Bull/Bear Pitch on the Largest Video Game Maker: Activision

(This is a highly-abbreviated version of a full SumZero report republished with the authors' consent)

Bull Quick Thesis
– I believe ATVI has a strong management team that is navigating a transitioning business to strong growth and cash flow generation through digital initiatives.
– ATVI has positioned itself to benefit from industry trends with streamlined hit strategy and the largest digital and Asian / Foreign presence.
– ATVI has history and reputation of significantly beating guidance and consensus estimates.
– I recommend buying the stock with a $16.75 target price based on 10% LFCF yield (32% premium to current)
– Current LFCF yield of ATVI is 13% which is representative of low/negative growth business facing fundamental business deterioration.
– Yield is a >60% discount to peers.
– ATVI’s current valuation implies it is an unsustainable business in secular decline, trading at a significant discount to peers.
– Despite ATVI’s history, market continues to conservatively forecast projections.

Bear Quick Thesis
--We don't often get the chance to bet against a company on the cusp of experiencing new major competitive challenges. When we do get the chance, most investors know about the threat and position themselves for it.
--74% of analysts rate ATVI as a buy and 26% of analysts rate it a hold. Not one analyst has this stock pinned to the wall with a sell rating. We believe that bulls have overlooked a major risk to ATVI's revenue stream, namely, that Guild Wars 2 will spark a severe defection from World of Warcraft (WoW).
--The traditional video game industry is in steep decline. Nintendo is coming off of its worst fiscal year ever, and Sony’s PlayStation division has been suffering large losses (over $2 billion last year) as well. NPD Group reports that U.S. videogame sales fell 29% from a year earlier, while sales of hardware fell 45%. This is the seventh consecutive month of decline. Even Zynga has had trouble retaining users in its social games.
--WoW has helped ATVI maintain its stock price, with this one single game providing roughly 25% of the revenue for the company via its expansion packs and monthly payments. WoW has very high operating leverage (costs are mostly fixed), and any decline in revenue has dramatic effects on the bottom line. Guild Wars 2 is a fierce competitor that is creeping up on Activision's WoW title at the end of August 2012, that we believe many investors have not factored into their assessments. Guild Wars 2 has been ruled by many as superior to WoW even before the game has come out.
--If WoW subscription and software sales were to decline by 25%, we estimate that gross profit of the subscription business would drop to $779 million from $1.12 billion currently, and that gross margin would drop to 76% from 82%. Altogether, gross profit would be $368 million lower. Therefore, we expect that operating income attributable to WoW will drop even more than 25%.
--The creation of a new phenomenal gaming franchise is unlikely in the current fiscal year since all titles currently being worked on are public information. Given that there are no new blockbusters that ATVI is hiding from us we must then focus on the revenue generation ATVI could make from current titles and those in production.
--We plan to sell the company after earnings and begin shorting it. You can try to time your trades but make sure you have a decent sized position by the time Guild Wars 2 is released on August 28th. Once gamers see the reviews that the game receives the conversion to Guild Wars 2 from other MMORPG's will begin and ATVI will see margins and revenues crash through the floor on earnings.

John Pulliam (Vela Capital) called for a massive short on Zynga in April when it was trading for $10.30. Now he is targeting $4 a share for shares of Facebook. Want a look at his full short thesis on Facebook, which is a stunning 13-pages long and includes an in-depth valuation and strategic analysis? If you're interested in taking at look at the real thing, email elite@sumzero.com for more information.

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