Video Game Pair Trade: Buy Activision, Short Electronic Arts

The AllStar Portfolio bought Activision (ATVI) this week just before the company raised its FY (Mar) 2008 revenue outlook on strong sales of Guitar Hero III and Call of Duty 4. The stock had sold down to $19 per share since its earnings release Nov. 5th as both the company and video game retailer Gamestop (GME) on Nov 20th set an overly cautious tone for the holiday season, despite both companies handily beating estimates for the past quarter. Though we made a quick 16% this week on the trade following confirmation of strength during the Black Friday weekend, we are holding ATVI for the long-term as the immense sell-through of its key titles will continue to outpace conservative estimates. Moreover, unlike larger, more diversified video game publishers like Electronic Arts (ERTS), the success of hit titles will further boost the company’s margins to lead profits well past still cautious estimates.

We agree with the growing number of analysts that have projected ATVI to surpass its FY outlook of $0.85 EPS (adjusted) and $2.30 billion in revenue. Call of Duty 4: Modern Warfare is also likely to remain one of the top titles this season on the positive reviews by gaming critics. Spiderman 3 has also seen success, one of the company’s licensed titles. Most importantly, there are no longer concerns that ERTS’s Rockband will sour sales of Guitar Hero III: Legends of Rock. Rockband sells at almost twice the price and was released a month later than Guitar Hero III. Additionally, Electronic Arts president John Riccitiello commented, “We won’t be able to put up enough inventory [of Rockband] to meet the demand of this fiscal or calendar year.” Guitar Hero will not even have to compete with Rockband in Europe, as it will not be released until 2008. Rockband is also limited to the PS3 and Xbox 360, missing out on the still robust sales of the Wii console.

In general, video games are insensitive to weaknesses in consumer spending. With those concerns now out of the way, the only concerns left are that the company has peaked with its key games out this year, and will slow next year on tougher comparisons. Two analysts have downgraded the stock: Janco Partners to market perform from accumulate, and Piper Jaffray to neutral from buy. While there no doubt that game publishers need to constantly innovate, we believe the company still has opportunities in FY 2009 on its licensed franchises, including Tony Hawk and James Bond which is more successful in Europe. ATVI also acquired Bizzare Studios a U.K.-based developer that will allow new expansion into the genre of racing games.

Despite our confidence in the video game software cycle, with a slight premium on its expected forward earnings multiple, we are shorting a smaller position in ERTS as an industry hedge on concerns that its own key titles may not live up to expectations. The company recently cut prices on games including NCAA Football, Madden, NBA Live, Nascar, Medal of Honor, Tiger Woods and FIFA ‘08. Also, despite enthusiasm following the companies recent quarter, Deutsche Bank put a sell rating on the stock noting the premium on shares. We share these concerns for a larger developer like ERTS as the company is not as capable of driving top-line acceleration, especially with most of its hit titles not benefitting from the success of the Wii. Though console cycles are longer today, if we see the usual past trend of gaming stocks collapse in the year following a console release, we expect ERTS to be one of the hardest hit.

Neal Sangani

Disclosures: My comments are for educational purposes only.