Matthew Ganucheau, CFA's  Instablog

Activision-Blizzard is the dominant player in the fast growing video game industry, owning 3 of the biggest franchises, Call of Duty, World of Warcraft, and Guitar Hero, among others. With the upcoming release of Call of Duty: Modern Warfare 2 in November, I felt it timely to review ATVI's investment characteristics and to try to determine why the market is over looking this undervalued space. During the first 3 quarters of 2009, video game sales have suffered from the combination of the largest financial crisis and recession in the post-WWII period, and what has been a weak video game release slate. However, with the economy climbing out of recession and an extremely strong Q4 release slate coming out of Activision-Blizzard, along with much easier comparison numbers going forward, I believe that this industry is ripe for expanding earnings, multiples, and stock prices. Below I review the results of my research into Activision-Blizzard and discuss why I think that ATVI represents a very compelling investment.  





Large Cap Growth Company for a Low Multiple 
Global  video game software revenue has grown at a 20.4% CAGR from 1996 to 2009, and ATVI is the dominant player in this industry.  The company has historically sold at a forward median p/e multiple of 26.5x (ex extreme periods like 2006), and is currently selling for 15.5x 2010 estimated EPS of $0.78, and for 1.3x BV. Excluding the $2.23 in net cash per share on ATVI's balance sheet, is appears even cheaper, selling at just 12.6x 2010 estimated EPS. These multiples are low considering that ATVI is expected to grow EPS by 20% in 2009 and 20.5% in 2010, and will most likely expand as concerns about ATVI's overhangs fade. 

        Estimates/Mults   2008   2009   2010   2011                 EPS   $0.58   $0.65   $0.78   $0.94 Exp Growth     17.0%   20.0%   20.5% EBITDA   1,249.0   1,453.0   1,538.0   1,785.0 Exp Growth     16.3%   5.8%   16.1% Revenue   4,980.8   4,551.0   5,111.0   5,517.0 Exp Growth     -8.6%   12.3%   7.9%                 P/E     18.5x   15.4x   12.8x EV/EBITDA     8.5x   8.1x   7.0x P/S     3.3x   3.0x   2.8x                 Long-term Growth Rate   17.0%   17.0%   17.0% PEG     1.09x   0.90x   0.75x                 Installed base   103   151   190     (millions)   84.0%   46.6%   25.8%    

Cheap Relative to History and the Overall Market
Forward multiple for shares of Activision before the reverse acquisition with Blizzard had a range of roughly 14x-40x over the past five years versus a current valuation level of 15.4x 2010 estimated EPS. Additionally, ATVI shares are also cheaper than the overall market. Consensus GAAP estimates for the S&P 500 for 2010 call for $64 in earnings, and at 1029 the S&P is trading at 16.1x consensus estimated 2010 GAAP EPS (14.5x consensus 2010 operating EPS estimate of $71). Excluding the $2.23 in net cash on ATVI's balance sheet, ATVI is selling at just 12.6x 2010 estimated EPS of $0.78. Given this undervaluation relative to history and relative to the overall market, I believe that ATVI shares have the potential to exhibit significant multiple expansion as investors become more familiar with the combined Activision-Blizzard company, the World of Warcraft China transition, and most importantly, the music genre sales. 

Upside from DJ Hero
ATVI shares are cheap because they are over-discounting music genre fatigue (Guitar Hero) and the World of Warcraft transition in China to NetEase. Concerning the slowing music genre sales,  DJ Hero stole the show at this year's E3 conference, an industry trade show, and could reinvigorate music genre sales and expand the market beyond fans of rock and roll to those who enjoy mash-ups, dance and club music, a whole new demographic. Despite some early consumer skepticism, reviews of this game continue to come in very favorably. I was skeptical myself until watching the demo videos on the game's website, and I have to admit that it looks like it will be very successful. Furthermore, ATVI is being cautious with its guidance for DJ Hero, leading me to believe that there could be upside from a well received release. Moreover, the Call of Duty and World of Warcraft franchises are more important to the company's financial results than Guitar Hero, representing about 85% of operating income (GS), and as the main earnings drivers, Call of Duty and World of Warcraft strength should more than offset any weakness in music genre sales. 

Video Game Console Cycle Stage Beneficial for Game Publishers
Industry hardware price cuts should accelerate console sales, which should improve video game sales. Analysts at Goldman Sachs estimate that the video game industry's installed base is set to grow by 46% in 2009, with the Nintendo Wii and the PS3 leading the way. Growth is being fueled by video game console price cuts. Sony, Microsoft, and Nintendo all reduced the prices of their systems by $50 to $100 in Q309. More consoles lead to more software revenues for video game publishers at the same time as margins are expanding from scale efficiencies in game production. Moreover, this video game console is likely to be longer than the 5 year cycles we have seen in previous years, with the current cycle, beginning in 2006, already in its fourth year with no hints of new consoles any time soon. Industry insiders like video game publishers usually get a 2 year heads up about new consoles so they can begin working on the engines that will build the games, and none of the people I have talked to at these companies have heard anything about new consoles. These factors are both net positives for earnings.

Price Target
Applying a 20% discount to ATVI's historical 26.5x median P/E multiple to account for the current limited transparency into the combined Activision-Blizzard business and for any possible integration issues, we get a forward multiple of 21.2x. Applying this 21.2x multiple to ATVI's estimated 2011 EPS of $0.94, we arrive at a price target of $19.92, representing 66% upside from current levels.

Catalysts 
Improved visibility into 2010 EPS potential and sustained earnings power from a very strong second half 2009 game release slate, improved visibility surrounding the WoW transition in China, fading of concerns about the slowing music genre sales from a successful DJ Hero launch, and higher game sales from installed-base growth resulting from higher console sales after Q3's price cuts. 

Risks
Risks include a lack of popular titles and retail softness relative to higher production and marketing costs which could negatively affect ATVI's results, any possible weakness in the company's key franchises such as WoW or CoD, a weakening console cycle with declining tie ratios (games sold per console), and any possible integration issues or problems realizing synergies from the Activision / Blizzard combination in 2008.




Disclosure: Author and Author's firm both have long positions in ATVI. 

 

 

A lot has been said about the threat to GameStop's business model from the digital downloading of games and content via the internet. After seeing the extremely low valuation being place on the stock by the marketplace, it seems to me that the threat has been overblown and may already be priced into the stock.

GameStop is currently trading at about 8.4x 2009's estimated earnings per share of $2.82, which is at the bottom of its historical forward P/E range of 6.9x to 30.2x. Moreover, the market is expecting very little growth from the company in 2010 and 2011, with the estimates for EPS forecasting only 10.6% growth for 2010 and 1.3% growth for 2011. This presents the opportunity for GameStop to beat very low expectations and for the stock to appreciate as the estimates are increased and as the multiple expands. As this happens I expect the stock to appreciate to more normalized levels. 

Applying the historical median forward P/E multiple to GameStop's 2011 consensus EPS estimate of $3.16, we reach a one year price target of $52. Catalysts for reaching this target are a recognition of the company's ability to generate and grow earnings even in tough economic environments, a change in the extremely negative perception toward the risks to the company surrounding the advent of the digital delivery of video games, lack of negative impact from recent entrants such as Best Buy into the used video game market. While the historical median P/E multiple may be too high given the concerns with the business, the current low valuation still places a lot of room for upside for the stock.




       

Reasons that digital downloading is not yet a practical alternative to having a physical copy of a game: 
 
 1) No instruction manual; reduced Christmas/Birthday gift excitement/capability; loaning and swapping of games, portability, and renting all are impossible with digital downloads. 
 
2) Downloading times, charges. ISPs are getting concerned about bandwidth use, and are now limiting the speeds and total bandwidth a user has, charging 'per gigabyte' fees. Also, many games are around 50 gigabytes, which would take a very long time to download.
 
3) The majority of the world cannot even obtain high-speed broadband internet, let alone broadband fast enough to download 50gb games within minutes. At current speeds, it would take days to weeks to download games, so people would buy a game, and then have to wait for days to weeks for it to download. This eliminates the instant gratification that many gamers want when buying a video game.
 
4) Physical back-up issues. Consumers like having games in a case, not on a hard drive. They don't trust the reliability of hard drives. For example, many consumers would rather buy a cd instead of downloading an album from iTunes. When a drive fails they are afraid of losing everything. If that happens, not only would it be a pain to get a new hard drive, but then consumers would have to download gigs and gigs of data again, which would be a very time consuming and potentially costly effort.

5) Hard drives get fragmented, they slow down, they produce an awful lot of heat, and in the end a download system would result in a limited amount of games you could have (to around 20 for a 1 terabyte drive). Serious gamers who buy a lot of games would run out of hard drive space fairly quickly.

 6) Digital downloads with no hard copy game eliminate the trade-in value that games currently have. For a digital download model to work, game makers would have to reduce prices to compensate consumers for the lack of trade-in value and also for the other shortcomings mentioned above.  

Also, it can be argued that the downloads of additional content for video games are extending the useful lives of used games, which makes them more valuable in the secondary market and actually helps GameStop's business. The console cycle being longer is an issue, but there are several new things coming out that could excite the marketplace like XBox's Project Natal that could help drive sales. 

The digital delivery of the gaming content through services like OnLive will no doubt run into issues with gamers, especially with them not wanting to pay for a monthly service, not wanting their gaming to hog all of their household's bandwidth, and last but not least, not wanting their games to be lower quality looking then they are currently. OnLive will only send content in 720p HD resolution, which for gamers currently getting their games in 1080p is not an exciting prospect.   

Conclusion: For digital downloads to be desirable, technology will have to evolve to the point where downloading a video game will take less time than going to a store and purchasing it and ISPs do not charge for or restrict heavy downloading access. This may happen eventually, but near to medium term it is hard to see how digital downloads of games could replace the current physical game copy delivery model. However, the approach of cloud-based gaming systems where the controls are sent to the server and the compressed video is sent to a tv is more of an issue. One such company is coming to the market place in 2010 called OnLive. Concerning the cloud-based gaming content distribution model that is evolving out of soon to be new entrant OnLive, the gaming experience will have to match that of the systems that are currently in place, especially with regard to the HD resolution. It is my opinion that OnLive may be more of a threat to computer-based gaming where screen sizes are smaller and resolution is less of an issue, and should OnLive fail to be the complete game changer that the market is currently expecting, GameStop's share could present a compelling investment opportunity. 

Disclosure: As of the submission of this article, neither the author nor the author's firm hold a position in GameStop shares.