Activision Blizzard (NASDAQ:ATVI) beat market expectations and its own guidance for the third quarter of 2013, as it reported non-GAAP revenues of $657 million, more than 61% of which came from digital streams. The company’s prior guidance was for around $585 million while the consensus estimate was close to $590 million.  Activision did not launch any major new titles through the quarter as opposed to the third quarter of 2012, when it successfully launched the World of Warcraft: Mists of Pandaria expansion pack. As a result, GAAP revenues were down 18% as product sales fell 38%, but subscription, licensing and other revenues gained 18% and accounted for more than half of the company’s GAAP revenues for the quarter.
Results were helped by strong performances from two of the company’s flagship franchises: Call of Duty and Skylanders, which were both in the list of year-to-date top five best selling games in North America and Europe. Call of Duty Black Ops II contributed significantly to digital sales, with online playing time by all users across the globe exceeding 4 billion hours. Including digital sales, the game has now generated more revenues in a single year than any other console game has in the past.  Skylanders has generated over $1.5 billion in life-to-date revenue since its launch in October 2011 and is currently the highest selling video game targeting kids this year. However, the game faces tough completion from Disney’s Infinity, which follows a similar gaming model and has performed well over the last two months.
Activision completed the buyout of 429 million shares for $13.60 per share from Vivendi on October 11, leaving the company with approximately $3.4 billion in cash and a total debt of $4.75 billion. We have updated our model to account for the transaction. Our price estimate for Activision Blizzard is now $18, implying a premium of 10% to the current market price. However, the estimate is dependent on the success of the next generation Sony Playstation 4 and Microsoft (NASDAQ:MSFT) Xbox One consoles, which are expected to launch later this month.
Getting Ready For The Console Transition
While Activision’s results so far this year have been good, its actual test is still to come. With the highly anticipated launch of the eighth generation consoles just around the corner, the company has launched new editions of its popular franchises, Call of Duty: Ghosts and Skylanders SWAP Force. Activision is hoping that the performance of the games on the current generation consoles will carry over into the next generation. To allow for a smooth transition, the company will allow players who purchase Call of Duty: Ghosts for their current console to download the next-generation version within the same console family for just $10. Activision has already sold more than $1 billion of the new title to retail stores across the globe and had 15,000 midnight openings for the launch on October 5. The game will also include à la carte DLC packs, micro DLC and Season Passes allowing the company to generate more digital revenues.
Video game sales surged the last time the console product cycle was refreshed. The Xbox 360 was released in November 2005 and the Playstation 3 was launched in the following year leading to a 19% increase in sales. However, the true impact of the new product cycle was felt only after 2007, the first full year that Xbox 360 and Playstation 3 were in the market, as software sales jumped 43% in 2007. ((When Is It Time To Take Profits On GameStop?, Seeking Alpha))
According to our analysis, Activision had a market share of nearly 20% in the U.S. video games market last year, with Call of Duty: Black Ops II accounting for 14% of the Xbox games sold and 18% of the Playstation 3 games.  The company is in a strong position to capitalize on the sales boost brought on by the new consoles. However, we might not see such a significant surge in sales this time around, particularly given the advent of casual gaming on mobiles and tablets. We currently expect a double digit growth rate for Activision’s sales from the Microsoft and Sony console platforms from 2014 onwards. However, there is a 20% downside to our price estimate, should the growth rate be below 5% through the remainder of the decade.
Will Skylanders Go The Way Of World of Warcraft?
Skylanders is one of Activision’s biggest success stories. The game requires gamers to purchase physical models of the franchise’s characters which have to be placed on the “The Portal of Power” to be accessed on screen, allowing Acitivison to gain from game sales as well as toy sales. However, Disney (NYSE:DIS) has adopted a similar model for its Disney Infinity game which also utilizes the company’s strong intellectual property (IP) portfolio to boost popularity. Disney Infinity was named the third highest selling game in August by research group NPD and ranked seventh in the charts for September.  Skylanders will have to ward off tough competition from Disney to maintain its success rate in the coming years.
Activision has already seen one of its seemingly infallible franchises, World of Warcraft, slide down the charts. The game was once the world’s biggest massively multiplayer online role-playing game (MMORPG) franchise reaching a peak of nearly 12 million subscribers in 2010 and generating close to $1 billion in annual revenues. However, strong competition from free-to-play online MMORPGs like Aion: Ascension, Vindictus and Allods Online have cut into WoW’s market. The number of subscribers fell to 8.3 million at the end of the March quarter and further 7.7 million by the end of June. The company was able to arrest the slide somewhat in third quarter, ending September with 7.6 million subscribers. Although it is still the most popular subscription-based MMORPG, World of Warcraft is no longer the powerhouse it once was. We expect a steady decline in the number of WoW subscribers in the next few years. Activision will have to work hard to keep Skylanders from falling into the same competitive trap that WoW slid into.Notes: