ACTIVISION BLIZZARD INC ATVI S
November 14, 2011 - 3:16pm EST by
acslater787
2011 2012
Price: 12.95 EPS $0.85 $0.78
Shares Out. (in M): 1,144 P/E 15.2x 16.6x
Market Cap (in M): 14,817 P/FCF 13.0x 15.0x
Net Debt (in M): -3,508 EBIT 1,325 1,280
TEV: 11,309 TEV/EBIT 8.5x 8.9x
Borrow Cost: NA

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Description

 
This is not the next _______ (short with 50%+ downside) but does represent a decent and highly liquid risk/reward above $14 with a 6-12 month time frame. Please see long writeup from Feb 2010 from JackBlack for further background on the company and industry. 
 
Summary: ATVI is a business with core franchises transitioning to maturity and long-term decline. This bet could be viewed as another way to be bullish on ERTS as its main product launches in late 2011 are direct competition to ATVI. As ATVI's highest margin recurring cash flow game World of Warcraft loses subscribers throughout 2012, the earnings power of the business may be closer to 78c compared to sell-side consensus at 96c. At 13-14x this number, ATVI could be a < $10 stock compared to upside to $14.
 
 
1. Core World of Warcraft franchise is in decline. This represents > 50% of operating income.

Online MMO World of Warcraft has been the stalwart of PC gaming since it really started growing in 2005. For readers who aren't familiar with MMO or Warcraft, see here: http://www.southparkstudios.com/full-episodes/s10e08-make-love-not-warcraft.
 
The core number of WoW subscribers peaked in late 2010 and has been declining at a faster rate throughout 2011. While management blames the near-term issues on a decline in Asian subscribers and add-on content that is defeated too quickly by skilled gamers, we think it stems from user fatigue with the game and competing/substitute products. Though bulls point to an expansion pack for the game due out around summer 2012, the initial reaction to the add-on content has been lampooned. These hardcore sci-fi/fantasy gamers are being offered a decidedly pop culture bill of goods called "Mists of Pandaria" that looks a lot more like Kung Fu Panda than typical WoW content. We don't claim to be the target customer but understand that a cool reception to the expansion pack should result in a revenue disappointment and further subscriber attrition in 2012.
 
What further compounds the risks for Warcraft is imminent competition from ERTS. Electronic Arts will release its own highly anticipated MMO called Star Wars: The Old Republic on 12/20/2011. There are numerous execution risks around the launch for ERTS, but suffice it to say there has not been hefty competition for WoW for some time. PC gamers invest a lot of time to build characters in these virtual worlds and do not typically pay for more than one subscription at a time. We think that ATVI will bleed a large number of WoW subscribers to ERTS: Star Wars loyalists and fatigued WoW users interested in building something new. The Street is flattish for WoW subs in 2012 while we think the decline could be > 2m subs on a base of what is now 10.3m
 
ATVI's actions indicate concern over WoW even if mgmt doesn't sound alarmed. Offering to package PC game Diablo 3 (a big ATVI/Blizzard title for 2012) for free with another year of WoW subscription is a move to protect market share and merely shifts revenue from one product to another. Allowing new users to play for free on levels 1-20 of the game before signing up is another tactic to try to hook users. Finally, transactional models with the character's pets is a nice idea but ATVI seems to be nearing the end of potential innovations to monetize the user base just as people are losing interest.
 
All this puts the cash flow from the average $15/month WoW subscriber at risk. The operating leverage that worked so beautifully as WoW grew from nothing to 12m users is just as sharp on the way down. Bulls point to the MoP expansion pack and believe that ATVI will grow its MMO revenue ~10% in 2012. If they are taking from one pocket (offering Diablo 3 for free) and still seeing sub losses we think MMO revenue could decline closer to (8%). Given WoW's high operating margins this could amount to an 10-15c delta on 2012 EPS.
 
 
WoW Subs
Jan-04 0.25
Jan-05 0.75
Dec-05 5.5
Mar-06 6
Sep-06 7
Jan-07 8
Jul-07 9
Jan-08 10
Oct-08 11
Dec-08 11.5
Oct-10 12
Mar-11 11.5
Jun-11 11.1
Sep-11 10.5
 
 
2. Call of Duty franchise is peaking now. Negative reviews may mean less downloadable content or subscription revenue 

The Call of Duty franchise is the other material piece of ATVI. Make no mistake that Diablo 3, Starcraft 3, Skylander and other titles matter, but WoW and CoD really drive this business (along with the belief whether terminal value resides in the franchise itself or the development team).
 
The release of Modern Warfare 3 was met with great fanfare on 11/8 and will be received as one of the most bought video games of all time. We don't dispute that people lined up at midnight in droves to buy the game...or that the installed base of Xboxes and Playstations is much higher than it was in 2010. 
 
But, negative reviews from the core fanbase started pouring online within 24 hours after the release. Users are saying that this should not have been a $60 game and they feel somewhat cheated that it's just a revamp of prior versions of the franchise. Usually reviews on this Metacritic site aren't relevant for dominant franchises that sell multiple millions of titles like CoD. But when > 9,000 gamers on Xbox and PS3 rate the game less than a 3 out of 10 it is relevant. In particular, CoD is pushing its "Elite" subscription-based product that offers users add-on content for $50/year instead of buying 3 add-on map packs per year at $15 apiece. 
http://www.metacritic.com/game/playstation-3/call-of-duty-modern-warfare-3
http://www.pcgamer.com/2011/11/14/modern-warfare-3-dev-attempts-to-boost-metacritic-score-via-twitter/
 
The disappointment around the launch doesn't mean that people didn't buy the title or that its momentum will slow. It may mean that the take rate on the $50 subscription will be materially lower than expectations of ~20-25% which means estimates should point to the downside on that $300-400m slug of high-margin revenue
 
 

Risks
-Strong B/S: company has $3.5bn in cash and $1bn remaining on an authorized share repurchase. It's possible the company runs out and acquires TTWO ahead of the next GTA release, but they have been a buyer of their own stock around $11 and could be content to funnel FCF to buybacks
-underestimaing CoD, whose titles remains the most-played games on networks like Xbox Live
-Blizzard could come out with an unnamed new MMO in 2013+ to stop the bleeding on WoW
-We have no edge on the catalog or distribution business; too easy to point to bubble of music titles like Guitar Hero. Core Activision is capable of producing future hits
 
 
Note: when you think of where an edge comes from on an investment, it's usually easier on stocks that are underfollowed. Video games seem to be a different story as it is difficult to model hit titles from year to year. A subscription game like WoW should be easier, but even so I have found sell-side models to be extremely vauge. Granted, they have to take mgmt at their word, which is often just a best guess rather than an informed debate over drivers of a business model. But there could be opportunity here simply because nobody is that great at building up the pieces farther than 3-6 months out.

Catalyst

Continued subscriber losses for WoW now-2012. We should get sub numbers quarterly going forward
ERTS Star Wars MMO launch 12/20
Monthly NPD video game data + initial reaction to CoD franchise in 4Q11 / 1Q12
 
 
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    Description

     
    This is not the next _______ (short with 50%+ downside) but does represent a decent and highly liquid risk/reward above $14 with a 6-12 month time frame. Please see long writeup from Feb 2010 from JackBlack for further background on the company and industry. 
     
    Summary: ATVI is a business with core franchises transitioning to maturity and long-term decline. This bet could be viewed as another way to be bullish on ERTS as its main product launches in late 2011 are direct competition to ATVI. As ATVI's highest margin recurring cash flow game World of Warcraft loses subscribers throughout 2012, the earnings power of the business may be closer to 78c compared to sell-side consensus at 96c. At 13-14x this number, ATVI could be a < $10 stock compared to upside to $14.
     
     
    1. Core World of Warcraft franchise is in decline. This represents > 50% of operating income.

    Online MMO World of Warcraft has been the stalwart of PC gaming since it really started growing in 2005. For readers who aren't familiar with MMO or Warcraft, see here: http://www.southparkstudios.com/full-episodes/s10e08-make-love-not-warcraft.
     
    The core number of WoW subscribers peaked in late 2010 and has been declining at a faster rate throughout 2011. While management blames the near-term issues on a decline in Asian subscribers and add-on content that is defeated too quickly by skilled gamers, we think it stems from user fatigue with the game and competing/substitute products. Though bulls point to an expansion pack for the game due out around summer 2012, the initial reaction to the add-on content has been lampooned. These hardcore sci-fi/fantasy gamers are being offered a decidedly pop culture bill of goods called "Mists of Pandaria" that looks a lot more like Kung Fu Panda than typical WoW content. We don't claim to be the target customer but understand that a cool reception to the expansion pack should result in a revenue disappointment and further subscriber attrition in 2012.
     
    What further compounds the risks for Warcraft is imminent competition from ERTS. Electronic Arts will release its own highly anticipated MMO called Star Wars: The Old Republic on 12/20/2011. There are numerous execution risks around the launch for ERTS, but suffice it to say there has not been hefty competition for WoW for some time. PC gamers invest a lot of time to build characters in these virtual worlds and do not typically pay for more than one subscription at a time. We think that ATVI will bleed a large number of WoW subscribers to ERTS: Star Wars loyalists and fatigued WoW users interested in building something new. The Street is flattish for WoW subs in 2012 while we think the decline could be > 2m subs on a base of what is now 10.3m
     
    ATVI's actions indicate concern over WoW even if mgmt doesn't sound alarmed. Offering to package PC game Diablo 3 (a big ATVI/Blizzard title for 2012) for free with another year of WoW subscription is a move to protect market share and merely shifts revenue from one product to another. Allowing new users to play for free on levels 1-20 of the game before signing up is another tactic to try to hook users. Finally, transactional models with the character's pets is a nice idea but ATVI seems to be nearing the end of potential innovations to monetize the user base just as people are losing interest.
     
    All this puts the cash flow from the average $15/month WoW subscriber at risk. The operating leverage that worked so beautifully as WoW grew from nothing to 12m users is just as sharp on the way down. Bulls point to the MoP expansion pack and believe that ATVI will grow its MMO revenue ~10% in 2012. If they are taking from one pocket (offering Diablo 3 for free) and still seeing sub losses we think MMO revenue could decline closer to (8%). Given WoW's high operating margins this could amount to an 10-15c delta on 2012 EPS.
     
     
    WoW Subs
    Jan-04 0.25
    Jan-05 0.75
    Dec-05 5.5
    Mar-06 6
    Sep-06 7
    Jan-07 8
    Jul-07 9
    Jan-08 10
    Oct-08 11
    Dec-08 11.5
    Oct-10 12
    Mar-11 11.5
    Jun-11 11.1
    Sep-11 10.5
     
     
    2. Call of Duty franchise is peaking now. Negative reviews may mean less downloadable content or subscription revenue 

    The Call of Duty franchise is the other material piece of ATVI. Make no mistake that Diablo 3, Starcraft 3, Skylander and other titles matter, but WoW and CoD really drive this business (along with the belief whether terminal value resides in the franchise itself or the development team).
     
    The release of Modern Warfare 3 was met with great fanfare on 11/8 and will be received as one of the most bought video games of all time. We don't dispute that people lined up at midnight in droves to buy the game...or that the installed base of Xboxes and Playstations is much higher than it was in 2010. 
     
    But, negative reviews from the core fanbase started pouring online within 24 hours after the release. Users are saying that this should not have been a $60 game and they feel somewhat cheated that it's just a revamp of prior versions of the franchise. Usually reviews on this Metacritic site aren't relevant for dominant franchises that sell multiple millions of titles like CoD. But when > 9,000 gamers on Xbox and PS3 rate the game less than a 3 out of 10 it is relevant. In particular, CoD is pushing its "Elite" subscription-based product that offers users add-on content for $50/year instead of buying 3 add-on map packs per year at $15 apiece. 
    http://www.metacritic.com/game/playstation-3/call-of-duty-modern-warfare-3
    http://www.pcgamer.com/2011/11/14/modern-warfare-3-dev-attempts-to-boost-metacritic-score-via-twitter/
     
    The disappointment around the launch doesn't mean that people didn't buy the title or that its momentum will slow. It may mean that the take rate on the $50 subscription will be materially lower than expectations of ~20-25% which means estimates should point to the downside on that $300-400m slug of high-margin revenue
     
     

    Risks
    -Strong B/S: company has $3.5bn in cash and $1bn remaining on an authorized share repurchase. It's possible the company runs out and acquires TTWO ahead of the next GTA release, but they have been a buyer of their own stock around $11 and could be content to funnel FCF to buybacks
    -underestimaing CoD, whose titles remains the most-played games on networks like Xbox Live
    -Blizzard could come out with an unnamed new MMO in 2013+ to stop the bleeding on WoW
    -We have no edge on the catalog or distribution business; too easy to point to bubble of music titles like Guitar Hero. Core Activision is capable of producing future hits
     
     
    Note: when you think of where an edge comes from on an investment, it's usually easier on stocks that are underfollowed. Video games seem to be a different story as it is difficult to model hit titles from year to year. A subscription game like WoW should be easier, but even so I have found sell-side models to be extremely vauge. Granted, they have to take mgmt at their word, which is often just a best guess rather than an informed debate over drivers of a business model. But there could be opportunity here simply because nobody is that great at building up the pieces farther than 3-6 months out.

    Catalyst

    Continued subscriber losses for WoW now-2012. We should get sub numbers quarterly going forward
    ERTS Star Wars MMO launch 12/20
    Monthly NPD video game data + initial reaction to CoD franchise in 4Q11 / 1Q12
     
     

    Messages


    SubjectRE: questions
    Entry11/14/2011 05:32 PM
    Memberacslater787
    Thanks for the questions - trying to be a better community member here and reduce response time + transition away from the Ryan Howard-esque swing for the fences/strike out a lot VIC postings...lest my anonymous online persona take a hit.
     
    1/2. WoW could have a long tail, but the admittedly anecdotal checks that I have done lately show growing unrest in the user base in the western world. Blaming China subs is fine and may well be true - it generally foots with ARPU falling by less than subs. But, the same underlying trends exist in the western world and are a precursor to attrition:
    -rising user complaints online about the quality of gameplay
    -rising user complaints about how quickly new content is defeated
    -vitriol towards next expansion pack (really? we're going from a Tolkein-like lich king to cartoon pandas?)
     
    Offering Diablo 3 for free to anyone who signs on for another year of WoW is a strong sign in my opinion that they're seeing the initial cracks. Otherwise, why do it? I know they're trying to build a Diablo community and create post-sale transactional revenue, but it smacks of desperation by doing it well before the D3 release. Further, if someone was considering spending $60 on D3 it probably won't deter them from dropping $60 on ERTS' MMO just because they feel locked into WoW.
     
    I don't have a strong opinion on how they monetize the Asian user base and bulls would point to a foray for WoW into Brazil, too. But the delta on flat subs in 2012 vs how bad it could get is a real problem for earnings in 2012.
     
    3. Bobby hasn't sold in a while, true. Brian Kelly was on the tape this fall cashing out some old options.
     

    Brian Kelly is co-chairman and has been with ATVI since 1991. The below is stock sales + option exercise = $228m

    Sept 2011: $11.5m

    Nov 2009: $12m

    Aug 2009: $13m

    May 2009: $72m

    Mar  2009: $31m

    Aug 2008: $37m

    Feb 2005: $51m

    Kotick is CEO and has been with ATVI since 1991. The below is stock sales + option exercise = $182m

    Nov 2009: $37m

    Aug 2009: $9m

    May 2009: $31m

    Mar 2009: $12m

    Aug 2008: $34m

    Sept 2005: $11m

    Feb 2005: $48m


    SubjectRE: RE: RE: questions
    Entry11/15/2011 08:50 AM
    Memberacslater787
    Nails, thanks. I guess that's my variant perception vs the market on WoW. I think we're seeing the initial signs that WoW is cracking and despite the game's massive success I don't think it has had a competitor on the level of ERTS' SWTOR for years (easy to say that now before the game comes out, I realize). I think the catalyst to drive people away from WoW is  happening over the next 6 months. I fully agree that WoW has a long tail and isn't going away, but if they lose 2.5m subs vs market's expectation for flat subs in 2012 I think you can get paid over the next 6-12 months.
     
    I think downside here is to $9-10, but recognize the company has $1bn on the buyback and has been active in its own shares around $11. Of course they don't get a multiple for the buyback, but it isn't optically an expensive stock. Above $14 I'd be more excited about this setup. Now back to playing MW3...
     

    SubjectWoW Subs
    Entry11/15/2011 01:28 PM
    MemberSiren81

    Do you know if WoW subs are declining b/c of lost market share or because the category is shrinking? If its market share, where are users migrating to?


    SubjectERTS?
    Entry11/18/2011 11:51 AM
    Memberacslater787
    Would be curious if anybody following this space has thoughts on ERTS. Is it overowned by hedge funds waiting for a pop from the ZNGA IPO?
     
    On the plus side: Battlefield 3 continues to do well, pre-orders for SWTOR MMO look good relative to expectations, decent fall season for EA sports, growth in digital and social/online gaming seems to be good, ZNGA IPO coming next month
     
    On the downside: poor reviews for Need For Speed's latest installment, declining engagement with Sims on Facebook (more sentiment than EPS), it's ultimately still a game designer and ERTS takes longer than most to crank out games vs ZNGA, GLUU, etc.

    Subjectlong thesis
    Entry11/23/2011 01:20 PM
    Memberrjm59
    Thanks for the writeup.  I found this long thesis here, was wondering if you have any thoughts or comments:  http://harbor.typepad.com/analysis/2011/10/activision-blizzard-atvi.html
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