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 22^nd 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.

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 18^th, 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 4^th 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 31^st, 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!