With the highly anticipated launch of the next generation Microsoft (NASDAQ:MSFT) and Sony consoles just around the corner, Activision Blizzard (NASDAQ:ATVI) is gearing up for the gaming revolution by focusing on its core assets. The video game publisher launched 2014 editions of its flagship franchises, Call of Duty: Ghosts and Skylanders SWAP Force, earlier this month. More recently, the company announced Warlords of Draenor, the next expansion pack for World of Warcraft during BlizzCon 2013. 
According to our analysis, Activision has a market share of 17% in the video games market worldwide and will be looking to leverage its strong position to gain from sales boost that the new consoles are expected to bring.  Our price estimate for Activision Blizzard is $18, in line with the current market price. However, this estimate is subject to a strong performance by the consoles in the next few years.
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Is Warlords A Long Term Solution?
World of Warcraft is the world’s biggest massively multiplayer online role-playing game (MMORPG) and generates nearly $1 billion in annual revenues for Activision. But the popularity of the game has waned since it reached a peak of nearly 12 million subscribers in 2010. Strong competition from free-to-play online MMORPGs like Aion: Ascension, Vindictus and Allods Online cut the number of subscribers down to just 7.6 million by the end of the last quarter after the company reported 8.3 million subscribers in March.
Activision might be resorting to expansion packs to arrest the slide and maintain gamer interest. The company has already announced that it is working on the successor to Warlords of Draenor, before it even launched. The last pack, Mists of Pandaria, sold 2.7 million copies on the first day of its release last year and led to a short term spike in subscribers as the figure jumped from 9.1 million in August to 10 million at the end of September. We might see a similar short-term increase after the launch of Warlords of Draenor but prospects for the game are uncertain.
Do Not Jump The Gun
The expectations attached with the new consoles have sent gaming stocks soaring this year, despite declining sales across the industry. Activision has gained 63% since the turn of the year while its main competitor, Electronic Arts (NASDAQ:EA), has seen its stock climb 82% during the same time period. The consoles will be launched during the holiday season, which is usually the strongest quarter for the industry, accounting for nearly 40% of video game sales.  However, history tells us that the true impact of the product cycle can only be gauged after the consoles have been allowed to settle in. Although there was a small spike in sales in 2005 and 2006 when the Xbox 360 and Playstation 3 consoles were released, it wasn’t until 2007 that gamers and the market adapted to the new consoles and video game software sales surged by nearly 50%. 
Going by the historical trend, we expect a moderate reception for the Xbox One and the Playstation 4, despite the euphoria surrounding the launch. Going forward however, we believe that gamers will still turn to consoles for gaming at home, even though the gaming landscape has changed significantly with the advent of casual gaming of smartphones and tablets. We expect a double digit long-term growth rate for sales on both consoles, but there would be a 20% downside to our price estimate if the growth rate were below 5% through the remainder of the decade.
The Main Games Will Deliver
Activision relies on four main franchises: Call of Duty, Diablo, Skylanders and World of Warcraft. These four video games accounted more than 8o% of the company’s $4.8 billion revenues in 2012. Call of Duty and Skylanders have been among the top five best selling games in North America and Europe so far this year.  Call of Duty: Black Ops II accounted for 14% of the Xbox games sold and 18% of the Playstation 3 games sold in the U.S. last year, establishing it as the premier first person shooter.  We believe that Call of Duty will be pivotal for Activision as it looks to latch on to the next generation of gaming. 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, making the transition to the new consoles smooth.
Skylanders is the highest-selling video game targeting kids this year but it faces tough competition from Disney’s Infinity, which follows a similar gaming model requiring gamers to purchase physical toy characters that can be accessed in the game. According to research group NPD, Disney Infinity was the third highest selling game in August and the seventh highest selling game in September.  The game leverages Disney’s suite of intellectual properties like The Incredibles, Pirates of the Caribbean and Toy Story.  The popularity of its characters, particularly among the target demographic, gives it an edge over Skylanders. We will keep a close eye on Skylanders SWAP Force to see if Activision can regain some ground in this domain.Notes:
- World of Warcraft: Warlords of Draenor Announced [↩]
- VGChartz [↩] [↩]
- Income Statement, GameStop 10K [↩]
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- Activision Blizzard Management Discusses Q3 2013 Results – Earnings Call Transcript [↩]
- U.S. Video-Game Sales Rise in September on ‘Grand Theft’ [↩]
- Disney Infinity Characters [↩]