Although there were nearly 400 companies lighting up acres of convention floor space with sights, sounds, and plenty of over-the-top glitz at this year's Electronic Entertainment Expo (E3) in Los Angeles, David Gardner and I had our unwavering sights set on Activision Blizzard (Nasdaq: ATVI). Activision owns some of the best video game properties on the planet, has a fortress-like balance sheet, and is on the verge of what may turn out to be its best year ever for new releases.

Yet Activision's stock has languished over the past couple years. That's despite the company delivering the single biggest game ever, Call of Duty: Modern Warfare 2, generating more than $1.5 billion in cash flow, and returning more than $1 billion to shareholders in share buybacks and dividends. What's keeping Activision down?

That's just one of the questions we asked Thomas Tippl, Activision Blizzard's chief operating officer, when we interviewed him at E3. Tippl joined Activision in 2005 as its chief financial officer and assumed his current role after the company's merger with Vivendi's Blizzard in 2008. Read on for his thoughts on:

  • Activision's biggest opportunity over the next 12 months
  • Microsoft's (Nasdaq: MSFT) new, must-have Kinect device and the future of innovation for video game hardware
  • The numbers he watches, what it's like working with CEO Bobby Kotick, and the true motive behind Activision's merger with Blizzard
  • Gaming in the cloud, and why Cataclysm could take World of Warcraft to even bigger heights
  • And, of course, Activision's beaten-down stock

First things first
Matt Argersinger: Great to meet you, Thomas. What is the single biggest thing for you for Activision over the next 12 months?

Thomas Tippl: It's definitely a very dynamic industry and an industry where you have to be very fast on your feet. I think that's been one of Activision's hallmarks. We have never traveled hopefully. We've always focused on where the opportunities are and quickly shifted our resources, in terms of development talent, marketing dollars, capital, against those biggest opportunities.

It's tough to pick out one thing that's the biggest, because I think we've got a whole portfolio. I don't know if I should go alphabetically or by timing, to make sure none of my children feels mistreated. [Laughter.] But obviously next on deck is Starcraft II in July, which has been so highly anticipated. The beta is going extremely well. We're very excited about bringing that franchise back and, with that, the complete revamp of Battle.net, which I'm not sure is that well understood.

For the first time, you have the whole Blizzard community united on one portal into their games through the same PC online gaming portal. For the first time, you'll be able to use real-life ID, like in Facebook, so you'll be able to track down your friends. For the first time, you'll be able to communicate across games. If you're part of a guild, a group, a team in World of Warcraft for example, you can send a message to your buddies in Starcraft and vice-versa. So they can join you for a 30-minute match in Starcraft, and then you can join them for a raid [in World of Warcraft]. We think that provides an enormous opportunity to provide all games for the Blizzard community. I think this is a phenomenal opportunity right out of the gate. And then obviously, as Diablo III gets ready, it's another opportunity for this platform.

So Blizzard is going to be huge. We have an incredibly talented development team there. It's one of the best organizations in video games.

David Gardner: Thomas, let me just ask briefly about Battle.net. In addition to being an investor, I'm a longtime video game player, so I've played pretty much all Blizzard games. Now, when I was playing Diablo II, I was coming through Battle.net, was I not?

Tippl: You were for Diablo, but not for World of Warcraft. World of Warcraft -- 11.5 million subscribers -- did not go through Battle.net. Now, everybody goes through Battle.net, and everybody will be able to communicate across all the games.

Argersinger: Staying with the online theme, there seems to be a slew of new free-to-play MMO (massive multiplayer online) games -- Perfect World (Nasdaq: PWRD) and a few other companies out there -- at E3 this year. How does Activision respond? What's the competition like from that?

Tippl: Most of the free-to-play games are relatively basic. Games like Farmville have attracted a lot of casual players, and this is part of the reason why the more casual console market [such as the Nintendo Wii] has come under pressure. But this isn't impacting games like Call of Duty. Call of Duty is getting played more hours than ever. We sell more copies than ever. Since the launch of Call of Duty: Modern Warfare 2, 25 million people have played. We're going from strength to strength.

And what we're doing on the online front, and coming back to some of the opportunities I mentioned earlier, you think about the fact that we really haven't done much yet on the online content side. If you compare to what we've done on Call of Duty so far, we've only really focused on downloadable content. Now over the last 12 months we've done a lot of research on what else that player community wants to see in terms of product features, gameplay modes, online services. We're now working on putting that into a package to enhance the online experience of our games. You will see and hear more details about that once we get closer to launch, but it's an enormous opportunity where we can do a much better job -- just like Blizzard did -- on providing the community all of their unmet needs, enhancing what they already love about the game, and giving them no reason to leave the Call of Duty franchise during the course of the year to play something else because they don't get the fresh content, or continued innovation on gameplay, services, characters, weapons, and so forth.

So there's a big opportunity for us to take a lot of the elements that are working so well for Blizzard and apply them to Call of Duty. One of the most obvious examples is that so far, we force the Call of Duty player to start over every year with their character. If you think about it, that's crazy. So these types of changes aren't difficult to make and make a whole lot of sense.

Microsoft's big move
Argersinger: The Kinect device from Microsoft seems like it's probably, at least for this holiday season, going to be the killer game console to have. Any response to that from Activision?

Tippl: Yes, I think that's great to see a lot of new technology innovation happening from the first parties [the console makers]. It reignited the buzz in the industry. There's a lot of marketing investment that the first parties are going to put against that, which gets people to engage, particularly the ones that haven't played as much lately. It gives them a reason to re-engage with new products.

I think a lot of the success will depend on where the price points are going to land, because we've seen that in our own peripheral business. Consumers are cash-strapped, unemployment rates are high. So you need to have very sharp price points to make sure you can drive a large enough installed base. If they price it right, and they support it like I know they will from a marketing perspective, then I think it has great potential.

The view from inside
Argersinger: So you recently became the COO of Activision Blizzard, and you were the CFO, I believe, for four years prior to that?

Tippl: Yes, I was the CFO for three years, then the chief corporate officer overseeing all corporate functions, including HR, legal, IT, finance, and strategy. And now I'm also overseeing the rest of the business, so to speak -- the Activision publishing business and Blizzard.

Argersinger: Is there one financial metric or operating metric that you pay attention to the most in your roles -- that you look at routinely to see how Activision is doing?

Tippl: We've always been very focused on operating margin expansion, to create leverage in this business, and so I'm very focused on profitability. I'm also very focused on cash flow. I review cash flow performance every other week. So we're very focused on profitability and cash flow.

Gardner: What is it like working with Bobby Kotick -- and what would Bobby say it's like working with you?

Tippl: Well, you should ask him about that! [Laughter.]

Gardner: Well, I can at least get half of it. [Laughter.]

Tippl: Working with Bobby is great. I have not met many entrepreneurs who have the vision that he has, that have the insatiable desire to raise the bar every time. Where nothing is ever good enough. Where you go to the office and you know you'll never be bored. Bobby has incredible vision, unbelievable energy. Activision Blizzard is his job, his hobby, and his sport. That's the kind of environment that appeals to me, because I'm very passionate about what I'm doing, and so is he. So I love working with him.

Gardner: What precipitated the Blizzard thinking? Where did the idea of merging come from?

Tippl: I remember very vividly, because it was in the summer of 2006, when we did a three-year strategic planning exercise. We looked at what are the growth plans for our internal franchises. As part of that strategic planning, we looked at what external growth opportunities that might allow us to achieve our objectives faster or exceed them. As part of that, we looked at all the market segments, such as the MMO segment as one that we weren't in. As we were analyzing that business we realized  [World of Warcraft] had about 5 million subscribers, times $15 per month, times 12 months -- wow, that's a helluva business!

Then we started peeling back the onion and understanding that it was a community that required a lot of back-office infrastructure, and all the complexities around customer service, credit card management, fraud prevention, the fact that no Western company had had any success in Asia. So we looked at this and said, well, it's probably not a smart idea to do this ourselves. We concluded there would be no financially responsible way to participate in what was / is the most attractive part of the video game industry. That was the origin of starting conversations with Vivendi.

Argersinger: There's been lots of buzz about OnLive, which actually goes live tomorrow. Your thoughts on the cloud gaming business, what that means for Activision? Could we be facing a console-free video game industry a few years down the road?

Tippl: Not if you want to play Call of Duty. Sixty frames per second. I'm not confident you'll see that soon. I do think you'll see continued technology innovation, and I do think OnLive can work for a number of games. How their business model is going to work remains to be seen. It seems that they've already made some changes from what I've read briefly.

For us, we think the big opportunity for a number of our franchises is in an environment where the PC is connected to the TV, where you do have a local hard drive space. And there are a lot of companies putting resources to that end, whether that's the hardware makers like Dell [Nasdaq: Dell] or HP [NYSE: HPQ], whether that's cable companies trying to figure out how to participate in this growing part of the market, whether it's network providers figuring out how the PC you already have communicate wirelessly with your TV so you don't have to have another piece of equipment in your living room.

There is a tremendous amount of talent and capital currently being applied to find new ways to get consumers connected to an interactive entertainment experience in the comfort of their home. Obviously, Microsoft, Nintendo [Pink Sheets: NTDOY.PK] and Sony [NYSE: SNE] are already there. There's a lot to like from a publisher perspective, to have an open platform, but there's also a lot of value that Microsoft, Sony, and Nintendo provide through their closed and well-protected systems. I don't think any of them are going away. I think you'll see some new options emerging that are going to be either server-based, or a PC-TV solution.

Gardner: I know how the game developers talk about Cataclysm, but how do you see Cataclysm from a business standpoint?

Tippl: I think it's going to be the best [World of Warcraft] expansion pack for Blizzard yet. For the first time, they have gone back and redone the early parts of the game. That will make a huge difference in two ways. World of Warcraft players don't usually just play one character. They go back and start a new character that they're leveling up. They'll have an opportunity to start back and experience the world they are familiar with but with now all the new innovations and graphics quality. Great for existing players.

Even more importantly, what we learned with new players coming into World of Warcraft is that the ones that go and exceed level 10 with their characters are the players that we're likely going to keep. The players that try the game and never get beyond level 10 are those that we are likely losing. So going back and investing and redoing these earlier levels and making those very compelling gives us a great opportunity to increase our trial-to-subscription conversion rates. And that's why I'm very excited about Cataclysm.

Making the stock a winner
Argersinger: So coming from The Motley Fool, we follow Activision's stock pretty closely. We think it's pretty beaten down, think it's a bargain. Is the market missing something, or are we missing something?

Tippl: I'm not in the business of putting valuations on stocks. I'll leave that to Wall Street. What we need to make sure is that we put the points on the board. Stepping back for a second, over the last year we generated $1.2 billion of operating cash flow, which based on our market cap was a 9% cash yield. With a balance sheet that had $3.4 billion of cash and no debt, that looks stronger than U.S. Treasuries, but yielding 9%. And we also distributed a full 9% to our shareholders through our share buyback and dividend -- we actually distributed the full 9%.

So we think we manage the business in a very shareholder-friendly way. We delivered record results in 2009. If we keep doing that, sooner or later, we think, the stock will respond. But today of course it comes down to folks who manage money and the analysts who put their recommendations up.

Gardner: Have you all been waiting for some years to do a dividend? Were you planning or wanting to do that? Is that something Bobby always wanted to do, or was it a newer, surprise kind of thinking?

Tippl: I don't think it really made sense to consider until after we merged with Blizzard. Because Blizzard, with World of Warcraft, has a very predictable subscription business, so predictable cash flow, which made it a worthwhile consideration. Again we listen to shareholders, and not all our shareholders were knocking on our door saying they wanted a dividend, but some of our shareholders felt that, based on the Blizzard cash flow model, that we could do it, and that it would attract new investors to our stock that can only buy stocks for their portfolio that offer dividends.

Lastly, I'd say we looked at this as yet another clear sign on how we are different from anybody else in the interactive entertainment industry, and frankly most of the technology industry as well. I think it was well appreciated, our shareholders certainly supported it. It's not a huge dividend at about a 1.5% yield, but another sign that we're different from the rest of the pack.

Gardner: I don't know why the market values things the way it does better than anyone else, but I expect one of the things that might be weighing on the stock is unwinding the World of Warcraft franchise over time. At a certain point, you'll hit a peak user base, and then, presumably, Diablo III comes on line, and you have other answers for people. The process for unwinding the World of Warcraft franchise, is that something you've thought through? Are you still going to be running it 10 years from now, or are you going to have everybody running off on another game in three years? And that's at a scale that's massive, so I'm really curious about that.

Tippl: I think we will have World of Warcraft 10 years from now, and it's going to be a great business. Because it's not just a game you play once, it's really, it's a community, it's a social network, it's where you spend time with your friends. It's not a thing you buy, it's a place you go. We will continue to bring new content to the game, new services to the game, and that's how you keep the users engaged. You can't take it for granted. If you stop innovating, if you stop bringing out compelling content, then you won't be able to grow. But I don't see that happening any time soon. We're very focused on continuing to keep those players happy and I think we have a pipeline that will accomplish that.

Argersinger: Great, Thomas, thanks very much for your time today.

Tippl: You're very welcome.

For the full transcript of our interview with Thomas Tippl, as well as our special reports covering The Fool's trip to this year's E3, take a free 30-day, no-obligation trial to Motley Fool Stock Advisor. Don't forget to sound off in the comments section below and let us know your take on what the future holds for Activision and the video game industry.

Fool analyst Matt Argersinger compiled this article and has written puts on Activision Blizzard. Activision Blizzard and Nintendo are Motley Fool Stock Advisor recommendations. Microsoft is an Inside Value recommendation. Perfect World is a Rule Breakers pick. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Activision Blizzard. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.