Wall Street is a fan of gaming these days. Activision Blizzard (NASDAQ:ATVI), the video game industry's leading publisher, has trounced the broader market by notching 21% growth so far in 2018 compared to a 3% gain for the S&P 500.
Following the company's 75% spike last year, it's tempting to call the rally overdone. After all, Activision's key audience size growth metric has been trending lower for more than a year. But there are more reasons to be bullish about this business than to think its best days are behind it.
Changing the game
At a glance, Activision's latest earnings results might not appear strong enough to support the head-turning gains the stock has posted this year. Sales rose by a modest 14% in the first quarter as the publisher's pool of active players dropped to 374 million from 385 million in the prior quarter.
Yet beneath those broader trends, there's evidence of a strengthening business. Both the Activision and Blizzard publishing arms protected their audience sizes last quarter, for example, even though there were no major content releases in tentpole franchises like Call of Duty and World of Warcraft. That success is a direct payoff of the company's diversification strategy that's added several new hit brands, like Overwatch and Hearthstone, to Activision's portfolio in the past few years.
Gaming franchises are becoming fundamentally more valuable, too. Activision is selling a greater portion of its games directly through online sales channels, and that's raising its initial profit margins. Yet the bigger payoff comes down the line as microtransactions, and routine content releases keep gamers engaged for many months after the title's initial release.
As a result, Activision doesn't have to rely entirely on the bump in sales around a game's launch to generate most of its returns. Instead, it's shifting to a "games-as-a-service" business model that benefits from both higher profit margins and a smoother growth profile.
Risks and outlook
Those improvements don't free the company from the burden of producing a steady stream of innovative content that resonates with gaming fans. There are many ways to fall short in this respect, too. Rival Electronic Arts (EA) sold about 1 million fewer copies of its Star Wars: Battlefront title than management had projected last year, for example. There's always the risk that one or more of Activision's major annual releases stumbles in the same way.
Yet EA still managed impressive operating and financial results last year, which demonstrates just how favorable the sales environment is in the video game industry today. And as the market leader, Activision is in even better position to benefit from bigger trends like the shift toward digital spending and the rising popularity of video gaming as a spectator sport.
CEO Bobby Kotick and his team lifted their 2018 outlook slightly in May, and that modest uptick was a reflection of the fact that a disproportionate amount of Activision's earnings this year will come in the latter half when new franchise installments are released in brands like Call of Duty and World of Warcraft.
A cautious investor could look at that seasonality risk as a reason to hold back on buying shares today, especially given Activision's rally over the last few years. On the other hand, that surge has been supported by fundamental improvements to the developer's portfolio in its business model and growth prospects. These changes, by powering long-term earnings gains, could easily keep Wall Street playing catch-up on this high-flying stock.