- Activision Blizzard seems somewhat undervalued going into its Q4 2015 earnings.
- Expectations on Q4'15 earnings/sales seem a bit high, but FY'16 estimates look way too conservative.
- As such, I believe Activision Blizzard stock has meaningful upside from its low base despite weak market sentiment.
- I anticipate the stock to move higher following the earnings release, and I'm initiating a price target of $39.75.
For the most part, I really like Activision Blizzard going into its upcoming Q4 2015 earnings conference call, as investors have flooded out of the bigger entertainment software names in the past month. Activision Blizzard (NASDAQ:ATVI) has gotten a lot cheaper, which lowers expectations going into earnings as in-line guidance with a modest beat on earnings will be sufficient. I anticipate the stock to move somewhat higher as much of the bad news seems already baked in.
A big chunk of Activision Blizzards footprint leans heavily towards PC titles and are sold via it’s Blizzard platform with the exception of the Call of Duty franchise, which is marketed via Steam. However, Black Ops 3 likely got hit with higher mix-shift to physical copies, which have lower gross margins as a result of the $350 PS4 bundles, which has damaging implications on sell through for the holiday quarter, i.e. the company could be hit with some sales headwinds. However, demand for the title outstripped expectations.
Physical game sales declined by 3% year-over-year in the December period according to NPD Group. However, NPD figures exclude digital and according to Wedbush analyst Michael Pachter, approximately 25% of game sales were digital in FY’15. There could be an earnings surprise in store, and with the close of the King Digital acquisition following regulatory approvals in South Korea, I’m starting to see the silver lining to the name (even prior to earnings). Expectation for core franchises excluding King Digital is 5% CAGR for the foreseeable 5-year period, according to Activision’s investor day. So, the long-term guidance seems relatively conservative for core game franchises excluding mobile. Furthermore, industry wide forecasts indicate that PCs are positioned to grow relatively quickly when compared to consoles, so the organic growth from incremental attach rates from add-in-boards would further indicate that PC game sales will continue to trend higher given the complimentary nature of GPUs and digital game sales. In other words, it’s worth following the hardware, and since ATVI is positioned strongly with mobile and PC franchises, I see a pathway to sustained 10%+ revenue growth given the long-term dynamics of PCs and VR.
However, excluding aggressive assumptions on PC growth, console sales were relatively strong in the holiday quarter, so the installed base is significantly larger, which implies gaming software will start to pick up momentum due to a wider base, which creates more room for game purchases and less purchases of hardware. As such, I view the long-term estimates by the sell side somewhat conservative, but find near term estimates slightly aggressive. However, Activision Blizzard tends to guide extremely conservatively, which is why they usually beat by a healthy margin.
According to Wedbush Securities analyst Michael Pachter:
We expect upside driven by new release Call of Duty: Black Ops III and digital momentum. We expect revenue of $2,228 million and EPS of $0.87, compared with consensus of $2,198 million and $0.86, and guidance of $2,148 million and $0.82. Initial FY:16 guidance is likely to be well below current consensus (some analysts included King in their estimates) due to management’s conservatism. We do not expect detailed guidance with King until the deal closes (likely by the end of Q1:16), but earlier accretion commentary suggested contribution of $1.5 billion in revenue and $0.50 in EPS over three quarters.
Michael Pachter makes some salient points with regards to next-year’s guidance. Forecasting revenue growth for game sales is relatively difficult due to the non-recurring nature and choppiness of title releases. Nonetheless, it’s worth mentioning that Activision Blizzard has a relatively strong line-up for the upcoming year, and the company's current outlook will likely start below the consensus range due to the timing of closing the King Digital acquisition. Nonetheless, there's meaningful upside to sales and earnings since the approval in Korea happened relatively quickly.
The stock moved higher on the Wednesday session in anticipation of a beat on both sales and earnings for Q4’15. The current analyst consensus for Q4’15 non-GAAP sales and earnings is $2.2 billion and $0.86 respectively. The analyst consensus is above the management outlook of $2.148 billion for sales and $0.82 for Q4’15. Given the heightened expectation it seems somewhat difficult to beat by a considerable margin on sales, however the sell-side models anticipate heightened tax expenses with a lower earnings base, which implies that the management team has maneuverability with its tax rate.
Of course, Activision Blizzard’s tax rate is a black box, but if I had to anticipate a financial reason for why earnings will beat it would pertain primarily to its tax rate. Furthermore, the justification for a sales beat is driven by a sales mix shift from physical disks to digital sales, which is not reflected in NPD assumptions. So, if you tack on the incremental mix of digital relative to disk, we arrive at approximately a $52 million beat on top line expectations, however, due to the precision of these mix-shift assumptions it seems somewhat difficult to rally around expectations for the Q4’15 print out. But, given the material drop-off in the stock (roughly 30% drop from year highs), it’s fair to assume that the Activision Blizzard stock will recover due to the broadly anticipated outcome of weak or in-line guidance for FY’16 and a modest beat to Q4’15 expectations.
As such, I feel fairly confident in Activision Blizzard. I see it as part recovery, but also momentum due to upside to the growth rate. Of course, anticipating heightened growth in this environment seems somewhat risky, but given the changing mix to mobile and PC and maturation of consoles, I feel confident that FY’16 will prove to be one heck of a year.
I’m going to recommend the stock here as a conviction buy, and I’m initiating a price target of $39.75 (20.925x non-GAAP EPS), which implies 30% upside from current levels. The stock won’t exceed its 52-week highs given the weak equity environment due to rising rates. Returns are likely to compress due to weakening sentiment, which results in multiple compression. I currently anticipate non-GAAP EPS of $1.90, which is conservative as its inclusive of accretion from the King Digital acquisition. Furthermore, I anticipate the Activision Blizzard stock to outperform the market as fundamentals will drive the stock higher despite weakening macro specific trends. Despite weakness to broad market sentiment, the stock has enough near term catalysts to move meaningfully higher from the low $30s.