Activision Salutes Those About to Rock

With the help of consumer focus groups, the gamemaker has produced such hits as Call of Duty and Guitar Hero, and is expected to nearly double its earnings

Call it a lesson from the Battlezone. In 1998, video game maker Activision (ATVI) launched a version of the popular arcade game featuring a tank battle between the U.S. and the Soviet Union on other planets. It was one of several mid-'90s games—including Heavy Gear and Dark Reign—that turned into expensive flops for the company. The common theme? "They were well-produced and highly rated," says Activision Chairman and Chief Executive Robert Kotick. "And they had no audience."

The experience prompted Kotick to change the way he managed video game development. Rather than rely on programmers to formulate game ideas, Kotick started commissioning focus groups to gauge what customers wanted. Even as he introduced a more top-down approach for ideas, he gave game developers more responsibility for the profitability of their creations. Now they compete for corporate resources and look for ways to reduce costs. Before, Kotick notes, the average programmer "didn't know the difference between a balance sheet and a bedsheet."

The results have validated Kotick's strategy. Activision's stock returned 182% over the past five years, vs. 76% for the Standard & Poor's 500-stock index and 63% for the company's longtime rival Electronic Arts (ERTS). Earlier this year, Activision shot its way past EA to become the top independent video game maker in North America. EA's hefty international sales keep it twice as big overall, $3.1 billion in sales for the fiscal year that ended Mar. 31, vs. $1.5 billion for Activision. But Activision, based in Santa Monica, Calif., is expected to have another strong year thanks to the many game franchises the company has built. "We're more bullish than ever on Activision," says Michael Pachter, an analyst at Wedbush Morgan Securities who follows the company.

Studio Stable

It's been a remarkable ride for Activision, which was the first independent video game producer, making games for the Atari system back in 1979. In 1990, Kotick, a high-tech entrepreneur, bought control of the then-bankrupt company for $440,000. Today, Activision has a stock market value of $5.5 billion. Analyst Pachter expects the company to earn $165 million on sales of $1.8 billion this year, nearly twice what it earned in fiscal 2007.

Kotick's strategy involved separating the company into a dozen small studios focusing on particular games. There's one that develops the games licensed from Marvel Entertainment (MVL), including Spider-Man and X-Men. Another for those from DreamWorks Animation (DWA), namely Shrek the Third and the upcoming Bee Movie. Under the new business model, studio employees get bonuses for meeting or exceeding profit targets set for their units. Kotick says the strategy has turned employees into brand managers, planning years ahead and keeping several versions of their games under development at the same time. That allows them to stagger releases so the company can produce more consistent sales.

Kotick and his studio heads don't always agree. For example, Kotick says he doesn't believe celebrity voices add significantly to sales because consumers buy games based on the quality of the play, not who was in the movie. But he let his Marvel team pay "a fortune" to star Tobey Maguire to provide the voice for the Spider-Man games. The latest, for Spider-Man 3, which was released in May, has sold more than 5 million copies at roughly $40 apiece retail. Jerry Seinfeld's voice is also featured in the Bee Movie game.

Rockin' On

The consumer focus group approach has also led to some successful games. The company discovered through customer research that the World War II action genre was in need of a good game and released Call of Duty in 2003. The game has become one of the company's biggest sellers. In a sign of how the franchises can evolve, the latest version, Call of Duty 4: Modern Warfare, features contemporary combat in the Middle East. It will be released in November.

There still could be bumps ahead. Activision is one of dozens of companies being investigated by the Securities & Exchange Commission for allegedly backdating stock options to generate more money for managers receiving them. The company restated its earnings to reflect $66 million in additional charges related to grants made during a 13-year period ending in 2006. An internal company investigation cleared Kotick of any "intentional wrongdoing." The company says it is cooperating with the SEC.

Meanwhile, archrival EA and MTV Games (VIA) are launching a game called Rock Band in November that could eat into sales of one of Activision's strongest new franchises, Guitar Hero. Both games allow players to pretend they are rock stars by pressing buttons on a guitar-shaped device. Activision acquired Guitar Hero's publisher, RedOctane, last year for $100 million. Kotick is keeping the management team that created the game in place, giving the former owners as much as $51 million if they meet future profit targets.

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