The video game industry was on fire in 2018 with esports and whole new genres (such as battle royale) taking center stage. However, shares of Activision Blizzard (NASDAQ:ATVI) took a beating toward the end of 2018, as economic concerns swept across the market. Investors got extra-cautious about Activision when management reported during the third-quarter earnings conference call that some games are not performing well.
Eventually, a growing industry should pull Activision out of its slump. Let's review three metrics that provide an overview of the company's challenges in the short term, and show why shareholders should stay the course with this leading game maker.
Some games are doing well, others not so much
One of the most important metrics the company reports every quarter is monthly active users, which is a measure of how many people are playing the company's games. Here's a look at the recent trend:
|Segment||Monthly Active Users (millions)|
|Q3 2018||Q2 2018||Q1 2018||Q4 2017||Q3 2017||Q2 2017|
As I've explained previously, the decline in King users is due to less engaged players leaving the installed base. King continues to generate stable revenue and operating income each quarter, driven by the strong performance from the Candy Crush franchise. Candy Crush Saga was the top-grossing title in U.S. mobile app stores during the third quarter.
The recent decline in Blizzard users is concerning, but 37 million is still higher than the 26 million users Blizzard reported before Overwatch released in May 2016. However, Overwatch is already showing signs of cresting its peak, since the company credited the year-over-year decline in Blizzard MAUs to lower user numbers for Hearthstone and Overwatch. Keep in mind: Overwatch was one of four games that generated two-thirds of the company's revenue in 2017.
President and chief operating officer Coddy Johnson mentioned on the third-quarter conference call that while some franchises, including Call of Duty, World of Warcraft, and Candy Crush, were performing well regarding player engagement, "not all our franchises are experiencing the momentum we see in Call of Duty and Candy Crush." Overwatch is likely one of those underperforming games.
I wouldn't worry about the decline in the total MAU number, especially since in-game spending across all the company's games continues to hover over $4 billion annually. Instead, I would keep my eye on the trend in Blizzard MAUs. The second season of Overwatch League is ramping up in February, and Blizzard is always working on updates to its games to improve the gaming experience. A big update to Overwatch, for example, could bring players back to that game, causing a bump in MAUs for the Blizzard segment. That would be an encouraging sign for investors, especially with the competition from other games in the marketplace like Fortnite.
Revenue growth could accelerate again
Overall, operating performance through the first three quarters of 2018 was solid, but growth on the top line was slow last year. We'll see how the fourth quarter turned out when the company reports earnings results on Feb. 12. Management anticipates record revenue of $7.355 billion for the full year on a GAAP (generally accepted accounting principles) basis, and $7.475 billion on an non-GAAP basis.
In the above chart, note the sharp upward swing in revenue in 2016 followed by flattish growth over the last two years. The company got a boost to its top line following the $5.9 billion acquisition of King Digital Entertainment in 2016, but investors need to have confidence that the company can keep growing revenue. This is especially important because Activision hasn't released a new franchise since Overwatch in 2016, and as discussed above, the game has already started to show signs of peaking.
The fourth-quarter conference call could provide clues about how 2019 will shape up for the company. Activision has been starting to target the mobile game market more than previously, as noted by the announcement in November of a new mobile version of the classic Diablo franchise.
Plus, Activision has a partnership with Tencent to launch a mobile version of Call of Duty in China. China is the world's largest gaming market, and mobile esports is getting popular in the Middle Kingdom. During the last conference call, CEO Bobby Kotick said, "We have an exciting future plan for Call of Duty players, including our new Call of Duty professional player opportunities and lots of exciting new content in 2019 and beyond."
I wouldn't be surprised if the company's next big moneymaker from the Activision or Blizzard segment is a mobile game.
Growing dividend payout
It's clear Activision faces some challenges in the year ahead. The company must guard its user base against the onslaught of Fortnite, which continues to remain the most popular game in the industry even after Activision's release of Call of Duty: Black Ops 4. At the same time, Activision needs to grow viewership for Overwatch League for it to be a significant and stable revenue generator for the company over time.
Despite these obstacles, the company has a solid financial position and pays out an annual dividend to shareholders. Activision generated $1.78 billion of free cash flow over the last year. On a per-share basis, Activision has grown free cash flow 120% over the previous five years. That growth in free cash flow has fueled an annual increase in the dividend since 2010, as you can see in this chart:
As noted by the blue line in the above chart, the company paid out 14% of its free cash flow as dividends last year. Because of that low payout ratio, Activision can continue raising the dividend even in years when free cash flow doesn't increase.
A few final words
My colleague Keith Noonan believes Activision Blizzard could potentially double within the next two years. I own shares of Activision and share his optimism.
Ultimately, a growing industry and more people playing games will create growth opportunities for the leading companies in the industry that have the cash to spend on new game development and other initiatives like esports, merchandise, and cinematic experiences.
For these reasons, I expect Activision Blizzard to be a more valuable company in 10 years than it is today.