Activision Blizzard's Buyback Unlocks Tremendous Value

Just two months ago, shares of Activision Blizzard (NASDAQ: ATVI  ) jumped to an all-time high of $18.43 per share on news that the company was finally gaining its independence from majority owner Vivendi (NASDAQOTH: VIVHY  ) . Since then, shares of Activision have dropped over 11%; has the market already forgotten about the key benefits of Activision's independence

To answer this question and to illustrate why Activision is still a solid buy, it is important to consider how the company will look after the transactions close.

Deal details
Vivendi's ownership of 684 million Activision shares (61% of shares outstanding) will drop to 84 million shares (12% of shares outstanding) as a result of these transactions:

  • Activision will purchase 429 million shares from Vivendi for $5.8 billion. This purchase will be financed by $1.2 billion in cash on hand and the issuance of $4.6 billion in debt.
  • An investor group led by Activision CEO Bobby Kotick will purchase 172 million shares for $2.3 billion.

Activision's repurchase and retirement of 429 million shares reduces the outstanding share count by 38% based on the 1.119 billion shares outstanding as of June 30, 2013. 

Pro forma valuation
Not convinced that this share repurchase will have a material effect on Activision? Consider this estimation of Activision's pro forma results based on the pre- and post-transaction equity structure:

  Pre-Transaction Adjustments Pro Forma
Basic shares outstanding (in millions) 1,119 (429) 690
       
Cash and equivalents (in billions) $4.55 ($1.23) $3.32
Debt (in billions) $0 $4.75 4.75
Net cash (debt) (in billions) $4.55 ($3.52) ($1.43)
       
Shareholder's equity (in billions) $11.94 ($5.83) $6.11
Debt to equity ratio 0.00  

0.78

       
TTM net income (in billions) $1.36 ($0.18)*  $1.18
TTM basic EPS  $1.22    $1.71
TTM price to earnings ratio 13.50   9.56

* Reduction to net income is an approximation of pro forma interest expense which assumes a 5% weighted average interest rate on debt issued in connection with the transaction.

There's an added bonus that is often overlooked: the retirement of 429 million shares will save the company $82 million per year in dividend payments based on Activision's 2013 dividend of $0.19 per share.

Comparison to peer group
In an industry known for inconsistent profits, Activision Blizzard already stood out as a compelling value with reliable earnings and a trailing P/E of less than 14. Here's how the company stacks up against its peers:

 

ATVI
(Pre-transaction)

EA TTWO
CAPS rating (out of five stars) 4 stars 2 stars 4 stars
Share price $16.37 $24.07 $16.80
Market capitalization (in billions) $18.33 $7.74 $1.62
       
TTM P/S ratio 3.71 2.04 1.43
TTM P/E ratio 13.74 66.40 248.70
Forward P/E ratio 12.79 16.37 16.15
       
Debt to equity ratio 0.00 0.23 0.88
Dividend yield 1.2% 0% 0%
Free cash flow yield 6.7% 2.6% 2.1%

Sources: Motley Fool CAPS and Yahoo! Finance-10/8/13

Electronic Arts (NASDAQ: EA  ) and Take Two Interactive (NASDAQ: TTWO  ) trade at significantly lower price to sales ratios than Activision as a result of recent struggles to maintain consistent profitability. Based on earnings and cash flow, however, Activision's shares are cheaper both before and after the buyback transaction. Based on the pro forma data above, Activision's pro forma TTM P/E ratio less than 10 stands out against the company's peers, as does its healthy free cash flow and growing annual dividend. Even after taking on $4.75 billion in debt, it is estimated that Activision will have a lower debt to equity ratio (0.78) than Take Two (0.88). 

Activision is a buy
All three companies have a strong lineup of titles and an upcoming windfall thanks to the long-awaited console refresh. If EA and Take Two can achieve analysts' expectations for the next year, the forward P/E of 16 for each company is a very reasonable valuation. However, the already compelling case for Activision becomes even more clear after considering the illustrative pro forma adjustments above; there is huge upside for shareholders as the buyback transaction will unlock tremendous value by reducing the outstanding share count and resulting in earnings accretion of approximately 30%.

The market seemed to recognize this potential initially following the announcement of the buyback deal, but has since lost sight of this significant catalyst.


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