2/11/2010
By Brian Sozzi, Research Analyst

The videogame console cycle for investors in the big three independently traded software publishers (Electronic Arts, Activision Blizzard, and THQ) has almost been a complete bust. I say almost as the merger between Activision and Blizzard (division of Vivendi at the time) in 2008 was a seminal moment for the industry, not only creating an industry titan but also marrying two different spectrums of the gaming industry (console and online).  Holiday 2009 will go down in the record books as one of disappointment, with rampant software price cuts at big box retailers and no true blockbuster game outside of Activision Blizzard's Call of Duty: Modern Warfare 2.   That said, I sense that the fortunes (i.e. financial numbers) of the publishing sector are about to be reignited at long last, though not for all parties involved.

Price cuts on current generation consoles and handhelds have begun.  With these price reductions now in scope, the installed base is poised to hit a monstrous 265 million (218 million 2009) plus by the end of 2010.  Assuming modest software dollar growth, all signs point to solid overall revenue growth looking forward.  Note this excludes the robust trends we are seeing from digital, which for these companies include mobile phone games, online games, digital downloads, and expansion packs.  Detailed below is an over view of how we believe investors should approach the sector.

Activision Blizzard Inc. (ATVI)
* Rating: Buy
* Price Target: $14.00

It's our opinion that Activision Blizzard shares are deserving of a PE multiple of 18.0x our FY10 EPS estimate of $0.76, or 16.8x working off our FY11 EPS estimate of $0.83.  Presently, the stock commands PE multiples of 14.4x and 13.3x our respective annual EPS forecasts. 

On both accounts, the stock trades below shares of most comparable rival Electronic Arts Inc. (ERTS); 26.0x our calendar 2010 EPS estimate or 19.0x our calendar 2011 projection.  We believe that Activision Blizzard shares at least should trade on a comparable multiple to Electronic Arts.  Whereas Electronic Arts continues to struggle in product execution, cost containment, and financial forecasting Activision Blizzard does not sport such troubles.  Activision Blizzard has the greater potential to raise forecasts in 2010 and 2011 as opposed to Electronic Arts, reflecting (1) stable, yet growing revenue stream from Blizzard division (MMORPGs represent 23% of annual revenues), (2) enactment of cost reduction measures in the music business, (3) portfolio of franchises that are highly relevant in a competitive industry backdrop, meaning they should hold launch prices longer, (4) growing of China operations, currently 6% of annual revenues, evident for 2010, and (5) cash rich balance sheet that is being utilized on share repurchases.

Activision Blizzard had an impressive holiday quarter, registering in excess of $1.0 billion in sales from Call of Duty: Modern Warfare 2, and having success with DJ Hero (Tony Hawk: Ride did not live up to expectations).  We believe Activision Blizzard's title plans, including margin favorable PC titles Starcraft II and World of Warcraft: Cataclysm, another Call of Duty game, and improved economics behind the Guitar Hero franchise, not to mention healthier industry conditions, signal that management's initial FY10 guidance will prove conservative.  The announcement of a new $1.0 billion share repurchase program and a $0.15 P/S dividend (dividend unheard of in game software industry) suggests confidence in the go forward anticipated growth rates of the business.

THQ Inc. (THQI)
* Rating: Buy
* Price Target: $8.00

The company has aggressively managed down its fixed cost structure though the closure of unproductive studios and improved economics behind games for the Wii, Playstation 3, and Xbox 360.  We view favorably THQ's strategy of targeted game releases executed upon well, meaning outlined launch dates are hit on time and quality is evident.  Furthermore, the extension of brands to digital mediums such as Facebook, in addition to an E3 convention unveiling of an online MMO, positions THQ in critical growth areas of the interactive game market.

We see the following as earnings catalysts (1) lower breakeven rate of the business being met with stronger sales trends, (2) gross margin tailwind from new WWE license agreement, (3) release of titles in FY11 that were not included in the FY10 count, and (4) market trends that are a sharp, positive reversal of fortunes as opposed to FY10.  Presently valued at a mere 11.0x our FY11 EPS estimate of $0.50, the stock offers one of the most attractive valuations among our cyclical sector coverage (includes other videogame publishers). 

Electronic Arts Inc. (ERTS)
* Rating: Avoid

The company has one of the most promising title slates amongst game publishers for calendar 2010.  Medal of Honor returns after a three-year hiatus to a storyline etched in the mold of Activision Blizzard's Call of Duty: Modern Warfare, which should garner the interest of shooter aficionados and fans of the series.  Not much attention is being paid to Electronic Arts co-publishing a title with Gears of War developer Epic Games; a shooter is projected for a post holiday launch.  Moreover, Mass Effect 2 recently launched to rave reviews (Medacritic rating of 96), and Battlefield Bad Company has all the makings of a 1.0 million plus unit seller.

Nonetheless, although there is promise in what Electronic Arts is bringing to market, and operating conditions for the sector should be greatly improved in 2010 as opposed to 2009 (new motion controllers/hardware price cuts sparking increase in installed base and tie ratios) continued disappointment by Electronic Arts on sales and earnings must not be overlooked.  Electronic Arts will use FY11 to invest aggressively in its growing digital games platform (there is a need to utilize Playfish to the fullest given the robust premium paid to purchase the developer) and market perceived "AAA" titles.  These factors are likely to exacerbate the softness that Electronic Arts is seeing in the packaged goods industry, as implied by below consensus initial FY11 sales and earnings guidance.

In order for Electronic Arts shares to realize trading multiple expansion, one or all of the following has to occur:

1. Packaged goods industry returns to growth (Electronic Arts guidance for FY11 is flat to -3%).
2. Cost reduction efforts in FY10 find a way to the earnings line rather than getting reinvested in marketing, game development, and Playfish.
3. Earnings warnings lessen in magnitude or cease altogether.
4. Electronic Arts uses its hefty cash pile to pursue a structurally changing acquisition at a reasonable valuation.

Brian Sozzi
Wall Street Strategies