The purpose of this article is to serve as part 2 to the article "Why I Left My Cheerleader Pom-Pons At The Door And Sold Activision Blizzard." The original article can be read here.
I recommend readers start by reading the original article, if they have not done so already. It's also recommended they specifically read through the comments in the original article. The comments are important as some inspired this continuation article. Furthermore some of the comments will be referred to here, which will work in conjunction with the reflection on this articles thesis.
The investment world is subject to many theories and hypothesis. One such hypothesis, is the Rational Expectations Hypothesis. This article is not meant to be a lecture, but to sum up this hypothesis, it basically states that investors will act rationally and intelligently in their investment decisions, after weighing all possible information available to them. The hypothesis basically means, that investors should always do what is considered to be rational, and therefore as a result, an efficient stock market should exist. Furthermore, because of this, the price of a stock at any given time, will be a reflection and sum of all of this rationalization.
After reflecting on the many comments submitted from the original article for Activision Blizzard (ATVI), I started to consider that the Rational Expectations Hypothesis is actually flawed. In this continuation article, I will attempt to prove the flaws, by using some of the actual self-proclaimed ATVI investors, from the original article as a reference. This article will also dive deeper into the analysis of ATVI, Electronic Arts (EA), and Perfect World Co (PWRD).
The bullet list below is the consolidated comments from the original article, to be addressed here in part 2:
- ATVI (including Bungie) consistently creates polished video games, will continue to do so, and as a result is in a unique competitive position to be a winner for investors.
- Diablo 3 is the most anticipated game in 10 years, and will generate superior revenue for ATVI as a result.
- The new concept of the real money auction house, RMAH of Diablo 3, will deliver healthy residual revenues to ATVI's coffers.
- The decline or plateau of WOW subscriptions, has little to no affect on the numbers or stock performance of ATVI.
- ATVI or "Blizzard" specifically has a unique culture, the very best in development teams, and as a result has a competitive advantage over its peer competitors.
- The Vivendi (VIVHY.PK) parent, and the considerations and uncertainty it poses to the ATVI equation.
- The performance, and patters thus far for ATVI's common share price, and the future.
- Hardcore gamers know that ATVI will do well, based on their personal enjoyment of ATVI's products. Gamers as a result, believe that this is a paramount qualitative reason to hold ATVI stock, and will trump all other investment rational.
Special Notes: The original article, drew some criticism for only examining a 3-year chart. As a result, this article, will be using a 5-year chart. The reasoning was to account for the in 2007 merger with Vivendi (one of the major reasons for the price appreciation at this time).
5-Year ATVI chart with 261-week WMA, and Linear Regression added
Approximate ATVI Metrics: P/E 15.2, EPS $0.84, Beta 0.54, ROE 9.2
The reader will notice that the linear regression line is relatively flat with a slight downward trend. This has consistently constituted the overall trend for ATVI over the past 5 years. Furthermore examining the 261-week (5-year) WMA, notice that the current price is above the WMA. This may be good for momentum and growth-orientated investors, if coupled with a higher buying interest volume. However this could most likely, be due to the release of Diablo 3.
On the other side of the coin, value-oriented investors would be buying above the moving average. Moreover value investors would be working with a high P/E ratio in comparison with peers. The objective here is not to say that ATVI's stock price will not increase. On the contrary, ATVI has a good possibility of breaking through $13, with the release of Diablo 3 (due to hype). It is unknown for how long ATVI would stay above $13, and for what reasons, as it is purely speculative.
Investors should consider that over the last 5 years, ATVI has virtually existed in the price channel of approximately $10 to $12. Although this is a 20% variance (if investors were perfect timers they could make money 20% timing the ups and downs), consider that ATVI's Beta is 0.54. This is generally not indicative of a high-growth stock. This differs from the consensus that most investors are holding ATVI for the potential of capital appreciation versus stability or income.
Moving forward to the first bullet point, ATVI has released the following polished/hit games during the past 5 years. (Call of Duty Black Ops, WOW Burning Crusade, WOW Wrath of the Lich King, StarCraft 2, WOW Cataclysm). In short, 5 games/expansions in 5 years. There is Diablo 3, the last WOW expansion (Panda's), 2 StarCraft expansions, and Titan yet to come.
The point here is, that in the past 5 years, with all these 5 polished hit games, ATVI has not broken out of its price channel of $10 to $12 (sans the VIVHY.Pk merger). In addition, in those 5 years the maximum WOW subs thus far have been obtained and have declined. The record-making release of Black Ops occurred, and StarCraft 2 (which was just as anticipated as Diablo 3 I will add). This line up of quality IP, and polish, was unable to make the stock price of ATVI appreciate and hold above the price channel.
The amount of total WOW subscriptions have declined. The WOW subs may increase with the launch of Mist of Pandaria, but may taper off, within 6 months as shown on previous expansions. ATVI, has no plans for future WOW expansions after Pandaria. By using the record and sales numbers of all of these past hit game releases, one could make the point that Diablo 3, will not be able to increase the share price of ATVI as in the past.
Many comments have asked how I know WOW will decline, or why is it showing signs of weakness? To answer this I will use an analogy. Picture WOW as a 7-year old car. As the owner and operator (gamer) of the car, you have loved the car, and had many great adventures over the past 7 years of owning the car. You may be able to trick out the car, by adding a new exhaust system, or rims (the Panda expansion). But in the end, it is still just a 7-year old car. If you choose to hold onto the car, the 7-year old car, then becomes a 8, 9, or 10-year old car. At some point, you start to see newer cars drive by, and yearn to upgrade, or get rid of your old car. The very same thing has occurred in the past with Ultima Online and Everquest. The only difference is, WOW was a really good, reliable, and popular model of car. Some gamers still play Ultima Online, and Everquest, but in a reduced matter. This is the nature of gaming, and it will happen to WOW. This is not taking into consideration the many choices that are out there currently, and will continue to come.
As for the RMAH of Diablo 3, it has the potential to disappoint investors. The reason for this, is that the RMAH provides 10 free of charge slots for players to use, and hard core players can opt out of the RMAH completely. Most players, are deemed to be casual, and will not require more than these 10 free slots, and will manage the free allowance to the maximum. Professional players, that are considering making a business of selling Diablo 3 items, may find workarounds to paying fees. For example, if a professional player requires more than 10 slots, what will stop these pro players, from buying another game license, and leveraging another 10 free slots? These pro players can have a business partner hand-off/transfer items to facilitate these transactions. As a result, this would help lower fees paid to ATVI as much as possible. As a result, there may be little residual revenue generated for ATVI from Diablo 3.
Additional thoughts to consider is that, according to a Standard and Poor's S&P ATVI report, 35% of ATVI's shares are institutionally held. The retail investor needs to consider, that institutional investors do not care how good a game is, how it plays, or how polished it is. Most institutional investors only care about the financials, and stock performance. This can be in the from of growth (which ATVI has not shown thus far compared with peers), income 1.5% dividend, or stability in earnings. The key here, is that once the WOW subscriptions succumb to their inevitable age, this could cause an exodus of the institutional ATVI shareholder. And thus will translate to a stampede of elephants running over the retail investors. (or gamers who are passionately holding ATVI for the long term). To reiterate this point, with a Beta of 0.54, ATVI is more like a utility company. Using the utility company analogy, if the steady stream of electricity usage fees (WOW subs) is at risk of decline, institutional investors will sell based on the loss of residual revenue. The metrics on this will be detailed in the peer examination below.
Depending on when investors purchased their ATVI shares, since 2009 the buy and hold investor, has not fared so well. If ATVI's history is any indication of the future performance, Diablo 3, or any other game produced in the future, should not make ATVI's share price increase. ATVI is expected to continue to release games. That is its business, and therefore no matter how anticipated it is, it will be technically already priced in perpetually. Furthermore, all new ATVI games, will have to compensate for the inevitable decline of the WOW subs. So an offsetting, or lateral revenue/earnings swap, will need to occur overtime. There is no guarantee that Titan will fill this void, or Skylanders. Titan is not a WOW replacement, it is a completely different game, and is rumored to be a casual game. Titan could very well be a flop, or be a lateral transfer for the attrition loss of subs from WOW, which means that ATVI numbers may very well stay static.
There is still the Vivendi wild card, since 6 Vivendi directors sit on ATVI's board, there are many possibilities that can occur both negative and positive with Vivendi as the parent company. Vivendi owns 52% of ATVI, and this ties into the fact that 35% of the shares are held by institutional investors. As a result, there is a risk to retail investors, because they do not have the control of over 87% of the shares held & traded. This leads back to the possible institutional elephant stampede.
A reader in the original article commented that investors cannot gauge the success of ATVI just based on WOW, because all of its other IP, successful franchises, and future games will compensate for any decline in WOW. However I believe, that this statement is wrong, using EA as an example.
5-Year Chart of EA with 261-WMA, and Linear Regression Added.
Approximate EA Metrics: P/E 67.5, EPS $0.24, Beta 1.23, ROE 3.0
EA has great intellectual property, and talent, as does ATVI. I am not going to compare the companies in that regard (consumer preference), but I will say that EA's BioWare division commands tremendous respect. EA has created original IP in the form of Dragon Age, Mass Effect, and a substantial list of other titles. I would even go as far to say that EA has released more titles than ATVI. However, all that matters is the financial numbers, and with examining the top lines, both EA, and ATVI have revenue over $4 billion, and less than $5 billion.
What is the difference then between EA, and ATVI? Mainly, EA has horrible net profit, and ATVI does not (only recently). ATVI's recent profitability, is most likely attributed to the recent game releases mentioned above, but if the reader examines the prior years, ATVI does not net very much in comparison, even with the WOW juggernaut. As a result, the difference in my opinion, is that EA lacks the success of WOW. For that matter, ATVI has just as much of a chance to have its financial numbers look like that of EA's or even worse, once you pull WOW out of the equation. This is a fact, and is proven right in the numbers.
If the reader is still not convinced, consider the roughly 10 million subscribers at an average of $13/mth equates to $1.3 billion ($13/mth is a rough average $10/mth could be used to compensate for the lower paying subs). The sum $1.3 billion is more than ATVI's entire net profit last year. If the WOW subscriptions drop in half over the next few years (as speculated in some comments), to even a respectable 5 million subs, the $1.3 billion will drop in half. Any way that investors look at it, $1.3 billion, is either roughly 28% of ATVI total revenue, and/or all of its current net profit. As a result, any change in the WOW subs number, will add considerable volatility to the overall picture and performance of ATVI.
Furthermore, it is unknown if Diablo 3 will sell more than StarCraft 2, and all of the WOW expansions released thus far. As a result, all that matters is the WOW subs, and the residual revenue that they generate. Otherwise it is just the expected game release, after release for ATVI. Furthermore, investors need to consider the developmental costs, recovery of these costs (sales), minus the marketing, customer service, and the a risk of flop. Because of all of these factors, it all comes down to the number of WOW subs.
PWRD, does not have this problem as shown below.
1-Year Chart of PWRD with 50 WMA, and Linear Regression Added. (5-year would not produce WMA, due to technical difficulties, 5-year with Linear Regression and no WMA below)
Approximate Metrics: P/E 4.0, EPS $3.19, Beta 1.85, ROE 27.3
Readers can clearly see, that the revenue is growing at a considerable rate for PWRD. Furthermore, PWRD's net profit, is almost as much as ATVI. In consideration, that PWRD, has less top line revenue, it shows that it is more efficient than ATVI. Furthermore, note the consistency in the revenue growth and earnings for PWRD versus ATVI. As a result, it does not matter about individual opinions, regarding Free-to-Play F2P games and their respective quality. All that matters is the financial numbers, and clearly, the numbers speak to the fact, that PWRD has a winning formula over ATVI.
ROE is an important ratio, because it reflects the profitability of the shareholder capital in the business. PWRD's ROE smashes that of EA, and even ATVI's. Moreover, PWRD has doubled revenue from 2008 to 2011, whereas both EA and ATVI have not. PWRD's EPS is roughly 3 times greater than ATVI's, and significantly more than EA's.
With a look at the balance sheet, it shows that ATVI has $7 billion in goodwill (this is a large number compared with peers), whereas PWRD only has $500 million. Having $7 billion in goodwill for ATVI is risky for investors, since it represents around half of their total asset value. As for the cash situation, ATVI has $3.5 billion, but PWRD has a respectable $2.3 billion.
PWRD, has proven that the F2P model works, by its financial numbers. Furthermore with that said, the F2P model is a better model, than the RMAH in Diablo 3. The reason for this is that the lion share of the money goes to the game company itself , for the purchase of in game items, rather than the players minus fees. Since PWRD has replicated this successful F2P model, over its multitude of games lineup, it has multiple residual revenue streams as a result (Whereas ATVI only has WOW, and an unknown amount in Diablo 3). Lastly PWRD also has the China factor. Meaning that because PWRD is a Chinese company, it has a significantly large local population base (market), in which it is well attuned to supply and cater to its needs. Furthermore, PWRD does not have to work with a partnership in China like ATVI does with Netease (NTES).
In conclusion, using some fanatical ATVI investors as examples suggests the Rational Expectation Hypothesis is flawed. This is due to the fact, that some fanatical investors may forgo acting rationally, and make their investments decisions, based purely on their love, and personal experience with a company's product.
Charts and Source Information: Courtesy Of RBC Direct Investing