Industry consolidation in the ever-changing gaming industry has peaked at all-time highs as Microsoft (NASDAQ:MSFT) took the investor world by surprise earlier this year with its announcement that it’s planning to buy out Activision Blizzard (NASDAQ:ATVI), an old industry veteran, in a $68.7 billion all-cash deal.
The unprecedented deal is successful in generating value on both sides. On one end it allows for the gaming industry veteran’s shareholders to take a graceful exit at a very generous $95 per share offer, a price that Activision Blizzard is going to have a very difficult time reaching as a standalone company any time soon, especially within the increasingly negative macroeconomic environment.
On the other end, Microsoft has been looking for ways to further establish its “games as a subscription” model for years now, and gaining access to the veteran’s deep IP portfolio is only the latest step in the plan. In an effort to further diversify revenue sources and fuel growth, the company created the first Netflix-esque game subscription service called “Game Pass.” While Microsoft once again came out swinging with strong results, beating Wall Street expectations all across the board, Activision Blizzard showed multiple signs of weakness, signaling that a sale could not have come at a better time.
The scandal and the arbitrage opportunity.
On July 20, 2021, California’s Department of Fair Employment filed a lawsuit against Activision after collecting “numerous complaints about unlawful harassment, discrimination, and retaliation” at the company. Higher ups in the company have claimed to be aware of the entire situation, allegedly trying to push things under the rug, according to various news reports. Company insiders have complained about the existence of a “frat boy” culture with female employees at the company reportedly often subjected to sexual harassment, discrimination, and retaliation, as well as lower pay and lower opportunity levels than their male peers.
Due to the scandal, many high-ranking executives and developers have decided to step down, including Blizzard co-head Jen Oneal, Overwatch 2 executive producer Chacko Sonny, the chief legal officer Claire Hart, and many others. The list of resignations most notably excludes CEO Bobby Kotick.
After a backlash from the public, the company’s stock price has taken a nosedive. After peaking beyond the $100 per share level earlier the same year, Activision Blizzard stock tumbled all the way down to $57.29 per share, prior to the announcement of the deal.
This temporary weakness in both price and reputation appears to have been capitalized upon by Microsoft in a timely manner. Long looking forward to expanding the gaming arm of their personal computing division, Microsoft has taken the investment world by surprise with the sudden and unexpected announcement of the acquisition. The all-cash transaction, worth nearly $68.7 billion, is by many being marked as the greatest deal in the history of the gaming industry. Considering that the company has agreed to purchase Activision Blizzard at $95 per share, this presents us with an arbitrage opportunity. As of today, Activision is selling for $76 per share, indicating 23.37% upside potential, if we decide to take on the bet. Given the current sentiment in the markets, this would be an extraordinary result.
How likely is it to close?
The very fact that the gap between the acquisition price and the current price is not closing should indicate that the fears over the deal not closing are still very much strong. Simply put, the market is not convinced that Microsoft will be able to get the deal through and is pricing both the potential failure risk and the time value of money in the stock price. The spreads have particularly widened with the promise of the new administration to take a tougher stance on big tech and consolidation in the space. Alongside changes in the US political landscape since the takeover by the new administration, regulators have toughened up their stance on antitrust matters, especially so when it comes to big tech. Traditionally, the core of the administration surrounding President Biden would be generally considered more “business friendly” as it remains aligned to the center.
However, a new force within the Democratic party that’s led by figureheads such as Bernie Sanders and Elizabeth Warren has been increasingly gaining support and influence. They have advocated for years for a tougher stance on big business and more specifically a more strong-handed approach when it comes to matters such as M&A. A part of the effort was the attempt to introduce “The Prohibiting Anticompetitive Mergers Act of 2022,” which is a relatively controversial bill designed to block and limit major M&A activity. Even though most expert analysts would agree that the bill will have a tough time getting through Congress, the centrist-leaning branch is still likely going to have to somehow find a way to appease the left-leaning group.
In a very clear statement that the new regulatory crackdown has become a reality, Lockheed Martin (LMT) has been forced to terminate its $4.4 billion strong deal to acquire Aerojet Rocketdyne (AJRD). In another sign of the crackdown, the Department of Justice filed a lawsuit to block UnitedHealth’s (UNH) planned $13B purchase of Change Healthcare (CHNG). A somewhat brighter outlook on the state of things is that some of the big deals, albeit not in “big tech” still manage to get through. One of the latest major deals that have gone through has been the AT&T (T) and Warner Bros Discovery (WBD) reverse Morris’ trust concerning the Warner Media spin-off. This particular deal is interesting in the sense that the streaming space faces a relatively similar level of industry consolidation.
In my personal view, I hold a strong opinion that the deal is most likely getting through. The risks remain still a reality. The approach to consolidation in the industry is somewhat different from the other industries, related to the relatively low cost of capital and the subsequent lack of a deep moat. Studios and publishers are emerging almost daily and often end up being very successful. The industry at large still remains significantly fragmented. Further to the point, the two market leaders in terms of revenue are both non-American companies, which opens a different political narrative as to why the deal getting through would make sense. Tencent (OTCPK:TCEHY) on one end is a Chinese conglomerate, while Sony (SONY) on the other end is a Japanese tech giant. This deal would solidify Microsoft’s position as one of the three big industry-leading names.
Latest earnings delivery
All the negative coverage, brain drain, and push-back of triple-A titles down the road have taken a significant impact on the company’s bottom line. Activision Blizzard released a quite lackluster earnings report on the 25th of April. The company however claims that this is mostly due to the way it handles product cycles, but it remains a fact that several IPs were pushed down the road in the release timeline after the scandal broke loose. Activision Blizzard has reported adjusted earnings of $0.64 a share on revenue of $1.77 billion, missing Wall Street consensus calls for earnings per share of 71 cents and sales of $1.82 billion.
Even if the product cycle played a major role, perhaps the most difficult to deal with was the continuation of the decline in monthly average users for the gaming powerhouse. Activision Blizzard reported an MAU decline across the board, most noticeable in the Activision Studio which declined to 100 million MAU, compared to the 150 million MAU of last year. Net revenue for the Activision publishing division that includes the franchise slid 49% year over year to $453 million. That also was reported as 33% below the $681 million analyst expectation for the segment. While the Call of Duty franchise is taking a back seat for the remainder of the year, the company is getting ready for a long-planned Diablo Immortal launch that is expected in June of this year. It was reported that already 30 million customers have signed up for the game, prior to the release. Even if disliked by the fanbase, the revenue-generating ability of this mobile game is significant. It the Important to note here that, the entire Blizzard studio generated only 22 million MAU for the quarter.
While the results remain slightly disappointing, the overall impact on Microsoft if the deal passes through is abysmal at best. The company has been specifically targeted for its creative studios and the deep IP portfolio, as well as how well they integrate into the Windows-maker’s ambition of creating the “Netflix of gaming,” and not necessarily for what Activision Blizzard represents as of today in terms of financial potential.
While Activision Blizzard results were largely disappointing, Microsoft came out swinging on the other end, once again proving capable of beating Wall Street expectations. Revenue was $49.36 billion, up almost 18% year over year and beating the $49.04 billion Street estimate. All three segments contributed almost $15 billion each. Microsoft topped the EPS estimate by $0.03, earning $2.22 per share for its shareholders, and surpassed the $2.19 estimate. The operating income was up to $20.36 billion and capital expenditures were set at $5.34 billion for the quarter, slightly missing the estimate of $5.73 billion. In a summary of financial results for the ending quarter, the company has once again highlighted that it generated significant shareholder value by delivering $12.4 billion back to its shareholders, $7.8 billion via share repurchases, and $4.6 billion through its dividend program. Compared to the Netflix (NFLX) earnings debacle, this once again emphasizes why most investors should agree that Microsoft deserved to take the streaming giant’s place in the “FAANG” acronym.
What does Microsoft get from the acquisition?
The story of how Microsoft first played into the idea of creating the first Netflix-Esque subscription service for video games began years ago when the tallies of the last generation console war were being counted. Sony has left Microsoft bruised up and beaten badly as their heavy focus on “exclusive content” yielded extraordinary results with their PlayStation 4 outselling its Xbox One rival by almost 3:1. Sony managed to ship close to 120 million console units, while Microsoft on the other end was forced to stop releasing console sales as early as 2015, with the estimate being that the company managed to ship around 40 million console units.
Only months after the disastrous launch of the console, Don Mattrick, the previous head of Xbox, has been forced to leave with industry veteran Phil Spencer taking his place. Spencer’s vision has seen a huge shift in focus from a two-decade-long pursuit of brick and mortar games and hardware sales to assembling a roster of studios whose games can be played across a range of devices. His most important contribution to this day was doubling down on the “subscription service” model gamble that started its life under his predecessor as a small project codenamed Arches.
Following the enormous success that Netflix had as an early adopter of the video subscription model, or the success Spotify (SPOT) achieved as an early adopter music subscription model, Spencer realized the true potential that games as a subscription model would have. Microsoft’s pitch to conquer the gaming world was simply titled “Game Pass.” The platform proved a huge success since its inception back in 2017, attracting more than 25 million subscribers. For a flat monthly fee of $10 or $15, the subscribers have access to a huge cross-platform library of more than 300 titles, including features such as day one releases and backward compatibility.
As the industry prepares for the wider adoption of subscription-based business models, acquisitions of gaming studios have been heating up over the course of the last couple of years. Studio acquisitions are a key aspect of the new subscription model strategy as they allow the companies to expand their existing library of game titles, but also more importantly allow exclusive access to the future pipeline of those studios’ products. Game industry mergers and acquisitions are estimated to nearly triple to $90 billion in 2022 from $26.2 billion in 2021, according to research firm PitchBook.
Microsoft already has a series of well-known studios under its umbrella, but the effort has been pushed in the last couple of years. The Activision Blizzard deal is not the first major deal the company has done lately. Just last year, Microsoft acquired ZeniMax Media for $7.5 billion, bringing eight different game studios under its umbrella. All the game titles acquired, including the likes of Elder Scrolls, Fallout, Dishonored, Doom, Quake, and others can already be found on Game Pass. Microsoft currently owns 23 game studios, while adding nine more with the latest deal. The studio acquisitions create value for Microsoft in two different ways. First, they enable the company to push out games directly to its subscription service. The logic is simple here, the more studios and IPs they own, the lower the incentive for the average gamer to look at anyone else other than Game Pass and Microsoft. The second value-generating factor is the direct contribution to the console wars, that’s by significantly boosting console sales through the use of “exclusive titles.” In a similar manner in which movies and TV shows could be made exclusively available on certain streaming platforms, games are often made “Xbox” or “PlayStation” exclusives, meaning the developer enters a deal with a hardware company for the product to be available to purchase only on their platforms.
What does Activision bring over?
Activision Blizzard is a true veteran of the industry and one of the greatest video game companies in existence. It was founded back in 2008 in its current form and is based in Santa Monica. It develops and distributes content and services on video game consoles, personal computers, and mobile devices, including subscription, full-game, and in-game sales, as well as by licensing software to third-party or related-party companies that distribute Activision and Blizzard products. The company has a prestigious lineup of IPs and franchises that include names such as Call of Duty, World of Warcraft, Overwatch, Diablo, Candy Crush, and others that generate an industry-leading 400 million MAU.
Conclusion and ending thoughts
The Microsoft-Activision deal has been a great deal for the shareholders of both companies involved. The acquisition is a tremendous value generator. The acquired is a true veteran of the industry and one of the greatest video game companies in existence that commands a lineup of prestigious IPs and franchises including names such as Call of Duty, Diablo, World of Warcraft, Candy Crush, Overwatch, Diablo, and many others that generate an industry-close to 400 million MAU. The series of unfortunate events that came to be would have most likely kept strong pressure on the company stock for a long time. With this deal, shareholders have been granted a very generous exit.
The arbitrage opportunity that was born out of Microsoft’s acquisition of Activision Blizzard is a true value generator and an investment opportunity that is proving increasingly more lucrative by the day, especially given today’s uncertain market environment. Still, major risks loom ahead with the government taking an increasingly aggressive antitrust position. However, given the negative stock market climate, the 23% “guaranteed” return is definitely something that is worth thinking about.
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