Activision–strong 2009, better 2010 in store

The earnings conference call

I listened to a replay of ATVI’s fourth-quarter earnings conference call the other day.  It was an odd event, in my opinion, conveying lots of data but not that much information.  This may in part have been due to the fact that the analysts participating in the call ranged from the very knowledgeable to people who gave no evidence they knew anything about either ATVI or the video game industry.  A fact of life on today’s Wall Street, or an indicator of the declining importance of the video game industry to investors?

High- and low-lights:

1.  Call of Duty: Modern Warfare II was a smash hit, selling an astounding 12 million copies during the quarter.  That probably translated into $250 million in operating profit.

2.  Starcraft II enters beta-testing this month in the US, Europe and parts of the Pacific.  Starcraft and Warcraft are the two premier properties of Blizzard, which merged with the original Activision a couple of years ago.  Blizzard has built the Warcraft franchise into by far the largest Massively Multiplayer Online Role Playing Game in the world, with 11.5 million subscribers.  Warcraft generated $1.2 billion in revenue for ATVI in 2009, with operating income of about $550 million.  That’s the lion’s share of what ATVI earned.

Starcraft II, which has already been anticipated for several years, marks the start of ATVI’s attempt to duplicate Blizzard’s Warcraft feat.  The huge success of Modern Warfare II prompted ATVI to shift the beta-test from late-2009 into 2010, so it wouldn’t interfere with sales of MWII.  The Starcraft II game is very important to the investment case for ATVI.  It will probably be launching in the second half of 2010.

3.  The company announced a new $1 billion stock buyback (after finishing a $1.25 billion buyback in 2009), and a $.15 per share annual dividend.

I’m normally not a big fan of stock buybacks.  Although managements talk about them as being a “return” to shareholders, they typically only offset the dilution caused by issuance of stock options to high-level executives.  In this case, however, the buyback is big, the company is very cash-generative and the stock is (I think) cheap (remember, though, that I own it so I’m disposed to think so).  This buyback makes more sense.

As to the dividend, I think it’s partly a sign the company thinks it’s maturing, partly a recognition of changing investor preferences in the US–meaning aging Baby Boomers are looking for dividend-paying stocks.

4.  Tony Hawk‘s new game was a no-show.  The game required an expensive skateboard peripheral, not exactly a plus during recession.  In addition, fans apparently thought the gameplay wasn’t very interesting, either.  In a perverse way, this is good news.  It’s not that long ago that TH represented the bulk of ATVI’s earnings, so a mediocre minus TH game would have been disastrous.  Shows how far ATVI has come, and/or how key the merger with Blizzard has been.

5.  ATVI had a $409 million writeoff of intangibles during the quarter, throwing the company into a GAAP loss for the December quarter, despite the strength of Worlds of Warcraft and of MW II.

Strangely, ATVI didn’t mention the writedown during the conference call, or that it had replaced the head of its music games division, where the writedown seems to have been centered.  No analyst asked about it, either.  ATVI’s printed materials only referred to a “rightsizing” of the music business.  ATVI did say it was going to emphasize music software, not hardware, in 2010, but I wanted more explanation.

Why am I worked up about the writedown?  ATVI uses a form of project accounting to report its video game results.  It estimates the amount of revenue a game will produce over its lifetime.  It then uses this estimate to apportion costs as revenue comes in.  If, for example, it costs 50 to develop a game that the company estimates will bring in 100, the firm will assign 1 in expense against every 2 of sales it gets.

In this case, ATVI is basically saying it has just realized that it has spent $409 million more on developing certain games than it now expects it will ever get back in sales of them.

Whoops, I just lost $400+ million.  –I guess it can happen.  But you’d think shareholders deserve an explanation, or at least a comment like, “We zigged when we should have zagged,” or “Yes, it’s a big number, and it is three months’ earnings–but it’s only three months’ earnings.” ATVI, you’re better than this.  A definite lowlight.

6.  2009 eps of $.69 (non-GAAP and ex-writeoffs) and $.70 projected for 2010.  The non-GAAP figures are probably the best basis for understanding the going-forward earning power of ATVI.

There’s no percentage for ATVI in making anything but a very conservative estimate, since the game software industry is in such turmoil.  My guess is that $.70 is easily achievable, just by avoiding this year the operating losses of 2009 on Tony Hawk + Guitar Hero. Upside could come from Worlds of Warcraft, where new content is being introduced for the first time in over a year, and a good launch from Starcraft II.

7.  ATVI is down on casual/mobile/social networking games.  They’re faddish and easy/cheap to make.  Therefore, there are no real barriers to entry and profits will be hard to come by.

My thoughts:

ATVI is the last man standing in a rapidly changing video game industry.  It has the best content and, thanks to Blizzard, by far the strongest orientation toward online.   It may also be able to pick up interesting properties from distressed competitors at reasonable prices.

Investor focus should be on #1 and #2 above, I think.  At something like 14x 2010 earnings per share, strong cash generation and no debt, the stock looks cheap to me.

As you may gather, I wasn’t overwhelmed by the quarter-end results announcement.  But Wall Street clearly expected a lot worse than what ATVI said.  The stock went up by almost 10% the following trading day.  Who am I to argue.

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