Activision Blizzard - Part 3: Risks

This is a continuation of a series on posts on Activision Blizzard.

In the last two posts, we established the investment thesis and laid out the positives for this stock. Today, we shall delve on the most important topic - the risks. Every investment has risks and it is important to lay out all the risk scenarios. I did not lay out the worst case scenario for Hyflux in 2011 and lost 80% of my capital. So, no matter how positive we are on a potential idea, learning the risks and debating these with other like minded friends would be paramount. Below's the key risks for ATVI.

Risk #1 - Old Franchises

Some of Activision's franchises are old, stale and overmilked. The two particularly at risk are Call of Duty and Candy Crush and together they contribute to c.20% of ATVI's annual revenue. If they do badly, we could expect a similar 20% hit to profits. This would be quite a bit of damage. Let's talk about Call of Duty.

This game came out in 2003 and had 16 titles since then. In the last ten years, ATVI launched a new Call of Duty title every year. It launched so many titles that some titles even have the same names, like Call of Duty: Modern Warfare. It came out in 2005 as Call of Duty 4: Modern Warfare and then relaunched again this year as Call of Duty: Modern Warfare. Spot the difference? 

The other peripheral risk is that Call of Duty is a console game. Together with other games, ATVI has concentration risk with 60% exposure to Sony Playstation and 30% to Xbox (and 10% Nintendo and others). If game console goes out of favour it would further exacerbate the decline of Call of Duty. 

Then, we have Candy Crush. This game came out in 2012 and took the world by storm much like Angry Birds and Plant vs Zombies. It's very simple and everyone can play. It also deployed tactics (discussed in the first post) to get people hooked. People also see through the tricks, it's not so much skill but the algorithm behind that determined whether you can clear the level. After seven years, there is only so many candies you want to match. The franchise is really getting tired and ATVI and King (the original company behind Candy Crush) had not been able to do come up with another game.

As such, ATVI needs to quickly grow other revenue (esports, advertisements, new games) to offset the decline in these two games. It's probably in the works. The management team knows these problem and it is not as if they were in denial. The risk is that these games decline much faster than expected. So, the mitigating factor here is good execution from the team.

This brings us to the next risk.

Bobby Kotick - CEO of Activision Blizzard

Risk #2 - Key Man Risk

Bobby Kotick is the CEO of Activision Blizzard, a position he held since 1991 after he bought 25% stake in the company (then Activision). He is an amazing entrepreneur, having the clear vision that gaming is big business back when gaming was just a geek niche. He engineered the merger between Activision and Blizzard. He was also big in giving back to society. With the success of Call of Duty, he created the Call of Duty Endowment to help war veterans. Then in 2016, he saw the potential of esports and jumped right into it, two feet deep by launching Overwatch League.

Over the last 28 years, he grew ATVI's revenue from USD 28m to USD 7.5bn (with mergers of course) with the best franchises in gaming. If Bob Kotick decided to retire tomorrow, ATVI share price would suffer a huge drop. Having said that, he does have a team in place with both the CFO and the COO having been in the company for close to ten years. 

Sadly, he is also often villianized by gamers for his many comments on how he could exploit games and get gamers to pay more. But that is what it's all about. Just like how we pay up for Disney soft toys and Avengers exhibition tickets. There is a tail risk if these gouging go to extremes like some pharmaceutical drugs, but we are not there yet. In short, this is a risk to watch out for but it's not a high probability event.

Worst case scenario

What is the worst that can happen?

Lastly, we need to discuss the worst case scenario - what can go wrong? Laying out a realistic worst case scenario requires experience and logic. It's not easy. The absolute worst case is bankruptcy, like Hyflux but that's not likely to happen with ATVI. This firm generated USD 2-2.5bn of free cashflow. It had so much cash pouring in it decided to spend USD 1.5bn buying back its own shares last year. It also increased its dividends by 9%.

ATVI also has no debt. It has USD 4.6bn of cash on its balance sheet at the end of 2018 but only USD 2.6bn in long term debt. But it does have USD 9.8bn of goodwill as a result of its past acquisitions. Goodwill arises when acquirers pay more than accountable for tangible assets. These are usually intangibles like brand, franchises, trademarks and synergies. In some cases, it's just bad acquisitions whereby the acquirers overpaid. But in ATVI's case, given how successful it had become, the goodwill is likely to be real and not get impaired. 

Putting things together, given its strong balance sheet, high free cashflow generation capability, the worst case scenario is not going to be bankruptcy. It would be business deterioration as discussed. We might expect ATVI to lose 20% of its profits as some of its franchises faltered. This would bring bring FCF to say USD 1.8bn (0.8 * USD 2.2bn). Over the past 10 years, ATVI's FCF yield ranged from 4% to 10% so assuming that the market then gives it 7% FCF yield (mid range) on this FCF USD 1.8bn, we would get to a market cap USD 25bn and adding back its cash, the worst case market cap could be USD 27bn. This would mean that ATVI's share price is c.USD 35.

As of last week, ATVI traded at USD 42, so that means that in the worst case, we could see another 17% downside for ATVI and if it ever falls close to USD 35, the risk reward would be really favourable. ATVI was trading above USD 80 just two years ago. So we are talking about 17% downside vs more than 100% upside.

Buy ATVI if it breaks $40! Huat Ah!

Activision Blizzard - Part 2: Positives

This is a continuation of the previous post on Activision Blizzard with ticker code ATVI.

In the last post we established ATVI's investment thesis. It is one of the best gaming companies in the world with eight strong franchises. It has a huge loyal user base across these various games and it is starting its own esports global league with Overwatch. In this post, we shall explore deeply into some of these positives as well as the risks involved (in the next post).

Positive #1 - Innovation

ATVI is one of the rare companies in the gaming world that has continued to create new gaming franchises after franchises. I first got to know ATVI when it launched Diablo which much fanfare in 1996 - 23 years ago. Back then, it was just Blizzard. Activision hadn't bought Blizzard yet. But they really marketed it quite well and we saw on TV how people queued up to buy Diablo cartridges. In Singapore, we couldn't wait to get our hands on it and played it together with friends.

Those were the days where not everyone had a gaming console or a PC, so we would gathered at some friends' place to play Diablo together. Geez, how many would remember those good old days? Then Blizzard launched Warcraft and Activision launched Call of Duty. These games were huge hits, selling millions of copies in the first few days. Then came Starcraft, then Skylanders for the kids. Every few years, it would launch sequels of the old hits and create hypes all over again. It was a formula for success. Years later, Hollywood caught on.

ATVI's biggest game in recent years

Just when the whole gaming industry lacked innovation, ATVI launched Overwatch and revived and expanded a whole new genre. Before Overwatch, gaming genres were pretty much fixed and dead. At the beginning, the old arcade genres had whole games on just one static screen (think Pacman or Space Invaders). In 1985, Nintendo introduced the Super Mario Bros conveyor-type games into living rooms with its home consoles. There was also racing, music/rhythm and sports. Then Street Fighter brought us player vs player. In 1992, Wolfenstein 3D came in as the first first person shooter game genre. This became a really big hit. Around the same time, the Japanese came up with role playing, which was slow but people somehow liked it. There were also strategy games, multiplayer online and others but things were turning stale.

In 2016, Overwatch picked up the online multiplayer first person shooter game and brought it to a whole new level. The game had specific heroes with specific strengths and weaknesses and teams with the right heroes had to train together in order to win. Strictly speaking, Counterstrike created this genre around 1999 but Overwatch made it really big by incorporate the new elements - dyamic gameplay, heroes, character backstory, variety in maps and stunning graphics. It made ATVI more than a billion dollars on its first year of release. Today, 40 million players play Overwatch and seizing the day, ATVI quickly launched Overwatch League in 2017, creating the first 12 competing teams. Overwatch became the the English Premium League / NBA of gaming.

To further enhance its moat in esports, ATVI bought Major League gaming for USD 46m to learn the know-how of managing esports. Overwatch would not be its only esports title. Starcraft had long had esports potential and we would expect more to come. In time, ATVI would be able to create its own World Cup / Olympics for gaming. Think of the revenue potential! As a quick gauge, FIFA made USD 6bn from the last World Cup according to New York Times!

Positive #2 - Ads and Ecosystem

Starting with Overwatch, ATVI had more than 300m monthly active users across all its platforms. Specifically 32m from Blizzard, 56m from Activision and a whopping 262m from King (although 97% of these users don't pay anything, they play Candy Crush for free). ATVI believes it can generate a lot more revenue from these 300m users.

Advertising is the obvious starting point. For Candy Crush users not paying a single cent, ATVI can easily show them 30 second ads as they play. This had become the main model for most casual games. To continue playing, users have to watch ads. It gets a bit frustrating, but hey, there's never free lunches right? ATVI believes that it can generate USD 200m revenue by showing ads to its 300m users.

Building on its eco-systems, ATVI had launched, or rather relaunched its own gaming site Battle.net. This site was already live in 1996 when Blizzard launched Diablo. But with its huge portfolio of games and the advent of game streaming. ATVI decided to use this as a platform for its gamers to play straight from the browser. For now, fans can only play Activision Blizzard games, but who knows, it might become an open platform some day.

Ecosystems are powerful weapons in the era of mobile and internet. Amazon built a huge ecosystem in e-commerce becoming the de-facto online store to buy anything. It fortified it with its Prime membership, putting in video and music. It makes one difficult to unplug. Google has the same strategy starting with search, Gmail, Android and its growing plethora of services. Facebook realized it was losing out and launched its own cryptocurrency for payment, backed by real currencies.

ATVI's ecosystem is still in its early days but more will be done. As a sidenote, it is expanding its franchises into movies. Skylander launched a successful series with Netflix and would have a Hollywood movie in a year or two. The Warcraft movie had a surprising hit in China although it flopped in the US. There would be more movies to come and analysts had put down a USD 50m revenue for 2019 and 2020.

Incrementally, these positives can add USD 250m to USD 500m or more if some of the optionalities like esports materialize. At USD 250m, the lower bound, it's only a small drop in its USD 7.5bn annual revenue, but still it's a good start. 

In the next post, we would discuss the risks and the conclusion.

Activision Blizzard - Part 1: Investment Thesis

Gaming has become part and parcel of everyday life no thanks to casual mobile gaming that had captured the eyes and minds of people young and old. The industry, segregated into mobile games, PC, console and others, is today a USD140bn industry which is larger than Hollywood and music combined.

What's more, the growth is accelerating. Esports, games with millions of spectators watching professional gamers play against others, is set to grow as big as traditional sports. This comes with it ticket sales, sponsorships, advertisements and merchandise purchases which would also serve connect the internet and real lives.

Esports gonna be as big as soccer!

At the core of it all stands two companies: Tencent and Activision Blizzard. Okay, maybe not just these two, but they are definitely up there on the league table alongside Electronic Arts, Nintendo, Microsoft (Xbox), Sony (Playstation) and dare I say, Razer, our homegrown mouse powerhouse! Today, we are going to do some deep dive analysis into Activision Blizzard (ticker code ATVI).

Investment Thesis

ATVI is one of the leading gaming company in the world having grown its franchises over the past twenty years across different eras, genres and gaming devices. Today, it boasts 345m monthly active users (MAU) across 8 blockbuster titles including Warcraft, Overwatch, Call of Duty and Candy Crush. Some of these titles has also established esports leagues and ATVI stands to benefit as esports take off in the near future. It also boasts strong track records in both innovation and M&As and should continue to produce and acquire new esports franchises in the future.

ATVI has consistently generated positive free cashflow and analysts had estimated that it could generate USD 2.2 to 2.5bn in FCF in the next three years and likely grow to USD 3bn in the future. As such, at its market cap of USD 32bn today, it would mean that ATVI is trading at 6.9%, 7.8% and 9.4% FCF yield respectively. This represents significantly margin of safety for a gaming leader with strong branding and strong franchises.

So, in essence, that was the investment thesis for ATVI. The investment thesis is the reason why we want to buy a stock. It should be easily articulated and remembered. Then as we research further, we should identify the supporting positive factors and also the risks. In the next few paragraphs, we would describe industry background, business model and the positives for ATVI - brand stickiness in gaming and how it further enhances AVTI's moat surrounding one of the most solid business models on our planet.

Gaming's beginnings and business models

The gaming business started in the late 1960s and early 1970s with arcade games which later evolved into console gaming and now mobile and multi-device gaming. We are also catching glimpses of the future - game streaming, just like what Netflix did for movies and Spotify for music. The business model has a recurring income stream since the days of console gaming. This was the famous razor-blade model whereby users paid up once for razor (the console) and then made further recurring payments for the blade (the games which used to cost $20 but are now costing $50 to $70!). In game streaming, this revenue stream gets further stability as each gamer pays a monthly subscription just like today's Netflix and Spotify users.

The original Gillette razor and razor blade

In the last 50 odd years, scientists had studied gaming thoroughly and had seen the impact on human brains. In short, gaming is a form of addiction, just like smoking, alcohol, drugs, sex, casinos, chasing Korean drama, Facebook and reading investment blogs (just kidding). In the spectrum of various addictions, it is probably not as bad as casinos or smoking but it's definitely worse than losing sleep chasing Korean drama or constantly checking Facebook and neglecting your family. Games are now designed specifically to entice with cues that would trigger desirable actions which would then lead to rewards. This releases dopamine into our brains, making us feel good and hence constantly seeking to replicate this cycle.

In casinos with the slot machines, the cues would be the near misses such as lining up two sevens (while three sevens would mean hitting the jackpot) that would trigger the gamer to keep pulling the slot lever (hence burning a lot of cash along the way). Once in a while, three fruits (not three sevens) would line up and reward the players with a small payout, keeping them hoping for more. Over hours, days, weeks and even years, pathological gamblers become stuck and would squander all their monies and go into debt, leaving their lives in ruins. As this became clear, governments started regulating casinos.

Mobile or console gaming, today is not regulated. Well, first, most gamers do not spend enough to go into debt. But games work with the same principles: cues, triggering actions which sometimes lead to rewards. For instance, Candy Crush, gamers would quickly find out that it happens very often that they will run out of moves and very coincidentally, only one more move is needed to complete the level. To complete the level, one would have to fork out $1.99 for that one move. This is very powerful and 3-5% or sometimes more of the population ultimately falls for it.

Out of moves!

There are many more well research cues that game designers use to ensure that gamers come back for more. We discussed near misses, there's also level progression, rankings, competition with friends, rewarding gamers with awesome story graphics and ending scenes, rare collectors items in games and many more. Guess what, Activision Blizzard knows them all and had been using these for years.

Brands

In one of their most successful games - World of Warcraft, the average gamer spend a crazy 22 hours per week in the game. Almost 30% of players play more than 30 hours per week. That's 6 hours from Monday to Friday. In most CBD* jobs in Singapore where white collar workers do 90 minute lunches and multiple coffee breaks, the hours on Warcraft spent beats full-time job hours. Maybe some CBD workers are spending lunch and coffee breaks playing World of Warcraft.

ATVI understands games better than anyone else. But it also understands branding and marketing. The company had successfully generated so much hype for most its top franchises that almost always guaranteed sellouts. In one recent instance, Call of Duty - Ghost sold USD 1 billion dollars on its first day. As such, ATVI boasts eight billion dollar franchises namely: Call of Duty, Warcraft, Overwatch, Candy Crush, Diablo, Starcraft, Heartstones and Skylanders. It constantly rotates new sequels amongst these franchises not unlike what Disney is doing with Marvel, Star Wars, Pirates of the Caribbean, Indiana Jones, Pixar and more recently remakes of old Disney cartoons. This strategy generates some stability in an industry with constant hits and misses.

As such, in recent years, we had seen strong and growing free cashflows (in both Disney and ATVI). In the next post, we shall discuss the other positives and risks. Huat Ah!

*CBD stand for Central Business District.