Activision Blizzard Inc.'s Special Sauce

Source: Activision Blizzard.

Activision Blizzard is avideo game company with a roughly $20 billion market cap whose shares are up more than 150% over the past five years, and it may have its best years ahead of it yet. Video games have entered the mainstream, and the revenues from the biggest game franchises dwarf those of the biggest blockbuster films.

While a stock likeTake-Two Interactivehas performed better than Activision over the past five years, it has done so largely on the backs of its excellent NBA franchise and Grand Theft Auto (GTA) games. The company releases a GTA game about once every five years, and when it does, they are usually a smashing success both critically and commercially. For investors looking for a riskier investment in a company with a much smaller market cap, I'd recommend taking a deeper look at TTWO.

However, I prefer Activision for my investing dollars because of how it has largely upended the traditional video game business model and made it much more safe and predictable, while still providing tremendous upside.

Recurring revenues turn good to greatThe video game industry reminds me a lot of the music industry, up to a certain point. Years ago, both industries sold hard copies of content that they created and curated. They were disconnected from the customer until it was time to purchase a new CD or game cartridge. However, while music producers were disrupted by upstarts, the smartest video game producers realized they should be disrupting themselves.

Digital downloads of video games have reduced packaging costs and cut out middlemen while giving companies like Activision a continuous link to consumers. World of Warcraft, one of the company's most important franchises, ended Q2 with 5.6 million subscribers. While this is down from all-time highs, it is an incredible revenue engine. Users pay $15 per month to access this online world and interact with other players. This comes to a yearly run rate of over $1 billion. Players are also given the opportunity to make in-game purchases of better equipment, weapons, horses, etc. It costs a lot less to design and produce a special virtual helmet than a real one, and these incremental sales are basically pure profit.

Activision Blizzard has a number of other games that draw millions of online players. One of its newer releases,Destiny, already boasts 20 million registered players. It is this type of recurring revenue that allows the company's revenue growth to look so smooth. With a few very minor blips along the way, the top line has grown from $1.47 billion in 2006 to $4.65 billion on a trailing-12-month basis. With relatively new creations like Skylanders, which was first released in late 2011, already becoming dominant brands, revenue growth in the future should continue along this trajectory.

Source: Activision Blizzard.

Iterate, don't innovateThis talk about recurring revenue extends across game franchises as well. Call of Duty (COD) was created in 2003 and has since sold over 175 million copies.. Graphics, stories, and consoles have all changed along the way, but the brand has remained incredibly robust. In 2013, one edition of Call of Duty brought in over $1 billion in first-day retail sales. Activision must still produce quality products, but it has a tremendous built-in branding advantage over other games in the same genre. These games cost a lot of money to make well, and there is a huge built-in audience who will buy every iteration and expansion pack with a COD moniker.

Even with these massive software sales, Activision doesn't let other revenue streams run dry. According to a press release accompanying Q2 results, the company noted, "Season pass, downloadable content, and micro-transaction offerings [for Call of Duty] have helped drive increased engagement and monetization." Massive upfront sales, increased user engagement, and recurring revenue are the special sauce that leads to the company's prodigious free cash flow. On a trailing-12-month basis, that number came in at $1.3 billion.

What to do with all that cash?What a company does with the cash it generates is of critical importance for shareholders. Burning it on excessive executive compensation, empire building acquisitions, or imprudent share repurchases can destroy shareholder value. Activision Blizzard has laid out a solid road map for organic growth that involves more than 10 total properties under its corporate umbrella.If it can deploy the same blueprint for its new brands that have proven so successful in the past, these investments should pay off big time.

Some of the cash is returned to shareholders in the form of a dividend. The current yield is less than 1%, but this doesn't concern me for a few reasons. The stock performance has been tremendous over the last 2.5 years, rising around 170%. With that sharp rise, the yield for new investors will be lower. Since instituting the annual dividend in 2010, management has raised it every year, from $0.15 at inception to $0.23, where it stands today. Finally, the payout ratio remains very low at 18%, which means it can comfortably be serviced and raised.

I expect the company to continue to hike its payout for many years to come without any negative impact on investments in new games, franchises, or other business opportunities.

Parting thoughtsActivision Blizzard is an example of a company that has made a traditionally uncertain business into one of predictability. I feel very confident holding onto my shares for the foreseeable future. It should continue to generate tremendous amounts of excess free cash flow from its subscription businesses and sales of powerfully branded console games like Call of Duty and Skylanders. It also has a great deal of optionality in terms of licensing its characters and brands for use in other mediums, such as aWarcraft film expected to be released in 2016.

Even after its recent run-up, the company's forward P/E remains under 19. I think this is a fair price to pay, and I remain a happy long-term shareholder.

The article Activision Blizzard Inc.'s Special Sauce originally appeared on

James Sullivan owns shares of Activision Blizzard. The Motley Fool recommends ATVI and TTWO. The Motley Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright 1995 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.