Analysis: ATVI

Activision Blizzard (ATVI) reported better-than-expected results for its fiscal third quarter after the closing bell on Thursday.

On the top line, net bookings came in at $1.21 billion (-27.1% YoY) exceeding the $1.166 billion consensus. But that number includes the impact of deferred revenue that declined by $68 million in the quarter; add that $68 million back and Activision generated net revenues of $1.28 billion in the quarter.

On the bottom line (where we also account for the impact of deferred earnings - which declined by $0.06 in the quarter), adjusted earnings of $0.32 per share (-39.6% YoY) surpassed expectations of $0.23 per share.

But despite the beat, shares came under pressure on the release as fourth-quarter and full-year guidance came in below expectations, with management seeing 4Q19 revenue (net bookings) coming in at $2.65 billion and full year net bookings coming in at $6.33 billion vs. expectations of $2.746 billion and $6.384 billion, respectively.

In addition, on the bottom line, management sees 4Q19 adjusted earnings coming in at $1.15 per share vs. expectations of $1.27 per share, resulting in full-year adjusted earnings of $2.17 per share vs. a $2.20 per share consensus.

While the guidance was lighter than expected, we want to call out that management has a known history of under promising and over delivering. To this point, actual earnings results have exceeded management's guidance going back more that 12 consecutive quarters and three fiscal years. Given the success of "Call of Duty: Modern Warfare" and "Call of Duty: Mobile," we believe this coming quarter to be no different and expect results to outperform current guidance.

For example, in 4Q16, management guided for EPS of $0.74 only to achieve actual earnings of $0.92 per share (an $0.18 differential) and in 4Q17 the guidance was for $0.82 per share with the actual results coming in at $0.93 per share (an $0.11 differential).

In 4Q18 the outperformance was not as large, with actual earnings coming in at $1.29 per share vs. guidance of $1.27 per share (a $0.02 differential). But the final quarter of 2018 saw Activision go head to head with Take-Two's highly anticipated "Red Dead Redemption Two." As a result, we believe that while guidance was disappointing, management is once again setting up for a fourth quarter earnings beat, especially considering the strong initial uptake of "Call of Duty: Modern Warfare" and "Call of Duty: Mobile."

"Our third quarter results exceeded our prior outlook for both revenue and earnings per share," said CEO Bobby Kotick on the release, noting that recent launches have "enabled significant growth" in audiences of "Call of Duty" and "World of Warcraft" franchises.

"As we introduce mobile and free-to-play games based on our franchises we believe we can increase audience size, engagement and monetization across our wholly owned franchises. With a strong content pipeline and momentum in mobile, esports and advertising, we are confident we will remain a leader in connecting and engaging the world through epic entertainment," Kotick added.

As for the quarter, by segment, Activision Publishing saw net revenues of $209 million vs. expectations of $205 million. Blizzard Entertainment saw net revenues of $392 million vs. expectations of $374 million. And, King Digital, the company's mobile division, saw net revenues of $500 vs. expectations of $505 million. The company also realized approximately $113 million in "non-reportable segments" revenue, which includes sales from the studios and distribution business as well as unallocated corporate income and expenses.

Breaking net revenue down by platform, the company realized console net sales (19% of the total) of $241 million, PC net sales (27% of the total) of $341 million, and mobile/ancillary net sales (41% of the total) of $525 million. Activision also realized $175 million (14% of the total) in "other" revenue. 

It is important to break down revenues by distribution channel: Digital online channels yield higher margins compared with physical sales and, as a result, increased share of digital sales will enhance the company's ability to expand margins going forward. On that note, Activision generated $1.014 billion in sales from digital online channels (79% of the total), while traditional retail channels (7% of the total), generated $93 million in sales. Activision also realized $175 million in sales from "other" channels (14% of the total).

On the engagement front, Activision Publishing had 36 million monthly active users (MAUs), while Blizzard Entertainment saw 33 million MAUs and King sported 247 million MAUs.

All in, while this may not have been the reaction we were looking for, we remain confident in our price target, believing that management under guided fourth-quarter results and the company's content portfolio has never been stronger.

We do wish management had provided more detail -- it only said that "'Modern Warfare' is off to an exceptional start and we have more surprises in store that we think will delight existing and new players in the coming months." 

But, still, we believe new content releases for the title (such as the rumored additional maps and battle royal mode) will help sustain strong sales momentum into he holiday season.

Moreover, with over 100 million downloads of "Call of Duty: Mobile" in its first month and with management calling out "really strong" retention, we believe the franchise to be as strong as ever and that Activision is in a position to successfully monetize it with both in-game content as well as via cross-sale opportunities.

When asked if the launch of "Modern Warfare" was resulting in any cannibalization of mobile version, management quickly pointed to the opposite dynamic, saying that it "just had a really strong launch for 'Modern Warfare,' which suggests we're creating a really strong franchise ecosystem globally, where these products are actually complementing one another and not competing with one another."

Management also said it's able to cross promote its products across it ecosystems.

Looking ahead, while we do believe the upcoming holiday season to be a "Call of Duty" story, we see strength sustaining beyond the end of 2019 and into 2020 as Activision's pipeline appears to be as strong as ever following the unveiling of "Diablo 4" and "Overwatch 2," though launch dates have yet to be confirmed, not to mention the coming release of "Diablo Immortal," the franchises mobile installment, also no confirmed launch date. Management will no doubt seek to establish an ecosystem for these games akin to what we are now seeing with "Call of Duty."

Mobile versions of the company's franchises clearly appear to be part of the game plan going forward, though management was short on details. When asked on the call "would Mobile make sense for any of the other 10 pool franchises like a "World of Warcraft" or an "Overwatch"? Management responded by saying, "It is a massive opportunity and we think not just for 'Call of Duty' and not just for 'Diablo Immortal.'"

It's also looking at all of the company's franchises for opportunities to reimagine existing IP on the mobile platform, management said.

As it relates to esports, we continue to believe Activision's prior and ongoing investments puts it in a position to lead the charge. But while we do not weigh this as heavily into our thinking in the near-term due to the ongoing investments required before it begins to impact the bottom line, we believe the coming second season of the "Overwatch League" will aid in sustaining excitement for the eventual launch of "Overwatch 2," while the inaugural season of the "Call of Duty League" stands to benefit from the current momentum being seen from recent title launches.

All in, when we initiated the name Wednesday here, we told members, "discipline, no matter how strong our conviction, must be maintained. As we are initiating this name ahead of tomorrow's earnings, an event that can be volatile for any name, we will keep our buy relatively small at just over 1% of our total portfolio."

Because of this discipline, we now have optionality and with our view on the stock and conviction in the underlying fundamentals being unchanged following the release and commentary from management, will look to take advantage of the weakness in coming days to increase our exposure and reduce our overall cost basis. We reiterate our $62 price target and One rating.