ATVI and ERTS–the last men standing

ATVI and ERTS are the only two large third-party video game software companies left standing (sorry, Ubisoft).  Add Nintendo to the list and you can delete “third-party” from the statement.

Sega was acquired years ago by pachinko machine maker Sammy and lost the lion’s share of its game staff.  Sony’s traditional Japanese management practices managed to alienate most of its developers and drive them out of the company, mostly between the PSI and PSII generations.  (By the way, one of the reasons social networking and online casual games have been so successful is the surfeit of game developers looking for work.)  Microsoft never arrived.  And Vivendi’s games unit, which contained Blizzard, maker of the Warcraft and Starcraft franchises, recently merged with Activision.

rising risk in shrink-wrapped game software

As I’ve written elsewhere in this blog, the risk profile of video game software development has risen radically over the past decade.  The short version of why:  there are about 300,000 inveterate gamers in the US and, say, 600,000 worldwide.  These are people who will buy any reasonable game, pay full price, play it 20-30 hours a week until they beat it, and then go on to the next one. Since games that work in one part of the world usually don’t appeal to gamers in another (Blizzard games are the notable exception), a game software company can probably count on selling 400,000 units of a good game to this sure-fire audience.  If we say that the development company gets operating income of $30 (after marketing costs) on each unit sold, then we can pencil in a minimum of $12 million in cash coming in the door from a good piece of software.

A couple of console generations ago, when development costs were, say, $5 million per game, the existence of these hard-core customers assured a profit.  Now, with costs having risen above $20 million, the “sure thing” money from video game-crazy customers only covers about half the price of making the software.  So the video game company has to rely on the much less predictable group of casual gamers to end up in the black.

The king of the mega-hit in the era of high development costs has been ATVI.  It gave us, among others, Tony Hawk, Guitar Hero and Call of Duty.

musical chairs

Because of its apparent Midas touch in the now-risky business of shrink-wrapped software, recent turnover of talent at ATVI has become a source of concern for Wall Street.  Specifically:

–after racking up huge losses by expanding its music game division just as demand for the genre was waning, the head of this unit departed ATVI.

–the founders, and many professional employees working at, Infinity Ward, creator of Call of Duty, left ATVI.  They formed a new company, Respawn, funded by ERTS.  All sorts of lawsuits are in the works.  One might see this move as a return to the womb, since the principals of Infinity Ward made their reputation by working on the ERTS game, Medal of Honor. Conspiracy theorists have seen the ERTS support as payback for ATVI’s pirating key developers from ERTS last summer.

–Michael Griffith, president and CEO of Activision Publishing, stepped down from his job, although he remains with the company.

At the same time:

–Bungie, the developer of the wildly successful Halo franchise for MSFT, has signed a ten-year deal with ATVI.  Halo still belongs to MSFT; anything new is ATVI’s.

It’s hard to know whether in a net basis ATVI is better or worse off with its new cast of characters.  My guess is that the business is relatively unchanged.  It’s also important to note that the Warcraft side of ATVI, which accounts for the majority of its profits is unaffected.

ATVI’s stock

ATVI has been a severe market laggard during the past year.  The stock was fine until last fall, when news began to emerge that the 2009 holiday selling season was going to be a relatively poor one.  Modern Warfare 2, the latest installment in the Call of Duty franchise, ensured that ATVI was relatively insulated from industry woes–though it did have the music game writeoff mentioned above.  But MW2 did little for ATVI other than preventing it from falling.

The stock began to perk up earlier this year, as the market began to look for laggards and after ATVI revised up its March quarter earnings guidance.  But then the Infinity Ward stories began to break and ATVI shares started to slide.

What to do?  I’m keeping my shares for now.  I take comfort from the huge (but maturing) cash generation from Warcraft;  I hope Starcraft will eventually get released; and I think ATVI management is sound.  I also own a social networking game company (DeNA in Japan) so ATVI isn’t an all or nothing bet for me.

If I saw someone working for me doing what I describe in the paragraph above, I would be very skeptical and wonder if he needed to wake up and smell the coffee.  For anyone wanting to switch to a different consumer discretionary name, however, the current period of stock market weakness is a natural time to do so.  Stocks that have gone up a lot tend to be hit by the heaviest profit-taking.  Stocks like ATVI don’t go down as much because they never went up.

ATVI reports after the close tonight.  Maybe the company will shed more light on its situation then.

If so, I’ll write about ATVI again tomorrow.