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Is Activision Blizzard, Inc. (ATVI) a Buy?

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Activision Blizzard, Inc. (One of the most successful video game franchises in history, Call of Duty, is set for a new release this holiday season. Activision Blizzard, Inc. (NASDAQ:ATVI), the company behind Call of Duty, has been releasing a new game in the series every year since Call of Duty 4: Modern Warfare was released in 2007 and sold over 16 million copies. The most recent title in the series, released last year, grossed $1 billion in the first 15 days of release.

With Call of Duty and a few other extremely popular games in its library, is Activision Blizzard’s stock a buy?

World of Warcraft, world of profits

Along with Call of Duty Activision Blizzard also owns World of Warcraft, the world’s most subscribed massively multiplayer online role playing game, or MMORPG. Players buy a monthly subscription in order to play the game, and with 8.3 million players as of the end of the first quarter and a monthly subscription cost of about $15 World of Warcraft is a cash cow for Activision Blizzard.

The bad news for the company is that the number of subscribers dropped from 9.6 million to 8.3 million in just three months. World of Warcraft is an old game, first released in 2004, and it seems that its best days may be behind it. It still remains very popular, and likely will for quite some time given the community which exists within the game. But I would expect subscriber numbers to slowly decline going forward.

A look at profits

The company’s stock was largely flat since 2008, trading around $12 per share, but in 2013 it surged up to $15 per share. This puts the P/E ratio based on 2012 numbers at just about 15. But this doesn’t tell the whole story.

Activision is sitting on quite a bit of cash. At the end of the first quarter the company had a total of $4.6 billion in cash and investments and no debt. This works out to $4.11 per share in net cash, or a whopping 27% of the total market capitalization. This cash makes the company look far more expensive than it really is.

A better measure of profitability than net income or even free cash flow is the owner earnings. While net income was $1.15 billion and free cash flow was $1.27 billion in 2012 owner earnings came in at $1.4 billion. Here’s a table of all three values over the past 5 years:

2008 2009 2010 2011 2012
Net income $-107 $113 $418 $1,085 $1,149
Free cash flow $333 $1,114 $1,279 $880 $1,272
Owner earnings $512 $1,004 $1,143 $1,440 $1,400

Data from Morningstar

In 2008 Activision merged with Vivendi Games to form Activision Blizzard, so 2009 was the first year where the new company existed for the full year. Since 2009 net income has grown by a factor of 10, free cash flow has grown by 14% and owner earnings have grown by about 40%.

I think that owner earnings creates the most useful picture for valuation purposes, and 2012 saw a slight decline in this value. Owner earnings for the first quarter of 2013 were $542 million, up from $426 million in the same period a year ago, so this decline doesn’t seem to be a serious problem.

Valuation

So how much is a share of Activision Blizzard worth? Well, there’s the $4.11 per share in cash and the $1.25 per share in owner earnings from 2012. Subtracting the cash yields a P/OE ratio of about 8.7. I’ll do a simple discounted cash flow calculation to estimate the fair value of the stock, using a discount rate of both 12% and 15% to define a fair value range. I’ll assume that owner earnings grow by 6% annually for the next 10 years and by 3% annually in perpetuity after that. Using these parameters I arrive at a fair value range of $17.06 – $21.71.

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