Modern Marvel

So we all know that Modern Warfare 2’s arrival this week has propelled its brand and developer into the straosphere – but what do the successes mean for parent firm Activision? Lazard Capital Markets analyst Colin Sebastian offers a look at the future potential of the publisher…

Our positive investment thesis on Activision Blizzard is based primarily on: 1) the cyclical growth of the overall video game industry; 2) the ability of well capitalised publishers to take advantage of diversifying revenue streams, such as downloadable content; and 3) industry-leading margins associated with both wholly-owned key Blizzard franchises (e.g., World of Warcraft, StarCraft, Diablo) and standalone Activision franchises (eg. Call of Duty). We believe the product roadmap presented by management, and track record of operational execution, provide solid visibility for positive momentum and earnings growth in 2009 and 2010.

Call of Duty takes its place among the top entertainment properties of all time.
This week’s launch of Call of Duty: Modern Warfare 2 will quickly claim a visible spot among the top ten entertainment properties of all time — in our estimation likely generating more than $1 billion in retail sales worldwide over the first several months after release, in the same category with media heavyweights such as the movie Titanic and the album Thriller. And we expect that momentum to carry through 2010 as multi-player online game-play supported by add-on content packs” will maintain user engagement. While there is ongoing debate as to whether the title will sell 12 million units or up to 15 million units in 4Q, more important in our view is the intrinsic value of the franchise, and that it could tap into a broader group of media and tech investors, as previously witnessed upon the launch of other high-profile games such as Halo and Grand Theft Auto.


We believe initial sell-through is tracking in line or slightly ahead of our 4Q unit estimate.
Based on our initial retail channel checks, we estimate that day one sell-through in North America for Modern Warfare 2 is close to three million units, and five to six million worldwide. Over the first week, we expect the title to sell-through roughly eight million units worldwide. Importantly, we note that extrapolating sales trends from the first day or two of sell-through carries with it a high margin of error, and we believe that recent more optimistic estimates of week one sales may be somewhat underestimating the natural fall-off in unit sales in the days following release. More importantly, we believe the title is tracking in line to slightly above our Q4 unit estimate of 12.5M.


Spotlight may begin to shine on the positives rather than the negatives.
3Q marked the final quarter of an unusually quiet period for Activision in terms of product releases, with the investor spotlight focused on the overhangs from a weaker market for music games, fast-declining Wii sales trends industry-wide, the ongoing transition issues of World of Warcraft in China, and ongoing insider share sales. We believe these concerns were somewhat magnified during periods with relatively less product momentum, and seasonally slow sales, but may appear less relevant as the spotlight shifts toward more important drivers of financial results, most notably the performance of Modern Warfare 2, the ongoing strength of World of Warcraft, and the 2010 launches of the online platform and Starcraft 2. Over the next three quarters, we expect Activision to generate approximately $0.65 in earnings, compared with $0.20 over the trailing three quarters. This is based on the seasonal increase in game sales, the launch of Modern Warfare 2 this holiday, the launch of StarCraft II in 1H10, and a stable contribution from World of Warcraft.

Interactive entertainment still driving the bulk of industry growth.
In some circles, the video game industry still carries second-tier status relative to the more established, though passive forms of entertainment such as cinema, television and music. However, the underlying secular growth trends driving interactive entertainment remain positive with a clear shift in consumer usage patterns that favor the content over legacy forms of media. In just the past five years, the gender and age distribution of game players has expanded well beyond the stereotypes, and according to the industry trade association ESA, the average age of video gamers is 35, and 40 per cent of game players are female.

As a result of the positive secular growth trends, many top-tier media companies have half-heartedly embraced video games, more often than not as an extension or spoke off of existing brands, rather than establishing independent creative hubs of game development. While this strategy has clear value to support existing properties, we believe it is a fairly narrow embrace of interactive media, ignoring the potential to maximise engagement with consumers. There are notable exceptions, such as Disney’s acquisition of Club Penguin, which has proven to be a successful pathway for the company to leverage the converging trends of Internet usage and interactive content. In addition, Vivendi has clearly embraced interactive entertainment, initially with the acquisition of Havas (included Blizzard) in 1998, followed by the merger of Blizzard with Activision in 2008 (Vivendi owns over half of ATVI shares).

Nonetheless, the relative apathy shown by major media to the fastest-growing form of entertainment has left the bulk of industry sales in the hands of independent developers and publishers (see the following chart). Nonetheless, every year there is a blockbuster video game (eg. Grand Theft Auto, Halo) that generates shock-waves within media companies as they assess their market share and strategy across the landscape. This year, that title is Call of Duty: Modern Warfare 2.


Activision Blizzard emerging as a next-generation media company.
World of Warcraft and Call of Duty are two media properties in their prime, the first with an enviable online subscription revenue model generating more than a billion dollars annually in high-margin revenues, and the second another billion-dollar franchise that has taken the helm as the most popular console game in the Western world. Interestingly, consumers continue to show a willingness to pay for interactive entertainment through both the traditional retail channel as well as over the Internet, while traditional forms of media continue to struggle with disrupting distribution trends and unclear business models. In this respect, video game companies, particularly those in Asia, are leading the charge by capitalising on flexible revenue streams, such as time cards, premium upgrades, virtual goods, lead generation, and subscriptions.

Industry remains in near-term funk, but shares still appear undervalued.
We note that shares of ATVI trade at 7.6x EV/EBITDA, in line with traditional media companies, while generating higher growth and margins. Applying a higher Internet multiples to EBITDA (11x) and EPS (20x) suggest shares are worth closer to the $15 to $16 range. We also note that ATVI trades relatively on par with ERTS, despite having a more visible and favorable growth and margin profile.

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