188.8.131.52 FCFFWith invested capital andNOPLAT computed, FCFF can be calculated.
Exhibit 9 computes FCFF by summingNOPLAT to decreases in invested capital. Computing FCFF in this manner isslightly different than calculating it in accordance with Formula 3. However,both ways yield the same result. Noncash operating expenses includedepreciation and amortization, and changes in invested capital include capitalexpenditures (CAPEX) and investments in intangibles, among others.
To computeCAPEX, depreciation is summed to the increase in net P&E. Similarly, tocompute investments in intangibles, amortization is summed to the increase inintangible assets. As a result, since changes in invested capital aresubtracted in Formula 3, depreciation and amortization included in “Noncashoperating expenses” offset depreciation and amortization used in thecomputation of CAPEX and investments in intangibles. This adjustment was madebecause current software development and IP licenses are included in workingcapital, and to compute investments in intangible assets, the amortization ofall intangible assets is used. This amortization is related to both current andnoncurrent intangible assets. Therefore, it is impossible to separateinvestments in intangibles and changes in working capital. Also, sinceamortization is included in several line items of the income statements, I donot forecast amortization separately.
Exhibit 9 provides the gross investmentin working capital, CAPEX in P&E and goodwill. However, these are notincluded in the computation of FCFF. Also, given thatcompanies convert their foreign balance sheet into their home currency, theline items will capture true investments and currency-based translations. Thesecurrency effects can be partially undone by subtracting the increase in the item “Foreign currency translationadjustments” from the accumulated other comprehensive income (loss) statement.Nonetheless, this item may include operating and nonoperating items. In thecase of ATVI, these adjustments are rather small, therefore I include them inthe computation of FCFF and consider their value to be zero going forward.In 2016, ATVI’s FCFF islower-than-usual due to the increase in acquired intangibles and goodwillassociated with King’s acquisition.
5.1.2 Performance AnalysisTo analyze performance, Ifocus on the main elements of value creation: ROIC and revenue growth. Acomplete analysis of past performance will support forecasts. Appendix 3presents ATVI’s performance measures, including revenue growth rates, ROICdecomposition, and financing ratios..1.2.
1ROICSince ATVI relies onsignificant investments in intangibles, such as software development andfranchises, the value of these resources is included in the calculation ofROIC. This view is consistent with the formulation of ATVI’s invested capital.Koller et al. (2015) suggest the following ROIC decomposition: (17) First, operating margin(EBIT-to-revenues) is analyzed. Figure 7 shows a summary of ATVI’s historicaloperating margin and its elements.As can be seen, product costs have been decreasing over the lastthree years as a percentage of revenues.
This is clearly the effect of theincrease in revenues from digital channels. As previously mentioned, thisdistribution channel has typically lower costs when compared to retailchannels. Also, game operations and distribution costs increased dramaticallyin 2016.
These represent the costs to operate games, such as server maintenancecosts and customer service. The rise of this item means that ATVI has beenincreasing its expenditures to support the growing online activity across itstitles, especially after the acquisition of King which increased the totalnumber of titles. Additionally, sales and marketing-to-revenues increased almost3% in 2016.
This is due to the amortization expense of the customer base intangibleasset acquired from King. Finally, software royalties, amortization, and IPlicenses increased slightly in 2016 due to the additional amortization expensesrelated to King’s franchises. More titles ultimately lead to an increase inthis item.
It is also important to note that, even though all the other ratiosappear to be fairly stable over the years, ATVI has been increasing itsmarketing and product development efforts. This is consistent with the industrycost structure. The two costs combined accounted for 33% of the revenues in2016. To conclude, althoughproduct costs have been decreasing over time, the expenses related to the Kingacquisition led to an operating margin of 20,1% in 2016, a decrease of 6,4%since 2015, and to a lower ROIC of 14%.Second, ATVI’s capitalturnover (revenues-to-invested capital) averages at 0,77. As expected, this isprimarily driven by the efficiency of goodwill and intangibles. 5.
1.2.2 Revenue growthATVI’s revenues have beengrowing at a CAGR of 6,8% from 2011 to 2016. The company provides the amount ofrevenues attributed to each platform.
This template will be used for therevenue forecast. PC, console and mobile include the revenues from PC, console,and mobile games, respectively. “Other” includes the revenues from the MLG,studios and distribution businesses. Figure 8 shows ATVI historical revenuegrowth from 2011 to 2016, by platform.Consistent with industrydynamics, most of the growth has been derived from mobile games, especiallywith the addition of King’s titles that boosted mobile games revenues in 2016.Mobile games accounted for 25% of total revenues in 2016, a 16% increase since2015.
From 2011 to 2016, this platform registered a 42,5% CAGR. As a result ofthis expansion, console games have been growing at a much smaller rate of 0,1%for the same time period. Console games generally experience higher growth inyears when new consoles are released by Sony, Microsoft, and Nintendo.
PC gameshave been growing at a 5,3% CAGR. In 2016, PC sales increased 41,7% (y-o-y)primarily due to the release of Overwatch. 5.1.3 ForecastsATVI will be valued underdifferent scenarios. However, this section will only focus on forecasts for thebusiness-as-usual scenario.
Under this scenario, historical trends will bemaintained in the future. The resulting valuations of the other scenarios arepresented in section 5.1.
6.Since the model isalready laid out for historical values, the forecasts of FCFF and ROIC arecomputed in the same way as when examining past performance.Before forecasting thefinancial statements year-by-year, however, an explicit forecast period must bechosen before the company reaches steady-state performance. By that time, thecompany will be valued using a perpetuity-based formula.
Koller et al. (2015)suggest forecasting each financial statement line item during a five-year toseven-year explicit forecast period. Also, the authors advocate that thisperiod should represent the years it takes for the company to reach a growthrate similar to that of the economy. Herewith, I assume ATVI will reachsteady-state after 2024. I believe using a five-year forecast window willresult in a meaningful undervaluation that will not be able to capture ATVI’spotential growth, particularly in the mobile space.Additionally, I use 2018as the first year of projections.
Given the proximity to the last quarter of2017, I have reasonable comfort projecting that quarter. Also, ATVI’s quarterlyfinancial statements do not include some data needed for the construction ofinvested capital and NOPLAT, such as accrued payroll-related costs and thebreakdown of income taxes. Furthermore, for eachline item in the income statement and balance sheet, historical ratios arecomputed followed by forecast ratios corresponding to each projected year. Themajority of the forecast ratios are derived from revenues’ estimates.
Hence,for some line items, multiplying a forecast ratio by theestimate of revenues will yield the estimate of that specific line item forthat year. Appendix 4 shows the forecast assumptions for the income statementand balance sheet. 5.
1.3.1 Income StatementAssumptions5.
1RevenuesGiven that revenues fromeach platform are growing at a different speed, I can identify how eachplatform is contributing to the company’s valuation. Figure 9 shows the revenueforecast for each platform.Following historical andindustry trends, I expect that most of ATVI’s future revenues will be derivedfrom mobile games. I believe the acquisition of King will help ATVI conquer themobile territory. I forecast double-digit growth for this platform until 2020.Afterwards, the growth rate will decline, reaching 3,6% in 2024, accounting for35% of revenues. Moreover, PC games’ growth rate will not be as generous asmobile games’ for the first projection years. However, since most competitivegaming is performed on the PC, I expect this platform to reach a 4,8% (y-o-y) growthrate in 2024.
PC growth rates will be optimistic since the majority of ATVI’swell-appraised franchises will benefit from the tailwind of eSports.Furthermore, console games will be affected by the expansion of PC and mobilegames. I expect console games to grow at a 1,4% CAGR from 2016 to 2021. This issomewhat lower than the U.S. industry rate of 4%.
1In 2019, I foresee console games will regain its popularity due to the releaseof new consoles,2consequently reaching a 4% growth rate (y-o-y). Nonetheless, this will notchange the overall declining popularity of this platform. Accordingly, I expecta 2,9% growth rate in perpetuity. Lastly, other revenues are generated fromATVI’s studio and MLG businesses. These revenues are derived from ATVI’s effortsin driving player investment outside of game purchases with the release offilms based on its franchises and management of eSports communities. In thenear future, this segment will experience generous growth.
However, as ATVIreaches a mature stage in 2024, I conservatively estimate that this segmentwill reach a growth rate of 3,1% going into perpetuity. 184.108.40.206.
2Cost of Goods SoldFirst, product costsinclude the manufacturing, warehousing and distribution costs associated withthe sale of physical games. This figure decreases with the increase in revenuesfrom digital channels, which have relatively lower product costs. Purchasingvideo games online instead of buying them directly from a retail store hasbecome a mainstream. As more of ATVI’s revenues shift to digital, product costsare likely to decrease. Consistent with historical and industry analysis, Iforecast product costs-to-revenues to decrease to 8% in 2019.
Afterwards, themarket for digital games will become more competitive. As a result, productcosts-to-revenues are expected to increase to 11% in 2024. Second, gameoperations and distributions costs are expected to be around 12% of revenues.Although this ratio increased dramatically in 2016 due to the acquisition ofKing, I still believe that its future value will be close to 2016 values sinceATVI needs to increase expenditures to support the online activity across itstitles.
Finally, software royalties, amortization, and IP licenses generallyincrease with the release of new titles, which translates into an increase inamortization expenses. In 2019, ATVI may need to create a new title to staycompetitive, thus I increase the ratio of the aforementioned figure as apercentage of revenues to 13%. Afterwards, this figure is expected to trendtowards its historical levels, reaching 10% in 2024. Overall, gross Figure 10: Gross Profit and COGS Projections % revenues profitand COGS margins are expected to be 67% and 33% in 2024, respectively (seeFigure 10).5.
220.127.116.11Other Operating ExpensesTo support its current and future releases, ATVI must increase its developmentefforts. High product development costs potentially mean innovation and newtitles, which will ultimately lead to positive revenue growth. Developing newgames will allow the company to maintain its industry-leading position and meetits customers’ high expectations, thus I consider product development aprerequisite for growth.
Herewith, I forecast this figure to increase to 15,4%of total revenues in 2024. Further, one of the most expensive aspects of publishing a game is themarketing of the product. This process happens when the game is in developmentand lasts after the game is shipped. This expense generally includes bannerads, online promotions, TV commercials, magazine prints, among others. Topromote its franchises, ATVI must increase its advertising expenses. I assumethat marketing investments will tend towards 16% in 2024, as a percentage ofrevenues.Moreover, I assume the ratio of general and administrative-to-revenueswill evolve towards its average historical average of 9,7%. Figure 11 shows theprojections of the aforementioned expenses as a percentage of revenues.
Lastly, depreciation-to-netproperty and equipment is assumed to decrease slightly to 40% in 2024 becauseATVI does not need too many depreciable assets to run its business. 18.104.22.168.4Interest Rates, Taxes, and DividendsBoth interest expense andincome are estimated based on the level of debt or excess cash at the beginningof the year to prevent circular calculations. To estimate interest income, Iuse the 2016 rate of return of 0,2%. For interest expenses, I use ATVI’s costof debt of 4,2%.
3The marginal tax rate isestimated at 35%, the U.S. federal rate. I forecast ATVI’s operating cash taxrate at its last five-year average of 11%. To forecast the provision for incometaxes in the income statement, I compute operating taxes on EBIT and addnonoperating taxes.
To generate nonoperating taxes, I multiply the marginal taxrate by nonoperating income and expenses.Finally, I expect thedividend payout ratio to be 20% going forward. 22.214.171.124 Balance Sheet Assumptions5.
126.96.36.199Working CapitalOne the one hand, mostline items in working capital are estimated as a percentage of sales or days’sales.
4On the other hand, inventories and accounts payable are estimated as apercentage of COGS, since these are tied to input prices. As a result of thechange from physical to digital distribution channels, I forecast a decrease inthe number of days it takes ATVI to sell its inventory. This reflects the significantreduction in production, deployment and storage costs it takes to produce agame today. Therefore, in 2024, I foresee that it will take three days for thefirm to turn its inventory, on average. Moreover, since 2016’s levels alreadyreflect the influence of King’s acquisition on the balance sheet, I keep allother items at 2016 levels. Also, most of these ratios have been rather stablethroughout the years, thus it is reasonable to assume they will be close tohistorical levels. 5.1.
3.2.2Long-term Operating AssetsThe ratios of netP&E, noncurrent software development, IPLs, other noncurrent assets andacquired intangibles-to-revenues are estimated at their 2016 levels.Additionally, CAPEX in P&E is estimated the same way as it is computed historically,by summing the change of net P&E to the depreciation of that year. Finally, I set investments in goodwill equalto zero. Since ATVI has already all the business units it needs to compete inthe industry, I do not project any major acquisition.
Also, major acquisitionsrarely happen and once they are achieved, financial statements must bereworked, resulting in uncertainty in the model. Therefore, I hold goodwillconstant at its current level. Figure 12 shows invested capital forecasts andits main components.188.8.131.52.
3Balancing the Balance SheetThe balance sheet islinked to the income statement through retained earnings. Using the principleof clean surplus accounting (Koller et al., 2015), 2017’s retained earnings canbe estimated as follows: (18) This formula is thenapplied to all future years. The statement of retained earnings is presented atthe bottom of Exhibit 7 inAppendix 2.Furthermore, to balancethe balance sheet, a combination of excess cash, debt and a new item named “newdebt” are used. First, I assume additional paid-in capital, treasury stock,accumulated other comprehensive loss and existing debt will be kept at currentlevels. Then, to complete the balance sheet, new debt or excess cash are set tozero.
Lastly, the primary accounting identity – assets equal liabilities plusshareholder’s equity – is used to determine the remaining figure. For example,in 2017, long-term debt, additional paid-in capital, treasury stock andaccumulated other comprehensive loss are held at current levels as of September30, 2017 (see Exhibit 3). Next, summing total assets less excess cash (residualassets) equals $14,7 billion (see Exhibit 2). Then, summing liabilities andshareholder’s equity, excluding new debt (residual liabilities and equity),gives $18,7 billion. Since residual liabilities and equity are greater thanresidual assets, new debt is set to zero. Thus, total liabilities and equity equal$18,7 billion.
To balance the balance sheet, excess cash is set to $4 billion,increasing total assets to $18,7 billion. Also, excess cash and debt are notpart of FCFF, thus not affecting valuation.184.108.40.206 FCFF and ROIC Source: Own estimates.
To conclude, with the forecast of the incomestatement and balance sheet, FCFF and ROIC are computed in the same way theywere computed historically. Figures 13 and 14 presents FCFF amounts1Source: 2017 Video Games Report, Euromonitor.2 New consoles generally releaseevery six or seven years.3 Estimated in section 220.127.116.11.4 Multiplying a percent-of-revenueratio by 365 gives that ratio in days’ sales.