side of the business the only two releases scheduled as of now are Deadpool: The Game and Walking Dead: Survival Instinct. Bungie’s new game, code named Destiny, is also in development, though Activision has not released any details about the game or its release window. For a business model that relies heavily on blockbuster hits the lack of visibility for upcoming hits is a little worrying. 

Activison has also seemed to unofficially suspend its stock buyback program.  Activision repurchased $261 million worth of stock in the first quarter of this year and $54 million in the second quarter. Activision did not repurchase any shares in the third quarter despite having $946 million left to their repurchase authorization and $3.4 billion in cash and investments on their balance sheet. Management would not comment specifically on the lack of share repurchases during the quarter, though speculation is that Vivendi is looking to sell their share of Activision. Vivendi still owns 684 million shares, or 62% of outstanding shares, from their merger in 2007. Last summer Vivendi was rumored to be looking to sell their stake in Activision to Microsoft, Time Warner, or Tencent. Vivendi may have failed to reach a deal over the past summer, though they could still be looking to offload their $7 billion stake in the company. Activision could actually buyout part or all of Vivendi’s share of the company through financing, a potential reason for the pause in share repurchases.     

Paying Investors to Wait

Activison has a lot of unanswered questions and CEO Bobby Kotick did not give many answers to investors this past quarter. Despite all of the questions Activision is still home to numerous blockbuster franchises that have generated $1 billion operating cash flows three years running. Activision is trading at just 9.8 times expected 2012 earnings and has 26% of their market cap in cash. With several big games still in development from Bungie and Blizzard, now might be time to buy into Activision.  There is still time to answer the questions that investors have and Activision pays a healthy 1.7% annual dividend for patient investors.  Activision’s dividend even has room to grow since they only paid out 23% of 2011’s free cash flow. 

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AllPrologue owns shares of Activision Blizzard and Microsoft. The Motley Fool owns shares of Activision Blizzard and Microsoft and is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). Motley Fool newsletter services recommend Activision Blizzard and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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