Activision Blizzard (ATVI) confirmed it is facing a transition year in 2019 with its 1Q19 earnings report and guidance update.  First quarter earnings exceeded Wall Street expectations but management guided 2Q19 below current estimates and maintained full year guidance issued earlier this year.  The combination of exiting the Destiny franchise, tough competition from free-to-play games, a limited new release schedule at Blizzard, and a decision to increase investments in existing franchises means that earnings are under pressure this year.  Key to the outlook for ATVI is whether 2019 proves transitory or is the beginning of sustained period of slower growth.  Given the large and growing global video game market, management’s excellent track record, and a strong group of leading game franchises, Northlake is willing to give ATVI shares the benefit of the doubt and wait for late 2019 and 2020 catalysts.

While we wait for new games from the company’s Blizzard division and the strategic direction for the massive and critical Call of Duty franchise, we take comfort in the trends at the King mobile gaming division.  King publishes the massive Candy Crush game series.  Despite being on top of mobile game charts for years, recently growth in users and revenue has reaccelerated.  King’s strength is especially important to ATVI as management ups investment in the Call of Duty, Hearthstone, Overwatch, and Diablo game franchises.  ATVI has been hurt by the rise of free-to-play games like Fortnite and Apex Legends.  Management has correctly identified the importance of publishing premier games with ongoing content updates.  This is more important than ever as gamers have become accustomed to constant high quality updates to game play and the industry has become reliant on monetizing games through these updates.  Last quarter our earnings summary noted the following and this remains the case today:

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.

There is no guarantee that ATVI’s next wave of games coming later this year and next year will prove popular and improve engagement and monetization.  However, historical growth has been excellent and management has continuously developed and sustained new franchises, so we believe it will pay to wait.

ATVI shares currently trade at 22x and 19x 2019 and 2020 estimated earnings respectively, below the long-term average multiple in the low-to-mid 20s.  As the 2020 outlook comes into clearer focus with new game launches, investor confidence should rise.  Typically, ATVI also beats its guidance.  There is no guidance yet for 2020 but we think the street has modeled conservatively based on general management commentary.   A return to 22x 2020 earnings offers 20% upside for ATVI shares.  Should 2019 and 2020 earnings exceed current estimates, upside is greater.

The path ahead the next couple of quarters for ATVI could be choppy with few catalysts but we think the payoff could be large and current valuations near historical lows protect downside while we wait.

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.