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ATVI AT A GLANCE

P/E ► 75.4 AVG EV/EBITDA ► 23.4 HIGH ROA ► 2.6% AVG ROE ► 3% AVG Debt to Equity ► 0.172 VERY LOW Current Ratio ► 4.13 HIGH Interest Coverage Ratio ► 37.0 HIGH

 

 

 

 

 

 

Activision publishes and distributes video games. Along with primary competitor Electronic Arts (ERTS), ATVI develops software for the PC and video game console markets. In 2007, Activision had three of the top 10 selling games, including Call of Duty 4: Modern Warfare (third place), Guitar Hero III: Legends of Rock (fourth place), and Guitar Hero II (eight place).^[1]

In December 2007, Activision announced it was acquiring Vivendi (EPA: VIV)'s video game division, Blizzard, in a stock deal that will result in Vivendi owning the majority of Activision shares. The addition of Blizzard, which publishes the popular World of Warcraft online game, creates a larger company than primary competitor Electronic Arts (ERTS) and allows Activision to be a key player in both its traditional market, console gaming, as well as the quickly growing online space.^[2] Because online games charge a recurring monthly fee instead of a single upfront purchase prices, they can make money in China where traditional, single-license videogame companies have been unsuccessful because of rampant piracy. Blizzard licenses World of Warcraft to The9 (NCTY) in China, where the game has over 1M users.^[3]

The video gaming industry has grown rapidly in the last two decades, with striking similarities to the movie business. Large publishing houses (production studios) support development studios (writers, directors, artists, etc.) through a long development cycle (filming and editing), during which a game (movie) makes no money. At the end of development, the publisher (production studio) licenses the game for distribution, promoting it in magazines, and reaping most of the revenue. However, if a game fails to sell well, the publisher will not recoup its initial investment. Mindful of this fact, dominant publishers such as Activision and Electronic Arts have largely stayed to a simple formula - develop successful concepts for game franchises, and then launch a series of sequels.

Business Description

Activision is a developer, publisher, and distributor of video games. It sells software for a variety of gaming platforms, such as the PC, XBox, Playstation, Wii, and other portable devices. ATVI divides its financial reporting into Publishing and Distribution segments.

• Publishing - markets and distributes games that were either developed in-house or by affiliated development companies.^[4]
• Distribution - dedicated business in Europe that only provides logistical and sales services to third parties ^[5]

Development refers to the creation of content in a game, from story design to construction of the underlying game-engine and graphics creation. The costs of development have become increasingly high as users demand sophistication in technical and artistic content. For example, a player can live out a "virtual life" in online games such as World of Warcraft, using a combination of technologies that were impossible less than 10 years ago.^[6] As a result, many once-independent developers have become affiliated or been acquired by larger publishing companies, such as ATVI, who have deep pockets to support a game through development (when it does not generate revenue) and who also reap most of the benefits after publication.

ATVI has focused on franchise hits, such as the Call of Duty and Tony Hawk franchises, and other movie related tie-in products like the Spiderman games^[7], which ensure high revenues due to repeat sales and have lower costs of production since some of the older technology can be reused. Its primary competitor, Electronic Arts (ERTS) employs a similar model.

But change is on the horizon as the online-game subscription model has gained traction. Subscription-based online games may be the answer for sustainable long-term growth in this space - but in the short term, the online capability of game consoles have made a significant contribution to video game revenues and ensured that traditional gaming platforms will stay relevant. Meanwhile, the pending merger agreement with Blizzard addresses investors' concerns about Actvision's lack of depth in the online field.

Financial Analysis

Note: ATVI reports on a March 31 FY end

Activision has seen sales growth averaging 20% over the past five years, beating the industry growth rate of 12%. In addition, in Q3 FY2008 (not pictured) the company had net revenues of $1.48 billion, a year-over-year growth of 80%^[9], and a figure approaching the revenue of the entire prior (FY2007) fiscal year($1.5bn). Much of this revenue growth can be attributed to the franchises Call of Duty (which launched Call of Duty 4) and Guitar Hero (which saw strong sales of Guitar Hero 2, as well as the new release Guitar Hero 3)^[10]. Margin in FY2006 dived to nearly 1%, largely due to investment costs required for development in the next generation consoles such as Xbox and Playstation 3. It has since recovered to 4.8% GAAP in FY2007. The company reported a 27% non-GAAP (adjusted for non-cash items) operating income in Q3 FY2008. ^[11]

The Distribution business mentioned above in the business description is a primary contributor of European revenues, contributing $393MM in FY2007. ATVI's organic growth from the primary Publishing segment abroad still underperforms when compared with its competitors, such as Electronic Arts (ERTS)^[13]

Console titles dominate Activision's product portfolio, with Hand-held and PC titles holding distant second and third place status. Console titles increased from 69% to 74% of ATVI's revenues over the above period, mostly at the expense of the PC segment, which has decreased from 19% to 7% over the 2005-2007 period. ^[14]

Video Game Sales

2007 Sales: Top Ten

In 2007, Activision had 3 of the top 10 selling titles, outpacing all the competition except for Nintento, which had 4.^[15]

2006 Sales: Top Ten

Trends/Forces

More casual gamers will boost revenue growth

FY2007 included by a number of blockbuster franchise hits in the gaming industry (see Video Game Sales), such as Halo 3, Guitar Hero 3, and Super Mario Galaxy.^[16] Casual gamers have flocked to the next generation of video game consoles, such as the Wii, as seen in the difference between sales in 2006 and 2007, and the share of gamers over 35 and women gamers has also increased.^[17] These individuals, who once only played Solitaire and Freecell on their computers, have begun to turn to console video games as an alternative entertainment source. As video-games become more mainstream, sales have grown in 2007 and the early part of 2008. For information about market segmentation between casual and serious gaming enthusiasts, please see the Casual Games Market Report (2007)

ATVI's focus on game franchises limits the breadth of the development pipeline

Activision has historically focused on franchise hits as well as tie-in games to other entertainment media, such as the Spider-man 3 games. The company's stable financial position makes it capable of supporting these blockbusters which require funding as they are under development for long periods. However, there is more underlying market appeal from several franchises, rather than just sequels for only a few franchises. The lack of breadth is highlighted by the RedOctane purchase (creators of Guitar Hero 2) during FY2007, leading to the release of Guitar Hero III and growth revenues in Q3FY2008 to levels on par with the entire fiscal year prior (FY2007). ^[18] Although acquisitions are an option, they are expensive, and Activision seeks to continue creating new products on its own. It has announced several movie tie-in games, such as James Bond and Kung Fu Panda, for 2008.^[19]

Game Consoles Wars: Xbox 360 vs. PS3 vs. Wii are a source of volatility for game publishers

Each gaming platform's software must be developed independently, and games are partially tied to platform sales, as characterized by EA's' anticipation of a PS3 victory and subsequent mismanagement of their portfolio during the Wii launch year. The underallocation of Wii games and overallocation of PS3 games was particularly poor timing given the Wii's blockbuster sales and the PS3's relative poor performance, since console sales aid in game title sales.^[20] ATVI has found itself scrambling to launch more Wii titles in 2008 to match software demand, promising franchise hits on the Wii platform.^[21] This is a challenge because underlying technologies and development platforms for each are different, as demonstrated by the botched Guitar Hero III Wii release. Activision, in the process of porting the game software, released Guitar Hero III Wii discs that only contained mono sound, a terrible error for a music/rhythm game.^[22]

Online Gaming presents a Challenge and Opportunity

As suggested by the merger discussed above with Vivendi Games, both ATVI and Vivendi (EPA: VIV) see online gaming as an area of opportunity. Online gaming typically is more social, and allows for community building and virtual relationships, wrapping end-users up in an immersing world and compelling them to spend their money. Competitor EA has purchased development studios in both 2007 and 2006 for the purpose of building out its online-gaming capability.^[23] This arena offers new revenue models as well, with subscription being the norm, reminiscent of Software as a Service, although other ad-based models are also being explored. While potentially lucrative, the new segment presents its own challenges, with higher development costs and a history of costly flops, such as "Sims Online" in 2003, which sold poorly despite significant hype and anticipation at industry trade shows.^[24] Industry analysts believed that the game’s target demographic of casual gamers was reluctant to pay a monthly subscription fee of $10, and wary of giving their credit card information over the Internet.^[25]

High Recession Resistant Economy

Unlike certain private equity transactions that burden the balance sheets of the companies they are acquiring with debt, Vivendi is actually putting in $1.7 billion in cash into the newly formed company, part of which would be used to acquire shares of Activision Blizzard through a tender offer. Vivendi estimates that the company will earn $1.20 per share in calendar year 2009, giving Activision Blizzard a 2009 P/E of 27.35 but analyst estimates are higher at $1.29 for fiscal 2009, which ends in March 2009. Even a P/E of 27.35 is not very expensive for a leader in a high growth recession resistant industry

Competition

• Electronic Arts (ERTS) - The industry's largest player, with a significant portfolio of sports-related software titles that generate consistent revenue year after year.
• Take-Two Interactive Software (TTWO) - the publisher of the Grand Theft Auto franchise, which will see the launch of Grand Theft Auto 4 in 2008.
• Konami (KNM) - Japanese publisher, which has published hits such as the Metal Gear franchise
• THQ (THQI) - Developer/Publisher which houses 16 development studios.

Both developers and publishers compete with Activision, although they may have different target segments. Most similar in operating structure is Electronic Arts (ERTS), which has the largest portfolio of blockbuster games, including many sports titles, and other game franchises with long histories of success. Take-Two Interactive Software (TTWO) is the publisher of the Grand Theft Auto series. Grand Theft Auto 4 is set to launch early in CY2008, and it is expected to beat Halo 3 record-breaking sales.^[26] Electronic Arts (ERTS) has put in a bid for Take-Two Interactive Software (TTWO) which is set to expire on May 16, 2008. ^[27]

The market size of the industry has grown rapidly, as seen in the table below.

Market Share

Activision is one of the industry's largest players, trailing Electronic Arts (ERTS). Should the Vivendi (EPA: VIV) merger go through, Activision Blizzard would be the largest player in the video game industry. Market share is calculated as share of total industry revenues by Datamonitor.

References

1. ↑ 1Up.com "NPD Fallout: Activision is Top Publisher of 2007" January 18, 2008
2. ↑ BusinessWeek "Vivendi, Activision Form Games Juggernaut" December 2, 2007
3. ↑ PCAdvisor.com "World of Warcraft users exceed 1m in China" April 14, 2008
4. ↑ Activision FY2007 10-K "General" pg.3
5. ↑ Activision FY2007 10-K "General" pg.3
6. ↑ ArsTechnica "The runaway costs of game development" November 7, 2005
7. ↑ Activision FY2007 10-K "General" pg.3
8. ↑ Activision FY2007 Annual Report "Operations by Reportable Segments and Geographic Areas" pg.82
9. ↑ Activision Q3 FY2008 Earnings Call Transcript February 7, 2008
10. ↑ Activision Q3 FY2008 Earnings Call Transcript February 7, 2008
11. ↑ Activision Q3 FY2008 Earnings Call Transcript February 7, 2008
12. ↑ Activision FY2007 Annual Report "Operations by Reportable Segments and Geographic Areas" pg.82
13. ↑ Morningstar Analysis "Activision" July 2, 2007
14. ↑ Activision FY2007 Annual Report "Operations by Reportable Segments and Geographic Areas" pg.82
15. ↑ PGNx Media "NPD Group Reveals Best Selling Games of 2007" January 18, 2008
16. ↑ Silicone Valley Insider "Remember The Video Game Boom? It's Ending Soon (GME)" April 21, 2008
17. ↑ ArsTechnica "Growth of gaming in 2007 far outpaces movies, music" January 24, 2008
18. ↑ Activision FY2007 Annual Report "Acquisitions" pg.76
19. ↑ Gamespot.com "Activision confirms Bond movie tie-in, new COD, two Guitar Heroes" February 8, 2008
20. ↑ San Jose Mercury News "EA'S FUMBLE" May 27, 2007
21. ↑ Gamespot.com "Activision confirms Bond movie tie-in, new COD, two Guitar Heroes" February 8, 2008
22. ↑ Wired Blogs "Activision Will Replace Guitar Hero Wii Discs In 2008" December 7, 2007
23. ↑ BusinessWeek "Activision-Vivendi's Game-Changing Deal" December 4, 2007
24. ↑ BusinessWeek "Activision-Vivendi's Game-Changing Deal" December 4, 2007
25. ↑ Wired.com "Sims Flop Dogs Game Developers" May 12, 2003
26. ↑ Telegraph "Grand Theft Auto IV could outsell Halo 3" April 18, 2008
27. ↑ DealBook Blog, NYTimes "EA Extends Deadline for Take-Two Offer" April 18, 2008
28. ↑ Datamonitor Industry Reports "US - Video Game Industry" July 15, 2007