Equity Research ACTIVISION, INC. (ATVI-NASDAQ)

Transcription

1 Equity Research May 28, 2008 Abdul Saleh North Canal Street, Chicago, IL ACTIVISION, INC. (ATVI-NASDAQ) ATVI: Zacks Company Report - HOLD Current Recommendation Hold Prior Recommendation Buy Date of Last Change 02/21/2007 Current Price (05/27/08) $33.39 Six- Month Target Price $30.00 SUMMARY DATA 52-Week High $ Week Low $17.11 One-Year Return (%) Beta 1.81 Average Daily Volume (sh) 4,783,509 Shares Outstanding (mil) 294 Market Capitalization ($mil) $9,809 Short Interest Ratio (days) 2.07 Institutional Ownership (%) 88 Insider Ownership (%) 9 Annual Cash Dividend $0.00 Dividend Yield (%) Yr. Historical Growth Rates Sales (%) 23.6 Earnings Per Share (%) 26.1 Dividend (%) N/A P/E using TTM EPS 27.8 P/E using 2009 Estimate 26.1 P/E using 2010 Estimate N/A Zacks Rank 3 OUTLOOK Activision reported revenues of $602.5 billion in Q4:FY08, almost double from a year ago. The year-over-year growth was fuelled by success of Guitar Hero III: Legends of Rocks and Call of Duty4: Modern Warfare. Gross margin improved to 41.8% from 31.0% in Q4:FY07 but was down from 48.5% recorded in Q3:FY08. GAAP EPS was $0.14. Excluding stockbased compensation expense, EPS was $0.17. For fiscal 2008, the company reported record revenues of $2.9 billion compared to $1.5 billion in 2007, driven by the releases of Call of Duty 4, Guitar Hero III, Spiderman 3, Transformers, Shrek the Third and Tony Hawk s Proving Ground. Margins improved both on a GAAP and a non-gaap basis. For Q1 2009, management expects revenues of $500 million and diluted EPS of $0.04. For full year 2009, management expects revenues of $2.75 billion and EPS of $0.72 on a standalone basis (excluding Vivendi games). We maintain our Hold rating on shares of Activision and target price of $30. Risk Level Above Avg. Type of Stock Large-Growth Industry Toys/Game/Hobby Zacks Rank in Industry 2 of 14 ZACKS ESTIMATES Revenue (in millions of $) Q1 Q2 Q3 Q4 Year (Jun) (Sep) (Dec) (Mar) (Mar) A 223 A 816 A 188 A 1,468 A A 188 A 823 A 313 A 1,513 A A 318 A 1,483 A 603 A 2,898 A E 350 E 1,586 E 665 E 3,101 E Earnings per Share (EPS is operating earnings before non-recurring items and stock options expense) Q1 Q2 Q3 Q4 Year (Jun) (Sep) (Dec) (Mar) (Mar) $0.01 A -$0.05 A $0.23 A -$0.03 A $0.14 A $0.05 A -$0.08 A $0.48 A -$0.04 A $0.33 A 2008 $0.11 A $0.02 A $0.90 A $0.17 A $1.20 A 2009 $0.13 E $0.02 E $0.93 E $0.20 E $1.28 E Zacks Projected EPS Growth Rate - Next 5 Years % 20 Consensus Projected EPS Growth - Next 5 Years % 19 Copyright 2008, Zacks Investment Research. All Rights Reserved.

2 OVERVIEW Founded in 1979, Activision, Inc. is based in Santa Monica, California. ATVI is a leading international developer, publisher and distributor of video game software. The company has a diverse portfolio of products covering various categories and markets and is used on various game hardware platforms and operating systems. Activision offers products, which include game categories, such as action/adventure, action sports, racing, role-playing, simulation, first-person action, music-based gaming, and strategy. The company s target customer base includes game enthusiasts, mass-market consumers, and youth. ATVI offers its products primarily in versions that operate on the Sony PlayStation 2, Sony PlayStation 3, Nintendo Wii, Microsoft Xbox 360 console systems, Nintendo Game Boy Advance, Sony PlayStation Portable, and Nintendo Dual Screen hand-held devices, and personal computers. The company operates in two segments Publishing and Distribution. Publishing business involves the development (internally and externally), marketing, sale of products directly, by license, or through its affiliate label program with certain third-party publishers. In the United States, the company sells its products directly to mass-market retailers, consumer electronics stores, discount warehouses and game specialty stores. The international business is conducted through offices in the UK, Germany, France, Italy, Spain, the Netherlands, Australia, Sweden, Canada, South Korea and Japan. The Distribution business consists of operations in the UK, the Netherlands and Germany that provide sales and logistic services to third-party publishers of interactive entertainment software, Activision s publishing operations, and manufacturers of interactive entertainment hardware. In fiscal 2007, the Publishing segment accounted for approximately 74% of total revenues while the Distribution segment generated the remaining 26% of the revenues. On a geographical basis, North America accounted for 50% of the total revenues and Europe generated 47% of the revenues. The remaining 3% was contributed by operations in other countries. The North American customers include Best Buy, Blockbuster, Circuit City, GameStop, Target and Wal-Mart. In fiscal 2007, Wal-Mart and GameStop accounted of 22% and 8% of the total sales respectively. BULL STORY The key to the entertainment software business is establishing as many hits as possible and releasing new versions, or sequels, for the most popular games on a regular basis to drive a large recurring revenue stream. While Activision does not have nearly as many top-selling games as Electronic Arts (the company s competitor), it does have a diverse portfolio with a large number of new products in its pipeline. In fiscal 2007, the company s product portfolio included products such as Call of Duty 3, Guitar Hero II, Tony Hawk s Project 8, Tony Hawk s Downhill Jam, Marvel: Ultimate Alliance, Over the Hedge, and X-Men: The Official Game. Activision has a multi-year, multi-property publishing agreement with DreamWorks Animation LLC which grants the company the exclusive right to publish video games based on DreamWorks Animation movie releases which include Shrek 2, Madagascar, Over the Hedge, and all other respective forthcoming sequels. The company has a strategic alliance with Harrah s Entertainment, Inc. that grants the company exclusive and worldwide rights to develop and publish World Series of Poker video games based on the popular World Series of Poker Tournament. Activision s exclusive multi-year agreement with professional skateboarder Tony Hawk enables the company to develop video games using his name. Consequently in fiscal 2007 the company released eight successful titles in the Tony Hawk franchise. Moreover, the company has agreements with MGM Interactive and EON Productions Ltd. for developing and publishing video games based on the James Bond license and with Hasbro Properties Group to develop and publish video games based on the Transformers brand. These agreements bode well for the company to generate a recurring stream of revenue in future. Zacks Investment Research Page 2

3 Console Video Game Software Retail Sales Total U.S. Source: NPD/Retail Track The company is best known for its action/adventure strategy and simulation products and has been successful in the superheroes and skateboarding categories with the release of Spider-Man and X-Men consoles, as well as the Tony Hawk franchise. Activision successfully launched the first person action categories through the release of Call of Duty and plans to continue it in the long term as well. In addition, the company entered the music based gaming genre in fiscal 2007, with the acquisition of the Guitar Hero franchise from Red Octane. This franchise combines interactive software with a hardware peripheral in the form of a guitar and provides a significant growth opportunity for the company. Recently, the company acquired UK-based Bizarre Creations, a videogame development studio which specializes in the racing category. The acquisition will enable Activision to enter the $1.4 billion racing category, which is the fourth most popular videogame genre and represents more than 10% of the total video game in circulation worldwide. The pending acquisition of Vivendi will further expand the company s global footprint and increase market share in Asia. On an international basis, the company has established itself as a leader in value software publishing business with products under the Cabela s, Rapala, World Series of Poker, and Greg Hasting s Paintball licenses. Value software is typically less sophisticated and less complex, both in terms of the development process and consumer gameplay. Activision also distributes products on behalf of affiliates. Meanwhile, the company reported revenues of $602.5 billion in the fourth quarter of fiscal 2008, almost double from a year ago. The year over year growth was fuelled by success of Guitar Hero III: Legends of Rocks and Call of Duty4: Modern Warfare. The gross margin improved to 41.8% from 31.0% in the prioryear period but was down from 48.5% recorded in the previous quarter. GAAP net income was $44.1 million or $0.14 per diluted share compared to a net income of $272.2 million or $0.86 per diluted share in the December quarter and a net loss of $14.4 million or ($0.05) per diluted share in the corresponding quarter of fiscal For fiscal 2008, the company reported record revenues of $2.90 billion compared to $1.5 billion in 2007, driven by the releases of Call of Duty 4, Guitar Hero III, Spiderman 3, Transformers, Shrek the Third and Tony Hawk s Proving Ground. On a GAAP basis, the company posted a net income of $344.9 million or $1.10 per diluted share compared to a net income of $85.8 million or $0.28 per diluted share in the last fiscal year. Operating margin was 16.5% compared to 4.8% recorded a year ago. On a non-gaap basis, the company reported a net income of $377.5 million or $1.20 per diluted share in fiscal 2008 compared to a net income of $101.3 million or $0.33 per diluted share in Operating margin came in at 18.4% compared to 6.5% in the prior year, and above management s targeted range of 15% 18%. Finally, Activision has a strong balance sheet and the free cash flow (operating cash flow less capital expenditures) generated by the company remains healthy. The company exited fiscal 2008 with cash, Zacks Investment Research Page 3

4 cash equivalents and short-term investments of $1.4 billion, up from $1.2 billion at the end of the previous quarter, and no debt. BEAR STORY The entertainment software industry is characterized by intense competition and rapid technological changes. Activision primarily competes with publishers of personal computer and video game console interactive entertainment software. The significant competitors in the third-party software business include competitors like, Take-Two Interactive Software, Vivendi Games Publishing, Electronic Arts, Ubisoft Entertainment, Walt Disney etc. The company also competes with the integrated video game console hardware and software companies such as Sony, Nintendo, and Microsoft in the development of software titles for their respective platforms. The life of any one game product is relatively short. Sales are relatively high during the first few months after introduction, followed by a rapid decline thereafter. A delay in company s product release or disruptions following the commercial release of products developed by other companies has an adverse impact on the company s sales. Most of these competitors have greater financial, marketing and product development resources. In fiscal 2006, Microsoft released Xbox and in fiscal 2007, Sony and Nintendo introduced their respective nextgeneration hardware platforms, the PlayStation 3 and Wii. Another major concern for the company is customer concentration. The company derives a significant portion of its revenues from a relatively small number of brands. In fiscal 2007, 39% of its consolidated net revenues (and 52% of its publishing revenues) were derived from three brands, which accounted for 17%, 13%, and 9% of consolidated net revenues, respectively (and 23%, 18%, and 11% of publishing revenues, respectively). The loss of any significant customer will have a major effect on the top-line. PS2 Software Sales Jan. 06 Oct. 07 Source: NPD Zacks Investment Research Page 4

5 RECENT NEWS Fourth Quarter Highlights On May 8, ATVI reported results for the fiscal fourth quarter, ended March 31, Revenues of $602.5 million jumped 93% from a year ago. The year over year growth was fuelled by success of Guitar Hero III: Legends of Rocks and Call of Duty4: Modern Warfare. In the previous quarter, the company reported revenues of $1.48 billion as the third quarter is a seasonally strong quarter for the company. The gross margin improved to 41.8% from 31.0% in the prior-year period but was down from 48.5% recorded in the previous quarter. On a GAAP basis, the company posted a net income of $44.1 million or $0.14 per diluted share compared to a net income of $272.2 million or $0.86 per diluted share in the December quarter and a net loss of $14.4 million or ($0.05) per diluted share in the corresponding quarter of fiscal Excluding stock-based compensation expense, the company posted a net income of $54.9 million or $0.17 per diluted share in the quarter versus a net income of $284.9 million or $0.90 per share in the fourth quarter of fiscal 2008 and a net income of $10.1 million or $0.04 per diluted share in the December quarter. By geography, North America accounted for 61% of total revenues while international revenues accounted for the remaining 39%. On a segment basis, publishing segment revenues soared 85% year over year to $513.5 million while revenues from distribution grew 15% year over year basis to $88.9 million. For fiscal 2008, the company reported record revenues of $2.90 billion compared to $1.5 billion in 2007, driven by the releases of Call of Duty 4, Guitar Hero III, Spiderman 3, Transformers, Shrek the Third and Tony Hawk s Proving Ground. On a GAAP basis, the company posted a net income of $344.9 million or $1.10 per diluted share compared to a net income of $85.8 million or $0.28 per diluted share in the last fiscal year. Operating margin was 16.5% compared to 4.8% recorded a year ago. On a non-gaap basis, the company reported a net income of $377.5 million or $1.20 per diluted share in fiscal 2008 compared to a net income of $101.3 million or $0.33 per diluted share in Operating margin came in at 18.4% compared to 6.5% in the prior year, and above management s targeted range of 15% 18%. The company exited fiscal 2008 with cash, cash equivalents and short-term investments of $1.4 billion, up from $1.2 billion at the end of the previous quarter, and no debt. At the end of the quarter, accounts receivable was $203.4 million, down from $704 million at the end of the December quarter, due to collections. As of March 31, 2008, inventories were $146.8 million, down from $153.4 million on December 31, Guidance for Q and Full Fiscal 2009 Going forward, on a stand-alone basis (excluding Vivendi), management expects revenues of $500 million and diluted EPS of $0.04 in the first quarter of fiscal 2009, assuming a diluted share count of $325 million. Excluding the impact of equity-based compensation expense ($0.02 per share) and one-time costs related to the Vivendi transaction ($0.07 per share), non-gaap EPS is estimated to be $0.13. During the quarter, the company will release Enemy Territory : QUAKE WARS for the Xbox 360 video game and entertainment system from Microsoft and PLAYSTATION 3 computer entertainment system; Kung Fu Panda, on the Xbox 360 video game and entertainment system from Microsoft and PLAYSTATION 3 computer entertainment system, PlayStation 2 computer entertainment system, the Nintendo Wii, Games for Windows and the Nintendo DS ; Guitar Hero : On Tour for the Nintendo DS; and Guitar Hero : Aerosmith for the Xbox 360 video game and entertainment system from Microsoft, PLAYSTATION 3 computer entertainment system, PlayStation 2 computer entertainment system and the Nintendo Wii. Management also announced online functionality for certain key titles to be released in the December quarter of fiscal 2009 and thereafter is expected to become a significant component of game play for Zacks Investment Research Page 5

6 certain platforms for which the company will have continuing performance obligations beyond the sale of the game. As a result, ATVI expects to begin recognizing a substantial amount of net revenues and costs of sales from these online-enabled games over a service period, which the company estimates to be six months beginning the month after shipment. Meanwhile, ATVI anticipates that a considerable amount of net revenues and costs of sales that would have been recognized in the fiscal year ending March 2009 will be recognized later in the calendar year For fiscal 2009, on a stand-alone basis (excluding Vivendi), management expects revenues of $2.75 billion and EPS of $0.72, assuming a diluted share count of $329 million. On a non-gaap basis (excluding the impact of the change in deferred revenue related to online-enabled games), revenues are forecasted to come around $3.1 billion. Excluding the impact of equity-based compensation expense ($0.12 per share), one-time costs related to the Vivendi transaction ($0.07 per share) and the impact of the change in deferred net revenues and cost of sales related to online-enabled games ($0.39 per share), the company estimates to record EPS of $1.30. Agreement with Vivendi On December 2, ATVI announced that it has signed a definitive agreement to combine Vivendi Games with ATVI, which in turn will create the world s largest pure-play online and console game publishers. Vivendi Games include Blizzard Entertainment s World of Warcraft, a multi-player online role-playing game franchise. Upon the closure of the transaction, Activision will be renamed Activision Blizzard. Under the terms of the agreement, Vivendi Games will be merged with a wholly owned subsidiary of ATVI and shares of Vivendi Games will be converted into million new shares of ATVI at a price of $27.50 per diluted share. This implies a value of approximately $8.1 billion for Vivendi Games. Concurrently with the merger, Vivendi will purchase 62.9 million newly issued shares of ATVI at a price of $27.50 per share for $1.7 billion. As a result of these transactions, Vivendi will have approximately 52% ownership stake in Activision Blizzard on a fully diluted basis. The transaction is expected to close in the first half of Upon closure, Activision will launch a $4 billion all-cash tender offer for purchasing up to million shares at $27.50 per share. The tender offer will be funded by Activision Blizzard s cash on hand at closing, including the $1.7 billion in cash received from the Vivendi share purchase. In addition, Vivendi has agreed to acquire the newly issued shares for up to an additional $700 million of shares of ATVI at $27.50 per share from Activision Blizzard. Acquisition On September 26, 2007, Activision acquired UK-based video game developer Bizarre Creations. Bizarre Creations is one of the world s premier video game developers and a leader in racing category. The acquisition will enable Activision to enter the $1.4 billion racing category, which is the fourth most popular videogame genre and represents more than 10% of the total video game worldwide. Bizarre Creations develops "Project Gotham Racing," a series for Microsoft's Xbox and Xbox 360. It is also about to accomplish development of "The Club," a third-person action game for Sega. Activision expects that its first game from Bizarre Creations will be released after fiscal year VALUATION Activision s FY08 revenue grew 92% to $2.9 billion from $1.5 billion in fiscal 2007, well ahead of expectations, and about 4x overall industry growth. Activision had the #1 and #2 titles; Guitar Hero III was a social phenomenon, while Call of Duty 4 was the best game of the year as is evident in its long and strong sell through. Volume from these two titles helped to generate operating leverage not seen before, and not "expected" until late-cycle. Non-GAAP EPS jumped to $1.20 from $0.33 in fiscal 2007, well ahead of guidance at the beginning of the year for non-gaap EPS of $0.65. Zacks Investment Research Page 6

7 Fiscal Q4:FY08 revenue was $602 million, up 93% from a year ago, and well ahead of raised guidance of $350 million. In the quarter, publishing revenues were up 131% to $484 million from $209 million a year ago, with major upside coming from console sales (up 167%) and PC sales (up 326%). Upside was driven by a very high sell through of Guitar Hero III and Call of Duty 4 as there were no major releases in the quarter at all. Despite a 62% increase in costs, gross margins were up to 42% compared to 31.1% a year ago. Non-GAAP EPS were $0.17, versus guidance of $0.04, and a loss of $0.03 a year ago and compared to our estimate of $0.05. While Activision s recent results have been impressive, we believe that favorable operating momentum exists in the coming quarters. The company s portfolio of proven franchises, success of newly launched properties, impressive product pipeline and excellent financial condition paves the way for further growth. However, we think the prospects are largely built into the stock at the current time, leading us to our Hold rating. The shares are trading at roughly 26.1x our revised fiscal 2009 EPS estimate of $1.28, which excludes stock option expense and 29.2x our 2009 EPS estimate that includes stock option expense (GAAP). Our current target price of $30 implies a P/E multiple of 23.4x our FY2009 EPS estimate, which is currently higher than the industry median but towards the mid-point of ATVI s historical range. Multiples on forward operating earnings seems to be a bit lower when the company s cash balance of nearly $1.4 billion ($4.54 per diluted share) is backed out. Industry Comparables Pr Chg P/E CurrFY EPS Gr Price/ Price/ Price/ YTD 5Yr Est Book Sales CF(ttm) ACTIVISION INC Industry Mean Industry Median S&P ELECTR ARTS N/M HASBRO INC THQ INC TAKE-TWO INTER N/M Zacks Investment Research Page 7

8 PROJECTED INCOME STATEMENT & BALANCE SHEET Activision Inc Income Statement and Balance Sheet (Dollars in millions, except EPS data) 03/04 03/05 03/06 03/07 03/08 03/09E Sales 948 1,406 1,468 1,513 2,898 3,101 Cost of Goods Sold ,635 1,734 SG&A Other operating expenses Interest and other Zacks Adjusted Income before NRI Net Income Diluted EPS before NRI Reported EPS Selected Balance Sheet Information As of 03/31/08 Cash & Marketable Securities ,449 1,449 Current Assets 812 1,122 1,116 1,401 1,979 1,979 Current Liabilities Long Term Debt Shareholder's Equity 833 1,100 1,226 1,412 1,948 1,948 HISTORICAL ZACKS RECOMMENDATIONS Zacks Investment Research Page 8

9 DISCLOSURES The analysts contributing to this report do not hold any shares of ATVI. Zacks EPS and revenue forecasts are not consensus forecasts. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Buy- Zacks expects that the subject company will outperform the broader U.S. equity market over the next one to two quarters. Hold- Zacks expects that the company will perform in line with the broader U.S. equity market over the next one to two quarters. Sell- Zacks expects the company will under perform the broader U.S. Equity market over the next one to two quarters. The current distribution of Zacks Ratings is as follows on the 1097 companies covered: Buy- 24.5%, Hold- 68.7%, and Sell 5.9%. Data is as of midnight on the business day immediately prior to this publication. Zacks Investment Research Page 9