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Introduction

After a period with declining World of Warcraft (WOW) subscribers, the trend is now positive again. Why? Well, Activision Blizzard (NASDAQ:ATVI) just released the expansion pack Mist of Pandaria (MoP), and some of the old players have bought the game and renewed their expired subscription. MoP has also received pretty good reviews, and one may think that WOW could return to the glory days of 2010. But as I will argue in this article, I think that is highly optimistic, and I expect the operating income of WOW to decline significantly over the coming years. Since World of Warcraft, along with Call of Duty, generates over 100% of the operating income of ATVI (I will explain later how I estimated that number), lower WOW profit will significantly impact the future income of ATVI.

Sources: Mmodata.net and my own estimates

Why the subscriber count will decline in 2013 and 2014

World of Warcraft is an old game, and while it is still the market leader in the Massive Multiplayer Online (MMO) genre, it is no longer considered the "best" MMO, as Guild Wars 2 was recently released, and has received superior reviews. World of Warcraft still holds off very well, as it is a game with extremely long longevity and players have gained social contacts through the game. With the release of the expansion pack, Blizzard and its investors hope that the subscriber count will stabilize over the next 2-3 years until the expected successor to World of Warcraft, Titan, is released.

So as a potential investor in Activision, I quickly realized that I needed to analyze whether those "hopes" were realistic. Therefore, I have researched the target group's reaction to Mist of Pandaria.

First of all, I like to start off with a quote from a PCgamer:

For returnees, the additions to the game and new content are very enjoyable, but it is fundamentally still World of Warcraft with a few bits strapped onto it rather than a whole new game. If you're coming back from a more recent MMO, things like the stodgy combat are going to feel far older than you remember, and the basic mechanics and philosophies remain the same. Pandaria as a place is firmly a vacation for your character rather than a Cataclysm style reinvention of their world, and you're only going to avoid the old grind for so long before it's back to business as usual in the endgame.

If you remember the game fondly enough to have read this far, it's worth returning for a month or two to check it out. You're unlikely to stick around much longer though, unless you really get back into the social side, or the raids and next chapters of Pandaria's story prove incredibly compelling.

But that was just a quote from one reviewer. What about the players? Below are a few quotes from the forums of Battle.net, Anandtech.com, Pcgamer and mmorpg.com:

Im sorry, but after Guild Wars 2 and The old republic now being free to play... it seems dumb to justify 15 dollars a month for WOW

Exactly, the 15$ a month is why I don't play WoW anymore and why I quit SWOR back then. I give myself a 5$ or less allowance in GW2, so far so good.

You should really play the game... or just get your facts right. GW2 Rid this game of many pointless timesinks, many of which are still found in wow (Flights, crafting, travel, grinding) so don't give me that crap about spending CRAZY amounts of time playing to offset the cost of Gems... It's just not true. It's extremely balanced, especially given it's young age.

GW2. WoW is a crappy old outdated game with nothing but grind. It also bleeds massively now.

GW2 moves forward in game designing, WoW moves backwards.

I have a mitigated opinion when it comes to GW2 vs WoW, I like both games and all... But for PvP, I hate to say this on a Blizzard forum but Guild Wars 2 is just plain better.

Through my research, I never read a single comment from a player who had re-found his love for the game, and/or believes the game is superior to Guild Wars 2. Most players think the expansion is pretty good, but it is my understanding that players who have renewed their expired subscriptions, mostly just want to try out the game, and they won't be playing it for a longer period. Analysts, however, do not seem worried about lower subscriber numbers in the future, and they are still very optimistic on the expected future growth rate of ATVI. I believe they have probably compared WOW to Guild Wars, and they have noticed that Guild War 2 only has "2 million" active players, and therefore concluded that World of Warcraft is still vastly superior to its main competitor.

However, they are in my opinion wrong, as they have completely ignored the somewhat unknown game, Leagues of Legends (LOL). Leagues of Legends is a MOBA game, which is somewhat different from World of Warcraft. But it is my understanding that analysts are too blindsided on the MMO market, rather than the gaming market as a whole, and if they paid more attention to the rise in popularity of the MOBA games (besides LOL, Dota and Heroes of Newerth are also very popular), they would realize that the threat to World of Warcraft doesn't just come from Guild Wars 2 or Star Wars Galaxy, but a much wider range of games. They would probably also have noticed that Leagues of Legends has the most active players of any game, as it recently overtook that position from World of Warcraft.

In a previous article, I briefly explained why Leagues of Legends (LOL) had become such a success:

It's very casual friendly, which means that it's targeting a large part of the non-hardcore gamers. Blizzard has over the last years actually tried to make their games easier to play for the casual players. Games such as Starcraft 2, Diablo 3 and the latest expansion pack of WOW are in a lot of ways easier to play than their predecessors. However, there is a very thin line between giving new players a great experience, and not making the game too easy so that it hurts the longevity of the game. To be honest though, I think Blizzard (in general) is missing the point, and they haven't focused enough on what really matters: The social experience, which is an area where Diablo 3 and Starcraft 2 have failed. On the other hand, LOL shines here as the game revolves around team play, and it is free to play, which means that you can play together with all your friends.

Over the coming years, I expect an increasing amount of World of Warcraft players to cancel their subscriptions. Why pay money for an old game when you can play a superior game (Guild Wars 2) for free, or have fun with the casual-friendly Leagues of Legends?

What does this mean for the ATVI?

Well, obviously it means a lower operating profit (ceteris paribus), but by how much exactly? There is no clear answer to that, as ATVI doesn't break out the income statement on a game-by-game basis. Rather, they divide the income statement into Activision profit and Blizzard profit, and they also separate revenue generated by PC sales, Nintendo sales, Playstation sales and Xbox sales.

But after spending 40+ hours of research on analyzing sales estimates for each game sold by ATVI over the last 3 years, obtaining knowledge of advertising spending, length of product development, number of employed devoted to each game, I was somewhat able to match costs and revenues for each game. In the below graphs, you can see how close my model is to match the actual reported results.

Given my knowledge of the cost structure of ATVI, I have estimated the operating profit for each game. Below you can see the operating profit for World of Warcraft since 2010 on quarterly basis, and my estimate for the next 8 quarters.

As you can see, I expect operating profit to decline substantially. Though it is worth noting that according to my estimations, World of Warcraft barely contributed to the bottom line in the last quarter (Q2 2012), and I expect operating profit to be $152 million in Q3 and $168 million in Q4. The increase in profit is explained by the release of Mist of Pandaria and the increased subscriber count, though it will be partially offset by increased advertising spending.

So I promised in the title that I would analyze how this impacts ATVI (rather than just World of Warcraft). In the below diagram, you can see my pre-tax operating profit estimates for every game. While my focus in this article is on WOW, I have spent a similar amount of time analyzing every other game series, and therefore I believe my estimates are somewhat close to the "truth."

According to my estimates, operating profit will increase from TTM $1200 to $1250 over the next twelve months. So you may think that this means ATVI will be fine without WOW declining, and that ATVI is still undervalued. But I think you are wrong. First of all, the diagram only shows the expected operating profit for the next twelve months, and as you may have noticed (from the above graph), I estimate that the decline in WOW-operating profit won't happen before Q1 2013, and therefore the "decline" will not be felt over the next twelve months.

When earnings for Q3 and Q4 are reported, I expect some analysts to take those results as a proof that ATVI is growth-company, and the management team of ATVI may even mention in one of the coming quarters that operating profit from World of Warcraft has increased over the last quarters as an indicator that World of Warcraft is not declining/still growing. But that (hypothetical) statement is obviously highly misleading, as the decline won't be seen on the income statement (Non-GAAP) until the first quarter in 2013, and from then on, profits will continue to drop.

Another thing to note is that the estimates from the diagram are pre-tax. Taxes are expected to rise from roughly 12% to 17%, and therefore operating profit will, according to my estimates, be unchanged over the next twelve months. Analysts, however, estimate that operating profit will increase by 14%! I think they are wrong, and I believe ATVI will go through a couple of tough years, where they will disappoint analysts/investors.

I am considering shorting the company, but I am waiting till post-Q4 as I expect over $1 billion in earnings in that quarter (pre-tax) due to expected releases of Heart of the Swarm, Call of Duty Black Ops 2, Skylander Giants, and a relatively high subscriber count of World of Warcraft combined with lower advertising spending.

But after Q4, I think profits will drop significantly, and earnings will disappoint investors and analysts, whom I expect haven't done enough research on the company. The stock price may rise to $12 after Q4, but I expect it could fall $9-10 within 2014.

Source: Why World Of Warcraft Will Drag Activision Blizzard's Earnings Down