Another Record Quarter for this Industry Leader

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

There have been so many headlines declaring the rise of mobile and social games and the fall of the classic console and computer games that many investors take this premise as fact. While it is certainly true that Apple's iPad and Facebook's social network platform have created a new genre of gaming, it is far too early to declare the end of the production of high-quality games for consoles and computers.

Game publishers have struggled

A look at the stock price history of the major pure-play gaming publishers over the past year seems to support the premise that big-budget gaming is dead:

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ATVI data by YCharts

Zynga's (NASDAQ: ZNGA) well-hyped IPO and equally well-publicized crash have clearly demonstrated that the popularity of social gaming does not necessarily translate into shareholder returns. In fact, questions regarding Zynga's ability to monetize its games have caused analysts to predict a double-digit decline in revenues and negative earnings for Zynga in 2013.

Looking back before the debut of Zynga, the five-year chart doesn't look much better for gaming publishers:

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ATVI data by YCharts

Electronic Arts (NASDAQ: EA) has struggled to remain profitable despite wildly popular sports franchises such as Madden Football, NBA Live, and Tiger Woods Golf. Additionally, EA has a wide range of games using popular television and movie franchises such as The Simpsons and Star Wars and board games such as Monopoly. Many of these games are popular, but have proven to be unprofitable especially given the royalties paid for the rights to use the intellectual property of these well-known franchises.

Take-Two Interactive Software (NASDAQ: TTWO) has seemingly been on the verge of huge earnings each quarter, but the earnings never materialize. Like EA, Take-Two has a solid lineup of games including the 2K Sports games, Grand Theft Auto, and more. Both Take-Two and EA have a wide lineup of games that look great on paper, but do not translate well to the bottom line for shareholders (or at least haven't in recent years). This difficulty has been a consistent theme across the gaming industry, as long-time publishers such as Atari and THQ have gone out of business.

Activision Blizzard (NASDAQ: ATVI) gets lumped in with EA, Take-Two, Zynga, and the masses of small (or private) game publishers. In most investors' minds, they are all either struggling to convert to mobile and social platforms or failing to monetize these "platforms of the future."

The bottom line is that investors see the failures of Atari and THQ and the recent struggles of once-successful companies like EA and believe that video game publishers should be avoided altogether. There's a fundamental flaw in this logic, which is incredibly simple yet always overlooked: there is still money to be made in the traditional, full-budget gaming realm. Despite not being rewarded with a rising share price in recent years, Activision has been doing just that year after year.

A unique focus on developing profitable games

Under the leadership of CEO Bobby Kotick, Activision has developed some of the best-selling video games of all time. These franchises include Call of Duty, World of Warcraft, Diablo, Starcraft, and Skylanders. The games are exquisitely designed with an unparalleled attention to detail and ability to engage the user for hours of entertainment. The games are so successful that Activision has been able to collect record revenues either through the sale of sequels or add-on packs or through monthly subscriptions to multiplayer services. In each case, the company is mindful of the bottom line as the franchises evolve; if it determines that a franchise isn't sufficiently profitable, Activision will walk away. Many questioned this decision when the company abandoned its Guitar Hero franchise, but the company's results since then have demonstrated that Activision is stronger because it makes the tough decisions.

Q4 2012 was a record quarter

Activision just released its Q4 2012 earnings report, and the results were tremendous. Aside from beating analyst expectations on both the top and bottom lines, Activision reported record revenue of $2.6 billion and EPS of $0.78 (non-GAAP). Activision's trailing price to earnings ratio is a mere 10 based on the latest quarter's results. Equally impressive is Activision's ability to consistently generate cash; based on its Q4 results, the company boasts a trailing free cash flow yield of 9.5%. 

A P/E of 10 and free cash flow yield near 10% are startlingly cheap valuations for a company that continues to demonstrate growth potential. To further support the premise that Activision is undervalued is the fact that the company has a $13.5 billion market capitalization, including $4.4 billion in cash and no debt. This rock solid balance sheet already allowed the company to return over $500 million in each of the past two years to shareholders in the form of dividends and share repurchases. As noted in the earnings release, this is just the beginning of Activision's plans to maximize shareholder value: 

"The company is considering or may consider during 2013, substantial stock repurchases, dividends, acquisitions, licensing or other non-ordinary course transactions, and significant debt financings relating thereto. The company’s first quarter and full year 2013 outlooks do not take into account any such transactions or financings that may or may not occur during the year, with the exception of the $0.19 cent per share cash dividend announced below."

It is speculation at this point what form any transaction will take, but the key takeaway here is that Activision has generated a ton of cash, has the ability to return a third of its market capitalization to shareholders, and has the business savvy to evaluate the alternatives and determine the best way to unlock value for shareholders.

Looking ahead

A record-breaking quarter and a valuation (based on P/E or free cash flow yield) that is significantly better than its competition should be reason enough to consider an investment in Activision. However, there is more to the story, including a number of catalysts for 2013 and beyond:

  • Sequels and expansion packs - 2013 is off to a quick start with the January release of Revolution, the latest expansion pack to Black Ops IIHeart of the Swarm, the second title in the Starcraft II series is due for release later in Q1. More will certainly follow later in the year.
  • Continued growth in China - Activision's partnership with Tencent Holdings to bring Call of Duty multiplayer action to China is only in its first months of operation. With an estimated addressable market of 160 million users (and growing), this is a tremendous opportunity to leverage Call of Duty's track record of success in other parts of the world.
  • New gaming platforms - While Nintendo's Wii U hasn't been well received initially, there is much more excitement building around the next generation consoles from Microsoft (NASDAQ: MSFT) and Sony. In fact, the hype and speculation surrounding the next Xbox has suggested that the next generation console will have Siri-like voice control, unleash Kinect's full-motion sensing ability, and perhaps even prevent the use of used games. Any (or all) of these events would result in additional opportunities for Activision to create the latest must-have sequels to its existing lineup of games. With weak PC sales and a lackluster reception for the company's Surface tablet, Microsoft has plenty of incentive to make sure that its gaming console is a success both as a gaming device and as a gateway to broader home entertainment; a large part of this success will involve partnering with publishers like Activision to ensure that state-of-the-art titles are available to drive demand.
  • New franchises - In addition to the long-awaited project codenamed Titan, the company is in the process of developing a number of other franchises. The power of these new franchises should not be overlooked; Skylanders was initially panned by many critics when it was announced, yet it was the #1 selling kids title last quarter and has generated $1 billion since release. 

While Activision will be facing some difficult comps in 2013 after the record-breaking releases of Black Ops II and Diablo III, there is plenty of opportunity for the company to continue to grow over the long term.

Activision is a Top 10 stock

Last summer, I made the bold prediction that 2013 would be "the year of the Activision breakout" and concluded that a reasonable price target would be $18 per share. What has changed since then? Activision has solidly exceeded analyst estimates two more times, has successfully released several titles, has generated around $1 billion in free cash flow, and has become even more undervalued by traditional metrics. Continued solid execution, future market opportunity, and plenty of catalysts to drive the stock price forward make Activision a compelling buy today and a Top 10 stock.

Stay tuned for more on Activision as the company's plans to deploy its growing cash balance help determine whether $18 per share is possible or not.

For more on the Top 10 stocks:

  1. Apple
  2. Diageo
  3. Coca-Cola
  4. Chipotle Mexican Grill
  5. Costco Wholesale
  6. 3D Systems
  7. Canadian National Railway
  8. National Oilwell Varco
  9. Berkshire Hathaway
  10. Activision Blizzard

Brian Shaw owns shares of Activision Blizzard. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley Fool owns shares of 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.

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