Activision Blizzard’s (NASDAQ:ATVI) stock has jumped nearly 13% since the company reported earnings for the fourth quarter of 2012 on February 7. The video game publisher beat the disappointing industry trend of this holiday season, with a 25% year-on-year increase in revenues and operating income breaching the $1 billion mark for the first time in a quarter. However, we believe that the company might still be undervalued and have revised our price for Activision’s stock to $16, implying a premium of 15% to the current market price. Continued strong performances by the flagship Call of Duty franchise and the innovative Skylanders franchise are key to our evaluation, particularly as next generation consoles are launched.
Call Of Duty Continues To Perform
Call of Duty has been Activision’s cash cow in the last few years. Annual editions of the franchise have made it to the top ten games in terms of sales, both in Europe and the U.S. in the last five years. The last two editions, Modern Warfare 2 and Black Ops 2 made it to the top spot in both geographies, according to data from VGChartz.
Releasing a new title each year has helped the company establish the franchise. This is particularly evident when we take a look at the competition. In 2007, Microsoft’s (NASDAQ:MSFT) Halo 3 outsold Activision’s Call of Duty: Modern Warfare, both in the U.S. and Europe. Microsoft then took an extended break while Activision released titles like World at War, Modern Warfare 2, Black Ops and Modern Warfare 3, firmly establishing its franchise as the premier first person shooter. As a result, when Microsoft released Halo 4 in 2012, it failed to put up strong competition to Call of Duty: Black Ops 2. Total Black Ops 2 unit sales were nearly twice as much as total Halo 4 sales.
Activision is more focused on the X-Box than on the Playstation since Black Ops 2 unit sales on the X-Box 360 is nearly twice as much as Playstation 3 sales. Revenues earned from the X-Box 360 are 20% higher than Playstation 3 revenues. With both company’s expected to release the next generation consoles within the next two years, we expect a big boost in sales on both platforms from 2015 onwards. This will be helped by the established Call of Duty franchise.
Innovative Skylanders Franchise
At the end of the September quarter, Activision announced that its Skylanders franchise which was launched in the ending months of 2011, had generated life-to-date revenues of $500 million. In its last earnings report, the company announced that the life-to-date revenues brought in by the franchise had increased to $1 billion. The franchise not only generates income through unit sales but also requires gamers to purchase physical models of the franchise’s characters that have to be placed on the “The Portal of Power”, for the user to access the character. Its toy sales have generated revenues of $100 million.
While the innovative monetization strategy drove a 200% increase in annual PC and others division revenue, the franchise will face stiff competition from Disney’s infinity video game, which is being developed along similar lines and will also incorporate the company’s popular characters from franchises like the Incredibles, Monsters. Inc and Pirates Of The Caribbean.
Despite the increased competition, we believe that Skylanders has already established itself in the domain to drive revenue growth in the next few years. We expect double-digit revenue growth through 2013 and 2014, with a slower growth rate in 2015 and 2016. We expect revenues to decline thereafter, as the product cycle comes to an end.
Next Generation Consoles Will Lead To Higher Spending
While the highly anticipated launch of the X-Box 720 and the Playstation 4 will help revenues, Activision will also have to invest in developing and marketing games designed for the new consoles. Selling, general and administrative expenses have been around 25% of the gross profits for the last three years, but we expect an increase to 30% in the next three to four years as the company launches marketing campaigns to promote games to maintain a market advantage. Following that, we expect SG&A expenses to be around 25% of the gross profits.
Research and development expenses are around 17% of the gross profits, but we expect a near term increase to 25%, as the company develops new games for the next generation consoles.