Macro Tsimmis

intelligently hedged investment

BUY Activision Blizzard (ATVI)—games people play

Posted by intelledgement on Fri, 02 Jan 09

The merger of Activision and Vivendi (former corporate home of Blizzard and Sierra) last July has created a game publisher powerhouse. Between them, the Activision Blizzard (ATVI) combine have leading franchise-level products in the online, computer, and console markets including first-person shooter, sports action, role-playing, and strategy games. Among their leading products are Cabela’s line of hunting games (yes, they are allied with CAB, another ISOP pick), Call of Duty (first-person shooter), Guitar Hero (music role-playing), Spiderman, Starcraft (strategy), Tony Hawk (sports action), Transformers, X-Men Origins, and World of Warcraft (fantasy role-playing).

Revenues and operating profits and net profits had all been growing strongly leading into the merger. While growing, net profits were only around 10% of revenues due to significant R&D investments. (As with movies, game publishing requires significant up front development and marketing investments.) Of course, the merger means that it will be hard to derive much utility from quarter-over-quarter comparables for the next year or so. But a spate of significant releases in 2009—including significant additions to the Call of Duty and Guitar Hero franchises, the years-in-the-making Starcraft II release, and licensed product games Ice Age and Madagascar—should not only boost revenues but improve the ratio of net profits to revenues.

In their most recently reported quarter (3Q08), the company had revenues of $711 million, up on a y-o-y basis for the 19th consecutive quarter. They recorded a net loss of $108 million—breaking a string of profitable quarters—which loss was mostly attributable to one-time merger costs, which turned what would otherwise have been a seven cents/share profit into an eight cents/share loss. Their debt is negligible and they have $2.4 billion of cash on hand. And some of that cash is being used for an ongoing $1B share buyback program.

The $711 million of 3Q08 revenues was mostly from massively multiplayer online role-playing game (MMORPG) subscriptions (38%; most of this is World of Warcraft) and console game sales (38%; Guitar Hero and Call of Duty are the two leaders here). Handhelds game sales account for 11% of sales, and PC game sales—the only segment that is declining in absolute dollars year-over-year—account for 4%. Distribution of third-party interactive entertainment hardware and software products—mostly in Europe—accounts for 8% of revenues. Regionally, revenues were: Americas 41%, Europe 41%, Asia 9%, and distribution (which for some reason is not broken down regionally) 8%. $6 million of revenues generated from discontinued Blizzard operations accounts for the last 1% in both the regional and product breakdowns.

While we anticipate tough times ahead for the economy, traditionally the entertainment sector has done well under those conditions. Movies famously were very profitable during the Depression. And purely from a consumer value perspective, computer games are a superior entertainment value. An $8 ticket to a first-run movie buys you two hours of entertainment; $60 for Diablo gets you at least 30 hours—if all you do is play through the AI vs. player set scenarios that come with the game—but more likely hundreds of hours if you play other players over the web on Activision Blizzard’s free-to-Diablo-owners Battle.net servers. A W0W subscription is $15/month (less if you pay upfront for multiple months) and on average, players are online for about 22 hours a week, so that is a similar entertainment bargain. (And with the WoW subscriber base now in excess of 11.5 million, that’s a nice revenue stream for the company.)

Be that as it may, the market’s overall view of ATVI is not very rosy just now. During 2008, it fell from a split adjusted $14.85 to $8.64,  a decline of 42%. The NASDAQ was down 41% in that same timeframe, but we believe that ATVI should be significantly outperforming the market, and is relatively undervalued here.

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