Activision’s 4Q10: a reprise of 4Q09

the results

Activision reported fourth quarter and full year 2010 results after the market closed in New York on Wednesday. On a non-GAAP (Generally Accepted Accounting Principles) basis, the firm earned $.53 a share–in line with Wall Street analysts’ expectations–vs. $51 in the year ago quarter.  For the full year, GAAP earnings per share were $.34 vs $.09 in 2009.  On a non-GAAP basis, eps were $.79 vs. $.69.

On a GAAP  basis, however, ATVI reported an operating loss in the vicinity of $400 million for the closing three months of the year–the second time in a row they’ve accomplished this “feat.”

The company issued initial (non-GAAP) guidance for 2011 of $.70 per share in earnings, or about an 11% year on year decline (more on this below), which was lower than analysts’ preliminary guesses of a flat earnings year.  (Some are also saying that ATVI is guiding to earnings of $.07 a share for the March quarter, which would be below analysts’ estimates of $.10.  I don’t think that’s right, though, since the $.07 includes $.02-$.-3 of restructuring charges.  In other words, ATVI guidance is for earnings of $.10 per share for March.)

ATVI also announced that its board of directors had authorized a 10% increase in the dividend to $.165 per share and a $1.5 billion share buyback.

The shares were down about 7% in the aftermarket.   As I’m writing this, in the early afternoon of February 10th, ATVI shares are down about 10% on very heavy volume.

the details

1.  Bobby Kotick has developed feet of clay.  The CEO of ATVI has had a well-deserved reputation for quickly focusing his firm on new trends and deftly cutting his exposure to the old without taking big losses.  No more.  For the second year in a row, ATVI is taking a gigantic writeoff related to the Activision side of the business.

Elements of the writeoff are scattered around in different accounting categories, however, including some costs that will only be recognized in 2011, so I find it difficult to figure out exactly how big the current damage is.  $400 million + is the best I can do.  Unlike last year, when management blithely ignored the loss completely in the conference call, there were at least a few passing references to it Wednesday night.

What’s happening?  ATVI’s financials suggest that, ex Call of Duty, the Activision side of the house continues to be deeply in loss. That got the former Activision-side top brass fired a year or so ago.   After posting a large deficit ex CoD again in 2010, new management has decided to:

–stop making new versions of Guitar Hero and concentrate on digital downloads to the title’s waning fan base,

–shut down True Crime,

–not launch a new Tony Hawk game this year (no more, ever?).

ATVI will also be laying off 500 employees.  This will leave the Activision part of ATVI with Call of Duty, the Bungie team that’s developing a new MMO, and some niche products like Cabelas hunting games, that make money.

2.  Blizzard is doing fine–better than fine, actually.

–Non-GAAP operating income, at $850 million, was up 53% year on year. 

–World of Warcraft has over 12 million subscribers globally.  Blizzard’s new partner, NetEase, is making it easier to get permission from Beijing to introduce new WoW software to China. 

–WoW: Cataclysm sold 4.7 million units during its launch month in December.

–Starcraft II has sold almost 4.5 million units, as well.

–Blizzard has also been talking about a new WoW-like game it is developing, code name: Titan.

3.  Call of Duty is, too.

–Despite pre-launch worries that Call of Duty: Black Ops could never surpass the success of the 2009 entry in the game series, CoD: Modern Warfare 2, the number of players of Black Ops during its first three months is about 50% higher than for MW2.

–First-day downloads of the initial expansion pack for Black Ops (just launched) were 25% higher than for the comparable release for MW2.

4.  ATVI will be announcing a mystery new gaming initiative at Toy Fair today.

5.  New releases for 2011?  Will there be any?

–There’ll certainly be one for Call of Duty. But ATVI is (sensibly) unwilling to project that it will meet the lofty sales standards of Black Ops. Other than that, the current-year cupboard may be pretty bare.

–There’s no word from Blizzard on (the now long-awaited) Diablo III. All we know is it’s not ready for beta testing yet.  A 2011 launch has not been ruled out.

–Heart of the Swarm, the Zerg entry in the Starcraft II series, is certainly a 2012 event (if then).

–The Bungie MMO definitely won’t debut this year.

–On the bright side, there won’t be self-inflicted losses from Guitar Hero et al. But worries the new Blizzard launches could be pushed back into 2012 are the main reason for ATVI’s conservative earnings guidance.

why the big selloff in the stock?

1.  Some investors may be throwing in the towel.  ATVI has been a severe underperformer over the past two years.  Another huge writeoff and prediction of a down earnings year in 2011–especially when most other firms, video game and otherwise are posting surprisingly good results–may have been more than many investors are able to take.  Some professional investors who use mechanical rules for buying and selling, in an attempt to keep emotion out of their decisions, may also have been forced by them to divest.

2.  Has Bobby Kotick lost the magic touch?  I thought the Activision division problems had been fixed last year.  It’s distressing to see that it has required another year of large losses to get management to smell the coffee.  Odder still, ATVI has been much more aware than its rivals about the threat from casual and mobile games.

3.  It’s also possible that ATVI’s juvenile attempt to divert investor attention from the writeoffs by not mentioning them is undermining investor confidence in management’s integrity and competence.

where to from here?

ATVI is a stock I’ve been consistently wrong about, so maybe you should skip this part and make up your own mind without my two cents. 

First of all, the company has about $3 a share in cash on the balance sheet, and no debt.  It is generating cash flow from operations, principally from Blizzard, of about $1.15 a share.  That level of cash generation can probably continue indefinitely.  True, there may not be a new mega-hit like Starcraft II in 2011, but there won’t be Guitar Hero, Tony Hawk or True Crime to pile up offsetting red ink.  And MMOs, a field Blizzard leads, are the future for serious gamers.

Assume a current stock price of $11 and subtract the $3 in cash.  The remaining $8 is equal to about 7x cash flow.  If the current level of cash flow is sustainable–and I think it is–the stock is cheap.  It’s the equivalent of a bond that yields 15%.  If this were a different industry, or if ownership weren’t so concentrated in Vivendi’s hands, a takeover bid would be a good possibility.  I don’t think that’s likely here, though.

The big question is whether there’s anything in ATVI’s future that could make it less cheap than it is today.  A new Bungie MMO, a big increase in the number of WoW subscribers, new online moneymaking opportunities for Starcraft or Call of Duty are all possibilities that come to mind.  Also, in time, and with more forthright communication, management may win back investor trust.  In addition, at some time before the end of summer, focus will turn to 2012, which could be a year with two or three big new releases.

I can easily imagine circumstances–and again I have been as cold as ice with this stock–where ATVI is trading 20% higher than it is today six months from now.  Like almost any value stock, however, the “what” is easier to figure out than the “when.”

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