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Activision Blizzard: undervalued compared to peers?

|Includes: Activision Blizzard, Inc (ATVI), EA

*Update after earnings*

 

It is my belief that the reporting of the headlines is slightly misleading resulting in a substantial move to the downside (6-8%). The company reported stronger than expected 2010 earnings with improving margins and excellent cash flows. The concern however focuses on the guidance for 2011 and the discontinuing of Guitar Hero (amongst other historically popular titles like Tony Hawk and True Crime). It should be noted that the company’s guidance does NOT include a title from Blizzard, it was anticipated by the market (and by us) that Diablo 3 would definitely be released in this fiscal year. The company is being prudent by excluding the revenue and EPS impacts of this release until a date is confirmed. It is a case of ‘when’ and not ‘if’ this game will be released and this could still well be in 2011, Blizzard is afforded a unique flexibility in its release schedule so that it can be satisfied with the quality of its games, which is a hallmark of the studio. It appears possible that the discontinuing of some well known, but no longer very profitable, titles maybe being mixed up in the earnings release. Whilst there have been and will be material impacts on the company (decrease intangibles and restructuring costs include in numbers) we feel that the continuing focus of management on the most successful and profitable franchise is very positive.

 

It should be noted that the company purchased $966mln of its own stock under its buyback program with an average price of ~$11.23. The company announced, along with an increased dividend, a new $1.5bln buyback program. This represents approximately 30% of the available float and was not included in the guidance for EPS due to the speculative nature of the buyback.

 

We will be using weakness to add to our position. Re-iterate: Buy

 

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The current malaise in the video gaming sector has unfairly discounted the ‘best in class’ asset and presents a compelling buying opportunity based on its exceptional balance sheet and record breaking franchises. Activision Blizzard has a unique business model in the sector combining the predictable cash flows generated by consumer subscriptions to its Massively Multiplayer Online Role-Playing Games (MMORPG) such as World of Warcraft, with blockbuster games such as Call of Duty. Despite the obvious attractions of this model Activision currently trades at a discount to its sector peers and we believe this presents an excellent opportunity to initiate a position.

 

 

 

With $2-3 of cash per share, no debt and a dividend yielding 1.26% (at the time of writing) Activision Blizzard (NASDAQ:ATVI) has an exceptional balance sheet. Whilst this strength is not a reason in itself for the company to be valued more highly by the market we believe it adds a fundamental base to the stock which reduces the risk of our investment. The state of the computer gaming industry as a whole, highlighted by the flat to declining industry sales in 2010, and the mid-cycle phase of console regeneration has caused significant distribution in the sector recently. The lack of growth in game sales is a concern however we believe that ATVI’s competitors are bearing the burden of these declines as the company’s most successful titles continue to exceed sales records for all forms of entertainment let alone video games!

 

For the sake of brevity in this thesis I will not be going into detail regarding the companies current games since these titles are well known to most and have been covered in depth numerous times. Needless to say we believe the company’s current slates of products are exceptionally strong and should continue to provide excellent cash flows for the company into the future. I will instead focus on the overall strategy of the company and a few issues and opportunities on the horizon.

 

The apparent lack of enthusiasm for the mobile gaming sector displayed by ATVI appears strange considering it is the one bright spot for growth in the industry. Management has made it clear they feel focusing on the higher quality, higher margin game is the best strategy for the company to focus on and we agree with this assessment. The mobile gaming area is definitely growing and there is a huge potential market for these games however the low margins and fickle nature of consumers make them a particularly hard segment to captivate and monetise effectively.  We see a larger risk in overpaying for content or studios that are in vogue than missing out on this market. During the recent conference call for Electronic Arts (ERTS) COO John Schappert said:

 

Our second point about the industry relates to the reliability of retail tracking services and the near total absence of digital sales recorded by those databases. This is a point I made on our last call. Today, we estimate that digital sales represent roughly 30% of revenue in Western markets and roughly 45% worldwide, sales not captured in the retail tracking data. The exclusion of this data works to the disadvantage of investors and companies that participate in this sector. So my take away is this. Contrary to the headlines, there's a solid growth story for publishers that have invested in HD consoles, as well as digital goods and services.”

 

I believe these comments are especially relevant to ATVI, considering the company is focussed not only on the high quality HD console games, but also has been aggressively expanding its digital sales with downloadable ‘map-packs’ and extensions for its hit releases. There can be no higher complement for ATVI than to have its business model copied by its rivals. ERTS, once the biggest and best known brand in the business, was at pains to emphasise in its recent call that the company was going to focus on publishing fewer titles but over better quality. This is the strategy that ATVI has executing for some time now, combined with its rivals continued attempts to challenge World of Warcraft in the MMORPG segment, we feel strongly that ATVI is the strongest company in its sector.

 

The strength of ATVI is in its studios, the steady cash flows from the Blizzard’s slate of games (WoW, Starcraft, and Diablo) are the most important aspect of the company and we feel the company could almost justify its current value based purely on this business alone. By combining Activision with Blizzard Bobby Kotick managed to stabilise the cash flows of a company in an industry with notoriously lumpy revenue stream. He also combined his company with a studio that enjoys a reputation for excellence and a hugely loyal fan base. As well as new map-packs for Starcraft 2, the imminent release of Diablo 3 and the continuing success of WoW, Blizzard is also working on a new MMORPG title provisionally named ‘Titan’. We would expect this title to continue the success of the studio based on the track record and attention detail it has exhibited thus far and the following amongst gamers it has established. Recently ATVI announced it had signed an exclusive publishing deal with the creators of the hugely successful ‘Halo’ franchise for their new, as yet unnamed, IP. In joining with ATVI Bungie has bought into the stability, resources and proven execution in the space that only ATVI can provide. ATVI in turn has added another very strong studio to its portfolio and will be able to leverage its publishing and marketing expertise to the new IP which I would expect to garner a lot of hype considering the pedigree of Bungie. This of course does not guarantee another blockbuster title and new ‘pillar’ of earnings for ATVI however the ingredients are there. Interestingly the contract agreed between the two parties makes it clear that creative control of the IP will remain firmly with Bungie, as with Blizzard. This is only significant because of its relevance to the on going saga of Infinity Ward and its ex-chiefs Vince Zampella and Jason West. This story has definitely weighed on the stock because of its implications for the company’s ‘Call of Duty’ franchise. Zampella and West oversaw the creation of the hugely popular ‘Modern Warfare’ arc of the franchise and they will not be returning to oversee the 3rd instalment due to their falling out with ATVI. Whilst this is a potential problem for the company we feel the news has been priced into the stock already and their departure allows for fresh talent to carry the idea forward. With regards to the impending legal cases it is hard to ascertain what will happen but bearing in mind the contracts and relationships ATVI has formed we find it hard to believe there will be any serious material effects to the company.

 

The alternative view to our thesis is that with everyone rating them a buy (or hold at worst) the company is already well known and is trading accordingly. This would mean that the market has priced in the current strength of its products and any sign of weakness from the company’s ‘earnings pillars’ would have a serious impact on the company since they are currently priced to perfection. It is certainly noticeable that the expectations for their new releases are so high that it is hard if not impossible for the company to positively surprise the market despite smashing records. The high ownership of the company by Vivendi, who received the stake following the merger of Activision and Blizzard, is also cause for concern for investors. In holding 60% of the company it is unlikely that Vivendi would want to jeopardise its investment, however, it will cause other investors to think twice in case their interests in the company are not aligned with those of Vivendi. Another issue that is some levelled at the company is its relationship with its customer. In targeting the ‘hard-core’ gamer as opposed to the ‘casual’ gamer, management, especially Bobby Kotick, have left themselves open to the criticism of the dedicated fan. In general I believe most of the vitriol directed at Mr Kotick is a distraction and whilst the majority of gamers might not like the CEO they continue to ‘vote with their feet’. Whilst it would be preferable for Mr Kotick to be ‘likeable’ his focus on improving the business with steady revenues and improving margins is more important to investors in our opinion.

             

 

Bearing all the above in mind we rate Activision Blizzard a Buy with a minimum price target of $14 based on 15x 2010 earnings of $0.77 plus $2.5 in cash. With Take Two Interactive (NASDAQ:TTWO) trading at a current and forward PE of 23 and Electronic Arts (ERTS) trading at a forward PE of 27 (no current PE due to a loss in current year) we feel that this multiple is justifiable. In the short-term whilst we believe the company will easily beat its estimates for 2010 conservative guidance for 2011 might weigh on the stock we would see this as an opportunity to add to our position.

 

Disclosure: Long ATVI, Short ERTS. May adjust positions through earnings.