Activision: Potential for Explosive Returns

Purpose of Report: This is a report follow-up to ATVI ’s most recent earnings results.

Short Summary:

Activision is trading at fair value at current prices. It has the potential to hit at least “one home run” title. This has not been adequately priced in its stock price, and the stock represents a buying opportunity.

Detailed Summary:

Activision Blizzard is the dominant game maker with such titles as Call of Duty, World of Warcraft, and the Guitar Hero franchise. These titles have sufficient recurring revenue and growth. The company’s hidden value lies in upcoming titles for 2009.

The purpose of this report is not to speculate on the value of the company should these titles become blockbusters. This will require further analysis as more information (indicators of strong demand) becomes available. Therefore, investors should consider ATVI a core holding, with the potential for explosive returns some time between late 2009 and early 2010.

The mere market speculation and the potential for “Blockbusters" for 2009 make ATVI a potentially good performing company to own in bad times, but especially in good times.

Quarterly Result Summary:

Earnings exceeded expectations due to a strong execution in the company business strategy, strong partnerships with its retail channels, and product inelasticity to a weak economy.

- Diluted earnings were 0.15 vs 0.07 last year.

- non-GAAP EPS was $0.08, $0.05 ahead of outlook (Non-GAAP is generally not a usable figure, but is required for comparative year-over-year analysis, adjusting for the ATVI +Vendor merger)

Note: 0.02 earnings came from a lower tax rate (32% from 34%)

ATVI has broadened its retail channel in China with a partnership with NetEase (NTES). This is a risk factor from an operational perspective, so investors need to monitor the initial success rates of this partnership.

Side note: I cover GME (long) and another user has identified GME 's business model versus online game purchasing to be a future trend.

Qualitative Analysis:

ATVI spent 18 years developing a competitive advantage. Therefore, it is rightfully worth 4x market share more, than that of Electronic Arts (ERTS). Think about ERTS. The company depends on sports games and recurring revenue is achieved by releasing upgraded versions of sports games. It bombed on Spore. ATVI is taking a different approach in launching potential “blockbusters.” ERTS also cut costs by laying off workers. ATVI is investing in new potential opportunities.

Costs have increased slightly for the company, but are being spent in areas that will benefit the company: customer service and development cost (R&D @ $251M).

As Kotick stated on the conference call:

we think the best use of our capital is investing in our business and that’s the combination of investing in intellectual property development and development talent and in the repurchase of our own securities, so I would say that’s our focus right now.

Highlights (Balance Sheet Analysis):

• accounts receivable balance was $185 million, a decrease of about $1 billion versus prior quarter end, due to continued holiday collections
• company had no debt and approximately $3.1 billion in cash and investments
• $317 million of free cash flow was generated in the quarter

2009 Outlook (Updated):

Management stated the following:

Our long-term company-wide focus on profitability is still expected to yield another year of operating margin expansion and EPS growth. For calendar 2009, we are increasing our GAAP net revenue outlook by $100 million to $4.3 billion, and increasing non-GAAP also by $100 million to $4.8 billion.

For calendar 2009, we are raising our GAAP EPS to $0.24 and we are also raising our non-GAAP EPS outlook to $0.63.

Analysis of Outlook:

Using non-GAAP EPS (to adjust for post-merger year-over-year comparisons), a conservative P/E of 15 I would arrive at a baseline price target of $9.45. Applying a “blockbuster” premium and using a forward P/E of 20- 25 would yield a price target of $12.60 - $15.75.

Positive Trends:

ATVI is exposed to lower margins in its sale of hardware for Guitar Hero. This is an area for improvement.

Overall sales growth is, at best, under 10%. Strong and strategic partnerships with its retail channel will be important in ATVI ’s continued success. For example, the tough economy will force retailers to choose “wisely”. This means stocking ATVI product.

2009 Strategy continues to be executed well and achieved through:

(1) Product balance – can Guitar Hero finally crack the European market?

(2) Strengthening development capabilities – example: extend shelf life by selling new maps for Call of Duty

(3) Allocating resources to top customers

We continue to focus our global resources disproportionately against the top markets on our top customers and against our top titles. With this focus, we built share in our core music and shooter genres in four of our top five countries in the March quarter, including in the U.S., and led to our overall over-performance in Q1.

Outliers – Blockbuster game releases?

X -Men: Origins, Transformers, and Ice Age are all based on movie hits. Will the consumer buy these games just because the movie was a blockbuster? My bet is ”yes” for the former two, but I believe the core franchise (WoW and CoD) will continue to be the driver for revenue.

On guitar hero:

Overall, our strategy for growing the Guitar Hero franchise is focused on three vectors -- satisfying and expanding our audience, building international sales further, and improving operating margins.

User base: 15M have guitar hero. 170M have a console. There is clearly room for Guitar hero to keep growing.

Guitar Hero Metallica and Guitar Hero Smash Hits. Then, in the back half, we plan to release Guitar Hero Van Halen

Release of DJ Hero

We have already sold more than 3 million units and to date, more than 40 million professional songs have been downloaded for Guitar Hero.

Below is a news clipping to illustrate the “integration” of music and gaming:

The lineup shows how Activision expects to maintain momentum on its multibillion-dollar music-related games business: by segmenting the market to reach different types of music fans and players. Guitar Hero 5, with its indie and classic rock tunes, should appeal to the core audience of that franchise. Band Hero is targeted at the more casual player, with family-friendly Top 40 hits. And DJ Hero will have a turntable and feature dance, hip-hop and other genres of club music.

Conclusion:

Applying non-GAAP a P/E of 15 I would arrive at a baseline price of $9.45. Applying that “blockbuster” premium would justify applying a forward P/E of 20- 25 would yield a price target between $12.60 - $15.75.

Risks to Assessment:

- Failure for Dan Rosensweig (former Yahoo (YHOO) COO) to lead Guitar Hero as expected

- Unknown launch of superior titles from competitors

- Sudden decline in demand for existing “hit” titles

- Global and US Unemployment levels high enough to change the behaviour of game players (beyond an unemployment rate of 10%)

Investment Strategy:

Invest up to 10% in ATVI . Accumulate on weakness (@ prices around $9.50). Do not be afraid to sell and to take profits at the identified target price. Market enthusiasm may price the stock beyond proven fundamental value. The company will only have proven itself if indeed the new titles sell well, and the uptake of the Guitar Hero franchise is greater than that estimated in this report.

Quarterly Results Source: SeekingAlpha.com

Disclosure: I hold a long position on ATVI in my stock portfolio on kaChing. My portfolio is being followed by over 300 users in this social investing network community.

Comments

[inSearchOfV...:]

Today ATVI is selling at a PE of 347 with a qtrly earnings growth of 340. Isn't ATVI fairly priced and what factors in the future could potentially sustain this growth rate.

May 27 08:57 AM

[inSearchOfV...:]

Sorry, made a mistake in PE, took numbers from yahoo finance.

May 27 09:29 AM

[J. Crighton:]

My thoughts:

I agree with you that ATVI is a barain right now and there is some wonderfull money to be made by going long.

I do however disagree with you regarding Guitar Hero, it seems to be falling into the same trap as ERTS is in regards to it's recycling of the sports genre which is EA's lifeblood. The examples you've mentioned (GH: Metallica, GH: Van Halen, etc) seem to play into a recycling theme. I think that although there is growth there will also be burnout.

I'll be honest I don't play GH, so I don't know if what I'm about to suggest has already happened but I think that there is some good news in that I think they can move to an iTunes type lineup for people who have GH, they can just pay a fee and download individual songs. This would give Activision a great long term revenue stream in my opinion, since you only have to pragram that song once it would soon pay for itself.

One thought for the future: Diablo III. This title may not be out until mid 2010 (or possibly early 2011). But I believe this title is probably going to a massive hit. It's from a strong franchise with a dedicated following. It's playable singley or in group online. In my opinion Diablo III could be as big a hit a World of Warcraft. Thrown in monthly subscription fees for the online side and thats going to be some major revenue.

Disclosure: Long on ATVI

May 27 10:18 AM

[robert99:]

ATVI is a good long term play on the future of the video game industry. It's simply the best managed large cap video game company in the world, and if the industry continues to grow as it has been doing for the last 20 years, ATVI will provide nice returns for the next 20.

May 27 02:33 PM

[schnoogens:]

Don't forget about Starcraft 2. The first game is essentially the national sport of South Korea. Gamers have been waiting 12 years for it to arrive.

MW2 will be the best selling game of 2009/2010. The top 3 played Xbox games are:
1. Halo 3
2. COD: WaW
3. COD: MW

Once MW2 hits all of the COD players will leap to it. That's what I plan to do, and everyone I talk to online can't wait for MW2 to hit.

Diablo 3 will be massive, but I'm guessing it won't land until 2011.

They need to focus on selling downloadable songs for GH rather than pushing peripherals. I think they are starting to oversell individual discs of content and could easily make up the revenue with digital downloads. In addition, it limits freight/production costs.

I'm long on ATVI.

May 27 09:36 PM