Investing in Video Games Part 1: Activision Blizzard is a Bad Bet


Hello fellow life forms... yes I was watching Big Bang Theory before writing this... I decided to start a short investment series on publicly traded video game companies. As many of you know, several video game related companies are traded on the open market but for many people the financial jargon is unfamiliar. Even if you had a business degree, it is still hard to determine what is or is not a good investment else every fund managers and advisers would be filthy rich, yet most make less than average wage.

As I have stated in previous podcasts I have been running an investment company since 2008 and I figured I would write a bit about investing to help people get their feet wet or just to answer some questions. Please feel free to ask questions below.

Disclaimer

I am not a paid financial adviser nor would I ever reduce myself into such a job. Why? Because the premise of being a "financial/stock/money adviser" its an oxymoron. If you were good at picking stocks/bonds/commodities/investments you wouldn't need a job doing so. You would be filthy rich just doing it for yourself. I am writing this series for two reasons, because I want to further the GameTangents.com website and because frankly I hate unscrupulous people and unfortunately most everyone in the financial industry is suspect due to their "middle man" status.

Investment Rules I Believe In:

  1. If you don't get it, research. If you still don't get it, avoid.
  2. Success is inflation plus 5%.
  3. The investment world is a playground for big money. The odds are not on your side.
  4. Learn how to hedge.
  5. Never trust a stranger for investment advice, refer to the disclaimer above.

Point #1 should be obvious. You probably heard of the acronym KISS (keep it simple, stupid), this point is slightly better advice. Since no one understands everything, it makes more sense to at least try to learn else you will never understand anything. Do some research. What that entails depends on the investment in question and since we plan to focus on video gaming stocks, you should get familiar with the various companies, what they sell or what services they offer, who runs them, their comparative financial performances, and what they are working on. Other important factors to consider are the economic conditions of major markets and industry trends. As a useful reference, here are some revenue estimates for video game specifically by country:

Asia: $34 billion
China ~ $17b
Japan ~ $12b
South Korea ~ $3b
North America: $22 billion
USA ~ $20b
West Europe: $15 billion
Germany ~ $3.5b
UK ~ $3.5b
France ~ $2.5b
Italy ~ $1.5b
Spain ~ $1.5b
A
South America: $3.5 billion
Eastern Europe: $1.8 billion Australia: $1.2 billion Middle East & Africa: $1 billion



Point #2 is just a general rule of thumb. Since investing is supposed to make money, it only makes sense that you have to out-perform the general inflation rate else you will be losing money. I picked 5% because 3.5% is easily achieved through risk free treasuries. 5%-6% is easily achieved through relatively low risk bonds. And finally 8%-9% is what you make if you own and self manage real estate when you account for income and capital gains (rise in property value). So in theory, you would be successful 95% of the time if you simply own and rent real estate but its never really that simple so I will come back to real estate in a later article.

Point #3 is a realization I made over years of watching and researching stocks before I formed my own company. The bottom line is that the big guys have a lot of money... so much so that when they act, market valuations move with them. If you don't believe me, just check the institutional ownership of most stocks and you will find that most large companies are 95% institutionally owned. What this means is that business valuations (aka stock price) is more dependent on what these guys believe than the actual performance of the business itself. That said, most of the time, institutions make decisions based on business performance but this is definitely not always true. Remember, these companies are just run by regular people, most of which without high level educations nor above average intelligence. The only real qualification to run a fund is whether or not you can convince people to buy your fund. Let me give you an example of valuation gone wrong; Imagine that there are 3 stocks to pick from, Sony, Microsoft, and Nintendo. Now imagine that the only people who have money are the Sony Playstation fan-boys/girls. If we asked these folks which company they wish to invest into, how do you supposed most will invest? A big majority will believe, based on their personal attachment, that Sony is the best investment because they love their product and they would buy it themselves. Chances are they know nothing about the internal working at Sony nor do they know anything about the executives running the show. Since they mostly buy Sony stock, the price of Sony stock will be much higher than the other two regardless of real business performance. You would be surprised at how fallible fund managers and investment advisers really are although you can always refer to the stock market in 2008/2009 as proof. Further, some financial professionals (not all) are dirty and find ways to influence the market using client money, for their own personal benefit. But generally speaking, advisers and managers are just salespeople and they sell their service to make money from you rather than from their own performance. You cannot depend on them to be objective and since they control such a huge portion of the public investment market, it follows that stock prices will be irrational very often. This is what is meant by point #3. So what does one do when you cannot depend on the market in general to price things fairly? See point #4.

Point #4 is possibly the most important one. Hedging, a word derived from hedgehog spines, has similar functionality in the investment world. The spines on the hedgehog are a protection mechanism against predators. In the case of the investment world, the predators would include anything that can work against your investment. Hedging on its own is a very broad catch phrase and has little meaning without specific application. For instance, what is a hedge fund exactly? The definition used to mean a fund that invests in such a way that they mitigate investment risk but as we all know, based on their collective performance over the last 60 years, this is simply not true as they barely perform as well as the general markets if not worse after fees. The reason they continue to get away with calling themselves "hedge" funds is because hedging has a very broad definition. Almost anything can be considered a hedge. For instance, hedge funds believe they are hedging simply by having a huge diverse portfolio of stocks... they claim that such a strategy mitigates the risk of any single company going out of business but as we all know, such a strategy is silly because it also mitigates the benefit of active management to begin with. You might as well invest in a generic index fund that has a little of every stock than one being managed for high fees that does the same thing. Anyway, as I have illustrated, hedging can mean anything if you phrase it the right way. Here are the definitions we are going to use for Hedging and Risk:

  • Hedging: A hedge is a financial action that limits the potential downside risk of a specific investment. A hedged portfolio assumes a market-wide risk and should be hedged uniformly for that risk.
  • Risk: A risk is a measurable threat to a financial investment.

Point #5 was already covered in the disclaimer. The fact is that there is no point in trusting someone to invest for you when they themselves have not succeeded with their own money. There are exceptions to this rule but you would need to know the individual on a very personal level to make that determination so I would operate as if it were always true.

Lets pause on the investment primer and look at a real company.


Activision Blizzard Inc.

GTan Rating: 2/5 (avoid)
Morningstar Rating: 1 star (out of 5)
S&P Capital IQ Rating: 3 star (out of 5)
Reuters Rating: Hold
Smart Consensus Rating: Hold

Share Price: $23.54
Valuation:
$16.89 billion
Cash on hand: $4.2 billion
Debt: $4.32 billion
Yearly Revenue: $4.29 billion
Yearly Net Profit: $707 million
Earning Per Share: $0.94
Price/Earnings: 25.00
Dividend Yield: 0.85%
Dividend/Share: $0.20
3 Year Performance: Stagnant
5 Year Performance: Slowly Shrinking
10 Year Performance: Inconsistent Due To Blizzard Purchase
Earning Consistency: Very Volatile
Risk Level: Very High Risk
Total Executive Compensation (2012): $92.6m (10% of company profit)
Total Executive Compensation (2013): $26.0m (2.5% of company profit)

You have to be careful with Activision Blizzard because their 10 year financial statement is extremely skewed by the Blizzard purchase back in 2008. Its important to note that Activision paid a healthy $8.2 billion for Blizzard of which they diluted their shareholders more than 100%. Whether or not that purchase has provided increased profit to previous Activision shareholders is a matter of opinion. Certainly, the monthly pay structure of World of Warcraft has provided Activision with a more consistent revenue stream than standard released games that are normally front ended. Consistency is good however Blizzard asset revenue has been shrinking regularly since 2010. Interestingly, Activision assets have been blistering hot since then with Call of Duty setting sales records a few years in a row and Skylanders making a huge comeback. I would argue that Activision investors would be up a lot more if the Blizzard purchase had never happened but that is an argument for another day and it remains to be seen if Blizzard is able to continue their success into the future because if they did, then eventually the deal will pay off. We do know that Robert Kotick made an enormous amount of money with the deal because his pay was clearly based on both revenue and the amount of assets he and the other executives are managing regardless of performance. The bottom line is that Activision Blizzard has not grown profit much at all over the last 5 years. In fact, revenue has been down since 2012 and revenue the last 4 quarters is almost exactly the same as it was in 2009. Their last quarter was very good but the problem with Activision Blizzard is that they always hype their future earnings. Interestingly, no one believed the hype between 2007 and 2012 but at the beginning of 2013 all that changed and their stock has skyrocketed to new high despite no meaningful change in the business itself. One major change however is they started a huge buyback campaign eliminating about 25% of their stock from the market.

Okay so why do I rate them at 2/5? Two major reasons, #1 I don't trust them (well... less than most). Clearly, there is a lot of self interest by the executive wing and their salaries are incredibly high reaching about 10% of all earnings in 2012 which is generally unheard of in the stock market. To put things into perspective, the staff at Microsoft, a vastly larger and more complex company with over $22 Billion in net earnings only took about 0.1% in executive compensation and that was a record high in 2013. Even at the reduced 2013 compensation, Kotick and crew took home about 2.5% of all earnings despite a slowing business and this does not count any earnings they made from their 25% ownership into the company itself through their external partnerships. Again lets compare that to another huge company in Exxon Mobile; their executives barely took home 0.23% of earnings or 10 times less than Activision executives based on actual profit. Berkshire Hathaway, a $330b company, pays their executives less than $2 million a year. Mega search engine Google only coughs up 0.25% of earnings.

Reason #2, stagnant performance and bad decisions historically. Lets face it, their financial performance is not very good relative to its selling price. A stock price that is 25 times earnings (aka P/E) assumes a huge amount of growth in the future beyond that of a normal company. But based on the last 5 years of numbers, we have not seen any growth at all (if it were not for the buybacks) and there is no reason to assume that this will change regardless of how one might feel about their coming releases. The fact is that WoW is still shrinking rapidly and that still makes up about 20%-25% of all Activision revenue (down from 50% back in 2010). Further, Call of Duty sales seem to have flattened as of last year and are not growing as fast as previous years. The only good news, in terms of business, is the shift to digital which has increased profit significantly since 2009. But even that seems to have flattened as margins (both revenue and net) have not improved much since 2011. On top of that, Activision has plenty of skeletons in their closet. Anyone remember Guitar Hero? This was a major money maker not too long ago as was Tony Hawk which they diluted to high hell with too many releases, until it became boring and irrelevant. I do not think that project Destiny will break any records and I think that Call of Duty is starting to shrink in popularity. This means that unless they buy back more shares or improve margins, earnings are not going anywhere. Given the high price of the stock currently, I am not sure that buybacks will do much good either especially since they barely have enough cash to cover debt.

Why 2 stars instead of 1? Despite a very low dividend, Activision has been buying back shares at a torrid pace which, in this case, is better than a dividend since they are a standard corporation and thus are double taxed. I have no doubt in my mind that their stock performance is greatly influenced by the share buybacks but this is still good for investors since it sends share value up.

Summary:
- Very high current valuation sitting at P/E 25
- Unscrupulous Executive Behavior
- Stagnant and/or shrinking revenue growth
- Stagnant and/or shrinking net earning (EPS buoyed by buybacks)
- Prime franchises seem to be losing steam in WoW & Call of Duty
+ Massive Share Buybacks (creating large EPS spike)




Thank you for reading part 1. In the next article I will cover a few more primer elements such as what to look for in a stock brokerage account, and a few options that I recommend for low cost trading. I will also cover a little about hedging against the general market which has resulted in nearly a 4,000% (yes that is not a typo) return on my portfolio since 2007. I will also cover another gaming company and maybe this time I will pick something I might actually invest into.

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