In this chapter, ATVI
will be valued using three methods: enterprise-DCF, EP, and relative valuation.
This section starts with
the reorganization of ATVI’s financial statements. Next, the core elements of
value creation are analyzed: ROIC and revenue growth. Furthermore, the main
forecast assumptions are presented, before moving to a discussion regarding
WACC and CV. It ends with the presentation of results under different scenarios
and a sensitivity analysis.
5.1.1 Reorganizing Financial Statements
To value ATVI’s
operations, operating items must be separated from nonoperating items and
sources of financing. However, the
financial statements provided by the company mix these items. To ultimately
compute FCFF and ROIC, one must first reorganize the balance sheet and income
statement to create invested capital and NOPLAT, respectively. These variables
are derived from operating items. Exhibits 2 through 9 in Appendix 2 specify the reorganization
of ATVI’s financials, keeping as close as possible the structure provided by ATVI’s
annual reports. Beyond that, although projections are included in the
financial statements, forecasts will be exposed in section 5.1.3.
220.127.116.11 Invested Capital
Invested capital measures
the total investor capital necessary to fund operations (Koller et al., 2015).
To compute invested capital, the reorganized balance sheet (Exhibits 2 and 3)
is used. ATVI’s invested capital sums operating working capital and long-term
operating assets. Exhibit 4 shows the calculation of ATVI’s invested capital.
To begin with, operating
working capital equals operating current assets minus operating current
liabilities. Current assets include ATVI’s operating cash balance,1
accounts receivable, inventories, software development, IP licenses and other
current assets. Current liabilities include accounts payable, deferred
revenues, accrued payroll-related costs and other current liabilities.
operating assets include net property and equipment (P), long-term
software development and IP licenses, intangible assets, goodwill and other
long-term assets (net of liabilities). Software development and IP licenses are
crucial for ATVI’s ongoing operations.2
They represent the payments made to third-party developers that allow ATVI to
publish their content, and to IP holders, for the use of their IP, such as
software, music, characters, and copyrights. Additionally, they represent the
direct costs incurred for internally-developed products. Also, ATVI’s
intangible assets represent its loyal customer base, brands/franchises, and
trademarks from which the company derives competitive advantages. These assets
will be treated no differently than P: their amortization is treated as
if it was depreciation and investments in intangible assets are treated as if
they were capital expenditures. Also, goodwill accounts for a large percentage
of the firm’s assets. In 2016, goodwill increased $2,7 billion due to the
acquisition of King. This value is primarily attributable to the benefits ATVI
expects to receive from its expansion in the mobile sector, future franchises,
technology and management team’s proven ability to create games. Since the
expansion of the mobile sector and the ability to develop franchises are
necessary for ATVI to thrive, I consider goodwill an operating asset.
Moreover, total funds
invested can be calculated by summing invested capital and nonoperating assets.
For ATVI, nonoperating assets include excess cash, short-term and long-term
investments and cash in escrow.3
Finally, total funds invested can also be calculated as the sum of debt,
equity and their equivalents. Summing invested capital and nonoperating assets
yields the same value as the cumulative sources of financing each year.
Interest payable, short and long-term debt represent the company’s debt.
Restructuring reserves are considered debt equivalents. Shareholder’s equity
and operating deferred-tax liabilities (net of assets) represent the company’s
equity and its equivalents. Deferred taxes reflect the differences in how companies and governments
treat taxes. Exhibit 5 shows the net tax effect of these differences and
computes operating deferred-tax assets. I consider all deferred taxes
operational. To avoid these differences, cash-based taxes will be used to
calculate NOPLAT later on. The deferred-tax account is referred to as an equity
equivalent because it reflects the correction to retained earnings that would
be made if the firm reported cash taxes to investors.
NOPLAT is the after-tax
profit generated from operations that is available to debt and equity holders.
Only the profits generated by the firm’s invested capital are included in
NOPLAT. Therefore, interest and income from nonoperating assets are excluded
from NOPLAT. To calculate NOPLAT, the reorganized income statement (Exhibit 6)
is used. The calculation of NOPLAT is exposed in Exhibit 7.
First, net operating
profit or earnings before interest and taxes (EBIT) is calculated. EBIT equals
revenues minus operating expenses. Operating expenses include the company’s
cost of goods sold (COGS), product development, sales and marketing, general
and administrative and depreciation. Amortization expenses are embedded in
several line items of the income statement, namely within software royalties,
amortization and IP licenses, sales and marketing and general and
administrative. ATVI reports two types of amortization expenses: one related to
acquired intangibles and other related to capitalized software development
costs and IP licenses. Since all intangible assets are included in invested
capital, I consider their respective amortization an operating expense.
Furthermore, general and administrative do not include expenses related to
acquisitions. For example, in 2011, the company had an expense of $1 million
related to organizational restructuring as a result of the merger between
Activision, Inc. and Vivendi S.A. Also, in 2016, the company incurred $38
million of expenses related to the King Acquisition. Since these were one-time
events and their value will not grow with the business, I consider them
nonoperational. Additionally, in 2011, the company had a restructuring expense
of $25 million related to the discontinuation of the development of music-based
games and related reduction of headcount. Since ATVI does not expect to incur
additional restructuring charges going forward, I consider this expense
Second, operating cash
taxes are subtracted from EBIT to calculate NOPLAT. Reported taxes are
calculated after nonoperating income and interest. Since NOPLAT only
incorporates operational items, the effects of interest and nonoperating items
must be removed from taxes. To estimate operating cash taxes, I follow a
three-step process. First, I check the tax reconciliation table (top of Exhibit
8) provided by the company’s financial statements. This table reports the
breakdown of the taxes the company pays each year, as a percentage of total
taxes paid. Second, I compute the marginal tax rate. In ATVI’s case, the
marginal tax rate is the sum of the federal and state tax rates. To compute
marginal taxes on EBIT, I multiply the marginal tax rate by EBIT. Third,
operating taxes are adjusted by other operating taxes excluded from the
marginal tax rate. In this case, I consider research and development credits,
foreign rate differential and the tax benefit related to share-based payments
operational. Nonoperating taxes are computed as the difference between reported
and operating taxes. Finally, operating cash taxes are calculated by
subtracting the increase in operating deferred-tax liabilities (net of assets).
Exhibit 8 shows the aforementioned three-step process.
To conclude, NOPLAT can
be reconciled to net income. The reconciliation is displayed in the bottom half
of Exhibit 7. Computing NOPLAT in two ways will support the robustness of the
model. Therefore, NOPLAT should be the same when calculated bottom-up from net
income and top-down from revenues.
With invested capital and
NOPLAT computed, FCFF can be calculated. Exhibit 9 computes FCFF by summing
NOPLAT to decreases in invested capital. Computing FCFF in this manner is
slightly different than calculating it in accordance with Formula 3. However,
both ways yield the same result. Noncash operating expenses include
depreciation and amortization, and changes in invested capital include capital
expenditures (CAPEX) and investments in intangibles, among others. To compute
CAPEX, depreciation is summed to the increase in net P&E. Similarly, to
compute investments in intangibles, amortization is summed to the increase in
intangible assets. As a result, since changes in invested capital are
subtracted in Formula 3, depreciation and amortization included in “Noncash
operating expenses” offset depreciation and amortization used in the
computation of CAPEX and investments in intangibles. This adjustment was made
because current software development and IP licenses are included in working
capital, and to compute investments in intangible assets, the amortization of
all intangible assets is used. This amortization is related to both current and
noncurrent intangible assets. Therefore, it is impossible to separate
investments in intangibles and changes in working capital. Also, since
amortization is included in several line items of the income statements, I do
not forecast amortization separately. Exhibit 9 provides the gross investment
in working capital, CAPEX in P&E and goodwill. However, these are not
included in the computation of FCFF.
Also, given that
companies convert their foreign balance sheet into their home currency, the
line items will capture true investments and currency-based translations. These
currency effects can be partially undone by subtracting the increase in the item “Foreign currency translation
adjustments” from the accumulated other comprehensive income (loss) statement.
Nonetheless, this item may include operating and nonoperating items. In the
case of ATVI, these adjustments are rather small, therefore I include them in
the computation of FCFF and consider their value to be zero going forward.
In 2016, ATVI’s FCFF is
lower-than-usual due to the increase in acquired intangibles and goodwill
associated with King’s acquisition.
5.1.2 Performance Analysis
To analyze performance, I
focus on the main elements of value creation: ROIC and revenue growth. A
complete analysis of past performance will support forecasts. Appendix 3
presents ATVI’s performance measures, including revenue growth rates, ROIC
decomposition, and financing ratios.
Since ATVI relies on
significant investments in intangibles, such as software development and
franchises, the value of these resources is included in the calculation of
ROIC. This view is consistent with the formulation of ATVI’s invested capital.
Koller et al. (2015) suggest the following ROIC decomposition:
First, operating margin
(EBIT-to-revenues) is analyzed. Figure 7 shows a summary of ATVI’s historical
operating margin and its elements.
As can be seen, product costs have been decreasing over the last
three years as a percentage of revenues. This is clearly the effect of the
increase in revenues from digital channels. As previously mentioned, this
distribution channel has typically lower costs when compared to retail
channels. Also, game operations and distribution costs increased dramatically
in 2016. These represent the costs to operate games, such as server maintenance
costs and customer service. The rise of this item means that ATVI has been
increasing its expenditures to support the growing online activity across its
titles, especially after the acquisition of King which increased the total
number of titles. Additionally, sales and marketing-to-revenues increased almost
3% in 2016. This is due to the amortization expense of the customer base intangible
asset acquired from King. Finally, software royalties, amortization, and IP
licenses increased slightly in 2016 due to the additional amortization expenses
related to King’s franchises. More titles ultimately lead to an increase in
this item. It is also important to note that, even though all the other ratios
appear to be fairly stable over the years, ATVI has been increasing its
marketing and product development efforts. This is consistent with the industry
cost structure. The two costs combined accounted for 33% of the revenues in
product costs have been decreasing over time, the expenses related to the King
acquisition led to an operating margin of 20,1% in 2016, a decrease of 6,4%
since 2015, and to a lower ROIC of 14%.
Second, ATVI’s capital
turnover (revenues-to-invested capital) averages at 0,77. As expected, this is
primarily driven by the efficiency of goodwill and intangibles.
18.104.22.168 Revenue growth
ATVI’s revenues have been
growing at a CAGR of 6,8% from 2011 to 2016. The company provides the amount of
revenues attributed to each platform. This template will be used for the
revenue forecast. PC, console and mobile include the revenues from PC, console,
and mobile games, respectively. “Other” includes the revenues from the MLG,
studios and distribution businesses. Figure 8 shows ATVI historical revenue
growth from 2011 to 2016, by platform.
Consistent with industry
dynamics, most of the growth has been derived from mobile games, especially
with the addition of King’s titles that boosted mobile games revenues in 2016.
Mobile games accounted for 25% of total revenues in 2016, a 16% increase since
2015. From 2011 to 2016, this platform registered a 42,5% CAGR. As a result of
this expansion, console games have been growing at a much smaller rate of 0,1%
for the same time period. Console games generally experience higher growth in
years when new consoles are released by Sony, Microsoft, and Nintendo. PC games
have been growing at a 5,3% CAGR. In 2016, PC sales increased 41,7% (y-o-y)
primarily due to the release of Overwatch.
ATVI will be valued under
different scenarios. However, this section will only focus on forecasts for the
business-as-usual scenario. Under this scenario, historical trends will be
maintained in the future. The resulting valuations of the other scenarios are
presented in section 5.1.6.
Since the model is
already laid out for historical values, the forecasts of FCFF and ROIC are
computed in the same way as when examining past performance.
Before forecasting the
financial statements year-by-year, however, an explicit forecast period must be
chosen before the company reaches steady-state performance. By that time, the
company will be valued using a perpetuity-based formula. Koller et al. (2015)
suggest forecasting each financial statement line item during a five-year to
seven-year explicit forecast period. Also, the authors advocate that this
period should represent the years it takes for the company to reach a growth
rate similar to that of the economy. Herewith, I assume ATVI will reach
steady-state after 2024. I believe using a five-year forecast window will
result in a meaningful undervaluation that will not be able to capture ATVI’s
potential growth, particularly in the mobile space.
Additionally, I use 2018
as the first year of projections. Given the proximity to the last quarter of
2017, I have reasonable comfort projecting that quarter. Also, ATVI’s quarterly
financial statements do not include some data needed for the construction of
invested capital and NOPLAT, such as accrued payroll-related costs and the
breakdown of income taxes.
Furthermore, for each
line item in the income statement and balance sheet, historical ratios are
computed followed by forecast ratios corresponding to each projected year. The
majority of the forecast ratios are derived from revenues’ estimates. Hence,
for some line items, multiplying a
forecast ratio by the
estimate of revenues will yield the estimate of that specific line item for
that year. Appendix 4 shows the forecast assumptions for the income statement
and balance sheet.
22.214.171.124 Income Statement
Given that revenues from
each platform are growing at a different speed, I can identify how each
platform is contributing to the company’s valuation. Figure 9 shows the revenue
forecast for each platform.
Following historical and
industry trends, I expect that most of ATVI’s future revenues will be derived
from mobile games. I believe the acquisition of King will help ATVI conquer the
mobile territory. I forecast double-digit growth for this platform until 2020.
Afterwards, the growth rate will decline, reaching 3,6% in 2024, accounting for
35% of revenues. Moreover, PC games’ growth rate will not be as generous as
mobile games’ for the first projection years. However, since most competitive
gaming is performed on the PC, I expect this platform to reach a 4,8% (y-o-y) growth
rate in 2024. PC growth rates will be optimistic since the majority of ATVI’s
well-appraised franchises will benefit from the tailwind of eSports.
Furthermore, console games will be affected by the expansion of PC and mobile
games. I expect console games to grow at a 1,4% CAGR from 2016 to 2021. This is
somewhat lower than the U.S. industry rate of 4%.4
In 2019, I foresee console games will regain its popularity due to the release
of new consoles,5
consequently reaching a 4% growth rate (y-o-y). Nonetheless, this will not
change the overall declining popularity of this platform. Accordingly, I expect
a 2,9% growth rate in perpetuity. Lastly, other revenues are generated from
ATVI’s studio and MLG businesses. These revenues are derived from ATVI’s efforts
in driving player investment outside of game purchases with the release of
films based on its franchises and management of eSports communities. In the
near future, this segment will experience generous growth. However, as ATVI
reaches a mature stage in 2024, I conservatively estimate that this segment
will reach a growth rate of 3,1% going into perpetuity.
1 ATVI reports in
its balance sheet its “Cash and cash equivalents”, which can be divided into
cash, foreign government treasury bills and money market funds. However, it
does not disclose how much cash is used to fund operations. Koller et al.
(2015) suggest that operating cash may be 2% of revenues. Although this figure
is not a rule, I also assume the same percentage of revenues due to lack of
2 Koller et al.
(2015) suggest the capitalization of product development expenses for technology
companies to get a more accurate measure of invested capital. Since ATVI
already capitalizes software development costs and IP licenses on the balance
sheet, the adjustment proposed by the authors is not considered. After the
release of a game, these capitalized costs are amortized. Also, the capitalized
costs related to products that are canceled or are expected to be abandoned are
charged in “Product development” in the income statement.
3 ATVI was required to deposit $3,56 billion cash
to be held in an escrow account until the completion of the King acquisition.
This cash was not accessible for operating cash needs. Since this was a
one-time event and the asset will not grow with the business, I consider it
Source: 2017 Video Games Report, Euromonitor.
5 New consoles generally release
every six or seven years.