ATVI’s -41% slump might be a good thing - but it probably isn’t over yet

December 3, 2018

ATVI’s -41% slump might be a good thing – but it probably isn’t over yet

One of the challenges associated with mature bull markets is the fact that they generally reflect a healthy overall economic backdrop. Why is that a challenge? Because when investors begin to recognize the fact that the economy has been healthy for a long time, the natural next question starts become how much longer it can last. Since the stock market is an emotional animal, uncertainty about the economy’s ability to keep chugging along with healthy growth numbers usually results in exactly what we have been seeing throughout practically the entire year: increased volatility that makes it harder for the market to sustain long-term trends.

The fact is that no matter what alarmists might say or have you believe right now, the market isn’t definitively bearish right now. After reaching a new high in the beginning of October, the market dropped roughly 10% for the second time this year. A second legitimate correction in a year is a noteworthy event, since before this year, the market had managed to avoid any kind of drawdown of more than about 5% since late 2015 – and even that correction lasted only a few months before resuming the market’s longer upward trend. Until the market breaks down below its most immediately support around its February 2018 lows, however, it’s difficult to really start beating the bearish drum very hard.

One of the sectors that has been beat down the most over the last couple of months is technology; and while the market seems to focus on hardware-driven industries, like networking and semiconductors, another segment that has seen its share of volatility is software – more specifically, software gaming companies. This is a segment that I think the market has always treated as being highly cyclical and sensitive to broad economic pressures. That makes sense up to a point, since video games and gaming consoles have historically proven to be something of a luxury item, where sales growth is easier to achieve when economic activity like job creation and wages are increasing. I’m starting to think, however that a generational shift could make this segment less sensitive than it has been – and that means that this is a market segment that could continue to perform well even if the broader economy does actually begin to slow down.



Gaming has been around for a long time, of course, so the generational shift I’m talking about isn’t necessarily to suggest that there are going to be more gamers than their have been; in fact, there are a number of industry metrics that indicate total users could be leveling off or, in some cases even declining. The shift I think is occurring comes in the way gaming is treated as a regular activity in households.

I’ll use my family as an example. I grew up in the early decades of video games; I can remember when Pong was a big deal, and I blew major chunks of my allowance and lawn-mowing money at the arcade on Space Invaders, Pac-Man, and about a dozen other games from that age. Gaming consoles like Atari and Nintendo quickly found a place in my home, and I was as enthusiastic about my video games as anybody. When I started my own family, I still played video games, but the demands of providing for my family, along with the other demands of life meant that gaming became nothing more than an occasional diversion for me.

For my sons, however, gaming is a completely different story. Now in college, and working to build their own careers and lives, it’s been interesting to see how they make time to include gaming in their daily lives. Where my wife and I budget for things like dinner and a movie date nights, they budget for monthly subscriptions to their favorite games and gaming platforms, including paid updates. My sons represent the demographic that gaming companies like Activision Blizzard (ATVI), Take Two Interactive (TTWO) and Electronic Arts (EA) have been focusing their attention on for years; instead of simply trying to produce another cool game each year to generate a new batch of sales, these companies have transformed their development activities and business models to emphasize a continuous relationship with their customers, with revenue opportunities from monthly subscriptions that provide automatic updates and early release access to in-game purchase options for modules that provide specific, specialized gaming functions and features.



My boys eat those things up, and they aren’t the only ones; it’s something that I’ve noticed really appeals to the Millennial generation. I think that means that gaming is becoming more and more a fundamental part of the economic landscape, because even if the economy does turn bearish, Millennials are going to find ways to make allowances for their games in their regular budgets. It means that while they may not become the same kind of defensive profile that I would put utilities or food and beverage companies into, I think that when the market does finally turn bearish, and even when the economy turns recessionary, gaming companies will maintain their fundamental strength far better than many analysts and experts think.

ATVI is one of the stocks in the gaming industry that I think really bears paying attention to. If you’re familiar with games like Call of Duty, World of Warcraft, Skylanders, or even Candy Crush, then you’re familiar with this company’s work. The stock hit an all-time high at the beginning of October at nearly $85 per share, but has dropped more than 41% since then. I’m not sure the drop is over yet, and in fact I’m still not sure the stock is a great value yet, even with the stock down as big as it is. Its fundamentals, however are solid, and its value proposition is getting more and more interesting practically every day.



Fundamental and Value Profile

Activision Blizzard, Inc. is a developer and publisher of interactive entertainment content and services. The Company develops and distributes content and services across various gaming platforms, including video game consoles, personal computers (PC) and mobile devices. Its segments include Activision Publishing, Inc. (Activision), Blizzard Entertainment, Inc. (Blizzard), King Digital Entertainment (King) and Other. Activision is a developer and publisher of interactive software products and content. Blizzard is engaged in developing and publishing of interactive software products and entertainment content, particularly in PC gaming. King is a mobile entertainment company. It is engaged in other businesses, including The Major League Gaming (MLG) business; The Activision Blizzard Studios (Studios) business, and The Activision Blizzard Distribution (Distribution) business. It also develops products spanning other genres, including action/adventure, role-playing and simulation. ATVI’s current market cap is $38.1 billion.

  • Earnings and Sales Growth: Over the last twelve months, earnings  declined about -16%, while sales declined about -6.5%. This is a reflection of a decline in ATVI’s total user base, and increasing concentration of its revenue from its top franchises, and the fact that the gaming industry is intensely competitive. The picture did improve in the last quarter, as earnings grew 34%, although revenues continued to decline about -7%. The company’s margin profile, however is a sign of strength, since Net Income increased to 17% of Revenues in the last quarter versus 8.17% over the last year.
  • Free Cash Flow: ATVI’s free cash flow is attractive, at a little over $1.7 billion.
  • Debt to Equity: ATVI has a debt/equity ratio of .25. This number declined significantly over the last quarter, and reflects the company’s conservative approach to debt. Their balance sheet shows more than $3.3 billion in cash and liquid assets in the last quarter versus $2.6 billion in long-term debt.
  • Dividend: ATVI pays an annual dividend of $.34 per share, which isn’t very impressive given the fact that translates to an annual yield that is less than 1%. Keep in mind, however that very few software companies, much less gaming stocks pay a divided at all.
  • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for ATVI is $13.97, which translates to a Price/Book ratio of 3.57 at the stock’s current price. Their historical average Price/Book ratio is 3.83, which is only about 6.7% below the stock’s current price. Their Price/Cash Flow, ratio, however is about 30% below its historical average; if you use both numbers, you get a long-term price target between $53.50 and nearly $65 per share. Given the speed and depth of the stock’s decline since October, I don’t the worst is over, but that should only serve to improve the stock’s value proposition for picky value investors like me. Given the stock’s current fundamentals, it would start to look very compelling at around $43 per share.



Technical Profile

Here’s a look at the stock’s latest technical chart.

 

  • Current Price Action/Trends and Pivots: ATVI’s decline really accelerated at the beginning of November, with the stock gapping down from around $64 per share to its current level around $49. That’s a decline of nearly 30% in just a couple of weeks, and it has pushed the stock not only to a new 52-week low, but also to a price level that it hasn’t seen since April of 2017. The stock’s immediate resistance is between $52.50 and $53, with support right around its recent low in the $47 range.
  • Near-term Keys: The gap that was created overnight when the stock plunged from a bit above $64 to around $55 earlier this year is interesting. If the stock can start to build some positive momentum, a push above $53 (or better, $55) creates a strong opportunity for a short-term bullish trade using call options or just buying the stock outright, with a target price at roughly half the total distance of the gap, which is between $59 and $60 per share. If, however, the stock drops below $47, it could drop all the way to $40 without much difficulty, and so that could provide an interesting shorting opportunity, or a chance to buy put options. The stock’s value proposition is interesting right now, but not quite compelling enough to prompt me to say it’s a great buy right now; but if it does break down, any kind of stabilization between $40 and $43 would be very hard to ignore.