Activision Blizzard, Inc. (NASDAQ:ATVI) is having a rough go of it lately. Activision stock has pulled back 10% after hitting an all-time high last week. The culprit in the weakness seen in Activision stock appears to be the runaway success of Epic Games’ Fortnite Battle Royale.
But that may not be all that’s going on. Activision stock had rallied sharply before the recent decline, and moved to a point where valuation looked stretched. ATVI still trades at 29x its EPS guidance for 2018. And yet the growth posted of late simply doesn’t seem strong enough to support that type of multiple.
Admittedly, there are long-term reasons for optimism. And I’ve been too cautious on Activision stock in the past. Back in December, I called out three potential drivers that could drive Activision stock higher and all three remain intact.
Still, with ATVI gaining another 13% so far this year, the rally looks too far, too fast. And the recent decline could continue – even if the impact from Fortnite proves to be short-lived.
The Growth Problem for Activision Stock
For all the optimism toward Activision Blizzard Inc, it’s not as if growth has been all that impressive. Between 2010 and 2015, non-GAAP net income actually declined. 2016 saw a big jump from the acquisition of King Digital Entertainment.
The company’s recapitalization through a share repurchase with former parent Vivendi SA (ADR) (OTCMKTS:VIVHY) was a huge success. But the operating business simply hasn’t shown that much growth.
Indeed, in 2017, adjusted EPS rose 1.4%. Free cash flow increased 2%. And it’s not hard to see why. For all the talk about eGaming, new releases, and digital downloads, Activision Blizzard remains significantly reliant on legacy franchises.
Per the 10-K, 66% of revenue still came from four games: Call of Duty, Candy Crush, World of Warcraft, and Overwatch. Figures in the filing suggest those four games, as a group, grew revenue just 1-2%.
Two-thirds of the business is coming from games that don’t offer much in the way of growth. WoW has been declining for years. (Concerns about its trajectory were a key reason why Activision stock was rangebound for the first few years of this decade.)
Call of Duty remains a dominant title, but growth prospects are limited. Activision has revitalized Candy Crush to its credit, but at some point it seems likely that game will fade.
Outside of Overwatch, then, Activision’s growth prospects are reliant on basically one-third of the business. That creates quite a bit of pressure. And if Fortnite can divert even some of Activision’s engagement, the big four games could see growth turn negative.
The Long-Term Bull Case for Activision Stock
Looking forward, there admittedly is more reason for optimism toward Activision stock. 2018 guidance looks better, with the company targeting adjusted EPS of $2.45. That suggests 10%+ growth year-over-year – and Activision’s guidance is notoriously conservative. (Activision originally guided for $1.70 in 2017 EPS; the actual figure was $2.21.)
Digital delivery should help margins, as Activision keeps money given to retailers like GameStop Corp. (NYSE:GME) for in-store sales. Overwatch League could add as much as $0.29 in EPS, according to analysts at William Blair, even if that benefit will take a few years to achieve.
Candy Crush was expected to decline – one reason Activision was able to make the acquisition at such a cheap price – but trends at Zynga Inc (NASDAQ:ZNGA) and other mobile players show that franchises have a longer shelf life than some feared.
There’s incremental revenue from in-game play. Advertising revenue presents another opportunity. Activision is paying down ~$1 billion in debt this year, which will lower interest expense and add a few more pennies to EPS.
Activision Blizzard Inc should grow. But I’m skeptical it will grow enough to support a nearly 30x EPS multiple. Electronic Arts Inc. (NASDAQ:EA) trades at about 25x 2018 EPS estimates, backing out its net cash.
Take-Two Interactive Software, Inc (NASDAQ:TTWO) trades at 18x next year’s consensus, excluding its cash. Some of the long-term tailwinds benefiting Activision are helping those companies too – and yet Activision stock is more expensive.
Again, I’ve been too cautious so far on ATVI, which is just a few sessions off from trading at an all-time high. But I am skeptical there’s quite enough growth here.
The intense reaction to Fortnite seems to show that conviction isn’t quite what it used to be, either. Activision is a great company, and it will grow. That doesn’t necessarily mean Activision stock is a buy.
As of this writing, Vince Martin has no positions in any securities mentioned.