Why Investors Should Pay Attention To Activision Blizzard

The gaming industry is crushing it this year, and Activision Blizzard (ATVI), the company behind huge franchises like OverWatch, World of Warcraft, and Candy Crush, is one of the biggest and best-performing players in the space.

In this clip from Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann walk listeners through the fundamentals of the company, how the stock has performed over the last few years, where the majority of revenue is coming from and why that's such a good sign for future growth potential, the most important question marks going forward, and more.

A full transcript follows the video.

Dylan Lewis: Why don't we start out with the big fish in the space, Activision. I think a lot of Fools are probably familiar with this company. It's been a recommendation for quite some time, as you mentioned, going back to 2014. But, I think it's been involved in the premium services for over a decade.

David Kretzmann: Yeah.

Lewis: And gamers might know this company for its Overwatch and Warcraft franchises, among some others. Recent quarter, the company hit new records for revenue, EPS, and cash flow. David, what's been fueling all that growth for them?

Kretzmann: You teed that up nicely. The company, essentially, has three different segments. You have Activision, which is probably best known for Call of Duty and Destiny, those shooter action games. Then, you have Blizzard, which is best known for the online multiplayer games like World of Warcraft and Overwatch. Then, a couple years ago, they acquired King Digital, which is mobile gaming, most famously Candy Crush.

Lewis: I feel like you can see someone playing Candy Crush on any metro commute, it's always there.

Kretzmann: It has some incredible staying power, we can talk about that. The main highlight for me this quarter, that Blizzard segment is really doing well thanks to Overwatch, which is now the eighth billion-dollar franchise in the company's overall portfolio of game franchises. That's pretty incredible for just a year. And it's Blizzard's fastest-growing new franchise ever. It's reached over 30 million players globally in less than a year after launch, it launched in spring of last year. That Blizzard segment, thanks to Overwatch, is doing really well. You're seeing their monthly active user count continue to tick up steadily thanks to Overwatch.

Lewis: This is, in some ways, kind of like the social media platforms we talk about, where there is that MAU number you can look at an addition to some of the more financial metrics, and get a sense of how these platforms and games are doing.

Kretzmann: Yeah, absolutely. One of the things to keep in mind with these video game companies is their quarter-to-quarter results and year-to-year results will be lumpy depending on the timing of a game release. Call of Duty, I'm not sure what sequel they're on, probably seven or eight at this point, but that's obviously huge. Pretty much anything that has Call of Duty on [it] will sell well, even if the reviews aren't all that great. So, that is something to keep in mind. Depending on when you have these new games developed and launched, you will see those numbers ebb and flow. But all in all, you do want to see that user count and overall user engagement continue to tick up over time, because that usually leads to pretty good financial results.

Lewis: In some ways, it's kind of like the movie studio business. You find something that resonates with your audience, and you milk, you keep putting out titles in that franchise, because you know it's a story, or the characters, or a storytelling approach, or something like that, that people just love, and they can't get enough of. So, you see that yearly releases or every other year releases for a lot of these titles.

Kretzmann: Yeah. That's been an overarching theme and revolution of the video game space. If you go back five or 10 years, primarily, you would go into the store and buy the physical disc of the game. In that case, the shelf life of the game wasn't necessarily that long. You needed to get that physical disc in front of customers, whether it was at Wal-Mart or GameStop or wherever. And if you didn't do well at that initial launch, then the shelf life of that game probably wouldn't be too long. But, the shift toward digital, where people are downloading the games, they're able to do microtransactions within the games, they're able to download extra maps or levels of the games over time, then all of the sudden you can buy a game in 2014 and still be playing it today, still be paying money as a player and a user of that game. That's part of the reason why you're seeing the profitability of all of these companies we're talking about today continue to tick up over time, because that digital revenue is high margin. Once you get those users and you're able to continue to engage with them over time, it doesn't cost a lot to sell another map to them digitally, where people can just download over the internet.

Lewis: And you can push updates to those users, too, right?

Kretzmann: Yeah, you're seeing a lot of live events and live updates and things like that. These games are very much a living entity. It's not like you're just buy one physical disc and then that's the only edition you have going forward. It will continue to evolve over time.

Lewis: And you see that in the company financials, too. Looking at the most recent quarter for Activision, online sales were up 50% year over year, and they now make up 80% of revenue, which is crazy. And some of that is the transition to digital away from physical with those games. I think some of that is also the acquisition of the King Digital property, and everything they have under their umbrella. One of the things that is interesting with Activision is, particularly relative to these other video game publishers, they actually have a surprising amount of goodwill on their balance sheet. About half their assets are in goodwill. For people who might not remember, goodwill is an intangible asset often tied to the difference between what you can actually tie value to and what you pay for something in an acquisition. Other times it's brought in with brand value and things like that. They bought King Digital for $6 billion a couple years ago, and that is part of that huge goodwill number. And I think a lot of people are wondering how that acquisition looks and what the property is doing for them.

Kretzmann: Yeah, to me that's the biggest question mark still with the company. When Activision acquired King back in late 2015, and that acquisition was announced, King had about 475 million monthly active users, almost half a billion, which is more than Twitter and a lot of these other social networks, so that's an incredible number. But that slow and steadily ticked downward each quarter up until now, where now it's at about 350 million monthly active users. But there are some bright spots there. The ratio of daily active users to monthly active users, so, essentially, the hyper-engaged users, is at a record high. And the people who are paying for the games are paying more each quarter. So, it's kind of like you have this small but growing base of really engaged people who are just playing Candy Crush like crazy, and they're paying a lot to upgrade through the game, and different things like that. Those people are paying more. That's how management will spin it. But I think overall, the question there is, how easy is it for them to replicate that success with Candy Crush, or is that all it's about. One thing that was interesting in the conference call this quarter was, they mentioned that Activision and King will be partnering up, and they'll look to build a Call of Duty mobile game. I think that could justify the acquisition to me even more than just bringing Candy Crush under your umbrella. But if they're able to use King's expertise in developing mobile games, and transition Call of Duty into the mobile space, that could be really interesting, and I could see that justifying the premium that they paid. Hopefully that would help them avoid having to write down that goodwill and admit that they paid too much for King. So, some things to like there, but for me, that's probably the biggest question mark with Activision, still to be determined.