Why long TTWO?
Obviously, GTAV has been a massive success wildly in excess of expectations. It will be the most successful game ever, even before it hits the PC and new generation consoles. In 3 days it sold $1 billion. TTWO is bound to exceed expectations for the quarter massively, by 50% or more in terms of revenues.
Yet, the stock is being sold. The stock is being sold on account of 2 different theses:
- A "sell the news" reaction. This was bound to happen as there was significant hype building into the game's launch. However, one should understand that even taking into account the hype, the game is exceeding expectations by a mile. And it hasn't yet been released for the PC or the still-incoming new generation consoles. Additionally, there's still the online component which will be released in October and lead to further monetization. In short, this "sell the news" is an opportunity to buy because the news exceeded expectations wildly and the upside from the game is not over yet;
- More importantly, TTWO is still seen as a "one trick pony". This is very important in that investors expect the company to live or die from the success of GTAV and have little else beyond that game. Yet, at this point this is clearly false. TTWO is nearly as diversified as the other gaming giants, having such well-known franchises as NBA 2K, L.A. Noire, Max Payne, Midnight Club, Red Dead (Redemption), BioShock, Borderlands, Mafia, Sid Meier's Civilization and XCOM. In short, it's far from a "one trick pony" even though GTAV is a tremendous success.
In light of these falsifiable theses on the sell/short side, what one has in TTWO is a gaming stock trading for what should be 5 times 2013 P/E, on the verge of a massive earnings and revenue expectations beat. TTWO has a market capitalization of just $1.5 billion.
Why short ATVI?
On the other side of the pair trade, you have Activision Blizzard. Like TTWO, ATVI is basically diversified among many franchises but also has a large money maker, the subscription-based massive multiplayer World of Warcraft. Other franchises include Call of Duty, Spider-Man, X-Men, James Bond, Transformers, Spyro, StarCraft, Diablo, Skylanders and Warcraft.
While TTWO's main bread winner is just enjoying a massive success, ATVI's World of Warcraft has been bleeding players, hit by the major new trend towards freemium play in massive multiplayer games. This trend has even ensnared previous giant competitors such as Star Wars: The Old Republic or Sony's Everquest, never mind the huge success League of Legends. So it's not like ATVI is facing a temporary setback here - the erosion in this segment is real and not going away. It will be hard to justify paying a monthly subscription when there are many high-quality free to play alternatives.
The erosion in subscriber numbers for World of Warcraft has been ongoing and relentless (Source: ATVI 10-Q):
At June 30, 2013, the worldwide subscriber* base for World of Warcraft was 7.7 million, compared to a subscriber base of 8.3 million at March 31, 2013, and 9.1 million at June 30, 2012
Given this threat one would be excused to think that ATVI would be somewhat discounted. But it isn't. ATVI trades for 19.1 times 2013 earnings and carries a full $19 billion market capitalization.
Worse still, the upcoming -- though court-challenged -- move to buy out part of Vivendi's shareholding will saddle ATVI with massive debt, which for a game publisher carries undue risk as THQ has recently shown.
TTWO presents a situation where it will wildly exceed expectations but the stock hasn't really reacted yet because it's being sold on the news and there's the feeling that it is a "one trick pony". Going through TTWO's list of significant franchises it's clear to see that even if GTAV is highly relevant, TTWO has other sources of revenues and income for the times between GTA launches. And even GTAV itself still has several monetization opportunities down the road, when it launches in the PC, the new generation consoles and online (October).
On the other hand, while ATVI is very diversified along many different and powerful franchises, its chief subscription money-maker is under distress. And the distress is unlikely to go away. And with the Vivendi deal its equity will turn much riskier due to a higher debt load. This makes it likely that ATVI won't sustain a premium valuation versus TTWO's bottom of the barrel valuation.
Given the similar potential, and TTWO's better present moment and the likelihood that it will smash expectations, it is hard to understand how TTWO can be valued at less than 1/10th ATVI's market capitalization and 1/4th the prospective price/earnings ratio. Thus, it seems very likely that TTWO will head up from its present quote, perhaps by as much as 100%, whereas ATVI will stagnate or head down.
In short, this makes for a decent pair trade where an investor would go long TTWO shares and short an equal amount of ATVI. Amazingly, both stocks closed on Friday at the same $16.99.