Activision Blizzard (NASDAQ:ATVI) has been helped by a shift to digital distribution and propriety franchises over the last five years. The company’s revenues have grown at a compound annual growth rate (CAGR) of close to 10% since 2008 while gross profits have grown at a rate of nearly 16% and cash profits at 18%. Margin expansion, helped by increased digital revenues, is one of the main reasons for the impressive top line growth. Digital revenues accounted for 27% of revenues in 2009 with gross margins at 58%. In 2012, the contribution from digital revenues increased to 32% with a subsequent increase in gross margins to 74%. In the June quarter, digital revenues accounted for 37% of Activision’s GAAP net revenues and 63% of its Non-GAAP revenues.
We expect gross margins to stay at around 75% through the decade. Our price estimate for Activision Blizzard is $17, in line with the current market price.
Digital Revenues to Help Margins
Activision’s digital revenues come from four streams: extra downloadable content (DLC), full game downloads, in game advertising and subscriptions. The first three are directly linked to sales of Activision’s games. With three established franchises in Skylanders, Call of Duty and Diablo and a strong pipeline, we believe Activision is well-positioned for the console transition later this year. This will boost its digital revenues as most games contain DLC. For example, the company recently launched DLC in the form of Apocalypse for Call of Duty: Black Ops II.  We believe that Activision can maintain margins around the current level as it shifts to the low cost digital domain.
However, the company is losing subscribers for its massively multiplayer online role-playing game (MMORPG), World of Warcraft (WoW), which is cutting into its subscription revenues. The number of subscribers has dropped from a peak of nearly 12 million in 2010 to just 7.7 million at the end of June. Several free-to-play online MMORPGs like Aion: Ascension, Vindictus and Allods Online have taken the impetus away from WoW. We remain conservative in our forecast for WoW, and expect the company to retain at least 5 million subscribers by the end of the decade.
Lower Intellectual Property License Costs
Intellectual property (IP) license costs represent license fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, music, other intellectual property or proprietary rights in the development of Activision Blizzard’s products.
Activision’s IP license costs have come down dramatically, from $306 million (18% of gross profits) in 2008 to $66 million (2% of gross profits). One of the main reasons behind this is the end of the Guitar Hero franchise, which incurred significant IP costs as well as collaboration with Vivendi. The company is now focusing on propriety franchises like Call of Duty and Skylanders.
We currently expect a slight increase in IP costs to 3% of gross profits as the company might have to renew its agreements with various parties as the new consoles roll in. However, our model is quite sensitive to this figure. There is downside of 10% to our price estimate for Activision’s stock should the IP costs go back to 10% of gross profits. On the other hand, there is also 10% upside to our estimate should Activision continue to focus on propriety franchises, with IP costs dropping to 1% of gross profits. You can modify the interactive chart below to gauge the effect that a change in forecast would have on our price estimate for Activision.Notes: