Why you should accumulate shares of Activision Blizzard

Long-term investors can accumulate the shares of Nasdaq listed Activision Blizzard (Ticker: ATVI). ATVI is a global leader in interactive gaming with a strong execution track record over the last decade. Post recent correction (last 6 months) in the stock of around 30 per cent, its valuation, at 17 times CY22 EPS, is attractive and is backed by good business prospects. The recent correction was due to company specific issues, which are fixable and unlikely to impact long term fundamentals of the company (see ‘recent events’ below). Thus, the stock now offers a good entry point for investors. However, given global indices are broadly at close to all time high levels, although the ATVI valuation is cheap, it will not be immune to impact of broader market corrections. So, investors can accumulate over a period of time starting now.

Business and prospects

ATVI is a leading global developer and publisher of interactive entertainment content and services. It was formed by the merger of Activision Inc and Vivendi Games (owner of Blizzard Entertainment) in 2008. It develops and distributes content and services on video game consoles, personal computers and mobile devices. The company also operates esports leagues (multiplayer video games played competitively for spectators) and offers digital advertising within some of its content. With a market cap of around $50 billion and CY21 revenue at close to $9 billion, it is globally (excluding China) the largest pure-play gaming software company in terms of revenue and second largest in terms of market cap. It has a rich intellectual property in the gaming business and owns some of the most popular franchises such as Call of Duty, World of Warcraft, Diablo, Overwatch and Candy Crush.

The company has maintained independence of its acquired/merged entities to ensure creative freedom and thus has three main reporting segments – Activision (owns Call of Duty), Blizzard (World of Warcraft) and King (Candy Crush). The three segments accounted for 49, 24 and 27 per cent of CY20 revenue respectively. Activision and Blizzard segments make revenue by full game and in-game sales, subscriptions and by licensing to third party distribution companies. The King segment, which is primarily free-to-play, generates revenue from in-game advertising and in-game sales. Most of company’s products and content are available in a digital format which allows consumers to purchase and download the content directly to their console, PCs, mobile device through its own proprietary gaming service and through its platform partners such as Nintendo, Microsoft, Sony Interactive Entertainment. In terms of geographic segment, sales in US generated 48 per cent of CY20 revenue, EMEA 32 per cent, and rest of the world accounting for 20 per cent.

ATVI is focussed on three strategic drivers to grow its business – one, expanding audience reach by reinvesting in existing franchises and creating new franchises, offering content across multiple platforms (such as consoles, PCs, mobiles) and multiple business models (premium, free to play, subscription based etc). The second driver is to deepen consumer engagement. This is achieved by providing high quality and in-depth content that keeps consumers engaged for long periods of time following a game’s release and enabling players to connect socially within franchise communities. The third strategic driver is to increase player investment by enabling them to invest in franchises by purchasing in-game content. In addition to high margin recurring revenue, player investments also increase their engagement.

Broadly ATVI is exposed to structural growth drivers as gaming finds increasing traction across the world driven by improvement in living standards making console/PC games more affordable and wider adoption of smartphones increasing the total addressable audience. Looking beyond the next few years, the new emerging Metaverse concept which can significantly enhance gaming experience to new level could provide another platform of growth for ATVI.

One risk the company faces is dependence on few popular franchises, For example in CY20, three franchises (Call of Duty, Candy Crush and World of Warcraft) collectively accounted for 76 per cent of revenues. However this is common across the industry and expected to remain so. Thus ability to maintain quality and popularity of top franchises is key to success. The company’s past successful track record over the last decade lends confidence on future prospects as far as dealing with this risk is concerned.

Financials and valuation

With 3 quarters in current year already completed, ATVI is expected to close CY21 with revenue of $8.73 billion and adjusted net profit of $2.99 billion, representing Y-o-Y growth of 4 and 10 per cent respectively. It has healthy profitability margins with EBITDA margin at 43 per cent and net profit margin at 34 per cent. It also has a strong cash generation with positive free cash flows every year over the last decade and CY21 free cash flows (FCF yield attractive at around 6 per cent now) expected to match its net profit number. It also has a solid balance sheet with net cash at approximately 12 per cent of its current market cap. Between CY15-20, it delivered revenue and net profit CAGR of 12 and 20 per cent respectively.

At its current price of $65.16 the stock trades at around 17 times its estimated CY22 EPS (Bloomberg Consensus). This is at a good 27 per cent discount to both its 2- and 5-year average which is at around 23.5 times for both periods. Given its strong execution track record, solid financials, this current discount provides a good entry point. Its peer Electronic Arts trades at CY22 PE of 18 times and Indian gaming company Nazara trades at one year forward PE of 125 times.

Recent events

In the last 6 months, ATVI stock has corrected by around 30 per cent. This was triggered by two factors. The first being a lawsuit filed against the company by California’s Department of Fair Employment and Housing over allegations of sexual harassment and assault. Post this lawsuit and consequent negative publicity, the company has also seen some employee turnover. While this does not reflect well on the company, it has since proactively taken steps to correct the shortcomings, implemented a zero-tolerance harassment policy and has committed to becoming the most inclusive company in its industry. The steps and investments it is making towards this lends confidence the company can overcome the present travail. ATVI’s long standing CEO Bobby Kotick is recently reported to have said that he would consider resigning if he does not fix the company’s current cultural problems ‘with speed’.

The second factor that impacted stock was its recent announcement that that two of its games that consensus was expecting to be released in 2022, would be postponed. This was also fallout of the employee churn the company has seen after the lawsuit. While this delay is a short term negative for the stock (already discounted), it does not impact long-term fundamentals. Short-term lumpiness and delays in releases are not unusual in the gaming business and ATVI itself has had many similar instances in the past which have not impacted its performance over the years.

With the stock having reflected the impact of recent events and trading a good discount to historical average and backed by a solid balance sheet, the risk-reward is now attractive. Any change in CEO will be a signal to markets that ATVI is taking responsibility at top most level for cultural issues of the past and that could be the next immediate catalyst.

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