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.

 

 

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

 

 

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. 

 

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. 

 

 

-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.

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