Why Activision Blizzard's Earnings Are Outstanding

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That brings us to Activision Blizzard (Nasdaq: ATVI  ) , whose recent revenue and earnings are plotted below.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, Activision Blizzard generated $1,279 million cash on net income of $418 million. That means it turned 28.8% of its revenue into FCF. That sounds pretty impressive. Still, it always pays to compare that figure to sector and industry peers and competitors, to see how your company stacks up.

Company

TTM Revenue

TTM FCF

TTM FCF Margin

 Activision Blizzard $4,447 $1,279 28.8%
 Electronic Arts (Nasdaq: ERTS  ) $3,478 $260 7.5%
 Konami (NYSE: KNM  ) $3,199 $223 7.0%
 The9 (Nasdaq: NCTY  ) $111 ($19) (16.6%)

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. TTM = trailing 12 months.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash comes from high-quality sources. They need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much.

So how does the cash flow at Activision Blizzard look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With 11.5% of operating cash flow coming from questionable sources, Activision Blizzard investors should take a closer look at the underlying numbers. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 7.9% of cash flow from operations. Overall, the biggest drag on FCF also came from other operating activities (which can include deferred income taxes, pension charges, and other one-off items) which consumed 20.2% of cash from operations.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.

Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. Activision Blizzard is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 18, 2011, at 11:29 AM, bottomfisherman wrote:

    They are two trick pony, Call of Duty and W.O.W. and wow is getting stale and they have nothing new, exciting or cutting edge on the horizon. Look for earnings to decrease. Remember this rule of investing: Past performance is not an indication of future return.

  • Report this Comment On February 18, 2011, at 7:54 PM, IRunMan wrote:

    C'mon Seth. Your articles are nearly carbon copies of each other. I could probably write a program to write your articles for you.....though maybe you already have one. I will be sending a complaint if this trend continues.

  • Report this Comment On February 19, 2011, at 1:44 AM, ganeshsastri wrote:

    The Article says:

    Over the past 12 months, Activision Blizzard generated $1,279 million cash on net income of $418 million.

    Clearly there is an error in the figure of net income.

    Why is there a big GAP between the understanding of many analysts and GAAP? GAAP figures are clearly the most reliable indicator of performance and financial state of a company. Any thing else - Operating Cash Flow, FCF, ADJUSTED Net Income - is imaginary. Instead of saying Adjusted Net Income, say IMAGINARY NET INCOME.

  • Report this Comment On February 19, 2011, at 6:14 PM, chrisguns521 wrote:

    @bottomfisherman

    Activision and especially blizzard are not a two trick pony. Both modern warefare 2 and black ops set sales records. Although wow is almost at the end of it lifespan, it still has 12 millions sunscribers and it was leaked that they are working on a next gen mmo codenamed Titan. We also have a brand new title coming from bungie this year that is a first person shooter mmo. Starcraft is also one of the most competitive games in the world. Im going to keep buying these stocks while its low.

  • Report this Comment On February 19, 2011, at 10:46 PM, tcnh6633 wrote:

    Sorry Seth - I just sold out at $11.

  • Report this Comment On February 21, 2011, at 5:34 PM, ecburton wrote:

    @Bottomfisherman:

    Two trick pony? I think not. I'm surprised you haven't heard of Starcraft and Diablo, and the fact that the very highly anticipated Diablo 3 will be shipping out the end of the year, Still, bought 1K of Blizz stock over two years ago, and it's 1.50 per share less now. This, after the release of WoW's latest expansion, COD: Black Ops, and StarCraft 2. Would have earned more had I put the money in a passbook savings account.

    @Chrisquns52: don't get your hopes up too high. I sure did, and for naught.

  • Report this Comment On February 22, 2011, at 8:11 PM, Borbality wrote:

    What scares me about ATVI stock is that everyone says how great their earnings are RIGHT NOW, and the cash flow (including goodwill) RIGHT NOW. If the earnings are so great right now, and the stock still doesn't move, then what in the world will happen if the earnings suddenly aren't so great? I sold after holding for about a year and coming out even.

  • Report this Comment On February 22, 2011, at 8:13 PM, Borbality wrote:

    PS i don't see how they can make much money off of Starcraft. I bought the game for $60 and play against my brother once or twice a week, and love it. I have no interest in the single player mode or sequels, and there is no charge to play online. Big whoop $60 from me. This is a tough business and not one I want to invest in.

  • Report this Comment On February 23, 2011, at 8:10 PM, ecburton wrote:

    @Borbality

    Starcraft (the original) is a national religion in Korea. Incidentally, SC2 is not so much. Seems the Koreans are not keen on the idea of Blizzard controlling BlizzardNet and sanctioning all online play. (Blizzard's online involvement was much less instrusive with the original.) But probably a good play that you dumped the stock. As soon as Diablo 3 releases I'll wait to break even, then I'm out too.

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