Activision Blizzard Experiences Step Change in Shift to Digital

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Activision Blizzard (ATVI) reported better-than-expected top and bottom line 3Q17 results. The strong quarter flowed through to increases in 2017 sales and earnings guidance. Important game launches including Destiny 2 and Call of Duty:WWII appear to have gone well so far. Other key franchises such as Hearthstone, World of Warcraft, and Candy Crush continue to deliver for ATVI. Even the existing library of older titles is contributing to the strong results, with remastered versions of popular games driving renewed interest. Investors and gamers alike are excited for the inaugural regular season of the new competitive e-sports Overwatch League, which will begin on January 10th, 2018. In total, ATVI is firing on all cylinders across all three of the Activision, Blizzard, and King divisions.

ATVI released Destiny 2 during the third quarter, noting that the much-anticipated sequel to the 2014 smash hit was performing better than the original Destiny as measured by consumer spending and time spent per player. Notably, more than half of all Destiny 2 console copies sold were digital full-game downloads, representing a significant increase from the 30-40% of copies of the original Destiny. This industry-wide shift to digital full-game downloads has provided a strong benefit to ATVI and other video game producers, as they are able to collect nearly $10 in additional profit compared to physical game discs sold. Importantly, the trend seems to have accelerated beyond the estimated pace of 5% per year increases. Pre-orders for Call of Duty:WWII also consisted of a higher digital mix than prior years, although not to the same degree as Destiny 2.

During BlizzCon 2017, ATVI announced new expansions for World of Warcraft and Hearthstone. As gamers continue to spend more time playing each game, expansions and other add-on content have proven to be efficient in driving increased engagement and player spending for minimal development costs. Reflecting this successful strategy, Blizzard noted that they are investing more on World of Warcraft than ever before.

Similarly, ATVI has been releasing remastered versions of popular older titles, demonstrating the value of their massive library of intellectual property. Over time, ATVI will use these library titles to branch out into new mobile games as well. In the meantime, King Digital’s Candy Crush franchise is performing well. Tests around mobile game advertising are ongoing, with refinements being made to ad formats while ATVI builds out the necessary sales, servicing, and targeting support on the back end. Mobile ad inventory is expected to ramp up in 2018. Early success has led to growing traction among entertainment, technology, and banking advertisers in large markets such as the US and UK.

Excitement for the upcoming start of the first season of the e-sports Overwatch League is building. 12 teams, some owned by other professional sports team owners, will compete to win the fandom of the growing 35 million registered Overwatch player community. Two major sponsorships from HP and Intel represent initial success on the marketing front, with many more sponsors expected to support and benefit from the growing interest in e-sports.

In summary, ATVI’s ongoing stretch of strong execution against conservative guidance should lead to further success. With several key franchises that are just entering their prime earning periods, all three divisions of the company are poised for continued growth. Opportunities stemming from mobile advertising and e-sports initiatives will begin to be meaningful contributors in the near future. Further bolstered by a step change in the industry-wide shift to digital full-game downloads, Northlake believes ATVI can climb into the mid-$70’s as EPS grows toward $3 in the coming years.

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. 

Sticking With Small Cap and Small Cap Growth To Yearend

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There are no changes to the recommendations from Northlake’s Market Cap and Style models for December.  The Market Cap model remains on a small cap signal for the second consecutive month and the Style model favors growth for the third consecutive month.  The signals from both models strengthened slightly for December.  Client positions following the models will remain invested in the Russell 2000 Small Cap (IWM) and the Russell 2000 Growth (IWO) for a least another month.

November was a good month for the stock market that on the surface featured the continued trend of low volatility.  However, the relative performance of small vs. large cap and growth vs. value was volatile within the month with a return to rapid rotation.  For example, small caps lagged to start the month, while growth took a big hit at the end of November.  Northlake’s models are composed mostly of longer term indicators but do include trend and technical factors that are designed to pick up short-term stock market gyrations.  Overall, the models are telling us that the economy and interest rates remain favorable for stocks, arguing for an aggressive posture that favors more volatile, higher beta assets like small cap and growth stocks.

A couple of things we are watching as we head toward yearend and into 2018 are Federal Reserve policy and earnings growth.  Led by the investor interpretation of future Fed actions, interest rates have risen modestly in the past month in anticipation of continuing increases in the Fed Funds rate through 2018.  Third quarter earnings showed nice growth and investors liked what was reported but the rate of earnings growth decelerated, albeit from elevated levels, and is projected to decelerate in the future (independent of corporate tax cuts).  Market history suggests that tighter monetary policy and peaking earnings growth are headwinds for stock prices.  Northlake does not see either of these issues as a big problem looking out the next six months but we are monitoring each closely.

Last month’s fresh signals in small cap and small cap growth performed in line with the benchmark S&P 500.

IWM and IWO are 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.  IWM is used as a hedging vehicle in the Entermedia Fund.  Entermedia is along/short equity hedge fund managed and controlled by Steve Birenberg.