When Activision Blizzard Inc. (ATVI) was formed in 2008, nobody could predict that it would become the world’s largest video game publisher in just five years. However, that’s exactly what happened and today, the company’s franchise portfolio has earned it historical records like the “Call of Duty” game launch, which achieved the highest first-day sales in the entire entertainment industry. But this firm’s success doesn’t lie exclusively in the past, as 2013’s profitability exceeded expectations, making Activision the top console and handheld publisher of the year.
Although consumers are currently transitioning from their previous consoles to Sony Corporation (ADR) (SNE)’s PS4 and Microsoft Corporation (MSFT)’s Xbox One, thereby temporarily redirecting spending from software to hardware, the popular game franchise is bound to pick up again in the second quarter of 2014. Furthermore, the company’s recent focus on releasing downloadable content (DLC) has been successful, generating a secondary revenue stream and extending user engagement. The result has been highly positive, as seen in the multibillion dollar franchises WoW and CoD.
So, in the article below, I will analyze Activision's past profitability, capital and operating efficiency, in addition to looking at which institutional investors have bought the company’s stock this past quarter. Based on this information, we will get an understanding of the company´s revenues, operating metrics and quality of earnings, as well as decipher if it will be worth investing in.
Profitability is a class of financial metric used to analyze a business’ ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. There are several profitability metrics, like return on assets, quality of earnings, cash flows and revenues, which allow us to elucidate if the company is really making money.
ROA - Return On Assets = Net Income/Total Assets
ROA gives us an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, this metric is displayed as a percentage and, in simple terms, tells you what earnings were generated from invested capital (assets).
I dislike the fact that Activision's ROA decreased from 8.13% in 2010 to a current 7.16%, as I’m always looking to invest in companies that generate increasing ROAs. The company’s ratio is evidence of it generating less from its assets than it did in 2010, which is somewhat worrisome.
Quality of Earnings
Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies. In order to assess Activision's quality of earnings we will compare the level of income with operating cash flows.
The company's profits declined at a rate of 11%, but since cash flow growth was larger there is evidence that profits are being created through boost in sales and cost reductions. In fact, the Destiny franchise, which will be launched this year, should boost sales even further, as it’s expected to be the sixth billion dollar franchise – next to World of Warcraft, Call of Duty, Skylanders, Diablo and Star Craft – to conquer the gaming market.
Working capital measures a company's efficiency, as well as its short-term financial health. This ratio indicates whether a company has enough short term assets to cover its short term debt. Most believe that a ratio between 1.2 and 2.0 is sufficient, so usually anything below 1 is negative and anything over 2 means that the company is not investing excess assets.
Activision’s current ratio (working capital measurement) increased from 2.10 in 2010 to 2.60 in 2012, which shows that the company has a strong balance sheet and can pay off its obligations. Looking for companies with current ratios above 1 is a must for long-term investors.
A Challenging Market
Despite Activision’s solid financial results, the threat from other large game publishers remains a concern for management. While console manufacturers like Sony, Microsoft, and Nintendo are fighting for consumers, Take-Two Interactive Software Inc. (TTWO) and Electronic Arts Inc. (EA) present the stiffest competition for the firm. In terms of mobile and social gaming, for example, EA is way ahead and although Activision’s publishing subsidiary for third-party mobile games will tap into this segment, results may take years to develop.
Gross Margin: Gross Income/Sales
The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors -and overall industry- is more efficient and will attract more investors willing to pay, as these businesses are very capable of making a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).
Over the past three years, Activision’s gross margin has increased from an already solid 63.1% in 2010 to 66.6% in 2012. An increasing margin indicates that the company has, in fact, gained efficiency and should therefore be an interesting option for investors.
Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
The fact that Activision’s revenue growth of 7.20% has outpaced the assets growth (-10%) on a percentage basis, indicates that the company is making money on its assets, which is always a positive sign.
It’s important to check which hedge funds bought Activision’s stock in the last quarter and at what price they did so, because if a prominent institutional investor put money into the company’s stock it will pass strict fundamental standards. I feel encouraged by the fact that investment gurus Ray Dalio (Trades, Portfolio) and Eric Mindich (Trades, Portfolio) bought this firm’s shares last quarter, at an average price of $17.22, since it demonstrates that hedge funds have confidence in reaping future profits from their investment.
Currently, many analysts have a good outlook for Activision. Analysts at MSN money are predicting that the firm’s EPS of $0.03 in 2013 will jump to $0.73 for fiscal year 2014. However, analysts at Bloomberg are estimating revenue to grow only slightly from 2013’s $4.67 billion to $4.71 billioon in fiscal year 2014.
In spite of some troublesome aspects regarding a drop in ROA and the never-ending competition of the gaming industry, Activision remains a solid investment for long-term profits. The multibillion dollar franchises created in the past are sure to continue looking forward, and I believe management’s focus on branching out to non-traditional gaming segments, like the mobile sector, will drive future profits. I also remain impressed by the company’s gross profit margins, which could jump to 80% once the “WoW” pay-to-play model enters new platforms. Also, with the stock currently trading at a 9% price discount relative to the industry median of 24.3x, I believe this is a good time for investors to buy shares.
Disclosure: Patricio Kehoe hold no position in any stocks mentioned.