Investment Analysis – Activision Blizzard Inc.
Welcome to the BHB Investment Analysis of Activision Blizzard Inc. (#ATVI)
This is a long post due to its nature and purpose and so I have broken it down into 4 sections: (you can click the header to jump to that particular section)
- COMPANY OVERVIEW – This is to understand more about the company; What they do, where they do business and what their products are.
- HISTORICAL FINANCIAL REVIEW – Here I look at the Income Statement, Balance Sheet and Cash Flow Statement. Providing a better understanding of the financial performance and situation.
- COMPANY VALUATION REVIEW – Now I look at some of the common valuation ratio’s and models. Looking at how they compare with similar business and try to understand what fair value is.
- BHB INVESTMENT ANALYSIS CONCLUSION: Finally I summaries my thoughts and target prices.
RESOURCES & REFERENCES:
The following information comes from a combination of places as follows:
– Company details and figures from the Activision Blizzard, Inc. Form 10-K for Fiscal Year Ending December 31, 2019 and the Form 10-Q for 2020 Q3. This information can be found at investor.activision.com.
– Company and fundamental information from SharePad. Which is a data analysis and portfolio management software package that I subscribe to.
– Financial data, ratios, fair values as well as charts from Finbox.io. Finbox is a web-based stock market research platform that offers enterprise quality data and insights. This is another service I subscribe to.
– Other data from finance sites such as yahoo for bond/gilt rates etc. to help with assumptions and valuation models.
Disclaimer: This investment analysis should not be reviewed as investment advice. It should be used for information or to support/challenge your own research and assumptions. At the time of writing this post I do not hold any position in Activision Blizzard Inc. (#ATVI) or Electronic Arts Inc. (#EA), however I do hold a small position in Take-Two Interactive Software Inc. (#TTWO) which I have held since February 2020.
1. COMPANY OVERVIEW
Activision Blizzard, Inc. is a leading global developer and publisher of interactive entertainment content and services. They develop and distribute content and services on video game consoles, personal computers (PC’s), and mobile devices. They also operate esports leagues and offer digital advertising within their content.
Company Vision & Strategy
Their objective is to continue to be a worldwide leader in the development, publishing, and distribution of high-quality interactive entertainment. In pursuit of this objective, they focus on three strategic pillars:
Expanding audience reach
Driving deep consumer engagement
Providing more opportunities for player investment
Activision Blizzard, Inc. conduct their business through three reportable segments:
1. ACTIVISION PUBLISHING, INC.
Activision Publishing, Inc. is a leading global developer and publisher of interactive software products and entertainment content, particularly for the console platform. They primarily deliver content through retail and digital channels. This includes full-game and in-game sales as well as by licensing software to third-party or related-party companies that distribute Activision products. Activision also includes the activities from the Call of Duty League which is a global professional esports league with city based teams for Call of Duty®.
Activision’s key product franchise is Call of Duty, a first-person action title for console and PC Platforms and following the October 1, 2019 launch of Call of Duty: Mobile, the mobile platform.
2. BLIZZARD ENTERTAINMENT, INC.
Blizzard is a leading global developer and publisher of interactive software products and entertainment content, particularly for the PC platform. They primarily deliver content through retail and digital channels, including subscriptions, full-game, and in-game sales, as well as by licensing software to third-party or related-party companies. Blizzard also maintains a proprietary online gaming service, Blizzard Battle.net®, which facilitates digital distribution of Blizzard content and selected Activision content, online social connectivity, and the creation of user-generated content. Blizzard also includes the activities of the Overwatch League™, the first major global professional esports league with city-based teams.
Blizzard’s key product franchises include: World of Warcraft®, a subscription bases massive multi-player online role playing game for the PC platform; Diablo®, an action role-playing franchise for the PC and console platforms; Hearthstone®, an online collectible card franchise for the PC and mobile platforms; Overwatch®, a team-based first-person action title for the PC and console platforms.
3. KING DIGITAL ENTERTAINMENT
King is a leading global developer and publisher of interactive entertainment content and services, particularly for the mobile platform. They do also distribute their content and services on the PC platform, primarily via Facebook. King’s games are free to play; however, players can acquire in-game items, either with virtual currency or real currency, and they continue to focus on in-game advertising as a growing source of additional revenue.
King’s key product franchise is Candy Crush™, which features “match three” games for the mobile and PC platforms.
They also engage in other businesses that do not represent reportable segments, including the Activision Blizzard Distribution business, which consists of operations in Europe that provide warehousing, logistics, and sales distribution services to third-party publishers of interactive entertainment software, their own publishing operations, and manufacturers of interactive entertainment hardware.
Significant Customers & Products
Activision Blizzard, Inc. does sell directly to end consumers in certain instances, such as sales through Blizzard Battle.net, in other instances their customers may be platform providers such as Sony, Microsoft, Google and Apple or retailers such as Walmart and GameStop.
For year ending December 31, 2019, the top three franchises were Call of Duty, Candy Crush and World of Warcraft, collectively accounting for 67% of net revenues. Activision Blizzard have some of the most recognised and popular franchises around.
Activision Blizzard are a global company but the U.S. is by far the biggest market with 46% of the turnover.
As mentioned already there are 3 segments to the business with Activision having the biggest % of turnover but there is not a significant difference between them.
They operate within two main distribution channels; Digital Online Channels and Retail Channels. Figures from the year ending 2019 10-k form show Digital Online Channels having 76% of the net revenues, Retail Channels with 14% and then 10% classified as other.
With regards to net revenue by platform, Mobile and ancillary is now the largest with 33.9% of net revenue followed by Console with 29.6%, PC with 26.5% and then 10% assigned to other.
2. HISTORICAL FINANCIAL REVIEW
Activision have experienced good growth over the last 10 years, however performance in 2019 was not great and showed a reduction in several key metrics. After reading through the year end 2019 10-K report, the management team have highlighted poor execution as the main driver for the poor performance. This triggered a company restructure aiming to resolve these issues and help the company organise themselves in a way that maximises the effectiveness of the current business units and industry direction.
At the time of writing this the 2020 Q3 figures have just been released and 2020 is looking to be an extremely strong year. The pandemic have forced people to stay at home for long periods of time and a lot of people suddenly have a lot of free time on their hands. This seems to have triggered an increase in game playing on all platforms.
Through this section I will reference comparisons with some of Activisions key competitors. I have used Electronic Arts Inc. (#EA) and Take-Two Interactive Inc. (TTWO) as the main companies to compare with due to them being closer in size and with similar business models. Other competitors were harder to use for comparisons due to being much smaller in size or due to having “gaming” as a segment of their business, rather than their main business.
Activision Blizzard’s revenue is strong with 2019 delivering $6.5 billon. 2020 is looking very strong with the first 3 quarters of revenue already reaching $5.7 billon and Q4 is usually the best quarter of the year due to holiday purchases.
It is also worth pointing out that Activision Blizzard have one of the largest revenues within the Entertainment-Media Industry. They have revenues roughly $2 billon more than Electronic Arts and over $4 billon more than Take-Two Interactive.
Gross Profits have been increasing steadily over the year with the exception of 2019. The gross profit margins have been consistently above 63% and even with reduced gross profit in 2019 they managed to record their highest annual margin of 67.8%. The first 3 quarters of 2020 are showing further improvements with margins currently at 74.6%.
Electronics Arts have been delivering gross profit margins consistently above 70% but Take-Two Interactive are behind running at margins below 50%.
Activision Blizzard have been consistently growing operating income at an average of 25% per year for the last 5 years. Operating margin coming in above 25% and potentially looking at above 30% by the end of the 2020. Activision Blizzard also have the highest operating income margin out of the 3 comparing companies with Electronic Arts not too far behind.
NET PROFIT/NET INCOME:
Net income has been increasing for several years and escalated over the last few years. The main reason for the increase seems to be driven by a reduction income tax expense. Net Income margin is the highest out of the 3 comparing companies. Activision Blizzard also have the highest growth forecast of the 3 with Net Income margins forecast to be around 32%.
Again, solid EBITDA actuals and growth over the years. EBITDA currently coming in at around 37% of revenue which is considerably higher than the two comparing companies. Forecasted EBITDA growth is expected to be around 68% which is lot more than Electronic Arts at 29%. Take-Two interactive also have a strong growth forecast at 61%.
EARNINGS PER SHARE (EPS):
Growing steadily over the last 10 years with the exception of 2017. 2017 was impacted dramatically by a huge increase in income tax expenses. 2020 performance is looking good and EPS is forecasted increase significantly. 2020 forecast is around 3.44, vs 1.96 in 2019 and 2.42 in 2018.
EPS growth looks positive but Activision Blizzard do have a much lower EPS than the comparing companies. Electronic Arts have an EPS of 4.81 (forecast of 5.35) and Take-Two Interactive have an EPS of 5.32 (forecast of 5.60). Since Activision Blizzard has the higher earnings of the 3 this highlights the much bigger shares outstanding. When looking into this, Activision Blizzards shares outstanding has been increasing over the last 7 years whereas Electronic Arts have been buying back shares. Activision Blizzard are showing to have a buy back yield of -0.1% vs Electronic Arts yield of 1.9%. Take-Two Interactives shares outstanding is fairly static with a 0.3% yield but they have much lower shares outstanding.
CASH & CASH EQUIVALENTS:
Activision Blizzard finished 2019 with $5.8 billon in cash and cash equivalents. At the end of Q3 2020 they were sitting on $7.4 billon. That is averaging around 30% growth for the last two years.
They also have nearly double the cash and cash equivalents compared to Electronic Arts at around $3.8 billon. Take-Two interactive are much lower with around $1.4 billon.
Accounts receivable has been increasing over the years but the increase is inline with revenue increase. It has been hovering at around 13% of revenue for the last 10 years. The Q3 2020 accounts receivable are around 10.9% but it looks like it will return to around 13% by year end.
Electronic Arts has a similar accounts receivable as a % of revenue, but interestingly Take-Two Interactive are considerably higher at 30%.
TOTAL CURRENT ASSETS:
$7.3 billon in total current assets at the end of 2019. Q3 2020 shows $9 billon and possibly $10 billon by the end of 2020. That’s a 19% increase from 2018 to 2019, and potentially around 37% increase in 2020.
GOODWILL & INTAGIBLES:
Activision Blizzard are currently sat with $10.4 billion of goodwill. There is $7.8 billon on the balance sheet since before 2010. This looks to be linked to the Blizzard as a segment and is probably from the merger in 2008. They then added another $2.6 billon with the purchase of King.
Activision Blizzards Goodwill & Intangibles are significantly more than Electronic Arts at $1.9 billon and Take-Two Interactive at $1 billon.
Total assets finished at $19.8 billion at the end of 2019 and were $21.6 billon at the end of Q3 2020. They have grown on average 4.6% over the last 10 years but growth has accelerated in the last 2 years. As mentioned previously it’s worth noting that over half of the total assets are goodwill & intangibles.
CURRENT PORTION OF DEBT:
Nothing due in 2020. You will see from the long term debt they have cleared Long term debt due for the next two years.
TOTAL CURRENT LIABILITIES:
This has stayed pretty consistent over the last 10 years. It has fluctuated between $2.6 billion and $2.9 billon and is easily covered by cash & cash equivalent’s.
The cash ratio has been above 2x for the last 2 years and is recently at 3x. So short debt debt is well covered by cash. Electronic Arts are currently at 2.43, but historically they have a higher cash ratio than Activision Blizzard. Take Two interactive have had a ratio below 1 for many years but have recently reached 1.03x.
LONG TERM DEBT:
At the end of 2019 long term debt was £2.68 billon. In Q3 2020 they issued another $2b of debt in the form of unsecured 10 year and 30 year notes. They used this $2b to redeem all outstanding $1.05b of notes due 2021 and 2022. The remaining $950m is to further strengthen the balance sheet, taking advantage of the low interest rates.
Activision Blizzard is debt heavy in comparison to Electronic Arts and Take-Two Interactive. Electronic Arts have debt of $397m and Take-Two Interactive have only $5.2m.
Activision Blizzards Debt / EBITDA is only 1.2. However, Electronic Arts and Take Two Interactive have much lower debt / EBITDA ratios at approximately 0.15 and 0.06. As long as Activision Blizzards Debt / EBITDA stays at these levels I can accept the higher debt levels. If this was to increase above 2 and towards 3 I would be more concerned.
OTHER CURRENT & NON-CURRENT LIABILITIES:
Both current liabilities and non-current liabilities look relatively high. Looking at the 2019 10-k form I can see that Activision Blizzard have contractual agreements and obligations with third parties. These obligations are for non-cancellable operating lease agreements, facility and equipment leases. There are also things such as product development work and hosting services. These obligations are also contracted to the third parties performance or ability to deliver on product development.
ADDITIONAL PAID IN CAPITAL:
End of Year 2019 shows Additional Paid in Capital at $11.2b. This has been steadily increasing through the years and continued through 2020.
Retained earnings have increased considerably over the years. Year end 2019 finished at $7.8b and Q3 2020 is at $9.2 billon.
Cash Flow Statement:
CHANGES IN CASH & CASH EQUIVALENTS:
Cash and cash equivalents obviously took a big hit in 2015 and 2016 with the acquisition of King. There was -$3.5b in escrow in 2015 and then -$4.5b in cash acquisitions in 2016. There was also a drop in 2018 driven by $1.7b of debt repayment.
2017 and 2019 averages around $1.5b positive change and 2020 is looking to exceed that at the moment. This will also included the $950m from new debt issued.
Activision Blizzard do like to issued debt to keep a healthy amount of cash available. When a large amount of debt is due, the more often than not issue new debt. It is worth recognising that ending cash increases on average 17% a year while debt is reducing around 7% a year. So they are not completely relying on debt to increase cash.
CASH FROM OPERATIONS:
Activision Blizzard Q3 2020 report shows $1.1b in cash from operating activities vs a full Year 2019 of $1.8b. So looking to be equal or above by 2020 year end. Cash from operations has been sporadic over the years but has increased an average of 10% over the last 5 years.
FREE CASH FLOW:
Free cash flow has been increasing on average 10% per year over the last 5 years. This aligns with the increase in operating cash flows. CAPEX has only been increasing an average of 2% per year. 2020 free cash flow is on track to grow substantially in 2020. In 2019 FCF was $1.7b and at the end of Q3 2020 it sits at $1b. Historically Q4 has delivered almost half of the year end free cash flows.
Free cash flow for Activision Blizzard does look stable and safe with relatively steady growth. The full year 2019 FCF margin was 26.4% which is lower than both Take Two Interactive (29.1%) and Electronic Arts (28.8).
3. COMPANY VALUATION REVIEW
Valuing a company is the hardest part of analysing a company. I use valuation ratios and valuation models to help me come up with my fair values. The valuation ratios I use to understand where the company is relative to its competition and its own historical levels. I then use different models to calculate fair values. Finbox have their own models using their assumptions which I use as a reference. I then like to build my own models using my own assumptions and compare the two. From there I can come up with fair value I feel comfortable. The fair value price however isn’t the price I will necessarily buy at. I will generally always apply a margin of safety to that price. The margin of safety I apply depends on how confident I am with my assumptions, as well as how much I like the company fundamentals.
At the time of writing Activision Blizzard has a P/E Ratio of 28.8x which is lower than it’s 5 year average (38.4x) and it’s 10 year average (29.7x). It is also lower than the two comparable competitors with Electronic Arts at 29.4x and Take-Two Interactive at 42.2x. Compared to it’s own history and it’s competitors it is relatively low at the moment. Their forward P/E however is 24.4x.
A current PEG of 0.9 is historically high with it only being higher twice in the last 10 years. Electronic Arts are at 0.6 and Take-Two Interactive are at 1.3, both are also high verses their historic averages.
PRICE TO LTM FCF RATIO:
Price to FCF is currently at 32.9x which is very high vs it’s average since 2019 at 21.2x. It is also considerably higher than Electronic Arts at 20.2x and Take-Two Interactive at 18.0x
BEN GRAHAM FORMULA (INTRINSIC VALUE):
The Ben Graham Formula is showing Activision Blizzard to be valued at $81.19. That has significantly increase from around $60 at the end of 2019. The current price as of writing is $82.58, so not far away.
There are currently 32 Analysts rating Activision Blizzard with an average target price of $96.41, and a range from $73 – $110.
FAIR VALUE MODELS – FINBOX:
Finbox has a fair value for Activision Blizzard Inc. of $80.44. Their fair value is an average of several finbox models. The model showing the highest fair value is the 10Y DCF EBITDA Exit and shows a fair value of $110.34. The lowest fair value is the 5Y DCF Growth Exit model which has a fair value of $58.70. The models for Activision Blizzard Inc. have a certainty rating of HIGH.
FAIR VALUE MODELS – BHB:
These are the models I build myself using my own assumptions. The average fair value I get is $97.22 that is using models that primarily look at Free Cash Flow and EBITDA. For your information, some of the assumptions and calculations I use in these models are as follows:
Risk Free Rate = 2.5%
BETA = 0.65
Weighted Average Cost of Capital (WACC) = 7.2%
Cost of Debt = 3.2%
Cost of Equity = 6.1%
Debt % of Capital = 6.1%
Tax Rate = 24%
Perpetual Growth Rate = 2.5%
Growth Rate = 17% (Analyst forecast =24.4%)
Based on the confidence of my assumptions and all the information reviewed, I would apply a 15% margin of safety. This puts the BHB fair value price at $82.64.
Activision Blizzard has been on a good rally this year with its stock price up over 40%. The price did however drop significantly in 2019 due to poor performance. At the current price of $82.58, it has really caught back up to where it was in 2018.
BHB INVESTMENT ANALYSIS CONCLUSION:
Activision Blizzard is a good company that with is performing well and has further potential. It is a company I would like to invest in for the right price and return.
I like that Activision Blizzard Inc. is a successful global business with with strong franchises. With the purchase of King and the expansion into esports, they have all the gaming segments covered. The fact that they are one of the largest pure gaming companies in the world is also reassuring.
Their revenue and income is strong, but they need to continue the progress made in 2020 following their poor performance in 2019. This also means successfully completing the restructure and extracting the value from that.
If I do opened a position in Activision Blizzard I will be keeping a close eye on their progress. I especially want to see growth in mobile and esports, which is where I believe there is a lot of potential. The overall growth rate is also critical to deliver the return on investment that came from the models. Ideally I would also like to see operating cash flow growth. Operating Cash flow is where they are slightly behind their competition in terms of % of revenue.
Finally, the management of Activision Blizzard Inc. like to use debt as a way of maintaining cash levels. At the moment the debt is manageable but I will be watching the debt / EBITDA levels.
The fair value with a margin of safety was $82.64. This is not far away from the current value at the time of writing. However, looking at the technical charts there should be some better entry points.
I will initiate a small position if the price pulls back to $78, with the aim to add more at $74. There is a chance the price will pull back further to $70 which is where I will then significantly increase the position. This would then be at a price with a really strong margin of safety and solid return. Ideally the price will drop to $70 before the 2020 year end results presentation in Feb 2021. If the 2020 results finish strong the price might not see $70 again for a while.
I will initiate a small position at $78 with the aim to purchase more at $74. I am hoping the price will drop to $70, which is where I will significantly increase my position.