When deciding where to invest your hard-earned money, identifying companies with a competitive advantage is crucial in a hypercompetitive world where businesses are constantly trying to gain an advantage over the other to capture market share. When you find a company that consistently earns high-profit margins year after year, you have likely found a business that has something that competitors can't match -- what Warren Buffett calls a "durable competitive advantage."
Mastercard (MA 0.53%) and Activision Blizzard (ATVI) are two such companies. Let's take a look at the qualities that make each worthy of your portfolio.
Mastercard wants to make it as easy as possible to use its cards anywhere and however, customers want. Image Source: Mastercard.
Mastercard
Mastercard's revenue grew 11% in 2016 to $10.7 billion, primarily from collecting a small transaction fee every time a cardholder uses one of its branded cards for payment. In the last quarter, Mastercard processed 14.7 billion transactions, an increase of 17% year over year. The company also offers value-added services like security, consulting, and data analytics to supplement its revenue from processing credit card transactions.
Mastercard's vast processing network is difficult for competitors to duplicate. The network is also very inexpensive to maintain, given Mastercard's extremely high margins.
| Year | Pre-Tax Profit Margin |
|---|---|
| 2016 | 52.4% |
| 2015 | 51.3% |
| 2014 | 53.8% |
Data source: 2016 annual report.
Right now, the main focus of the company is to spread its brand outside of the U.S., where Mastercard has a lot of growth potential in markets such as the Middle East, Asia-Pacific, and India. These markets were key contributors to the company's first-quarter growth in processed transactions. About 85% of the world's payments are still conducted via cash and check, which is a big opportunity for Mastercard as e-commerce continues to grow and more people migrate to electronic forms of payment, including the use of credit cards.
The stock is not cheap, sporting a price to earnings ratio of 29 times 2017 expected earnings. In fact, it rarely sells for less than 25 times earnings. Mastercard deserves a premium valuation given its nearly impossible-to-duplicate processing network, brand, and the long runway of growth ahead.
Overwatch has been a global hit, reaching 30 million registered players in a year. Image source: Activision Blizzard.
Activision Blizzard
According to Nielsen, 64% of the U.S. population 13 years of age and older are gamers, and Activision Blizzard's games are arguably some of the most fun and enjoyable to play. Its latest hit, Overwatch, has reached 30 million registered players across the world in the first year since its release. Other games that have attracted millions of loyal players include Destiny and World of Warcraft.
Ever heard of Candy Crush? Yep, Activision owns that too.
When a gamer fires up a game and sees the Blizzard Entertainment logo, they know what they are in for. Activision Blizzard knows what gamers want and it delivers again and again, which has helped the company build one of the most recognized brands in the industry. The company has eight franchise games that have achieved $1 billion in lifetime sales. Players spent about 40 billion hours in Activision Blizzard's games over the past 12 months.
In recent years, more of the video game industry's revenue has come from digitally distributed content. Gamers can buy Overwatch for $59.99 (the standard price of a new game), and, over time, as players stay engaged with the game, they may want to buy in-game "loot boxes" that provide new outfits and other extras for in-game characters. These loot boxes cost from $1.99 to $39.99, depending on how many boxes you want to buy. The growth of revenue from in-game content, like loot boxes, is a key reason why Activision's non-GAAP operating margin has increased from 30% five years ago to 35% in 2016 because the cost to provide this content is nothing compared to the cost of creating the game itself.
| Company | Operating Margin (Excluding Stock-Based Compensation) |
|---|---|
| Activision Blizzard | 32.8% |
| Electronic Arts | 27.7% |
| Take-Two Interactive | 11.5% |
Data source: Annual report and quarterly earnings releases. Operating margin calculated using non-GAAP data excluding stock-based compensation.
In 2016, sales of in-game content made up 54.5% of the company's $6.6 billion in total revenue. In-game revenue jumped 126% in 2016, helped by the successful launch of Overwatch, which continues to gain millions of new players every quarter.
Digital revenue's growing importance is why player engagement is one of the most important metrics to evaluate video game companies. The more fun gamers are having, and the more time they spend with a game, the better chance they will spend additional money on in-game content.
As with Mastercard, you will have to pay up to own a piece of Activision. The stock's P/E ratio is currently about 30 times 2017 expected earnings, but this is another company worth shelling out for. In the future, look for further upside to margins from digital revenue growth. In addition, Activision Blizzard has adjacent growth opportunities in esports and consumer products that could build Activision into a global interactive entertainment powerhouse.
