Zynga Inc (ZNGA), Electronic Arts Inc. (EA), Perfect World Co., Ltd. (ADR) (PWRD): What Will They Do?

Some analysts suggested that Activision Blizzard, Inc. (NASDAQ:ATVI)’s stock rose recently because of their strong earnings, or because of perceived improvement in the gaming industry. However, I would argue that the company’s statement that they are considering, “substantial stock repurchases, dividends, acquisitions, licensing or other non-ordinary course transactions” is the real reason for investor enthusiasm around the stock. The big question now is, what will they do?

Zynga Inc (NASDAQ:ZNGA)Only One Of These Makes Sense
If Activision-Blizzard decides to make an acquisition, Electronic Arts Inc. (NASDAQ:EA) would be the big fish in the pond. The company has several great brands in the Madden, NCAA, Sims, Crysis, Assassin’s Creed games as well as over 250 mobile games. The problem is, their cash flow generation is wildly inconsistent. In two of the four quarters last year, the company actually reported negative operating cash flow. While $938 million of net cash looks good, compared to a market cap. of over $5 billion, this purchase would need to significantly add to earnings to make sense. The other challenge would be getting anti-trust clearance since Activision-Blizzard and Electronic Arts co-dominate the console industry.

Jumping both feet into the mobile and casual gaming business would mean an acquisition of Zynga Inc (NASDAQ:ZNGA). In the last few years, they have generated positive free cash flow. However, in the last four quarters, Zynga reported a net loss each time. The good news is, Zynga has attractive mobile titles like Cityville, Farmville, and Words With Friends, and $1.577 billion in net cash on the balance sheet. However, the company is expected to lose money the next two years. Even at half the market cap. of Electronic Arts Inc. (NASDAQ:EA), Zynga Inc (NASDAQ:ZNGA) doesn’t seem to bring nearly enough to the table.

One acquisition that could make sense is, online gaming specialist Perfect World Co., Ltd. (ADR) (NASDAQ:PWRD). The company has 12 online multiplayer games currently, just released 3 new games, and has 3 new games in development for 2013 and beyond. The company’s primary user base is in China, where Activision-Blizzard only gets about 9% of their revenue. In addition, the company generated about $154 million in positive free cash flow last year, and has $423 million in net cash on the balance sheet. The stock seems cheap at just 5.5 times projected earnings, and analysts are calling for 10% EPS growth in the next few years. Since Perfect World Co., Ltd. (ADR) (NASDAQ:PWRD) carries a $550 million market cap. and $423 million of that is cash and investments, Activision-Blizzard would get a lot of company for very little.

What They Probably Should Do
While potential acquisitions are interesting to talk about, I’m a much bigger fan of companies either buying back shares or paying better dividends. If Activision-Blizzard wants to reward shareholders on a permanent basis, either a large share repurchase plan, or a higher regular dividend would be the way to go.

I know that many people get excited about special one-time dividends, but these are short-term events. A one-time dividend is great if you bought before it was announced, but usually the stock’s value drops back to earth once the ex-dividend date passes. Large share buybacks and regular dividends provide a longer-term benefit.

Buyback Or Dividend Increase?
With 1.115 billion shares outstanding, what could the company afford if they instituted a share repurchase program? In the last year, the company’s cash and investments increased $850 million. At current prices, this amount would repurchase about 59 million shares. This would be the equivalent of 5.29% of the company’s diluted share count. The problem with this approach is, the stock is already more expensive compared to where it was most of last year. It seems this would just be another example of management waiting for the stock to rise and then repurchasing shares.

The best idea might be a boost in the company’s regular dividend. While this requires a longer-term commitment, Activision-Blizzard can afford this action. In the last four years, the company has generated over $1 billion in free cash flow on average, but paid out less than $200 million in regular dividends. In the company’s current quarter, their free cash flow payout ratio was just 17.06%. If the company boosted their payout to just 40% of free cash flow, this would mean total dividends of $0.36 per year versus the current payout of $0.19. This would increase the company’s yield to 2.52% at current prices, and still leave Activision-Blizzard a lot of flexibility.

In the end, the only phrase that scares me in Activision-Blizzard’s comment about their plans is the part about potential, “significant debt financings related thereto.” It’s one thing to spend cash on the balance sheet to reward shareholders with a higher dividend or share repurchases. We get into a whole different situation if the company decides to make an acquisition that requires debt financing. I have confidence that the company’s management will make the right move, but I’m a little worried that this stock price increase could be short lived. Only a large share repurchase or higher regular dividend would be guaranteed to create long-term value for shareholders.

The article What Will They Do? originally appeared on Fool.com and is written by Chad Henage.

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