Should You Follow Management's Big Buy in This Video Game Maker?

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

In July 2013, leading video game publisher Activision Blizzard (NASDAQ: ATVI) decided to get out from under majority owner Vivendi’s yoke, agreeing to pay $8.2 billion for most of the France-based conglomerate’s position. According to the announcement, $5.8 billion will be purchased by the company and $2.4 billion of the shares will be purchased by investors led by the company’s CEO and Chairman. The purchase reduces Activision's share count significantly, by roughly 38%, increasing the value of remaining shareholders’ stakes. So, should investors share management’s enthusiasm?

What’s the value?

Current management has done a good job by producing games that resonate with customers and add to the company’s bottom line. According to industry data provider NPD Group, the top two best-selling games in the world in 2012 were from Activision’s portfolio, Skylanders Giants and Call of Duty: Black Ops II. In addition, the company’s World of Warcraft franchise remained the top multi-player online game in the world, despite another year-over-year drop in subscribers.

In FY2013, Activision posted mixed results, as the lack of major title releases led to a tough comparison to its prior-year period when it had immediate commercial success with its latest Diablo game. For the period, the company posted a 13.9% decline in revenue, but a 41.9% increase in operating income, after adjusting for the effects of deferred revenue. While Activision’s top-line growth was weak, it generated a large increase in operating margin as management continues to focus its resources on its top game franchises.

Looking ahead, Activision’s near-term results are dependent on the console makers, as its game customers wait for the next generation hardware from Sony and Microsoft. In the meantime, the company is trying to drive incremental sales of new content through its online channel, an area that registered a sales increase in FY2013. Activision is also trying to mitigate the threats from game developers that offer their products for free and hope to cash in on advertising and virtual goods purchases.

Free: A tough business model

Of course, giving your product away for free and hoping to cash in on the back-end is a risky proposition as leading developer Zynga (NASDAQ: ZNGA) has found out through experience. The company has grown exponentially over the past five years as it produced popular games, including Zynga Poker and Farmville, and integrated itself tightly into Facebook, the source of roughly 86% of its overall revenue in 2012. However, near-term results have been hurt by negative growth in its user base and a need to restructure its top-heavy administrative overhead.

In FY2013, Zynga posted weak financial results, with a 24.4% decline in revenue and a steep drop in adjusted operating income. While the company continues to have three of the top ten games played on Facebook’s game network, its daily average users declined to 39 million from 72 million in the prior-year period. Fortunately, Zynga has a strong financial base, with over $1.5 billion in cash and marketable securities, but it has a hard road ahead in order to find profits from its free model.

Another way to go

Given competition and often changing loyalties in the video game sector, investors might want to consider the video game distributors that benefit from overall growth of the sector. GameStop (NYSE: GME) dominates the sector through its global network of over 6,600 retail stores, as well as its complementary businesses that include its Game Informer magazine, the third-largest consumer publication in the U.S. While the company was thought to be a dinosaur as more consumers purchase games online, it has morphed into a multi-channel operator and a valuable trade partner for consumers in the pre-owned market.

In its latest fiscal year, GameStop reported mixed financial results, with a 7% drop in overall revenue, but a 10.9% increase in adjusted operating income. The company’s top-line growth was hurt by a lack of new industry titles and lower hardware sales, as consumers wait for new consoles, including Sony’s PlayStation 4 that is expected to launch in the fourth quarter of 2013. However, GameStop continued to generate strong operating cash flow, due to a strong margin from its large pre-owned segment, allowing it to continue investing in its online capabilities.

The bottom line

Activision certainly enhanced its long-term value through its recapitalization deal, but it has rising competition from online developers and the makers of the console devices themselves. A better bet may be GameStop, a distributor that is moving its business online and benefits from an increase in the gaming population, regardless of which console or game is the flavor of the day. It is one for the portfolio.

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Robert Hanley owns shares of GameStop. The Motley Fool recommends Activision Blizzard. The Motley Fool owns shares of Activision Blizzard and GameStop. 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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