Diablo 3 Shows Why Video Game Companies Are Risky Investments

| About: Activision Blizzard, (ATVI)

A few months ago, the impending release of Activision-Blizzard's (NASDAQ:ATVI) anticipated mega-hit Diablo 3 had both the gaming and investor communities buzzing with excitement. Many pundits were calling Activision a buy before the game's release day, no doubt envisioning record breaking sales, glowing reviews, and a soaring stock price. Well, the first one happened: Diablo 3 absolutely smashed PC sales records with 3 million sold the first 24 hours and 6 million the first week. Unfortunately, while the game received decent critic reviews, user reviews were a complete bomb, with the game averaging a total of 3.8/10 on Metacritic. Shareholders didn't make out any better: on release day May 15, ATVI's stock price was $12.78/share. Last Friday, it closed at $11.64. During the same time period, the S&P rose more than 5%.

What went wrong? While Metacritic's user composite is notoriously unreliable, with many otherwise solid games like Diablo 3 getting their scores dragged down by angry consumers rating the game 0/10 as a vindictive gesture alone, it does reveal one important thing: that there were a lot of angry consumers. As an investor who also happens to be a Diablo 3 player, let me first make note that I actually find the game a lot of fun and don't regret my purchase at all. However, I also recognize that this is a sentiment that isn't shared by a significant percentage of my fellow players. The list of gripes are endless: a mismanaged launch, unstable servers, poor item design, lack of player-versus-player content...we've reached the point where one of Blizzard's own staff has come out and admitted that Diablo 3's end game content is unsustainable.

Peter Lynch has always advocated for investors to invest in what they know, but in this case, I chose to not invest in what I know, because I knew that while I enjoyed the game, many people didn't, and when it comes to making money, it's the masses that move markets. Many people, investors included, are consoling themselves and each other by saying it doesn't matter whether or not consumers like the game, Blizzard already made a ton of money from it, so it doesn't matter, right? Not true. A one time windfall is one thing, which is essentially what opening month sales are, but sustainable cash flows are another, and it's this latter model that is of prime concern to investors. Activision is a business-savvy company, and has designed Diablo 3 so that it could potentially be a source of recurring revenue through the inclusion of a real money auction house and future expansions. However, this design will only work if players keep playing the game. Right now, in its current state, Diablo 3 cannot promise that.

Sustainable cash flow is king in the world of business, and it's what drove Activision to become the largest game publisher in the United States. I am, of course, talking about World of Warcraft. As one of the most popular games in the world, it has been lining the company's pockets with money for years due to its subscription revenue business model. Unfortunately, the game is getting long in the tooth, with subscriptions in decline since early last year. If Activision is to maintain its dominance in the market, it must create a replacement for its cash cow. Diablo 3 will clearly not be that game. Considering the tremendous run World of Warcraft has enjoyed, it's exceedingly difficult for any game to be that game, which means that present day ATVI investors must face the possibility that they've purchased the company at its prime.

If Diablo 3 had been more of a success than it has, would the story unfold any differently? I doubt it, though the ending may be delayed. Let's look at some of Activision's previous megahits and their effect on its stock price. Starcraft 2 was released to universal acclaim and sold millions of copies. The stock didn't budge. Call of Duty: Black Ops was released to universal acclaim and sold millions of copies. The stock didn't budge. World of Warcraft: Cataclysm was released to universal acclaim and sold millions of copies. The stock soared...just kidding. It didn't budge.

This is the eternal curse of success for video game companies, and applies not only to Activision but other top dogs in the industry like Electronic Arts (NASDAQ:EA) and Take-Two Interactive (NASDAQ:TTWO). Due to the fleeting nature of a video game, even a tremendously popular one, success must be duplicated again and again and again just for the company to maintain its current financial position. Contrast this to a company like Coca-Cola (NYSE:KO), which has basically sold the same product for the last hundred years, and it quickly becomes obvious why achieving market-beating results as an investor is significantly more difficult when you're buying video game companies. For an example of what happens when your throne gets usurped, just look at EA post-2008, a company that once traded at $50 a share, saw its stock price fall off a cliff, and hasn't recovered since.

Not only that, the barriers of entry for the industry are exceedingly low, and the bar continues to lower every day with new technological advancements. Veteran companies like Activision and EA are constantly defending their turf from assault by hotshot upstarts like Zynga (NASDAQ:ZNGA), or even Masjeco Entertainment (NASDAQ:COOL). These days, all you need to make a smash hit is a computer, some programming skills, and a great idea. Of course, some college hacker in his dorm room isn't going to whip up something like Grand Theft Auto IV, which reportedly cost $100 million to develop, but with the advent of social and mobile gaming, he doesn't need to.

Constant success is difficult even for the most talented, respected, and experienced players in the industry, as demonstrated by Diablo 3. After all, Blizzard is indisputably one of the most revered video game companies in the world, with a seriously impressive track record to its name, yet still managed to produce a product that disappointed millions. A case study of the same company shows that even when you do achieve a huge run of successes, as noted above, that performance rarely translates into a higher stock price. It's a lose-lose scenario, where investors are doomed to mediocre results either way.

I love video games. I don't like investing in the companies that make them. While outperformance is certainly possible as a game investor, it's like having to clear a ten foot bar while other investors only have to clear a three foot bar. Most of the successes when it comes to investing in game companies will occur when said companies are still in their infancy, and as such, is an endeavor best left to venture capitalists. After all, as investors, we all play to win, but investing in the video game industry is a risk-filled maneuver that has uncomfortably high odds of ending in a game over.

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

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