Q2 Looks Fine as Doubts Mount on This Much-Loved Stock
Activision Blizzard, Inc.
Rating: Outperform
Price: $11.70
Q2 earnings should be in line or better. Activision should report Q2 results next week. We expect it to meet or beat Q2 forecasts. There is growing skepticism around this much-loved story based on a few rumors, largely insignificant business changes and lackluster industry sales. We remain confident in our forecasts and that Activision has set expectations low enough to drive estimates higher in the next two quarters.
‘World of Warcraft’ change in China is overblown. One of the most consistent questions we get asked is what the impact will be from World of Warcraft switching between operators in China. The short answer is that the overall impact to its results should be quite minimal—estimated to be less than $0.01 to EPS in Q2.
Industry weakness is overblown. June’s 29% decline in sell-through is the largest on record dating back to January 2001. Nevertheless, we are not ready to jump out of the window due to fear of a meltdown. Because expectations and guidance have been conservative, we think opportunities remain.
Investment thesis is intact. Activision is our top pick in videogames, due in part to its year-end slate. With the top game of the holiday in Modern Warfare 2, two new peripheral games in DJ Hero and Tony Hawk Ride, its foray into racing with Blur, and three Guitar Hero titles, there is little doubt in our minds that it should gain share. Our $15 price target is 19x our 2010 EPS estimate of $0.78.
Detailed Discussion
Activision Reports Q2 Results Sometime Next Week
Activision Blizzard (Activision) will likely report Q2 results sometime next week, likely on Wednesday or Thursday after the close of the market. Below, we lay out our expectations for its quarterly results, including a tie into U.S. sell-through as reported by NPD and our analysis of its World of Warcraft operations in China.
Net net, we expect Activision to meet or beat our and the Street’s Q2 forecasts when it reports. There is growing skepticism around this much-loved story based on a few rumors, largely insignificant business changes and lackluster overall industry sales. We remain confident in our forecasts and that Activision has set expectations more than low enough to drive Street estimates higher in the next two quarters.
Activision Title Comparison
Sources: Company reports, Pacific Crest Securities estimates
Recent Title Moves Have Not Changed Our Stance
Activision confirmed last week that it is moving Singularity, a rare internally developed new intellectual property, to 2010 from 2009. Given its showing at E3, we did not expect the game to be a blockbuster, and we hope that the extra time improves its chances, although there is certainly no guarantee that it will. We buy Activision’s admission that the game needed more time, given the lackluster buzz coming out of E3 and the fact that its developer, Raven, also developed Wolverine (launched in May) and Wolfenstein (to launch in August) this year.
We do not believe Activision moved the game out just because it already had this year “in the bag,” as many investors have suggested to us. Activision is not as prone to delays as most of its competitors, so it is likely that the game really, really needs the extra development time. This is especially true since it will now miss the holiday season, which Activision believes is a key window to launch new IP. Further, Activision’s CFO Thomas Tippl has commented publicly (in reference to competitors’ delays) that delaying games to smooth revenue is not a valuable exercise given the costs that accrue to capitalized development in waiting for launch. While this does not preclude Activision from partaking in the practice, it is another reference that points to its unlikelihood.
‘StarCraft 2’ Still Has Not Moved Out of the Year
We expect Blizzard to formally announce the open beta of StarCraft at BlizzCon in August. While this is later than we originally expected, we still are not convinced that it means the game will miss the year. Investors are right to have a heightened sense of worry when it comes to Blizzard games and delays given its previous track record; however, recent speculation that the game has already been delayed is premature.
Earlier this year, we moved StarCraft 2 to Q4 from Q3, and still feel comfortable about that timeframe. We are forecasting 4 million units and $185 million in revenue from the title, which assumes no additional revenue from Battle.net. If Blizzard is successful monetizing the game using Battle.net as a platform, it would be incremental to our estimates, but likely not until 2010.
Impact from China Operator Change Is Minimal
One of the most consistent questions we get asked is what the impact will be from World of Warcraft switching between operators in China. This switch has resulted in down time from June 7, when Blizzard’s contract with The9 (NCTY, $8.45, Sector Perform) expired. Since then, Blizzard has been working with NetEase (NTES, $39.17, Outperform), the game’s new operator, to get it up and running and to ensure a smooth transition when the servers are switched on in full. The more common questions related to this transition are: (1) how long will the servers be down?, (2) when will Lich King finally launch in China?, (3) how much is Activision spending on the transition process?, and (4) what is the incremental benefit to Activision from switching partners? These are valid questions. The short answer to all of them is that, given Activision’s size, the overall impact to its results is quite minimal. We lay each out below.
The servers should be up and running soon. Both Blizzard and NetEase originally targeted late June as the time they wanted to have WoW back in operation. However, both have also committed to having the smoothest transition possible. With the amount of gamer data that needs to be transferred, anything but near-perfection in preserving the data would be a disaster for the game. NetEase finished installation of the server hardware on June 24, and internal testing began several days later, but there has been no announcement of an expanded test since then.
Further, and more importantly, the government approval process is going slower than expected. This is one of the reasons Blizzard was unhappy with The9. One of the main benefits a Chinese operator can bring to a foreign game’s developer is ensuring a smooth government approval process by making certain it has done everything necessary to get approval in a timely manner. We believe that The9’s abilities in securing government approval were lacking, and that Blizzard was unhappy with its performance in this regard. Nevertheless, this is an obstacle that NetEase has yet to overcome and will need to shore up before the game can go live. Predicting timing is very difficult, so we are not ready to officially say when the game will be approved. However, we continue to believe that the delay’s bottom-line impact on Activision should be minimal unless it stretches over several quarters.
‘Lich King’ launch will take more time. A somewhat common misconception is that NetEase is waiting on approval for Lich King, WoW’s second major expansion pack, which launched in the West in November. Lich King has not been submitted by NetEase for approval. Rather, the old form of the game with content updates up to and through Burning Crusade (the game’s first expansion pack) is under review. Re-approval is required by law whenever a game changes operators. Right now, the focus is on perfecting the technology and getting the old game approved rather than on launching Lich King. However, once this is done, we believe that NetEase and Blizzard will quickly shift focus to getting Lich King approved as this is the catalyst needed to drive growth in the game.
Activision is spending very little on the transition. Neither Activision nor NetEase have discussed transition costs. However, we do not expect Activision to have to bear the costs of building server infrastructure, especially given our estimate of the royalty rate paid on revenue to be a modest 28% (32% including the upfront royalty). If Activision were sharing in the server costs, we believe it would require a much higher royalty from the game’s revenue.
Activision’s benefits from switching partners are somewhat intangible. Given that the royalty to Activision from NetEase is roughly 10% higher versus what it was receiving from The9, the incremental royalty revenue only amounts to roughly $0.01 in EPS per year. There are a few other reasons Activision would want to switch operators. First, as mentioned, The9 had executed poorly in working through the government approval process. Second, Blizzard now has a go-to partner for operation of its games. This simplifies its Chinese operations. Third, it is possible that Activision did not want Electronic Arts (ERTS, $20.93, Outperform) to benefit from any World of Warcraft performance (EA owns 15% of The9). While some may scratch their heads a little about this switch while looking at the financials, combining the story with other factors makes a little bit more sense.
Lost Q2 Revenue Is Almost Nil, but It May Recognize Some Upfront Payment
Activision issued caution on its last quarterly call regarding costs for the transition. At the time, we wrote that it seemed like more of an avenue to allow it to issue conservative Q2 guidance. After analyzing various sales data this quarter and comparing growth trends, we are even more convinced that this is the case. Further, we believe that NetEase will be recognizing the majority of the costs for the server buildout in its Q2 results, so the largest impact to Activision’s results will be from lost licensing revenue. In 2008, The9 recognized roughly $230 million in total World of Warcraft revenue. At a 22% royalty, Blizzard received roughly $50 million of that amount. Using that as a run-rate and dividing by 12 (the game was down for just under a month in June) yields $4.2 million in lost licensing revenue. After taxes and given Activision’s share count, this amounts to $0.002 (two-tenths of a cent) in EPS.
We believe Activision received a $30 million WoW license payment from NetEase in the quarter. Even if it amortizes this over the life of the three-year contract, it could recognize just under $1 million in the June quarter, which would help offset any risk from lost license fees.
Industry Weakness Is Overblown for Individual Publishers
Industry sales growth has been nonexistent due to tough comparisons since March, but without those difficult comparisons, sales were relatively healthy. However, June sales deviated from this trend, especially in a weak latter half of the month.
Sales are slower from a combination of a few factors, in our view. First, the retail environment has been poor all year. While videogames are more affected by the hardware cycle than the economic cycle, clearly the economy is having some impact on overall sales. Weak June sales coincided with a weakening in consumer confidence. Second, hardware sales have been dwindling since the beginning of the year. Part of this can be attributed to the economy, but it seems to us far more to do with pricing. Hardware prices this cycle have held up longer than in any other cycle. While price-sensitive consumers wait for price cuts and become an increasingly larger slice of the remaining addressable market, industry sales will continue to suffer.
June’s 29% decline is the largest on record for the data we have available, which dates back to January 2001. Nevertheless, we are not ready to jump out of the window due to fear of a meltdown. We are, however, peeking our heads out to see how far it is to the ground because increased vigilance is necessary. We continue to believe that there is money to be made investing in videogame companies. This is an industry that still generates nearly 50% of revenue in the last quarter of the year. Further, while NPD data has certainly not been positive for publishers, because expectations and guidance have been so conservative we think there are several opportunities remaining. After looking at each company’s holiday slates, we continue to recommend Activision, and because we believe it has one of the best opportunities to gain market share of all the companies we follow.
Currency Impact Has Been Material Year over Year
Average U.S. dollar to British pound exchange rates have gone to $1.55 in 2Q09 from $1.97 in 2Q08. A similar change has happened with the euro, although to a lesser extent, to $1.36 from $1.56 in the same time frame. The appreciation of the dollar has affected U.S.–based publishers with significant European operations. We estimate that if exchange rates were constant from Q2 last year, Activision’s revenue would be 6% higher in Q2 this year. However, this is built into estimates and will not be negative per se. Conversely, the dollar has depreciated in the beginning of Q3. Our estimates going forward are based on the Q2 average, so continued depreciation would provide a positive bias to estimates.
Q2 Results Look Good Due to Conservative Guidance
Activision’s June-quarter NPD sales were down 5% compared with our sell-in publishing estimate of down 22%. This reflects continued conservatism in guidance and Street estimates. We are still comfortable that Activision can beat estimates this quarter, despite the dire industry sales figures in Q2.
Activision Is Best Positioned for Holiday Share Gains
Activision is our top pick in videogames due in part to its year-end slate. This is the case despite its pushout of Singularity into next year. With the top game of the holiday in Modern Warfare 2, the two newest peripheral games in DJ Hero and Tony Hawk Ride, its foray into the racing genre with Blur, and three Guitar Hero titles with Band Hero, Guitar Hero V and Van Halen, there is little doubt in our minds that it should gain share. The main variable will be consumer acceptance of its high-ASP (average selling price) peripheral titles, which has been a risk for the past few years with Guitar Hero. However, the novelty of new peripherals for DJ Hero and Tony Hawk will likely keep the titles in high demand, so we see less risk than we would in the same year if this were each game’s second or third iteration.
Category: ATVI, Games | Tags: ATVI, Earnings Preview, Morning Note -