On Tuesday, Activision Blizzard (NASDAQ:ATVI) reported a strong profit that beat analyst estimates with EPS at $0.19 instead of consensus at $0.10. How could such a quiet quarter have been such a significant beat?
Blizzard reported record digital revenue, with its release of the Diablo 3 expansion, WoW expansion pre-order hype, and Hearthstone. Diablo 3 and WoW revenue was very visible for analyst, given the week 1 Diablo 3 sales were announced by Blizzard, and subscriber numbers don't fluctuate much and are clearly $15 a month. Thus, it seems that Hearthstone, and potentially WoW level 90 character sales must have contributed to this beat.
Why does this matter? Activision stock has essentially traded on World of Warcraft subscribers on with quarterly reports. Most aren't focused on solid one time game sales, and instead attempt to look forward to recurring revenue. The only true predictive power, to many, is World of Warcraft subscribers. Look to the massive Diablo 3 sales being overshadowed by a drop in WoW subs back in the Q3 2012 report as evidence of this.
Yet, Blizzard has proven that is can continuously monetize its games and that product cycle worries are overblown. That Blizzard can make a massively profitable free to play game with a small development team (I count 30 here) is only testament to their immense vision. These aren't hit or misses like movies, Blizzard does it right. Hearthstone is nothing short of amazing, as its strong metacritic reviews, huge downloads, and the commonplace "I can't believe how much I spent on cards". While the numbers weren't release as it seems ATVI wants to wait until the Android and iPhone release, it's been a pleasant surprise to say the least.
This is true of Activision as well. Worries that Call of Duty would fade continue, even many iterations and record breaking sales later. Moreover, many wonder whether they will create another hit that large. Again, one needs only to look at Skylanders and Destiny. Skylanders is incredible IP that topped video game sales charts (if merchandise is included), and that was Activision fabricated IP, albeit developed off of the stale Skylanders, it's a very different, new product. Destiny stands to be a huge game as it tracks for record pre-orders.
Recently though, many have been worried about the quoted $500mm expected to be spent on Destiny and other development in Q2. Yet, not only does Destiny use the past Halo hype, it also gets at what ATVI can count on to mark its huge success: a rewarding gameplay system. I don't mean intrinsically rewarding, I mean literally rewarding. World of Warcraft combined the rewards of the RPG system with the multiplayer world in which you could reap these rewards, Call of Duty Modern Warfare took the rewarding class system where no other shooter had before and as a stellar success. Bobby Kotick sees what he has in the past in Destiny, a shared world shooter which gets at the highly rewarding system for gamers, and therefore for profits.
While Destiny's success may be debated, my point would still hold without this: Activision Blizzard has visibility into the future even if video game sales can't be precisely predicted. CEO Bobby Kotick recently doubled down on his own personal stake in the firm by joining the consortium to purchase parent Vivendi's stake in the company. At a point, it's time to act like Warren Buffet, and step back and let great managers continue to do their job well.
Once the market recognizes that this isn't your typical video company, it will receive the proper valuation it deserves. A 20x PE looks high, but Activision is a cash flow machine, with around 100mm in capex a year but over $1bn in free cash flow a year. With no net debt, this company can essentially push all earnings directly into accretive share repurchases, becoming one of the few capital return stories in the tech space.
Moreover, its capital budgeting is extremely conservative. With no net debt, yet this immense free cash flow there is definitely potential for a LBO. Quick math of 33% sponsor equity at a $15bn buyout puts $10bn in debt if they settle their current net debt. I assume they can get significantly lower than 10% in today's low rate environment, thus putting them below their 1bn in FCF, which I expect only to grow.
Sponsors would likely see that their multiple expand as well. In the earnings call, ATVI was asked about the potential for proprietary video games, in the wake of the rumored Electronic Arts (NASDAQ:EA)/Comcast (NASDAQ:CMCSA) deal which actually sent the stock down. But in the world of the potential for an Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) top box, Chromecast, Xbox trying to be an entertainment center, there is clearly a battle for the home entertainment ecosystem brewing. Moreover, even wireless companies see the potential for synergies with AT&T's (NYSE:T) potential bid for DirectTV (DTV). Just like Halo created the prominence of the Xbox, proprietary content could be big for winning this battle. If Amazon, for example, wanted to continue on its low margin high volume push, it could buy ATVI for a large premium such that it likely wouldn't see significant return on the company directly if it bought it at a premium, but would be willing to forgo this value if it could draw many to its ecosystem. Thus, ATVI welcomed this possibility on its earnings call when it answered the question.
Rather than a specific target price, I expect to hold this over a long time frame and evaluate when the market is finally granting a strong valuation.
Risks of course, are that this trend of strong products will end. Yet my continued love for all of their releases has finally convinced me of their consistent quality. It will only be a matter of time until the Street feels the same.
Disclosure: I am long ATVI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.