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Activision Blizzard (ATVI), was, without question, the standout performer in the video game sector over the past holiday season. The company has some of the best titles in the business under its belt, a key component for franchising success in this highly competitive, but booming segment of the entertainment industry. Indeed, despite the sluggish economy, the gaming sector has defied the odds, with record sales being notched across the board. Activision Blizzard’s Call of Duty: Black Ops game tallied over $1 billion in global sales during the 2010 holiday period.  The escape from real-life problems, at a reasonable price point, has never been more in vogue.

One of the major reasons we like this stock is because the company has three very popular franchises; Guitar Hero, Call of Duty, and World of Warcraft. Gamers are renowned as being fiercely loyal to a franchise they deem worthy. This is a powerful positive in an industry that is highly competitive and hit-driven. It is also susceptible to rapid technological change, but Activision Blizzard appears to have an edge in that sphere, thanks to the development of cutting-edge technological expertise (see below). Investors should note, however, that game developers are dependent on the success of new video game platforms, which generally tend to be launched every five years or so.

Piggybacking on the November 15th launch of the latest in the hugely popular interactive vehicle, Call of Duty: Black Ops, we see strong sales of high-margined Map Packs going into 2011. We are looking for three to five Call of Duty Map Pack offerings this year, compared to two in 2010. (Map Packs are digital terrains that can be linked to the original game and allow a gamer to battle other players on that different terrain.) This should set the stage for very healthy Call of Duty digital sales in 2011, besides the substantial potential for subscription-based revenue. Furthermore, World of Warcraft’s latest addition: Cataclysm looks to be attracting a great deal of new users to the franchise, as well as retaining and pulling back old ones. Moreover, Activision’s prospective launch of Diablo III could provide earnings upside.

The success of its products has enabled the company to procure a strong financial base. The rewards for success in this industry are enviable, thanks to the high margins that can be generated from interactive gaming products and services. With a debt-free balance sheet, $2.8 billion of cash on the books (as of 9/30/10), and strong cash flow, Activision can afford to pay out a decent dividend to keep shareholders mollified in times of stock price stagnation (as experienced over the last couple of years). We believe 2011 will be a breakout year, however, with share net rising to at least $0.60.

Although Activision has taken over three years to unveil its Internet strategy, it now states that it is transitioning part of its business to cloud computing, a move that is expected to have implications for the entire gaming industry. This technology will permit ATVI to become much less dependent upon Nintendo’s Wii, Microsoft’s (MSFT - Free Microsoft Stock Report) Xbox, and Sony’s (SNE) Playstation. It will effectively enhance gamer’s experience via Internet-hosted applications and tools, whereby a user could download an app to his or her smartphone or laptop or both, and schedule a game with others through Facebook. He or she could also boast about real-time statistics, or even air a video-clip of a winning move on Youtube. Casual players would be able to catch clips of actual gamers in action. This will increase the number of hours played, and enhance the time spent verbally obsessing about players, statistics, and achievements in a talk-based forum. All this should ultimately increase subscription rates. Activision is also touting Internet-connected TV’s, so that it can cultivate a more direct relationship with its audience. This would elicit real-time user feedback on how to make the games more realistic, and provide better customer service. Ultimately, ATVI says that it wants to turn itself into a media company. Online gaming gives Activision a powerful distribution platform for entertainment. There appears to be a strong desire to see Call of Duty turned into a movie.

One drawback is retaining talented software engineers, who command very high salaries, and will move for better pay or to start their own companies at the drop of a hat. Although this keeps the cost of gaming software high, with more than 77 million online gamers increasing at a 4% average annual rate, we foresee many more IT engineers going into this business, keeping salaries under control.

 

At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.