By Carr Lanphier
Electronic Arts (EA) and Activision Blizzard (ATVI) have an opportunity to improve their competitive positioning when the next-generation consoles Xbox One and PlayStation 4 are launched this fall. The video game industry is increasingly driven by blockbuster titles, as demonstrated by the September release of Grand Theft Auto V. As the two largest publishers in the video game industry, EA and Activision possess the financial resources, intellectual property and devoted fan bases to maintain leading positions and fortify their economic moats early in the console cycle.
In our view, EA and Activision Blizzard are the only two video game publishers with economic moats and are well positioned to increase sales, enhance profitability and drive attractive returns on invested capital in the coming years. We believe Activision and EA can generate normalized free cash flows of roughly $1.3 billion and $400 million, respectively (7% and 5% yields at today's prices), which would put both firms in a strong position heading into the console cycle.
The Largest Video Game Publishers Have Carved Out Economic Moats
EA and Activision have the intangible assets and deep pockets to develop franchises that can sustain growth and profitability. Video game sales are concentrating around blockbuster titles, pushing publishers to concentrate investments around titles that have the greatest chance of success. This also increases publishers' financial exposure to a title flop. Today, it is not uncommon for blockbuster games to cost tens of millions of dollars to produce - Grand Theft Auto V cost Take-Two Interactive more than $200 million to produce. Large publishers, like EA and Activision, have the budgets to diversify their risk and produce multiple blockbuster titles each year, giving them an advantage over smaller publishers.
Franchise fans are the foundation of EA's and Activision's success and their most important platform for growing sales and profits. Existing blockbuster franchises garner the majority of sales each year for most established publishers, because franchise fans purchase new titles in popular franchises and create buzz around pending releases. Firms without well-known franchises have to create new franchises, which need large marketing budgets to raise customer awareness and which increase the publishers' financial exposure to a flop. Additionally, established franchises have communities that enhance the user experience, particularly in multiplayer games. These communities create social networks that encourage users to keep playing a particular game, increasing the depth and duration of customers' engagement.
We believe one of the most reliable indications of a publisher's future performance is the health of its franchise portfolio - along with its financial health. For most publishers, a few titles generate the majority of sales from year to year. Every top-five console game title of the past five years was from an established franchise (excluding Wii Sports and Wii Fit, which were launched exclusively on Nintendo's Wii platform). The more hit franchises that a publisher has in its portfolio, the better its prospects for future sales.
EA's and Activision's franchise portfolios include some of the highest-grossing franchises in media history. Both companies have produced at least one top-five game in each of the past five years - Activision's Call of Duty has been best-selling for the past four years, generating more than 161 million units in lifetime sales, while EA's Madden NFL has been a stalwart title since the 1990s and Battlefield is gaining momentum. We also believe the blockbuster trend is appreciating the value of the publishers' mega-hit franchises. We estimate that EA has between three and five franchises that will generate an average of $300 million per title in annual sales over the next five years, while Activision probably owns more than three franchises that could each generate more than $500 million in annual sales over the same period.
EA's Strategy: An Ambitious Project Load for Long-Term Gain
We believe EA could strengthen its economic moat in the next console cycle through an aggressive multipronged strategy. The firm plans to improve its competitive position by lowering development costs, improving its position in the sports game market, launching three new console franchises and expanding its presence in the mobile platform.
First, EA's new development engines (EA Sports Ignite and Frostbite 3) are driving down the cost of building high-quality games. Development engines standardize code regularly used in background gaming software - for example, code that dictates how wind interacts with avatar clothing - which cuts out repetitive (non-value-added) work for programmers. EA also gains an attractive cost lever as enhancements to the engines' code will improve the time to market, quality and cost efficiency of future EA games. We anticipate these benefits will be reflected in the company's fiscal 2014 cost structure; management forecast operating expenses to be flat year over year, which would be a significant achievement as costs normally rise during a console cycle.
Next, we expect EA to continue its dynasty in sports video games. For years EA's established sports brands have blanketed a majority of the sports game market segment - the firm estimated it held a whopping 63% share in fiscal 2006 - leaving little room for new competitors. Today EA commands nearly 50% of the $2 billion U.S. sports segment, according to IBISWorld Data. Other publishers can develop competing sports games by licensing a league's intellectual property if EA doesn't hold the exclusive rights to the league, and the majority of EA's sports games are nonexclusive. However, going head-to-head with EA - given the firm's competitive position - isn't an appealing proposition for most publishers.
EA has ensured the near- to medium-term viability of each of its sports franchises by renewing every major contract with its previous sports league partners. One of the only ways to nullify the advantage of EA's established presence is to buy an exclusive IP license from a league. However, this is risky because EA has the experience and data to accurately estimate the value of the league's license. Moreover, EA has the scale to bid more aggressively (if needed) than almost any other publisher. To illustrate, Take-Two Interactive, (TTWO), the second-largest sports publisher with 6% of sports game market segment, outbid EA for an exclusive Major League Baseball license in 2005, but it ended up losing an estimated $30 million-$35 million in 2009 on the MLB franchise, which was the last time Take-Two addressed MLB 2K's profitability. Now that EA has all of its major contracts currently in hand, outbidding it for league licenses is no longer a near-term option.
Third, we believe the benefits of combining a development engine with the sports license renewal are greater than the sum of the parts. Licenses from sports leagues typically include an up-front fee and a per-unit fee, so publishers entering the sports market need to generate relatively high sales to break even on the up-front cost of the league license. EA already has a dominant position in sports games and an established user base that is acclimated to EA's game play and controls, which makes it even more challenging for new sports publishers to successfully enter the market. On top of that, EA Sports Ignite is reducing EA's development cost structure to improve game quality, meaning that new entrants may have to outspend EA each year to keep pace in game play quality. The combination of substantial up-front costs, fixed per-unit costs and increasing variable costs is not a scenario most publishers want to consider.
Another aspect of EA's strategy we like is its choice to release a multitude of high-quality and award-winning titles fairly early in the console cycle when consumers are more impressionable. EA's ambitious slate of title releases for the next-generation console is weighted toward 2014 and includes three new franchises that will require significant financial and developmental support - Plants vs. Zombies: Garden Warfare, Titanfall and Star Wars: Battlefront.
Finally, we like that EA is adopting a "freemium"-based sales model for its mobile games. Freemium games are free for users to download, and they generate revenue through sales of virtual items that help players quickly level up or access new levels. The freemium sales model is successful because free games are downloaded more often than paid games, and they tempt users to purchase otherwise inaccessible items from the in-game store.
To date, the highest-grossing mobile games are freemium and frequently use social competition to increase user spending. We believe this model can be particularly effective for EA, which already has a cross-platform strategy that incorporates match play and online rankings for competitive gamers. In the past two years, EA's sales on smartphones and tablets have nearly tripled to $274 million, from $92 million in fiscal 2011, and we believe that EA's mobile sales could grow at a 20%-30% compound annual rate over the next five years with the addition of the freemium sales model.
EA's Bold Plan Entails Risks
While we like EA's ambitious strategy, the firm could be taking risks that ultimately cause it to miss its 2014 expectations. In the July first quarter earnings call, EA management predicted that non-GAAP sales will grow 5% (to $4 billion) and operating costs will remain flat. However, there are two major factors that we expect could cause EA to miss its guidance.
First, console cycles have historically decreased game sales and increased development costs. New consoles take up a large portion of consumer wallet share ($400 for the PS4, $500 for the Xbox One), which cuts into game purchases. EA expects the addition of a Battlefield title and growth from FIFA and Madden sales will offset this decline.
Second, EA could be spreading itself across too many projects. EA is planning to transition its existing franchises to the next-generation consoles (including Need for Speed, FIFA, Battlefield and Madden NFL), build out its presence in the mobile market, and launch its new franchises. Despite the benefits of the development engines and low costs of mobile development, we are wary that EA may not have the creative resources to develop, market and support all of these projects in a compressed time frame, while keeping its operating expenses in check.
EA's Shares Are Fully Valued Today Given the Risk Profile
Our $21 per share fair value estimate implies a fiscal 2014 price/earnings multiple of approximately 18 times. The stock is trading at more than a 30% premium to our fair value estimate, and shares have more than doubled in value from August 2012. We attribute the substantial ramp in price to improved profitability, changes in leadership (John Riccitiello resigned from the CEO position in March after overseeing several franchise missteps), and management's optimism regarding the coming console cycle. While we believe EA's shares are fully valued given the firm's current position and risk profile, we expect the performance of EA's new franchises could be a good indicator of its short- to medium-term financial opportunity.
Management has pursued an aggressive growth strategy over the past five years, with mixed results. Operationally, we like that the firm has made significant strides that have improved its overall profitability. EA dramatically reduced the number of titles it publishes each year to focus investments on a few franchises that drive the majority of its sales, which has led to significant margin improvement. However, EA also spent more than $100 million on its Star Wars massive multiplayer online game in an ill-fated attempt to take on World of Warcraft, which weighed on margins in 2012.
EA's capital allocation has been similarly mixed. The company spent more than $1.1 billion acquiring Playfish (2009) and PopCap (2011) to gain traction in the fledgling mobile and social gaming markets. While these acquisitions made EA the only publisher with a presence on the PC, console, mobile and social platforms, we believe the acquisition prices were too high and expect it will be several years before EA realizes a return on its investments.
Activision's Strategy: Don't Change Strategies
Given the uncertainty that goes with a console transition, we like that Activision is sticking to its methodical strategy of "measure thrice, cut once." The firm is expected to launch four key titles in 2013 and 2014: Destiny, Call of Duty: Ghosts, Skylanders SWAP Force and Diablo III (which has been adapted from the PC version). We expect Activision will maintain its leadership by putting significant development and marketing dollars behind four to eight titles per year over the next five years. We also anticipate the company will take advantage of new video game opportunities in emerging markets and continue to support and monetize its legacy MMO franchise, World of Warcraft.
Activision is launching one new franchise, Destiny. While launching a new franchise title carries greater risks than publishing established ones, we have confidence that Destiny will be a blockbuster FPS title because of the depth of development and marketing Activision has invested. Developed by Bungie (the studio that produced the hit Halo series), Destiny utilizes the new capabilities of the next-generation consoles, allowing players to seamlessly move from single-player campaign to multiplayer campaign to multiplayer matches. The game has been used extensively by Activision's marketing team as a tease of what's to come in next-generation consoles. Despite the stiff competition in the FPS genre, we expect Destiny will be very well received by audiences when it is released in 2014, and we wouldn't be surprised if it became another prize mega-franchise in Activision's already large trophy case.
We expect Activision will increase its advertising budget to close to $450 million in 2013 and concentrate spending on Call of Duty: Ghosts and Skylanders, which face the stiffest competition in EA's Battlefield and Disney's Infinity, respectively. We believe Activision will feel the financial ramifications for several years if either of EA's titles overtakes Ghosts or Skylanders, so we expect Activision to spare little expense in marketing its two titles. We expect the majority of Destiny's marketing budget will be pushed out until fiscal 2014.
Activision is slowly expanding beyond the PC and console markets. The company is targeting opportunities in new mediums with its existing IP by testing freemium models of Call of Duty and All Stars (Blizzard's new game that includes the main characters from hit Blizzard franchises) in China, which represents a significant new market opportunity. Activision's testing tracks user behavior, which could lead to valuable information on players' PC habits as well as information on players' spending habits in freemium games. We view this as an important incremental step in the firm's long-term evolution, and we believe its current scale and global distribution should translate into more effective IP production that supports its narrow economic moat.
World of Warcraft remains a lucrative cash cow worthy of Activision's support. Despite recent user declines, World of Warcraft continues to dominate the massively multiplayer online role-playing game market. In the past decade there have been a multitude of competitors, some spending hundreds of millions of dollars, in failed attempts to break WoW's hold on the MMORPG market. Activision has hinted that a MMORPG successor to World of Warcraft, code-named Titan, is in development, but recent comments by management indicate that Titan may not be ready before 2016. While we believe WoW has reached a mature state, the game continues to generate meaningful cash flows, and we expect Activision will continue supporting it until after Titan's launch.
Fairly Valued: Activision's Share Price Reflects Industry Leadership
Our $17 fair value estimate for Activision translates into a fiscal 2013 price/earnings multiple of 25 times, and shares trade solidly in 3-star territory. Relative to EA, we view Activision's strategy as reliable and methodical. Management has established a record of prudent investments and excellent cash flow generation. Activision has sustained ROICs above 40% for the past three years by leveraging established franchises, carefully building new franchises, and developing innovative monetization strategies. Activision pumped out nearly $1.5 billion of free cash flow in 2012, and we expect its slow expansion into new markets could expand future cash flows.
We also like that Activision will no longer be a subsidiary of Vivendi. In July, Activision announced its agreement with Vivendi, Activision's majority shareholder, in which Vivendi would sell more than 600 million Activision Blizzard shares for $8.2 billion (or $13.60 each), effectively reducing Vivendi's stake to 12% from 63%. Activision will buy back 429 million shares for $5.83 billion, while an investor group led by Activision Blizzard CEO Bobby Kotick and co-chairman Brian Kelly will repurchase the remaining 172 million shares for $2.34 billion. Activision will finance its repurchase with cash on hand and $4.75 billion of new debt. The deal is expected to close by the end of September.
In our view, an independently held Activision has more freedom to act in the best interests of all shareholders. We had concerns that Vivendi might have used its majority stake to push for a special dividend that would bleed Activision's balance sheet of cash and leave the firm in a less competitive position. Instead, the deal, as outlined, seems to be a win-win for Vivendi and Activision.