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, Inc. (NASDAQ:ATVI), 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 Inc. (NASDAQ:EA) and Take-Two Interactive Software, Inc. (NASDAQ:TTWO) 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.