Investment Thesis
I am recommending a Buy position for Activision. Based on multiple valuation methods, the average fair market value of ATVI is $41.33. Activision is the largest video game firm in the world. It currently controls the entire video game realm with famous franchises including Call of Duty, Diablo, Starcraft, Warcraft, and the recently acquired Candy Crush. ATVI also owns Major League Gaming, a professional E-sports organization that hosts major video game tournaments worldwide. I believe they are positioned for a large growth as they enter a new genre of gaming with their game Overwatch, a first person shooter game. They are also expected to release a movie in 2016 made after the hit franchise Warcraft. And as Virtual Reality systems such as Oculus develop, so too will ATVI build games for that arena.
Economy
The markets have been very volatile at the beginning of 2016 giving ATVI a YTD return of nearly -18% while the S&P 500 only suffered -5%. The economy for video games is still very strong and spans worldwide. Four out of five households owned a video game console in 2014 and the U.S Computer and Video game sales have been increasing year-on-year, including during the financial crisis.[1] Over the last five years, ATVI has had a total return of 200%, outperforming the S&P 500 by near 4x.
Industry
The video game industry is in a mature state characterized by cyclical growth and strong competition. The industry relies on constant new releases of popular video games to attract consumer sentiment and fuel demand. Over the last decade we’ve seen a large shift over to “social games”, that is, games connected to the internet and played with other players. Sales are largely generated through new channels that incorporate downloadable content, in-game purchases, advertisement revenue, and subscription fees. E-sports has also risen to play a major role in gaming industry. MLG hosts professional competitions in Call of Duty, CounterStrike: GO, DOTA 2, Halo, and Starcraft. The number of live viewers at the largest E-sports event reached 36 million in 2015.[2]
Company
Activision is primarily driven by the sale of its video games. They have large market shares in all types of gaming systems which includes mobile phones, gaming consoles, and PC. They recently acquired King Digital, the producer of Candy Crush. Candy Crush was the top downloaded game in the iOS store in 2015[3] and ranked #6 in the highest grossing app.[4] Activision is also known for World of Warcraft (WoW), the largest Massively Multiplayer Online Role-Playing Game in the world which hit a subscriber base of 12.5 million players in 2012[5]. From this player base, Activision is earning revenues from WoW’s player subscription fee starting at $15 per month. Last year, ATVI generated around $4.6B in revenue while King generated around $2B. Together in 2016, they are expected to generate around $6.5B.
DCF/NPV Valuation
A DCF model was created to estimate ATVI’s net present value.
The following assumptions were made: a 6% projected growth for 2016 from the completion of the King Digital acquisition. Revenues from mobile would grow from last year as the smart phone industry grew, and a conservative yet consistent year-on-year growth between 1-2% for the next 10 years. After that, ATVI is project to grow indefinitely with a terminal growth rate of 2%. ATVI historically has no debt. They recently took on debt for the purchase of King Digital and has been paying it down annually. This debt is projected to be completely paid off in the future and accounted for that in our assumptions. Their NPV and Share price is highly affected by the discount rate and growth rate as reflected below. As they move away from debt and towards full equity, their value increases.
APV Valuation
Due to ATVI’s recent change in capital structure, An APV model was also created to account for that. ATVI went from no debt, to taking on close to $5B of financial leverage on their balance sheet after acquiring King Digital. An APV valuation would account for the tax shields gained from interest. The APV model resulted in an intrinsic value of $33.10 per share. The table below shows the APV projected cash flow and tax shields. This is under the assumption that ATVI’s capital structure remain consistent in mostly equities and they continue to gradually pay off their current debt.
PE EPS Multiple Valuation
The last method of valuating ATVI is to project the EPS growth over the next 10 years and multiply the terminal EPS by the forward P/E ratio. Their Price-to-Earnings ratio is currently 25.63. Their expected EPS in year 2025E is 1.65. This is a conservative number and it assumes their outstanding shares remain constant. Using the projected DCF model as a base, the estimated fair value based on the PE EPS multiple was $42.27.
Technical Analysis
From a technical analysis perspective, the stock has dropped approximately 20% from its 52-week highs. On the monthly chart, we can see a very strong convincing bounce off the 20-day moving average, that has acted as a strong support level. The moving averages are signaling a bullish movement. The most recent red candlestick has a long bottom tail which shows very strong buying after ATVI dropped for that day.
Conclusion
Activision is expected to have a huge boost in earnings this year due to the King Acquisition. Growth is expected to subside the following year but remain stable as mobile games grow slowly with console and PC. Outside of mobile, PC is projected to growth at a rate of 7% and console games are expected to grow 9% in revenues, year-over-year. Operating margins have increased slowly since 2014 and will expect to grow on average 1% a year. The recommend fair value price is based off three different valuations, a DCF, an APV, and a PE Muliples, all of which result in a higher expected share price. ATVI’s share price is expected to increase by 20% over the next 10 years in a neutral to bullish economy.
[1] http://www.theesa.com/wp-content/uploads/2015/04/ESA-Essential-Facts-2015.pdf
[2] http://www.theverge.com/2013/11/19/5123724/league-of-legends-world-championship-32-million-viewers
[3] http://recode.net/2015/09/02/candy-crush-saga-clash-of-clans-top-apple-app-store-downloads-sales/
[4] https://thinkgaming.com/app-sales-data/2/candy-crush-saga/
[5] http://www.statista.com/statistics/276601/number-of-world-of-warcraft-subscribers-by-quarter/