Is Activision Blizzard a Cash King?

As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight four companies in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

Today, let's look at Activision Blizzard (NASDAQ: ATVI  ) and three of its peers.

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio. A sustained high cash king margin can be a good predictor of long-term stock returns.

To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = Free cash flow / sales

Let's take McDonald's as an example. In the four quarters ending in December, the restaurateur generated $6.97 billion in operating cash flow. It invested about $3.05 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment from its operating cash flow. That leaves us with $3.92 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 14% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.14 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Four companies
Here are the cash king margins for four industry peers over a few periods.

Company

Cash King Margin (TTM)

1 Year Ago

3 Years Ago

5 Years Ago

Activision Blizzard

26.2%

18.5%

26%

13.5%

Electronic Arts (NASDAQ: EA  )

6.4%

2.4%

(5.5%)

4.7%

Take-Two Interactive Software (NASDAQ: TTWO  )

(0.4%)

(9.8%)

(8%)

11.3%

Sony (NYSE: SNE  )

1.7%

2.8%

8.1%

3.2%

Source: S&P Capital IQ.

Activision Blizzard is the only one of the listed companies that meets our 10% threshold, offering us very high cash king margins at 26.2%. Its current margins are also nearly double what they were five years ago. Electronic Arts offers the second highest margins at 6.4%. While its margins have fluctuated significantly over the last five years, its current margins are the highest they have been in the periods shown. Sony, on the other hand, offers margins below 2%, the lowest in the times shown. Take-Two has negative margins, which are drastically reduced from its 11.3% margins five years ago.

Activision Blizzard has a strong track record of marketing top-selling video games, releasing the highly popular Call of Duty and Black Ops 2 at the end of last year. While it may suffer from the declining interest in console games, Activision's possession of popular non-console games like World of Warcraft may help protect the company if the decline of console sales continues. That could give it a competitive advantage over Electronic Arts and Take-Two, both of which see a significant majority of their revenue coming from console games. On the other hand, Sony and Microsoft are both planning to roll out new consoles soon. If these new consoles increase interest in traditional games, Activision, Electronic Arts, and Take-Two may all benefit. However, that outcome is far from certain.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

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