Activision Blizzard Vs. Electronic Arts: Both Are Good Buys

Includes: ATVI, EA
by: Helix Investment Research

The world of video games is changing. Gone are the days when games were merely played on consoles. Today, they are played on all sorts of devices, from consoles to browsers to smartphones and tablets. And through it all, 2 public companies have proven that they have what it takes to outwit the competition and succeed.

Activision Blizzard (NASDAQ:ATVI) and Electronic Arts (ERTS) are the two largest public video game companies in the world. The upcoming IPO of Zynga could very well change that, but most investors will be unable to invest in Zynga at this point. We will most likely profile Zynga when it becomes public, but for now, we will focus on Activision and EA. Below is a quick financial and operational overview of these 2 companies.

Activision Blizzard & Electronic Arts Overview

Activision Blizzard Electronic Arts
Stock Price (12/12/11) $12.12 $21.64
Market Capitalization (12/12/11) $13.87 Billion $7.19 Billion
YTD Performance (S&P 500 is -1.88%) -2.56% +32.35%
Dividend Yield 1.36% N/A
Net Cash $2.926 Billion $756 Million
P/E 18.93 N/A
GAAP EPS (3 Quarters of 2011) $0.84 $0.08
Non-GAAP EPS (3 Quarters of 2011) $0.31 -$0.07
GAAP Revenues (3 Quarters of 2011) $3.348 Billion $2.804 Billion
Non-GAAP Revenues (3 Quarters of 2011) $2.080 Billion $2.553 Billion
Reuters Average Price Target (Upside %) $15.77 (30.12%) $25.92 (19.56%)

The above table deserves some explanations. Activision's results look worse in a non-GAAP environment, while EA's look better in a GAAP environment. This is due to the different business mixes of these two companies, the use of deferred revenue, and different proportions of revenues derived from digital/subscription sources. Thus, in the short term, it is unwise to simply look at EPS/revenues to gauge which is the better company. So how does one determine which is the better company?

Activision Blizzard, created by merging Activision and Vivendi's Blizzard division, owns what are seen by many as the two largest franchises in the video game industry: "Call of Duty" and "World of Warcraft." Each has millions of players all over the world, and the newest "Call of Duty" game broke the $1 billion sales mark in just 16 days, a new record both for the franchise and the industry.

Each new "Call of Duty" game continues to set the industry benchmark for sales and profits, allowing Activision to report a string of record quarters. The Blizzard division, backed by the unmatched "World of Warcraft" franchise is also performing well overall. But, World of Warcraft subscribers actually fell, marring an otherwise good quarter.

The company reported that subscribers fell to 10.3 million from 11.4 million in March. This is of concern because of how "World of Warcraft" contributes to Activision's bottom line. There is a reason that Activision is consistently profitable, while many of its competitors are not. It is because it has a reliable source of revenue and profits from "World of Warcraft" subscriptions, which boast far higher margins than "traditional" video games.

The effect of this loss is subscribers is already evident. Operating margins at the Blizzard division have declined from a high 50% range to the 40% range. To be fair, a good deal of this is due to accelerated development of Blizzard games, such as "Diablo III," but some of it is no doubt due to a decline in "Warcraft" subscribers.

The weakness at "World of Warcraft" highlights both Activision's strongest asset and its greatest liability. Its franchises allow it to outperform its competitors. But only as long as the franchises are appealing. For all the bluster about diversification, Activision's results are still driven largely by "Call of Duty" and "World of Warcraft," and should anything go wrong with them, we do not think its other games can make up for weakness at these core franchises.

Activision Blizzard may be the most profitable video game company, but it is in danger of missing the next revolution in video gaming: smartphones and tablets. Activision Blizzard has no products on Facebook, and has made what is at best a half-hearted attempt to gain a foothold in the mobile gaming world. Activision Blizzard CEO Robert Kotick has said that:

We're never the first on a new platform. We're usually the best, but not the first. We have a lot that we're developing for mobile. We have a lot that we're developing for Facebook as a platform. We're taking our time.

We cannot help but wonder if Activision is being too cautious, too conservative. Being the best may matter more in traditional video gaming, but being first matters more in the mobile world. And by ceding its first-mover status, we wonder if Activision can meaningfully break into this sector. And while Zynga may have control over social gaming on Facebook, it is Electronic Arts that has the widest overall presence in the social/mobile world.

Electronic Arts has long been seen as the Burker King to Activision's McDonald's (NYSE:MCD). A profitable competitor, but one that will never actually displace Activision as the leader in this industry. But lately, Electronic Arts has been focusing more and more on the social/mobile sector, somewhere where Activision cannot be found. Robert Kotick boasts that Activision will be the best, not always the first, but we think this does not matter in this sector.

Electronic Arts has gotten too far ahead to be caught at this point. It has 103 iPhone games in the App Store, and 42 iPad games, boasting a breadth and selection matched by few, if any competitors. Its games regularly top the App Store charts, and the company is moving aggressively to diversify away from the franchise model. EA CEO John Riccitiello says that the company's goal is to make its games playable on any device or platform. "We put the company back on track by embracing the very thing [casual and mobile gaming] that threatened us," Riccitiello said in a recent speech.

Electronic Arts bought Playfish in 2009 for $275 million, taking control of one of Zynga's main rivals. The result of that acquisition is that EA now has the #2 Facebook game: The Sims Social. And the company acquired PopCap this year for $750 million to gain an even larger foothold in the "casual" gaming sector, particularly on the iPad and the iPhone.

And the results are showing. EA's shift away from traditional video games has paid off, and growth in its digital division is soaring. The division grew by 30% this quarter when compared to the prior quarter,and has grown over 36% from a year ago. EA is clearly the leader in mobile gaming, and is making serious challenges to Zynga in social gaming. But do not think that this means the company is abandoning traditional video games.

Electronic Arts is a fierce competitor, challenging Activision at every turn. "Battlefield" is the company's "Call of Duty," and although it is not as successful, it is profitable. The latest version, "Battlefield 3," has sold 8 million copies. And EA is close to launching what could be a company-changing product.

On Deember 20, EA will launch "Star Wars: The Old Republic." At a cost of $135 million, this is probably the most expensive video game ever produced, and has pressured EA's profits for several quarters. Yet EA already reports it has enough subscribers to turn a profit. The beta test attracted 750,000 players, 250,000 more than what EA CEO John Riccitiello says the company needs for the game to be profitable. And any "Star Wars" product is likely to attract millions of players, and bring millions into EA's coffers.

And while Activision CEO Robert Kotick doubts the game's profitability, arguing that LucasArts will be the primary beneficiary, we do not expect him to say anything else. He can do nothing but criticize what is likely the first serious challenge to World of Warcraft's dominance in the massively multiplayer online role playing game sector.

Electronic Arts and Activision Blizzard are both quality companies, each with strengths and weaknesses. So which is the better buy here? As with all things, the answer is that it depends. Activision is cheaper than EA, but EA has much more growth potential due to its presence in mobile and social gaming, something Activision has yet to expand into. But Activision controls the 2 best franchises in the industry, and both allow Activision to report higher profits than any of its competitors.

However, we think both companies should be successful in the long run. Neither company has demonstrated a lack of innovation, and we think that wise investors will pick at least one of them to add to their portfolios. More value-oriented investors should pick Activision, while growth-oriented investors should pick EA. Both companies will continue to innovate, dominating the industry. Video games have proven to be very profitable, and we think that owning either of these companies will be a profitable bet for investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.