Activision Blizzard (ATVI) reported record 4Q18 earnings in line with expectations despite sales coming in weaker than hoped. Guidance for 2019 was poor, with sales now expected to be 13% below previous consensus estimates and earnings of $2.10 coming in 16% below consensus. Along with the disappointing guidance, ATVI announced a layoff of 8% of employees as part of a restructuring plan aimed at improving overall efficiency and increasing the pace of content releases for crucial franchises. The stock had fallen over 40% in the months before this report due to several issues including increased competition, a rapidly evolving industry, and the unexpected news of ATVI parting ways with Bungie and the Destiny franchise intellectual property rights. Shares of ATVI staged a relief rally upon learning the latest updates, signaling that investors likely expected the news to be worse than it was.

The sales shortfall in the quarter was primarily attributed to a lack of in-game spending on Call of Duty: Black Ops 4 (CoD), Overwatch, and Hearthstone. ATVI noted that in-game spending on CoD improved with a new content launch late in the quarter, while the weakness from the Blizzard segment was expected to take longer to improve. The Blizzard segment also faces a tough comparison in 2019, with no major frontline releases planned to build on the strong performance of last year’s World of Warcraft (WoW) expansion. The ongoing weakness at Blizzard is the primary cause of the sales guidance shortfall. On an encouraging note, player engagement remains high for Blizzard’s franchises despite the current lack of in-game spending.

The King segment stood out as a positive among the many concerns in the quarter, with the slowly ramping mobile advertising business finally starting to contribute meaningful results. Ad bookings grew compared to both 4Q17 and 3Q18. King launched an updated version of the popular Candy Crush franchise that has gotten off to a fast start, leading monthly active users to grow sequentially from last quarter for the first time since ATVI acquired King.

Northlake believes ATVI is making the right changes with the restructuring plan. Removing redundancies in back office and consumer marketing positions while hiring more game development talent will help reduce costs and allow ATVI to create more expansion/add-on content for existing franchises. In turn, the increased pace of content releases should drive higher engagement and in-game spending. Gamers are playing fewer games, and spending more time and money with each game. The restructuring plan allows ATVI to benefit from this industry-wide trend. An additional benefit of hiring more developers is the ability to make quicker fixes to games in the event that the gaming community dislikes aspects of new launches, as exemplified by the initial problems surrounding Destiny 2 at launch that took a long time to correct and partially led to the split between ATVI and Bungie.

ATVI is working through several challenges amid increased competition and a quickly changing industry. Free-to-play games with in-game spending such as Fortnite have become much more popular. Competitors are evaluating new business models and delivery technologies around streaming and subscriptions, such as Electronic Arts’ EA Origin plan. Gamers are playing fewer games, and playing them longer, which benefits deeply engaging franchises such as Take Two’s Grand Theft Auto and Red Dead Redemption. Mobile game developer Zynga has demonstrated the strength of a business model focused almost exclusively on adding live services to existing franchises instead of constantly launching new titles. At the same time, gamers have become more influential in causing changes to games when they don’t like particular aspects, forcing game companies to be nimble in responding.

Northlake expects ATVI to improve in all these areas as part of the restructuring plan. ATVI should continue to lead the industry in developing esports, with the popular Overwatch League beginning its second season and CoD expected to develop a new league soon. Thanks to King, ATVI should also continue to lead on developing a strong mobile advertising business. While 2019 appears to be a difficult year, Northlake doesn’t believe it makes sense to sell ATVI at current depressed levels. Looking ahead, if ATVI struggles to get back on track, Northlake could consider selling shares as they approach $50. However, Northlake expects ATVI to climb back above $50 in the medium-term reflecting roughly 19x 2020 EPS of $2.59, with longer-term upside potential to get back into the $60-$80 range as 2021 and 2022 EPS expectations of $3.00 and $3.68 respectively begin to appear more achievable.

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. Steve is portfolio manager and managing partner of Entermedia, long/short equity hedge funds focused on media, entertainment, leisure, communications, and related technologies.