Chit Chat Stocks - Activision Blizzard (ATVI) | Fundamental Analysis

Episode Date: February 14, 2021

Activision Blizzard develops and publishes gaming content. The company's top three brands are Activision, Blizzard Entertainment, and King. Activision Blizzard distributes its content across consoles, PCs, and mobile devices. Enjoy the show! Subscribe to 7 Investing with the code "CCM": https://7investing.com/subscribe/ Subscribe to us on YouTube: https://www.youtube.com/c/ChitChatMoney Follow us on Twitter: https://twitter.com/chitchatmoney Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now please enjoy this episode. Welcome in. This is the Fundamental Analysis Show on Chit Chat Money, our Sunday episode. And today we're going to be talking about Activision Blizzard. Fair warning, full disclosure,

this is something we own in our Arch Capital Fund. So obviously we're going to be a little biased and probably sound a little bullish, but this whole show is not about whether to buy or sell something. It is about just going over the fundamentals of the company, some of the risks, some of the growth opportunities. But if you're listening, you probably know how that goes. But before we talk about Activision Blizzard, we're going to be talking about 7investing. Whose turn is it? Ryan, is it me or you to do the pitch? I can go for it. So you get $10 off if you use our code. And we're getting a whole lot of referrals, it looks like. So you guys are helping yourselves out.

yeah good for you uh i guess good for us as well but good for you primarily because their returns have been incredible and so uh much better than mine personally uh actually i'd say you know whatever but uh it's pretty close yeah i mean a lot of people are doing well right now but they are definitely doing well so uh yeah feel free to and you obviously don't have to invest in everything they invest but you get all those picks and you can kind of nitpick which ones you like the most and it's not just a ticker they do the full research they'll talk with you about it you know you can yeah i don't know they have a full research part of it it's not just all right buy this with no context they're putting all the research behind it yeah exactly um all right let's

talk activision blizzard uh they are a developer and publisher of gaming content so i feel like most investors are probably familiar with them uh but they're most well known for their three big brands um i guess it's their only three brands but it's activision uh blizzard entertainment and king um and so activision is like that is really they have some other smaller titles but it's really known for their call of duty titles and they have different iterations off of call of duty i think there's a new call of duty that comes out every year yes um and so some of the iterations that are out now are war zone uh modern warfare and then black ops i believe well it's black ops cold war i don't know if it's black ops 3 or something they got a lot of them and then but

there's also the mobile title um and so there's just these different modes warzone is their battle royale so this is kind of based off the fortnite premise where you get on your team uh you can multiplayer it so you've got friends on the mic and then you can try to be the last team surviving that kind of thing and then some are more like search and destroy so you have objectives uh you can also do those multiplayer style uh but they that's basically sort of their namesake that is really what they make a lot of their money off of is the call of duty brand um and then they also have a call of duty league which i think is in 12 cities that's like pro gamers people like to watch that stuff uh just hit the record uh viewers for the championship this fall something like 300,000

viewers so growing you know pretty quickly and the way they generate revenue from that i believe it's a 50 50 split where between the gamers and then the game makers um so it's like ads if you're streaming on Twitch or you're sponsored by some energy drink or something like that. So that kind of money, the streaming dollars, all that kind of stuff, it's split. It's revenue split between the gamers and the games. And then Blizzard Entertainment is more of their, this is really designed for their intense gamers. And I guess some of the Call of Duty players might call themselves intense gamers, but this is more the titles like World of Warcraft, Diablo, Overwatch, Hearthstone, Those are games where it's really like a whole other world, essentially.

And it has... Yeah, it's like fantasy stuff. Yeah, it has the least amount of MAUs by a lot, but it is by far the most valuable MAUs. The ARPU on those users, on Blizzards, is twice that of either Activision or King Games. So were you just doing that kind of on bookings, trailing bookings versus users type deal? yeah i did revenue but uh similar i mean you could have yeah it probably could have done bookings i think it was like i'm not it was about double the blizzard or sorry blizzard was about double uh arpu of activision and then like seven times the arpu of king yeah king's doing pretty

well and so yeah those are the guys you know they are uh really sort of diehards they're probably a harder fan base to please with your games like if you have a bad one they'll let you know um because because a lot of those titles have been around for a really long time. But King, these are their mobile titles, so the more past-the-time type of games. So Candy Crush, Diamond Diaries, Bubble Witch. Led by Candy Crush. Candy Crush is a majority of the revenue. Yeah, and they have that brand, King brand, has the most users because it's real easy. You just download it onto your phone. You don't have to pay. It's kind of free to play.

you just uh there's in-game monetization there's some ads but really it's kind of you're just trying to pass the time on your phone um and so the arpu on that is really really low um but now i'll get into the history it's a conglomerate now obviously with those three brands but it started as activision publishing in 1979 by david crane and alan miller um and it was actually born out of atari i shouldn't say born out of atari there were people that were working at so alan miller and David Crane were working at Atari and they were upset about some of the creator's rights issues. So Atari was taking a lot of the credit, I guess, for some of the games. And so they split off. They became the first third party publisher ever and were really successful with it. And they

would put the creator's name on the games. So I think fans really liked that. And then they kind of stalled out in the 80s. But in 1991, Bobby Cota came along and became CEO and they went public in 1993 they actually inspired a lot of copycats as well so people were like well you don't have to own the console you can be a publisher also um and so blizzard entertainment was actually founded in 1991 by three ucla grads and both companies were having a lot of success as third-party developers finally in 2008 activision merged with vivendi who owned the blizzard brand and that was the start of the combined entity and in 2016 activision bought king games for 5.9 billion in cash. So for reference, last year, King did 2.1 billion in revenue and almost a

billion in operating income. I think they have more than 40% operating margins. So I think that, yeah, they definitely recouped that investment. The investment looks good now. I mean, if you can assume more than a five times operating income multiple, which seems safe to assume, yeah, that investment is worth a lot more. But that's kind of the history behind the business. I'll let you get into the valuation. okay yeah so right now they have an enterprise value of about 74 billion dollars it's a bit different than their market cap because they have a big net cash position ticker is atvi ev to sales is 9.2 if you do ev to trailing 12 month bookings it's about 8.8 so bookings are

growing a little faster and just to explain uh video game companies have to amortize their revenue over a 23 or 24 month period so even if someone spends money on a game they have to you know, whatever, realize it over the period, even though they're getting all that cash up front. I don't think it's a linear, you know, amortization, but it's just something that's going to happen. So, bookings is kind of the number you want to track for current revenue. I mean, you got to look at revenue and bookings, but in reality, bookings is more of a current metric. Revenue can be inflated even if trailing, you know, cash coming in was higher. EV to free cash flow is about 41 right now from our, I'm using the internal estimate that we did.

We X out stock-based compensation, so it's going to be a little higher from multiple right now. And then looking forward, it's a lot better, though. You can see that the last quarter, they had just, I don't know, the numbers were looking better. Forward should be just a little bit better. EV to operating income is 27. So, again, you're getting a premium valuation here compared to the market. Well, actually, EV to operating income is lower than the market right now. I usually think, I assigned 25 in my head, but right now the market's at like above 30.

EV or market, like price to operating income? Because I feel like the average market multiple is not. I think enterprise value is probably higher on average because there's a net debt position out there, right? I guess that's true. I'm assuming it's lower, but again, on a case-by-case basis, you're kind of looking at Activision on its own. Activision through various return on invested capital calculations, you could say they get in between 15% and 23% return on invested capital, at least over the past year. So very strong there. Their dividend per share

is about 47 cents. It's a less than 1% yield, but it's growing at about 15% each year. And they just authorized a $4 billion share buyback program. But they do do a lot of stock-based compensation. So they're not going to do $4 billion over the next two years, which is when the program goes, so they hopefully should reduce the share count. But we'll see. Watch out for that share count to go down. High working capital number, and they have about $3.6 billion in long-term debt, but no need to worry about that because they have almost $9 billion in cash right now. And make sure when you're doing the earnings again, which Ryan will go through, to reconcile the deferred revenue. Cash flow is probably the best profitability metric to use here.

Yeah. And if you're thinking, God, why are they sitting on $8 or $9 billion in cash? Shouldn't they be putting that to work? They announced that they will, like Brett said. So $4 billion share buyback program over the next two years, that is not a small amount. That's about 5% of the market cap, maybe 6% or 7% actually. so yeah they are starting to put that money to work but i'll talk about the full year 2020 earnings so revenue for the year was 8.1 billion up 25 percent year over year about 82 percent of that revenue is now coming from digital channels net bookings grew 32 percent year over year i think net bookings was about 8.4 billion whereas revenue was 8.1 and then operating income for the year was $2.7 billion. And that was growing 70% year over year. Their operating margin is about 34% right now for the entire enterprise. That's a really impressive number, I guess. Earnings per share grew 45% year over year. They had more than 400 million monthly active users throughout the

year. Share dilution was about 1%. So share count is still growing. On a trailing basis, yes. You look at share repurchases, take it with a grain of salt because if they're issuing shares or they have stock-based compensation and they're buying back shares, the only important number is the diluted shares outstanding in the end. You're looking for the net. So pay attention to that number. And then free cash flow was about $2.2 billion for the year, 27% free cash flow margins. And then, as Brett said, they announced a two-year, $4 billion buyback program and raised the dividend 15%. Honestly, the numbers looked incredible this quarter. The stock jumped after the quarter, I think, around like 6% or 7%.

And people were already pricing in a good quarter. So, it was, yeah, they crushed estimates. They crushed their own estimates. Yeah, no complaints for their earnings last quarter. It looked like every part of the business was doing well. cox panoramic wi-fi includes advanced security to help protect all your connected devices you'll get real-time alerts oh like this one so you don't have to worry about malware or when your kid downloads a song from a shady link and now all your computer can play is

red color red color where are you all blocked thanks to advanced security included with cox panoramic wi-fi advanced security must be enabled in the panoramic wi-fi app restrictions apply welcome back next up we're going to hit the more qualitative stuff for activision blizzard so first up we'll be digging trenches uh this is the rating we have for activision blizzard's moat so what would you give them a zero one two or three for your moat rating i'll probably go a 2.6 i usually only do half sir but 2.5 maybe uh it's my only yes okay so the titles uh are are worth a ton uh and it's very hard to repeat but they are obviously competing uh for consumers time which is like the most competitive place in the world

right now with all the different content coming out and indie games and stuff like that so um they're just a hyper competitive landscape but uh yeah the brands are worth a ton and there's always going to be a fan base around most of those names yeah yeah interesting yeah the i'd say 2.5 as well it's good it's a good mode it's not a great one uh there's competitors there's a lot of people spending money to compete with them so but and you also got to look at it okay call of duty probably has a higher mode than candy crush or king right so parts of the business may have a higher mode parts of it a little bit lower yeah and there's also kind of the nostalgia factor for a lot of the players when it comes to call of duty because earlier like uh 10 years ago

or so when a lot of these there was less competition oh call of duty was still popular then so there's the you've they've proven that the fan bases are very loyal and that they'll stick around so there there obviously is some attraction to those brands i mean diablo is like 25 years old and it's still very popular so for sure um yeah why don't you talk further reading what are you looking for okay they have a thing for blizzard called blizzcon it's coming up soon uh hopefully get some good announcements and their new go-to-market strategy it'll be interesting to see if they do a similar thing for those titles as they've done with call of duty so having you know premium free-to-play and mobile um they right now all of them essentially have a premium and

esports but adding on the free-to-play stuff for console and then having the mobile titles as well they've hinted at it during their conference calls uh so we'll see if that happens we'll be interesting to see kind of what the announcements are uh you know see what the kind of games are going uh what the reviews are not reviews kind of the excitement around that stuff is yeah it's virtual isn't it oh i bet so yeah yeah because i think they're headquartered in santa monica which uh i assume is still sort of not allowing big events like this yeah definitely not yeah and even if it was there'd be a live stream anyways i'm sorry uh well further reading for me ea's new battlefield is coming out uh or it's yeah it's definitely coming out 2021 yeah but uh

it's rumored that there will be a battle royale mode to it i don't know if that's been officially announced and i i just am interested to see how much market share that's able to take from warzone because it's very sort of similar models uh and i assume a lot of overlap on the fan bases there so i'm curious what effect that ends up having on warzone yeah it's interesting because everyone's trying to create recreate what happened with fortnite they're trying to do the you know the battle royale hunter whatever one versus a hundred or teams and stuff versus teams kind of going through these things and it's interesting to see how companies are going to try to differentiate themselves right because you could argue that if everyone is always going on to war zone or

something like that then they'll probably continue to go on to something like that but it's not that hard if someone's like all right there's a new one coming out just text your friends let's try this one yeah great all right future growth opportunities what do you have so mine is war zone which is their free-to-play title again similar and it's for consoles uh and cross platform i assume you can do it on pcs and other stuff as well but it's for call of duty it launched this march so the ideal was very or sorry excuse me i'm mixing up my words the timing was very ideal and it has grown to close to 100 million users i think um it complements the premium title well and it keeps people engaged with the call of duty content because you know you typically it's

just a 60 game once a year probably get tired that after that after a while but now they can do continual updates to warzone add new stuff over time and it keeps people engaged with the call of duty franchise outside of the yearly release i think they can one increase bookings from that as well they've shown that and two it can drive more people to be like all right yeah i consistently buy the annual title i think you can rise or a rising tide kind of lifts all boat deal you know yeah and the other thing with warzone is it's free to play so you think about call of you think of it as a mode of call of duty and call of duty the actual game itself you have to buy whatever it is 60 bucks for the uh unit there but then you can download warzone independently

from that and it's free to play but then it also introduces a recurring revenue feature with the sort of subscription type battle pass thing. Right, right. I don't know if it's actually titled the battle pass, but so the monetization kind of comes after the fact. And so if you're just looking at hours played, it probably correlates pretty strongly with monetization. I think, gosh, I want to say that Call of Duty hours

are up 3x this year, but don't quote me on that. They had some stuff in their investor relations page. I think it doubled. Doubled or something like that. The numbers look good on that. and also warzone is going to be helpful eventually now cloud i don't know when cloud gaming is going to come or streaming gaming you know the netflix of games that seems like with stadia and stuff that's kind of in a flop and we might be like five years out but eventually those titles will

probably do well on the cloud gaming when someone like us that doesn't own a console can access things just over the internet yeah yeah and it also provides a sense of sustainability uh and like reduces the cyclicality of the title because if you're doing it season by season you don't have to worry about whether your game's going to be a hit uh on a given year yeah and i think you can release new maps but uh once again it just i think it reduces some of the cyclicality of it my future growth opportunity is diablo uh they have diablo immortal which i believe is their mobile title so as i mentioned earlier average revenue per user is way higher on the blizzard titles and so the diablo brand has been around for 25 years and if you just go look up some of the fans of

diablo they are very hard to please uh and there's like people online that are like who's whose fault is it for selling diablo to activision who's at blame and then they're like well blizzard's time ago they're like no but who exactly did this and it's like okay so people are very hard to please and when they announced the diablo mobile title it was right during the friction between bobby kodak and another i forget whoever else it was but the guy ended up the head of blizzard ended up resigning yeah and so they were having a lot of conflict and part of part of that was because i think the head of blizzard was like listen we don't have the game isn't ready and bobby kodak's like we have to release something

and so they wanted to wait till yeah with a mobile title and people were just pissed but apparently they did some regional testing this quarter and it was well received i don't know if that's them sort of flaunting their own stuff and saying it was well received and maybe the fans think otherwise but if diablo immortal is sort of a precursor to their diablo 4 is more the console game so if the mobile game can kind of be like a tease or a trailer and get people excited for the actual diablo 4 which people seem to be really really excited about i think that could be a massive value driver over the next uh two or three years um just because those games people will spend endless amounts of money yeah it seems it seems weird that the and this is more

about gaming in general that there's the the 60 price point hasn't gone to a hundred dollars because i don't know it's been the same since the 90s it's kind of strange because you're playing a lot more than i mean it's like all right if you compare it to what like a dvd used to cost like 20 bucks you do that you watch the show or sorry the the movie it's like two hours maybe if it's a hit you watch it like four times over its life but with the games a lot of times people are blogging i don't know weeks hundreds and hundreds of hours over you know a few years it seems like they should be able to spend uh charge 100 bucks but industry standards 60 i don't know if that's gonna yeah i'd rather have like monetization later on in the life cycle of the game but the

other part is activision as the whole so the entire enterprise diablo world of warcraft that kind of stuff too but those ones those are titles that really really benefit from higher tech content so when you have like the newest generation of consoles out i think that's going to be huge uh yes because it helps support uh better graphics and stuff like that and pcs too the the pcs are ready they kind of have the chips in there everyone's got nvidia chips now on those and do the high not high frequency whatever high graphics graphics whatever gamings yeah and uh like for nintendo those that doesn't really matter that much like animal crossings people don't really care about the quality of the graphics for kids yeah uh having that new generation of

consoles is good i think and most of the revenue still comes from consoles uh for activision blizzard even though pc and mobile are also growing but uh most of it's still console based uh how highlights and lowlights what do you have so i like call of duty i like their strategy with call of duty i really think the four pillars of you know esports warzone or whatever free-to-play stuff they have mobile which has done phenomenal it has 300 million downloads worldwide and then the premium title they can all work off each other and just kind of increase that moat they have i think management strategy with applying the call of duty stuff will you know to all the other franchises or just something similar to what works with each franchise is smart

i think riding the new console wave is going to help them i think vr eventually will help them they'll be able to adapt to that riding the wave of mobile riding the wave of esports all those tailwinds will help them it's not like they're restricted like okay say if oculus takes over and it's the number one way people game well call of duty can go on there right um and then if you look at the margins the margins on call of duty or activision which is essentially all call of duty they're pretty insane i think they had 47 operating margins last quarter um low lights for me high stock based compensation spend um there are the threats from fortnite and apex legends although i think those are kind of officially done uh you know not really i mean i don't think

that's a risk anymore fortnight isn't taking over like people thought uh and you know we own it for a reason so not much else lowlights besides that yeah i don't think you need to over complicate the thesis on this there is a million and one tailwinds going on in the industry right now whether it's streaming and like secondary consumption of the games or the media whether that's twitch facebook stream youtube it's so many people are being drawn to it if you have the big titles the big brands and you're able to produce something that is good you're going to be doing just fine and activision has been doing just that we've seen it operationally uh through both ea and activision's financials they weren't everyone talks about the indie games everyone talks about

fortnight and the boom with that there was a one basically a one-year hiccup you yeah you have great brands in a booming industry you don't really have to over complicate the thesis and that's sort of my highlights um lowlights for me bobby kodak a little bit so obviously he is he's been around for a long time he's done really really well with activision but i think he's overly competent he is overcompensated he has taken in 30 million over the last three years which seems a bit each year and the thing is like if you've been around for 30 years i don't why do you need 30 million in income every year that seems excessive to me the other part is okay some of that is from incentive-based compensation most of it's from

incentive-based compensation uh and it's tied to good incentives in my opinion but there's some contract there are some parts of his contract that seem strange to me so he has his severance payout if he is uh terminated without cause which doesn't mean like they just wrong termination without cause is different than wrongful and wrongful termination so if he was just fired for poor performance that could be termination without cause he gets paid nearly 80 million with almost 30 million in lump sum payments and also he gets to i think he vests his options early which is a lot of that's sbc yeah i mean they got the sbc is just a big uh yeah i mean they could if they it seems like it's just something that it's just something that's going to impact

uh you know your free cash flow and earnings for sure maybe i'm thinking about the narrative wrong because maybe the employees and the developers want stock-based compensation and that incentivizes them to come yeah but we just need that employee ceo ratio to be more reasonable yeah because i don't know and with the bobby kodak and the blizzard fallout i think they and obviously gamers always complain you're always hearing complaints about titles and stuff like that but there is there's been a lot of backlash from the blizzard cohort because of the you know the ceo's gone or that the head of blizzard the head of creative there um and it just seems like there's been a lot of fallouts all related to bobby kodak so that's a little that's a little concerning um

Just something to watch for. But his track record speaks for itself. Yeah, the goal is, look, he says they're North Stars to get to a billion users. If they can get there, they're probably going to do quite well, even if they give out some stocks. So it's just no company's perfect, but it's just something to watch out for. Next up, though, we typically do more or less interested. Obviously, since we own the company, we are more interested.

uh but so we're going to hear some potential risk to talk about you know some of the potential downside ryan what do you have yeah so mine it was kind of hard to come up with any i guess the bobby kodak thing is a risk as much as a low light but blizzards yeah the blizzard is a little bit of a risk yeah uh i guess death by a thousand cuts would be the biggest potential low light so obviously competing for consumers time is really uh is hyper competitive and if the engines are able to democratize like game development the way that they claim they can in the future then more and more people are going to be making games a lot of the indie games are going to be hits i guess and then the other part is like you've got a lot of gamers that are ages 18 to 38

for the call of duty brand um what if roblox who's really in with the 12 year old group is able to scale with that that age demographic yeah that could be you know then you have sort of a washout of your primary cohort yeah the biggest risk uh from competition is probably unity and roblox people say fortnite it's not true people say something like nintendo or other games it's just there's plenty going around the industry is going to be 200 billion dollars soon fortnite specifically no but unreal engine no unit unities because unreal is just for big games is it yeah so unit it's unity you know i remember we talked about this with cyber right so unity is for the shorter games or not shorter games um less complicated the triple a titles

uh so yeah unity and roblox seem like the biggest competitors from that from democratizing game access but it seems like i don't know to replicate a call of duty franchise people estimate you'd have to spend a hundred million dollars at least at least so i mean there's some economies of scale there you can't just replicate warzone or the call of duty premium games or the blizzard games overnight yeah i mean it sounds good in theory to be like well if the game engines get good enough anyone can do it yeah i i mean that's got to be really really hard to replicate time consuming as well as capital intensive what's the biggest risk for you yeah so i have uh this is a shorter term risk is just i mean you got to think okay you got or at least you got to be ready if you're an

investor for when the economy reopens uh and people are allowed to do things throughout i don't know they're not stuck in their homes like they were in 2020 that could be a short-term headwind i don't think it impacts the long-term trajectory of the gaming industry but yeah i mean they're you know growth might slow a bit for a few months or something like that and maus did fall year over year for the fourth quarter so that is worth noting did we catch it kind of at a peak possibly um but uh it i would say no i think over the next decade it's only going to be growth in terms of users from there that's what we hope that's what we hope but there is yeah i don't know if it's a risk for the long-term trajectory but just be ready in the short term

if say people start just wanting to do stuff outside i don't know if that's actually going to happen but everything's opened up social events baseball games stuff like that yeah per consumer our per consumer attention paid to these brands will probably never be higher than it was this like during covid yeah potentially potentially yeah so yeah there are definitely some one-time blips from this year but overall it feels less like it was just a one-time one-hit wonder yeah and then yeah we just want to put these risks down there i mean because if you're listening you're thinking of investing or you may be new or you're an individual investor like when you come across a company to invest in uh there's never they're never going to be perfect

if the company was perfect it would be priced to infinity and there would be no returns left so you have to be taking on some risk and there's always potential risk with the business so we just want to highlight that uh because a lot of other like shows or youtube channels or stuff like that they make it seem like an investment is a hundred percent guarantee no investment is a hundred percent i'm guaranteed we could easily be wrong about activision but yeah anything else before we close out no i think that's it okay that's gonna do it make sure as always uh to what do i gotta say the disclosure disclosure we should write this down uh our okay we are we're general partners at arch capital and we are generally on activision blizzard so yes so not advice yeah so

and any other things that are mentioned on the show clients may own in their portfolios we are not financial advisor. So anything on the show is not formal advice or recommendation. Thank you all for listening to this episode. We will see you next time.