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8/5/2010 7:47:55 PM - Activision Blizzard Reports Disappointing Results

Activision Blizzard (ATVI) reported disappointing second quarter results today and dramatically lowered their revenue and earnings projections for the third quarter. The stock price fell about 7% in after-hours trading. A user on a financial message board asked why the share price seemed to often ignore good news but fall precipitously on bad. Following is my response:

ATVI's current PE is 50. What more do you want?

The forward PE is north of 14 for a company with low double-digit earnings growth and heavily dependent on one title - World of Warcraft (WoW) - for a huge chunk of its ongoing profits. With WoW starting to show its age and the subscriber base beginning to shrink, concern about what will replace it...and over the stock price...will only grow. The sequel could sell 10 million copies and still be considered a huge failure. That's a high bar to clear. Remember EverQuest? EverQuest 2 didn't do nearly as well. Remember the PlayStation 2? The PlayStation 3 didn't fare nearly as well.

The story is similar with the recently released Starcraft 2. It sold a million copies on its first day - a huge number for a PC title - and yet several analysts immediately called the numbers disappointing. I suspect that the extremely weak outlook for the third quarter was based in no small part on Starcraft 2 selling below what were, in retrospect, astronomical expectations.

My point is that ATVI is already priced for perfection. If they stumble at all, the stock price will suffer. If they perform up to (extremely high) expectations, the upside will be limited because the market was already expecting that.

ATVI is also facing an industry in which all of the growth is in new areas like social, casual, and online gaming - areas far different than the ones in which they've traditionally excelled. Whereas WoW is a social and online game requiring monthly payments, that was an easier transition for a traditional game company like ATVI. WoW required a massive development budget, hundreds of servers at launch, significant retail distribution, loads of expensive advertising, and a title with massive name recognition. It's easier for companies like Activision to dominate that market because the barriers to entry are so high that they face little competition.

In the fragmented future of gaming, though, ATVI will find it far more difficult to rely upon a small number of "sure-fire" hits (such as World of Warcraft, Call of Duty, Starcraft, and Diablo) to generate the lion's share of their revenue and profits. They'll have to balance the cannibalization that will occur as they introduce games that can be played to at least some degree for free (such as Zynga's FarmVille, which is supported via ads and micro-transactions) with the losses that such titles will inflict upon their traditional business (which is dependent upon retail purchases and/or monthly fees.) They'll have to figure out how to be both innovative (in terms of developing appealing new gameplay mechanics) and disciplined (so that if a particular title doesn't do as well as expected the losses are not catastrophic.) They'll find it more expensive to retain the best talent as it will become increasingly easy for experienced developers to raise startup capital and strike out on their own.

What it all adds up to is that ATVI is facing an industry in transition and it's never easy for a company to undergo - as famed economist Joseph Schumpeter once called it - the "creative destruction" necessary to successfully navigate from one industry model to another. I suspect that there will be some significant bumps along the road, and anyone expecting to hold ATVI for the long term should expect that. It's quite possible that ATVI's place in the new world won't be nearly as dominant as it was in the old.

- TZ

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