ACTIVISION BLIZZARD, INC.

Thesis Summary

Activision Blizzard (ATVI) is a leading video game developer and publisher in North America. Since last October, ATVI’s market cap dropped just over 40% due to a chain of bad press as shown below.

In addition to these news, ATVI’s management announced that the next two years will see lower video game releases as the company undergoes a restructuring program to re-focus on their core franchises. A deep dive into these headlines shows that the market has most likely over-punished the stock. Overall, I believe that Mr. Market presents an opportunity to own a high-quality business with a capable management team and a healthy runway for growth. At this price point, my conservative analysis and base case valuation conclude that this investment opportunity can provide a 30% upside, with little to no downside risk in the long term.

Business Overview

Activision Blizzard is a leading interactive entertainment company with five operating units: Activision Publishing, Blizzard Entertainment, King Digital Entertainment, Major League Gaming (MLG), and Activision Blizzard Studios. The first three units develop, publish, and distribute video games; while the latter two units leverage ATVI’s franchises to engage gamers through esports, film, and television content. As shown in the graph below, ATVI is primarily a videogame company and this report will largely ignore ATVI’s non-video game endeavors.

At a high level, ATVI’s strategy is to leverage its franchises to entertain and engage its audiences through blockbuster AAA video games, esports, film, and TV content. For example, using the Warcraft franchise, ATVI delivered World of Warcraft, Hearthstone, Warcraft (the 2016 film), and to some extent Heroes of the Storm. In the past decade, ATVI has grown both organically and through acquisitions. Each of the three primary divisions has its own specialty in the gaming industry.

Activision

Activision is traditionally a developer and publisher of console games; however, nowadays, many of their popular games have also been adapted to PC and mobile. Aside from developing, marketing, and selling internally developed games, Activision often partners with other established developers to release new titles. Activision’s two primary franchises are Call of Duty, a first-person shooter, and Skylanders, a collectible-toy-based action and adventure series for children. Activision has been releasing new titles for these franchises every year since inception. Annual Call of Duty and Skylander games have been released since 2003 and 2011 respectively. In addition to earning the initial game sale, ATVI also monetizes their games through microtransactions, or MTX, and downloadable content, or DLC. These games are distributed through online third-party marketplaces, like the PlayStation Store and Steam, and through traditional retailers, like GameStop.

Blizzard

Blizzard, previously owned by Vivendi Games before being acquired by Activision in 2008, traditionally develops and publishes PC games; however, much like in Activision’s case, many of their games have been adapted to the other two platforms. Blizzard almost exclusively publishes internally developed games from its own franchises: World of Warcraft, StarCraft, Diablo, Hearthstone, Overwatch, and Heroes of the Storm. Unlike Activision, Blizzard tends to release new titles less frequently, opting to maintain their player base through frequent patches and DLCs. Blizzard’s monetization strategy varies from game to game: World of Warcraft utilizes a subscription model, Overwatch and Diablo have the usual one- time purchase fee, while StarCraft, Hearthstone, and Heroes of the Storm use the freemium model. All their PC games are distributed through their own platform called Battle.net.

King

King, acquired by ATVI in 2016, is a developer and publisher of mobile and Facebook games, which are typically distributed through Facebook, Apple’s App Store, or Google’s Play Store. Their key franchises include The Candy Crush Sagas, Farm Heroes, Pet Rescue, and Bubble Witch. King’s games are free to play and monetized through in-game currency and advertising.

Activision Blizzard’s Economics

Revenues

ATVI’s 2018 revenues were $7.5bn after growing at a 11% CAGR in the past decade. Video game revenues are inherently volatile due to the hit-or-miss nature of blockbuster releases, and somewhat cyclical due to the releases of new consoles. Even Call of Duty, which has consistently been the annual best-seller in the US since 20102, can experience these sudden ups and downs. ATVI mitigates this volatility by (1) providing alternative monetization models such as microtransactions, subscriptions, and advertising, and

(2) diversifying their portfolio of franchises across genres, platforms, and geographies. Microtransactions allow publishers to monetize successful games years after their release; this is exemplified by Rockstar’s Grand Theft Auto V. As shown below, ATVI’s overall revenue growth is “balanced out” by design.

AVTI’s focus on core franchises allows them to gain a certain level of stickiness to their annual releases. The Entertainment Software Association’s (ESA) 2018 report shows that familiarity with the franchise is a major factor influencing US consumers’ decision to purchase video games.

Margins

Like any other software company, ATVI has strong margins. Average gross, operating, and EBT margins were 65%, 24%, and 16% respectively for the past five years, with small fluctuations depending on revenues. Moreover, excluding non-recurring costs and amortization of intangibles, operating margins were 28% on a 5-year average. Since 2009, ATVI’s gross margins increased from 46% to 66% due to the industry shift towards digitally distributed games. However, this gross margin expansion was not passed down to operating margins due to heavy reinvestments in product development, S&M, and G&A.

Scalability

In theory, videogames are infinitely scalable: you can sell unlimited copies at almost no cost; in reality, however, this scale is limited by their short life cycles. With certain exceptions, AAA game sales tend to last about 2 years before completely losing its popularity. Franchises, on the other hand, can scale better over longer periods of time with sequels, spinoffs, cross platforming, etc. As mentioned previously, Blizzard has been able to leverage its Warcraft franchise for over two decades with a myriad of diverse content.

Video Game Industry Analysis

Recession-Resistant Growth

Looking back, the global video game industry has grown exponentially from $5.1 billion in 2007 to $22 billion in 2018. According to ESA, computer and video game sales in the US remained fairly strong during the 2008 recession as shown below.

Additionally, ESA’s annual survey also showed that consumers recognize that video games provide a higher bang for their buck, beating other forms of entertainment such as video and music streaming services, movies, and DVDs.

Future Core Growth

The two graphs below summarize the size and growth prospects of the video game industry.

The key takeaway is that future growth will be fueled by mobile gaming and the Asia Pacific region, and ATVI has been actively trying to capitalize on these trends. Activision and Blizzard are bringing their core franchises, Call of Duty and Diablo, to the mobile platform. It is important to note that the mobile gamer in China is different from that of the US and the rest of the west. Sociopolitical factors in China, most notably the 15-year long console ban and the rapid integration of mobile devices, has allowed the Chinese midcore and hardcore gamer to adapt to mobile gaming. The result is that the Chinese mobile gamer does not mind playing non-casual games on smartphones, evidenced by the number of MOBA, RPG, and MMORPG games ranked at the top of China’s Android and iOS app stores. In contrast, the western mobile app store is filled with casual, strategy, and puzzle games. Western midcore and hardcore gamers typically prefer to game on consoles or PCs. This core difference is why I believe Activision and Blizzard’s core franchises can translate well into these growth sectors. King’s growth, on the other hand, will come from the monetization of engagement through advertising. Despite losing just over half (280 million) of its active users since 2015 Q1, King’s revenues have actually been growing steadily to an all-time high in 2018.

Other Industry Tailwinds

Esports has become an emerging sector within the gaming industry. ATVI has also made efforts to capitalize on this trend, acquiring MLG in 2016 and starting their own Call of Duty and Overwatch leagues. Although ATVI’s esports leagues are dwarfed by other ones, namely League of Legends, CS: GO and DOTA 2, they can still reap the benefits of advertising and media rights from increased fan engagement.

Economic Moats

ATVI vs Smaller Studios

AAA studios can protect themselves against potential new entrants through scale advantages. AAA game development is extremely demanding, costing upwards of $20 million and up to $100 million. Indie studios, which typically get funding from small venture-capital-like independent publishers, simply do not have the capital, human resources, or expertise to develop projects of that magnitude. Promising mid-sized studios typically get acquired by the big publishers before working on their first AAA release. Additionally, this barrier to entry will increase over time through a virtuous cycle where new console releases push big publishers to reinvest their profits to create games with better graphics and engines, raising consumer expectations and demand for the next release. In fact, ESA reports that quality of graphics has become the number one factor influencing decisions to purchase video games in 2017 and 2018, followed by price. Even in the mobile platform, top games have become sophisticated and expensive to develop. In a 2017 market report, mobile game developers claimed that their 5 biggest challenges, from top to bottom, were amount of releases (competition), rising user acquisition costs, rising marketing costs, amount of free content (also competition), and development costs. Nevertheless, despite the sea of mobile games released every year, those developed by bigger studios, such as King and Supercell, have consistently stayed at the top of app store charts; while simple, one-hit-wonder games, such as Flappy Bird, have largely lost their player base over time.

ATVI vs Other AAA Studios

Much like ATVI, other big publishers have also focused on their core franchises. This softens competition as each franchise tends to “stay in their lane”, as different game genres attract different audiences. As an obvious example, EA’s FIFA and ATVI’s Call of Duty are hardly competitors. Even within the same genre, franchises can differentiate themselves by tweaking certain experiences. For instance, although EA’s Battlefield and ATVI’s Call of Duty are both regarded as FPS games, each game provides a different multiplayer experience: Battlefield opting for more strategic and realistic mechanics, while Call of Duty goes for a fast-paced run and gun action.

Management

Ability

ATVI’s CEO, Bobby Kotick, has been with the company ever since 1991 when he first purchased a stake in the business. Under his leadership, ATVI’s stock, excluding dividends and buybacks, has grown at an 18% CAGR from 1993 to 2018. In his letters and interviews, he has shown a consistent focus on long- term value creation for shareholders, often citing Buffett on topics such as reporting lumpy earnings and avoiding the institutional imperative. Additionally, his letters sometimes highlight key metrics such as free cash flows, operating margins, and returns on invested capital despite the fact that the latter two are not tied to his compensation. Granted, he only seems to bring up certain metrics in the record-breaking years. Given ATVI’s capital-light nature, capital allocation plays an ever-important role in creating shareholder value.

The chart above outlines the three key transactions in 2008, 2013, and 2016 that shaped ATVI’s capital allocation policies. The first transaction in 2008 was the merger between Activision and Blizzard, which was previously owned by Vivendi. Activision paid with approximately 295 million newly issued shares, worth about $8 billion, and allowed Vivendi to purchase an additional 63 million shares for $1.7 billion. In short, ATVI essentially paid $6.4 billion in the form of 360 million shares. After the merger, Vivendi owned 54% of common shares outstanding. In 2009, ATVI began repurchasing shares opportunistically with the goal of returning value to shareholders by “stepping in when they see market volatility”.

In 2013, ATVI introduced leverage to their capital structure after repurchasing nearly $6 billion worth of shares from Vivendi at $13.60 each, giving the majority stake to the public. This transaction was financed with $1.2 billion of excess cash and $4.8 billion of long-term debt. In 2013, ATVI reallocated its capital towards repaying debt, reducing it to $4 billion in 2015. In 2016, ATVI acquired all of King’s shares for $5.9 billion, at an attractive price of 6.4x EV/EBITDA based on adjusted figures. ATVI paid $3.6 billion with excess cash and $2.3 billion with newly issued debt. Since then, management has been deleveraging their balance sheet, reducing debt to $2.7 billion and holding a net cash position of $1.6 billion today. Despite having authorization from the Board, management’ lack of buybacks in recent years has allowed an overall share dilution with outstanding shares increasing about 5% since 2013. Below is summary of ATVI’s capital allocation since 2017.

Overall, I would argue that management has been fairly opportunistic with their capital allocation. They bought back shares when the market did not reflect the company’s intrinsic value, acquired the top mobile gaming company at a fairly low multiple, and kept the balance sheet clean to take advantage of new opportunities. Furthermore, management has aggressively allocated almost all of their annual excess capital to one activity, instead of “playing it safe” and allocating it to different channels every year.

Integrity

Kotick, who engineered the 2013 transaction, also forced Vivendi to sell an additional 172 million shares, valued at $2 billion, to a private group of investors called ASAC. This group included himself, Brian Kelly, who was the Co-Chairman at the time, Davis Advisors, Leonard Green & Partners, Tencent, and Fidelity (FMRC). This transaction prompted a shareholder derivative lawsuit against Kotick and Kelly for not allowing ATVI to simply repurchase the additional 172 million shares. The lawsuit also revealed that the two executives also negotiated with ASAC to receive 25% of upside gains, conditional to certain thresholds, despite only contributing $100 million or 6% of equity in ASAC. In this transaction, Kotick and Kelly have undoubtedly put themselves first, depriving the rest of the shareholders from additional gains. This holding company still exists today, though its ownership in ATVI has decreased significantly, last reported to hold about 20 million shares in August of 2016. Ultimately, it is up to the reader to extrapolate from this event. I personally find it difficult to judge its potential impact on this thesis and will therefore apply an additional layer of conservatism in valuing the company.

Alignment of Incentives

Collectively, insiders invested approximately $450 million in ATVI, taking 1.29%. Additionally, with an estimated net worth of $7 billion, Kotick’s $110 million stake in the company is rather insignificant. Kelly, who has been slowly selling his shares after taking a Chairman and Director role, only has about $385 thousand invested in ATVI. Management’s compensation structured is summarized below.

Total compensation for the CEO and the average total for other NEOs is about $29 million and $11 million respectively. Option and bonus targets are determined based on adjusted operating income, adjusted EPS, adjusted FCF, and custom strategic objectives for each executive. I would argue that targets were fairly easy because, on average, targets were exceeded by 21 percentage points. Despite their efforts to reward long-term performance, I am going to assume that management is getting overpaid.

Returns on Invested Capital

ATVI achieved an average return on invested capital of 15% over the past 10 years.

Valuation

Given the difficulty of predicting ATVI’s pipeline and the probability of each game’s success, I decided to value the company using comparable multiples.

As shown above, ATVI is currently trading at a discount compared to its peers on an EV/EBITDA basis. Like ATVI, EA and TTWO also have sticky and popular franchises, sound economics, strong barriers to entry, and recession-resistant revenue growth. Nonetheless, I believe that ATVI stands above its peers and deserves a higher multiple because it has the largest exposure to the Asia Pacific region and mobile gaming markets, the two fastest-growing segments in the future. In 2018, ATVI and TTWO’s Asia Pacific revenues were $1 billion and $111 million respectively. EA does not specifically disclose revenues from that region, which is a hint that it is insignificant. On the other hand, ATVI and EA’s mobile gaming revenues were just over $2 billion and $672 million respectively; while TTWO operated entirely on console and PC. I believe these figures show not only ATVI’s superior position for growth, but also management’s proactive investment in long-run opportunities.

Based on these qualitative assessments, my valuation model simply argues that ATVI’s EBITDA multiple is at least better than EA’s and at most significantly lower than TTWO’s current multiple and ATVI’s all-time high of 30x. The range is therefore between 16x and 22x, with a base case of 19x. $2.5 billion (2019 EBITDA) x 19 + $1.6 billion (net cash position) = $47.5 billion market cap or $62 per share (30% upside).

Risks

Given my qualitative analysis, in my opinion, the probability of permanent capital loss in the long run is slim. Nonetheless, I have listed the most notable risks and mitigating factors below.

Strong Chinese Regulations

As mentioned before, China is the largest and fastest-growing market in the videogame industry. The Chinese government has the ultimate say as to whether a game can be legally sold and monetized in the country. Even after being tweaked by Chinese publishers like Tencent and NetEase, games can still be blocked or pulled out of the market if they do not appeal to the Chinese government. Most recently in August of 2018, Monster Hunter: World, the newest sequel to a known franchise in China, was pulled out of the market because it did not align with “socialist core values”. This example shows that no game is truly safe, and this risk is beyond any developer’s control. Moreover, China’s effort to combat video game addiction can slow down the industry’s overall growth.

Unpredictable Success in Games

As previously mentioned, the success of a video game is difficult to predict, even for publishers. Games with the highest development and marketing costs do not always become the most successful ones. For example, EA’s Apex Legends became a bigger success than Anthem, which was advertised far more. Apex Legends was not even mentioned in EA’s earnings calls until after the game had already gained its popularity. Moreover, certain gaming trends, such as the battle royale genre, can emerge and disappear unexpectedly. For example, the sudden rise and fall of the futuristic shooter genre, where players could double jump and run on walls, led to the unpopular reception of Call of Duty: Infinite Warfare. I believe that the best way to mitigate these risks is to diversify franchise portfolios across genres, platforms, and geographies; and ATVI has done so adequately.

Shift Towards Freemium Games

I personally do not believe this is a real risk, but it is hard to ignore this conversation in the gaming industry. The consensus view is that the rise of freemium games is a race to the bottom scenario, and AAA games’ pricing power will diminish over time. However, I would argue that this is simply a shift in monetization strategy and AAA games will continue to be profitable. Gamers already recognize that video games provide the highest dollar value compared to other forms of entertainment. I believe that customers who were willing to pay for a $60 to $80 blockbuster game, will also be willing to pay for in- game content through microtransactions. Conversely, those who were once deterred by the $60 to $80 price tag can now add value to the game through their engagement.