Key Points

• I see 34% potential upside in ATVI’s share price and have a $66/share target by year end 2017.
• Audience engagement is at record highs and growing, rivaling that of major TV streaming services.
• ATVI’s latest game, Overwatch, was a major hit domestically and internationally while MAU’s across multiple titles continue to grow.

Introduction

I’ll start straight out of the gates by coming clean…..I’m a gamer. Always have been, always will be. In fact, I’ve recently logged 100+ hours (and recently prestiged for the second time – only gaming nerds like me know or even care what that means) into Activision Blizzard’s (ATVI) most recent team-based shooter game, Overwatch. I love shooter games and while I played ATVI’s Call of Duty series for many years, I never spent as much time on it as I do on Overwatch. To further emphasize this point,last year I got into EA’s Star Wars Battlefront (One of ATVI’s competitors and comparable team-based shooter game), but after paying for the expansion pack and six months of play, it just got stale. Since starting Overwatch, I’ve been hooked, hence sparking my curiosity about the video game industry and ATVI. In this blog I’ll cover some of the key reasons ATVI has been doing so well, what makes their games so special and why ATVI could be a strong long-term addition to your portfolio.

Before diving into the details, let’s just review some of the key financial metrics from ATVI’s latest quarterly results (which completely blew away expectations, by the way):

• Full year 2016 GAAP revenues of $6.61B, up 42% year-over-year.
• Full  year 2016 operating cash flow of $2.2B, up 71% YOY.
• GAAp 2016 EPS of $1.28, up 7.5% YOY. Non-GAAP 2016 EPS of $2.18, up 68% YOY.
• Net revenues from Asia grew 88% YOY and now makes up 15% of revenues, up from 11% in 2015.

 

Who is ATVI and How do They  Make Money?

ATVI is a video game developer founded in 2008 as a result of a merger between Vivendi and Activision and operates five business units:  Activision, Blizzard Entertainment, Major League Gaming, Activision Blizzard Studios and King Digital Entertainment. You might recognize the name through a number of successful franchises they’ve developed:

Revenues are derived from games sold (either online or in traditional retail stores), in-game purchases, downloadable content, licensing royalties and subscription fees.

The video game industry is a lot like the entertainment/film industry in the sense that they have to continue to create new ideas and new games or add new content to existing games to drive incremental revenue, meaning cash flows are not always predictable. The reason for this is most casual gamers will buy a game, pour in tons of hours up front and then never play again afterwards.  Driving consistent and even incremental revenue is not an easy task and being creative and successful at keeping audiences engaged at the same time are an extremely difficult endeavor to pull off. So far it seems ATVI has done that well. Below is a snapshot of ATVI’s Strategic Focus which is built around the franchises they own:

If you’ve ever played any of these games above, then you know exactly how addicting and fun they can be. Just ask anyone who’s ever played one of these games and you’ll know what I’m talking about. This graphic speaks well to how ATVI plans to continue to deliver results around their core franchises with the intent of focusing on the four “pillars” which are:

1. Expanding their audience
2. Deepening engagement
3. Providing opportunities for player investment
4. A newly added one which is to “Increase touch points for their franchises” -> this appears to be adding a consumer product segment (i.e. toys)

 

The Audience for Video Games is Probably Bigger Than You Think

I’ve played a ridiculous number of games across multiple consoles including: Atari, TurboGrafx 16, Nintendo, Super Nintendo, Nintendo 64 and Playstations 2-4. I can confidently say I’ve easily put in thousands of hours of gameplay to date. And in case you’re sitting there judging me, just think about how many hours of worthless television and commercial watching you’ve done over the past X amount of years. My point is, if a 35 year old man can carve out time playing video games, think of the hours spent by others with even more time on their hands playing video games. I saw an interesting slide in ATVI’s latest quarterly results comparing engaged ATVI users to users on Netflix and Snapchat. In 2016 alone, ATVI users spent 43B hours (yes, that’s Billion!) playing and viewing their games. That’s on par with Netflix’s 45B and almost 1.5 times Snapchat’s 26B. That’s incredible. Here’s the slide:

ATVI has built an impressive portfolio of unique, fun and immersive games which can easily be seen from this single metric above. The fact people spend as much time playing ATVI’s games as watching TV speaks wonders to the sort of content ATVI has created. To further emphasize this point, it is known that Netflix has about 6,000 titles (including TV shows and movies) to choose from. ATVI only has 13 key titles to their name, yet their audience spends almost as much time playing/watching their games as all Netflix users spend on a platform with nearly 600 x’s the number of options!  The level of user engagement is nothing short of phenomenal.

You might think that the audience for playing games only includes adolescent boys who have nothing else to do during their weeknights and weekends. For awhile I thought that was the case as well, but it turns out the market is much bigger than that. Here are some facts produced by the Entertainment Software Association in their 2015 Essential Facts About the Computer and Video Game Industry:

• 51% of U.S. households have a dedicated gaming console.
• 4 out of 5 households own a device used to play video games.
• 56% people playing are male, 44% female <- much greater than I expected
• The average male playing games is 35 years old. 43 years old for females. <- even more surprising
• People who play more games today vs. 3 years ago are doing so at the expense of watching TV and watching movies (in theaters and at home).

The point of this is that the audience for video games is wide and diverse, hence the incredible amount of hours put into ATVI’s games. Additionally, considering how digitally connected the world has become, it’s likely video games will continue to be a primary form of entertainment for the foreseeable future. True, much of the world is moving to mobile games, but when true gamers sit at a PC or console and play ATVI’s games, user engagement is unlike anything else. Now let’s get into why I’m so passionate about ATVI and why I see great potential in their future.

Successful Endeavors to Date

If you took note of ATVI’s stock price recently,  you’ll have noticed a huge spike in it after it’s 4Q 2016 results were released:

Not only did ATVI blow away the market’s expectations as well as their own internal estimates, the numbers they are posting for audience engagement and plans to leverage their intellectual property (IP) were both audacious and exciting.

Overwatch – One of the best first person shooters I’ve ever played

One of the key reasons in the strength of the stock was likely due to the tremendous success of ATVI’s latest team-based shooter game, Overwatch. It was reported that over 25M users had registered for the game in 2016, a new record at ATVI in terms of how fast it reached 25M. Not only was it a huge success in America, it’s also gained extreme popularity around the world, including in China and South Korea, where if you didn’t already know, video games are a kind of a big deal. On top of that, the game won 55 Game of the Year awards last year.

I believe the reason why Overwatch was so widely appealing is the way in which ATVI develops its characters (or heroes), making them all extremely unique with their own powers and characteristics which better connects with its audience. People literally identify themselves with each of these characters, so much so that people dress themselves up in character form just for the fun of it. If you want proof, check out #overwatchcosplay on Instagram (at time of writing this there were ~88,000 Overwatch cosplay posts). Compare that to the world’s most well-known movies and characters: #starwarscosplay ~ 113,000 posts and #marvelcosplay ~ 152,000 posts. And those franchises have been around for decades!

Unlike other games, your character has access to all the weapons he needs so there is no need to “level up” to unlock better weapons. The fun begins right from the time you start the game. You play to earn experience points (XP) to unlock items like character skins, victory poses, emotes and voice lines. This allows the player ample room to personalize their own hero. In addition, Overwatch’s gameplay is team based meaning you have to collaborate with others online in order to either capture a point or move a payload, for example. Furthermore, during major holidays (like Halloween, Christmas and Chinese New Year’s) or events (Summer Olympics), ATVI releases custom skins, emotes, voice lines etc. that can be unlocked through loot boxes which are earned every time you earn a certain amount of XP. This year round event based approach to the game as well as the various play modes it offers keeps the game fresh and fun. However, as of writing this it’s understood Overwatch is not doing an Easter event which is disappointing. I’m not sure what the next holiday is after Easter besides Halloween and seven months is a long time to wait for new stuff. There is one point of reconciliation though, and that is the release of Orisa (a new tank hero) to console players this week. Hopefully that helps fill the void until the next major event.

—        Note: Below is a brief rant about my Overwatch frustrations. Feel free to skip, unless you are an Overwatch rep, in which case please read and consider as feedback.      —

I will also briefly touch on one other point of contention I have with Blizzard and that is the lack of consistent, reliable players in Competitive game mode. I’ve played far too many games where people are either not communicating using their mics or rage quit because the rest of their team simply sucks, bringing the whole team down and your SR (skill rating) along with it. In Competitive mode, your SR determines your tier – Bronze, Silver, Gold, Platinum, Diamond, Master, Grand Master and of course anyone playing Comp wants to progress and see their rating increase. However, when you play with inconsistent or non-communicative teammates, massive frustration sets in as your SR plateaus and no meaningful progress is made or worse, your SR declines. Not only do people not want to lose, but they want to see they can improve their SR over time and nothing  ruins the experience more than playing with bad teammates. If anyone from the Overwatch team is reading this, may I make this one suggestion: At least create a similar level AI to immediately fill the spot of the player who quits the game with a character that rounds the team out. While losing a game is already painful enough for me, losing with a 5-man team and not even having a chance is worse. It kills the experience. I at least want to have a chance to win.

—————————— End of Rant 🙂 ——————————–

Other Key Metrics

Some other notable standouts from ATVI’s most recent quarter were Blizzard’s record of 41 million Monthly Active Users (MAUs) which is up annually 37% from 2015 and 87% from 2014. MAU’s for Overwatch were not released, but for another popular game, World of Warcraft (Legion Expansion), MAUs were up 10% year-over-year and Hearthstone, a collectible card video game, saw MAUs up 20% YOY. Impressive metrics no doubt.

Another key measure of ATVI’s success is their ability to efficiently distribute content through digital channels. Digital revenue was up in 2016 by 94% to $4.9 billion compared to 2015 which was up by 20% compared to 2014. Digital revenue may be a combination of games downloaded either through ATVI-owned websites or third-party websites/distribution channels or downloadable content such as multi-player content packs and in-game purchases (i.e. micro transactions). Digital revenue is important as the process to transact over a device that saves your payment info (such as your phone, PC or console) is nearly frictionless compared to the older models which relied solely on retail stores distribution.

Lastly, revenues from Asia grew 88% YOY and now make up 15% of ATVI’s total revenues. It has been known that for Western gaming companies to make headways in Asia is an extremely difficult endeavor. This past year ATVI has been able to further penetrate that market opening up abundant opportunities for international expansion.

Keys to Continued Success and Outlook for 2017

After a record breaking 2016, ATVI has set new expectations in place for the coming year. The front half of 2017 is expected to see little activity from the Blizzard side as there are no major game releases and they plan to focus on leveraging existing franchises and developing new in-game content. The Activision side is also expected to see a light front half of the year but could see some excitement in the second half with a Destiny sequel and new Call of Duty title. Regardless of the lack of release of new titles this year, there are a few key things to watch as ATVI further develops content around existing franchises. Those include:

• Continued execution of Overwatch player engagement and year-round events.
• Execution of deepening engagement through e-sports for Overwatch. Not much has been said about the Overwatch League except that they are selling teams and monetizing media rights this year and are looking forward to building global city-based teams with an annual schedule for viewership.This may be interesting to watch in tandem with their existing Call of Duty League and how it may form synergies with their acquisition of Major League Gaming.
• They’ve noted a recent hiring of a Disney and Mattel  veteran to lead their Consumer Products division. It will be interesting to see how they develop this new “pillar” to create more touch points with their audience.
• ATVI’s film and TV division’s first launch of Skylanders Academy on Netflix in October 2016. The series is young and so far reviews on various ratings sites have been mediocre.
• Additional content for World of Warcraft
• Updates on MAU’s for existing franchises

Let’s now take a look at some key quantitative and qualitative metrics supporting my thesis of ATVI and talk about where I see the stock price heading.

Stock Price Analysis

Quantitative Measures

There are a wide array of financial metrics to consider when valuing a company and deciding when is a good time to buy. In a previous blog about Finding Value in Midstream Companies, we detailed some of the metrics I like to utilize. Though not all apply to companies in the tech space, there are a few that remain useful, most notably Return on Equity, Return on Invested Capital and Free Cash Flow. ATVI’s performance as measured by these metrics, while not outstanding at present, are good and  improving.

Return on invested capital (ROIC) for 2016 was calculated to be 10%, up slightly from 9.7% last year . Return on equity (ROE) for the recent year was slightly lower than 2015 at 11.19%.  Free cash flow, however, has taken center stage in the eyes of Wall Street as it had increased 87% to $2.0B. Cash flow is often seen as the primary indication of the health of a company and ability to be profitable. I’ve ignored earnings per share growth here as that ratio can be skewed by the effect of deferred revenues and expenses related to stock-based compensation. In any case, the above metrics of ROIC and ROE, while not in the 15% or above range (which is typically where I like to see them), still lend support for owning ATVI shares over the longer term, particularly when combined with the step up in cash flow.

Cash Reserve

In ATVI’s 2016 10K, they noted their foreign subsidiaries are holding approximately $1.9B in cash and cash equivalents overseas and they even state they do not intend to repatriate the funds. Rather, those funds will be reserved for investments in the business outside the U.S.. Given the headway they’ve made internationally these past two years, this seems like a smart move. To put this number in perspective, Call of Duty Modern Warfare 2, the most expensive game produced to date spent almost $200MM on marketing and $50MM to develop. Given the size of ATVI’s cash held outside the U.S., the opportunity to fund marketing campaigns for existing franchises this year looks quite promising.

Share Repurchase Program

On February 2, 2017, the ATVI Board also authorized a share repurchase program of $1B over the course of the next two years. This amount has increased 33% from the previous authorization of $750MM back in 2015.

Qualitative Measures

No analysis of a stock is complete without some qualitative discussion. Though some would like to think stock picking is purely scientific, even the top investors know there is as much art as there is science in it. Some of the key qualitative factors I like to look at when evaluating a company are below:

• Chief Executive Officer – Robert Kotick is the CEO of the company, having started off as CEO of Activision in 1991 and been with the firm ever since. It’s nice to see a long-term CEO stay as long as someone like Robert has as it is evidence of his passion and dedication for the product and the company’s customers. Another reason I like Robert is that in his conference calls, he usually starts by noting how well the company has done as a result of its greatest asset: Its people. Executives who are compassionate and praise their teams regularly typically inspire the best work out of their employees.
• Company awards – ATVI has also been named to Fortune’s “100 Best Companies to Work for” for three consecutive years now. That kind of publicity not only distinguishes the company from its competitors, but also tends to attract top talent.
• Game awards – Overwatch  last year won multiple Game of the Year awards while other titles like Call of Duty, World of Warcraft and Starcraft have also won various awards.
• BlizzCon – who else has a Comic-Con type event whose tickets sell out in a matter of minutes? ’nuff said.

Risks

While it is impossible to entirely eliminate risks and uncertainties from any investment thesis, it is useful to try and understand and identify what might go wrong. In the case of ATIV, the primary things to look out for include:

• Content creation risk – company’s inability to create meaningful, new content for the audience and keep them engaged. (Moderate risk)
• Execution risk – delay of new games being developed and released (Low risk)
• Economic risk – a larger economic downturn which would reduce customers’ willingness to purchase games and other related content. A rise in interest rates will also tend to temper consumer spending. (Moderate risk)

Price Target

I had noticed most analysts put ATVI’s price target at around $51 to $58/share for 2017 while also indicating a very narrow economic moat. These price targets and opinions of these analysts are underestimating the strength ATVI’s brand, IP and creative ability. I have a $66/share price target for year end 2017 using my own conservative assumptions and research as stated above. Given a 75% margin of safety, I’d also be comfortable buying shares at prices $49 or lower.

Disclosure: I recently purchased shares of ATVI.

Disclaimer: The opinions expressed in this article are those of my own and are expressly meant to give the reader my own insight into companies I believe will provide long-term value to investors.