Activision Blizzard: Big Analysis of Infinity Ward Legal Battle

In March 2010, Activision Blizzard (NASDAQ:ATVI) terminated the employment of Jason West and Vince Zampella, the former co-heads of Infinity Ward studios, for insubordination and breach of fiduciary duty. Infinity Ward is the studio responsible for creating the Call of Duty brand. Call of Duty: Modern Warfare 2, which was the last iteration of the franchise released prior to the firings, became one of the best-selling games of all time.

In March 2010, Mr. West and Mr. Zampella filed a lawsuit against Activision alleging damages, including punitive damages, in excess of $36 million, an amount which increased during discovery to over $1 billion, as well as declaratory relief. Mr. West and Mr. Zampella went on to found their own studio, Respawn Entertainment, which will work with Activision competitor Electronic Arts (“EA”) in the EA Partners Program, under which EA publishes and distributes games developed by third-party developers. We expect the first Respawn Entertainment game to be released in FY:14.

In April 2010, Activision filed a cross complaint against Mr. West and Mr. Zampella, asserting claims for breach of contract and fiduciary duty, among other claims, and seeking damages and declaratory relief.
 
In December 2010, Activision filed a $400 million claim against EA, claiming that EA interfered with the contracts of Mr. West and Mr. Zampella, and that it aided and abetted the two men in breaching their fiduciary duties to Activision. In January 2011, the court granted Activision’s motion to amend its cross complaint against Mr. West and Mr. Zampella to add EA as a party.
 
According to Bloomberg Businessweek, at a hearing on Wednesday, Activision and EA announced that they would file a settlement agreement in court. Also on Wednesday, the judge presiding over the case denied Activision’s attempt to delay the West v. Activision trial an additional 30 days from its May 29 trial date. Activision had been asking for additional time for its new lead lawyer to get up to speed on the case.

We do not believe that the undisclosed settlement amount was material to either Activision or EA, and think it is entirely possible that little or no compensation actually changed hands. We thought Activision’s case was weak, given that Messrs. West and Zampella were under a contract due to expire later in 2010, and we do not believe that an employer has a valid claim against an employee solely because that employee seeks to test his market value by speaking to a prospective employer. We believe that the settlement agreement signals that Activision will not attempt to block or delay the first release from Respawn Entertainment, which we continue to expect in FY:14. We also believe that Activision is unlikely to receive a material judgment against Mr. West and Mr. Zampella, as the pair were fired by the company. In our view, it is far more likely that Mr. West and Mr. Zampella will receive a material amount of compensation from Activision, and Monday, Activision paid $42 million due under its contract with the pair. The company continues to accrue bonuses and other monies allegedly owed in connection with the matter. As such, we do not think any prospective settlement will meaningfully impact Activision’s profitability.

Maintaining our OUTPERFORM rating and $19 price target, which reflects a forward multiple of almost 17x our 2012 EPS estimate of $0.96 plus an estimated $3/share in cash. This is at the low end of its historical multiple range, reflecting, we believe, industry malaise and risk from dependence on a few franchises.

Risks to attainment of our share price target include changes to game release timing, greater than expected deterioration of the average selling price for game software, the effects of competition, changes in macroeconomic factors, and lower than- expected consumer demand for video game hardware.

Michael Pachter is an analyst at Wedbush Morgan.