Should Activision Blizzard Aspire to be a Movie Studio?

Leo 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) CEO Bobby Kotick wants to make video games as mainstream as movies. Let’s take a closer look at Activision Blizzard's current product cycle, and decide whether Activision's "movie studio" strategy is sustainable.

Coming soon to a console near you

After the most recent installment of its best-selling Call of Duty franchise, Black Ops 2, topped $1 billion in retail sales within its first 15 days, Kotick told the press, “Sales for the Call of Duty franchise have exceeded worldwide theatrical box office receipts for Harry Potter and Star Wars.”

There's a reason Kotick is sticking with his "games as movies" strategy, since games are increasingly expensive to produce - costing an average of $15-$20 million per PC or console release. 

Under Kotick, Activision has turned the North American video game publishing industry into a two-horse race between itself and Electronic Arts (NASDAQ: EA). Both publishers aspire to be movie studios, relying heavily on blockbuster titles (Mass Effect, Call of Duty) or aging franchises (The Sims, Madden, Warcraft) to consistently generate revenue.

Meanwhile, Take-Two Interactive Software (NASDAQ: TTWO), the parent company of 2K, Rockstar and Bethesda, trails in a distant third place in the North American market, despite publishing major hits such as Bioshock, Grand Theft Auto and Borderlands. Take-Two's titles, while acclaimed by video gamers and critics, lack the blockbuster appeal of Activision and EA's titles.

Call of Duty

Activision's Call of Duty is a first person shooter which was first released in 2003. Today, it is Activision's most important franchise, accounting for 45% of the company's EBITDA. Since its inception, 17 different sequels have been released, across all major gaming platforms. With that kind of saturation over a decade, have sales slowed down at all?

<table> <tbody> <tr> <td> <p><span><span><span><strong>Game</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Release Date</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>First-day Sales</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>% Change (Y-O-Y)</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Call of Duty Black Ops </em></span></span></span></p> </td> <td> <p><span><span><span>Nov. 9, 2010</span></span></span></p> </td> <td> <p><span><span><span>$360 million</span></span></span></p> </td> <td> <p><span><span><span>+16% </span></span></span></p> <p><span><span><span>(from Modern Warfare 2’s $310 million)</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Call of Duty Modern Warfare 3</em></span></span></span></p> </td> <td> <p><span><span><span>Nov. 8, 2011 </span></span></span></p> </td> <td> <p><span><span><span>$400 million</span></span></span></p> </td> <td> <p><span><span><span>+11%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><em>Call of Duty Black Ops 2</em></span></span></span></p> </td> <td> <p><span><span><span>Nov. 13, 2012 </span></span></span></p> </td> <td> <p><span><span><span>$500 million</span></span></span></p> </td> <td> <p><span><span><span>+25%</span></span></span></p> </td> </tr> </tbody> </table>


If anything, these numbers show that initial demand is accelerating, after a minor dip with Modern Warfare 3. Although Black Ops 2’s initial numbers look strong, several analysts expect final sales to come in 15% lower than Modern Warfare 3.

We’ll have to wait for Activision’s official earnings release on Feb. 7 for clearer numbers, but any decline in Black Ops 2 sales - especially during the holiday season - will be viewed as a sign of diminishing returns for the venerable franchise.

World of Warcraft

World of Warcraft, launched in 2004, is Activision’s primary MMORPG (massive multiplayer online role playing game), and considered a genre-defining title.

Created by its subsidiary Blizzard, World of Warcraft subscriptions, combined with Blizzard’s Starcraft and Diablo franchises, account for 49% of the company’s annual revenue. World of Warcraft is Blizzard’s most valuable title, since it charges $15 per month while Starcraft 2 and Diablo 3 do not charge monthly fees.

Analysts have been concerned regarding the age of the game and increased competition from similar competitors, who offer more graphically advanced MMOs. Let's examine World of Warcraft's fluctuating subscriber base over the past five years, and notice how Activision periodically releases expansions to the game to keep players interested.

<img src="/media/images/user_15178/me_large.jpg" />

Releasing expansions, which introduce new characters, areas, and items, has helped the game stay afloat, but growth has apparently peaked at the 10 million mark.

That means any positive news regarding World of Warcraft will have limited impact, while any negative news could instantly sink the stock. The fact that Activision is now making the game free-to-play should also raise red flags.

Digital Downloads Increase Margins

Activision Blizzard’s digital sector, which offers direct download games and DLC (downloadable content) add-ons for its games, posted strong growth last quarter, accounting for 51% of total revenues.

This is a promising trend, since digital downloads increase margins by reducing the need for optical discs and paper packaging. Video game publishers now offer “Digital Collectors’ Editions” of their games, which reward customers with exclusive in-game virtual goods, instead of physical collectibles. 

Electronic Arts also reaped the benefits of this trend, posting a 40% gain in total digital revenues last quarter. Take-Two fared even better, posting 102% growth in its digital segment.

EPS/Revenue Growth

Let’s take a look at how Activision Blizzard has fared on the top and bottom lines over the past four years.

<img src="http://media.ycharts.com/charts/6b9035b4f808fd7e2db2f4ae87ed648b.png" />

ATVI EPS Diluted TTM data by YCharts

Both earnings and revenue have recovered steadily, thanks to rising operating margins from digital sales.

Activision also sees a bright fourth quarter ahead, forecasting earnings of $0.71 per share -- a 14.5% increase over the prior year quarter -- due to a strong holiday shopping season.

We'll need a few more baskets for our eggs...

Activision’s glaring weakness is its lack of diversification. Any decline in the Call of Duty or World of Warcraft franchises could hurt revenue growth so badly that investors might rush for the exits. Kotick's "movie studio" approach is dangerous and puts all of the company's eggs in two baskets. The company already lost one major franchise - Guitar Hero - after imitators flooded the marketplace with similar products.

Looking forward, Activision plans to release the free-to-play Call of Duty Online, which will generate revenue through micro-transactions (in-game item purchases). It will also release the eagerly anticipated sequel to Starcraft 2 - Heart of the Swarm - which should be an easy sell to the original game’s 6 million players.

Its new franchise, Skylanders - collectible toys that synchronize with a corresponding video game - is also expected to remain strong in 2013. The line has generated over $500 million in revenue since its October 2011 debut.

An upcoming MMORPG is also in the works, as a proper replacement for its aging World of Warcraft franchise.

The Foolish Fundamentals

Let's take a look at how Activision stacks up against its competitors in terms of financial strength.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Total Debt</strong></td> <td><strong>Total Cash</strong></td> </tr> <tr> <td><strong>Activision</strong></td> <td>$0</td> <td>$3.36 billion</td> </tr> <tr> <td><strong>Electronic Arts</strong></td> <td>$0.54 billion</td> <td>$1.32 billion</td> </tr> <tr> <td><strong>Take-Two</strong></td> <td>$0.33 billion</td> <td>$0.33 billion</td> </tr> </tbody> </table>


In addition to that pristine balance sheet, Activision offers a 1.6% annual dividend, and trades at a fundamentally cheap forward P/E of 11.8 with a price-to-book ratio of 1.12.

In my opinion, that makes Activision the best value in the video game industry today, despite its top-heavy dependence on key franchises. 


Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard. You can follow Leo Sun on Twitter at https://twitter.com/leokornsun for more investing ideas.

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