Activision Blizzard (ATVI) reported a much-needed beat-and-raise quarter.  Strength was broad-based with Call of Duty, Candy Crush, and World of Warcraft all exceeding expectations.  Management raised 2021 guidance to reflect the results, with a portion of the upside held back due to the shift of Diablo Immortal from 2021 to 2022.  Given current strength across the portfolio, delaying the game to 2022 is a positive as it adds more content to sustain growth beyond 2021 and grants the game’s developers more time to add all the features expected.

Stock Reaction: ATVI shares are rallying 2-3% in response to the earnings.  The stock has been very weak lately due to a lawsuit filed by the State of California concerning the company’s labor practices.  In addition, video game stocks have pulled back as engagement has softened with people spending more time out and about in a largely reopened economy.  The rise in the shares could prove to be a “dead cat bounce” but we think valuation, an improvement in management response to the issues raised by the lawsuit, and signals that the game development pipeline is intact should allow the shares to continue to recover.

Earnings Analysis:  The main discussion on the conference call related to the California lawsuit accusing ATVI of discrimination against certain classes of employees, especially women.  The suit was filed a few weeks ago and management’s initial response created a firestorm when they denied the allegations.  Employees revolted and staged a walk out.  Over the past week, management has adopted a much-improved tone and seems to be sincere in the changes they are undertaking.  Importantly, there have been senior management changes at Blizzard, where the issues are concentrated.  Thus far, management indicated they have seen no decline in game play at Blizzard titles and development of future Blizzard games remains on track.  The biggest risk related to the lawsuit and its aftermath is that Blizzard game titles to be released in 2021 and 2022 are delayed.

Positively, financial results were strong and management expressed confidence with the increase to 2021 guidance.  We were most impressed by the strength at Candy Crush.  ATVI made a great acquisition of King several years ago to establish its leadership in mobile gaming.  Mobile games have since become the driver of the video game industry.  Management also made a smart move recently to accelerate investment at King to ensure that fresh content is available monthly.  Mobile games are all about recurring spending, so an increased content cadence is smart.

Similarly, Call of Duty is also performing well thanks to a change in management strategy and increased investment.  All formats of Call of Duty including mobile, online, and packaged are benefiting from changes made by management.  The different game formats complement one another and drive monetization through synergy.

The execution by management at King and Call of Duty increase confidence that potential issues at Blizzard will handled well and the Blizzard game pipeline stays intact.  Blizzard is a key component of growth, especially in 2022 and beyond.

Also addressed on the conference call was player engagement now that global economies have largely reopened.  As expected, engagement is down sequentially.  However, thus far, the declines are less than expected by management and analysts.  This is an important factor to monitor and if current trends hold, there is further upside to 2021 earnings estimates.

Target Price:  We previously held a $115 target price for ATVI shares based on 25 times 2022 earnings estimates.  The shares currently trade at 18 times 2022 estimates, a discount on an absolute and relative basis to the stock’s history.  Coming out of this quarter, estimates for next year are flat to slightly higher.  The fallout from the California lawsuit has lowered confidence in management generally and presents challenges for the game pipeline, especially at Blizzard.  We expect ATVI to ultimately get past the current issues and achieve our $115 target.  In the near-term, it is more realistic to expect a return to the mid-$90s, which still equates to 15% plus upside. 

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.