I’ve been spending some time this morning digesting the news that the UK’s Competition and Markets Authority (CMA) has blocked the $MSFT acquisition of $ATVI. The announcement from the CMA is linked here and is about twenty pages long. After reading and organizing some thoughts, I decided I want to share major points on the decision.
CMA’s Conclusions
After the CMA’s investigation and assessment of the acquisition, they concluded that the action may result in a “substantial lessening of competition” (SLC) in the cloud gaming services within the UK. This is a very different reasoning from the initial concerns surrounding the ideas that Microsoft would withhold the large Call of Duty franchise from competitor’s platforms. The CMA says that the deal could change “the future of the fast-growing cloud gaming market, leading to reduced innovation and less choice for UK gamers over the years to come.”
Microsoft provided a Cloud Remedy Proposal to the CMA in which they would be committed to license Activision games royalty-free to specific cloud gaming providers for 10 years. A proposed change in consumer licenses of the games would also give the right to stream an Activision game within the cloud service provider’s online store. This essentially means that if Steam’s online store was selling Activision games, the consumers of those games would be able to play it on Steam’s cloud service (assuming they have one) and wouldn’t be forced to use Microsoft’s cloud gaming service. Microsoft also offered to appoint a monitoring trustee to ensure compliance with the proposed remedy.
The CAM determined that the proposed remedy was unlikely to provide structural remedies to the SLC. Their reasoning for this is that the proposal limits different types of commercial relationships between cloud gaming service providers and game publishers, restricting arrangements like exclusive content, early access, or gaming subscription services. They also conclude that this proposal lessens the incentives for Activision to make their games available on non-Windows operating systems which may exclude or restrict cloud service providers who wish to use other operating systems now and in the future.
The CMA ends their conclusions by stating that the “only effective remedy to this SLC and its adverse consequences is to prohibit the Merger.”
My Opinions
I was shocked to read that this rejection was literally only about cloud gaming. The CMA even recognized that they understand the public support for deal as it would
It is extra odd when considering the fact that cloud gaming is such a small part for the entire video game industry, let alone Microsoft. Google’s cloud gaming attempt with Stadia failed and was officially discontinued in January of 2023, only three years after it was launched in November of 2019. Amazon’s attempt at cloud gaming, called Luna, is still up and running but has mixed reception and not a huge base due to major complaints around impracticality, lag issues, and extra monthly fees to access all the content.
These other players aren’t struggling because Microsoft is out-competing them, its because cloud-gaming just isn’t as good compared to console or PC gaming. I’ve messed around with Xbox’s cloud service called X Cloud Gaming. It’s not mind-blowing.
As internet speeds improve over time and as it becomes more cost effective for companies to house all of the necessary computing power that is needed to offer cloud gaming services, I’m sure the sector will grow. With Microsoft having a 60-70% market share in cloud gaming, the CMA is concerned that this deal would make their market share greater, and as a result make the industry less competitive. The CMA seems to believe they are forward-looking in terms of the potential growth in cloud gaming, but given the context of the small size of cloud gaming relative to the entire industry and the significant time and money it will take to get cloud gaming anywhere close to being competitive with console/PC gaming, it seems the CMA’s focus on cloud is extremely misled.
Moving Forward
Next steps lie at the Competition Appeal Tribunal (CAT). This is the special judicial body within the UK that hears and decides on cases involving competitive regulatory issues. Just last November, the CAT overruled the CMA’s decision on a case involving Apple for disregarding statutory time limits. In Apple’s case, this was a procedural error and was overrule quickly. Microsoft’s case does not have any procedural issues (though if there are some they may appear in the near future).
The CMA’s initial key concern when the merger was first reviewed was regarding foreclosure in the console market. Their concerns then of Activision games becoming exclusive to Game Pass or removed from Playstation were entirely misinterpreted on the CMA’s part. Now the focus is on cloud gaming and their decision to block a merger over an infant market at the expense of greater aggregate consumer benefit within PC and console gaming. The CMA may have a hard time explaining to the CAT why this is reasonable.
Immediately following the CMA’s decision, Microsoft and Activision reaffirmed their commitment to this deal and that they would appeal the decision. Lulu Cheng Meservey, CCO of Activision Blizzard, tweeted that “the UK is closed for business”. Brad Smith, Vice Chairman of Microsoft, tweeted that they will appeal the CMA in an offical statement. Their statement says that the decision “reflect[s] a flawed understanding of this market and they way the relevant cloud technology actually works.”
The deal has been cleared in other jurisdictions such as Japan, South Africa, Brazil, Saudi Arabia, Serbia, and Chile. It should be cleared by others in the near future as the European Union has a May 22nd deadline, an August trial within the US is expected, and Australia and New Zealand appear to be waiting further outcomes from the CAT as their historical ties with UK show.
Microsoft has been more cooperative and friendly with regulators than nearly any big tech company I can think of. Now, they have no choice but to fight to back as they have shown they dedicated to this deal and will see it to the end. I hope we get to see this to fruition, however, there is always the risk impatient and despairing investors push Activision to take the $3 billion break up fee. Only time will tell.
In the meantime, $ATVI is down over 11% in today’s trading session, wiping out almost three months of uptrending gains for the stock. My current position is still up over 3% with a cost basis of $74.07. If prices manage to drop below my cost basis before more news develops, I may look to add to my position.
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Market Cycle
The market is in a weird spot to kick off 2023. So far, this year feels like the inverse of 2022. High inflation, which defined most of the last year, seems to have given way to a narrative of falling inflation. Wages data, small business surveys, CPI, and ISM data (all items we cover regularly on the weekly market recaps) suggest softening.
The graph above is called “The Psychological Pitfalls Of A Market Cycle”. It’s broken up into four distinct areas indicated by the colors. The orange color on the far left is the Mark Up phase of a cycle, next is Distribution, followed by Mark Down, and ending with Accumulation in the dark red before the cycle repeats again with Mark Up.
We have had three consecutive inflation reports that showed no major inflation concerns. In fact, two of those three reports actually contained negative surprises! The Fed on Wednesday acknowledged weakening inflation while also mentioning that they still have work to do. Anyways, it is clear that the market’s narrative has shifted to declining inflation and that the Fed will pivot dovish sooner or later. Therefore, now is a great time to look for some early cycle outperformers.
The Soft Line Industry
Before I dive into why this sector could be good for cycle moves in the near term, lets discuss what soft lines are. If you google what the soft line industry is, you will see a site that says they sell primarily soft merchandise. Not a very helpful explanation, but it is technically correct and is a term that is used in retail quite often.
Soft lines are retailers that sell smaller items that are usually soft. Consumer items like linens, clothing, shoes, bags, towels, mats, pillows, and sometimes even beauty products. These kinds of goods may be called soft items. They are typically more difficult to handle in the supply chain than hard goods. Hard goods are stackable, easy to store, and easy to transport while soft goods need to be packaged carefully, they can wrinkle, they need to be presented aesthetically in stores, and are more sensitive to restocking.
Soft Line – Early Cycle Mover
Now back to the cycle. The uncertain backdrop of the economy appears to be closely tied to the health of the US consumer. With that said, I believe the soft line industry is at an interesting value point. Morgan Stanley’s US Soft Lines Retail Equity Analyst, Alex Straton, called the coming year a ‘tale of two halves’ in a Thoughts on The Market Podcast last week when discussing soft lines.
What they meant by this is that the first half of what retailers are facing is harder expectations from an income statement perspective caused by an ongoing excess inventory overhang (Nike’s large inventory in the end of 2022 is a great example of this) and possible recessionary conditions from a macro perspective. An article from Morgan Stanley claimed that census forecasts for the S&P 500 have earnings growth at almost 4%, this is overly optimistic in their view. Consensus earnings growth expectations specifically for soft lines are even more optimistic at 15%.
These stocks can be moved significantly based on earnings revisions. If we have negative earnings revisions ahead based on the assumption that expectations are unrealistic, it’s likely that the stocks move downwards from here, hitting a bottom sometime in the first half of the year.
The second half of the year presents a very different story – hence the tale of two halves. If earnings revisions/expectations become more realistic, the industry will be in a position to more easily meet top line returns and margins may receive year-over-year relief. This relief may come from falling fright costs, falling price of cotton, promotions, etc. On top of that, as we go through the year, inventory should mostly reach normalization. Lastly, a recovering macro perspective should be more solidified in the second half of the year. With this improving backdrop and the fact that soft lines are early cycle outperformers, they could quickly pivot off the bottom and see gains.
It is impossible to ever call a bottom accurately and consistently on anything. But given the case for the industry turn around as we have laid out, there are a few data points to keep an eye on to help you realize when the time to initiate might be near. The first indication is 2023 guidance, and we should get more information on this in the coming weeks as earnings season continues.
The other item that we will spend more time explaining is inventory levels. Cleaner levels are essential to having a view on how long the margin risk that hit retailers in the second half of 2022 could potentially linger into this year. Last year, there was a lot of market discussion around the inventory problem. It was seen as a key risk to earnings with oversupply and lagging demand creating the perfect storm for pressuring margins.
Today, retailers have made good progress of working down inventory levels in the third quarter of 2022, but there’s still much room to go. Look at the examples below from Tapestry’s ($TPR) Q1 2023 earnings report, Ralph Lauren’s ($RL) Q2 2023 earnings report, Nike’s ($NKE) Q2 2023 earnings report, and VF’s ($VFC) Q2 2023 earnings report. What we would rather see here is that inventory levels are in line with forward sales growth.
How To See The Opportunity
As we look across the soft line space for opportunities to take advantage of for an early cycle move, make sure that you’re sticking to sound fundamental and intangible analysis. What I mean by fundamental is if the company is growing or outperforming (beauty stores like Ulta are a great example of this), look for diversification in selling channels, be aware of company events such as restructuring or leadership changes, understand if their margins reasonable, and look to see if investors are rewarded with buybacks, dividends, and/or sufficient price appreciation. What I mean by intangible is if the company has a strong brand, if the brand has value, if that brand value had an upward trajector, and do the products speak to the consumer.
If you can answer most of these items in a positive light, then you may have located a good company for this early move.
For me, certain subsectors of this industry particularly interest me and others that don’t. One to avoid, in my opinion, is activewear. These items saw strength in Covid as people gained a higher affinity for staying healthy, exercising, and taking care of their bodies. Long term, the category has really nice upside potential, but for the purposes of getting early cycle returns, the lingering strength from Covid may negate the strategy.
My other point is on mid-tier brands vs luxury/high-tier brands. A debate as old as time. I lean high-tier, for a couple of reasons. One is that higher wealth consumers will be less affected by a recession if one happens. The global economy is growing, China is opening, and India looks to be on the verge of its most performative decade ever. These items will boost attention to and desire for world-renown luxury brands. Another point I have is called revenge shopping. The Economist touched on this phenomenon which is where people are more willing to splurge on high-end items currently because they have been pinching pennies and living a stressful life since Covid that they feel they should treat themselves.
My Picks
Having said this, here are a couple of stocks I have my eyes on:
Tapestry ($TPR), the luxury brand company that operates through Coach, Kate Spade, and Stuart Weitzman. P/E ratio of 12.3, pays a 2.57% dividend, and has had decent sales growth over the last five years.
Ralph Lauren Corp. ($RL) sells premium lifestyle products including the well-known Ralph Lauren clothing brand but also sells accessories, home furnishings, and many other soft line products. P/E ratio of 17.3, pays a 2.35% dividend, and has performed great share buybacks of the last 10 years.
Steven Madden Ltd. ($SHOO) designs, markets, and sells fashion-forward footwear through several well-known brands including Steve Madden, Anne Klein, GREATS, and others through wholesale and direct-to-consumer segments. P/E ratio of 11.4, pays a 2.3% dividend, and has shown impressive sales growth over the past decade with the exception of 2020.
Burberry Group PLC ($BURBY) is a holding company that designs, manufactures, and sells apparels and accessories under the luxury Burberry brand. P/E ratio of 21.18, dividend yield of 2% that pays semi-annually, and touts some very stable margins and impressive FCF per share.
I also like Columbia Sportswear ($COLM) but did not dive into them too much as I believe seasonality may dampen the early cycle mover strategy discussed here.
Of these five, I have initiated a small position in Steven Madden Ltd. ($SHOO) and will wait for their earnings report on February 23rd before adding heavy. The reason for this is so that I can get another temperature check on the inventory levels, sales levels, and the margins are trending in the right direction. So far, sales and margins are. Inventory, which is the key, still needs improvement however.
Thank you for reading! If you like pieces like this, follow my Twitter or my CommonStock page where I post updates on the economic data throughout the week. And go check out the 3X discord where I’m actively conversing about ideas like this!
Recently, in an article from the Economist, I read how the seaport town of Esbjerg in South Denmark has boomed in the past decade due to the green industry, mostly caused by the wind industry. The change of the town’s economy is the product of a much bigger change that is underway within the North Sea. And this change is one that I think may be another green energy add to my portfolio among the likes of $NEE and $AY.
The North Sea
For those that don’t know, the North Sea lies between Great Britain, Norway, Denmark, Germany, the Netherlands, and Belgium. It connects the Atlantic Ocean to the English Channel in the South and the Norwegian Sea in the North while covering about 220,000 square miles. It hosts key northern European shipping lanes and is a major area for fishing, recreation, and tourism in bordering countries.
For decades, the North Sea has been a vital source for Europe’s oil and gas but it is shifting to green energy. Although the region’s hydrocarbons are finite, its strong gales are certainly not, which has created a vast opportunity for wind and wave power sources. The importance of this shift has been exacerbated by the oil squeeze caused by Putin’s war in Ukraine and climate change.
Currently, there are dozens of offshore wind farms in operation throughout the North Sea. Managing these farms takes quite a lot. There are offshore windfarm bases that are often 30+ miles away from the coast. Rather than sailing back and forth, operators spend weeks at sea on these platforms that are equipped with gyms, chefs, video games and other amenities to keep them around. The wind farms are moving further and further away at sea to capture stronger and more consistent winds.
Long term, the ambition within the North Sea Economy is to produce electricity. The objective is to produce 260 gigawatts of offshore wind power by 2050.
A study was done a few years ago, that found that at least 600 gigawatts of infrastructure could be installed in the North Sea. The European Commission looked into what power is needed, and the sum of those needs reaches 300 to 400 gigawatts.
That is enough to power all of today’s 200 million households in Europe and is about 5x what is currently produced in the North Sea. This power is to be cheap and green which is key for producing hydrogen.
Natural gas is typically used for producing hydrogen, this is known as blue hydrogen. With the amount of green energy the North Sea plans to produce, it will be a key area for producing green hydrogen, which produces far less carbon dioxide.
Hydrogen is central to the world’s climate targets. It is a way to store electricity when it can’t be used straight away. This is perfect for windfarms, because when the wind blows strongly there’s no way of knowing if that power has an immediate demand.
Hydrogen can also be used as a fuel in industries that cannot be easily electrified like air transport, shipping, or steel making. If we have enough green hydrogen to power these items, than a big carbon dioxide problem is solved.
Ørsted
Orsted is the world’s biggest offshore wind developer and used to be known as Danish Oil and Natural Gas. They were a traditional conventional power utility company and have transitioned today into becoming a pure renewable energy company.
Orsted has found that the North Sea is very attractive for windfarms due to the relatively shallow depths, the soft seabed which is good for building the turbines, the gales, and the surrounding countries with heavy energy consumption centers are all positives, making the North Sea the honeypot for offshore power.
Windfarm technology has developed out of teen years and is able to be scale dup massively now. It is no longer an expensive idea that needs subsidies for supports, it is cost competitive and Orsted believes that the goals for 2050 can be done.
Of the 300 to 400 gigawatts needed by 2050, Ulrik Stridbaek of Orsted anticipates that 200 to 300 gigawatts of that could come from the North Sea.
Orsted now can build larger turbines, larger offshore windsites, and can erect 80 to 100 turbines in one go. As that number as increased, so has the windsites which have grown to produce 1 to 2 gigawatts per site. This is the equivalent of a nuclear power site.
The next step to scale up to 5 to 10 gigawatts presents the problem of how to get the power to shore in an efficient way which is thy Orsted is also getting involved in building what is called energy islands. These islands are a physical hub for connecting large scale offshore wind power and then interconnecting to shore as well as hosting hydrogen production and other activities that make sense to have nearby the farms.
As shown in the graphics above, Orsted has a litany of projects undergoing construction, even more that have been awarded, and a number of auctions for even further future projects throughout the globe, not just the North Sea. Their offshore wind build-out plan shows that they will almost triple their installed capacity by 2027.
Their energy capacity is growing and so are their financials. Their EBITDA grew over 300% YoY in their last earnings report. Total Net profits were up 1,800%. As climate change becomes a more followed issue and as Europe tries to get out of Putin’s oil pocket, Orsted and their projects will only benefit providing additional growth on the income statement.
Overall, this may be another long-term green energy play that I buy, add, and hold onto with the likes of $AY and $NEE. Orsted trades on most brokerages as an ADR with the name $DNNGY and is currently priced at $32.31. As always, do your own research, but heed that especially this time as ADR’s carry a different set of risks. Thank you for reading!
Quick foreword for you before you continue reading. I wrote this analysis for a stock pitch competition on a platform called CommonStock. The competition has a grand prize of $5,000 dollars. Winning that prize would be absolutely a huge blessing for my life right now. I also pay for this website and work hard to make my information accessible here and on social media. So if you read this article, appreciate the information, and want to show me some support please go over to CommonStock and upvote and comment on my post using this link to help me in the competition. Thank you and lets get to the analysis!
If you don’t know, Activision is a giant gaming company and thus I thought that it was only right to slide in as much gaming slang as I can into this pitch. So if you’re not a gamer, pull up Urban Dictionary or click the links to look up the gaming terms in italics and dive into the analysis!
Thesis:
Activision stock ($ATVI) presents a poggers merger arbitrage opportunity with Microsoft announcing on January 18th, 2022, their agreement to purchase Activision Blizzard for $95 cash per share with an expected closing date of July 2023. At a current share price of $77.30, this arbitrage opportunity boasts roughly 25% upside in less than a year if the deal goes through. Several analysts predict that the FTC is unlikely to stop the deal, which makes this attractive acquisition play the perfect spot to buy into a stock that is down over 25% from the highs of last year and let your position sit with a safe amount of risk and reward in this volatile market.
Business and Industry Review
Activision Blizzard is one of the world’s largest video game publishers and owns an OP lineup of some of the biggest and well-known video game franchises around including Call of Duty and Crash Bandicoot from the Activision segment, World of Warcraft and Diablo from the Blizzard Segment, and Candy Crush from the mobile focused King segment.
Through strategic acquisitions of studios and development of diverse product lines, Activision has built multiple revenue streams which include premium full game sales, free-to-play offerings which offer in-game content and currency for purchase, game subscriptions for ongoing access, and ad revenue from mobile game offerings. Activision Blizzard also has ownership of Major League Gaming (MLG), the professional esports organization that holds official video game tournaments for sweats throughout North America. The company plans to build an e-sports focused television network and leverage Activision’s competitive titles in the process.
As of 2021, the global video game market value was $178 billion in U.S. dollars and is predicted to reach $268 billion by 2025 with roughly 26% of the global population regularly playing video games. This number has grown significantly in the last few years due to the growing popularity of mobile games, with 69% of gamers saying a smartphone device is their platform of choice, followed by PCs and then consoles.
As the sixth largest video game publisher in the world and publisher of some of the most lucrative franchises of all time, Activision is strategically positioned with their diverse lineup of titles available on most platforms to benefit from that worldwide growth. Though plagued with game delays last year caused by COVID-19 and workplace issues, it appears that Activision may even be able outpace the industry’s growth this year as they push hard to develop new versions of their existing franchises and introduce new ones. For example, the new addition to the Diablo franchise, Diablo Immortal, was just released last month on mobile and PC, Overwatch 2 is coming October 4th 2022, Warcraft Arclight Rumble (a WOW mobile game) is set to release later this year, followed by the next World of Warcraft expansion, both the much awaited Diablo IV and the next Call of Duty: Modern Warfare installment are scheduled to release 2023, plus an unannounced survival game that information has yet to be released for.
Financials
Activision Blizzard appears to be very well managed with a balance sheet of nearly $11 billion in cash and cash equivalents which easily covers their $3.6 billion of long-term debt as of March 31st, 2022. The firm generated $627 million in free cash flow for Q1 2022 and $2.3 billion for its fiscal year 2021, averaging a free cash flow of $2.07 billion per year for the last three years. Given their hefty amount of cash and their ability to generate more of it year after year, it is reasonable to assume the firm can issue a large amount of debt to finance any potential acquisitions or pay down their current long-term debt.
The company’s last big acquisition was when they purchased King Digital, the mobile development company behind the hit Candy Crush game series, for $5.9 billion. For 2021, the King segment continues to be their fastest growing segment with $2.58 billion in net revenues, a $416 million increase from the prior year and a $549 million increase from the year before that. While some argue that capital may have been better allocated toward organic growth, the $5.9 billion dollar bet on King has paid off. Similar large acquisitions are not likely to continue as the company continues to focus on growing their reach and player investment in their franchises by producing “more frequent cadence of compelling content, introducing new free-to-play and mobile experiences, and making our franchises more social” as read from the 2021 annual report.
For their bottom line, Activision Blizzard has averaged a net income of $2.13 billion per year over the last 3 years with average net income margin of 27%. Such financial success has allowed the company to pay a small yearly dividend that has not yielded higher than 1% since 2015. Currently, the yield is sitting at 0.62%, just above its five-year average of 0.56%. The firm’s P/E ratio is at 24.6 just under the five-year average of 24.9. Looking at both metrics, it appears that the stock is fairly valued… luckily for us, tech and gaming giant Microsoft thinks otherwise.
Acquisition
Management Scandals:
Prior to the agreed acquisition, Activision experienced a workplace discrimination and harassment lawsuit that caused activist employees to attempt to remove CEO Bobby Kotick as CEO for falling “short of ensuring that all employees’ behavior was consistent with [Activision Blizzard’s] values” through a petition calling for his resignation that more than 1,800 employees signed. A Wall Street Journal story later revealed that Kotick knew about prior allegations and had protected certain executives from repercussions.
Despite this call to action, Kotick still remains CEO mostly due to his track record with the company. Kotick pulled the company out of bankruptcy three decades ago and positioned it to capitalize on booms in computing, video games, and now e-sports. His reputation as having one of the most revered minds in business has made him one of the highest paid executives in America and has earned him the full support of the board.
However, despite his history of successfully leading the company, this lawsuit portrayed the toxic work environment that developed over the years and caused the stock to drop from the high $90s down to $56.40 per share at the lowest.
Microsoft Deal:
It was at this point that Microsoft saw an opportunity to grow their gaming segment. On January 18, 2022, with the stock sitting at $65, Microsoft announced $68.7 billion deal to acquire Activision. Microsoft feels confident in their ability to improve Activision’s workplace environment and made their offer of $95.00 per share. The deal is expected to close in July of 2023 assuming regulatory approval is provided.
The US Federal Trade Commission and UK Competition and Market Authority are currently evaluating the deal and its impact on the gaming industry. If the deal goes through, Microsoft’s gaming market share will grow from 6.5% in 2020 to 10.7%.
Given the fact that Microsoft has promised to deliver the game lineup to all platforms as noted in a statement from Microsoft President Brad Smith, they have committed to respecting data privacy of consumers, and their presence in the gaming industry is still smaller than Tencent’s ($TCEHY), Sony’s ($SONY), and Apple’s ($AAPL), I believe the likelihood of the deal being stopped by authorities is slim.
Deal Outcomes:
The best-case scenario is an investor purchases $ATVI shares today, the deal goes through next year, and they are paid out $95 dollars per share, a roughly 25% increase on today’s price.
Next best scenario is an investor buys $ATVI shares today, the regulators terminate the deal, and say “GGs”. In this scenario, the investor still owns an extremely profitable and undervalued video game company based on the firm’s performance and financials detailed above. In addition to that, depending on the date when the deal is terminated, Activision Blizzard is entitled to a $2 to $3 billion reverse termination fee from Microsoft on top of the ~$2 billion in revenue that the company is already poised to make in 2022, giving them huge profits for fiscal year.
Worst case scenario is an investor buys $ATVI today and the deal gets terminated on Activision’s end for breaching any of the various merger agreement terms. This is unlikely to happen as the board and shareholders have already voted in approval of the acquisition. However, for the sake of analysis, if this does happen Activision must pay Microsoft a $2.27 billion termination fee effectively wiping out any expected profits for the year.
Expected Value:
Using these scenarios and a Barron’s article on the likelihood of the deal going through, we can make a straightforward arbitrage calculation to determine the expected value of the deal. Referencing the table below, the three scenarios are represented with my best guess on probabilities and share value with the information presented. With analyst consensus on the deal closing and a margin of safety if the regulators terminate the deal, the arbitrage play has inherent value above the current stock price.
As we get closer to the deal date and as regulatory entities issue their decisions, the arbitrage gap should tighten presenting a rare opportunity to camp cash in a stock with potential for a 25% gain if the transaction closes. On the other hand, if the deal does not close, Activision continues to operate with their current positive momentum that may one day grow them into an even larger video game company with a dividend to match.
Conclusion:
Activision presents an attractive merger arbitrage opportunity with Microsoft offering to purchase Activision Blizzard for $95 cash per share with an expected closing date of July 2023. At a current share price of $77.30, this arbitrage opportunity boasts roughly 25% upside in less than a year if the deal goes through, which looks more likely to happen than not. If the deal fails, the stock still looks like a great long-term hold due to its diverse product line and impressive financials, regardless of which way the termination fee falls.
Overall, the company provides an attractive opportunity to buy into a position with risk and rewards that are easy to understand, which is a factor that I greatly appreciation in today’s tumultuous market. The deal is so attractive that I have already bought into it!
How do you think the merger will play out? Do you think my valuation is correct? What are your opinions on the management scandal? Let me know your thoughts and questions below!
3M…this powerhouse of a company may not immediately be recognizable by most eyes, but when you start to look, you will see their logo everywhere. They are the manufacturer of many well-known brands such as Post-Its, Nexcare Band-Aids, ScotchTape, Filtrete, Command strips, and many more. They’ve paid uninterrupted dividends for over 100 years and have increased their dividend 63 years in a row. And yet, their stock price has dropped over 20% in the last year.
This company is a staunch representation of a tried and true business. They have survived the Great Depression of the 1930’s, they made it through the Great Recession in the 2000s, but can they now persevere through a shifting economy and the multi-billion dollar headwinds that face them currently as a much older, larger, and less nimble conglomerate?
Spoiler alert: I believe they can, and I also believe these headwinds are currently presenting investors with an amazing opportunity to build an extremely strong position in a very promising dividend king.
In this deep dive we will discuss 3M as whole, analyzing everything from their financials, product portfolio, competitive advantages, bearish litigations, dividend history, valuation, company outlook, risk, analyst consensus, and more. All so we can get the big picture and decide for if this is a good fit for your portfolio or a good time to add.
Without further ado, let’s jump in!
Business Overview
3M is a multinational industrial conglomerate that has operated since 1902 when it was known as Minnesota Mining and Manufacturing. They are well-known for their research and development laboratory which they use to leverage their science and technology across their vast line of product offerings.
As of 2020, 3M has four business segments: safety and industrial, healthcare, transportation and electronics, and consumer. Nearly half of the company’s revenue comes from outside the US and most of it comes from their industrial segment. 3M has over 55,000 products which touch every market imaginable and an even larger portfolio of patents. 3M manages a sticky product line that affords them pricing power while also retaining customer loyalty and market share where it competes.
Business Strategy
3M, at its core, is a materials science company. Their huge mob of engineers break everyday products down to their levels of basic chemistry in order to improve them.
For example, 3M’s Smog-reducing Granules were created in 2018 and were adapted and applied to roofing shingles to combat air pollution. The granules have a photocatalytic coating that 3M applies to the base mineral of the shingles so that when sunlight hits it, UV rays from the sun transform pollutants into a plant-usable form of nitrogen that washes away with rain or a quick rinse with the hose. Each ton of these shingles have the capacity to capture the smog created by a car that drives 3,000 miles a year.
Another example is their microreplication technology which has been around since the 60’s. It was originally used in overhead projectors but has now been adapted for multiple use-cases including brighter signs and reflectors, reduced friction for aerospace applications, and most recently as an alternative method for vaccine delivery.
3M holds onto their proprietary secrets making their technology difficult to imitate. Because of this, many of their products can get away with a 10-30% premium compared to similar products. 3M’s ability to adapt their technologies into multiple use cases increases the scope of their products which in turn reduces overall unit cost by quickening their progression through the manufacturing learning curve of the products and thus the realization of their margins.
3M develops their technologies internally and also (recently I might add) started to acquire smaller businesses to bring their technologies into their larger product portfolio. Acquiring these companies allows their products and technologies to progress quicker than if they had remained independent. 3M’s recent acquisitions in wound-care solutions provider Acelity and workflow solutions provider MModal will allow them to capitalize on the stable and growing healthcare market and push these companies to success that they most likely could not have reached on their own.
Despite pandemic-related and litigation-related headwinds, I believe that 3M is well positioned in a number of high growth markets that will allow them to grow their intrinsic value over the long term.
Competitive Advantages
We already touched on one of their advantages (cost advantage due to economies of scope and scale) in the prior section. The other advantage they have is in their intangible assets.
3M is a champion of innovation (my university would be proud (if you get this joke just know that you’re awesome)). Their Research and Development is arguably their core competence and they lean on it heavily. They leverage their R&D across all their products, and this has created many successful patents, proprietary technology, and brands.
About 6% of 3M’s sales is spent on R&D. Per the S&P 500, companies within the materials and industrials sectors spent 1.4% and 0.7%, respectively. 3M invests hard into their innovations and they earn a strong yield from these investments. Of the Top 10 Most Innovative Companies of 2021 as named by the Boston Consulting Group, 3M’s return on research capital was 8.82 and was only beat by TSLA. The rest of the group averaged a return of around 5.5. View the graphic below. This means that for every dollar spent on R&D in 2020, 3M yielded $8.82 in gross profits.
This is a testament to 3M’s business model which emphasizes effective commercialization of their R&D. 3M allots 15% of senior engineers’ time to unbudgeted work on any new ideas separate from their individual work responsibilities. 3M’s experience with R&D allows them the added benefit of knowing when to cut programs early when they know it won’t be profitable and speeding up programs when they will be. With over 55,000 products in their portfolio, 3M is not over-weighted in any individual asset which increases my confidence in its long term returns on research capital.
This emphasis on R&D creates better products. Better products mean 3M can charge a premium. And they do! Post-It notes typically sell at 30% premium over store brand alternatives. This is a steep premium, but consumers are willing to pay it due to the superior quality. This quality has caused 3M to grow in brand value in recent years, climbing from the 90th spot in Interbrand’s top 100 Best Global Brands in 2010 to the 67th spot in 2021, ahead of well-known brands like FedEx and Zoom.
This R&D also has the benefit of awarding many patents to 3M. Since 2001, the firm has been awarded over 9,000 US patents and has been awarded over 118,000 global patents throughout its history. The value of these patents are held within the firms Intangible Asset value of $5.2 billion from their 2021 balance sheet.
Managing this huge portfolio of products would be quite the undertaking for most companies. 3M manages it by regionalizing their supply chains to reduce the complexity and length of the manufacturing process. This translates to a decreased need for working capital and better capital efficiency, thus driving down unit costs, boosting gross margins (46.8% for 2021), and improving customer experience with fewer back orders. 3M also employs an ERP program which further enhances the functions of their supply chains and customer service.
On the topic of supply chains, much of 3M’s is vertically integrated. This further enhances their economies of scale and insulates them from localized supply chain issues. 3M has 200 plants around the world, most of which are, on average, larger and more productive than typical plants. This is true of their distribution centers as well.
Financials
For the income statement, 3M’s revenues have grown from $29.9 Billion in 2012 to $35.4 Billion in 2021. Revenues for 2021 were very strong, showing an increase of 9.8% on the prior year. The compound annual growth rate of revenues for the last 10 years is 1.69. Gross margins have averaged 48% through this time frame with 2021’s margins falling just short at 47%.
Over this 10-year period, revenues have grown by 16% and operating income has grown by 18%. This is particularly important because R&D is a substantial expense that lowers operating income. Over this 10-year period, 3M has increased R&D spending by 22% and yet, operating income was still able to grow by 18%, meaning other SG&A expenses are shrinking to keep operating income growing. This is great balance sheet management.
For the last 10 years, net income has grown from $4.4 billion to $5.9 billion and net profit margins have grown from 14.9% to 16.7%. This yields a CAGR of 2.91%. 3M is doing very well considering that all of the companies in the S&P 500 averaged a margin of 14.3% from 2001 to 2020.
For the balance sheet, 3M has grown total assets from $33.9 billion in 2012 to $47.1 billion in 2021, a $13.2 billion increase. Within the last 3 years, goodwill in the balance sheet has increased substantially because of the MModal and Acelity acquisitions.
At the same time total debt has grown from $6.1 billion to $18.3 billion, a $12.2 billion increase. Though I don’t like seeing debt grow this much, it is still smaller than the increase seen in total assets which is good. What’s even better is that after all investing and financing activities, 3M had an ending cash position of $4.6 billion in 2021. This tells me that 3M brings in and holds onto enough cash to finance any debt activities and still has enough money at the end of the day to pay dividends. Their debt to EBITDA, interest coverage, and free cash flow levels further support this.
The Bad News
On February 14th, 2022, 3M provided a financial guidance and strategic update for 2022. The presentation touched on a lot of things but managed to avoid addressing most investors’ concerns about the legal liabilities that currently surround the company.
3M currently has two legal headwinds. One is in regard to the company’s legacy PFAS chemicals and the other is concerning their military earplugs. The company’s military earplugs liability looks to be the larger of the two.
In 2008, 3M acquired a business that sold government-approved combat earplugs called Combat Arms Earplugs Version 2 (CAEv2) from 2003 till its discontinuation in 2015. The earplugs were widely used in Afghanistan and Iraq during that timeframe. More than 2 million servicemembers were deployed during that time.
The first lawsuit popped up in 2018 when a veteran claimed he had received hearing damage during his time serving because of the faulty earplugs. By the end of 2021, 3M had been received lawsuits representing over 13,000 claimants with similar allegations. Additionally, 290,000 unfiled claims have been maintained in the court, making this issue the largest multidistrict litigation (MDL) since the system was made in 1968. Some of these claims are likely to be dismissed, but the total legal liability is still huge here.
It is not yet clear whether the sheer size of this MDL will work in favor of 3M’s side or the other. Defendants have preferred MDLs as a way of taking care of a large number of cases by winning favorable pre-trial rulings, but the public attention surrounding this MDL could change that approach.
In 2018, 3M paid $9.1 million to settle claims by the US government that they concealed the plug’s defects but did not admit liability.
Hearing damage is the leading cause of disability reported to the VA. Different kinds of hearing damage get different settlement amounts. The average verdict of partial hearing loss is a $139,000 settlement and $14,000 for inner ear dysfunction.
Of the 11 bellwether trials that have taken place so far, 3M has won 6 and has paid combined verdicts of $51.4 million paid to 9 plaintiffs. The twelfth trial is taking place currently and 4 more trials are scheduled to take place before June. 3M plans to appeal adverse verdicts.
The potential for liabilities here is huge, but it is important to remember a few things with MDLs like these: (1) magnitude and validity of these cases are generally stronger at the beginning of this process and (2) settlements are generally paid out across several years.
With that in mind, many analysts say the overall earplug liability could range from $10 to $60 billion. Morningstar Analysts expect a $3 billion liability, but I think this number is very conservative. 3M retains about $2.5 billion of free cash flow every year after paying dividends, if we assume a spread of payments and full usage of this free cash flow, it looks like upwards of $40 billion of legal costs could be managed while also keeping the balance sheet at levels that leaves the dividend unharmed.
3M is going to need to lean on its strong balance sheet to cover these liabilities. They have already shown that they are taking steps to prepare for this. Last month, 3M announced a measly 0.7% increase on its dividend. This keeps their growth streak intact while not significantly dipping into the balance sheet that will be needed to cover these allegations.
Whew that’s a lot of information…but wait there’s more! We still have the PFAS liability to talk about.
3M manufactured Per- and Polyfluoroalkyl Substances (PFAS) from the 1950s through the 2000s. These chemicals used in a variety of their consumer and industrial products like fire-extinguisher foam, food wrapping, and nonstick and water-resistant coatings. These chemicals are quite toxic and have earned the nickname of “forever chemicals” because of the carbon fluorine bonds (one of the strongest bonds in organic chemistry) that the chemicals make use of. Those bonds give the chemicals a very long half-life which extends their persistence, toxicity, and occurrence in the blood of wildlife populations.
3M faces several lawsuits accusing them of polluting water supplies at locations where they had previously manufactured PFAS. Bellwether trials for this litigation are expected to begin in 2023 which is also the timeframe within which the EPA seeks to classify certain PFAS as hazardous substances. We will be waiting for years until the full scope of these liabilities are known.
Some analysts expect total liabilities for the PFAS cases to total around $10 billion with the worst-case scenario estimating $30 billion.
Ironically, despite all of these legal troubles, 3M was named as one of the World’s Most Ethical Companies by Ethisphere for the 9th year in a row on March 15th 2022.
Fair Value
Average analyst consensus on price target (as found on MarketWatch and Wallstreet Journal) predicts upside of 16%. Morningstar’s Analysis predicts 23%. Trefis predicts 27% upside. Most analysts have kept their rating as “hold” for MMM excepting Morgan Stanley who downgraded their rating in February.
The timing and the magnitude of these legal liabilities have a profound effect on the stock price. At the time of writing this, MMM stock price is $147.69. MMM is at a P/E of 14.2 and the industrial sector as a whole has a P/E of 19.0. It has a dividend yield of 4.04% which is 33% greater than their 5-year average. Additionally, MMM is only 4% away from its 52-week low.
All these things show that MMM is trading roughly at a 24% discount compared to the rest of the sector. This discount represents roughly $25 billion of market cap which could be interpreted as the amount of legal liabilities that the market has baked into 3M’s valuation.
3M’s discount appears reasonable based on the information we have today but should expected liabilities increase as we get more information from the bellwether trials, investors need to be ready for more downside. Until these liabilities are resolved, they will continue to be 3M’s headwind. Otherwise, their well-diversified and high-margin product line looks to, at the least, follow global GDP, if not surpassing it.
Let’s Get Technical
MMM’s chart has been in a declining channel (blue lines in the chart) since June of 2021 when it’s price was around $200. Since then, it has fallen to $140 in March of 2022 for a 30% loss. Price action has experienced a bounce off of the $140 level and closed at $149 at the time of writing this article.
That bounce occurred at the bottom of the channel and also at a support level at $140 that formed in March of 2021. Currently, the price action is hitting a resistance level at $150 that formed in September of 2020 and wasn’t previously broken till May of 2021 (grey lines in the chart).
Volume levels for the last two months have been higher than average which is good for price action, however, the MACD does not show signs of reversing (the two rows underneath the chart). The last time the MACD was at these levels was in April of 2020 when we saw the run from $120 up to $210.
Can we expect another run like that to happen soon? I do not believe so. The price of MMM has two tasks ahead of it, it needs to break through that $150 level with enough force to also break through the upper end of the channel before substantial gains on stock price can be realized.
That is how I would treat trading this stock in the short term. However, after having gone over the pending legal challenges the firm faces, I believe it is more likely that price action will stay within the declining channel.
My approach will be to accumulate shares while the price is stuck within this declining channel. This channel gives us a great opportunity to continue adding cheap shares and build up our dividend income which the firm has shown signs of keeping safe from the firm’s current issues.
The Good and The Bad – A Summary
Overall, there’s a lot to digest here. Believe it or not, I didn’t even get to include everything I wanted to in here! But this article presents the base case for MMM, so let’s review the good and the bad and see what we think.
The Good
The Bad
Diverse product portfolio that charges a premium
Though they are still growing, gross profits and R&D spending have started to slow
Greater R&D spending and returns than competitors
Recent emphasis on acquisitions is a shift in historical company strategy
R&D enables multiple use cases of existing platforms
Earplug liability uncertainty; max liability (extremely liberal estimation) of $60 billion
Strong intangible assets via patents
PFAS liability uncertainty; max liability estimated at $10 billion
Strong customer relationships supported by +100 years of operations
Slowing COVID sales from respirators and masks
Climbing revenues and margins
Mostly negative technical indicators
Balance sheet assets growing faster than liabilities
Ability to reposition portfolio towards faster-growing segments
Discounted Dividend King with 100+ years of consecutive payments and 60+ years of consecutive increases
My opinion of 3M is a bullish one. Yes, the legal liabilities facing the company are huge, but a majority of that cost is already baked into the stock price. Only time will tell, but as these cases progress, I don’t expect to see much more downside per the reasons discussed earlier.
In the meantime, 3M is at a roughly 20% discount and pays a 4% dividend. 3M has shown that they will protect the dividend growth streak through these headwinds. Therefore, as a dividend investor, I see a particularly rare opportunity here to build a substantial position in a market sector leader that is destined to bounce back once these legal headwinds are out the door.
As long as the price of 3M is held down by these legalities and they continue to show signs of protecting the dividend, I will be buying it up and reinvesting these cheap dividends.
Thank you for reading this analysis! Leave a comment or reach out to me on Twitter or CommonStock with any questions or comments you may have!
