Activision's Q1 Explored: What Does The Future Hold?
We analyze the earnings call and the publisher's strategy to "widen the moats" around its IP
Activision CEO Bobby Kotick, talking about 2012, noted Activision's four strong franchises that would do the heavy lifting for the year: Diablo III, StarCraft II: The Heart of the Swarm, Skylanders Giants and Call of Duty: Black Ops II. "We continue to heavily invest in our large franchises in order to further widen the moats that surround these successful properties," said Kotick. An interesting turn of phrase, which makes you think of defending territory rather than conquering new ones. Essentially, that's what 2012 is going to be for Activision, as the major new titles that (hopefully) will become franchises aren't coming out this year.
Activision's new CFO, Dennis Durkin, delivered the numbers. "For the quarter, on a GAAP basis, we generated better-than-expected results with revenues of $1.17 billion and operating margin of 44 percent and EPS of $0.33." While it's good to exceed expectations, the results were lower than last year. "As expected, our results were down versus the prior year due to tough comps and lower subscribers for Blizzard's World of Warcraft; lower sales of Call of Duty, including fewer and later ŕ la carte DLC releases and the impact of revenue recognition for Elite, as well as increased sales and marketing spend for our new IP end services."
Activision is not immune to the overall retail downturn, now well into its fourth year and dropping faster. That tells you something about the depth of the problem; not even the industry's leading franchise can overcome the trend lines.
How well is Activision positioned for the future? On the cash front, at least, the company's looking pretty good. Durkin lays it out: "On March 31, we had no debt and $3.5 billion in cash or nearly $3 per share in cash and investments. During the quarter, we generated operating cash flow of $153 million, and we repurchased 22 million shares for $261 million." That's a substantial amount of cash, enough to fund a lot of development, or some big acquisitions.
"Activision is not immune to the overall retail downturn"
What Activision isn't saying: There is no big push into digital, at least not into full-fledged mobile and social gaming or digital distribution. Here is the fundamental difference between EA and Activision. EA has had several years of expensive acquisitions (like PopCap for $750 million) in order to strengthen their portfolio in mobile, social and casual games. EA's also invested heavily in internal development, while reducing sharply the number of new retail titles. This has hammered EA's stock price and earnings, but the company has portrayed this as a necessary rough patch that will enable it to cash in at some point in the future.
Activision's strategy, on the other hand is to double down on retail. Sure, the publisher's building out its Call of Duty Elite service, and planning on more DLC and more ways to make money from Skylanders... but that's all centered around retail products. Even Blizzard's products will rack up impressive retail numbers, even though they all have strong online components. Activision's nod to the mobile gaming segment is to mention that Skylanders had greater total sales than Angry Birds. True, but I'll bet the margins for Angry Birds were much larger.
Blizzard managed to keep WoW subscriptions from eroding in the first quarter, which was no small feat given the slow erosion of subscribers during the past year. Still, breaking even was the best they could do, and they did it by bundling Diablo III with a subscription plan. Now they're hoping that pandas and Pokemon clones will keep the franchise breathing until Titan arrives. It seems pretty clear that while WoW will benefit from the Mists of Pandaria expansion, but it's not likely to lead to a big increase in subscriptions. It's mostly to keep the old warhorse on the battlefield while Titan gets ready for its debut. Will Blizzard stick to the subscription model for MMOs? Watching nearly every other MMO go free-to-play has to make you wonder how long they can hold out.
Activision's 2012 looks to be pretty good, although the industry in general will probably have another down year, and Activision will have to work hard to overcome that. Starcraft II: The Heart of the Swarm will be a huge hit, of course. Call of Duty: Black Ops II will no doubt post amazing sales numbers. Skylanders seems a sure bet to continue to do well in the toy and game market.
The Mists of Pandaria expansion... is mostly to keep the old warhorse on the battlefield while Titan gets ready for its debut"
We can learn more by listening to what wasn't said. The continuing industry decline in retail sales got a passing mention, but we didn't hear anything about how Activision will deal with this in the future. Was there any mention of the Wii U? No... and when asked about next generation consoles, there was a solid "No comment." No nod to Nintendo? No anticipation over how a new generation of consoles will bring retail sales back to the glory days of 2008? No, there wasn't any of that. The obvious inference is that the Wii U is not expected to make any significant impact on Activision's revenue for 2012.
Other subjects were left unsaid as well. Tablets? Tablet who? Smartphones? Digital distribution? Social games? Activision is placing its bets on their existing franchises for 2012, and it's a good bet to pay off handsomely. Still, it makes you wonder if the company will be ready to respond to further shifts in the indsutry. Accelerating changes have a way of catching companies by surprise, and it's not clear how Activision is prepared to deal with the unexpected.
Activision is clearly paying attention to the high margins available on digital products, and the interest of investors in seeing game companies properly capitalize on this. Roughly speaking, margins on digital products tend to be in the 50 percent range, compared to half that on packaged goods, which is why we see a continued emphasis on Call of Duty Elite, the new possibilities of Diablo III's Auction House, and other digital goods. Compared to the broad array of digital products EA is rolling out, and the digital revenue that it's realizing, Activision's efforts look tentative. Will Activision's moat-building prove to be more lucrative than EA's territorial expansions? We won't really know for a year or two.
I notice that both EA and Activision are careful to mention talent (i.e. employees and contractors) as a key part of their current success and their strategy for the future. This represents something of a change; in the past, the rank and file weren't mentioned overly much. Perhaps the attention to talent is due to the greater competition for top performers in all areas of gaming, as Zynga regularly poaches executives from EA, and both EA and Activision have some negative PR over employees to overcome. It is nice to see the contributions of those hardworking people recognized, and hopefully the recognition will continue.
The battle for profits in 2012 will be an intense one, made more so by the shifting nature of the battlefield itself. Will Activision unleash its cash hoard to acquire some big guns, and if so, would that be another company in the traditional space like Take-Two, or a digital player like Wooga? I don't think the company will; I think Activision believes it has strong enough opportunities with its own properties. Watching the publisher's strategy unfold will provide some excellent entertainment in its own right.