Is Activision Blizzard Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Activision Blizzard (NASDAQ: ATVI) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Activision's story, and we'll be grading the quality of that story in several ways:

• Growth: are profits, margins, and free cash flow all increasing?
• Valuation: is share price growing in line with earnings per share?
• Opportunities: is return on equity increasing while debt to equity declines?
• Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at Activision's key statistics:

ATVI Total Return Price data by YCharts

Source: YCharts.
*Period begins at end of Q1 2010.

ATVI Return on Equity data by YCharts

Source: YCharts.
*Period begins at end of Q1 2010.

How we got here and where we're going
Activision Blizzard slays six out of nine of our tests today, but those three bosses could fall in the future. One of its falling grades only happened because net income has far outpaced free cash flow during our tracked period -- however, the company's trailing 12-month free cash flow is actually higher than its net income. Activision's shares have made an impressive comeback this year, and have finally reclaimed the multi-year highs left behind early in 2008. This is a strong performance, but can Activision keep up the progress? Let's dig a little deeper to find out.

Activision's success largely depends on its ability to consistently land new games on top-seller lists. New games for its top four franchises -- Call of Duty, World of Warcraft, Skylanders and the Diablo/StarCraft duo (the two are released infrequently enough to count more as one annual-esque franchise for the games titan) -- produce the vast majority of Activision's earnings. The one-two punch of Skylanders: Spyro's Adventure and Skylanders Giants earned Activision sales in excess of $1 billion sales for 15 months. Its Starcraft II expansion pack Heart of the Swarm also racked up an incredible 11.1 million copies sold in only two days after release.

Activision may have very strong customer loyalty, but it isn't running short on challenges right now, either. Increasing competition from companies such as Disney (DIS 0.16%) and Electronic Arts (EA 1.30%) necessitate new games more often to keep customers' attention. Besides fending off threats to Call of Duty from EA's Battlefield and to Skylanders from Disney's upcoming Infinity, it has to woo back casual gamers, especially in China, which has seen mass defections from WoW in the past year.

That game's subscriber base plunged by 1.3 million users last quarter, pushing WoW down to its lowest subscriber level (though still far ahead of any competition) in over six years. To prevent further losses in China, Activision is making its first jump into free-to-play games through Hearthstone, which aims to extend the Warcraft brand into casual and smaller scale titles. Activision will be licensing the game to NetEase (NTES 1.09%), which already operates WoW in China. EA already succumbed to the free-to-play MMO trend with Star Wars: The Old Republic, and rumors of WoW's impending switch will only intensify now that plunging subscriber numbers are meeting with news that Activision is testing real-money purchases in-game, a hallmark of other free-to-play titles. WoW remains a huge cash cow for Activision, and the loss of significant subscriber revenues continues to be a weight on potential future growth.

Putting the pieces together
Today, Activision has many of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.