I once thought that Odds and Ends would be a regular feature of my blog–a place to record information that might be useful but which had no immediate stock market urgency. It hasn’t turned out that way. I’m not sure why.
Fir the first time in a long while, however, I”m writing about two items that really belong there: Activision and King Digital, and Urban Outfitters’ acquisition of a small upscale pizza business. Here they are.
the results
Activision reported fourth quarter and full year 2010 results after the market closed in New York on Wednesday. On a non-GAAP (Generally Accepted Accounting Principles) basis, the firm earned $.53 a share–in line with Wall Street analysts’ expectations–vs. $51 in the year ago quarter. For the full year, GAAP earnings per share were $.34 vs $.09 in 2009. On a non-GAAP basis, eps were $.79 vs. $.69.
On a GAAP basis, however, ATVI reported an operating loss in the vicinity of $400 million for the closing three months of the year–the second time in a row they’ve accomplished this “feat.”
The company issued initial (non-GAAP) guidance for 2011 of $.70 per share in earnings, or about an 11% year on year decline (more on this below), which was lower than analysts’ preliminary guesses of a flat earnings year. (Some are also saying that ATVI is guiding to earnings of $.07 a share for the March quarter, which would be below analysts’ estimates of $.10. I don’t think that’s right, though, since the $.07 includes $.02-$.-3 of restructuring charges. In other words, ATVI guidance is for earnings of $.10 per share for March.)
ATVI also announced that its board of directors had authorized a 10% increase in the dividend to $.165 per share and a $1.5 billion share buyback.
The shares were down about 7% in the aftermarket. As I’m writing this, in the early afternoon of February 10th, ATVI shares are down about 10% on very heavy volume.
the details
1. Bobby Kotick has developed feet of clay. The CEO of ATVI has had a well-deserved reputation for quickly focusing his firm on new trends and deftly cutting his exposure to the old without taking big losses. No more. For the second year in a row, ATVI is taking a gigantic writeoff related to the Activision side of the business.
Elements of the writeoff are scattered around in different accounting categories, however, including some costs that will only be recognized in 2011, so I find it difficult to figure out exactly how big the current damage is. $400 million + is the best I can do. Unlike last year, when management blithely ignored the loss completely in the conference call, there were at least a few passing references to it Wednesday night.
What’s happening? ATVI’s financials suggest that, ex Call of Duty, the Activision side of the house continues to be deeply in loss. That got the former Activision-side top brass fired a year or so ago. After posting a large deficit ex CoD again in 2010, new management has decided to:
–stop making new versions of Guitar Hero and concentrate on digital downloads to the title’s waning fan base,
–shut down True Crime,
–not launch a new Tony Hawk game this year (no more, ever?).
ATVI will also be laying off 500 employees. This will leave the Activision part of ATVI with Call of Duty, the Bungie team that’s developing a new MMO, and some niche products like Cabelas hunting games, that make money.
2. Blizzard is doing fine–better than fine, actually.
–Non-GAAP operating income, at $850 million, was up 53% year on year.
–World of Warcraft has over 12 million subscribers globally. Blizzard’s new partner, NetEase, is making it easier to get permission from Beijing to introduce new WoW software to China.
–WoW: Cataclysm sold 4.7 million units during its launch month in December.
–Starcraft II has sold almost 4.5 million units, as well.
–Blizzard has also been talking about a new WoW-like game it is developing, code name: Titan.
3. Call of Duty is, too.
–Despite pre-launch worries that Call of Duty: Black Ops could never surpass the success of the 2009 entry in the game series, CoD: Modern Warfare 2, the number of players of Black Ops during its first three months is about 50% higher than for MW2.
–First-day downloads of the initial expansion pack for Black Ops (just launched) were 25% higher than for the comparable release for MW2.
4. ATVI will be announcing a mystery new gaming initiative at Toy Fair today.
5. New releases for 2011? Will there be any?
–There’ll certainly be one for Call of Duty. But ATVI is (sensibly) unwilling to project that it will meet the lofty sales standards of Black Ops. Other than that, the current-year cupboard may be pretty bare.
–There’s no word from Blizzard on (the now long-awaited) Diablo III. All we know is it’s not ready for beta testing yet. A 2011 launch has not been ruled out.
–Heart of the Swarm, the Zerg entry in the Starcraft II series, is certainly a 2012 event (if then).
–The Bungie MMO definitely won’t debut this year.
–On the bright side, there won’t be self-inflicted losses from Guitar Hero et al. But worries the new Blizzard launches could be pushed back into 2012 are the main reason for ATVI’s conservative earnings guidance.
why the big selloff in the stock?
1. Some investors may be throwing in the towel. ATVI has been a severe underperformer over the past two years. Another huge writeoff and prediction of a down earnings year in 2011–especially when most other firms, video game and otherwise are posting surprisingly good results–may have been more than many investors are able to take. Some professional investors who use mechanical rules for buying and selling, in an attempt to keep emotion out of their decisions, may also have been forced by them to divest.
2. Has Bobby Kotick lost the magic touch? I thought the Activision division problems had been fixed last year. It’s distressing to see that it has required another year of large losses to get management to smell the coffee. Odder still, ATVI has been much more aware than its rivals about the threat from casual and mobile games.
3. It’s also possible that ATVI’s juvenile attempt to divert investor attention from the writeoffs by not mentioning them is undermining investor confidence in management’s integrity and competence.
where to from here?
ATVI is a stock I’ve been consistently wrong about, so maybe you should skip this part and make up your own mind without my two cents.
First of all, the company has about $3 a share in cash on the balance sheet, and no debt. It is generating cash flow from operations, principally from Blizzard, of about $1.15 a share. That level of cash generation can probably continue indefinitely. True, there may not be a new mega-hit like Starcraft II in 2011, but there won’t be Guitar Hero, Tony Hawk or True Crime to pile up offsetting red ink. And MMOs, a field Blizzard leads, are the future for serious gamers.
Assume a current stock price of $11 and subtract the $3 in cash. The remaining $8 is equal to about 7x cash flow. If the current level of cash flow is sustainable–and I think it is–the stock is cheap. It’s the equivalent of a bond that yields 15%. If this were a different industry, or if ownership weren’t so concentrated in Vivendi’s hands, a takeover bid would be a good possibility. I don’t think that’s likely here, though.
The big question is whether there’s anything in ATVI’s future that could make it less cheap than it is today. A new Bungie MMO, a big increase in the number of WoW subscribers, new online moneymaking opportunities for Starcraft or Call of Duty are all possibilities that come to mind. Also, in time, and with more forthright communication, management may win back investor trust. In addition, at some time before the end of summer, focus will turn to 2012, which could be a year with two or three big new releases.
I can easily imagine circumstances–and again I have been as cold as ice with this stock–where ATVI is trading 20% higher than it is today six months from now. Like almost any value stock, however, the “what” is easier to figure out than the “when.”
the results
After the New York close last Thursday, ATVI reported its September 2010 quarterly earnings results. On an adjusted basis, earnings per share were $.12 vs. the analysts’ consensus estimate of $.09 and the company’s guidance of $.08.
At the same time, despite the CEO, Bobby Kotick, citing “the continued strength in our business and our confidence in our continued execution,” ATVI revised down its expectations for the December quarter by about 4%, saying it was equal parts unfavorable foreign exchange movements (presumably meaning costs denominated in non-dollar currencies) and increasing competition in its Activision console game business. On this news, ATVI stock dropped about 3% in Friday trading.
the details
August was a busy month for Blizzard:
–It launched its long-awaited StarCraft II, which sold 1.5 million copies in its first two days and 3 million in its first thirty days. The fact that ATVI provided no information for the full quarter suggests sales slowed dramatically after that, however.
–It finally got government permission to launch the second expansion of World of Warcraft, named Wrath of the Lich King,in mainland China. This was enough to push global WoW subscriber numbers decisively above 11 million+, where it had been stuck for some time, to 12 million.
For the yearend holiday season:
–WoW: Cataclysm, the third WoW expansion, will be released on December 7th.
–Call of Duty: Black Ops launches on November 9th. Pre-sales for Black Ops have apparently been stronger than for Modern Warfare 2, which was ATVI’s blockbuster success of 2009.
–ATVI will also have its usual assortment of new Tony Hawk, music (DJ Hero 2) and James Bond games.
ATVI now has close to $3 billion in cash on its balance sheet. The company generated about $1.2 billion in cash over the past twelve months, half of which it has used since February to buy $600 million worth of stock (or 55 million shares, 4% of the amount outstanding) at an average cost of $10.90 or so.
stepping back
ATVI has been a disappointing stock this year and a severe laggard since the market bottom in March 2009. What can we expect from now on?
Here are the company’s year-to-date revenues and earnings by operating segment:
Activision Publishing: revenues $983 million, operating loss $88 million
Blizzard: revenues $1086 million, operating income $559 million.
This compares with an operating loss from the Activision segment of $49 million in the first nine months of 2009 and an operating profit of $393 million from Blizzard over the same period.
You might (correctly) say that this is not an entirely fair snapshot of ATVI’s results. The Activision segment is highly seasonally skewed toward the December quarter. Activision games also have their biggest sales in the US and European markets, both of which have been hardest hit by the financial crisis. However, the figures also points to two realities: the sudden maturation/contraction of the traditional video game console market, and (I think) that the cost structures of the game software companies are still geared for expansion. In other words, there is still considerable cost-cutting to do.
When Activision and Blizzard merged a few years ago, I imagined the resulting company as the marriage of two equals: Vivendi, the former owner of Blizzard, got better management for its games unit + a share in a viable shrink-wrapped software business; pre-merger Activision got access to a very talented group of developers + a share of a growing online subscription business in Massively Multiplayer Online Role Playing Games.
Today, the picture looks much different. Yes, Activision management doubtless helped Blizzard expand–and finally publish Star Craft II. But the key difference is due to the collapse of the traditional video game business. That’s what the numbers above show.
where to from here?
It seems to me that ATVI is trying to reposition itself, both in reality and in the minds of investors, as an incubator/administrative hub for MMORPGs. It already has the immensely successful World of Warcraft. It has just launched Star Craft II, which it hopes will be a second. And it is positioning the Call of Duty, franchise, and Black Ops in particular, to be much more like a MMORPG than a traditional console game.
In addition, ATVI says Blizzard is cooking up an as yet unidentified new MMORPG. And the company has hired the team that created Halo for MSFT to produce a fifth.
The growth investor “dream,” then, is that Star Craft emulates Warcraft in becoming a source of $300-$400 million in annual income over the next few years. And that it is followed by at least one other success–time frame unknown. It would also be helpful if some combination of reduced costs/higher revenue have the traditional Activision games turning a profit again.
On the other hand, eps will be around $.75 for 2010. What about 2011? The launch of Star Craft II looks like it generated operating income of about $160 million in the September quarter. Let’s assume ATVI produces an expansion pack next year that, to pluck a figure out of the air, generates half of the operating profit the game itself did, or about $80 million. Let’s also say that Blizzard overall, ex the Star Craft expansion pack, grows by $50 million next year. And let’s assume that the shrink-wrapped software business chips in an extra $30 million in 2011. Maybe cost-cutting helps, maybe a better economy–and ATVI has always had a knack for identifying new trends. That all ads up to flat earnings.
In any event, matching 2010’s earnings in 2011 is possible, if a tad on the optimistic side.
On the one hand, I find it hard to be confident that eps will be any higher than that. On the other, the company has no debt and is immensely cash generative. The prospective multiple is 12x-13x, ex the cash, which I think is reasonable. And ATVI is waiting in the wings to buy more stock just a few percent below today’s price.
My bottom line: For now, I think the stock goes sideways. I’m not in a hurry to sell and I’d be tempted to trade it if it spikes up. I’d also use it as a source of cash if another, really good, idea comes along.
the report
ATVI reported June quarter earnings after the close of trading in New York last Thursday. Earnings per share on a GAAP basis were $.17 vs. $.15 in the second quarter of 2009. On a non-GAAP basis, they were $.06 vs. $.08 in the second quarter of 2009.
The company forecast third quarter results that were slightly below sell-side analysts’ estimates, and it reaffirmed–but did not raise–full-year guidance.
Wall Street didn’t like any of this. The stock fell 6.5%, to $10.99, in Friday trading.
Why not?
GAAP vs. non-GAAP
ATVI reports revenues and earnings two ways. One is the way that Generally Accepted Accounting Principles require. The second is a non-GAAP method that the company feels gives pertinent information that GAAP doesn’t. Lots of companies do this. In ATVI’s case, the issue is how to report the purchase of game software that has online content. GAAP requires the company to estimate how long the customer will use that software and to spread the revenue, and associated costs, over the estimated period of time. ATVI’s non-GAAP reporting shows the revenue and costs recognized all at once.
2Q2010 earnings are much higher on a GAAP basis than non-GAAP because last year was a big one for online content. The positive glow is still being reflected in GAAP results this year. Non-GAAP shows only the cash coming in today.
The level of earnings isn’t really what the market reacted to on Friday, though. The composition of earnings was the issue.
Blizzard is doing fine…
Worlds of Warcraft continues to plug along, with about 11.5 million subscribers who paid $299 million to ATVI to play the game during the second quarter. That’s up 3% from the $290 million they kicked in during the comparable period of 2009.
More important, ATVI made operating income of $155 million from WoW this quarter, up 16% from the $134 million it earned in June of last year.
Starcraft II is finally out
Starcraft is the second of Blizzard’s signature titles. The long- awaited sequel to the original Starcraft title (1998) came out late last month. The only information ATVI has released so far on revenues is that the game has sold 1.5 million copies in its first two days. This would be the biggest launch in pc game history.
Just as encouraging, Blizzard says that while Starcraft online play is steadily building gamers are playing Warcraft online just as heavily as they were before the Starcraft launch.
The hope is, of course, that Blizzard can turn Starcraft, which has fanatic followers all over the world, into something akin to another Warcraft, generating large amounts of recurring revenue.
…not so for Activision
The Activision side of ATVI generated revenues of $333 million during the quarter, down 26% year on year. It made an operating loss of $53 million during the three months vs. operating income of $21 million in the June quarter of 2009.
Yes, the overall market for traditional video games is weaker and this is the offseason (Activision makes most of its money around the year-end holidays). But the company also had a couple of clunkers among its second quarter launches.
To some degree, these negatives were offset by continuing strong performance from Call of Duty: Modern Warfare 2. Online sales of add-on map packs are very strong. And the game remains the number one of its type in many markets.
The next iteration of the franchise, Call of Duty: Black Ops, is also outdoing MW2 in early pre-sales. And the company has new versions of its staple Guitar Hero and Tony Hawk games, as well as DJ Hero ready to meet seasonal demand.
what to do with the stock?
ATVI shares have been severe market laggards from the lows of March 2009. So the first observation one would make is that holding the stock so far, as I have done, has been a big error.
ATVI’s problems have been of three types:
–although Blizzard has performed extremely well, the overall video game market has been weak.
–the collapse of the music genre blindsided Activision, creating a large writedown last year
–worries about management stability have arisen, given the departure of key executives from the Call of Duty franchise and recent reports of CEO Bobby Kotick-related legal action.
On the other hand, the company owns Warcraft, Starcraft, Call of Duty, and has new potentially significant (but we don’t know what they are yet) products coming from both Blizzard and Bungie (the studio that made Halo).
The company is saying it will earn $.72 a share in 2010, meaning the stock is trading at under 15x times earnings. And ATVI has bought 31 million shares of its stock through the end of June at an average of just under $11 each. So–rightly or wrongly–it sees value at these levels.
So to me the stock still looks cheap.
Personally, I’m continuing to hold, but the leash is getting shorter. The risk, of course, as it is in any case like this, is that I’m letting ego get in the way of common sense–holding on because I somehow need to be right, rather than to make money.
the results
ATVI reported 1Q2010 financial results after the close last Thursday. Revenues were $714 million vs. company guidance, given on February 2, 2010, of $525 million. EPS was $.09 vs. guidance of $.02. Of the $.07 per share difference, $.05 comes from stronger than expected results from Call of Duty: Modern Warfare 2 and Worlds of Warcraft. The remainder comes from deferral into the June quarter of expenses ATVI had thought it would incur during the first three months of the year.
The company bought back 8.5 million shares during the quarter at an average price of $10.84, under its new $1 billion buyback program authorized on Feb 10th. This buying, by itself, won’t support the stock. But it does give an indication of what management considers a cheap price to be.
new guidance
The company raised its full-year earnings guidance, which is usually conservative, by $.02/share to $.72. This is effectively a reduction in eps guidance for the remaining nine months of 2010 by $.03, since 1Q already came in $.05 better than forecast. The reason? Recent industry experience is that licensed properties, like Spiderman, Legos or Shrek, which appeal to casual gamers and mainly to children and young adults, are selling more poorly than they traditionally have.
ATVI will doubtless make up the “lost” $.02 through strength in its core businesses, so the company could easily have left its guidance for the rest of the year unchanged. Lowering it simultaneously emphasizes the extraordinary strength of ATVI’s main franchises and underlines the weakness in the overall retail environment.
the main points of the conference call
—Starcraft II: Wings of Liberty will launch on July 27th, in 11 languages on 5 continents. Retail preorders are already very strong. Even though the game is in closed beta testing (and therefore not widely available), it is the second-most played PC game, trailing only Warcraft III. WOL is the first of three installments of SCII, each focused on one of the three races, Terrans, Protoss and Zerg, of SCI. WOL is the Terran game. ATVI expects sales of WOL to be enough to produce the first up year for sales of PC games in a decade.
Success of SCII and its eventual development of an equivalent to subscription-based Worlds of Warcraft is a major part of the positive case for ATVI.
–ATVI took great pains to point out that it has had three development studios working on the Call of Duty franchise, not just Infinity Ward, whose heads have left the company and are now being sued by ATVI. Sledgehammer, and Treyarch, developer of the next installment of COD, called Black Ops, which will be released late this year are the two others. The majority of Infinity Ward professionals remain with ATVI, at least for now, and the company is already at work rebuilding staff.
The major competition for Black Ops will be the latest installment of Halo, called Reach, from MSFT. ATVI expects Black Ops’ sales to outpace Reach’s, which seems a pretty safe bet, considering that Reach is only available for X-Box and Black Ops will have a version for PS3 as well. By release time, there will probably be 40 million X-Box 360s in Europe and North America, the main markets for this kind of game, plus 32 million PS3s. Even if we assume half the PS3 owners also have X-Box and all of them buy the X-Box version (decision: better graphics on PS3 vs. better online with X-Box Live), that still leaves 40% more potential buyers for the ATVI game than MSFT’s.
–ATVI also gave a few details of its 10-year contract with Bungie, the creator of Halo–the main one being that it expects the association to be accretive to margins from the beginning.
The Halo game still belongs to MSFT. But the studio, its 200 professionals and a new concept already under development, are now ATVI’s. Reason for the Bungie switch?–ATVI’s market power aside, it’s the chance to sell to–and earn royalties from–all those PS3 consoles.
bits and pieces
–Worlds of Warcraft has begun to see increases in its number of subscribers again. ATVI expects further gains as it launches the Cataclysm expansion pack later this year, overhauls the older areas of the site and gains permission from Beijing to add the Lich King expansion pack in China.
—WM2 players have logged 2+ billion hours of use on X-Box Live so far.
—ATVI had 1+ million downloads (at $15 each) of its latest COD extra map pack in its first 24 hours of availability. Another one is planned for the second half.
–The company still doesn’t see mobile as financially attractive enough to commit resources to, despite its fast growth.
my conclusion
The stock, trading at about 13% this year’s earnings and yielding 1.4%, seems cheap to me. The loss of the Infinity Ward executives could easily turn out to be a tempest in a teapot. But I think for the stock to advance significantly, WOL has to be a smash hit. I’m a long-time Starcraft fan, so I think it will be. But that’s the bet.