the report

ATVI reported June quarter earnings after the close of trading in New York last Thursday.  Earnings per share on a GAAP basis were $.17 vs. $.15 in the second quarter of 2009.  On a non-GAAP basis, they were $.06 vs. $.08 in the second quarter of 2009.

The company forecast third quarter results that were slightly below sell-side analysts’ estimates, and it reaffirmed–but did not raise–full-year guidance.

Wall Street didn’t like any of this.  The stock fell 6.5%, to $10.99, in Friday trading.

Why not?

GAAP vs. non-GAAP

ATVI reports revenues and earnings two ways.  One is the way that Generally Accepted Accounting Principles require.  The second is a non-GAAP method that the company feels gives pertinent information that GAAP doesn’t.  Lots of companies do this.  In ATVI’s case, the issue is how to report the purchase of game software that has online content.  GAAP requires the company to estimate how long the customer will use that software and to spread the revenue, and associated costs, over the estimated period of time.  ATVI’s non-GAAP reporting shows the revenue and costs recognized all at once.

2Q2010 earnings are much higher on a GAAP basis than non-GAAP because last year was a big one for online content.  The positive glow is still being reflected in GAAP results this year.  Non-GAAP shows only the cash coming in today.

The level of earnings isn’t really what the market reacted to on Friday, though.  The composition of earnings was the issue.

Blizzard is doing fine…

Worlds of Warcraft continues to plug along, with about 11.5 million subscribers who paid $299 million to ATVI to play the game during the second quarter.  That’s up 3% from the $290 million they kicked in during the comparable period of 2009.

More important, ATVI made operating income of $155 million from WoW this quarter, up 16% from the $134 million it earned in June of last year.

Starcraft II is finally out

Starcraft is the second of Blizzard’s signature titles.  The long- awaited sequel to the original Starcraft title (1998) came out late last month.  The only information ATVI has released so far on revenues is that the game has sold 1.5 million copies in its first two days.  This would be the biggest launch in pc game history.

Just as encouraging, Blizzard says that while Starcraft online play is steadily building gamers are playing Warcraft online just as heavily as they were before the Starcraft launch.

The hope is, of course, that Blizzard can turn Starcraft, which has fanatic followers all over the world, into something akin to another Warcraft, generating large amounts of recurring revenue.

…not so for Activision

The Activision side of ATVI generated revenues of $333 million during the quarter, down 26% year on year.  It made an operating loss of $53 million during the three months vs. operating income of $21 million in the June quarter of 2009.

Yes, the overall market for traditional video games is weaker and this is the offseason (Activision makes most of its money around the year-end holidays).  But the company also had a couple of clunkers among its second quarter launches.

To some degree, these negatives were offset by continuing strong performance from Call of Duty:  Modern Warfare 2. Online sales of add-on map packs are very strong.  And the game remains the number one of its type in many markets.

The next iteration of the franchise, Call of Duty:  Black Ops, is also outdoing MW2 in early pre-sales.  And the company has new versions of its staple Guitar Hero and Tony Hawk games, as well as DJ Hero ready to meet seasonal demand.

what to do with the stock?

ATVI shares have been severe market laggards from the lows of March 2009.  So the first observation one would make is that holding the stock so far, as I have done, has been a big error.

ATVI’s problems have been of three types:

–although Blizzard has performed extremely well, the overall video game market has been weak.

–the collapse of the music genre blindsided Activision, creating a large writedown last year

–worries about management stability have arisen, given the departure of key executives from the Call of Duty franchise and recent reports of CEO Bobby Kotick-related legal action.

On the other hand, the company owns Warcraft, Starcraft, Call of Duty, and has new potentially significant (but we don’t know what they are yet) products coming from both Blizzard and Bungie (the studio that made Halo).

The company is saying it will earn $.72 a share in 2010, meaning the stock is trading at under 15x times earnings.  And ATVI has bought 31 million shares of its stock through the end of June at an average of just under $11 each.  So–rightly or wrongly–it sees value at these levels.

So to me the stock still looks cheap.

Personally, I’m continuing to hold, but the leash is getting shorter.  The risk, of course, as it is in any case like this, is that I’m letting ego get in the way of common sense–holding on because I somehow need to be right, rather than to make money.