Activision Acts Like Best of Breed

The video-game sector's No. 2 player has been outperforming larger rival Electronic Arts.
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Navigating the transition to new technology has proven difficult for the video-game industry, but some companies seem to be having more trouble than others.

Most notable are the differences between the sector's two leading independent game publishers --

Electronic Arts

(ERTS)

and

Activision

(ATVI) - Get Report

. Despite being the dominant player and overseeing a massive increase in research-and-development spending with no end in sight, EA has seen sales and earnings crash over the last two years while repeatedly delaying titles and offering disappointing guidance.

Activision has hit its own rough spots -- its profit fell off a cliff last year, and it expects sales to slump this year -- but the company appears to be hitting fewer of them than EA. Indeed, some investors and analysts argue that EA could learn a thing or two from its smaller rival.

"There's no question that Activision is executing better," says one hedge fund manager who follows the sector but whose firm doesn't currently have a position in either company's stock. Because Activision is smaller (its $1.4 billion in trailing 12-month revenue was half that of EA's), "it's easier for them to be nimble," he says, but "also, partly, EA has screwed up."

After the two companies' earnings reports last week, the market seemed to agree. Both companies posted better-than-expected results for their fiscal fourth quarters, and both forecast down years next year. But after

reporting Wednesday, EA shares had

fallen 12% by the end of the week, and shares of Activision, which

reported on Thursday, were up 13% by the end of the day on Friday.

To be sure, EA has given plenty of reasons of late to shake such faith.

  • For the seventh straight quarter, the company offered a disappointing outlook -- and this time it was dramatic. EA now expects to earn as little as one-third the amount analysts previously expected in the current fiscal year. Even if it hits the top of its earnings range, the company would post a third straight year of earnings declines.
  • EA now expects sales to fall as much as 9% this year; this would mark the second straight year of slumping sales.
  • On its recent earnings call, EA warned that is has delayed its upcoming Superman and Medal of Honor games, only the latest in a series of release setbacks for the company that included the six-month delay in its recently released Godfather game. Although the Superman title is based on -- and was supposed to come out at the same time as -- the expected summer blockbuster film, EA now won't release the game until the DVD is released this fall, largely missing out on the publicity surrounding the movie's theatrical release.
  • Perhaps most disturbingly for investors, EA plans to increase research-and-development spending this current fiscal year by 15% to 20%. That's after the company's research budget has already jumped nearly 50% over the last two years amid growing concern among analysts and investors about when spending will begin to level out."Their R&D budget is huge," says Bill DeRosa, managing partner with Anthem Asset Management, who follows the video game sector but has no current positions in either EA or Activision. "It strikes me that they're pouring more and more into it, yet the titles don't seem that compelling."

In an interview last week, EA Chief Financial Officer Warren Jenson blamed his company's difficulties on a longer-than-anticipated transition period to new-console technology and what he called a "global transformation" of the video game business. The industry used to primarily focus on games for consoles such as

Sony's

(SNE) - Get Report

PlayStation 2 and the PC, which were both largely targeted at the three big markets of North America, Europe and Japan.

But even as game publishers are having to gear up for new consoles such as

Microsoft's

(MSFT) - Get Report

Xbox 360, other areas are becoming increasingly important, such as games for mobile phones, online games and Asian markets outside of Japan, Jenson said.

"This just has a lot more moving pieces," he said. "It's changing everything about gaming."

But Activision CEO Bobby Kottick argues that the two companies are just being run differently. EA is making risky investments in new areas while at the same time it has become somewhat complacent in its core console games business, Kottick said in an interview last week.

"When you're the No. 2 guy, you try harder," he said. "You have to be more opportunistic and entrepreneurial."

Of course, Activision has had its own troubles. It too has issued multiple earnings warnings in recent quarters, most notably in February, when it warned that sales for the current year will be down 30%.

But arguably that too shows a difference with EA. This year's revenue slump, for instance, is largely by choice: Amid an expected tough market, the company has decided to release fewer titles and to focus on next year, when industry sales are expected pick up dramatically.

"They're keeping their powder dry for next year," says the fund manager. "It's smart. It makes a lot of sense."

But not everyone agrees that Activision is being managed all that much better than EA. The chief difference between EA and Activision is simply that Activision has done a better job of managing investor perceptions, says James Lin, an analyst for industry consulting firm the Simba Group. As the biggest company in the industry -- and one that expenses its R&D efforts as it goes, rather than amortizing them over time -- EA typically is the first to react negatively to console transitions, says Lin, a former sell-side analyst. And it's usually the first to pick back up when the industry as a whole starts growing again.

EA has been struggling lately, Lin acknowledges. But the company is in no danger of losing its market leadership, he says.

"Does anybody actually believe that Activision or

THQ

(THQI)

are going to be in a better position that Electronic Arts?" asks Lin, who has no position in either stock. "Are you kidding me?"