Modern Warfare 2 Tops $1 billion in Revenue (ATVI, ERTS)

Another day, another big news item for ATVI.  The sixth iteration of Call of Duty has brought in $1,000,000,000 in revenue since it was released in November.  Yes, this is a record for video game sales.  ATVI is trading higher on the news, as opposed to yesterday when it was trading lower on approximately the same news released from Electronic Arts’ perspective.

Yes, the video game sector on the whole is weak.  But to reiterate the points made in our initial Activision posts (I, II, III), ATVI is in a great position relative to its competitors because their franchises are ones that consumers want to buy.  ATVI’s underlying financial numbers look great, and they have a product line that consumers will purchase regardless of any changes in their discretionary income.  While discretionary spending may be down in the last 18 months or so, consumer demand for quality products remains high.  As such, we will continue to see trends like CoD:MW2’s success, or the success of Avatar.

GOOG Threatens to Leave China (GOOG)

Google is down 1.5% premarket due to its threats to abandon China rather than censor its search results. This would hurt GOOG pretty minimally in the short-term, but long-term effects could be larger.

Ultimately, you have to trust that the people at GOOG know what they’re doing – I would be extremely surprised if GOOG ends up abandoning China, but just the news that it might be a possibility is enough to send investors into a little bit of a tailspin. We will monitor this situation closely, but our analysis is not changed tangibly by these developments.

ERTS Cuts Q4 Earnings Forecast (ATVI, ERTS, GME)

On the surface, the news just keeps on getting worse for ATVI – or does it?

First, GameStop (GME) posts disappointing results surrounding their holiday sales. To be fair, there is a VERY interesting take on GameStop over at SeekingAlpha.com regarding how the main metric that guided the “disappointing” holiday numbers, specifically, year over year same store sales, is not the metric to be using for a company like GME. This analysis is one that I find particularly interesting because it cuts against the grain and makes sense logically, but the market is obviously still punishing GME for lagging their year over year figures.

Now, however, Activision’s main rival, Electronic Arts (ERTS) is revising down their Q4 earnings due to the same weak holiday sales. My initial reaction is the same as what was written on SeekingAlpha this morning:

Electronic Arts simply “did not have the products that people wanted” and should be acknowledging that rather than “blaming everything on the environment.”

ATVI closed last night (1/11) at $10.89. It is looking like it dropped as low as $10.69 in pre-market. The thing to remember is that ATVI is not particularly affected by this news. I’m not going to say that poor numbers from GME and ERTS reflect well on ATVI’s strength in Q4, but the numbers don’t lie regarding the hit title Modern Warfare 2. This game has been the lone bright spot in a holiday season with no new consoles and very few impressive titles. Additionally, critics are raving about the new downloadable content (DLC) for the Guitar Hero series. Keep in mind that DLC is extremely high margin for ATVI and GME sees none of that revenue.

If you have conviction about the idea as I do, I think now represents a fantastic buying opportunity. The sector malaise is likely going to lead to selling pressure on ATVI, which allows the focused investor to pick up the name at a big discount. The basis for the ATVI recommendation is still intact: Modern Warfare 2 is breaking records, and the Call of Duty franchise will continue to be a cash cow. World of Warcraft is finding new ways to monetize the name (including a movie coming out in 2011). Starcraft II is still going to be a phenomenon of a release that will be coupled with the release of the new, improved battle.net which will offer premium service to its users.

ERTS and ATVI may look similar to some investors, but we know better.

Expanding into New Markets (GOOG)

One of the reasons that we keep harping on Google as a stock to purchase has to do with their ability to be a disruptive force in almost every market they enter. They are able to do this because their goal as a company is different from most. Specifically, a typical company is attempting to get their clients to spend money on their product. Google, on the other hand, is only looking to drive its advertising business. As such, they can offer a variety of (sometimes costly) services for free (or close to free), thereby destroying the business models of many embedded companies.

That is the theme of this article from The Choson Ilbo. The following quote is regarding the implementation of the Nexus One and its unique bypass of cellular providers:

This is expected to change the very landscape of the mobile communications industry. The days of mobile operators controlling prices will likely come to an end soon. With customers able to freely choose the cheapest service, telecom companies will see their role shrink to mere suppliers of cellular networks and their profits drop accordingly. As companies like Apple and Google expand into the handset market with their own software, existing handset manufacturers will see their powers diminish as well. In 2009 Samsung and LG Electronics boosted their shares of the global cell phone market to the 30-percent level for the first time and pulled in record earnings. But they account for no more than 5 percent of the world smartphone market. They may be riding high now, but there is no telling when they might be knocked out of the saddle. The only way to survive is to innovate, innovate, and innovate.

Sometimes the most important aspect of an event is lost in the hoopla. Everyone is/was very excited about the technological implications of the Nexus One, but the reality is that the long-term ramifications of Google into the handset market might be what people are still talking about years from now. As we alluded to earlier, Google isn’t really giving wireless providers a choice as far as adopting Android devices. In order to remain competitive in the short-term, these companies must accept Android devices – even while the long-term path continues to push cellular telephony more to the peripheral as internet telephony becomes the tool of the day.

Can cellular companies remain relevant? Just the fact that we can legitimately ask this question speaks to the power of Google’s (and Apple’s) ability to disrupt and to innovate.

Welcome to a new week with Invest Smarter. This week we’ll (finally) post Part III of our Google analysis, continue to cover relevant news to our investing ideas, begin an “Investment 101” series designed to get less experienced investors up to speed, and, if there is enough time, initiate coverage on our third stock.

As always, thank you for your readership.

The Effect of the Nexus One on Google’s Margins (GOOG)

The Wall Street Journal blog has a good summary of Goldman’s analysis of the effect of the Nexus One on Google’s margins.

Now for the bottom line. Goldman guesses that the hardware cost of making the $530 phone is about $300, which it will pay to HTC. So from the remaining $230, take away $50 per unit for warranty, after-sales service and R&D expenses — which HTC will cover apparently. Then take away HTC’s $75 profit cut. That leaves $105, from which Goldman subtracts an estimated $50 for Google’s R&D and marketing expenses. That leaves Google with about $55 for each phone it sells, a margin of about 10%. That would add at most 2% to Google’s earnings before interest and tax, a basic gauge of operating profit.

I’ve seen estimates for Nexus One sales as high as 5-6mm in 2010, but I think it’s safe to trust a Goldman analyst to have done his homework on these estimates. Based on the hype surrounding the phone, I think a modest beat of 3.5mm is reasonable – if Google is able to sell closer to 5 million phones, however, that does result in an EBIT (Earnings Before Interest + Tax Expenses) increase of $275mm.

That said, I think relying on this analysis misses the forest for the trees. The Nexus One may sell well, it may not. 3.5 million phones in your first real attempt at hardware sales is impressive, but Google has their eyes on a different prize: getting non-smartphone users hooked on the flexibility that constant access to the internet can provide. The chart below is what Google is really paying attention to, and the Nexus One is just one way to get more people more connected to the internet.

(Picture above can be found at www.abovethecrowd.com)

Best Google vs. Apple Piece Yet (GOOG, AAPL)

An absolutely great article by Bill Gurley about Google vs. Apple can be found here. His point of view aligns very perfectly with what we’ve been writing about here. Do yourself a favor and read the entire thing, but in the meantime, my favorite portion is blocked below for your convenience:

If Apple’s business model is aggressive relative to the carriers, in contrast Google’s seems unrealistically accommodating. You want to control the user interface? No problem. Want access to the code? We’ll make it open source. What kind of economics do we want? Nothing at all.  What the hell, we will pay you!  That’s right.  Google will give the carrier ad splits that result from implementing the Google search box on any Android phone. FBR Capital Markets suggests that Google is taking this idea one step further in its November 24, 2009 report titled Implications of a Potential Share Shift to Android-Based Wireless Devices. “Recent support for Android-based devices appears to be correlated with significant up-front financial incventives paid by Google to both carrier and handset vendors.” FBR goes on to suggest that these incentives may be as high as $25-50 per device. This is simply an offer that no carrier can refuse, particularly when U.S. carriers are currently in the habit of paying $50-150 per handset sold in subsidies

Simply, Apple entered the cell phone market by creating a phone so good, that every high end mobile phone purchaser wanted one. This has been a wildly successful strategy. Contrary to this, Google is entering the cell phone market by creating a phone that is also very, very good, but it’s adding a few wrinkles: it is accommodating to the present hierarchy.

Will it remain so accommodating in the future? It is naive to think that Google doesn’t see an opportunity somewhere down the road to bypass the cell-phone carriers altogether, but in the meantime, this is a palatable alternative to cell-service providers that allows the 99% of cell phone users who don’t own an iPhone to access an open-source, technologically advanced phone that major telephone companies will sell due to the favorable terms Google is offering.

Gamestop Revises Q4 Earnings Down (GME, ATVI)

Gamestop (GME) is one of the market’s bigger dogs today after revising earnings down to $1.25 – $1.29 for Q4 2009. This could be bad for ATVI, but as we’ve espoused here since beginning our coverage of Activision, it is specific titles that are more immune to economic cycles. As we alluded to in our earlier post this morning, Modern Warfare 2 continues to sell at exceptional levels, even as video game retailers are making excuses as to why they are floundering.

Our prediction here is that the bad weather around the holidays coupled with the consumer’s increasing propensity to shop online is what is ultimately going to hurt GME, but leave ATVI unscathed.