Ride Out the Recession with Activision Blizzard

Have you ever played a computer game that is so addictive and all consuming that you could actually die playing it?

I know the question sounds very odd, but this is neither a figment of my imagination nor the script of a terrible horror movie with that basic premise. In August 2005, a 28 year old South Korean man died of heart failure after playing a game called StarCraft for nearly 50 hours. I was introduced to StarCraft in 2000 when I joined a start-up in San Francisco and can personally attest to just how addictive and brilliant the game is.

Developed by Irvine, California based game studio Blizzard Entertainment, StarCraft is a real-time strategy game. Unlike other Massively Multiplayer Online Role-Playing Games [MMORPG] like World Of Warcraft (another Blizzard product) and Everquest, which charge you every month to play the game, one could play StarCraft on Blizzard's free online platform called Battlenet and the game became very popular in broadband connected South Korea. StarCraft became a televised sport for the country with teams training intensively in apartments, as the game requires both speed and strategic thinking. Prizes for Starcraft tournaments were often in the tens of thousands of dollars. I often tend to describe the game as "chess on crack".

Following the release of StarCraft in 1998, the company came out with a critically acclaimed expansion pack (sort of like a short sequel) later the same year. The original game sold 1.5 million copies in 1998 making it the best selling game that year.

In the decade that followed the release of the game, Blizzard sold 9.5 million copies of StarCraft worldwide, making it one of the best selling games of all time. I was so impressed by the quality of games Blizzard was producing, I sent the company a code sample but my linear application code probably did not hold a candle to the multi-threaded code that the hackers at Blizzard were writing. I also checked out the company as a potential investment but decided to hold back for two reasons. Blizzard is notoriously slow at coming out with new games and the game studio was part of French media giant Vivendi that also owns NBC Universal and the Universal Music Group [UMG]. Moreover after purchasing a copy of Starcraft and another popular game called Warcraft III that was released in July 2002, gamers could play online for free through Battlenet. Warcraft III was named "game of the year" by several magazines and sold more than 1 million copies within a month after release.

StarCraft II Screenshot

Blizzard or the folks at Vivendi must have realized that a subscription model like Sony's Everquest game that charges players each month or through prepaid game cards is a much more profitable model and in November 2004 the company released what would eventually become the largest MMORPG called World of Warcraft. According to Blizzard, as of January 2008 there were more than 10 million active World of Warcraft players.

Two recent events piqued my interest in Blizzard again. The release of a full fledged sequel for StarCraft called StarCraft II is expected to happen just ahead of the holiday season in early December 2008 and Vivendi merged its interactive entertainment division (which includes Blizzard) with Activision to create a separate public company called Activision Blizzard (ATVI). I would take the early December release date of Starcraft II with a pinch of salt even though Best Buy and Circuit City have 12/3/2008 listed on their pre-order pages. Blizzard is famous for delaying the release of its games (does software of any kind ever ship on time?) and has at times suspended development altogether.

Activision is another game company that holds its own in the game industry with popular releases like Guitar Hero, Call of Duty and the Spider-Man games just to name a few. Not only are the two companies respected leaders in the video game industry, Blizzard will benefit from Activision's expertise in the console area. Blizzard primarily makes games that are played on computers and its attempt at hiring a couple of external studios including one called Swingin' Ape Studios to develop a game called StarCraft Ghost for consoles such as the Playstation 2 (SNE) and XBox (MSFT) did not come to fruition. Starcraft Ghost was highly anticipated by Blizzard followers including yours truly but after numerous delays and the acquisition of Swingin' Ape Studios, Blizzard decided to postpone the game indefinitely. With this new partnership with Activision, there is a chance we might see Blizzard franchises like Diablo, StarCraft and Warcraft on the new generation consoles.

StarCraft Ghost Screenshot

Vivendi still owns a majority stake (52%) in the newly created Activision Blizzard but for investors it does not get more pure play than this. It is estimated that Electronic Arts (ERTS) and Activision combined will account for nearly half of all video game sales. StarCraft prompted the publication of not just the standard strategy guides that accompany many games but also full fledged novels. It appears that the movie studio Legendary Pictures is slated to release a big budget movie based on the World of Warcraft in 2009.

The stock is supposed to split 2:1 on September 5th and while a stock split in itself is a financial non-event, academic research has shown that the mean return of stocks that split is 9% higher in the first year after the split and this is primarily on account of higher earnings growth in the ensuing years. We discussed the effect of stock splits while featuring Logitech (LOGI) in the June 2006 edition of SINLetter and you can check it out here.

Numbers:

For the full year ended March 2008, Activision had revenue of $2.8 billion, operating margins of 16.55% and operating income of $479.61 million. For the calendar year 2007, Blizzard's revenue was $1.2 billion, up 58% year-over-year. Operating margins at Blizzard were estimated at 40% in the Vivendi press release announcing the spin-off. The combined company reported revenue of over $1 billion in the June quarter and according to this BusinessWeek article, Activision Blizzard is projected to have annual revenues of nearly $4.5 billion.

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 and I plan to initiate a position in the company both in the SINLetter model portfolio and my personal portfolio.

Conclusion:

With the entertainment cost of video games at just $0.60/hour when compared to $2/hour for DVD rentals according to this very interesting article, investing in the video game industry to ride out a recession or a slowdown may turn out to be a wise bet.

Disclosure: I plan to initiate a position in the company both in the SINLetter model portfolio and my personal portfolio

Comments

[borisb:]

Asif, this is a great long idea over most time frames. The part i am struggling with is what kind of long term upside objective? the market capitalization is already a whopping $23 Billion.

2008 Sep 08 01:04 PM

[Asif Suria:]

I agree Boris that this is not just a recession play but could do well as a very long-term investment as well. With a market cap of $23 billion and projected 2009 revenue of $4.5 billion, their P/S ratio works out to 5.11, which in my opinion is not very expensive if the merger with Blizzard improves operating and profit margins.

As I mentioned in the article, revenue could increase significantly if the company created console versions of Blizzard's franchises and/or introduced MMORPG versions of Diablo or Starcraft. It remains to be seen how the new company executes but I wanted a piece of the action while I could get it at a reasonable valuation.

2008 Sep 08 01:47 PM

[Tim Hiteshew:]

An expansion for WoW will be out by the end of 2008, as will the next installment of the Guitar Hero Franchise. Diablo III has been announced as a future release, as well as Call of Duty 5. Activision also has a license with Marvel in order to make games featuring their superheroes. The hits will keep coming for this company.

2008 Sep 08 03:27 PM

[xcelsior:]

The December 2008 release date for Starcraft 2 is such a lie. It will be AT LEAST several months after that before it is released.

2008 Sep 08 09:46 PM

[borisb:]

The online factor might be a serious growth catalyst going forward. I have been studying Guitar Hero and it looks like this franchise is multiplying. The Aerosmith title has sold better then the aerosmith CDs, and this coming Friday Activision will release the new Metallica tracks on the game platform on the same day the new music album itself is debuted. Prez. Bobby says there is a shortage of GH material to meet the demand for the next 5 years! Activision claims to have superior brand managment and might apply these skills to polish up Blizzard's portfolio. Also, Vivendi has been buying more then $3 million worth of ATVI stock a day since last tuesday, and last week on Bloomberg TV the prez of Vivendi bragged about how well A-B is positioned for the long term, but this piece was edited from the bloomberg.com interview clip. And finally Activision has reached the scale, $5 Billion-ish that everyone had hoped ERTS would but never did. FOr the first time an independent publisher will be larger then any of the inhouse software divisions of Nintendo, Sony, and MSFT. the ramifications of this milestone i am not exactly sure,
but it has been a big deal to many ERTS dreamers.

2008 Sep 08 09:50 PM