Given the concerns over "World of Warcraft" churn and competitive pressures, Activision Blizzard (ATVI) is trading at an irrationally low level. The fundamentals of the company are actually pretty strong, especially when compared to next generation social gaming firms like Zynga (ZNGA). I recommend that investors consider opening a long position in both Activision and smaller gaming-related companies like THQ (THQI) and Zoo Entertainment (ZOOG). These two companies are well positioned to gain from greater news flow and have excellent fundaments to justify significant value creation. I have provided investor relations services to firms within the field in the past, and I say with confidence that returns are largely a function of consumer psychology and communication.
In this article, I will run you through my DCF analysis on Activision and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Zynga and the owner of Xbox, Microsoft (MSFT).
First, let's begin with an assumption about revenues. Activision ended FY2011 with $4.76B in revenue, which represented a 6.9% gain off of the preceding year. Analysts model a 11.3% per annum growth rate over the next five years, and I share the sentiment. This is around 100 bps higher than that expected for the S&P 500 over the same time period.
Moving onto the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model that cost of goods sold will eat 40% of revenue over the next few years. The last three years have seen a dramatic decline in COGS expense from 53.9% to 36.9%, so 40% normalization is fairly conservative. I further assume SG&A, R&D, and capex as 21%, 14.3%, and 1.8% of revenue, respectively, which are roughly around their historical 3-year average levels.
We then need to subtract out net increases in working capital: we model accounts receivables as 15% of revenue; inventories as 8% of COGS; accounts payable as 9.5% of OPEX; and accrued expenses as 83% of SG&A.
Taking a perpetual growth rate of 1.5% and discounting backwards by a WACC of 10.7% over the next six years yields a fair value figure of $15.72, implying 34.2% upside. This is on top of a dividend yield of 1.5%.
All of this falls under an overall favorable context, despite "World of Warcraft" churn:
For the calendar year, on a GAAP basis, we generated record revenues of $4.8 billion, record operating margin of 28% and record EPS of $0.92. On a non-GAAP basis, for the calendar year, we generated significantly better-than-expected revenues of nearly $4.5 billion. We expanded our non-GAAP operating margin 170 basis points to a record 30.3%, and we grew EPS 18% to a record $0.93.
Despite challenging retail conditions, tough comps for Call of Duty and no frontline releases from Blizzard, we set new record results for the industry and exceeded our going-in expectations for 2011 by a wide margin.
Since our merger with Blizzard in 2008, our operating margins have increased by more than 625 basis points and reflect profitability well exceeding other interactive entertainment companies, most major media companies and several leaders in Internet and software.
From a multiples perspective, Activision is fairly attractive. It trades at a respective 12.7x and 11.1x past and forward earnings versus 11.5x and 10.6x for Microsoft. Given that Microsoft is thought as more of a computer software firm, it is not really meaningful to directly compare multiples to Activision. The point is, however, that both firms are attractive on a multiples basis. Considering that Zynga trades at 38.8x forward earnings, the two have room for their gaming operations to inflate.
Consensus estimates for Activision's EPS forecast that it will grow by 2.2% to $0.95 in 2012 and then by 11.6% and 16% in the following two years. Assuming a multiple of 14.5x and a conservative 2013 EPS of $1.03, the rough intrinsic value of the stock is $14.94, implying 27.6% upside.
Zynga is expected to grow its EPS by 8.3%, 38.5%, and 30.6% over the next three years. As I have explained here, Zynga's business model is highly uncertain. Greater mobile use may be a solid secular driver for value creation, but I anticipate that the Facebook craze will abruptly die in the next five years. Consequentially, all of the media talk about uncertainty for Activision and Microsoft is really a double standard. For investors looking to benefit from high risk-adjusted returns, Activision and Microsoft are thus attractive picks.
Disclaimer: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.