Macquarie: Activision Could Grow Margins To 45%, EA And Take-Two Could Hit 35%

• Shares of Activision Blizzard, Inc. ATVI, Electronic Arts Inc. EA and Take-Two Interactive Software, Inc. TTWO gained in low-single-digit percentages over the past one month.
• Macquarie’s Ben Schachter maintained Outperform ratings on all three companies, with price targets of $36 for Activision Blizzard, $83 for Electronic Arts and $38 for Take-Two.
• Schachter commented on the structural margins for video game companies as well as the key differences between the US pubs.

Online PC-centric companies in Asia are generating op margins of 40-45 percent or more, while US publishers have traditionally achieved 10-30 percent, analyst Ben Schachter said. He wrote, “In order to understand the potential LT margins for U.S. publishers, investors should understand how accounting impacts rev recognition as well as gross and operating margins.”

Schachter added that while Activision Blizzard could grow margins closer to 40-45 percent over time, Electronic Arts and Take-Two could grow to above 35 percent.

Revenue Recognition by Channel

1. AAA Physical Discs: All three companies recognize revenues based on the wholesale price paid by retailers minus 3-8 percent for reserves.
2. Digital Full-Game and Add-on Content for Console and PC: All three pubs recognize all digital console and PC revenue on a net basis.
3. Mobile: Activision Blizzard recognizes gross, which is 100 percent; while Electronic Arts and Take-Two recognize net of 70 percent.
4. China PC Distribution Partners: All recognize net, which is usually around 20-30 percent.
5. GAAP vs Non-GAAP: “Key difference relates to timing of rev recognition. Virtually all analysts focus on non-GAAP as it measures sales in real time,” Schachter stated.

Gross Margin

1. Channel Differences: Physical console has platform royalty, while digital console has royalty in revenue split. PC has no royalty, while mobile has revenue share.
2. Publisher Differences: Activision Blizzard and Take-Two capitalize software development costs and amortize the costs in COGS as they recognize revenue. Electronic Arts expenses development costs as they occur in R&D line below gross profit.
3. IP Differences: Some games must pay royalties to IP holders, like NFL, NBA and Star Wars. These range from 1-20 percent.
4. Internal/External Developer Royalties: Many development studios get royalties or bonuses depending on a game’s success. This could be 0-25 percent.
5. Online Games: Most hosting or customer service costs are in COGS.