Uncertainty Surrounds This Game Company

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

This year is an exciting one for the world of video games. With Sony and Microsoft set to launch new consoles this holiday season, the Playstation 4 and the Xbox One respectively, there should be a much needed jolt provided to the gaming industry. One of the biggest game companies, Activision Blizzard (NASDAQ: ATVI), is in prime position to benefit from this new generation of gaming. But the company is certainly not without problems.

A slowly deflating cash cow

When Activision reported its Q2 earnings recently, the results were a mixed bag. While GAAP numbers looked decent, with a 2% revenue decline and a 75% increase in net income, non-GAAP adjusted figures told a different story. Adjusted revenue fell 42%, while adjusted net income was just 8 cents per share compared to 20 cents per share one year ago.

One issue that Activision is facing is a declining user base for its popular World of Warcraft online game. After peaking at 12 million subscribers in 2010, the game now has just 7.7 million users, down from 8.3 million users last quarter. World of Warcraft is one of Activision's main cash cows, and its continuing decline is troubling for the company.

Franchise fatigue

One of Activision's big franchises is Call of Duty, a shooter which will see a new version this holiday season for current consoles as well as next-generation consoles. Call of Duty is one of the most popular franchises of all time, with the last version reaching $1 billion in sales in just 15 days. There is concern, however, that the franchise is starting to get tired. Each successive game is very similar to the last, and with plenty of competition Call of Duty's reign as king of the online shooter may be coming to an end. The upcoming version, Ghosts, is on track for fewer pre-orders than the previous version. Part of the reason for this could be uncertainty regarding the new console releases, but there's the possibility that interest for the game is lower than for previous iterations.

While many shooters have come and gone, Battlefield 4 from Electronic Arts (NASDAQ: EA) has a real chance at dethroning Call of Duty. Set to release a week before Call of Duty: Ghosts, EA's game could offer something new for gamers sick of the Call of Duty formula. The previous Battlefield game sold about 16 million copies worldwide, compared to the previous Call of Duty game's 24 million, and it will be interesting to see if this gap closes or reverses later this year.

Another big game coming out this year is Grand Theft Auto V from Take-Two (NASDAQ: TTWO). While GTA is a different genre of game than Call of Duty, the mega-popular series could still draw people away, especially those tired of the Call of Duty series.

Free at last

The big news for Activision this month was a deal struck with majority-owner Vivendi to buy back most of the company. Currently Vivendi owns 57% of the diluted share count, giving it control over Activision, but after the deal Vivendi will own just 12% of the company. The company will buy 429 million shares for $5.83 billion, while an investor group led by CEO Bobby Kotick will purchase 172 million shares for $2.34 billion. This represents an average purchase price of $13.60 per share.

Activision will fund this deal with mostly debt. The company has $4.6 billion in cash on the books, and after the deal the company will still have $3 billion in cash and $4.6 billion in debt. The share count will be reduced significantly, from 1.19 billion to about 750 million diluted shares. This will have the effect of boosting per-share numbers significantly, while reversing a net cash position into a net debt position.

Two scenarios

Activision is at somewhat of a crossroads, and there are two paths which it can take:

  1. World of Warcraft subscriber losses moderate and the company releases a new game that takes its place. Call of Duty remains the top shooter, and the new version at least matches the previous version's sales. The new console generation gives a boost to sales.

  2. World of Warcraft bleeds subscribers with no successor on the horizon. Gamers get sick of Call of Duty and switch to Battlefield or other games, sending the franchise into decline.

If these two giant franchises fade away it leaves Activision in a tough spot. There are some big releases on the horizon, such as Destiny from the studio responsible for the popular Halo series. Destiny is a persistent-world first person shooter where the universe of the game will be "alive", always active and always changing. This is different enough from Call of Duty such that it likely won't cannibalize sales. And given Halo's popularity Destiny could very well be the next $1 billion franchise for Activision.

Better than the rest

Although there is plenty of uncertainty surrounding Activision, it is still more reasonably priced than other gaming companies. Revenue and profits are expected to decline in 2013 compared to 2012, and the company estimates GAAP EPS to be $0.77, excluding the effect of the buyout deal. This is down from $1.01 in 2012. The buyout should boost the EPS to around $1.20 per share, excluding new interest payments, based on the new share count. Accounting for the debt which will be created, Activision's enterprise value is about 16.5 times expected earnings.

This isn't all that cheap. Last time I wrote about Activision the stock was trading at far lower levels, and the big boost received due to news of the buyout deal has pushed the stock to levels higher than I'd like to pay, especially given the weakness in World of Warcraft and the new debt. The stock is up about 20% since my first article, but I think that it's risen too high to consider any more.

Activision is, however, cheaper than its competition. Electronic Arts earned just $0.31 per share in fiscal 2013 ending in March after a steep revenue decline. Analysts expect earnings of $1.22 per share for the current year, but the forward P/E ratio of nearly 22 is far higher than that of Activision. This also assumes that EA can deliver these earnings, which may or may not be the case. EA does have Battlefield 4, its Call of Duty competitor, set to release this fall, as well as its popular slate of sports games, but it seems that high costs are eating away at the company's bottom line. EA spends almost twice as much on R&D as Activision does, with revenue declines and poor profitability to show for it.

Take-Two, publisher of the Grand Theft Auto series, has been losing money for the last two years. The upcoming release of GTA V will likely give the company a big boost, but with revenue essentially stagnant over the past decade there's not much of a reason to own Take-Two at this point.

The bottom line

After rising 20% since my last article Activision isn't nearly as attractive as it once was. The buyout deal adds significant debt, and the decline of World of Warcraft is leading to a lower level of profitability. Activision does have games such as the new Call of Duty in the pipeline, and the new console generation may provide a boost to sales, but it's difficult to recommend Activision at these prices. At $15 per share, where the stock was when I wrote my first article, the picture looks a lot better. But $18 per share is too much to pay.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . 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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