- Activision Blizzard flopped on revenue for Q4’15 and outlook fell short of expectations for FY’16.
- Regardless of the headline miss, I still think Activision Blizzard stock is undervalued and management guidance is too conservative.
- However, valuation compression seems inevitable given the potential risks of King Digital.
Activision Blizzard (NASDAQ:ATVI) had a pretty shaky quarter, and it was partially due to overestimations on revenue front for Q4’15, and a reset on expectations when pertaining to core Activision Blizzard earnings, as the company plans to launch the Destiny sequel in FY 2017 as opposed to FY 2016.
Quoted from earnings conference call:
On Destiny, we expect to deliver a new expansion in 2016 but note that we no longer expect a full game Destiny release during the year. We do however expect a full game Destiny sequel to now come in 2017.
The incremental accretion from King Digital Entertainment was factored into the company’s guidance, which was why investors were partially confused by the commentary provided by management.
Activision doesn’t anticipate margin leverage following the acquisition of King Digital? A total shocker. They plan to elaborate on their reasoning in its Q1’16 release, but my initial instinct is that the added restructuring charge from acquiring King will lead to limited margin accretion over the near-term with the consolidation of King and Activision business units to become a bigger theme in FY’17.
Source: Activision Blizzard
Activision Blizzard fell short of its own outlook as it reported non-GAAP revenue of $2.118 billion when compared to its outlook of $2.148 billion. The impact was partially due to console weakness, but mostly F/X impact. The dollar index had its strongest gains through Q4’15 as investors were fleeing emerging markets due to currency volatility and weakening macro growth assumption in China and other emerging markets (I recall economists revising macro growth assumptions across the globe in CY’15).
The net result was capital outflows in many of the emerging economies, which resulted in massive currency destabilization. The dollar index gained by 4% or so in Q4’15, which explains the 1.4% revenue miss. Last minute window dressing among portfolio managers to mask some exposure to emerging markets helps explain the currency outflow from emerging markets in Q4’15.
In my opinion, Activision had a fairly solid quarter despite excessive currency volatility and next year guidance of non-GAAP EPS of $1.75. The number wasn't too bad but could have been much better.
I think the concerns shared by buy side analysts is the long-term value of King Digital as it has experienced user base erosion over the course of FY’15. The drop off in engagement implies that King’s platform of mobile apps will generate lower earnings accretion over time unless Activision Blizzard is able to reverse the decline in engagement metrics over the next 12 to 24-month timeframe.
Otherwise, King will become a near-term contributor to earnings, but over the long-term, the price paid for the acquisition won’t generate a positive return on shareholder equity. It implies that investors are valuing the business as if it’s a capital sink rather than net accretive, as it’s hard to imagine how Activision Blizzard will generate long-term shareholder value from the transaction.
Now this dynamic may change assuming King’s engagement trends start to stabilize. This implies that Activision Blizzard is able to move more of the mobile app development in-house where they can focalize on converging Candy Crush into a more soft-core franchise with long-term retention dynamics built into the gameplay. Building a non-faddish mobile franchise hasn’t been accomplished quite yet, and the rapid growth of mobile apps is usually accompanied by a massive cool-off phase with the exception of network effect apps.
In other words, Activision Blizzard is making the bet that they can return Candy Crush to a stable growth vehicle and for all the historic success that Blizzard Entertainment has demonstrated with long-term retention dynamics in its core franchises (World of Warcraft, StarCraft and Diablo), there’s not a whole lot of conviction that Activision Blizzard can recreate Candy Crush into an annuity like revenue stream.
If earnings continue to decline as a result of base erosion at a 20% rate, the company’s total cumulative net income between FY’15 and FY’20 will amount to $1.7 billion, shareholder equity of $1.023 billion in FY’14 implies that at the current trajectory, King’s six-year value creation inclusive of assets on the balance sheet is $2.72 billion. Since Activision Blizzard paid $5.9 billion for the business, the metric of success isn’t the near-term impact on EPS, but whether the combined value of assets plus future earnings will exceed the $5.9 billion paid for the company.
It’s entirely plausible that King Digital goes from a $2.2 billion/year business to $0, or decline to a very un-meaningful amount. As such, it’s hard to attach a high market multiple that reflects “annuity like revenue” or even hope for a modest terminal growth assumption for King Digital. Therefore, I have to arrive at a more conservative valuation estimate in light of these stark realities given the potential risks of the acquisition and the somewhat reasonable likelihood that this is a Zynga 2.0 story.
Of course, we then discount the $2.7 billion by 9.07% (average market return of the S&P 500) to arrive at the present value of all net earnings + shareholder equity, which would amount to $1.7 billion. So, the net value creation based on the current revenue/earnings trajectory is $5.9 billion - $1.7 billion, which equals ($3.17 billion). I could extrapolate out further, but to maintain consistency with conventional models, I’m operating off of a five-year time frame.
Furthermore, I could have used unlevered free cash flow, but that would have deflated my present valuation even further. So, instead I’m valuing the business on a tangible basis to reflect the worst case scenario assuming the same cash could have been invested at a 9% return and the business does materially decelerate over the five-year time frame. I’m not attaching a market multiple to King Digital as a sum of the parts analysis doesn’t seem appropriate given a 50/50 likelihood of future write offs. Of course, Activision Blizzard’s savvy product development strategy could return King to stable growth, but to reflect concerns among the investor base I will adjust my valuation lower by $3.17 billion, which I will explain further.
Commentary from sell side analysts involves price target reductions: $40 from $47 in the case of Wedbush and $36 from $44 in the case of UBS. There’s a lot of confusion pertaining to the valuation among buy/sell side analysts:
With that said, we’re left pondering the correct valuation framework for Activision. As we have laid out above, Activision expects standalone EPS growth of 10% annually for three years from the $1.32 delivered in 2015. We think that the “right” valuation is a blended multiple that reflects Activision’s history of beating its annual guidance. We think that the “right” Activision standalone EPS figure will come in around $1.45 this year, and that the “right” King figure will be close to $0.55, for a blended $2.00 in EPS. Because both profit streams are likely to grow, and because once the two companies are combined, it will be difficult to discern the profit contribution from either, we expect the market to value Activision at a “normal” multiple that reflects the company’s superior growth prospects and its leadership position in a dynamic and growing industry. – Michael Pachter at Wedbush Securities
Despite a strong quarter for the Call of Duty franchise, ATVI's Q4 results & forward guidance fell short of expectations as the company's casual titles (Skylanders & Guitar Hero) underperformed and a Destiny sequel was shelved until 2017 (vs. expectations for 2016). That said, stronger than expected next-gen console revenues (+77% YoY vs. UBSe +55%) & continued mix shift towards digital (37% of revs in Q4'15 vs. 31% Q4'14) suggest industry tailwinds persist – as a result, our outlook for continued margin expansion & improved FCF generation (with potential for outsized cash returns to shareholders on a multi-year view) remains unchanged. In the near-term, we expect investors to look to the KING acquisition and the launch of the Overwatch title as key drivers for upside to 2016 expectations. – Eric Sheridan at UBS
That said, given the lineup of products to arrive in 2016, which include Overwatch as well as World of Warcraft: Legion, we believe the initial FY16 guidance parameters to be overly conservative and with Street expectations now level set with the inclusion of KING, we recommend investors use the weakness in ATVI shares to either initiate or add to positions. Our price target remains at $41 and we maintain our Outperform rating. – Stephen Ju at Credit Suisse
I’m maintaining my EPS estimate of $1.90 for FY’16, I still think there’s room for upside given near-term revenue drivers to PC downloads and upside to the next Modern Warfare franchise absent of competition from Destiny 2. Due to the conservative nature of ATVI’s guidance and stabilization of F/X I see a path to beating on revenue. Much of the F/X headwinds are temporary as I see a path to stabilization of global asset flows in CY’16 as opposed to CY’15.
I value the business at $35.65 after netting out the $3.17 billion and applying a 20.925 earnings multiple to FY’16 earnings. Therefore, I’m really operating off of an 18.78x net income multiple for FY’16 to reflect the conservatism of other analysts. The stock currently trades at $29.42, which implies 21.17% upside from current levels. This might seem aggressive. But given the depressed value it trades at, I believe value recovery will become the main catalyst to ATVI's valuation as broader market sentiment will most likely recover in the back half of 2016.