Videogame Makers are Seeing Bigger Returns

What do you do when revenue is slowly growing? Expand your margins. Electronic Arts see's its revenue rising from $1.66 billion in 2013 to $1.7 billion in 2014, yet it's forecasting explosive profit growth.  

Margin expansion
Electronic Arts operating expenses have been creeping up for the past 3 years, but for 2014 it wants to reduce operating expenses as a percent of revenue from 56% to 53%. This, combined with a switch to more digital sales, is going to boost its operating margin to 13% (from 10%), which will increases its operating profit to $504 million from $367 million. That works out to be a 37% growth rate.

37% profit growth, with only 2% revenue growth, is quite an accomplishment, and shows investors how managing your costs can significantly increase your bottom line. This also indicates that if Electronic Arts can find some revenue growth it will be able to generate more cash flow.

Finding revenue growth
To find revenue growth, it plans on launching several reiterations of past franchises to appeal to existing customers. One of those blockbuster entrants is Battlefield 4, which is due on Oct. 29.

The Battlefield franchise has been enjoying strong growth as consumers see it as an alternative to Call of Duty. Battlefield Bad Company 2 sold 6.74 million copies, then Battlefield 3 sold 16.12 million copies. Battlefield 4 should beat that and could top 20 million copies, if its a good game and next-generation consoles boost consumer interest.

Battlefield rewards Electronic Arts in two ways. The first is that it's in high demand and sells for $60. The second is that it will offer plenty of downloadable content, which will bring in even more money for EA. If consumers enjoy the game, there is a good chance they will purchase some or all of Battlefield's additional content. For Battlefield 3 roughly 25% of gamers purchased Battlefield Premium, which is an additional $50. Battlefield 4 should see similar success. 

Electronic Arts isn't the only game developer benefiting from margin expansion, though; Activision Blizzard is also focusing on maximizing its revenue stream.

Switch to digital sales
In 2009, Activision earned 27% of its revenue from digital sales, which has a gross margin of 58%. As of Activision's latest quarter, 37% of its revenue came from digital sales with a gross margin of 74%.

Looking ahead, digital gross margins should remain between 70% to 75%, and digital sales should keep increasing. One reason is by allowing its popular Call of Duty games (and other titles) to be purchased online, such as on the Xbox Live Marketplace. In Activision's latest quarter it noted that digital sales for its latest Call of Duty game had earned a record for digital sales and engagement.

When Call of Duty Ghosts comes out it will also be released with several expansions that are released through the year-long life cycle of the game. If a gamer purchases all 4 DLC's (assuming Activision releases 4 DLC's like it did in COD: Black Ops 2) then Activision rakes in an additional $50 to $60 a pop and sees a boost in margins.

Plus you should expect that many copies will be sold online due to lower levels of preorders coupled with record engagement, which is due to gamers waiting for the new consoles to come out. Once the consoles come out, some gamers will probably set up the Xbox marketplace and buy the game online.

Activision's switch to digital sales will propel earnings due to higher margins, which enables it to maximize its revenue stream. Another company trying to maximize its margins is Zynga .

Anyone who follows Zynga is aware of the numerous problems it has been facing as its games drop in popularity, with Zynga's monthly users declining by 13% in its first quarter. To compensate, it is reducing headcount. In June, Zynga laid off 520 of its workers to save $70 to $80 million annually. This comes on top of a 5% reduction in its workforce last year.

Cost controls are only part of the equation; companies need revenue growth. In Zynga's second quarter, it saw web bookings go down 44% year over year as its second biggest franchise, Zynga Poker, faced increased competition. This, combined with other factors, led to second quarter revenue decreasing 31% year over year.

Zynga was originally going to peruse online gambling, but has since left that strategy to focus on more traditional games. This is why I think Zynga is a bad investment, as falling revenue forces more and more job cuts, and the chance of growth in revenue disappears. Dozens of games have already been canceled to help the company save money.

Zynga does have $1.5 billion in cash, but that was down $138 million from the first quarter. As time goes on, Zynga's cash hoard will be slowly decrease, and its value will erode.

Final thoughts
Maximizing revenue streams will yield major benefits for both Activision and Electronic Arts. Both should see larger cash flows, which will enable them to invest in the business through share buybacks and other capital investments. Zynga is trying to maximize its shrinking revenue, but if it can't find another source of growth like Farmville or ZyngaPoker,it is doomed to fail.

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Callum Turcan has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard. 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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