Activision Blizzard (ATVI: Charts, News), the largest video game publisher in the world, beat Wall Street estimates with stronger-than-expected earnings and revenue last week. The company posted non-GAAP adjusted earnings of 62 cents per share on revenue of $2.41 billion. Analysts had forecast non-GAAP earnings of 56 cents per share on revenue of $2.21 billion. On a GAAP-adjusted basis, Activision's earnings came in at 8 cents per share, a significant improvement over the loss of 20 cents per share it posted a year earlier. Gross margins also increased 1,010 basis points to 48.7% from the prior year quarter, and operating margins improved 650 basis points to 1.8%. Net margins also rose 2,330 basis points to 7%.
Despite the company's financial strength, macro reports regarding a 34% plunge in January video game sales caused investors to dump the stock. Activision's weak guidance for 2012, which estimates GAAP-adjusted full-year earnings of 94 cents per share, missed Wall Street's expectations of 96 cents and exacerbated the sell-off. Activision attempted to assuage investors with a new $1 billion share buyback plan, and hiked its annual dividend by 9% to 18 cents per share.
For the fourth quarter, Activision attributed its strength to its Call of Duty military shooter franchise as well as its Skylander video game and toy line. The newest installment in the Call of Duty franchise, Modern Warfare 3, earned $1 billion in revenue within its first 16 days of sale in November, going on to become the best selling game of the holiday season. In addition, 1.5 million Call of Duty players have purchased an optional $49.99 per year subscription service to access additional downloadable content for the game. Activision's Skylander toys - collectible action figures with built-in chips that interact with a corresponding video game - generated $200 million in revenue last quarter. Skylanders are the first hybrid toys to successfully combine the past success of Pokemon with console-based role playing games.
Activision's most important business segment, the subscription-based online fantasy game World of Warcraft, posted another sequential decline in subscribers, dropping from 10.3 million to 10.2 million within three months. The 100,000 user decline was an improvement over the 700,000 user decline it posted in the third quarter. The game, which was released in 2004, has been losing users since peaking in October 2010 with 12 million customers. Activision reportedly used aggressive marketing, discounts and fresh game content to reduce user defections. However, this reduced the game's average revenue per customer.
Analysts have also expressed concern that Electronic Arts' (EA: Charts, News) new online game, Star Wars: The Old Republic, would erode World of Warcraft's user base at a faster than expected rate. Activision's Blizzard studio is developing a next-generation online game, codenamed "Titan", to succeed the aging World of Warcraft. Blizzard is also releasing two highly anticipated titles - Diablo 3 and Starcraft 2: Heart of the Swarm - later this year. Investors have speculated that Activision may be intentionally delaying these titles until its Call of Duty and World of Warcraft franchises began to weaken, in order to offset losses in these flagship franchises.
Analysts believe that Activision's online platform, Battle.net, which was inherited from Blizzard, will provide the company with more digital distribution opportunities, which will produce stronger margins. 50 million users currently use the Battle.net service. For the full year, Activision earned $1.6 billion - or 34% of its total revenue - from digital distribution. Revenue from this segment is expected to increase further in 2012. Digital distribution margins tend to be extremely high due to the lack of discs, boxes or manuals. Activision's rival Electronic Arts also reported massive revenue growth attributed to its digital distribution segment.
Shares of Activision currently trade at 11.4 times forward earnings with a 5-year PEG ratio of 1.03. If the company can shake off doubts regarding the future of its core franchises and increase its digital distribution revenues, then current prices may be a bargain for the patient investor.
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