Activision Blizzard: Great Buying Opportunity

Summary

• Activision Blizzard established the Overwatch League to gain from e-sports.
• The company sold the first seven teams, receiving about $140 million of unexpected revenue. It is estimated 21 more teams will be sold.
• Therefore, Activision is likely to beat earnings in 2017.
• I updated my model to take into account the recent events.

During its last earnings call, Activision Blizzard (NASDAQ:ATVI) set guidance of $6.3 billion in revenue for full 2017. However, the company is very likely to beat earnings. The main reason for this is the sale of seven Overwatch teams, which was not taken into account by the company when it provided the guidance during Q1 earnings call. Therefore, a buying opportunity has arisen. I will analyze it in this article, providing my updated valuation of the company.

Q1 earnings and guidance

First of all, it is necessary to analyze what was achieved in Q1 2017 and what was the guidance of Activision Blizzard’s management.

The company reported $1.73 billion of generated revenue, which represented 19% increase year over year. This led to a beat by $640 million on revenue and $0.28 on EPS. The main reason for this was the success of Blizzard’s Overwatch, which allowed the division to increase sales by 50% year over year. It is estimated nearly 2.2 million players have been joining the game every month, which means about 6.6 million new gamers were likely to have purchased the game in the three months since the last earnings report. Moreover, a significant milestone of 30 million players was surpassed in May, and, as a result, the game has generated over $1 billion since the release.

(Source: Polygon)

In addition, King’s revenue grew by hefty 129%, leading to an overall mobile and ancillary revenue increase of 95%.

During the earnings call, the company’s management provided its outlook for Q2 and full 2017. Here it was stated net revenues were expected to amount to $1.43 billion in Q2, with $0.38 EPS (including $0.11 GAAP deferrals recognition). The average analysts’ estimate on Yahoo Finance predicts $0.3 EPS in Q2 and $0.48 in Q3 2017. Activision provided the list of the main events that will drive profits in the second quarter:

Our Q2 slate includes one of Blizzard's busiest stretches of in-game content releases, including momentum from the March 28 World of Warcraft content update; a new Hearthstone expansion, Journey to Un'goro; the Overwatch Uprising event; and the Heroes of the Storm 2.0 launch with more content to come in the upcoming months. King will continue to drive live ops across its portfolio, albeit with some typical seasonality expected in Q2.

As regards the full year guidance, the numbers are as follows: Net revenues of $6.1 billion (including GAAP deferrals of $230 million) and non-GAAP EPS of $1.8. However, I believe the company did not take into account the recent sale of Overwatch teams, which means the guidance is likely to be beaten.

Overwatch teams

In July 2017, the company revealed it sold the first seven franchises in its Overwatch League, “the first major global professional league with city-based teams.” Activision also revealed the team owners, who include people from NBA, NFL, and MLB:

• Robert Kraft, Chairman and CEO of the Kraft Group and the New England Patriots (Boston)
• Jeff Wilpon, Co-Founder and Partner of Sterling.VC and COO of the New York Mets (New York)
• Noah Whinston, CEO of Immortals (Los Angeles)
• Ben Spoont, CEO and Co-Founder of Misfits Gaming (Miami-Orlando)
• Andy Miller, Chairman and Founder of NRG Esports (San Francisco)
• NetEase (Shanghai)
• Kevin Chou, Co-Founder of Kabam (Seoul)

The teams will have a city-based structure like it is done in traditional sports, and the first season is scheduled to launch by the end of 2017. It is also expected Activision will sell 21 more teams in the near future.

Why is it important for ATVI

First of all, it is clear e-sports are becoming even more popular and attracting the attention of major traditional sports leagues. Fortune provides an explanation of the business model:

The business model [of the NFL] is they create content, they build an audience around that content, and then they monetize the audience through media rights, sponsorship, merchandise, tickets, etc…The business model of the Overwatch League is exactly the same.

This also explains the shift in revenue sources in Q1 2017:

• Product sales, $509M (down 21.1%);
• Subscription, licensing and other revenues, $1.22B (up 50.2%)

As a result, it can be expected ATVI will transit towards business with more recurring revenue, making the company even more attractive.

However, the main takeaway from here is the fact that full-year revenues will get an unexpected boost from selling the teams. It is stated a fee for acquiring one franchise amounts to approximately $20 million. Therefore, seven teams that have been sold should provide about $140 million additional revenue for the company. Moreover, as 21 more teams are expected to be sold by the end of the year, revenues are likely to be much higher than it is currently expected.

It is worth noting the company has a sound history of beating estimates, as is evident from the last four quarters.

Model update

In the previous article, I valued the company using DCF modeling, estimating the fair price for the stock to be $55. I have updated my calculation, taking into account the recent events. Overall, the assumptions for the model are the following:

1. The average annual revenue growth rate over a horizon period of 5 years is estimated to be around 16.4%, with a 20% increase in 2017 and 23% increase in 2018. I have raised my assumption here to recognize $140 million of additional revenue from selling seven Overwatch teams in 2017, and possible revenue of $420 million from selling other 21 teams in 2018.

2. The average EBITDA margin will be around 36%, which is a conservative assumption, taking into consideration that revenue from e-sports should increase margins significantly.

3. I have also revised my assumption for the WACC. The after-tax cost of debt is 1.6%. The cost of equity capital (10.7%) is computed using CAPM, with 0.94 beta, 2.2% risk-free rate, and 9% market premium. The WACC is, therefore, 9.85%.

As a result, the model shows $53.46 billion equity value under the base scenario, which assumes the EV/EBITDA multiple will decrease to 15 by the end of the horizon period (2021). This is the same scenario I use for other gaming stocks like EA (EA) and Take-Two (TTWO). In ATVI's case, the fair value of the stock is $69.7. Under the optimistic scenario (17x EBITDA terminal value), equity value is $59.2 billion or $77.2 per share.

The sensitivity analysis shows a range of possible outcomes that will be driven by actual results of the corporation. In light of this, the fair price range is $65.9-73.4.

Final Words

Overall, as we can see Activision Blizzard is currently attractive for investment as the company will get an unexpected revenue boost from selling Overwatch League franchises.

In addition, the current stock price represents a significant support level, which means the probability of an upside move is higher than the probability of a drop.

At the same time, It should be noted the current price is only justified by the expectations of investors. This is because ATVI’s trailing P/E ratio is a hefty 45, while a forward P/E multiple is more reasonable 25. If Activision fails to execute its strategy in e-sports, or if Destiny 2 will not achieve a significant success, the stock price might react negatively. Therefore, investors should be cautious and keep their focus on the actual performance of the corporation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EA, ATVI over 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.