The company's streak has been going for the past few years. But you wouldn’t be able to guess that from a glance at its chart — the stock is basically flat for the past three years despite a huge run up in the market from their post-Lehman Brothers lows.
That type of divergence between business fundamentals and stock price is exactly what intrigues us here at Gurufocus. It’s what we look for in Gurufocus’ own Micro-Cap Magic Formula newsletter.
So let’s take a closer look at ATVI.
Let’s start by taking a look at Activision’s current valuation.
Over the past twelve months, Activision has generated just under $4.8 billion in revenue and $800 million in operating profit, for an operating margin of almost 17%. That’s not bad at all.
It also completely understates just how much money Activision is currently generating.
Activision has grown through acquisitions in the past, and they’ll likely continue to buy key franchises in the future. As part of these acquisitions, they place a value on the intangible assets (things like brand names) they purchase. Activision then slowly expenses these intangibles. This “expense” has no basis in economics, only in accounting land, and does not affect cash flow.
After adjusting for these “non-cash” expenses and some other write offs, Activision has actually earned $1.4 billion in operating profit, for an operating margin of just under 30%. With their current EV sitting at $11.4 billion, you’re buying the world’s best gaming company for under 8x EV / EBIT.
Returns on capital
So, we know Activision has some great franchises. But can they turn their great franchises into great returns on capital?
At first glance… No. Activision employs just under $12 billion in assets. With operating income coming in at $1.4 billion, that makes for an average at best return on capital of about 12%.
But dig a little deeper. Most of Activision’s assets are intangible assets like goodwill and acquired licenses. If we ignore those intangible assets, Activision employs just $4.3 billion in assets, and their return on capital skyrockets to over 33%. Outstanding!
And we’re not done yet. Activision’s balance sheet is shockingly conservative. The company has no debt and more than enough cash to pay off all of its liabilities. If we also ignore this excess cash, the company’s core business employs just over $1.9 billion in assets, and their return on capital falls just short of an other-worldly 74%!
Why can they enjoy such great profits? Because the gaming business is not easy to enter. Hit games these days require huge investments, both from a capital standpoint and a technical knowledge standpoint. They need to be marketed properly, and you need a relationship with console makers like Sony and Microsoft in order to even consider making your games for console.
Once they’re produced, games enter an incredibly competitive market place where it’s really, really difficult for a new brand to stand out.
In other words, the big players who already own all of the best brands and have relationships with the major players enjoy big competitive advantages.
We’ve established Activision is cheap. And their great brand names allow them to earn incredible returns on profits.
So what is the market so concerned about that it’s almost handing Activision away at today’s prices?
Two words: Angry Birds.
That’s right — the market’s concerned that Activision won’t be able to earn the types of returns it has in the past because of Angry Birds.
Well, not just Angry Birds.
First, the market’s concerned that tablet devices like the iPad are going to eventually crush the console systems and destroy a major point of distribution (and profits!) for Activision.
Second, the market’s concerned that the growing popularity of “casual” games like Angry Birds and Farmville will eat into a serious portion of Activision’s gamer base, resulting in lower sales and much lower profits.
Finally, the market’s concerned that the ease of distribution from tablet devices and the simplicity of creating games like Angry Birds will erode Activision’s competitive advantage.
So what’s the verdict? Is Activision a buy or sell?
As with all investing, that depends.
If you have a strong view that the market is wrong and Angry Birds, iPad and the like won’t destroy Activision’s competitive advantage, Activision is a steal.
If you think the iPad will destroy consoles and Activision’s moat, it’s probably a good deal overvalued at today’s prices.
If you don’t have a view one way or the other, then Activision is outside your circle of competence. It’s probably a pass. That’s okay — it’s tough to get an edge on these companies that are so dependent on future distribution and technology. Our Micro-Cap Magic Formula newsletter tries to avoid companies where we need to make that sort of call on technology. Instead, we look for businesses with entrenched competitive positions and moats that won’t be going away any time soon.