Activision Blizzard: Time To Restore A Position (NASDAQ:ATVI)

Background

After I sold my shares of Activision Blizzard (NASDAQ:ATVI) at close to $88 per share amid the appearance of the information about Microsoft’s buyout of ATVI, for almost a year, I had a neutral view on the company shares. As part of the article I wrote a year ago, I questioned the possibility of this deal closing. A year later, my point of view has not changed, while the probability of closing the deal, in my opinion, has significantly decreased since then. Nevertheless, the Q4 results interested me and I decided to update the company investment case in order to understand whether it is time to buy ATVI’s shares again. While the risks of the stock falling into the mid-60 range per share in the event of a deal cancellation remain, I believe that the time to start building a position in company’s shares has come. Let’s first take a look at the 4Q2022 financials, which I think are impressive, and then look at what a fair value of company’s shares is.

4th quarter results

Bookings totaled 3.5 billion (+44% YoY, +95% QoQ), 12% above consensus expectations. This result was the best quarterly result in the history of the company. The company revenue amounted to 2.3 billion (+8% YoY, +31% QoQ), 11% worse than expected. Adjusted for SBC EBITDA was at $562 million (-43% YoY, -9% QoQ). GAAP Diluted EPS was at $0.51 (-33% YoY, -8% QoQ). Let’s move on to reviewing the results by segments.

Activision

The segment net revenue totalled $1.8 billion (+60% YoY, >100% QoQ growth). The average number of monthly active players was at the level of 111 million (+4% YoY, +14% QoQ).

The success of the Call of Duty franchise on all types of platforms was the main segment growth driver. The launch of Call of Duty: Modern Warfare 2 was the best in the history of the franchise. Digital version sales were positively affected by the launch of the game in the Asia-Pacific region through the Steam store. The November release of COD: Warzone 2 also had a positive effect on the player engagement. CoD Mobile bookings rose YoY by double digits. The company plans to release a mobile version of Warzone, CoD: Warzone Mobile, this year, which should further expand franchise’s player community.

Blizzard

Segment net revenue was at $794 million (+89% YoY, +46% QoQ). Segment’s MAU was at 45 million (+88% YoY, +45% QoQ).

World of Warcraft has shown strong momentum with the launch of Wrath of the Lich King expansion for World of Warcraft Classic in September and the launch of Dragonflight expansion for the original World of Warcraft in November. While management noted that Dragonflight’s sales start was worse than the previous expansion, player feedback has been quite positive. A new mobile game in the Warcraft franchise: Arclight Rumble continues to undergo regional testing. The October launch of Overwatch 2 allowed the Overwatch franchise to hit all-time highs in player engagement. Diablo Immortal also contributed to the growth rate of segment’s bookings. The main segment booking driver for this year will be the long-awaited release of Diablo 4, which is scheduled for June 6, 2023.

Separately, I would like to note the news about the termination of the deal with NetEase for licensing ATVI games in China. At the moment, the company is looking for options for cooperation with other companies. The mobile game, Diablo Immortal, is covered by another contract, so its distribution in China continues.

King

Segment’s net revenue totalled $727 million (+6% YoY, +5% QoQ). The segment’s MAU was at 233 million (-3% YoY, -3% QoQ). The Candy Crush franchise remains the main driver of segment bookings growth. It has remained at the top of the US app stores for 22 quarters in a row. Management noted that segment’s advertising revenue was fairly stable, even despite the global slowdown in the advertising market.

Q1 2023 management guidance

Management expects Q1 bookings to rise by mid-teens. Revenue growth rate is expected at the high-teens. The increase in operating profit is projected at the high-single digit. Operational expense growth will be above bookings growth due to the increased development and marketing spending ahead of the release of Diablo 4 in June. 2023 bookings and operating profit growth is expected at the high-single digit, an increase in revenue is forecast at the level of high-teens.

Comparative valuation

Having briefly reviewed ATVI’s financials, let’s compare ATVI multiples with the peer multiples. The key goal of this analysis is to see what downside could be if the deal with Microsoft is cancelled. For comparison, I use the forward EV/EBITDA multiple. As peers, I chose Electronic Arts and Take-Two Interactive. The average EV/EBITDA multiple for these three companies is 15x. Take-Two has a 20x multiple, while ATVI has a 12x multiple and EA has a 13x multiple.

Now let’s compare fundamentals of these companies. To save time, let’s focus on the two most important indicators – the expected consensus growth rate of bookings YoY and the free cash flow margin. The average expected bookings growth rate of these companies is 12%. ATVI has this indicator at 11%, EA’s expected growth rate is 5%, and TTWO is expected to grow by 20%.

The average free cash flow margin for these companies is 13%. ATVI has the highest rate – 25%. TTWO’s FCF is close to zero (but will grow at a faster rate than peers), while EA’s margin is 16%. Thus, there are no particular reasons to go down by the multiple, as competitors are traded at a worse ratio of the EV/EBITDA multiple to the sum of the growth rates of bookings and the FCF margin.

Final Thoughts

The key point is the fair value of ATVI’s shares. This issue is not so simple. On one hand, we have a potential acquisition price of around $95, which gives us a 31% upside to the current price. On the other hand, as in my last article, I note that there is a possibility that the deal will not be closed. The news background in recent months clearly does not increase the probability of closing a deal. The fall of almost 5% on the eve of reporting due to fears that the regulator in the UK will probably block the deal is an example of this. In such conditions, the probability of closing the deal, in my opinion, is in the range of 10-15%. In such a case, it is important to determine the value of the company in case of cancellation of the transaction.

My ATVI’s fair value (multiple valuation + DCF) after the publication of the Q4 results is at $75, which is close to the current level. Adding a 15% chance of closing the deal by Microsoft to the valuation, I get a fair value of $78 per share. However, it is highly likely that if the deal is canceled, the shares will go to the mid-60s level and will be traded at this level for some time. However, a powerful driver in the form of the Diablo 4 release in June (if it will not be no rescheduled) cannot be ruled out either. The game can not only become a one-time inflow of bookings in the form of purchasing full versions of games, but also can become game-as-a-service, which will take the company to a new level of operating indicators. We will also most likely see the final decision on the deal towards the end of 1H2023. Having put together the pros and cons of buying shares now, company’s shares look attractive. I think the probability of the deal will be closed is low, but it is already quite possible to start (just start) buying position in company’s shares at the current level. However, I will leave a cash (2/3 of positions) to increase the position in case the MSFT+ATVI’s deal is cancelled and the shares will go down.