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ATVI Going Up

May 09, 2014 12:54 PM ETATVI
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Company Name: Activision Blizzard

Ticker: ATVI

Price: $19.4

52-week range: $13.27 - $21.50

Market cap: $13.8B

Recommendation: Buy

Activision

Activision develops (through studios it owns) and publishes console games. Current portfolio includes Call of Duty, Skylanders, Amazing Spiderman etc.

I expect Activision to slightly lose its market share in a growing market.

Ø We're at the beginning of the largest ever console cycle. A rising tide lifts all boats.

o Given the pattern of previous two cycles, console software sales are estimated to grow ~10% in 2014, ~40% in 2015, and ~20% in 2016.

Ø Very limited challenge from small independent competitors

o Small studios cannot afford developing high-quality titles. One AAA title can easily cost $10+m with the cost of a top title going up to $200+m.

o People tend to buy well-known franchises or titles published by well-known companies, as price of "trial and error" is high. Freemium model doesn't work in console market, as console (with global annual sales of ~26m units) has much smaller reach than smartphone (~900m units) and PC (~300m units).

Ø Launch of Destiny this fall can potentially offset increasing competition from other big names

o EA's new game Titanfall and Disney's to-be-released Infinity 2.0 will compete head-to-head with Activision's Call of Duty and Skylanders, respectively.

o Activision's to-be-released Destiny is expected to be a billion-dollar franchise.

Overall, I expect Activision to grow its topline and earnings by 5% in 2014, 35% in 2015, and 15% in 2016.

Blizzard

Blizzard develops PC and mobile games. Current portfolio includes World of Warcraft, Hearthstone, Diablo, Starcraft etc.

World of Warcraft (WoW)

Blizzard's cash cow. Originally launched in 2004 with 4 expansion packs released so far, this title is expected to be eventually replaced by a free-to-play MMO currently under development.

Ø Future pace of decline is expected to slow down

o The trend of declining subscriber numbers was reversed in Q4 2013. This was surprising, given that it was 3~4 quarters before the release of next expansion pack and historically seasonality hasn't affected subscriber numbers.

o Developing cycle for each future expansion pack is shortened from 7 quarters to 4~5 quarters.

World of Warcraft brought in ~$800m in 2013. I expect its revenue to fall by 10% every year. This estimate translates into ~$720m in 2014, ~$650m in 2015, and ~$590m in 2016.

Hearthstone

Launched in March 2014 and the profitability of which is largely ignored by the market, Hearthstone is the first influential online adoption of collectible card game (CCG). It's free-to-play and much easier to learn than other CCGs, so it has a much larger potential audience (like League of Legends to other MOBA games). On the development side, it's easy to tweak balance and add more interesting mechanisms that traditional board games cannot achieve.

Ø DAU estimated to be 2~3m globally

o Have 10m registered accounts as of April 2014

o Forum activities ~0.1x of that of League of Legends, which has ~30m DAUs

o Currently ranked No.3 and No.10 in China and US iTunes Store Top Grossing sections respectively

Ø ARPDAU estimated to be $0.2; revenue benchmarks

o Mobile casual games like Wind Runner and Dragon Flight have ARPDAU around $0.15. Most mobile RPG card games have ARPDAU above $0.6. But given those games are pay-to-win where a single person can spend hundreds of thousands dollars, I expect Hearthstone to be in the low range.

o This is equivalent to each DAU buying 60 packs of cards (300 cards) per year, which is expected to give 3 legendary cards (the rarest cards in this game)

o On average, Yu-Gi-Oh! sold ~2b cards annually from 2006 to 2011. If we assume everyone bought the cheapest card set ($2.5 per 10 cards), then annual sales would be ~$500m.

Ø High operating margin, ~50%

o The dev team is small (~20 people, compared to ~120 behind WoW).

o No product cost, as the game is online distributed.

o Firm level operating margin is 30%. Cost of sales and product development each accounts for 20% and 13% respectively.

I expect the game to generate revenue of ~$150m in 2014, ~$300m in 2015, and ~$500m in 2016. This translates into operating income of $75m, $150m, and $250m.

Heroes of the Storm

Blizzard's take on League of Legends (MOBA). This game is currently in Alpha test and expected to be released in Q4 2014. It's hard to see the potential yet, so this doesn't factor into my valuation. If this game can be as successful as League of Legends, it can achieve $500m of annual revenue in 4 years.

Other PC games

With one expansion pack for Diablo released in Q2 and one for Starcraft to be released in Q3, revenue this year is estimated to be $700m. It's hard to predict beyond that, as no games are announced to line up for years in the future. There was no major release in 2011, but other PC games still generated $300m revenue. So for simplicity, I assume that revenue generated by other PC games stays at $400m beyond 2014.

Valuation

CY2013 financial results (amount in millions)

Revenue

Operating Income

Activision

2895

971

Blizzard

1124

376

Distribution

323

8

Total

4342

1355

Revenue forecast

2014

2015

2016

Activision

3040

4104

4719

Blizzard

1540

1310

1450

Distribution

320

320

320

Total

4900

5734

6489

Operating income forecast

2014

2015

2016

Activision

1020

1376

1583

Blizzard

529

500

581

Distribution

10

10

10

Total

1559

1886

2174

Net income/EPS forecast (with interest expense of $220m, effective tax rate of 23%, and shares outstanding of 712m)

2014

2015

2016

Net Income

1024

1283

1500

EPS

1.44

1.80

2.11

If ATVI trades at 17.5x P/E, on par with its peer companies, then

2014

2015

2016

Share Price

25.2

31.5

36.9

Further Research

Ø More on Activision

Ø NetEase revenue breakdown and exposure to Blizzard

Disclosure: I am long ATVI.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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