No Matter What, 2013 Will Not Be As Good As Last Year

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

In 2012, Activision Blizzard (NASDAQ: ATVI) produced some ridiculously successful games. I would actually argue that Activision is the best producer of games for what I refer to as non-casual gamers. These customers may play casual games on a mobile device, but these games can't hope to match the immersive nature of PC or console gaming. When you have three of the four best selling games in North America and Europe, it's hard to produce a satisfactory encore.

If you are an investor in Activision you have to accept this reality. There is almost no way the company will be able to live up to 2012's results. However, just because a company is going to have a difficult year by comparison, doesn't mean it's not a worthwhile investment. In fact, investors need to be very careful about reading too much into NPD's research about the video game industry. A recent report said that “sales slumped 22% year-over-year”. There is just one massive problem. These numbers don't include digital sales.

The digital arena of gaming is becoming a larger and larger part of the pie. Companies like Zynga (NASDAQ: ZNGA) and their Farmville and Words With Friends games have zero physical sales. In addition, Zynga has the benefit of being associated with Facebook and their over 1 billion active users. The company essentially gives away its games, but then hopes to make money on the sale of virtual goods. In case you don't believe in virtual goods, consider that this market has grown from $1.6 billion in 2010 to an estimated near $3 billion for 2012.

Additional competitors like Perfect World (NASDAQ: PWRD) offer multiple on-line subscription based games based on Chinese novels, Dungeons & Dragons, and first person shooters. Perfect World operates primarily in the Chinese market where it's not unusual for gamers to pay not only for upgrades in their games, but also for their time on-line. Perfect World also is branching out geographically by licensing its games to companies in Japan, Europe, and the U.S. The company has a host of new games planned for 2013 and their subscription business could be a threat to the Blizzard portion of Activision. With companies like Zynga and Perfect World on the prowl, Activision needs to continue to push toward digital distribution.

In Activision's last quarter 51% of total revenues came from digital sales. With this move toward digital distribution, until there is research that includes both physical and digital sales, investors shouldn't underestimate Activision. If you want proof of Activision's dominance, just look at their quarterly results.

In the last quarter, Activision saw revenue jump over 35% and non-GAAP EPS rocketed up 114%. The company's Skylanders Spyro's Adventure took on special significance, because it was not only the number one console game, but it was also the number one action-figure line in the U.S. While these results are impressive, they make it harder for Activision to duplicate their success this year. To stay relevant, there are four major challenges that Activision must face in 2013.

The first challenge will be to try and make compelling games to follow up their 2012 hits. With Call of Duty: Black Ops II in stores now, the company should have an update to Call of Duty: Modern Warfare in 2013. The Call of Duty lineup always generates tremendous interest, and one way Activision could improve future releases is from the use of social media. The company should be able to post questions to its gaming audience about future product ideas. Activision's competition is getting better, and the company can't afford to have a big title fall flat.

For instance, Electronic Arts' (NASDAQ: EA) Battlefield series performed fairly well, and EA's Crysis 3 release soon is a follow up to a widely popular first person shooter. Electronic Arts's is similar to Activision in the sense they have a consistent refresh cycle with their Madden and NCAA franchises providing opportunities for new game releases each year. If Electronic Arts can make the Battlefield or Crysis game series compete on the same level as Call of Duty, then Activision would have serious problems. Even Microsoft continues to innovate with new releases of the wildly popular Halo franchise. Activision has already announced a follow up to Skylanders Spyro's Adventure, but a follow up to World of Warcraft: Mists of Pandaria will be tough.

The second challenge that faces Activision is how to keep its World of Warcraft and Diablo III audiences engaged and paying for their subscriptions. Generally speaking, it's difficult to keep a large audience playing without constant refreshes and new content. This has been a challenge for the previously mentioned Perfect World overseas, but they have some well-known titles being released in 2013, which could pull some players away from the World of Warcraft or Diablo franchises.

Third, Activision will have to continue pushing toward more of a digital distribution model. The company's gross margin of 72.53% is being propped up by the fact that they have a heavy concentration of subscription and PC based revenue. It is much more common for PC players to download games than it is for console gamers. Considering that Zynga and Perfect World specialize in on-line gaming and have gross margins of 71.53% and 81.48% respectively, you can see that Activision needs to keep pushing the envelope. By comparison, EA had a gross margin of just 37.41% in their recent quarter, and I'm sure this is connected to their high concentration of console games like Madden, the NCAA series, Battlefield, and the like.

Maybe the biggest challenge facing Activision in 2013 is keeping investors interested. The shares sell for 11.5 times projected earnings, and analysts are calling for almost 10% EPS growth going forward. By comparison, Electronic Arts sells for a similar multiple, yet is expected to grow at almost 14%. Zynga is tough to recommend at 249 times earnings, but Perfect World sells for just over 5 times earnings, and is set to pay a nice sized annual dividend that could reach double digits. By comparison, Activision's 1.59% yield isn't terrific, and I would expect the company to try and bump up this yield to keep investors tuned in. This year will be tough by comparison to 2012, but that just means next year Activision could surprise investors to the upside again.

MHenage owns shares of Perfect World . The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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