Activision Blizzard (ATVI) reported 1Q18 results above expectations, but provided underwhelming guidance for 2Q18. The full year outlook for 2018 was increased slightly, but still remains below street expectations. ATVI is typically quite conservative with guidance, and combined with the back-half weighted content slate compared to 2017, we expect results to surpass guidance for the full year.

Strength in the quarter was driven by in-game content sales which grew over 10% in all three segments. Both the Blizzard and King segments had strong sales, although profitability for Blizzard was limited by investments in growing the new Overwatch League (OWL). The Activision segment, especially Call of Duty: WWII, was negatively impacted by competition from Fortnite. ATVI also noted a slight benefit from earlier timing of sales compared to expectations.

Digging further into the Activision segment, excitement is building for Call of Duty: Black Ops 4. The Black Ops sub-franchise has been the most popular variant of the game to date; the expected inclusion of a “battle royale” game mode – similar to Fortnite – should alleviate some competitive concerns. Destiny 2 will launch the Warmind expansion this quarter, with a larger expansion planned for the fall. Both expansions have received praise from the Destiny community. Following up on the successful launch of a remastered version of Crash Bandicoot last year, ATVI will relaunch Spyro the Dragon this year. The ability to continue to monetize older games demonstrates the lasting value of the company’s game library and intellectual property.

The OWL continues to gain traction for the Blizzard segment. ATVI plans to add a handful of teams to the existing group of 12 by the end of the year. Interest from viewers and sponsors has been strong to date. ATVI expects to leverage the new capabilities and infrastructure built for OWL on other franchises in the near future, notably including Call of Duty. Blizzard recently launched a popular expansion to Hearthstone, with more in-game content and game modes still under development. World of Warcraft (WoW) has seen strong pre-sales for the expansion that will launch in August.

The King segment reached an important milestone in the quarter: the nascent digital advertising business reached profitability. Ad profits will ramp throughout the year before becoming a more meaningful contribution to ATVI in 2019. Key hires were made to bolster product development, marketing, and measurement capabilities. King is taking a creative approach to ads that drive engagement and monetization without negative impacts to the player experience. Ad formats that are supportive of gameplay (as opposed to disruptive) benefit gamers and advertisers alike. The two most popular versions of the crucial Candy Crush franchise remain at the top of the various app store game charts thanks to strong in-game content spending. King plans to launch new games in 2018 and beyond.

In summary, 1Q18 results demonstrated the durability of critical franchises owned by ATVI. Call of Duty struggled in 2016 only to rebound in 2017; 2018’s Black Ops 4 is expected to be even stronger and more innovative. Destiny 2 was initially plagued by gameplay issues voiced in the gaming community, but ongoing expansion content is addressing these issues and driving further engagement. WoW, Hearthstone, and Candy Crush are on a roll, and older games from the ATVI library remain in demand. Northlake sees ATVI as near fair value based on 25x 2018 EPS of $3, with upside to $80 as we move closer to 2019 EPS of $3.20.

ATVI is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.