Activision Blizzard Set For Outstanding Q4 Results: Buy Before Earnings

| About: Activision Blizzard, (ATVI)

Summary

Activision Blizzard has been on a tear lately, posting over 98% gains YTD and picked up extreme traction back in May.

Along with the rest of the market, the stock has experienced a retreat to 35, representing a fantastic buying opportunity.

Many want to talk about Call of Duty’s great Holiday success, but the Warcraft movie in 2016 and the movie and TV show business points to extreme upside.

Activision Blizzard (NASDAQ:ATVI) had an extremely successful 2015 in terms of advancing shareholder wealth and also increasing the intrinsic value of the company. There have been many articles written on the extreme potential and massive upside of ATVI despite its already massive gains. But there is more to be had in terms of upward price movement in the near future.

Most long position advocates like to point to the success of Call of Duty: Black Ops III and the upside of Activision Blizzard getting into movies and TV shows based off of their successful franchises, but there is so much more within the confines of their financial statements and notes to the financial statements that detail further reason to invest in ATVI under $40 a share.

Timely Leveraging and Superior Content Lead to Competitive Advantage

Traditionally, American multimedia graphics and software companies like Electronic Arts (NASDAQ:EA) and Take Two (NASDAQ:TTWO) have operating margins of 10%-30%, but according to Macquarie's recent report which sheds an overweight prediction on ATVI and EA, margins for EA can grow to as much as 35%, while ATVI can experience operating margins similar to its Japanese peers in the 40-45% range over time.

Now currently, Activision Blizzard only has an OM of 21%, and is clearly at a bigger growing stage than Electronic Arts right now despite its larger market capitalization of the two. This is evidenced by ATVI's EPS expected growth Y/Y to be almost 23% as opposed to EA's predicted 12%. In addition, EA's ROI stands at 24.5% as opposed to ATVI's 17%. Now once the Q4 numbers come out with the results back from Call of Duty and the King Digital (NYSE:KING) acquisition, the ROI for ATVI should go up considerably.

To me, the King acquisition was one of the most savvy moves of the gaming industry in all of 2015. They will import King's fantastic margins (33.7% OM, 55.9% ROI) onto their books and own a huge stake, perhaps one of the most addicting mobile gaming platforms of all time: the smartphone. Candy Crush will not be around forever, but it has outlasted the likes of Angry Birds for a reason. The high margins in mobile gaming will help out ATVI in the long term and the short term as well.

Leverage is a powerful financial tool, and Activision has a lot more leverage than Electronic Arts right now. $4.07B in total debt compared to $435M to EA. Leverage, as a basic financial principle, is only justified in a timely situation. Right now, the degree of financial leverage will help increase the earnings per share as long as operating income is higher than expected. With the holiday-winning Black Ops III in view, it's safe to say the boost in top line sales, combined with the already growing revenue, will lead to unexpectedly high earnings per share.

Activision Blizzard's operating margin already stands at 31% expect that number to increase to 35-38% once Q4 results are posted. Some might want to point to the economy and many future outlooks of the 2016 spending landscape as reasons not to be too optimistic. But truth is there will always be money in consumer's hearts for gaming Gaming is for any age, sex, or stage of life you are in, and almost every family of four or more will have a gaming console or PC one way or another. Couple that with a less competitive industry thanks to plenty of mergers and acquisitions we have an ideal landscape for growing margins

Valuation and Outlook

What makes Activision Blizzard's future any better or worse than Electronic Arts? First, let's take a look at some of the top selling video game franchises owned by EA or ATVI in terms of sales, and then put their reviews face to face:

All user ratings are obtained via Metacritic.

First we look at the two FPS shooters, and Call of Duty pretty much wins by default. They do have a lower user rating, but you do know there are a lot of first impulses and people just going to the website to rant initially post holidays for BO3. Those ratings will even out over time. Battlefield has the far inferior professional critic rating, and most people given the choice between the two would choose the easier to work with interface of Call of Duty, even if you are getting a similar game every time the franchise releases a new game.

World of Warcraft is older but still holds a special place in the hearts of PC gamers worldwide, while Star Wars the Old Republic came to be known as a catastrophic disappointment. As a person who has logged over 300 hours of gaming from Star Wars: The Old Republic, it does get repetitive early on.

In terms of sports obviously EA holds all the cards, but even then, users have been crying for competition for years, and madden 16's glitches are well documented. And even now at the later stage of the products' life many glitches have not been corrected. As an avid Madden Fan I did not even buy Madden 16. I was so discouraged by renting it that I just stuck with Madden 15.

Going to the bottom line averages, we see that ATVI beats EA easily for both user and critics ratings. As a person who has friends who are avid gamers, I can broadly say that while Activision seemingly has a cult of gamers who are into their products, EA can only boast a cult of people who hate their products. I know I do not speak for everyone who might come across this article or speak for gamers in general, but when it comes to making money you go with the broad consensus to determine direction.

Based on a growing industry, higher margins, returns and less competition, the market should be willing to assign Activision a P/E of 30. Based on an EPS of 1.58 next year, a conservative estimate to be sure based on 23% EPS growth Y/Y mentioned earlier, we get a fair value of $47.40. From these estimates and fairly conservative predictions over the course of 2016, we can safely say that Activision Blizzard at this time is very much undervalued and has a lot of room for growth.

Conclusion

Activision Blizzard is a classic case of how to correctly use financial leverage. Despite its high liquidity ratios (3.8 Quick Ratio) and decent price/FCF ratio (23.48), the company intentionally decided to take on more debt than the industry average (0.51 Debt/Equity) to bolster its EPS growth. In combination with industry growth, higher margins, and a high upside pipeline to address sustainability, Activision should be poised for another successful year in the market. Sure, it's not going to rise 90% again, but the success of Black Ops three will ensure short-term success and enable ATVI to beat their expected top and bottom line numbers and also show financial improvement across the other parts of the income statement. Increased game quality over its peers also will keep gamers hungry for more content.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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