Activision Blizzard (NYSE: ATVI) is an attractive buy due to its strong gaming franchises such as Call of Duty, Diablo, and Overwatch. While its release pipeline is smaller compared to other developers, monetization should further improve as core franchises continue to show strong underlying unit economics. While Activision undoubtedly trades at a rich multiple relative to the S&P 500, I think the stock offers downside protection due its valuable franchises, customer retention, and position in a recession-proof industry. In terms of upside, coverage focuses too much on the new release pipeline (short-term) and not nearly enough on how the strength of its franchises can enhance monetization. The market views COVID-19 as a temporary blessing but is not looking out far enough into the future to see that recent user growth can translate into higher future earnings power as engagement continues to climb.
INVESTMENT MERITS
Asymmetric Upside
Price target of $
Exposure to solid unit economics that are trending favorably, with downside protection through the company’s leading position in a recession-proof space.
Leading Franchises
Generally, video game sales have become increasingly concentrated among the top 15 franchises. Activision has demonstrated the strength of its franchises given the numerous releases without a reduction in quality.
Call of duty is the top franchise globally over the past decade and its mobile counterpart is a top-15 grossing game across app stores (150 million downloads). This franchise has exhibited low variance over time, with each subsequent release adding growth vs. the prior release.
Valuable PC franchises with World of Warcraft, Diablo, and Overwatch.
Attractive Industry Dynamics
Full game digital downloads taking share vs. retail channels (55% of new game sales in 2019 vs. 19% in 2015).
More players added each year (est. of 3 billion by 2023), with avg. minutes (U.S.) spent per day up to 65 in 2019 from 56 in 2017.
Video games have increasingly become more of a social network. Millions of players worldwide can actively communicate over a game’s online platform via cross-play communication. PC, Playstation, and Xbox users can play against each other on the same game.
Streaming via YouTube and Twitch has further added to the social reach.
Free-to-play games (e.g. Fortnite, Call of Duty Warzone) that can be used for cross-selling premium versions to new players.
Favorable Growth Drivers and Margin Upside
Improved margins (operating margin of 35% in 2020 vs. 21% in 2016), with a 500 bps addressable margin opportunity over the next 3-5 years due to 1.) downloadable content (DLC) and micro transactions (MTX) 2.) higher mix of digital sales (vs. retail) for console games and 3.) advertising revenue in mobile games.
DLC and MTX increase a game’s longevity, improve user retention, and reduce the need for a large catalog of new releases each year.
Segments:
1. Activision (~50% of rev.):
MAUs of 128 million (primarily console users) across titles such as Call of Duty (+ Call of Duty Warzone) and Call of Duty Black Ops: Cold War.
eSports offering through Call of Duty League and mobile gaming through Call of Duty Mobile.
2. Blizzard (24% of rev.):
MAUs of 29 million across titles such as World of Warcraft, Diablo and Overwatch, with esports offering through Overwatch League.
3. King (27% of rev.):
Includes popular mobile games such as Candy Crush, Farm Heroes, and Crash Bandicoot, with a combined 240 million MAUs.
VALUATION
Assumptions: No-add back for stock-based compensation, tax rate of 19% (consensus), 500 bps operating margin improvement by 2025, 785 million shares outstanding, no increase in D&A for FCFF calculation (held at 2020A).
KEY RISKS
Slower than expected adoption of next-gen consoles due to manufacturing shortcomings at Microsoft or Sony.
Delays on key announcements related to Diablo.
Large announcements from other developers/publishers (Fortnite and Grand Theft Auto come to mind). An update to Fortnite could cut into Warzone, which could also impact cross-selling opportunities.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
New game announcements for Overwatch and Diablo. While Call of Duty is the top franchise, Overwatch and Diablo have loyal users who have not seen a new release in years. Diablo 4 is currently in production but little details exist around the release calendar.
Higher adoption of next-gen consoles, where titles are 15% more expensive vs. PS4/Xbox One.
Earnings growth and margin improvement that exceed consensus estimates. The following changes could add up to 800 bps to operating margins.
Shift to digital sales = +100-300 bps - digital accounts for 55% of console game sales. Forecasts show that this is expected to be 65% in the near term and up to 85% over the next five years.
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