Vivendi buyback transaction
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In October 2013 Activision Blizzard, Inc. completed a share buyback transaction with its former majority shareholder Vivendi SA. Main part of the shares was repurchased by the company itself for a total amount of $5.8 billion while a group led by company’s CEO Brian Kotick and Co-Chairman Brian Kelly acquired the remaining stake of 172 million shares. This investor group currently owns approximately 24% stake in the company. All of these shares were purchased at a price of $13.6 per share, which represented a discount to market price of about 12% (at the time the transaction was announced in July of 2013). Since then the shares of Activision Blizzard performed reasonably well, rising by 23%, more or less in line with an S&P 500 rise of 20% during the same period. At the end of May 2014, Vivendi sold its remaining stake of 41.5 million shares in Activision for approximately $850 million, or $20.5 per share.
The path forward
Activision Blizzard has high cash flow generation ability. In 2013 it generated $1.2 billion of free cash flow. Based on a recent share price, this represents a 8.7% free cash flow yield. It is reasonable to assume that presence of the investment group that partnered with company’s management will have its influence on Activision’s financial strategy going forward. One possible alternative is to take the path of increased dividend payments. Such strategy can transform Activision Blizzard into an “income” type of stock. Another, and more interesting path is a continuation of share repurchases. With a small net debt of $494 million, company can easily add some more leverage in the amount of $2-3 billion. Channeling, for example, $2.5 billion and an annual free cash flow of $1.2 billion to share repurchases can allow the company to repurchase approximately $6 billion worth of stock over a three year period. Assuming an average cost of $20, $23, and $26 per share for the repurchased shares during 1st, 2nd and 3rd years, respectively, will decrease shares outstanding by about 40%. Applying current EV/EBITDA valuation ratio can value the shares at $25.7. Such valuation would provide the investor group with a total return of 89% over a period of 4-5 years and would increase their ownership to 40% of the company. Even without knowing how the exact scenario will develop, it is reasonable to assume that such possibilities, if they do materialize, will certainly contribute to decreased downside risk in Activision’s shares going forward. We therefore think that investors could find it attractive to implement an option-selling strategy on shares of Activision Blizzard in order to generate income from option premiums.
Conservative strategy for uncertain market conditions
During periods of uncertainty in markets many investors find it hard to initiate new long positions. Some experts perceive the market currently as overvalued and propagate caution and restraint. Focusing on fundamentals and timeless value-investing principles will serve investors well during such periods. Combining value and fundamental valuation approach with a conservative options strategy can provide additional downside protection while generating attractive income. The approach involves selling insurance policies (put options) against the decline of individual equities. By selling such an insurance policy you agree to buy the stock of a specific company at a certain price during some period of time, which can be anywhere between a month to one year or even longer. In return for agreeing to do so, you receive a premium, just like an insurance company. In case the stock price declines below the price at which you have agreed to purchase it, you will have to purchase and own the stock.
Both academic and business literature have proven that the approach of selling put options achieves better results than market averages over long periods of time with a volatility that is significantly lower than that of the market. The Chicago Board of Options Exchange (CBOE) has developed a Put Write S&P 500 Index, which measures the performance of a strategy wherein one sells an at-the-money put option with a maturity of one month on the S&P 500 Index, and continues to do this consistently each month. This strategy has outperformed both S&P 500 Index as well as Buy Write S&P 500 Index (a strategy of selling covered call options).
Let’s take a look at a possible put-write position in Activision Blizzard.
Valuation and put-write position example
Activision Blizzard’s market capitalization was $13.7 billion as of January 7th, 2015. Company is valued at an EV/EBITDA multiple of x8.4 (FY 2013). Based on January 7th 2015 closing prices, one could sell an out-of-the-money put option that matures in one year (January 15, 2016) and exercise price of $17 for a premium of $1.63. By doing this, investor agrees to purchase Activision’s shares for $17 per share in case the stock price declines below $17. Actual cost and breakeven price of shares for investor would be $15.37 as he receives $1.63 per share in premium upfront. At this purchase price Activision Blizzard would be valued at an EV/EBITDA multiple of x6.8. In percentage terms, a decline of 19% from current stock price is required to get to this price – a nice downside cushion during uncertain times. If, on the other hand, Activision’s shares will trade sideways or rise, investor will earn an annualized premium income of about 10.6% for taking the risk.