Analysis: ATVI

This afternoon, following the closing bell, Activision (ATVI) reported a top and bottom line beat with its fiscal fourth quarter results. On the top line, adjusted revenue (adjusted to include the impact of deferred revenue) of $2.64 billion (+7.67% YoY) exceeded expectations of $2.55 billion. On the bottom line, adjusted earnings (also adjusted to include the impact of deferred revenue) of $0.94 per share (+2.17% YoY) edged out consensus of $0.93 per share. With this, Activision finished off 2017 with $7.16 billion in adjusted revenue (an annual record) and $2.28 in adjusted EPS. Additionally, this marks a record year for the company in terms of both revenue and cash flow ($2.21 billion in operating cash flow for the year).

Looking ahead, management guided for 1Q18 revenue of $1.82 billion (versus consensus of $1.42 billion) with earnings of $0.65 per share on a non-GAAP basis (versus expectations of $0.43 per share). As for the full year 2018, management sees revenue coming in at $7.35 billion (versus estimates of $7.4 billion) with non-GAAP earnings of $2.45 per shares (versus consensus of $2.57 per share). That said, while full-year estimates appear to have come up short, management has a history of guiding conservatively and note that for the current quarter, revenue guidance was for $2.335 billion and earnings guidance was for $0.82 per share, both well short of the actual results. As for capital allocation, Activision's Board of Directors has declared a $0.34 per share cash dividend, representing an increase of 13% YoY and authorized over $1 billion to be used for debt paydown in 2018. 

Compounding the strong headline result's and forward guidance, engagement numbers continue to show momentum. In addition to Monthly Active Users (MAUs) climbing to 385 million in the quarter (up from 384 million in the prior quarter), this is the second quarter in a row with players across all segments (Activision, Blizzard and King) spending in excess of 50 minutes per day on the company's various titles. Moreover, looking at each segment individually, Activision Monthly Active Users (MAUs) of 55 million increased 12% QoQ, matching the segments prior quarterly record. Within the Blizzard segment, this marked the 6th consecutive quarter of MAUs coming in at over 40 million, and while this is down sequentially from 42 million in 3Q17 we note that the prior quarter was a record for MAUs in the segment. As for King, the company's mobile division, while MAUs declined 1% QoQ, to 290 million, time spent per player per day reached a record 37 minutes in the quarter. Furthermore, in its first week, the Overwatch League reached more than 10 million viewers and average 280,000 viewers on a per minute basis. As for the Call of Duty World League, since launching in December, the league has sold out all of its global open events. 

Before digging further into individual segment results, we want to note that full company in-game purchases reached a fourth-quarter record of $1 billion and an annual record of over $4 billion in 2017. This is a crucial metric as one of the pillars of our investment thesis is that video game developers are now finding new ways to increase the monetary life of games via initiatives such as in-game purchases as downloadable content. Furthermore, for a year with no major game releases, the Blizzard segment managed to deliver record full-year revenue and operating income results. Recall, another key factor in our investment thesis is that sales via digital channels will continue to grow, this is important as digital sales bring with them higher margins and, in the case of full-game downloads, reduces availability in the second-hand market, forcing would be buyers of used games to instead deal directly with Activision or buy new in stores. On that note, we are pleased to see that adjusted sales from digital channels reached a quarterly record of $1.62 billion (+6.58% YoY). Annually, this metric also reached a new record at $5.43 billion (+4.0% YoY). 

Looking to individual segment results, Activision Publishing produced revenue of $1.34 billion (+16% YoY), Blizzard Entertainment revenue came in at $599 million (-11% YoY) and King revenue was $16 million (+18% YoY). Regarding the decline Blizzard revenue, this does not come as a surprise given the lack of any major game releases from the segment in 2017. Another $207 million in revenue came from the company's "Other" segment, where items such as studio and distribution sales are located, among other non-core items. Annual results are even more impressive, with Activision publishing revenue increasing 18%, King revenues were up a whopping 26%, and while Blizzard revenues declined 12% YoY, we remind members that annual comps for the segment were difficult given the launch of Overwatch in 2016.

By distribution channel, excluding deferred revenue (a figure included in headline results), Activision saw 70% of sales in the quarter come from digital online channels, 16% come from retail channels and 14% come from "Other", defined as revenue from studios, distribution business, Major League Gaming and the Overwatch League. Importantly, on an annual basis, digital online channels share of revenue (excluding deferred revenue) increased from 74% of sales to 78%. As we noted above, this is an important factor to our investment thesis as digital sales tend to yield higher margins. 

Lastly, a quick note on Destiny 2 engagment. Last Tuesday, when we trimmed shares of Activision (see here), we noted, "While checks have shown that sales in Call of Duty: WW2 and Destiny 2, two of ATVI's most important titles, have been strong, we have some concerns with the engagement levels in the latter title, and this could lead to weaker sales in high-margin streams like add-on content and microtransactions down the road." However, management addressed these concerns on the call, noting that while engagement upon the release was strong, there have been "sentiment issues" since then. Speaking to how they plan to address these issues, Eric Hirshberg, CEO & president of Activision Publishing Inc, pointed to co-developer Bungie's recently released development roadmap here. It illustrates management's plans moving forward and specifically called out the launch of season 3 in May and a "major expansion" to be released at the end of the year. Additionally, Hirshberg noted that sentiment has already begun to shift. While it will it take time see the full impact of these changes, we are happy to see management addressing these issues and believe that the concerns surrounding the title will ultimately subside. We also note that our major concern relating to Destiny 2 engagement was how it would impact this release (it doesn't appear to have had any major negative implications) as the further we get from the original release, the less of an impact we expect Destiny 2 to have on overall sales.

All in, Activision delivered another strong quarter. We believe our thesis regarding growing in-game purchases and the shift to digital remains intact and continue to believe that Activision has a number of growth levers left to pull, including eSports, thanks to the successful launch of the Overwatch League (which we believe will aid in further pushing videogames mainstream) and the ability to port Blizzard content to mobile. Regarding the porting of Blizzard content, we believe this to be an underappreciated factor by the investment community as Blizzard franchises such as World of Warcraft and Hearthstone (and of course Overwatch) have an incredibly loyal fan base and mobile is the fastest growing segment in the company, as illustrated by its 26% full year YoY growth rate. While we are maintaining our Two rating, as we do not want members jumping in just yet given the broader market volatility, we believe ATVI will ultimately push higher and reiterate our $80 target. 

At the time of publication, Action Alerts PLUS, which Cramer co-manages as a charitable trust, was long ATVI.