Investment Idea #9
Humans are creatures of habit. Once we like something, we go back to it. We have found out that starting with simple financials kinda works. So, here we go again with our 9th idea:
Simple financials (Dec 2023 estimate, USD)
Sales: 9.6bn
EBITDA: 3.6bn
Net income: 2.7bn
FCF: 3.0bn
Debt: -9.1bn, Mkt Cap 65.0bn
Ratios
ROE 13.1%, ROIC 7.9%
EV/EBITDA 14.3x (Dec 24)
PER 19.9x (Dec 24)
Past margins: OPM 10-30%
Average FCF yield 3-4%
This is an exceptional company that sits in the epi-centre of content, community and cloud based platform today. It has created strong IPs generating tremendous FCF and it is also trying to forge a new path in a new business domain: esports.
I have actually written about this name in 2019, bought the stock and the thesis has played out well. Since then, it has gone through sexual harassment lawsuits, workplace misconduct and employees walkout (actually it’s all related to sexual harassment). Then, in the middle of all this, Microsoft decides to buy the company for $95 per share. But the merger was blocked by regulators who cited anti-competition concerns.
Yes, the stock we are discussing today is none other than Activision Blizzard (ATVI), the gaming giant with several billion dollar franchises and looking to build more. Its investment thesis has not changed much. Here’s an updated version from what I wrote in 2019.
Investment Thesis
ATVI is one of the leading gaming company in the world having grown its franchises over the past twenty years across different eras, genres and gaming devices. Today, it boasts 400m monthly active users (MAU) across several blockbuster franchises including Warcraft, Overwatch, Call of Duty and Candy Crush. Some of these titles has also established esports leagues and ATVI stands to benefit as esports take off in the near future. The company has generated c.USD2bn in FCF annually for the last 10 years and also boasts strong track records in both innovation and synergistic M&As. If successful, its merger with Microsoft will be win-win for both companies.
At this point, we probably need to discuss the elephant in the room: Microsoft’s (MSFT) takeover. In early 2022, it was announced that MSFT will buy ATVI for USD69bn or $95 per share in an all cash transaction. Since then, it has become a huge media circus and one helluva roller coaster ride for shareholders. Sony and other industry players voiced concerns that some big titles will become exclusive only to Microsoft’s Xbox. FTC and other regulators blocked the merger, arguing that other console makers like Sony and Nintendo would lose out.
MSFT and ATVI responded by offering 10 year licenses to rivals and also recently struck a deal with Nintendo with respect to Call of Duty, which will be the first time the franchise will be launched on Nintendo’s Switch. As such, a few weeks ago, US appeal court overruled the FTC and approved MSFT’s takeover, paving the way for the largest M&A in the gaming industry.
As of yesterday, it seemed that most regulatory hurdles could be cleared and ATVI and MSFT decided to move ahead with the merger plan even though ATVI could have walked away and take the USD3bn of breakup fee since the deadline for the completion has passed. But that has not happened, so we are still good to go!
We will come back to the merger again. Let’s look at the fundamentals first.
1. Fundamentals
ATVI has created and amassed a library of good IPs that keeps gamers coming back. Arguably its strongest IP: World of Warcraft is the world’s largest Massively Multiplayer Online Role Playing Game (MMORPG) with 8m active players after 19 years. Cumulatively, it has over 100m signed accounts and the IP has launched books, comics, card games and one Hollywood movie which flopped in Hollywood but ironicially became a hit in China. It has other IPs, which to surmise in a few words, are basically addictive money generating machines. Courtesy of Macrotrends, we have ATVI’s FCF chart below depicting how the company has generate stable and growing FCF over the years.
One reason for the strong addictive nature of ATVI’s games is also the franchises’ ability to bring communities together. Warcraft is the prime example but ATVI has also done well with Call of Duty, Overwatch and Diablo, creating hype and buzz around the games with every new launches. This is probably the biggest reason why Microsoft wanted the company. It could see how ATVI can be the winner in gaming which will grow into a USD600bn industry by 2030. Hence, by paying USD69bn, if it can capture 1/3 of this huge market, the deal will allow MSFT to add c.USD200bn in revenue annually.
Esports could be the potential icing on the cake for MSFT although the esports market is still super small today at just USD2bn comparatively. That said, ATVI has built Overwatch into the esports franchise with leagues and players not unlike football or soccer. Overwatch League is now into its 6th season and ATVI has followed-up with a Call of Duty League in 2019.
Management
Bobby Kotick has been CEO of ATVI since 1991 when he bought 25% of the company. He has been pretty much the leader, architect and engineer who built ATVI to what it is today. His legacy is largely maimed by the sexual harassment issue described briefly above. But by and large he has made ATVI into this cashflow generating machine today which he still owns with c.4m shares (0.5% of outstanding shares) which will be worth c.USD380m when MSFT buys him out at $95 per share.
I have written more about Bobby Kotick, ATVI’s fundamentals, potential risks and esports franchise, alas it may take more years for esports to really become big though.
http://8percentpa.blogspot.com/search/label/ATVI
2. Technicals
ATVI is a volatile stock and drawdowns had been treacherous despite its strong and stable FCF. In the last few years, it suffered two c.50% drawdowns only to see the stock rebound back to its previous high fairly quickly. Today, the share price is capped at $95 barring any higher bids from MSFT or other entities, as such, the stock may not be interesting at this level.
Risk-reward
We have always looked at the risk reward profile and what’s different for ATVI is that the profile is skewed towards the downside:
If the deal happens, MSFT buys ATVI for $95 per share which means that the upside is a mere 3%
If it doesn’t happen, then the share price would collapse as it did to c.$60. This would spell downside of 35%
As such, risk reward is not great, although the certainty of getting bought out at $95 is very high. The play here would be to buy it at $70-80, if for some reason, the stock trades down to this level over the next few months before the deal closes.
3. Valuations
Using our usual valuation methodologies to triangulate the fair value for ATVI, we have projected FCF USD2.5bn, Net Income at USD2.7bn and EBITDA at USD4bn. Applying the respective multiples give us limited upside (based on the table below) which means that the $95 that MSFT is paying is probably fair.
In conclusion, the analysis today does not warrant a buy at current price. But it would be worth considering as the price drops to $70-80, which is the range that the stock traded at since MSFT’s announcement until recent weeks when the merger looks like it will happen. The portfolio has owned this stock at $78 and hence in a similar position as Bobby Kotick, waiting to be taken out by MSFT. Hope that comes true!
Huat Ah!
Main blog:
http://8percentpa.blogspot.com/
This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.