Activision Gains After Strong Q4 Results But Challenges Lie Ahead, Stock Worth $22

Activision Blizzard’s (NASDAQ:ATVI) stock gained 8% in after hours trading as the company  once again beat market expectations, reporting  non-GAAP EPS of $0.79, higher than the consensus estimate of $0.74. ^[1] Activision’s performance was helped by strong sell-through of its flagship franchise, Call of Duty, and continued progress in the high-margin digital domain. The latest edition of the Call of Duty franchise, Call of Duty: Ghosts, was the best selling game for the newly released Playstation and Xbox One consoles in both North America and Europe through the December quarter. The eighth generation consoles have sold over 7 million units, combined, so far. Software sales have yet to pick up; research group NPD reported a 17% decrease in software sales for December while hardware sales climbed 28% (NPD’s figures do not include digital sales). We believe that the strong demand for the consoles portends a near-term software revival. Activision has a strong suite of gaming titles and is well placed to benefit from this trend. The company has issued a strong guidance for 2014, with an estimated non-GAAP EPS of $1.26 on revenues of $4.6 billion.

Following the earnings, we have revised our price estimate for Activision Blizzard to $22, which is about 10% ahead of the current market price.  We detail the changes below.

See our complete analysis of Activision’s stock here

New Consoles To Support Digital Growth

Video game publishers are no longer just reliant on physical sales of video games, but are also earning from digital support streams like extra downloadable content (DLC), full game downloads, in-game advertising and subscriptions. Digital sales accounted for 25% of Activision’s revenues through the fourth quarter and 34% for the full year.  Activision’s peers, Electronic Arts (NASDAQ:EA), earned a third of its fourth quarter revenues from digital streams. The launch of the next-generation consoles, which have faster processing, better connectivity and graphics support, has opened up new avenues for these companies to further expand in the digital domain.

Activision has already latched on to the digital trend; the Call of Duty franchise accounted for four of the top ten most played games on Xbox Live, Microsoft’s gaming network for the Xbox consoles. Gamers played Call of Duty: Black Ops II for more than 4 billion hours in 2013. The company is planning to launch more DLC and micro DLC to support Call of Duty: Ghosts, following the successful January release of the Onslaught DLC pack for Xbox. Digital streams have higher margins than physical streams. For 2013, the company reported an EBITDA margin of 33%. We expect a short term increase in product development and marketing expenses, but in the long term, digital growth will allow Activision to expand margins.

The Challenges

While digital prospects are good, they are dependent on the continued popularity of Activision’s titles. Annual editions of the Call of Duty franchise have made the top ten best selling games list across the globe for the last five years and the game is now the most popular first-person shooter (FPS). However, the game faces stiff competition from EA’s Battlefield 4. Although gamers initially experienced some glitches while playing the game, demand for the title has been strong; Battlefield 4 was listed by NPD group as the second highest selling game for December. This competition could be crucial in the console transition period as gamers adapt to the new technology and will be less likely to maintain loyalty to a franchise. FPS is a popular genre; games such as Call of Duty, Battlefield, Far Cry 3 and Halo 4 accounted for close to 20% of game sales worldwide in 2013. ^[2] The Call of Duty franchise accounted for nearly 60% of shooting sales while Battlefield had a market share of 20%, but this trend could change easily in the coming years.

Activision is already facing strong competition for its innovative cash cow Skylanders. 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. The game has generated more than $2 billion in revenues since its launch in October 2011, with 175 million toy units sold. It was also the number one kids’ game for the third year running in both North America and Europe. However, Disney (NYSE:DIS) has adopted a similar model for its Disney Infinity game which also leverages the company’s strong intellectual property (IP) portfolio, including The Incredibles, Pirates of the Caribbean and Toy Story, to boost popularity. NPD Group has listed Disney Infinity as the tenth highest selling game of 2013, whereas Skylanders SWAP Force held the same position for the month of December.

Also, competition from free-to-play titles has already had a major impact on Activision’s massively multiplayer online role-playing game (MMORPG), World of Warcraft. Although it is still the most popular in its domain, the game’s subscribers have gone down from peak of nearly 12 million in 2010 to 7.8 million. The figure is slightly up from the 7.6 million reported at the end of the September quarter, but down significantly from 8.3 million at the end of March. Free-to-play online MMORPGs like Aion: Ascension, Vindictus and Allods Online have cut into WoW’s market share, and the company recognizes the importance of this model. Activision is planning to launch three free-to-play franchises – Hearthstone, Heroes of Warcraft and Heroes of the Storm – to maintain interest in its paid titles. We will closely monitor this trend going forward.

Model Changes, New Price Estimate of $22

Activision reported a notable decline in expenditures for intellectual property licenses and product development. These costs have been coming down in the last few years as the company has been shifting its product mix to increase efficiency from individual titles. After adjusting for stock-based compensation, as well as amortization and write-offs of capitalized software development costs and intellectual property licenses, intellectual property costs have come down from 18% of gross profits in 2008 to 1.5%, while product development costs have dropped from 33% of gross profits in 2008 to 17%. We expect a slight increase in these costs in the next few years as Activision tries to retain customer loyalty through the console transition period. However, in the long term, the company’s strategy to earn higher revenue per title through secondary digital streams will lead to an overall decline in these expenses. We have adjusted our forecast to account for this trend.

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1. Activision Blizzard’s Management Discusses Q4 2013 Results – Earnings Call Transcript [↩]
2. VGChartz 2013 [↩]