Gaming in the Big Leagues


This article features Electronic Arts, Activision Blizzard, and Take-Two Interactive. Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley Fool owns shares of Activision Blizzard.

I love playing games like Call of Duty! It provides me a mind-numbing outlet at the end of a long day (or as a distraction to other things throughout the day). It's because of this intense interest of mine that I came to be attracted to the video game industry. One particular prospect I've kept my mind on over the past couple years has been Activision Blizzard , the maker of popular games like Call of Duty, Skylander's, Guitar Hero, and World of Warcraft.

Company data
Incorporated in 1979, Activision Blizzard has grown rapidly through a combination of profitable operations that have pushed organic growth, as well as a series of mergers, to become a large stand-alone developer of video games with a market capitalization of $19.1 billion. This compares favorably to the market caps of competitors like Electronic Arts and Take-Two Interactive of $8.17 billion and $1.58 billion, respectively.

While a high market cap is nice, it doesn't pay the bills. Rather, we should be most intrigued by the profitability of Activision Blizzard when pitted next to its peers. To begin with, Activision Blizzard has had a phenomenal few years. The company had a return on equity or ROE of -0.9% in 2008, now it boasts an ROE of 10.2% for its most-recent fiscal year. Likewise, net margin has improved considerably, going from a loss of 3.5% in 2008 to a gain of 23.7% in 2012.

Although the company's revenue has grown at an annualized rate of about 12.6%, the vast improvement in its bottom line appears to have been driven by a combination of lower R&D expense as a percentage of sales (which is mildly disconcerting), and lower cost of goods sold or COGS as a percentage of sales. To see the trend, check out the table below:

Personally, I am a little concerned about the company's R&D because I would expect an industry leader to increase R&D expense, especially when Electronic Arts, a company with only 78.2% of Activision's sales, spent nearly twice as much as Activision in 2012 on R&D.

Cost of goods sold
More interesting though is the company's COGS as a percentage of sales. What we see is that, since at least 2008, this ratio has been on a constant decline. When I looked through the company's annual reports, I found that a good portion of this decrease in COGS as a percentage of sales is derived from the sale of products that require less hardware peripherals (primarily Guitar Hero), as well as lower amortization costs related to capitalized software development, and intellectual property licenses.

Although the intellectual property licenses are pretty self-explanatory, the capitalized software-development amortization deserves a bit more explanation. Essentially, when a company develops software, it can usually write off a portion immediately, but some of the software costs need to be capitalized (i.e. added together almost as though it's a tangible asset) and amortized (think depreciation but for intangible assets).

If a company writes down these capitalized expenditures entirely over time without adding to them through the development of more software, then the lack of these expenses will increase the company's net income but will not increase the company's free cash flows. This would explain why we haven't seen much of change in Activision's cash generation over the past few years, but have seen its ROE and profit margins increase.

A look into the future
Moving forward, this could mean one of two things. If the company requires little or no additional software expenditures to stay competitive, its margins should continue to increase until all of its software development costs that have been capitalized are amortized.

The second scenario is that the company could require additional capital in order to develop more sophisticated systems due to competitors successfully catching up and threatening profitability. While most companies, who are in a market-leading position, would prefer the first option, the second option is more likely to occur due to competitive pressures. This suggests Activision's future free cash flow may be temporarily impaired.

Despite the future investments the company will have to make in an effort to stay competitive, its underlying business is sound. Every year, Call of Duty breaks the record for most sales of the year, while most of its other games perform well. Additionally, the company's five-year average free cash flow margin is about 22.1%, while it has a five-year average current ratio of about 2.16 and practically zero debt.

In juxtaposition to this, Electronic Arts has a five-year average free cash flow margin of 1.8%, while Take-Two Interactive Software's is about 5.9%. Furthermore, the five-year average current ratio for Electronic Arts is 1.67, vs. the five-year average current ratio of Take-Two Interactive of 2.43. This signifies that, while Take-Two Interactive has liquidity that is comparable to Activision Blizzard, it lacks the same level of profitability, while Electronic Arts lacks both. Simultaneously, both companies have debt, but with a five-year average long-term debt/equity ratio of 0.09 for Electronic Arts and a 0.33 ratio for Take-Two Interactive, suggesting they are solvent.

Looking at Activision and comparing it to its peers, you will notice that the company's fundamentals are, indeed, superior to Electronic Arts and Take-Two Interactive. Not only is it more profitable; it's also growing at a fair pace and generates a steady stream of cash.

However, the Foolish investor should keep in mind that future expenditures for additional software development will likely be required, which could temporarily impair its bottom line. But, any expense will be short-lived if the company can continue to develop blockbuster games.

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Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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