Activision’s 3Q10: plusses and minuses

the results

After the New York close last Thursday, ATVI reported its September 2010 quarterly earnings results.  On an adjusted basis, earnings per share were $.12 vs. the analysts’ consensus estimate of $.09 and the company’s guidance of $.08.

At the same time, despite the CEO, Bobby Kotick, citing “the continued strength in our business and our confidence in our continued execution,” ATVI revised down its expectations for the December quarter by about 4%, saying it was equal parts unfavorable foreign exchange movements (presumably meaning costs denominated in non-dollar currencies) and increasing competition in its Activision console game business.  On this news, ATVI stock dropped about 3% in Friday trading.

the details

August was a busy month for Blizzard:

–It launched its long-awaited StarCraft II, which sold 1.5 million copies in its first two days and 3 million in its first thirty days.  The fact that ATVI provided no information for the full quarter suggests sales slowed dramatically after that, however.

–It finally got government permission to launch the second expansion of World of Warcraft, named Wrath of the Lich King,in mainland China.  This was enough to push global WoW subscriber numbers decisively above 11 million+, where it had been stuck for some time, to 12 million.

For the yearend holiday season:

–WoW:  Cataclysm, the third WoW expansion, will be released on December 7th.

–Call of Duty:  Black Ops launches on November 9th.  Pre-sales for Black Ops have apparently been stronger than for Modern Warfare 2, which was ATVI’s blockbuster success of 2009.

–ATVI will also have its usual assortment of new Tony Hawk, music (DJ Hero 2) and James Bond games.

ATVI now has close to $3 billion in cash on its balance sheet.  The company generated about $1.2 billion in cash over the past twelve months, half of which it has used since February to buy $600 million worth of stock (or 55 million shares, 4% of the amount outstanding) at an average cost of $10.90 or so.

stepping back

ATVI has been a disappointing stock this year and a severe laggard since the market bottom in March 2009.  What can we expect from now on?

Here are the company’s year-to-date revenues and earnings by operating segment:

Activision Publishing:   revenues $983 million, operating loss $88 million

Blizzard:  revenues $1086 million, operating income $559 million.

This compares with an operating loss from the Activision segment of $49 million in the first nine months of 2009 and an operating profit of $393 million from Blizzard over the same period.

You might (correctly) say that this is not an entirely fair snapshot of ATVI’s results.  The Activision segment is highly seasonally skewed toward the December quarter.  Activision games also have their biggest sales in the US and European markets, both of which have been hardest hit by the financial crisis.  However, the figures also points to two realities:  the sudden maturation/contraction of the traditional video game console market, and (I think) that the cost structures of the game software companies are still geared for expansion.  In other words, there is still considerable cost-cutting to do.

When Activision and Blizzard merged a few years ago, I imagined the resulting company as the marriage of two equals:  Vivendi, the former owner of Blizzard, got better management for its games unit + a share in a viable shrink-wrapped software business; pre-merger Activision got access to a very talented group of developers + a share of a growing online subscription business in Massively Multiplayer Online Role Playing Games.

Today, the picture looks much different.  Yes, Activision management doubtless helped Blizzard expand–and finally publish Star Craft II. But the key difference is due to the collapse of the traditional video game business.  That’s what the numbers above show.

where to from here?

It seems to me that ATVI is trying to reposition itself, both in reality and in the minds of investors, as an incubator/administrative hub for MMORPGs.  It already has the immensely successful World of Warcraft. It has just launched Star Craft II, which it hopes will be a second.  And it is positioning the Call of Duty, franchise, and Black Ops in particular, to be much more like a MMORPG than a traditional console game.

In addition, ATVI says Blizzard is cooking up an as yet unidentified new MMORPG.  And the company has hired the team that created Halo for MSFT to produce a fifth.

The growth investor “dream,” then, is that Star Craft emulates Warcraft in becoming a source of $300-$400 million in annual income over the next few years.  And that it is followed by at least one other success–time frame unknown.  It would also be helpful if some combination of reduced costs/higher revenue have the traditional Activision games turning a profit again.

On the other hand, eps will be around $.75 for 2010.  What about 2011?  The launch of Star Craft II looks like it generated operating income of about $160 million in the September quarter.  Let’s assume ATVI produces an expansion pack next year that, to pluck a figure out of the air, generates half of the operating profit the game itself did, or about $80 million.  Let’s also say that Blizzard overall, ex the Star Craft expansion pack, grows by $50 million next year.  And let’s assume that the shrink-wrapped software business chips in an extra $30 million in 2011.  Maybe cost-cutting helps, maybe a better economy–and ATVI has always had a knack for identifying new trends.  That all ads up to flat earnings.

In any event, matching 2010’s earnings in 2011 is possible, if a tad on the optimistic side.

On the one hand, I find it hard to be confident that eps will be any higher than that.  On the other, the company has no debt and is immensely cash generative.  The prospective multiple is 12x-13x, ex the cash, which I think is reasonable.  And ATVI is waiting in the wings to buy more stock just a few percent below today’s price.

My bottom line:  For now, I think the stock goes sideways.  I’m not in a hurry to sell and I’d be tempted to trade it if it spikes up.  I’d also use it as a source of cash if another, really good, idea comes along.

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