Supernova's Winning Pick for Virtual Reality: Activision Blizzard Inc.

By Markets Fool.com

Editor's note: This article was originally published for Motley Fool Supernova members in March 2016. Activision Blizzard was the winner of March's Supernova Explorer 1 mission for virtual reality. The following write-up was the research on Activision Blizzard provided for the mission.

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Running time: about 3 minutes. Scroll to bottom for transcript.

I'm not sure I know a bigger fan of games than Supernova Chairman David Gardner. He hosts a regular board game competition at Fool HQ. He's a regular contributor on ourComputer & Video Gamersdiscussion board. He buys almost every major new video game that comes out and like me, has spent an unconscionable number of hours playing Hearthstone. There's even a rumor that David is the proud owner of every major game console from the Atari 2600 to the Xbox One (the Atari 2600 made its debut in 1977, by the way).

Of course, video games are far more than just glorious pastimes for David, me, and dozens of Fools I know personally. Video games are big business. Just check out these statistics from the Entertainment Software Association (ESA), a trade group that's responsible, among other things, for the massive E3 video game exposition that takes place in Los Angeles (David and I have been twice).

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Source: Entertainment Software Association.

That massive audience translated into $15.4 billion spent on video games in the U.S. in 2014 alone. And the lion's share of that massive pie went to Activision Blizzard (NASDAQ: ATVI), the largest and, in this Fool's opinion, best video game publisher on the planet. If you're looking for the best way to play the rise of virtual reality, why not invest in the company that, year-in and year-out, produces some of the most highly rated and most popular video game content across every platform?

A winning model

Bobby Kotick and business partner Brian Kelly bought a 25% stake in a nearly insolvent video game company back in 1990; Kotick became the CEO in early 1991. From their initial $400,000 investment, Kotick and Kelly set out to build a thriving video game publisher that focused on bringing top talent and intellectual property under their umbrella, while striking a balance between creative independence and financial prudence. That formula built Activision into the $22 billion juggernaut it is today. Kotick remains the CEO 25 years on, with a substantial amount of his personal wealth invested in the company through a limited partnership entity he still manages with Kelly.

Activision's blockbuster franchises likeCall of Duty,World of Warcraft,Destiny, andDiabloroutinely top the annual best-seller charts. And even though Activision just edges out video game rivalElectronic Arts in annual revenue, it clobbers EA when it comes to profitability. In 2015, Activision generated $1.3 billion in operating profits, whereas EA generated just $761 million, in spite of a comparable top line. That disparity is mostly thanks to Activision's diversified revenue model that relies increasingly on digital and subscription sales (versus one-time game sales) -- Activision generates profit margins EA can only dream about.And whereas EA's profits tend to be inconsistent and lumpy (owing to its more hit-driven model), Activision generates steady profits and substantial free cash flow, more than $1 billion in 2015 alone.

Here are the three main drivers that I think will propel Activision's business (and its stock price) over the next few years.

Driver 1: digital expansion

For most of the past three decades, video games were predominantly distributed via cartridges, floppy disks, and CDs, available for purchase either at video game retailers, electronic stores, big box retailers, or through direct mail. The Internet, and more specifically, the expansion of broadband connectivity, has changed the game in recent years. Today, video gamers can download not just ancillary content like new maps, levels, or weapons but entire games using Amazon.com, Valve, Battle.net (Activision's online gaming platform), or through the game consoles themselves.

By cutting out the middleman and avoiding the used game market completely (which stifles industry sales), publishers like Activision have been able to keep more of the rewards from their creations. Case in point: Activision's digital revenue -- the sales generated from online subscriptions, game downloads, upgrades, and in-game content -- grew 20% in 2015 and represented a 57% share of the company's total revenue. That marks the first time Activision's digital revenue exceeded its retail revenue, an important milestone and a major tipping point for Activision and the video game industry at large. How has that affected Activision's profitability? Activision's gross margin has increased from the 50% level several years ago to nearly 70% over the past couple of years. I expect Activision's margins to continue to march higher, as it continues to move from lower-margin hardware distribution and retail sales to a more digital future.

Driver 2: mobile engagement

Other than the popular (and addicting) Hearthstone, which, according to some estimates, has more than 30 million players, Activision has largely steered clear of the growing casual and free-to-play mobile game market. That is, until this past fall.

Like many investors and Activision fans, I was surprised (shocked is probably the better word) when Activision announced back in November that it was acquiring King Digital, the maker of popular mobile games like Candy Crush and Farm Heroes, for a king's ransom of $5.9 billion. For some uncomfortable context around that number, that's an almost 50% premium to whatDisneypaid for Lucasfilm back in 2012 -- which leads to an even more uncomfortable thought: Candy Crush is worth more thanStar Wars?

Source: King Digital.

To Activision, the answer is probably yes.

Mobile gaming is the fastest growing segment of the video game market, with an estimated size of $36 billion today that's projected to grow to $55 billion by 2019. By acquiring King Digital, Activision now enjoys dominance in mobile gaming, to go along with its leading position in PC and console gaming.

King has 474 million monthly active users -- that's more active users thanLinkedInorTwitter-- and 133 million daily users playing 1.4billiongames per day. King owns two of the top five grossing games on the Apple App Store. And like Activision, it has demonstrated its ability to develop franchises with deep user affinity and staying power.

Far beyond just a category killer, King diversifies Activision's revenue and gaming portfolio; enhances Activision's ability to reach more players in fast-growing regions such as Asia; and perhaps most importantly, provides a proven path to getting more of Activision's less-mobile-centric franchises in front of the eyes of the casual gamer. The cross-selling and promotional opportunities between the two companies could alone be worth billions.

Plus, Activision is also acquiring 1,600 "incredibly talented" people, as well as 12 development studios across Europe, Asia, and the U.S. Of those 1,600 people, none is more important than Riccardo Zacconi, King's co-founder and CEO, who signed a long-term contractual commitment with Activision and will continue to run King as an independent operating unit. That's been Activision's approach for a long time: attract and retain the best creative talent in the business and allow it to flourish independently, inside Activision's capital-rich ecosystem. It's the same tack taken most recently withDestiny, Activision's very successful and highly acclaimed new franchise, which was developed by Bungie, the creative studio behind the uber-popular Halofranchise.

Finally, the $5.9 billion price tag isn't all that much when you start really crunching the numbers. King generates $2 billion in annual revenue and nearly $600 million in annual free cash flow. This is a very profitable business, and Activision isn't really paying all that big of premium: $18 per share, or about 6.4 times King's estimated 2015 adjusted EBITDA. What's more, assuming the deal closes later this month, Activision expects King to add about 30% to its expected revenue and earnings per share in 2016 (not to mention adding a big boost to free cash flow).

But here's the kicker. Activision will be funding the purchase through a combination of offshore cash ($3.4 billion), debt ($2.3 billion), and a small sliver of unvested equity awards ($0.2 billion), which are presumably intended to incentivize King employees. Activision's use of cash and debt -- and very little equity -- signals that Activision's management thinks its stock price is still fairly or even undervalued (otherwise equity may have been the preferred option). Moreover, King's location in Ireland makes this a perfect opportunity to make use of Activision's substantial offshore cash hoard -- cash that it would otherwise have to pay taxes on were it to be repatriated back to the U.S. for other uses. It's not cut and dry, but you could almost slash that $3.4 billion by 35% -- the current U.S. marginal corporate tax rate. Finally, King finished the latest quarter with more than $900 million in net cash on its books. Taking that out of the total purchase price as well leaves Activision with an "adjusted" purchase price that's closer to $3.8 billion.

Driver 3: eSports

Finally, I remember having a conversation with Activision's Chief Operating Officer, Thomas Tippl, at E3 way back in 2009 when I first heard the term "eSports". According to Tippl, eSports, or competitive video gaming, was a market Activision was watching closely. Fast forward to today, and eSports hasn't just arrived, it's huge. According to an ESPN report last year (that's right, ESPN, the "Worldwide Leader in Sports"), more than 89 million people spent 3.7 billion hours watching eSports in 2014 -- figures that were almost assuredly bigger in 2015. Around 27 million people watched the League of Legends Championship on TV or through live streaming in 2014. That's more than the TV viewership for The Masters, and way more than the audience for the NBA Finals that year.

So it is little wonder why Activision stepped up to the plate and purchased Major League Gaming, one of the top eSports platforms, this past January. According to Mike Sepso, head of Activision's eSports segment, this was a pivotal part of his division's mandate to build "the ESPN of eSports". And commenting on Activision's most recent earnings conference call, Kotick couldn't resist drawing on another sensational comparison to illustrate the opportunity for eSports:

Last year, our Activision Blizzard games were played for over 14 billion hours, and spectators watched over 1.5 billion hours of video content based on our games. In the 2014/2015 seasons, fans of the NFL watched about 7 billion hours of nationally televised games, which is less than half the time spent engaged with our franchises. Those televised games generated approximately $7 billion of broadcast rights fees for the NFL and another $4 billion in other revenues, including sponsorships, merchandise, and ticket sales ... Our franchise today generates revenues principally from the sale of interactive content but not meaningful revenues from tournament play, advertising, broadcasting and pay-per-view, licensing, or merchandising, all of which are great future financial opportunities we are pursuing ... We think competitive gaming and the spectator opportunities connected to organized gaming competitions could provide sizable opportunities for shareholders and great rewards and recognition for our hundreds of millions of players. We continue to believe that eSports is another long-term growth pillar for the company, and our recent acquisition of Major League Gaming has accelerated our strategic plans.

Yes, Kotick is making a somewhat dubious comparison here, but it certainly illustrates how he and his team are thinking about the opportunity of eSports.

The Supernova Bottom Line

I barely mentioned the term "virtual reality" in this report -- mainly for this reason. Throughout its history, Activision Blizzard has been successful, because it's focused intensely on the quality of its content and the gaming experience. The platform hasn't mattered as much, because Activision has proven its ability to develop popular and commercially successful games on any platform -- most recently, mobile.

Virtual reality may or not become the next big video gaming technology, but rest assured, if it is, Activision will be making games for it. Just imagine strapping on a pair of VR goggles, climbing into one of those fancy VR treadmills, and jumping into the thick of a Call of Duty warzone. And you can bet there will be some epic eSports VR tournaments in the not so distant future. Activision and Major League Gaming will be there, too.

Just as it is in the entertainment world at large, content and distribution are king in the video game business, and no company occupies a higher throne than Activision Blizzard.

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Transcript:

Hello, Supernova Fools. I'm Matt Argersinger here at Motley Fool HQ's game room. Of course, you can see we've got Call of Duty on the Xbox, there. Of course, Call of Duty is one of the big games from Activision Blizzard, the biggest video game publisher on the planet and, in my opinion, the best.

They've got the best management team, certainly the best portfolio of games, and really the broadest portfolio in terms of platforms, as well, whether it's console games, PC desktop games, and of course, now mobile names.

They made a huge acquisition -- almost $6 billion actually -- buying King Digital last fall. King Digital, of course, the maker of Candy Crush. The big maker of mobile games. To get some context around that $6 billion number, that's more than Disney paid for Lucasfilm. In effect, Activision Blizzard paid more for Candy Crush than Disney paid for Star Wars.

Say what you will about it, but it's actually a pretty good deal. It brings in about 100 million more users to Activision's platform. It breaks them into mobile. It does a lot of things for the company and the price they paid, while it sounds big, is actually not as big once you really dig into the numbers. They took on a lot of debt to do the deal -- about $4 billion in net debt that they're going to have on their books -- that hopefully they can pay down some this year. So that's one risk to watch for.

One exciting thing to watch for with Activision Blizzard is that the Blizzard Publishing arm of the company is coming out with its first new franchise in something like 17 years. I'm not kidding you. The game is called Overwatch. Blizzard's been working on it for many years. It's really the first new massive role-playing game coming out of Blizzard in a very long time.

That's in beta testing, now. It's supposed to come out this summer. I'm very excited about that. I can write another leg up for Activision and another great franchise in their amazing portfolio of franchises. Of course, the Call of Duty. World of Warcraft. Destiny. The names go on and on. Overwatch's success is certainly one thing to watch with Activision Blizzard this year.

If you want exposure to the video game space and if you're interested in things like virtual reality and eSports, Activision Blizzard is the play. A great company. A company I've followed for a very long time. Love the games. Love the management team. Love the opportunity right now for Activision Blizzard.

Matthew Argersinger owns shares of Activision Blizzard, Amazon.com, Twitter, and Walt Disney. Matthew Argersinger has the following options: short October 2016 $100 calls on Walt Disney, short October 2016 $90 puts on Walt Disney, and long January 2018 $25 calls on Twitter. Simon Erickson owns shares of Activision Blizzard, Amazon.com, and Walt Disney. The Motley Fool owns shares of and recommends Activision Blizzard, Amazon.com, Twitter, and Walt Disney. The Motley Fool owns shares of LinkedIn. The Motley Fool recommends Electronic Arts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.