Is This Company Giving up its Lead?

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

I'm a little bit worried about the current leader in the gaming industry. Activision Blizzard (NASDAQ: ATVI) is going to have a difficult time maintaining the type of momentum investors have become used to this year. There's no question that the gaming industry is changing, and Activision is well positioned, but blockbuster releases don't come about every year. Though the company's current quarter results are extremely impressive, if investors are expecting this type of growth next year, they are likely to be disappointed.

Huge Results = Disappointment in the Future?

In the current quarter, Activision reported revenue growth of just under 20%, and non-GAAP earnings increased more than 114%. Though industry metrics have suggested that gaming sales are down, these results don't account for digital sales, which are becoming an increasingly important part of the industry. In fact, 57% of Activision's revenues came from digital channels during the quarter. The company's two divisions had strong new game releases that helped drive results. However, investors looking towards the future are probably wondering what the company can do to top these results? 

Activision - #1 Game and Toy but What's Next?

The company's Activision unit released the number one console game and the number one action figure in North America with Skylanders Spyro Adventure. While it's not unusual for a gaming company to expand its offerings into the toy arena as well, this has only happened a few times with these kinds of results. For instance, most people are aware of Rovio and that company's Angry Birds lineup, but when was the last time you saw toys centered around Battlefield 3, Farmville, or a Madden game? These heavily marketed games are owned by companies such as Electronic Arts (NASDAQ: EA) and Zynga (NASDAQ: ZNGA), yet a toy lineup isn't even a consideration. These companies have to make sure that they have enough hit titles to release, and it's highly unusual to see these titles morph into a hit toy line as well. While it's possible Activision may duplicate their success with future releases, it's not very likely, and investors should adjust their expectations appropriately. While the Activision brand has a huge release coming up with Call of Duty: Black Ops II, it's difficult to anticipate how this release will be received. The original Black Ops game didn't quite live up to the original Call of Duty: Modern Warfare franchise, and it's possible the sequel could disappoint. Though the company expects big results from the sequel, it also is the only large release from Activision over the next multiple months.

Blizzard – A Devilishly Good Year:

One thing that some investors may not be aware of is that Blizzard is more important to the company than the Activision division. In fact, Blizzard released two of the most popular PC games this year. Diablo III has consistently ranked as the number one PC game since its release early this year. World of Warcraft: Mists of Pandaria also ranks in the top five selling games this year. With about 10 million subscribers to World of Warcraft, this release helped reinvigorate online play. The challenge, of course, for any company in the gaming industry is coming up with a sequel or new release that will attract the same amount of attention as established franchises.

The Company Sits on Top of the Hill Financially:

One thing that Activision investors can consistently count on is the company's strong financials. In fact, by at least one measure, Activision is the most efficient gaming company. If you look at the company's operating margin of almost 27%, none of their competitors can match this mark. Traditionally speaking, online gaming companies should have a better operating margin than Activision. Console titles have costs that online companies don't incur. However, Zynga showed an operating margin of 23.57%, and even the Chinese online gaming company Perfect World (NASDAQ: PWRD) couldn't match up with a margin of 22.94%. In a more direct comparison, Electronic Arts' operating margin was just 16.26%, which shows the difficulty of running a high margin business and competing in console games. Activision's higher margin leads the company to generate significant cash flow, which is generally used to repurchase shares. In the last year, diluted shares are down almost 3%, and Activision still holds over $3.3 billion in cash and investments with no long-term debt.

What Have You Done for Me Lately?

While all of these results seem to point to the idea that Activision should be a great investment, in this market investors only want to ask: What have you done for me lately? While the company expects roughly 18% EPS growth for 2012, management has already mentioned next year's comparisons could be challenging. Investors looking for a play for next year may be hard-pressed to stick with Activision. Of the company's competitors, only Zynga is expected to see a decline in revenue like Activision next year. By contrast, Electronic Arts and Perfect World are both expected to see mid to high single-digit revenue growth in 2013. Though there's no question Activision is a hugely successful company, organic growth from these two competitors could attract investors' attention. Between the two, Perfect World is expected to grow slower at roughly 10% earnings growth in the next few years, but the company has a huge hidden dividend policy that could reward investors with double-digit payouts. While Electronic Arts is expected to grow earnings at better than 16% in the next few years, the company has been somewhat inconsistent. Zynga trades for a much higher multiple than its competition, has a negative operating margin, and is expected to see negative revenue growth next year. Depending on how Activision's games next year are received, the king of gaming may have to cede its throne to a competitor. Investors who aren't aware of these difficult comparisons in 2013 could be caught off guard. If you like Activision, make sure to add it to your personalized Watchlist so you can keep up with developments.

Dig Deeper

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MHenage owns shares of Perfect World. The Motley Fool owns shares of Activision Blizzard. Motley Fool newsletter services recommend Activision Blizzard, Electronic Arts, and Perfect World . 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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