A former Wall Street analyst discloses the topics that equity analysts and hedge fund managers are currently talking about.

Gaming is becoming a bigger part of our lives. Whether it's over our phones while on the subway, on the Xbox on our TV at home, or on Twitch on our PC, more and more of our time is spent playing or watching games. Over the last five years, Activison's stock has risen steadily higher on this gaming wave.

With the stock so high, will Activision be able to continue to squeeze more value out of something as silly and asinine as video games?

Bull thesis: Engagement = $$$

Gaming seems like a silly activity that is reserved either for pimply teenagers or for our most bored moments on the toilet. And yet, this silly activity has turned Activision into a behemoth company worth over $40 billion.

For bulls, the value of gaming can be seen in the engagement levels. Exactly how silly is something if we are increasingly spending more time in it and caring more about it?

From that lens, Activision is sitting on a treasure trove. In 2016, customers spent 43 billion hours playing or watching an Activision-Blizzard game, which is on par with Netflix usage and 1.5x Snapchat's usage. Other internet and tech companies would kill for this level of engagement. And yet, Activision still makes a significant portion of its revenue from simply selling a product for a fixed, up-front cost. With this level of customer engagement, many investors believe it is only a matter of time until the engagement translates into more revenue streams. Let's walk through some of the potential earnings drivers.

Strong franchise collection at core of business opportunities

At the core of Activision-Blizzard's business are a collection of beloved franchises within their Activision, Blizzard, and King segments.

A few notes for some context:

- Call of Duty is their largest franchise and has been around for 14 years. The company releases a new title in the franchise each year.

- Overwatch is the company's most recent franchise and is growing rapidly (recently hitting the 30 million registered user mark). Its success demonstrates the company's ability to create new franchises that gamers care about.

- World of Warcraft, at its peak, had 12 million subscribers paying a monthly fee to play the MMORPG.

- King has 342 million MAUs (as of 1Q17) and gives the company exposure to mobile and the casual gamer audience.

This collection of franchises provides several benefits to the company.

First, it generates high levels of engagement across its user base. Games from Blizzard in particular are much more likely to get a highly engaged user base (at least initially) due to the publisher's track record of high-quality games. High engagement means the company can monetize its collection of franchises in numerous different ways, including movies, merchandise (i.e. action figures), eSports (as I'll detail later), or other currently-undiscovered streams. While video game are notorious for turning into bad movies, they show the potential to be attractive to the large Chinese market, as evidenced by Warcraft's success there. And while the odds don't seem high, any future movie could potentially turn into a hit. Management has noted that they may be launching a CoD film at some point in the future as well.

Second, more of the industry growth should flow towards Activision's blockbuster titles. While there has been an explosion in games across the PC and mobile platforms (as the barriers to distribution have declined in line with the increase in digital distribution), the industry is also seeing increasing consolidation among the largest and most popular video games. As an example, while the app store now has more apps than ever before, consumers are increasingly only using a handful of apps on their phone. A similar dynamic is playing out among video games. Many analysts believe that more of the video game economics will continue to consolidate towards the most successful titles, which should position Activision well longer-term.

Third, Activision-Blizzard can continue to roll out sequels in its franchises with a good degree of revenue visibility. Activision-Blizzard will be launching Destiny and another CoD this year, and next year will be a potential WoW expansion and CoD Black Ops (the most successful series of the CoD franchise). Activision will also be rolling out a CoD mobile game made in partnership with King. These franchises warrant a strong multiple given the increased visibility into the company's future earnings potential.

Shift towards digital sales/transactions

The shift towards digital transactions is a well-known trend that the entire video game industry is benefiting from. Game transactions are increasingly becoming digital, which creates higher margin opportunities and new revenue streams for publishers. For clarity, we'll separate the digital transaction types into three groups: buying the game, in-game purchases, and DLC and other add-ons.

Buying the game

The first type is the actual sale of the video game. Ten years ago, just about all games were purchased by going to your local Best Buy, buying some CDs, and then throwing them into your PC or console. Today, you can now go into a digital store on your console/PC, purchase a game, and then have it immediately begin download and installation.

The degree of digital penetration varies by the platform. On PC and mobile, just about all game sales are made online. This has helped overall game transactions as these two platforms are also the faster-growing platforms. On console, digital game purchases are roughly 20-30% of total console game purchases.

There are a few barriers to console that may prevent it from reaching 100%. First, games are large in size. Console hard drive space is limited (moreso than for PCs and mobile phones), which means that gamers can only have ~10 games on their console at once. This also means that games take hours to download and install. Second, digital downloads are not as easily gifted for occasions as physical games are. It's just nicer to wrap up a Call of Duty box than it is to wrap up some symbolic representation of it. This may not seem big, but a large portion of video game sales still occur around the holidays or during birthdays, as many gamers don't have income.

Despite these barriers, digital transactions on consoles continue to grow. Activision reported that digital game purchases grew by 80% last year. And new titles such as Destiny are near the 30% range in digital purchases.

This is a major benefit primarily because digital game purchases have a higher gross margin. Activision has noted that they make around $10 more in gross profit on digital game purchases. This translates into a 20 point benefit on gross margins for each transaction. As game sales transition to digital, Activision's gross margin should continue to benefit.

In-game purchases

This is the digital transaction that many of us mobile gamers are probably familiar with. In-game purchases have grown in popularity over the years, beginning with the freemium model. Publishers have increasingly sold cosmetic items to gamers for money. Some games also sell other products, including items that allow a player to play longer, taunt other players, or gain an edge competitively (this one is generally frowned upon by gamers).

Importantly, in-game transactions allow publishers to monetize their games in a generally non-intrusive way. As mentioned above, Activision has a collection of franchises that have very high levels of engagement. Activision remains in the early innings of developing in-game transactions. As an example, Team Fortress 2 (developed by Valve, a competitor to Activision) was one of the early pioneers of in-game transactions and sells the usual collection of hats and weapons to players. Additionally, the game sells humorous player animations, including group dances. It sounds silly, I know. But it's actually one of the more popular sales, and it's not cheap either. With such high levels of engagement across their collections, there are likely numerous other monetization opportunities that have not yet been explored.

These types of transactions are still growing rapidly. Activision reported that in-game purchases doubled from $1.6 billion to $3.6 billion in 2016. Much of this was due to the acquisition of King, which makes most of its revenue from in-game purchases. However, excluding King, in-game purchases still grew 30% y/y.

DLC and other add-ons

Another type of digital transaction is what is known as downloadable content (DLC). This is generally an extension of the game that perhaps isn't big enough to warrant a sequel label. Instead, it might add new chapters in single player, new units to control, or new game modes. DLC adds another revenue stream while limiting the development time - the games use the same engine and much of the same code, it just adds a few more chapters to play.

Game developers are innovating in this area as well. Overwatch, a popular game made Blizzard, recently held an in-game "event" called Uprising. The event introduced a new coop game mode and numerous new items and skins that players could buy. Importantly, the event drove player engagement and more in-game purchases. These types of events extend engagement longer as the game remains fresh in players' minds. In turn, in-game transactions tend to see a spike around these events.

King advertising

Many analysts are bullish on the advertising opportunity at King. King owns the Candy Crush franchise, which is one of the most popular mobile apps.

Candy Crush gamers are currently offered more plays or more items to help them pass the current puzzle for a small fee. Like other games with in-game purchases, much of King's revenue comes from a small percentage of players, also known as "whales." According to analysis from Tapjoy, the top 10% of free-to-play mobile gamers generally make up 70% of in-game purchases. Conversion rates remain low for the other players, as many people still do not feel comfortable spending money in a video game.

King is currently testing an option for gamers to watch video advertisements in exchange for some of these items. The option should increase conversion rates and allow for greater monetization of the franchise, which has recently shown declining MAUs but increasing engagement levels (with time spent per DAU and DAU/MAU both growing).

Initial testing results have been positive, according to management. Players with the ad option have actually seen higher levels of engagement (as they can now play for longer periods of time). Brand advertisers have also seen high conversion rates. As a result, many analysts believe that King advertising could provide upside to their 2017 and 2018 revenue estimates.

A call option on the future of gaming as a sport

The eSports opportunity is often seen by analysts as the call option for the company. eSports has shown a lot of promise as a growing industry. In 2014, 89 million people spent 3.7 billion hours watching eSports, up from 74 million people and 2.4 billion hours in the prior year. Twitch, often seen as the leader in broadcasting, was purchased by Amazon for ~$1B in 2014. The company has about 100 million MAUs, about 10 million DAUs, an average daily user watch time of 1 hour and 46 minutes, and over 2 million monthly broadcasters. Numerous industry forecasts call for over $1 billion in revenue by 2020. The metrics are astonishing.

Source: Twitch.tv(note the numerous ways that the streamer monetizes his stream) — Source: Twitch.tv
(note the numerous ways that the streamer monetizes his stream)

With viewership on the rise, many believe that the monetization of the sport will follow. Currently eSports generates roughly $3.50 in ARPU, which compares to the major league sports that generate closer to $20 in ARPU. Potential revenue streams include content licensing, advertising, sponsorships, tickets, merchandise, and digital merchandise. Advertising in particular is likely to be the biggest revenue stream, as eSports captures a live audience, and also captures 2-3x more millenials than other sports.

Activision is beginning to take more aggressive steps to grow and monetize eSports. The company acquired Major League Gaming in 2015 and has begun to design games with eSports in mind. Overwatch is one of these games, and Activision is working on a league launch with team sales happening later this year. Details are currently scant, but the league will offer teams in different cities (akin to the L.A. Lakers in basketball) and plan to have a regular season and a playoff tournament.

The math for such a league is promising. Twitchmetrics shows that Overwatch already gets 28,000 average viewers at any given time on a third party platform. With in-game connectivity, a regular schedule of professional games, and more marketing, analysts believe this number could become a much higher percentage of the game's 30 million registered users. For reference, the MLS generates roughly 200,000-300,000 average viewers, while NBA games generate somewhere between 1.5m to 3.9m viewers.

While Overwatch's numbers might seem uninspiring, there are a few points to consider: 1) As mentioned above, viewership is growing rapidly, 2) MLG hopes to capture more audiences across different games, not just Overwatch, 3) Twitch viewership rises significantly during tournaments, 4) League of Legends peaked at 800,000 viewers, while Counter-Strike peaked at over 1 million, and 5) If Activision can capture just a fraction of the revenue from the other major leagues (like, say $200 million), this would translate into a meaningful contribution to EPS. Note that consensus estimates in 2018 and beyond do not factor in any eSports revenue, and therefore any contribution would represent upside to the consensus estimates.

Source: Howmuch.net, WWE financial filings, Dave Meltzer

Bears skeptical of CoD, console cycle, valuation

Today, the bear thesis is very different from what it might have been several years ago. With the stock up significantly and gaming acknowledged as a significant part of our lives, the concerns are largely focused on several specific elements of the story:

- Franchise fatigue. Bears believe that there may be some gamer fatigue with some of Activision's franchises. Specifically, Call of Duty sales may be slowing. It has now been 14 years since the first Call of Duty was released. While management and analysts did not expect Infinite Warfare to match Black Ops's success in 2016, the reception to the game has still fallen below expectations. This has led some bears to wonder whether gamers are simply tired of the Call of Duty franchise. If this assertion is true, this would not bode well for sales for future CoD launches and would represent a significant headwind to the Activision segment's sales each year.

- Console cycle lumpiness. Game purchases are lumpy in the console lifecycle. When a new console is about to come out, gamers tend to buy less games in anticipation of the next console. There is some fear that as Microsoft and Sony release new consoles (Xbox Scorpio and PlayStation Neo), gamers may defer their game purchases. However, both consoles will be backwards compatible, which should mitigate some of this risk.

- eSports could hit a wall. While the trajectory of eSports looks promising, eSports remains well below the audience levels of other more established leagues. eSports will need to show continued growth with engaging storylines, smooth viewability, and entertaining announcers. Within eSports, Activision-Blizzard will also need to capture more of the audience that is fragmented across different titles. Activision-Blizzard owns several promising eSport titles, but still lacks the biggest online properties such as League of Legends and Dota 2. And Twitch owns a significant portion of viewers as well (and is owned by Amazon). As a result, in order to become the "ESPN of eSports", Activision-Blizzard needs to 1) grow eSports as an industry, and 2) capture the majority of viewers across a fragmented landscape.

The characterization of eSports as a call option is not necessarily true as well. From what I can tell, it's true that eSports revenue is not really baked into consensus estimates. However, almost all analysts have written about eSports fairly extensively. Given the run up in the stock price, and how much management has talked up its Overwatch plans, I would be surprised if investors did not bake in some degree of eSports success into the multiple. And with expectations comes the potential for a letdown. Should eSports develop at a slower pace than investors expect, the stock could take a hit.

- Gamers may be more difficult to monetize. Many gamers are tech-savvy and somewhat paranoid. Any strategy that is aimed at squeezing more value out of this group must be well-thought out and intuitive. While DLC and in-game purchases have done well so far, it is a running joke among gamers that the publishers are increasingly taking this further and further beyond their comfort levels. While this group continues to spend money on digital content, there is a risk that Activision won't be able to monetize as much of their content as investors believe.

- King MAU declines. King MAUs have been declining since the acquisition in early 2016. Management would note that the declines have come with higher levels of player engagement. However, as is the case with Call of Duty, the fear is that gamers are developing fatigue towards certain franchises. Not only does this not bode well for future revenues from the franchise, but it is also likely to lead to increased investments into new franchise development, which could contract margins.

- High valuation. Activision currently trades at 26.7x P/E NTM and 18.7x EV/EBITDA, near 5-year highs, at a time when revenue and earnings growth is currently expected to be down in 2017. With high multiples come high expectations for eSports, for Call of Duty, for King revenue growth, for Overwatch, and for future game releases. Activision-Blizzard must show a continued ability to stay relevant to a harsh audience across different platforms.

Conclusion: High valuation means momentum must continue

With all-time highs in valuation and bulls focused on significant revenue and margin gains, Activision will need to show continued momentum for the stock to continue to move higher. In other words, gaming will need to continue to become a bigger part of our lives. Should any of the bear theses play out to some degree (whether it's the console cycle concern, CoD fatigue, or any of the numerous other concerns) and slow revenue gains, the stock will likely contract and the risk/reward will be revalued.