Activision Blizzard (ATVI) reported strong second quarter results with sales and profits substantially higher than expected. While guidance for the third quarter and full year were raised from previous levels, it appears investors expected a larger increase. ATVI has typically provided conservative guidance in the past, and this appears to be the case again this quarter. The stock reacted with a mild decline.

Strength in the second quarter was driven by the ongoing shift to digital sources of revenue. Despite not releasing any major games in the quarter, ATVI collected highly profitable in-game revenues of nearly $1 billion from existing titles. This is a testament to the strength of ATVI’s strategy of increasing player engagement by offering digital add-on content across a large library of strong franchises. ATVI is also able to leverage their library by releasing remastered versions of popular games, as demonstrated by the successful re-launch of Crash Bandicoot in the second quarter.

King, ATVI’s large, recent acquisition in mobile gaming, was the weakest segment in the quarter, with profits below expectations as monthly average users declined from both the previous year and previous quarter. We remain excited about the mobile advertising opportunity in the King segment. Engagement remains strong with players spending an average of 35 minutes per day in mobile games, more than the average time spent in either Snapchat or Instagram. In the short term, ATVI announced a partnership with Facebook (FB) to deliver display ads into mobile games. This buys ATVI time to continue the push towards delivering premium video ads on mobile devices. Northlake believes King is right to focus on protecting the user experience while testing various ad formats instead of rushing to monetize games as quickly as possible. King continues to see success from launching live operations and new features in existing games, as demonstrated by bookings per paying user rising for the 8^th quarter in a row to a new record.

ATVI made good progress towards the upcoming third quarter launch of the Overwatch League. So far, 7 teams for the new e-sports league have been purchased for $20 million each. ATVI is pleased with the quality of the new team owners, which include several owners of traditional sports teams. Revenue from team sales will be recognized over several periods and marketing expenses to launch the league will likely offset any benefit in the near term. However, we believe the Overwatch League will likely make material contributions over time. ATVI noted that there are currently 30 million Overwatch players, providing a large potential e-sports audience even if no one from the general public becomes interested.

Looking forward to the second half of 2017, ATVI will release major titles including Destiny 2 and Call of Duty: World War II. Both games are receiving positive attention leading up to the release dates and are expected to sell very well. However, as seen in the reaction to the recent quarter, elevated expectations can create downside risk if either title does not perform well. The upcoming release of a remastered version of Starcraft should also contribute, similar to the second quarter contribution from Crash Bandicoot.

In summary, ATVI continues to benefit from secular tailwinds as revenue increasingly comes from highly profitable digital sources like add-on content, full game downloads, and mobile game ads. Investor expectations have recently surpassed the typically conservative guidance from ATVI, but Northlake expects further upside as sales and profit margins expand. Additionally, untapped opportunities in e-sports, TV and film, and consumer products should drive earnings estimates even higher. As investors begin to evaluate ATVI on 2018 earnings of $2.50 or above, using the current 2017 P-E multiple of 29 could push shares toward $73.

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.