Wednesday, November 4, 2015

Analysis of Q3 Earning Release and King Entertainment Acquisition

Activision-Blizzard released their third quarter earnings last night followed by an earnings call this morning.  A few highlights from the release:  GAAP Warcraft revenue was down 5% for the quarter.  Non-GAAP revenue was down 26%.  See my post on the second quarter release for explanation of what the differences between those two are.  On a year-to-date basis, GAAP revenues were up 14% but non-GAAP revenues were down 18%.  Note that based on discussions in the slide deck that they went through in their earnings call, it appears that foreign currency is actually driving a lot of these decreases rather than any real decrease in results.

For those of you wondering how the whole foreign currency thing works, I'll use an average European subscriber to illustrate.  The subscription rate in Europe is €12.99 per month.  Last year, during the third quarter, the average exhange rate was 1.32 dollars per Euro, so last year, in the third quarter, that subscriber would have shown up on Blizzard's financial statements as generating US$17.15 per month.  This year, the average exchange rate in the third quarter was 1.11, so that same subscriber paying the exact same thing shows up as US$ 14.42, a decrease of 16%.  On a year-to-date basis, that decline would work out to 17.8%.  So that's what I'm referring to above.

Total Blizzard revenue was down 5% for the quarter with operating income down 22%.  Unlike a lot of multinational companies, the currency declines may have a bigger impact on their bottom line, because a lot of their expenses are in the U.S. in dollars, so don't benefit from the same foreign currency changes decreasing expenses as well as revenue.

Year to date, total Blizzard revenue was down 7% with operating income down 30%.

Despite those results, for Activision Blizzard as a whole, it was still an extremely profitable quarter with year to date earnings per share up more than 50% over prior year.  They are sitting at the end of September with almost $4.4 billion of cash on their balance sheet and $4.1 billion of debt, or $300 million of net cash.  Of course, the transaction with King Entertainment, which I'm going to discuss a bit more is going to cause cash to go down, and debt to go up.

One other interesting point came out of the earnings call itself.  The Company noted that they would no longer be disclosing total subscriber metrics for World of Warcraft after this quarter.  What they said on the call was that they believe there were better metrics out there for tracking "engagement."  I suspect this means that rather than information on subscribers, we'll begin to see data disclosed on Monthly Active Users ("MAU's") which is the metric that they use for most of their other platforms, along with information on play time per day per user.

Last but not least, there were absolutely no Warcraft related questions in the Q&A session following the call, which is not completely surprising given the King transaction.

King Entertainment Transaction

So in terms of the King Entertainment transaction, here are a few highlights.  The total purchase price of $5.9 billion is going to be paid using $3.9 billion of cash that they have on hand and $2.3 million of new debt (that is basically just being issued under their existing credit facilities).  They will inherit almost $1 billion of cash from King, so their cash balance following the deal should still be in the $2 billion range.

For the first six months of the year, King Entertainments revenue has been declining at a rate of around 11%.  However, their SEC filings are reported in US dollars, so they are subject to the same foreign currency issues mentioned above for Blizzard.  Their monthly active users grew at about a 3% rate over prior year.

King Entertainment is a little bit more profitable overall than Activision Blizzard.  Here is a great slide from their call this morning that shows how the two companies compare in terms of revenue and EBITDA for the previous twelve months:

Following the completion of the transaction, the combined company will have approximately $6.4 billion of debt.  However, the two companies combined generated around $1.8 billion of free cash flow in 2014, so there should be some really strong opportunities to pay down debt over the next few years.  Even at $6.4 billion, their debt stands at only 2.5x their expected EBITDA, which is a very reasonable ratio.

As further evidence, Activision Blizzard's debt was actually upgraded to investment grade by Moody's following the announcement last night.  Some very interesting comments below from Moody's in connection with the upgrade:

"Activision Blizzard's upgrade to a Baa3 senior unsecured rating reflects its leading position in the growing and fragmented gaming industry, strong diversification across multiple genres and gaming platforms, and strong track record of developing profitable and sustainable franchises with international appeal. The ratings and stable outlook take into account our expectation that management has the ability to make strategic investments to create new intellectual franchise properties to replace aging ones which face the potential risk of decline over time, and leveraging existing ones across various platforms."

The only other interesting point to note, is that unlike a typical transaction like this, there doesn't appear to be any kind of break-up fee built into the deal if the transaction doesn't close.  In the press release, they indicated that they expect the deal to close in Spring 2016 and they expect it to improve Activision Blizzard's earnings for 2016 by 30%.

So all indications are that this is a good deal for both companies.  It gives Blizzard access to a big player in mobile gaming as well as shfiting up their demographic a bit (King has a much larger percentage of female users than Blizzard, something both companies highlighted on the call).  For King, it gives them a partner than can hopefully help reignite their growth.

What will this mean for the average World of Warcraft player?  I'm sure there will be a lot of discussion on this in the coming months, but my initial reaction is probably not much.  They plan to continue to manage King Entertainment as a separate business unit, much as they do with Blizzard now.  While there is certainly some opportunities for cross promotion and increase mobile interfaces, that was something that Blizzard was working on anyway.  There isn't currently much of anything in terms of cross promotion between Activision and Blizzard, so not sure that aspect of how they operate will change adding one more party to the equation.  So while this is a great overall strategic move for Activision Blizzard as whole, it may not have much impact down in the trenches with individual titles.

One interesting data point that I ran this morning.  If you had chosen to invest 11 years worth of your subscription dollars in Activision Blizzard stock back in late 2008 / early 2009 after they acquired Blizzard from Vivendi, that $1,980 would be worth $8,400 today.  And things continue to look up for Activision Blizzard from here.

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