What makes Activision Blizzard so successful
Stock analysis of the week: Activision Blizzard
Non-GAAP revenue for the quarter improved 74% year over year to $ 1.77 billion (up from an estimate of $ 1.65 billion). Non-GAAP revenue improved 270% year-over-year to $ 773 million, driven by another strong quarter for the entire CoD franchise and the relaunch of Tony Hawks Pro Skater 1 & 2. Premium Modern Warfare sales are now the highest of any CoD title, with more than two-thirds purchased digitally, resulting in a significant increase in margins. Given the strength of Modern Warfare and Warzone, the launch of the next CoD franchise, Black Ops Cold War, on November 10, coupled with increased home vacation regulations, could give a bigger boost than expected for the fourth quarter and first half of 2021 bring.
Non-GAAP revenue improved 4% to $ 461 million as the World of Warcraft player base remained stable prior to the expected Shadowlands expansion on November 23rd. While the Overwatch League recently completed a successful 2020 season, the player base stagnated while waiting for Overwatch 2 to launch. We expect the title to be released in the first half of next year, with an announcement to be made at Blizzcon 2021 in February. King's revenue increased 7%, with in-app purchases and net ad bookings increasing despite the lower overall ad spending environment. Non-GAAP operating margin for the quarter improved from 28% last year to 44% as the significantly higher revenue more than offset ongoing investments in game development and operations.
Business strategy and outlook
Activision Blizzard is one of the world's largest independent video game publishers and owns some of the largest and most well-known video game franchises, including Call of Duty and World of Warcraft. We believe the company is well positioned to consolidate its leadership position by developing compelling new versions of its existing franchises and introducing new experiences such as Hearthstone and Overwatch. We anticipate that Activision will continue to benefit from the upcoming console upgrade cycle, ongoing revitalization of PC games and the growth of the wireless market through its subsidiary King Digital.
Activision has benefited from the shift in the industry towards a two-tier market made up of big AAA blockbuster titles on the one hand and smaller indie games on the other. Activision generally focuses on the high end of the market, with the company using its capital to fund higher-budget blockbusters and its marketing scale to support its titles across multiple advertising platforms. Activision's main competition continues to be other large third-party publishers such as Take-Two and EA, as well as console manufacturers (and first-time publishers) Sony and Microsoft.
Like its competitors, the company is focused on engaging users beyond original game sales by expanding monetization opportunities by expanding the use of multiplayer options and releasing downloadable content. Both methods encourage players to keep the original game longer than in previous generations and provide a stream of income from consumers buying the game second hand. Activision has used DLC and multiplayer to extend the life of multi-billion dollar franchises like Call of Duty, and we believe that newer franchises like Hearthstone and Overwatch can continue to thrive in the long term.
We anticipate Activision will continue to monetize the user base at King Digital by adding additional third-party ads to the company's mobile games. Although we believe that Activision can generate some additional income in this way, we would like to warn that a substantial contribution to sales could only appear after 2020.
Moat and Moat rating
We assign Activision a narrow moat rating. Activision Blizzard is one of the world's largest independent video game publishers and the company behind some of the most compelling and lucrative franchises of all time. Over the past 10 years, the video game industry has undergone a number of changes including two generation changes in consoles, the increase in digital downloads, the widespread adoption of mobile games, and the expansion of the F2P (free-to-play) business model. During the same period, Activision (the predecessor company) has grown from a console-based video game publisher to one of the largest publishers for both consoles and PC through its merger with Blizzard (then owned by Vivendi) in 2008. The company owns seven franchises with over $ 1 billion in revenue - World of Warcraft, Call of Duty, Skylanders, Diablo, StarCraft, Overwatch, and Hearthstone.
The portfolio of widely successful franchises allows the company to monetize its intellectual property year after year by providing content in the form of sequels, expansion packs, downloadable content or DLC and toys, such as the ten year old World of Warcraft franchise and the annual versions of Call of Duty. These franchises can also spawn games that take the company into new arenas like F2P (Hearthstone from WoW) and China (Call of Duty Online). The company's franchises have a dedicated user base that enables Activision to distribute more of its games through direct digital channels, bypassing retailers, achieving higher gross margins and improving the return on invested capital.
We believe that the console and PC video game market will continue to develop broadly into two segments: large budget AAA games and small budget indie games. Activision's size and the depth of its franchise slate allows the company to place bigger bets on new IP than many of its smaller midsize competitors. This ability to make larger investments makes the publisher one of the few destinations for studios looking to develop new AAA games on a big budget.
Fair value and profit drivers
Our fair value estimate of $ 73 per share implies a 2020 adjusted price / earnings ratio of 28 times, an enterprise value / adjusted EBITDA multiple of about 21, and a free cash flow rate of return of 4%.
2019 was a transition year for Activision as the company expanded its development workforce and focused on its six core areas - Call of Duty, Candy, Overwatch, Warcraft, Hearthstone and Diablo. As a result of the transition, 2019 revenue fell 14% to $ 6.5 billion as Blizzard didn't introduce new titles or expansions. Operating margins for the year rose 26.8% from 26.5% in 2018 as the company's announced downsizing more than offset increased developer hiring and lower revenue.
Overall, we expect the company's revenue to grow an average of 9% over the next five years, with the biggest growth coming in 2020 due to the impact of the coronavirus and the jobs it entails. We expect the cellular segment to grow 10% as the drop in the Candy Crush saga is offset by growth in the new King Digital real estate, the reintroduction of third-party ads, and Activision / Blizzard's efforts in the cellular space. Outside the cellular space, we expect 10% growth in PC sales from 2020 to 2024 and 9% growth in console sales over the same period. We expect operating margins to increase from 26.8% in 2019 to 31.3% in 2024. While our forecast for 2024 is above the 28.3% margin threshold set in 2015, we believe that growth in high-margin digital full-game sales and microtransactions will more than offset the declining contribution of the high-margin World of Warcraft game.
Risk and uncertainty
The Group's focus on franchise development could backfire if one of its franchises falls out of favor with gamers. The annual release cycle of franchises like Call of Duty could cause consumer fatigue and lost sales. World of Warcraft is generating excellent margins for Activision, but the game continues to lose users despite a recent expansion. We believe that if the company is unable to revive its WoW user base, it could have a disproportionately large impact on the bottom line.
Success attracts copycats, and the company must constantly defend itself against attacks from industry competitors while trying to develop new intellectual property. Most consumers have limited capacity to spend on games, and since fashions and trends are cyclical, it could have a disproportionate impact on Activision's cash flow. Activision is not as well represented in the cellular / tablet market as some of its competitors and could lose overall market share to these companies as this market grows in importance.
Activision Blizzard's stock was trading at $ 76.26 on the Nasdaq on November 3rd, 2020. This puts the paper slightly above our fair value estimate of USD 73. The share is thus roughly fairly valued, as can be seen from the 3-star share rating.
The analysis in this article is based on our professional investor tool. For more information on Morningstar Direct, please visit here.
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