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The 1 Thing You Should Know Before You Buy Activision Blizzard Stock

By John Ballard - May 28, 2021 at 10:39AM

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The shift to digital distribution of games will benefit this top game company for a long time.

Activision Blizzard (ATVI 0.63%) has enjoyed tremendous momentum in the Call of Duty franchise over the last year. Since Call of Duty: Mobile launched in October 2019, the stock has returned 82%. 

Still, over the last four years through the end of 2020, Activision Blizzard's revenue has only increased at a compound annual rate of 5.2%, or a cumulative increase of 22%. Management is guiding for revenue to improve by just 3.5% in 2021. Those are not the rates of a typical growth stock.

However, a closer look at the numbers reveals more growth brewing under the surface. From 2016 through 2020, revenue from digital channels (subscriptions, sales of in-game content updates, microtransactions, and other downloadable content) grew 8.2% per year. Digital sales mean a lot less cost to package game discs, which has led to record margins for the game producer.

The one thing investors should know is this: Even once the shift to digital distribution is complete and all gamers are buying games directly over their consoles, Activision Blizzard could still see further improvement to its profit margin over time, and it may actually see better revenue growth. Here's how.

Two gamers celebrating while playing a video game.

Image source: Getty Images.

Activision's operating margin is incredibly high

The percentage of Activision Blizzard's revenue that comes from digital sales channels, including downloaded games, subscriptions, in-game spending, and advertising, climbed from 73.6% of revenue in 2016 to 82.3% in 2020. 

This shift has significantly improved Activision's operating margin. In the first quarter, digital sales made up 88% of total revenue, pushing Activision's adjusted operating margin to 43%, which is in the same league as big tech giants like Alphabet and Facebook

At first glance, it might appear that Activision is just experiencing a displacement of retail revenue shifting to digital channels. If that's the case, Activision's margin improvement will eventually run its course, and at 43%, how much higher can it go? If Activision doesn't continue to drive higher margins, growth in profits will slow, and that could limit the long-term returns from the stock.

But it's not just retail displacement that is driving the growth in digital sales and margins.

Since 2016, annual revenue from the retail channel has fallen nearly $700 million. But over the same period, annual digital revenue rose by a far greater amount to a tune of $1.79 billion. That shows Activision is experiencing genuine growth, and no, it's not due to new players coming to the company's franchises, so what is going on?

More content releases are a big growth catalyst

Since 2016, monthly active users declined from 447 million to 397 million through the end of 2020. Activision achieved record revenue levels last year, so it's generating more revenue per monthly active user, and the company says this is tied to digital sales trends.

Because of the lucrative margins from digital distribution, all the big game companies have made a push to offer year-round content updates for existing titles. This is a top strategic priority for Activision Blizzard and its peers across the video game industry

And here's the most important takeaway: In its 2020 annual report, Activision Blizzard says that "if executed properly, additional player investment can increase engagement, as it provides more frequent and incremental content for our players (emphasis by author)." 

Since frequent content updates can lead to more opportunities for players to spend money on a title, it's possible that Activision could experience an acceleration in sales growth down the road. It's possible this might happen once the slower-growing retail channel sales are phased out, but there are other factors at play too.

Activision could squeeze more profit margin out of its existing users since it wouldn't have to spend as much on marketing to acquire new players. Plus, it would be able to scale its fixed costs of making games over a wider player base that purchases new content for the same titles.

This is why management is on course to hire 2,000 new developers by the end of next year. There's still tremendous value to create for shareholders by pumping out more content for players to purchase while playing.

Because Activision is still in the process of reworking other franchises with more content updates and new mobile versions of older franchises, its digital growth and margin improvement are likely far from over.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. John Ballard has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (A shares), Alphabet (C shares), and Facebook. The Motley Fool has a disclosure policy.

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