Electronic Arts And Activision Earnings Preview: Digital Streams Should Lead To Margin Expansion

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ATVI: Activision Blizzard logo
ATVI
Activision Blizzard

Gaming giants Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) will report earnings for the March quarter on Tuesday, May 6. [1] [2] The two companies together accounted for nearly 30% of global video game software sales last year and their results will help us gauge the state of the industry after the first full quarter in the new console cycle. [3] The latest report from research group NPD indicates that the software market is lagging behind the hardware market; software sales for March were down 28% year-on-year, while hardware sales surged 78%, driven by the recently launched Xbox One and Playstation 4. [4] However, the report only takes into account physical purchases at retail outlets and does not take into account sales via the digital medium, which has been gaining popularity.

Our $27 price estimate for Electronic Arts’ stock is in line with the current market price.

See our complete analysis of Activision’s stock here

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The Digital Revolution

The gaming landscape has changed over the last few years; the advent of smartphones and tablets has increased the ease of access to games, leading to the rise of casual gaming. Video game companies have had to change their business model to adapt to the evolving market and are no longer just reliant on physical sales of video games, but are also earning from digital support streams such as 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, while EA earned a third of its December quarter revenues from the digital medium.

Extra-downloadable content (DLC) was the biggest digital contributor for Electronic Arts last year, accounting for over 40% of December quarter revenues. Revenues from the stream were up 15% over the prior year, driven by FIFA Ultimate Team, FIFA Online 3 and Star Wars: The Old Republic. Full game downloads is another stream that is gaining popularity; 23% of EA’s December quarter product revenues came from full game downloads, gaining 157% over the prior year with strong results from Battlefield 4. The company also reported a 26% increase in mobile game sales, with over 71 million game downloads on Apple and Android platforms.

Costs associated with product revenues include production costs, warehousing and distribution costs, personnel costs, expenses for defective products and royalties for manufacturing and software developers. For service streams, the primary expenditures are on data center, server and bandwidth costs. Therefore, service revenues have higher gross margins of nearly 80%, whereas product streams have a gross margin of just 50%. Growth in service revenues will have a high impact on the companies’ bottom lines.

The Battle For The FPS Domain

First person shooting games (FPS) are a major genre, accounting for about 20% of the video game market in 2013 [5] (note: FPS games considered in our analysis are Call of Duty: Ghosts, Battlefield 4, Call of Duty: Black Ops II, Halo 4, BioShock Infinite, Far Cry 3, Dead Space 3 and Gears of War: Judgment). Activision’s Call of Duty franchise has dominated this market for the last six years, with annual editions making it to the list of top ten best selling games across the world, warding off competition from EA’s Battlefield and Microsoft’s Halo. The Call of Duty franchise accounted for nearly 60% of shooting sales last year.

However, Electronic Arts is making a fresh foray in this genre with its futuristic first-person multiplayer shooter, Titanfall. The game was developed by Respawn Entertainment, with the same developers who worked on establishing Activision’s Call of Duty franchise as the premier first person shooter. It is exclusively available for PC and Xbox consoles and is being promoted by Microsoft, which launched a bundled package, offering a free download of Titanfall with its Xbox One console. ((Buy Xbox One Titanfall Bundle. Get Titanfall). According to NPD’s report, Titanfall was the highest selling game in the U.S. in March, with Call Of Duty: Ghosts in fourth position. We will keep a close eye on this battle as it develops.

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Notes:
  1. Activision Blizzard First Quarter Calendar 2014 Results Conference Call, Investor Relations []
  2. Electronic Arts Q4 2014 Earnings Conference Call, Investor Relations []
  3. VGChartz, 2013 Global Yearly Chart []
  4. March NPD: PS4 leads hardware sales, Titanfall rules software []
  5. VGChartz []