Activision Blizzard, Inc. (ATVI)

“In the full two years since [its 2008 creation by] merger, this company produced $4.2 billion in gross profit. That’s revenues minus the cost of sales—before all operating costs and capital investments. In those same two years, this company distributed $2.1 billion to shareholders in the form of cash dividends and share buybacks. That’s a capital efficiency of 50%. …

“In terms of price, the company’s shares trade for an enterprise value of $11 billion. (Enterprise value is market cap plus debt minus cash.) The company generates roughly $1.5 billion a year in cash from operations, which puts its modified P/E at 7.3x. This falls well below our price threshold of 10 times cash earnings.

“Is this a high-quality business? At first glance, you’d say no. Yahoo Finance reports the company’s return on assets is only 5.9%—fairly pedestrian. Its return on equity is only 6.15%—nothing to brag about. But these numbers prove you have to do your homework. You can’t simply rely on databases and computer- generated numbers to define what stocks you buy. Remember, I explained this company is the product of a recent merger. The way merger accounting works, the purchase price of the deal in excess of the net tangible value of the company being acquired gets recorded as ‘goodwill’ on the balance sheet. So when you look at this company, you will find more than $7 billion of goodwill. It’s a completely meaningless figure, except that it reduces the recorded returns on assets and equity.

“Simply take out the goodwill number (which is an accounting fiction) and you end up with a company that holds $6 billion in assets (not $13 billion). On these $6 billion in assets, it’s earning $1.5 billion in cash each year. That’s a return on tangible assets of 25%. And that’s a much more accurate representation of its business. …  And finally, for investors, this stock comes with an ace in the hole. Vivendi, the large French media company, owns more than 60% of it. Vivendi made the acquisition during the merger that created this business in 2008. It can only make its money back if the company continues to return capital. And since Vivendi controls the company, you can be certain that’s going to happen. …

“As you might have figured out by now, the company I’ve been describing is Activision Blizzard, Inc. (ATVI). It’s one of the three major video game publishers in the world (along with Electronic Arts (EA) and Take-Two Interactive (TTWO)). It has two main franchises. The first is Call of Duty, a ‘first-person shooter’ game. Players take the role of soldiers in various combat situations. The game is massively popular and allows people to play together online. This is the franchise that sold $650 million of product in five days. The company’s other main franchise is potentially even bigger. It’s called World of Warcraft. It is a massively multiplayer online role-playing game (MMORPG). Currently, World of Warcraft has attracted 11 million subscribers, who develop characters in an alternate universe. This is a whole new form of entertainment, something that wouldn’t have been possible before the advent of low- cost broadband connectivity.

“And because access to the game is sold via subscription, the margins are incredibly high. In 2010, the company sold $3 billion of products at a cost of $1.3 billion. It sold $1.3 billion of subscriptions at a cost of only $241 million. Product sales as a percentage of total sales are falling as subscription sales continue to grow. And that means the company’s gross margins are likely to expand substantially over the next few years. Given the company’s extraordinary capital efficiency, most of these extra profits will wind up in the pockets of shareholders. Action to take: Buy Activision Blizzard up to $15. Use a 25% trailing stop loss.”

Porter Stansberry, Porter Stansberry’s Investment Advisory, October 2011

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