ACTIVISION BLIZZARD INC ATVI
February 09, 2010 - 9:59am EST by
JackBlack
2010 2011
Price: 10.15 EPS $0.65 $0.70
Shares Out. (in M): 1,332 P/E 15.6x 14.5x
Market Cap (in M): 13,520 P/FCF 10.6x 10.1x
Net Debt (in M): -2,830 EBIT 1,160 1,229
TEV: 10,690 TEV/EBIT 9.2x 8.7x

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Description

 

I am recommending building a position in ATVI pre 4Q09 earnings release on Wednesday, February 10 for both SHORT TERM TRADERS and LONG TERM INVESTORS. 

 

Activision Blizzard publishes online, personal computer, console, and hand-held games worldwide. The company develops and publishes video games, as well as maintains its proprietary online-game related service, Battle.net. The company's products cover various game categories, including action/adventure, action sports, racing, role-playing, simulation, first-person action, music, and strategy. Its products include World of Warcraft, Call of Duty, Guitar Hero, Tony Hawk, Spider-Man, X-Men, James Bond, and Transformers, as well as Diablo, StarCraft and Warcraft.

 

Short Term Investment Thesis:

 

  • The Video Game industry has been under pressure over the past few months due to weak 4Q09 earnings and tempered CY10 outlooks, however, I believe that these worries are largely priced in due to earnings and pre announcements by GameStop, UbiSoft and Electronic Arts.
  • While ATVI will not be immune to the macro weakness, its publishing business should fair better than its peers in both 4Q09 and CY10 due to its focus on the core gamer audience, which has been quite resilient.
  • 4Q09 should benefit from the incredibly strong performance of Call of Duty: Modern Warfare 2 (MW2), offset by weakness in the music genre (Guitar Hero, Band Hero and DJ Hero) and Tony Hawk Ride.
  • I also believe the market is also under appreciating the resiliency and profitability (~45% operating margin) of Blizzard's World of Warcraft franchise (recurring subscription revenue), which accounts for nearly half of the earnings of the company.
  • ATVI will benefit from a significantly more favorable release schedule than FY09:
    • 2 new Blizzard releases (Starcraft 2 and World of Warcraft: Cataclysm) vs. none...
    • MW2 Catalogue & Map Packs vs. Call of Duty
    • 2-3 New IP releases (Blur, Singularity, unannounced) vs. DJ Hero and Tony Hawk Ride

    2009   2010
         
Key Titles:   Modern Warfare 2   Modern Warfare 2 (catalogue + downloadable content)
    Prototype (new IP)   Call of Duty 7
    Tony Hawk Ride   Singularity (new IP)
    Marvel Ultimate Alliance 2   Tony Hawk 2
        Spiderman
        Blur (new IP)
        New Action Game (new IP)
         
         
Blizzard Titles:   NONE   Starcraft 2
        World of Warcraft: Cataclysm
        World of Warcraft: Wrath of the Lich King (CHINA)
         
         
Music Titles:   Guitar Hero 5   Guitar Hero 6
    DJ Hero   DJ Hero 2
    Band Hero   Multiple Guitar Hero SKUs
    Guitar Hero - Metallica    
    Guitar Hero - Van Halen    
    Guitar Hero - Smash Hits    
         
         
Movie Titles:   Transformers 2   Shrek Forever After
    X-Men: Wolverine   Dreamworks: How to Train Your Dragon
    Monsters vs. Aliens   James Bond
    Ice Age 3    

 

  • Installed base will benefit from PS3 and XBOX price cuts in mid-late 2009:
    • Installed base likely to grow 20-40%, expanding the addressable market
    • Checks indicate PS3 & XBOX continue to sell well post new years with particular strength in PS3, where demand is currently exceeding supply
  • Leaving aside all of the aforementioned tailwinds and easy comps from '09's weak consumer, even if we assume FY10 revenue is flat, there should be ample room for margin expansion and FCF growth:
    • PC releases, such as Starcraft and World of Warcraft in '10, are much higher margin than console based titles due to the ~$10 per unit royalty paid to Sony/Microsoft. Conservatively assuming Starcraft 2 and WoW: Cataclysm sell between 5-10m units, this would imply $50-$100m in incremental operating profit on top of '09 (no major PC releases)
    • New IP and Music sales in '10 should carry much higher gross and operating margins due to the higher plastic related COGS associated w/ '09's releases - Guitar Hero, DJ Hero, Band Hero and Tony Hawk Ride. While music revenue will likely be down in '10, profitability should be much better as the industry milks the installed base w/ higher margin software only sales. Comps should also be easy due to the relatively weak debuts of DJ Hero and Tony Hawk Ride. Assuming 500-1000bps improvement in margin on ~$750m in like for like revenue in '09, would add approximately $50m in additional profit.
    • This should add approximately 220-330 bps of margin expansion, which would imply that Non-GAAP operating margin could expand from 25-26% range in '09 to 28-29% range in '10, bringing the company very close to achiving its 30% long term target. And this assumes flat revenue growth.
  • Potential, highly plausible, upside scenarios not incorporated in my model is:
    • Economic rebound
    • Motion based sensing add-ons by Sony and Microsoft (Project Natal) generate buzz during Holiday 2010 and reinvigorates the industry.
    • Accelerated growth of subscription based revenue due to WoW expansion pack and Starcraft 2.
    • WoW China monetization via partnership w/ NetEase.
    • Another round of console price cuts in late 2010
    • Aggressive stock repurchases by the company

 

Long Term Investment Thesis

 

  • World of Warcraft and proven, key franchise titles provide a stable base of recurring cash flow:
    • Over 80% of revenues come from proven, annuity like franchises such as World of Warcraft, Call of Duty, Hero music genre, StarCraft 2, expansion packs and catalogue titles.
    • Each franchise carries significantly above average operating margins of 25-45%+ vs. the industry's 15-20% average margin.
    • Each year, recurring franchises represent 9-10 of the industry's top 10 best selling titles.
  •   Recurring revenue stream poised to increase significantly:
    • Blizzard subscription based revenue will benefit in 2010 and beyond from:
    • World of Warcraft: Cataclysm expansion pack in 2010
    • StarCraft 2 in 2010
    • World of Warcraft: Wrath of Lich King (China) in 2010
    • Diablo in 2011
    • Unannounced MMPORG in 2011-2012
    • Customers pay on a subscription basis, typically monthly in advance. Subscription revenue currently represents approximately 27% of revenue.
    • Blizzard's operating margins are 45%+.
    • Potential to leverage Blizzard's expertise in managing large on line communities to migrate Call of Duty and other key Activision franchises to an online, subscription based model.
  •  Transition to on-line distribution model will lead to margin expansion:
    •  Battle.net will be the hub of the Activision Blizzard community. It will become a hub of economic activity (downloadable content, marketplace, tournaments, etc.)
    • COGS on packaged software is approximately 38% of sales. Ample room for margin expansion as the company moves towards a digital distribution model, which eliminates material costs, bypasses retailers, and dampens the used-sales market.
  •  Extended console cycle will benefit all software publishers:
    •  Console makers (Sony, Nintendo and Microsoft) are collectively trying to maximize profit for the current generation of console. As such, none has signaled development of a next generation console (studio's typically hear about it 2-3 years in advance). The industry has not yet tapped out the processing and graphics capabilities of the existing consoles.
    • Console makers are instead investing in enhancements to their existing consoles, such as Microsoft's Project Natal, which will add gesture based gaming capabilities. Unlikely they would be doing this if they planned a new console in the next year or two.
    • Increasing installed base will expand market opportunity for software publishers. Development cost is largely fixed, which should lead to top line growth and margin expansion.
  • Free option on World of Warcraft China:
    •  Currently World of Warcraft China JV w/ NetEase has been prohibited from monetizing or signing up new users in China.
    • Additional $100-$150m in additional FCF not included in my model should ATVI be able to monetize World of Warcraft China asset.

 Key Value Drivers

  •  Increase in subscription based revenue w/ new Blizzard titles (StarCraft 2, Diablo, expansion packs)
  • 300-500bps of operating margin expansion over next few years
  • Transition to online distribution model over next 3-5 years will provide additional margin expansion opportunity
  • Expansion of installed base
  • Maintain success of key franchise titles

 

Warranted Value

  •  $16 (based on 8% yield on FY13 estimates plus FY10-12 cash build)
  • Downside is $9 (assume no top line growth from 2010-2012 and apply 9% yield on Blizzard franchise and 14% yield on Activision franchise)

 

Blizzard Franchise (MMPORG)   Activision Publishing
FY10 Revenue  $  1,281   FY10 Revenue  $   3,250
EBIT Margin 45%   EBIT Margin 20%
EBIT    $     577   EBIT    $     652
Tax Rate   30%   Tax Rate   30%
EBIAT    $     404   EBIAT    $     456
Plus: D&A (50%)  $     125   Plus: D&A (50%)  $     125
Less: CapEx (50%)  $    (28)   Less: CapEx (50%)  $     (28)
Unlevered FCF  $     501   Unlevered FCF  $     554
Cap Rate   9.0%   Cap  Rate   14.0%
Blizzard Value  $  5,568   Activision Value  $  3,957
             
    Sum of the Parts    
    Blizzard Value  $  5,568    
    Activision Value  $  3,957    
    Less: Debt    $         -      
    Plus: Cash    $  2,830    
    Equity Value  $12,355    
    Diluted shares out 1,332    
    Value per Share  $    9.28    

Key Risks

  •  Decrease in Blizzard revenue
  •  Failure to maintain quality of key franchises or new IP releases
  •  Free, casual games (Facebook, Zynga, etc.) take market share away from console & PC games
  •  New console cycle arises sooner than expected
  •  Delay in release of key titles such as Starcraft, WoW, Call of Duty

Model

  FY (Dec) FY (Dec) FY (Dec) FY (Dec) FY (Dec)
  2009 2010 2011 2012 2013
           
Product Sales (Publishing) 3250 3250 3331 3415 3415
% Growth   0.0% 2.5% 2.5% 0.0%
           
Subscription, Licensing & Other (Blizzard) 1250 1281 1377 1446 1519
% Growth   2.5% 7.5% 5.0% 5.0%
           
Total Net Revenue (non-GAAP) 4500 4531 4709 4861 4933
% Growth   0.7% 3.9% 3.2% 1.5%
           
Cost of Revenue (non-GAAP)          
           
Product Costs 1235 1219 1233 1246 1246
% Product Sales 38.0% 37.5% 37.0% 36.5% 36.5%
           
Software Royalties & Amortization 315 313 320 326 331
% Total Net Revenue 7.0% 6.9% 6.8% 6.7% 6.7%
           
Intellectual Property Licenses 225 222 226 228 232
% Total Net Revenue 5.0% 4.9% 4.8% 4.7% 4.7%
           
MMORPG 231 233 248 256 269
% Subscription, Licensing & Other Rev. 18.5% 18.2% 18.0% 17.7% 17.7%
           
Gross Income (non-GAAP) 2494 2545 2682 2804 2856
Gross Margin 55.4% 56.2% 57.0% 57.7% 57.9%
           
Product Development 527 521 527 540 567
% of Total Revenue 11.7% 11.5% 11.2% 11.1% 11.5%
           
Sales & Marketing 558 553 565 574 582
% of Total Revenue 12.4% 12.2% 12.0% 11.8% 11.8%
R&D          
G&A 369 367 377 384 390
% of Total Revenue 8.2% 8.1% 8.0% 7.9% 7.9%
           
EBIT (including stock comp) 1040 1104 1213 1307 1316
EBIT Margin 23.1% 24.4% 25.8% 26.9% 26.7%
           
Plus: Stock based comp 120 125 130 135 140
           
EBIT (Non-GAAP) 1160 1229 1343 1442 1456
EBIT Margin (non-GAAP) 25.8% 27.1% 28.5% 29.7% 29.5%
           
Taxes (348) (369) (403) (433) (437)
Tax Rate 30.0% 30.0% 30.0% 30.0% 30.0%
           
Plus: D&A - only true PP&E D&A Used 250 250 250 250 250
Less: CapEx (55) (55) (55) (55) (55)
           
Unlevered Free Cash Flow 1007 1055 1135 1205 1215
Unlevered FCF Yield 9.7% 10.2% 11.0% 11.6% 11.7%
           
Adjusted EBITDA (excl. stock based comp) 1410 1479 1593 1692 1706
EBITDA Margin 31.3% 32.6% 33.8% 34.8% 34.6%
EV / EBITDA 7.3x 7.0x 6.5x 6.1x 6.1x

 

 

Catalyst

FY10 guidance that will be given on 4Q09 earnings report on Wednesday, February 9, after market close

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    Description

     

    I am recommending building a position in ATVI pre 4Q09 earnings release on Wednesday, February 10 for both SHORT TERM TRADERS and LONG TERM INVESTORS. 

     

    Activision Blizzard publishes online, personal computer, console, and hand-held games worldwide. The company develops and publishes video games, as well as maintains its proprietary online-game related service, Battle.net. The company's products cover various game categories, including action/adventure, action sports, racing, role-playing, simulation, first-person action, music, and strategy. Its products include World of Warcraft, Call of Duty, Guitar Hero, Tony Hawk, Spider-Man, X-Men, James Bond, and Transformers, as well as Diablo, StarCraft and Warcraft.

     

    Short Term Investment Thesis:

     

        2009   2010
             
    Key Titles:   Modern Warfare 2   Modern Warfare 2 (catalogue + downloadable content)
        Prototype (new IP)   Call of Duty 7
        Tony Hawk Ride   Singularity (new IP)
        Marvel Ultimate Alliance 2   Tony Hawk 2
            Spiderman
            Blur (new IP)
            New Action Game (new IP)
             
             
    Blizzard Titles:   NONE   Starcraft 2
            World of Warcraft: Cataclysm
            World of Warcraft: Wrath of the Lich King (CHINA)
             
             
    Music Titles:   Guitar Hero 5   Guitar Hero 6
        DJ Hero   DJ Hero 2
        Band Hero   Multiple Guitar Hero SKUs
        Guitar Hero - Metallica    
        Guitar Hero - Van Halen    
        Guitar Hero - Smash Hits    
             
             
    Movie Titles:   Transformers 2   Shrek Forever After
        X-Men: Wolverine   Dreamworks: How to Train Your Dragon
        Monsters vs. Aliens   James Bond
        Ice Age 3    

     

     

    Long Term Investment Thesis

     

     Key Value Drivers

     

    Warranted Value

     

    Blizzard Franchise (MMPORG)   Activision Publishing
    FY10 Revenue  $  1,281   FY10 Revenue  $   3,250
    EBIT Margin 45%   EBIT Margin 20%
    EBIT    $     577   EBIT    $     652
    Tax Rate   30%   Tax Rate   30%
    EBIAT    $     404   EBIAT    $     456
    Plus: D&A (50%)  $     125   Plus: D&A (50%)  $     125
    Less: CapEx (50%)  $    (28)   Less: CapEx (50%)  $     (28)
    Unlevered FCF  $     501   Unlevered FCF  $     554
    Cap Rate   9.0%   Cap  Rate   14.0%
    Blizzard Value  $  5,568   Activision Value  $  3,957
                 
        Sum of the Parts    
        Blizzard Value  $  5,568    
        Activision Value  $  3,957    
        Less: Debt    $         -      
        Plus: Cash    $  2,830    
        Equity Value  $12,355    
        Diluted shares out 1,332    
        Value per Share  $    9.28    

    Key Risks

    Model

      FY (Dec) FY (Dec) FY (Dec) FY (Dec) FY (Dec)
      2009 2010 2011 2012 2013
               
    Product Sales (Publishing) 3250 3250 3331 3415 3415
    % Growth   0.0% 2.5% 2.5% 0.0%
               
    Subscription, Licensing & Other (Blizzard) 1250 1281 1377 1446 1519
    % Growth   2.5% 7.5% 5.0% 5.0%
               
    Total Net Revenue (non-GAAP) 4500 4531 4709 4861 4933
    % Growth   0.7% 3.9% 3.2% 1.5%
               
    Cost of Revenue (non-GAAP)          
               
    Product Costs 1235 1219 1233 1246 1246
    % Product Sales 38.0% 37.5% 37.0% 36.5% 36.5%
               
    Software Royalties & Amortization 315 313 320 326 331
    % Total Net Revenue 7.0% 6.9% 6.8% 6.7% 6.7%
               
    Intellectual Property Licenses 225 222 226 228 232
    % Total Net Revenue 5.0% 4.9% 4.8% 4.7% 4.7%
               
    MMORPG 231 233 248 256 269
    % Subscription, Licensing & Other Rev. 18.5% 18.2% 18.0% 17.7% 17.7%
               
    Gross Income (non-GAAP) 2494 2545 2682 2804 2856
    Gross Margin 55.4% 56.2% 57.0% 57.7% 57.9%
               
    Product Development 527 521 527 540 567
    % of Total Revenue 11.7% 11.5% 11.2% 11.1% 11.5%
               
    Sales & Marketing 558 553 565 574 582
    % of Total Revenue 12.4% 12.2% 12.0% 11.8% 11.8%
    R&D          
    G&A 369 367 377 384 390
    % of Total Revenue 8.2% 8.1% 8.0% 7.9% 7.9%
               
    EBIT (including stock comp) 1040 1104 1213 1307 1316
    EBIT Margin 23.1% 24.4% 25.8% 26.9% 26.7%
               
    Plus: Stock based comp 120 125 130 135 140
               
    EBIT (Non-GAAP) 1160 1229 1343 1442 1456
    EBIT Margin (non-GAAP) 25.8% 27.1% 28.5% 29.7% 29.5%
               
    Taxes (348) (369) (403) (433) (437)
    Tax Rate 30.0% 30.0% 30.0% 30.0% 30.0%
               
    Plus: D&A - only true PP&E D&A Used 250 250 250 250 250
    Less: CapEx (55) (55) (55) (55) (55)
               
    Unlevered Free Cash Flow 1007 1055 1135 1205 1215
    Unlevered FCF Yield 9.7% 10.2% 11.0% 11.6% 11.7%
               
    Adjusted EBITDA (excl. stock based comp) 1410 1479 1593 1692 1706
    EBITDA Margin 31.3% 32.6% 33.8% 34.8% 34.6%
    EV / EBITDA 7.3x 7.0x 6.5x 6.1x 6.1x

     

     

    Catalyst

    FY10 guidance that will be given on 4Q09 earnings report on Wednesday, February 9, after market close

    Messages


    SubjectRE: SC II delayed?
    Entry02/10/2010 01:17 PM
    Memberissambres839

    I'm curious Nails4, why are you super bearish on WoW?


    SubjectRE: SC II delayed?
    Entry02/10/2010 02:08 PM
    MemberJackBlack

    Thanks for your post... agree w/ Starcraft II risk for short term investors... I did have it in my risk factors... As a longer term investor, I'm OK stomaching a trade down due to a delay... Perhaps a good strategy for shorter term investors is to establish 50% position ahead of quarter and load up if it trades down due to the aforementioned risk scenario playing out... I'm sure the stock will get some support from value investors at $9...


    SubjectRE: RE: RE: SC II delayed?
    Entry02/10/2010 06:57 PM
    MemberJackBlack

    Thanks for your comments... I started doing my work on the name last fall w/ the hope that the low margin, but high revenue contributing music business would be weak over the holiday season due to a weak consumer and particularly tough comps (wall street estimates were a bit too high) after running so well for the past three years... I do agree with you that it is a shrinking franchise that has no shot of reaching its previous highs but it does have an attractive installed base that can be milked for profit... It was interesting to hear on today's call that Guitar Hero sales in FY09 was up for the XBOX360 and PS3 platforms... FY10 could benefit from the console price cuts in '09 as the casual PS2 gamer upgrades to the PS3 platform, but I'm not counting on that in my model... Demand is outstripping supply for the PS3 currently... Blueray is catching on, and PS3 actually has 60% market share (surpised me)... and Best Buy is pushing BlueRay hard, as its in their best interest... BlueRay DVD's had about the same floor space as regular DVDs based on my last store visit... I think it's smart that they are focusing only on Guitar Hero and DJ Hero and not band hero... Band Hero takes up too much space in the house, and it's tough to get a band together if everyone is bored w/ the product, that was definitely a fad...

    To address the comment about WoW high margin revenue coming only once every 3-5 years, I would say that the release schedule should be very favorable over the next 3 years... you have Starcraft 2 and WoW: Cataclysm in '10... this will be followed by Starcraft expansion packs (2 more) in 2011/2012... you have the potential of Diablo coming in say 2012, possibly sooner... with each of these launches I would expect it to have a positive impact to the WoW subscriber base, which should provide lift to the $1.2b in subscription revenue recorded in '09, which was flat despite not having a WoW release in 2 years... and I strongly believe there is ample opportunity to monitize the battle.net platform in the coming years... Starcraft 2 will have access to battle.net for free w/ purchase of the game... that is where you will meet to challenge opponents, participate in tournaments, download/buy new maps, socialize... I highly doubt that if Starcraft 2 hits critical mass over the next 2-3 years, I doubt that they will let people play on Battle.net for free... or at minimum you can bet that they will monitize this customer base (value added services, micro transactions, etc)... The chat between games (WoW chatting w/ Starcraft 2) feature is pretty neat too, which should help fend off some cannibilization (it's top of mind at Blizzard) concerns... I can envision the company just charging one subscription price for access of all of Blizzard games in the future via battle.net, which would likely grow the subscriber community from 11.5m people today to somewhere much greater... I was impressed at Blizzard's 4Q09 operating margins of 49%... 

    Concerns around WoW losing steam and shrinking are absolutely valid... WoW Cataclysm should help w/ continued growth as they upgrade the beginner level content, which was neglected as Blizzard developers were focused on their core gamer, designing the coolest stuff for the areas only high level players can access... they stated on the call that the product is very sticky once a player passes Level 10... so they're really focusing on improving the entry level play experience, and track record should suggest that they will be successful... if WoW were to become obsolete, I believe Blizzard would be in the best seat to displace it (likely the unnamed next MMPORG the studio is working on)... on obsolesence, I would still argue there's a long tail... people still play Ultima Online (10+ years old)... people still log on to play text based MUDs (20+ years old)... the social bonds keep people coming back for a long time... and it's difficult to reach the critical mass that WoW has... I'm very wary of many of the chinese companies that think they have mastered the process of developing many successful MMPORGs, like GAME... the barriers to entry are too high... while this argument could be used agaist Blizzard, Blizzard is buffeted from it's strong repuation and customer loyalty... go to BlizzCon... it's nuts.

    Thanks for everyone's interest... I think the earnings call luckily helped prove out some of the bullish bullet points I listed in my original writeup... biggest risk going forward here is if Battle.net runs into a few bumps in the road, causing a delay in Starcraft launch, which doesn't really hurt my long term thesis...


    SubjectGAAP vs non-GAAP
    Entry02/12/2010 11:38 AM
    Memberruby55

    Can give an example that demonstrates how net deferred revenue is created and how it is treated under GAAP and ATVI's non-GAAP metric?


    SubjectRE: GAAP vs non-GAAP
    Entry02/16/2010 09:46 AM
    MemberJackBlack

    GAAP Revenue for a majority of the packaged software that ATVI sells is recognized over a period of 12 months... Non-GAAP Revenue adjusts for changes in deferred revenue, and is a bit more accurate to the cash flow generation from quarter to quarter... Due to huge 4Q seasonality inherent in this consumer driven business, ATVI sells a lot of games in the december quarter, but most of that revenue goes directly into deferred revenue, and will be recognized over the course of the following year... As such, decenber Non-GAAP revenue will always be significantly higher than GAAP revenue... This trend reverses significantly in the March quarter, where Non-GAAP revenue is significantly lower than GAAP revenue...  Non-GAAP revenue is down due to seasonality and weak new release schedule, while GAAP revenue benefits from strong software sales over the holidays...   

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