Sell This Game Maker, Buy These Two Instead

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A few quarters ago, I owned Activision (NASDAQ: ATVI) shares, but sold them because it did not look like the market would ever appreciate its value. At the time, investors worried about the overhang of Vivendi owning a large percentage of the company. Today, Activision is now up 74% this year. Is it time to sell?

The catalyst

Vivendi said it would sell $5.8 billion worth of its Activision shares back to Activision for $13.60 per share, at a 10% discount at the time. Vivendi will lose its majority shareholder title, and will be left with just 12% of the company by still holding 83 million shares. The deal would boost earnings by between 23% and 33% (non-GAAP). Earnings will rise by between 18% and 29% on a GAAP basis. Activision will finance the deal by issuing debt: a whopping $4.6 billion. The $1.2 billion in domestic cash will also be used to fund the purchase. This leaves a comfortable $3 billion of cash on the balance sheet.

Raw deal for investors

The share buyback merits a rally in Activision shares because the company will not have Vivendi as a majority shareholder. Activision should have greater freedom in pursuing its business objectives without the meddling of Vivendi. The problem with this argument is that Vivendi never interfered with the way Activision was run. The conglomerate only distracted Activision by seeking ways to sell its position.

Activision is essentially leveraging its balance sheet to boost earnings per share, by taking advantage of extraordinarily low interest rates.

Many risks ahead

Activision must believe that it can generate a return higher than the interest paid to fund its debt. The company is doing well on most products. The game Call of Duty, for example, is a solid franchise that breaks records every time a new version is release. Conversely, popularity for World of Warcraft is dropping precipitously. Monthly subscribers dropped to 7.7 million, down from 8.3 million in May. If users continue to lose interest, a drop in subscriptions could make it more difficult for Activision to fund its debt load.

A strain on its balance sheet could force Activision to cut operating costs, which would includes jobs.

Alternative investments

Activision's market capitalization is more than double that of Electronic Arts (NASDAQ: EA), even after the appreciation in EA shares. Still, investors might want to look at EA or Take-Two (NASDAQ: TTWO).

NAME

MKT CAP, $

Electronic Arts

7.75B

Activision Blizzard

20.42B

Take-Two Interactive Software

1.47B

Data Source: Yahoo Finance

Take-Two is set to release Grand Theft Auto 5 this September. Shares are already up 29.4% in the last six months, so investors might want to wait for a pull-back:

TTWO data by YCharts

Take-Two issued $250 million worth of convertible senior notes in June. Investors reacted negatively to the news at the time, but the offering is nowhere near as big as the Activision debt-financed share buyback deal.

Sports game maker EA is up even more in the same period, up 69%. EA reported quarterly earnings that trounced forecasts. The company grew subscriptions for Battlefield 3 by 500,000 units. There are now more than 4 million subscribers for the hot game.

EA data by YCharts

Another reason to like EA is that mobile game demand is strong, rising 33% in sales year-over-year, to $104 million. Sales were helped by hot titles like The Simpsons: Tapped Out and Real Racing 3.

Foolish bottom line

Activision could face profit taking in the near future. Investors holding this company should look at Take-Two and EA as alternatives. A buying opportunity is created if Take-Two and EA drop alongside any profit-taking in Activision.

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Chris Lau has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard and Take-Two Interactive . The Motley 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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