It was a long time coming for shareholders of Activision Blizzard (ATVI), whose stock had essentially been range-bound for over three years before finally seeing a breakout last week. The catalyst was strong fourth quarter and full-year 2012 earnings, which combined trailing earnings that beat both analyst estimates and the company's own guidance with first quarter projections also coming in above Wall Street consensus.
Friday's close of $14.37 represents ATVI's highest close since the fall of 2008, yet the company still seems relatively cheap on a fundamental basis. The company has $3.93 per share in net cash, giving the company an enterprise value below $12 billion. Yet 2012 free cash flow was $1.27 billion, better than 10% of that enterprise value; trailing earnings of $1.01 (on a GAAP basis; non-GAAP was $1.18 per share) puts the stock's P/E around 14, or near 10 on an enterprise basis.
The company's full-year 2013 guidance of 68 cents per share (80 cents per share non-GAAP) appears disappointing at first, but as analyst Michael Pachter told Reuters, "Nobody believes their guidance." Sterne, Agee similarly noted the company's habit of "underpromising [and] overdelivering," as evidenced by the last two years' results. In 2011, the company guided for full-year revenues of $3.95 billion and GAAP EPS of 56 cents; the company would report 2011 sales of $4.755 billion and EPS of 92 cents. Heading into 2012, Activision again released remarkably low projections, guiding for $4.15 billion in sales and 63 cents in EPS (though 94 cents on a non-GAAP basis). The company would instead set records with $4.86 billion in GAAP revenues ($4.97 billion non-GAAP), with earnings figures of $1.01 GAAP and $1.18 non-GAAP beating initial guidance substantially.
Of course, as many bears have noted, there are reasons for Activision's low valuation. Video game sales have dropped for fourteen consecutive months, as the lack of new consoles and competition from free or low-priced digital downloads have eroded demand. The company's long-standing World of Warcraft franchise continues to see modest subscriber declines, raising concerns about the long-term viability of one of the company's key cash cows.
Another key concern facing the stock has been the overhang of a 61% stake in the company owned by Vivendi SA (OTCPK:VIVHY). Vivendi has been trying to unload its ownership for some time, to no avail, leading to fears that Vivendi will wind up dumping its shares on the open market, depressing ATVI's share price.
But in its earnings release -- and again on the Q4 conference call -- Activision made an interesting announcement:
The company is considering or may consider during 2013, substantial stock repurchases, dividends, acquisitions, licensing or other non-ordinary course transactions, and significant debt financings relating thereto.
On the conference call, Activision executives declined to comment further on their plans. Sterne, Agee wrote that "management appears to be hinting that they will use the company's balance sheet to purchase significant amount of shares in the near future." But it would appear that Activision is -- finally -- reviewing a series of options to boost its share price after years of middling, and remarkably stable, performance.
It could be that, with Vivendi failing to find a suitor among companies such as Microsoft (MSFT) and Disney (DIS), that Activision plans to simply buy Vivendi out itself. Vivendi's current stake is worth just under $10 billion (the 61% figure comes from Activision's most recent 10-Q, for the period ending September 30th, 2012). Activision has some $4.38 billion in cash and investments; it would have to borrow some $6 billion to buy out Vivendi and keep a reasonably safe cash balance. That type of debt would probably result in about $400 million in annual interest costs (assuming a 6.5% interest rate); with $1.56 billion in trailing EBITDA (earnings before interest, taxes, depreciation and amortization), the company's interest coverage ratio would be about 4:1.
Given the company's future challenges, that ratio might be considered a bit unsafe; but the current record demand for high-yield debt and Activision's steady cash flow history make it likely Activision could indeed finance such a repurchase. The buyout of those shares would vastly change ATVI's balance sheet; but, of course, its earnings profile would be dramatically different as well. GAAP earnings for 2013 at Activision's current guidance would increase to $1.74 per share, moving the company's forward P/E at 8.3. Analyst estimates -- accounting for Activision's historic bent toward underpromising -- would likely surpass $2 per share for 2013. Those earnings levels would seem likely to boost the share price -- even at 8x Wall Street consensus, the stock would reach $16, up over 10 percent from current levels -- or, at the very least, provide a solid floor for the stock.
Of course, the company mentioned other options, such as a dividend. The company boosted its annual dividend 5.6 percent to 19 cents, providing a modest 1.3 percent yield at current prices. But given the company's balance sheet, and low capital expenditure requirements, existing cash could easily support a $3 per share special dividend. The company could use the projected borrowings either to replace the 60 percent of cash held overseas (and thus avoid repatriation taxes) or boost the dividend to a higher level. A licensing deal -- creating a near-term infusion of cash -- could similarly be used to support a special dividend. Either way, such a payout would seem likely to give ATVI a boost.
The concept of an acquisition is interesting as well. A purchase of key rival Electronic Arts (EA) would be fascinating but likely a non-starter for several reasons. Take-Two Interactive (TTWO) would seem a possible target; the company's Grand Theft Auto game would add another blockbuster franchise to the Activision pipeline, while Activision's development team could aim to, unlike Take-Two, actually get new releases out on time.
What exactly Activision will wind up doing likely remains a mystery even to its executives, who appear to be in the process of evaluating a range of options. But it seems likely that any such transaction -- most notably a large repurchase or a dividend -- will be a short-term catalyst for the company's stock price. Activision executives have spent years cautiously managing their business and amassing a fortress balance sheet. Having now announced their desire to use those resources to boost the flagging share price, it seems likely that the company will do so judiciously and wisely.
The longer-term issues facing the company -- increasing development costs for the coming new console cycle, the need for success of its still relatively-secret Titan project to eventually replace World of Warcraft, and the competition from digital and mobile games -- will not necessarily be resolved by financial engineering or a mid-sized acquisition. But any large repurchase or special dividend should provide a shot in the arm to the stock price. With the company's fundamentals still relatively strong, investors would be well-served to have faith in Activision management and their plans for the company's balance sheet. More aggressive traders can also look to longer-term options -- the January 2014 15 call trades at $1.10 -- to leverage their exposure and hope for a significant jump when Activision's plans are released.
After those plans are announced, it seems likely that investors will have to re-evaluate the stock, because there seems a good chance that Activision's financial structure will have changed dramatically. In the meantime, however, Activision -- and its shareholders -- will have a range of options, many of which look likely to unlock further value.