Description

I am recommending building a position in ATVI pre 4Q09 earnings release on Wednesday, February 10 for both SHORT TERM TRADERS and LONG TERM INVESTORS. 

Activision Blizzard publishes online, personal computer, console, and hand-held games worldwide. The company develops and publishes video games, as well as maintains its proprietary online-game related service, Battle.net. The company's products cover various game categories, including action/adventure, action sports, racing, role-playing, simulation, first-person action, music, and strategy. Its products include World of Warcraft, Call of Duty, Guitar Hero, Tony Hawk, Spider-Man, X-Men, James Bond, and Transformers, as well as Diablo, StarCraft and Warcraft.

Short Term Investment Thesis:

• The Video Game industry has been under pressure over the past few months due to weak 4Q09 earnings and tempered CY10 outlooks, however, I believe that these worries are largely priced in due to earnings and pre announcements by GameStop, UbiSoft and Electronic Arts.
• While ATVI will not be immune to the macro weakness, its publishing business should fair better than its peers in both 4Q09 and CY10 due to its focus on the core gamer audience, which has been quite resilient.
• 4Q09 should benefit from the incredibly strong performance of Call of Duty: Modern Warfare 2 (MW2), offset by weakness in the music genre (Guitar Hero, Band Hero and DJ Hero) and Tony Hawk Ride.
• I also believe the market is also under appreciating the resiliency and profitability (~45% operating margin) of Blizzard's World of Warcraft franchise (recurring subscription revenue), which accounts for nearly half of the earnings of the company.
• ATVI will benefit from a significantly more favorable release schedule than FY09:
  • 2 new Blizzard releases (Starcraft 2 and World of Warcraft: Cataclysm) vs. none...
  • MW2 Catalogue & Map Packs vs. Call of Duty
  • 2-3 New IP releases (Blur, Singularity, unannounced) vs. DJ Hero and Tony Hawk Ride

• Installed base will benefit from PS3 and XBOX price cuts in mid-late 2009:
  • Installed base likely to grow 20-40%, expanding the addressable market
  • Checks indicate PS3 & XBOX continue to sell well post new years with particular strength in PS3, where demand is currently exceeding supply
• Leaving aside all of the aforementioned tailwinds and easy comps from '09's weak consumer, even if we assume FY10 revenue is flat, there should be ample room for margin expansion and FCF growth:
  • PC releases, such as Starcraft and World of Warcraft in '10, are much higher margin than console based titles due to the ~$10 per unit royalty paid to Sony/Microsoft. Conservatively assuming Starcraft 2 and WoW: Cataclysm sell between 5-10m units, this would imply $50-$100m in incremental operating profit on top of '09 (no major PC releases)
  • New IP and Music sales in '10 should carry much higher gross and operating margins due to the higher plastic related COGS associated w/ '09's releases - Guitar Hero, DJ Hero, Band Hero and Tony Hawk Ride. While music revenue will likely be down in '10, profitability should be much better as the industry milks the installed base w/ higher margin software only sales. Comps should also be easy due to the relatively weak debuts of DJ Hero and Tony Hawk Ride. Assuming 500-1000bps improvement in margin on ~$750m in like for like revenue in '09, would add approximately $50m in additional profit.
  • This should add approximately 220-330 bps of margin expansion, which would imply that Non-GAAP operating margin could expand from 25-26% range in '09 to 28-29% range in '10, bringing the company very close to achiving its 30% long term target. And this assumes flat revenue growth.
• Potential, highly plausible, upside scenarios not incorporated in my model is:
  • Economic rebound
  • Motion based sensing add-ons by Sony and Microsoft (Project Natal) generate buzz during Holiday 2010 and reinvigorates the industry.
  • Accelerated growth of subscription based revenue due to WoW expansion pack and Starcraft 2.
  • WoW China monetization via partnership w/ NetEase.
  • Another round of console price cuts in late 2010
  • Aggressive stock repurchases by the company

Long Term Investment Thesis

• World of Warcraft and proven, key franchise titles provide a stable base of recurring cash flow:
  • Over 80% of revenues come from proven, annuity like franchises such as World of Warcraft, Call of Duty, Hero music genre, StarCraft 2, expansion packs and catalogue titles.
  • Each franchise carries significantly above average operating margins of 25-45%+ vs. the industry's 15-20% average margin.
  • Each year, recurring franchises represent 9-10 of the industry's top 10 best selling titles.
•   Recurring revenue stream poised to increase significantly:
  • Blizzard subscription based revenue will benefit in 2010 and beyond from:
  • World of Warcraft: Cataclysm expansion pack in 2010
  • StarCraft 2 in 2010
  • World of Warcraft: Wrath of Lich King (China) in 2010
  • Diablo in 2011
  • Unannounced MMPORG in 2011-2012
  • Customers pay on a subscription basis, typically monthly in advance. Subscription revenue currently represents approximately 27% of revenue.
  • Blizzard's operating margins are 45%+.
  • Potential to leverage Blizzard's expertise in managing large on line communities to migrate Call of Duty and other key Activision franchises to an online, subscription based model.
•  Transition to on-line distribution model will lead to margin expansion:
  •  Battle.net will be the hub of the Activision Blizzard community. It will become a hub of economic activity (downloadable content, marketplace, tournaments, etc.)
  • COGS on packaged software is approximately 38% of sales. Ample room for margin expansion as the company moves towards a digital distribution model, which eliminates material costs, bypasses retailers, and dampens the used-sales market.
•  Extended console cycle will benefit all software publishers:
  •  Console makers (Sony, Nintendo and Microsoft) are collectively trying to maximize profit for the current generation of console. As such, none has signaled development of a next generation console (studio's typically hear about it 2-3 years in advance). The industry has not yet tapped out the processing and graphics capabilities of the existing consoles.
  • Console makers are instead investing in enhancements to their existing consoles, such as Microsoft's Project Natal, which will add gesture based gaming capabilities. Unlikely they would be doing this if they planned a new console in the next year or two.
  • Increasing installed base will expand market opportunity for software publishers. Development cost is largely fixed, which should lead to top line growth and margin expansion.
• Free option on World of Warcraft China:
  •  Currently World of Warcraft China JV w/ NetEase has been prohibited from monetizing or signing up new users in China.
  • Additional $100-$150m in additional FCF not included in my model should ATVI be able to monetize World of Warcraft China asset.

 Key Value Drivers

•  Increase in subscription based revenue w/ new Blizzard titles (StarCraft 2, Diablo, expansion packs)
• 300-500bps of operating margin expansion over next few years
• Transition to online distribution model over next 3-5 years will provide additional margin expansion opportunity
• Expansion of installed base
• Maintain success of key franchise titles

Warranted Value

•  $16 (based on 8% yield on FY13 estimates plus FY10-12 cash build)
• Downside is $9 (assume no top line growth from 2010-2012 and apply 9% yield on Blizzard franchise and 14% yield on Activision franchise)

Key Risks

•  Decrease in Blizzard revenue
•  Failure to maintain quality of key franchises or new IP releases
•  Free, casual games (Facebook, Zynga, etc.) take market share away from console & PC games
•  New console cycle arises sooner than expected
•  Delay in release of key titles such as Starcraft, WoW, Call of Duty

Model

Catalyst

FY10 guidance that will be given on 4Q09 earnings report on Wednesday, February 9, after market close