Warren Buffett knows how to profit in the stock market. Since 1965, $1 invested in Berkshire Hathaway would have turned into over $37,000 by the end of 2022. That comes to an annualized return of 19.8% per year, which is more than double the return of the S&P 500 index.
Activision Blizzard (ATVI) and Paramount Global (PARA -1.14%) (PARA.A -0.82%) are leading entertainment companies that Berkshire has been buying over the last year. Let's see what the market is missing in these two companies and why they are selling below their intrinsic value.
1. Activision Blizzard
Berkshire Hathaway originally disclosed a small position in Activision stock in the fourth quarter of 2021. After Microsoft announced a proposal to buy out the game maker for $95 per share in an all-cash deal in January 2022, Berkshire parked about $5 billion in the stock to take advantage of the price discrepancy between Activision's share price and Microsoft's offer.
Wall Street was skeptical about whether the deal would receive regulatory approval, and Activision stock has traded around $75 to $80 per share, representing a sizable discount to the buyout offer. However, recent developments suggest Microsoft could be moving closer to securing approval, which if completed would net Berkshire about $1 billion in profit on its Activision shares.
Earlier in March, Reuters reported that the European Union is set to approve the Microsoft-Activision merger. However, the deal still needs approval from the U.K. and U.S., and that's still a toss-up at this writing. There are concerns about Microsoft gaining too much control in the cloud gaming market with Activision's best-selling Call of Duty franchise.
Even if the deal were blocked by regulators in the U.S., Activision has enough catalysts in the near term to justify buying the stock right now. Activision reported a 43% year-over-year increase in bookings last quarter, driven by the October launch of Call of Duty: Modern Warfare 2. Activision has more coming in 2023, with the scheduled June releases of Diablo IV and content for Overwatch 2.
Activision is a cash cow, generating $2.1 billion in free cash flow on $7.5 billion in annual revenue. It also pays a small dividend to shareholders, with the yield currently sitting at 0.6%. If the acquisition doesn't get approved, shareholders will still own a very profitable interactive entertainment company with some of the most popular video games in a growing $200 billion industry. Moreover, the stock is trading at a discount to what a private market buyer would be willing to pay to own the whole company, as is evident by Microsoft's offer. That's a clear signal the stock is undervalued.
2. Paramount Global
Berkshire first disclosed a small position in Paramount Global in the first quarter of 2022. Because it makes up less than 1% of Berkshire's portfolio, it was likely one of Buffett's investing deputies (Ted Weschler or Todd Combs) who bought the stock.
Paramount is an interesting case because of the weak advertising market that has pressured growth at its media networks, such as CBS and other cable channels. Despite reporting a decline in TV media revenue last year, Berkshire added more shares to the position through the end of 2022.
Paramount owns valuable media properties, including Paramount Pictures, and the century-deep film library that goes with it. The hit show Yellowstone and top box office release Top Gun: Maverick were key growth drivers for Paramount+ in the fourth quarter.
In fact, Paramount's direct-to-consumer business, which also includes Pluto TV, added 10.8 million subscribers last quarter. Paramount's growth here looks strong relative to the competition, where Warner Bros. Discovery added 1.1 million additional subs across Discovery+ and HBO Max.
Overall, Paramount's streaming business is growing faster than Warner Bros. Discovery's, and it's also in a stronger financial position.
For example, Warner Bros. Discovery's total debt is 6 times its reported earnings before interest, taxes, depreciation, and amortization (EBITDA), according to generally accepted accounting principles (GAAP), while Paramount Global's debt is 2.5 times EBITDA.
Data by YCharts
The negative for Paramount is that it is trading at a higher valuation than Warner Bros. Discovery. On an enterprise-value-to-EBITDA basis, Paramount trades at a multiple of 10.6 compared to 7.3 for Warner Bros, based on 2023 EBITDA estimates.
But Paramount's stronger financial position and less exposure to cord-cutting are likely why Berkshire favors the CBS owner over the CNN owner. CBS has been rated the No. 1 broadcast network for 14 consecutive years. In the fourth quarter, Paramount's TV media segment saw a lower decline in revenue of 7% year over year, compared to Warner Bros. Discovery's 9% drop in network revenue.
Paramount should be able to maintain momentum in subscriber growth for Paramount+. This is due to another strong film slate in 2023, including a new Mission Impossible film. It's for these reasons that the stock could be undervalued and offer upside over the next few years.
