Activision Blizzard: Still Undervalued

Summary

• Activision Blizzard reported its Q3 earnigns, beating on revenue and EPS.
• The company's Destiny 2 was launched in September, and now it is the best-selling console game of 2017.
• The new Call of Duty and PC version of Destiny 2 will contribute to Q4 results.
• Activision remains to be a solid investment.

Activision continues to impress

Activision Blizzard (NASDAQ:ATVI) has been one of the best-performing gaming companies over the last years, and Q3 results confirmed the company has a strong position in the video game market. Hence, the corporation beat expectations on both EPS and revenue, demonstrating more than 16% revenue growth year over year. Thus, it's now been six consecutive quarters in which the corporation delivered better-than-expected results.

(Source: Seeking Alpha)

Let us look at Q3 results in more detail.

During the three-month period ended September 30, Activision Blizzard generated $1618 million in revenue (GAAP), versus $1568 million earned during the same period last year. The improvement is seen in all revenue segments: product sales increased 8.2% and subscription, licensing and other revenues (where King was the biggest contributor) grew by 1.7% year over year.

It is interesting to note that Activision and King divisions of the corporation more than doubled their operating income, while Blizzard's performance was down year over year. Moreover, King generated almost the same amount of revenue as Blizzard ($528 million vs. $531 million, respectively), which means the mobile segment has become an even more crucial source of revenue for the company. It can be expected the mobile segment will remain to be a significant profit driver in the coming years.

Candy Crush franchise's gross bookings were up 17% quarter-over-quarter and up 22% year-over-year, bringing the franchise back to its strongest bookings since Q4 of 2013. King is making progress on their pipeline and new games as well. The social casino game in partnership with Playstudios is currently in live testing and is now expected to launch globally in early part of next year and a strong pipeline of full game releases are in development for next year and beyond.

Another positive point is the fact that Activision Blizzard increased its cash pile from $3278 million in Q2 to $3576 million in Q3, while the debt position remained on the same level (the company has reduced its long-term debt by $500 million over last nine months). This indicates the corporation's financial health is improving and the level of an overall risk is going down, which is a positive signal for investors. Thus, ATVI's debt-to-cash ratio decreased from 1.5 to a more conservative level of 1.2.

Destiny 2 is a major success driver

Activision's stellar performance was primarily driven by the launch of Destiny 2, the sequel to 2014's Destiny, which was one of the most successful console games on the market. For instance, on day one of its release, Destiny 1 sold over US$500 million at retail, making it "the biggest new franchise launch of all time." Destiny 2 is repeating the story of success:

Destiny 2 is off to a strong start and after the PC launch is now ahead of Destiny 1 on total consumer spend, on time spent per player, attach rate to the expansion packs and average revenue per user.

After just one month, Destiny 2 became the best-selling game of 2017. It is revealed by NPD Group Destiny 2 was the top-selling game of September, and it can be assumed the game also took the top spot in October. This is because PC version of the game was launched on October 24, and it is claimed by many journalists and gamers this version of the game is the best-looking version, and it also brings different experience in comparison with the console edition. Therefore, it is clear many consumers will likely to buy the game twice, which will drive Activision's revenues higher.

Those numbers also make it [Destiny 2] the third-best-selling game of the last 12 months, behind Call of Duty: Infinite Warfare (out in September 2016) and Battlefield 1 (released October 2016). Who knows when Destiny 2 will pull ahead of those in sales, but the hotly-anticipated PC version -- plus the first DLC, which may come out in December -- will certainly keep the cash train rolling.

What is important to note is that PC version of Destiny 2 will be available exclusively via Blizzard Launcher (Battle.net), which means the corporation will save about 30% on publishing fees. When it comes to Destiny's numbers, 30% make a huge difference in terms of profit.

The new Call of Duty will contribute to Q4 results

The new CoD is "the return to its roots" for Activision as it is "the first game set during the Second World War in ten years." Many players demanded a more "grounded" CoD game from Activision, and the company clearly aimed to meet this demand.

The franchise has been a significant source of revenue for the corporation over last years. Hence, as it was mentioned earlier, Call of Duty: Infinite Warfare is still the best-selling game of the last 12 months, and the overall trend looks encouraging. It is worth mentioning that Call of Duty: WWII is set to release on November 3, which means the game sales will contribute to Q4 results along with Destiny 2 (PC).

(Source: Statistic Brain)

DCF modeling shows the stock has room to grow

ATVI stock price has increased almost 50% over last year, and now it is consolidating near the all-time high. At the same time, the stock still has room to grow, as the DCF analysis shows the company is undervalued.

ATVI data by YCharts

The analysis is based on certain assumptions.

1. The average annual revenue growth rate over the horizon period of 5 years is estimated to be around 13%, with a 5% increase in 2017. This complies with the results of Q3 2017 and will be achieved primarily by the success of Destiny 2, Call of Duty franchise, and King's Candy Crash and other mobile games. Moreover, the corporation has a very promising future in the field of esports with its Overwatch game, which I explained in my previous article.

2. The average EBITDA margin will be around 38%, which is a conservative assumption, taking into consideration higher returns will be achieved by retaining platform fees in the future. Moreover, increasing digitalization in the gaming industry will drive the margins higher.

3. The after-tax cost of debt is 1.8%. The cost of equity capital (12.5%) is computed using CAPM, with 1.12 beta, a 2.4% risk-free rate, and 9% market premium. The WACC is, therefore, 11.6%.

Here is the operating and balance sheet data used in the modeling:

Under the base scenario, which assumes 15x EBITDA terminal value, the fair share price is $73.5. 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 $69.4-77.5.

ATVI remains to be a solid investment

Overall, ATVI has shown solid results in Q3 2017, as all the segments (Activision, Blizzard, and King) demonstrated better-than-expected revenue numbers. The company's management also raised its full-year guidance for 2017, which shows the corporation is on the right track.

I also believe Activision Blizzard will show decent performance in Q4 2017 and will likely to beat earnings estimates, since the new Call of Duty game and PC version of Destiny 2 should contribute to the quarter's results significantly. Therefore, despite the fact that ATVI stock has already increased more than 50% over last year, the company remains to be a solid investment. This is supported by the DCF analysis, which indicates the stock is still undervalued.

Analyst’s 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.