Description

Thesis: Long ATVI. 

Activision (ATVI) shares are down -11% YTD and ~22% since the end of Q2, as the company has been impacted by sex harrassment & labor discrimination scandal (see Link for more background here) and concerns around China. However both of these issues are overblown, and not lasting concerns. Engagement should remain solid as COVID lingers + Competitive landscape doesn’t look bad this holiday season thx in part to competitors experiencing delays.

At current levels, ATVI offers a rare opportunity to own a blue chip consumer focused tech name at a discount. ATVI trades well below both its historical averages and the S&P. The difference vs Nasdaq 100 is even wider.

• Base Case: ~$90 is conservative PT ~12 months from now (assumes ~20x multiples on ’23 EPS of ~$4.50 (~5% haircut to ST’s $4.70 estimate), represents ~20% upside

• Bull/Upside Case: ~$110 – based on 23x and ST’s $4.70 estimate, represents ~45% upside

Background & Mgmt: ATVI is a top quality producer of video games, with a leading IP portfolio, that includes some of the most popular franchises (Call of Duty, OverWatch, Diablo, World of WarCraft and CandyCrush). See prior write-ups for more detail about ATVI and its games/franchises. Mgmt has very been effective in monetizing their portfolio by extending and prolonging the life of these franchises, and figuring out ways to foster in-game spending. For example, their acquisition of King in 2015 was regarded as a melting ice-cube by many, however Mgmt was able to keep Candy Crush bookings growing (despite declining King users) by being clever with in-game monetization features and growing advertising revenues. Modernizing assets was another avenue for squeezing more juice out of their IP. Last year they launched several old legacy hits that were "remastered and reimagined". They were also relatively early adopters of streaming focused events and e-Sports (OverWatch League) and had a partnership with YouTube. Besides the current labor issue, only real 'knock' on mgmt is that they have been known to give very conservative guidance. 

Outlook: The company had been an early beneficiary of COVID + Lockdowns, yet engagement levels remain elevated and have shown little signs of fading. In fact, August engagement looked remarkable on a YoY basis, as Steam players were up 20% YoY, and up 55% vs August 2019 levels. Variants and concerns around kids getting sick should help keep engagement up near term.

Even if engagement does ultimately begin to dwindle, the transition toward a higher % of digital revenues is permenant (think digital downloads and increased in-game spending/'micro transactions'), and this has resulted in structurally improved margins/steadier cashflows. 

Near term, the competitive landscape looks relatively favorable given delays by peers have setup their Core Call of Duty franchise to get a headstart this holiday season. EA’s latest Battlefield iteration got delayed ~1 month and TTWO’s upgraded version of the current GTA (i.e. not a sequel just upgraded for new consoles) has been delayed well past the holiday season into March.

2022 looks good as ATVI should have several blizzard games coming out early to mid next year (Diablo + Diablo Mobile). Biggest risk here is that these face delays like EA & TTWO did. Their Blizzard studio has historically moved very slow with their releases (albeit quality has usually been very high). Notably the company already had a "transition" year back in 2019 where they refocused resources on their Core franchises and biggest/best projects, while increasing developer headcount, all with the goal of speeding development turnaround. Possible that these efforts are what has helped ATVI avoid the delays experienced by peers. 

China Exposure: Bberg puts Asia at ~10-12% of Revenues, however this is mainly Japan and South Korea. Jefferies recently pegged ATVI's China exposure at 5% or less. Note consoles are not as popular overseas and were banned for years in China. ATVI's main exposure here is related to mobile games like Call of Duty Mobile and Diablo Mobile (known as "Diablo Immortal") which are developed in partnership with local developers like NTES and Tencent (thus less likely they are targetted for being American). 

Labor Issues: The sexual harrassment/discrimination scandal is certainly a PR nightmare but hard to imagine it results in any material fines for a company of this size, and I doubt it really impacts their engagement levels (users dont really care). The main risk is that it disrupts Mgmt/production and creates delays in the release schedule. 

• Given ~9.5k employees, and ~20% female (ie ~2k employees), we would have to apply some very aggressive assumptions about both the % of this group who chooses to join a class action lawsuit, and the $ amounts involved, to get something that looks compelling relative to the $16b decline in market cap since the end of Q2.
• Exec departures a bit harder to gauge here, 2 Blizzard execs recently departed and both worked on Overwatch game

Valuation:Valuation looks great at these levels (~$75), trading at a discount vs both historical averages and the broader market

• PE: ATVI now trades at ~19.6x consensus 2021 EPS and ~17.3x 2022, vs historical 5yr avg Fwd multiple of ~24x.
  • Ex- Cash, ATVI's PE multiple is closer to 16.5x/14.5x for ’21 and ’22 respectively
  • SPX trades at ~22x / 20x PE for 2021 / 2022, while Tech PE multiples are even higher with Nasdaq 100 at ~29x/26x
• EV/EBITDA – Trading at ~12x 2022 EBITDA vs. historical avg Fwd multiple of ~17x over past 5yrs
• Peer comparision is not as helpful here given there are relatively limited # of direct peers domestically. 
  • EA is arguably the best peer, but smaller and not as well regarded (ATVI has historically traded at a 2x premium on PE multiple to EA due to it being seen as a higher quality name than EA, with better mgmt). TTWO trades at a premium to the rest of the space as investors focus mainly on the next GTA sequel. Foreign peers such as Ubisoft and Square Enix command much lower multiples (due to overseas market) and are significantly smaller than ATVI. Similiar size foreign peers such as Nintendo have hardware revenues that impede direct comparisons. 
• Capital Return: If ATVI trades much lower, it is very likely that the board would push for aggressive repurchases given that valuation would be near trough lvls and ATVI has a very strong BS & FCF
  • Net cash of $5.6b + >$3b in annual FCF translates to ~$8.6b in firepower without incurring additional debt, (vs $58b market cap)
    • Unlikely but if they levered up to 2x, firepower increases to ~$16-17b (nearly 30% of mkt cap).
    • Note, board had authorized a $1.5b repurchase in Feb 2019, but this has remained largely unused. ATVI has not done any large scale repurchases since 2013. 

Risks

• Production Delays impact ATVI’s release schedule as they have peers EA and TTWO
  • Note, a slight delay in Call of Duty shouldnt be a big deal so long as they dont miss the holiday season window
• Major Mgmt changes/CEO leaves
  • Both the Chief Legal officer and the lead producer of Blizzard’s Overwatch franchise stepped down earlier this week
  • CEO Bobby Kotick has been around forever, and is very well regarded. It would not be good if the current labor issue forced Mgmt change, but this seems unlikely.
• China regulatory approvals delay upcoming mobile launches such as Diablo Mobile and impact Call of Duty Mobile revenues
• Engagement begins to wane / Users decline 

Catalyst

• New Releases remain on schedule (COD Vanguard in Oct 2021 + Diablo & Diablo Mobile in 2022) and receive good user reviews
• Litigation w/Feds, State of CA & former employees is settled (removes overhang)
• Repurchases