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Summary

  • ATVI's focus on existing, strong franchises makes the company's business model lower risk (less hit-and-miss) than the gaming industry at large.
  • The company's 10 year "Destiny" partnership with Bungie creates valuable optionality.
  • The gaming industry is growing 12% annually, but much of this growth is coming from mobile apps, where ATVI is less active.
  • High ROIC 25% pre-tax. 10-15% forward growth seems reasonable.
  • Shares seem slightly discounted but far from the 12-13x after-tax multiples of FCF, EPS and NOPLAT where I'd really be interested.

Business

Activision Blizzard (NASDAQ:ATVI) is a global, multi-platform game publisher.

I was skeptical of video game companies in general because I had the notion that the businesses lived and died by the success of individual titles. I did not think of it as a recurring revenue business. Further, I thought gamers were very fickle and generally rational shoppers looking at product reviews before making purchases, pirating games, etc.

I was surprised in reading ATVI's 10-K. 80% of FY13 revenue came from 3 franchises: Call of Duty, Skylanders and World of Warcraft. These franchises have made money for years and should continue to do so. They have very strong brand recognition among gamers and though WoW and CoD are getting a bit aged, I think there is still plenty of value to be derived from these franchises. I played WoW for a time several years ago, I know many people my age who are engrossed in the Call of Duty games, and my girlfriend's little brother has all of the Skylanders games and his parents and family have probably spent a total of $400-$600 on the games, portal, figures and other toys and accessories.

In the case of ATVI, the company seems to actually have a pretty strong recurring element to its revenue stream due to repeated successful title releases under increasingly strong franchise brands and a very loyal customer base.

The company has been dependent on the three franchises mentioned above for a while, but has 10-year publishing/distribution rights to the Destiny franchise, the first game of which is expected to be released this September. Destiny is being developed by Bungie, the developers of the Halo franchise from 2001-2010, which is a multi-billion dollar franchise and one of the most successful FPS franchises since 2000. Destiny will be another FPS franchise and from the video at the following link, it seems very similar to the Halo games. I don't know how receptive the gaming community will be to the franchise as there have been several high profile FPS releases of late and it is difficult to predict, but there is definitely the potential for ATVI to derive a great deal of revenue and profits from the franchise over the next 10 years and I wonder if that optionality is being captured in the company's current valuation.

The gaming market is growing fast. Gartner estimates the global gaming market to grow to $111B in 2015 or 12% annually from $79B in 2012. Much of the growth is expected to come from mobile apps where ATVI is less active though.

Overall, I like ATVI's business and see it as capable of sustaining somewhat steady performance through periodic new titles in strong brand franchises with loyal customers. I'm still a bit wary of the title-to-title nature of the business though, even if ATVI is less exposed to that by focusing on existing franchises. I'm also worried because although I certainly believe people will be playing video games in 10 years, I don't know how (console, genre, other technology, etc.).

Valuation

Calculating ROIC as EBIT/ (Total Assets - Goodwill - Current Liabilities), I got 25.7% pre-tax and close to 20% after-tax. That is well above-average but not as strong as many of the companies I've been looking at recently (a very high ROIC crowd, to be sure).

Over the past 10 years, the company has grown at the following CAGRs:

  • EBIT 21%
  • EPS 15.4%
  • Revenue 13.9%

There have been some concerns about declining subscriptions in the company's WoW franchise, but I think the other two major franchises still have plenty of life left in them and I think there is a decent chance of Destiny picking up the slack and then some. With that, I think the company will continue to be a low to mid-teens per share grower.

For 25% pre-tax ROIC and 10-15% growth, I'd see shares as fairly valued at 16-18x after-tax. ATVI currently trades at the following:

  • EV/EBIT 13.4x
  • P/FY14 non-GAAP EPS guidance 18x
  • EV/FCF 16.6x

The business seems slightly discounted, but insufficiently so. Closer to fair value than where I'd really seriously consider buying. I'd seek a discount of 35% or so because of the qualms I mentioned with the industry. 12-13x FCF, NOPLAT, and or EPS would be really compelling.

Conclusion

I was very surprised and impressed reading about ATVI's business, but I still have some qualms with the gaming industry. ATVI stock seems reasonably priced but nowhere near where I'd really feel compelled to perform deeper due diligence.

Source: Activision Blizzard: A Low-Risk Business Model In A Risky Industry - Compelling Value Here?