Activision Blizzard (ATVI 0.10%) is one of the world's largest game makers, having generated $7.5 billion in revenue last year. Millions of gamers all over the world play its franchises, including World of Warcraft, Call of Duty, and Overwatch.
Despite delivering a record year in revenue and profits in 2018, Activision Blizzard stock dived 35% after player engagement and spending in some of the company's core franchises softened toward the end of the year.
The recent drop in the stock price may have some investors wondering whether the stock is right for their portfolio. The company's recent performance has been uninspiring for sure, but as a shareholder, I plan on holding my shares for a long time. Here's why.
The industry has come a long way
Overall, the video game industry is a much lower-risk place to invest than it was 20 years ago, when game companies relied on hit releases sold at brick-and-mortar game stores to drive growth. Thanks to fast internet speeds, Activision and its peers have evolved to a live operations strategy, which involves releasing a game that gains a wide following, and then distributing a stream of new in-game updates that players can purchase to keep enjoying the same game for longer periods. This approach has allowed game companies to smooth out the revenue from a single game over years, and because more games are being downloaded directly to console or PC, profit margins have improved in the process.
Activision makes some of the most popular games in the industry, but obviously that hasn't been enough to keep the company's growth up. Activision has grown revenue and free cash flow by 68% and 461%, respectively, over the past 10 years. But over the past year, trailing-12-month revenue slid 17%.
Activision Blizzard can turn itself around, but it must increase the pace of delivering new in-game updates for its franchises. The main risk Activision faces is that, with so many entertainment options these days, games eventually get stale if there isn't enough content releasing throughout the year to keep games fresh and players engaged.
Adapting to changing conditions
Activision Blizzard has been quick to make changes when things aren't working out for the company. Years ago, the company canceled development of Guitar Hero when that once popular music game was no longer generating acceptable returns on investment, and management just recently made the same decision with the Destiny franchise, selling back the rights to that title to game developer Bungie.
Executives were quick to recognize last fall that the company wasn't growing as fast as the rest of the industry, which grew 13% last year to reach $140 billion, according to management's estimate. Activision Blizzard is currently undergoing a process to cut unnecessary expenses and redirect resources to its most popular franchises to release more content at a faster pace.
At this point, there's a lot of bad news baked into the stock price. The stock now sports a forward P/E of 21.6, compared with a forward earnings multiple of 29 a year ago, before the company ran into the recent player engagement issues. The current valuation reflects the expectation that Activision Blizzard will report lower revenue and profits this year. The game maker expects revenue to be $6.025 billion, down from $7.5 billion in 2018, but part of that drop is due to the removal of Destiny from the company's operating results.
However, analysts currently expect the company to return to growth in 2020. Investors should note that next year is the expected launch of a new generation of consoles from Sony and Microsoft. In the past, the transition to new consoles temporarily slowed sales of games, as gamers held back on spending to save up for a new $400 console.
It's unclear what impact the new console launches will have on game sales, because of the tendency of players to stick with the same titles for several months at a time. This trend could make next year's transition a lot smoother than in years past.
The stock remains a worthy investment
Looking at longer-term trends in the industry, there are several reasons to like Activision Blizzard. For one, there are more people playing games than ever before. Plus, the industry is growing at a nice clip, and with total sales in the gaming industry estimated at $140 billion -- which reflects game sales across all platforms -- Activision could gain more share of that spending over time.
In addition, Activision Blizzard has strong financial fortitude, with about $2 billion in net cash and $1.6 billion in annual free cash flow. The company certainly has the resources to make improvements to content development, hire talented game designers, and get the company growing again.
Over the past 20 years, the stock has returned 3,820%, annihilating the S&P 500's 123% return. That outperformance is directly correlated to a track record of consistently making games that have attracted over 300 million monthly active users to date.
As we've seen with Activision recently, operating performance for video game companies can be bumpy, but the long-term opportunities to capture more share of spending in a growing industry and expand into adjacent markets such as esports and consumer products should keep Activision a solid investment for many years.