Activision Blizzard (ATVI) A gaming (interactive entertainment) company with strong franchises & IP, long term growth track record, and a merger arbitrage opportunity due to Microsoft Activision deal
Microsoft to acquire Activision Blizzard
Activision Blizzard (ATVI) is a gaming (interactive entertainment) company, which has agreed to be purchased by Microsoft (MSFT) in an all-cash offer of $95/share, forecast to close around April-June 2023. The Microsoft Activision deal is a merger arbitrage opportunity for investors. Activision shares are currently trading at ~$80.50, so the market is pricing in a possibility that the deal may fall apart, i.e. an opportunity to buy below the takeover price. There are two possible outcomes:
A) The deal goes through (return comes from the premium of the offer price to the current
share price)
B) The deal does not go through (then the return is the long-term return available on the
Activision business itself)
Calculating the merger arbitrage return of Microsoft Activision deal
This return, taking into account the probabilities of the deal closing and potential losses and gains if it closes/does not close, can be calculated, after we make some educated guesses:
Transaction date:
The Microsoft Activision deal has a breakup fee. This escalates over time: before 18-Jan-2023 it is $2B, between this date and 18-Apr-2023 it is $2.5B, and after this date, $3B. According to the filings, the deal is expected to close by Jun-23. Let’s assume that it
takes the full period, and closes at the end of June 2023.
Share price if deal falls through:
Activision share price if the deal falls through: $65.42 (average share price 2017-2021). Activision traded between $38.17 (in 2017) and $96.68 (in 2021) in this period, with a median share price of $63.56. The merger was announced just after this period on 18th January 2022.
Probability of the deal closing:
According to a study of M&A deals in the period 2013-2018 by McKinsey, ~10% of M&A deals fall through, and five in ten of these are due to price disagreement, a focus on organic growth instead of growth through acquisition, and investor activism: which do not apply here, so there is a ~95%
probability of closing. To be conservative, let’s assume a 90% probability of the deal closing. Funding will not be an issue: Microsoft has sufficient cash to buy Activision. The main potential obstacle is regulatory approval from the FTC (Federal Trade Commission) in the US. If the deal closes then there would still be a number of significant competitors to Activision, namely Electronic Arts, Take Two Interactive, Zynga, Sony, etc. and it would be a long way from having a dominant market share in the industry, so it is unlikely to be blocked by regulators. Regulators are concerned with Microsoft limiting access to the Activision franchises like Call of Duty, by not allowing the games to be sold on rival platforms. However, Microsoft has stated that it will continue to support the games across other platforms: in it’s blog post, ‘Gaming for Everyone, everywhere: Our view of the Activision Blizzard acquisition.‘
It is also unlikely that there will be a higher bid for Activision from another company, for two main reasons: 1) financing is getting more difficult due to rapidly rising interest rates, 2) Activision is quite large and there are only a very few companies that have the ability to buy it
Estimated return of merger arbitrage in Microsoft Activision deal
Estimated return of merger arbitrage in Microsoft Activision deal
To say that the transaction has a 90% probability of happening, means that the transaction it is happened ten times, would close nine times and fall apart once. Of course, it will only happen once: but we can consider what would happen if we invested in a number of merger-arbitrage opportunities over time: e.g. if you invested in ten deals, each with a 90% probability, you would expect to make money 90% of the time. Therefore, if the investor applies the same criteria over time they can expected to make on average, the risk-weighted return. This can be calculated by also taking account of the potential downside as follows:
Expected profit per share (risk weighted return) = Probability of deal closing (90%) * upside per share ($95-$80.5) – probability of deal falling apart (10%) * downside per share ($80.50-$65.42)
Expected profit per share = $13.05 – $1.51 = $11.54 or 14.3%.
Annualised return: 14.3% in 10 months = 17.2% annualised.
Since the expected profit per share (risk weighed return) is positive and provides a return likely to exceed the stock market, it is a good investment opportunity.
In summary, Activision Blizzard is a strong business, with a limited downside if the deal falls through, a high probability of the deal closing and therefore is a good merger-arbitrage opportunity.
B) The Microsoft Activision deal does not close: calculation of return
There remains a small possibility, estimated at 10% that the deal will not close: therefore the company is now analysed to determine the likely return if this happens.
Business description
Activision Blizzard has three core gaming franchises which contribute ~80% of revenues:
1. Call of Duty (first person shooter military game) (Activision segment)
2. World of Warcraft (Battle.net) (Blizzard Segment)
3. Candy Crush (King segment)
Product sales are 88% digital, whether game licences, subscriptions to play their games online, or digital add-ons to enhance gameplay, and there is a minority of physical product sales (game software on physical media). An important trend in the industry is the shift to mobile: end user customers are using fewer PCs, tablets, consoles, and more mobile devices to play games.
Revenue is split approximately 50:50 between US and international, with 43% of revenues from Activision, 22% from Blizzard and 35% from King: margins are similar in all with Activision accounting for 48% of operating income.
Competition
Competitors are shown in the table below. Electronic Arts is the closest comparator, whose most
significant franchise is FIFA football.
Company
Ticker
Price: sales
Gross margin 10Y median
Operating margin 10Y median
ROE 10Y median
Revenue 10 Y CAGR
Activision Blizzard
ATVI
8.3
66.20%
25.10%
11.90%
6.40%
Electronic Arts
EA
5.1
73.30%
20.20%
22.30%
5.40%
Take Two Interactive
TTWO
5.7
42.70%
8.20%
12.80%
15.60%
Zynga
ZNGA
3.3
68.40%
-9.90%
-4.90%
9.40%
NetEase
NTES
4.3
56.50%
33.40%
25.10%
28.20%
RoBlox
RBLX
14.2
75.00%
-26.70%
31.40%
81%*
Activision Blizzard state that competition is intense within the gaming industry, as do Electronic Arts: however the latter also say that, ‘Many financially successful products and services within our industry are iterations of prior titles, with large established customer bases and significant
brand recognition, which makes competing in certain categories challenging.’ Activision also recently refocused on their core three franchises, which account for 82% of sales in 2021. This highlights the advantages of scale and IP in the space, and therefore there is some moat for
the incumbent gaming franchises.
Efficiency, Pricing Power vs competitors
Pricing power: the inputs for Activision Blizzard are mainly software developer time, and the outputs are IP in the form of new versions of existing games, or sometimes entirely new games. Activision have pricing power when it comes to their games, since they are unique: this is reflected in the company gross and operating margins (see next section), though most of their revenue is derived by selling to the end user customer through Sony, Microsoft, and the Apple store and Google Play store, rather than directly. These large distributors are essential for Activision, but Activision is not material to their overall sales.
Activision states that increased competition for, ‘digital shelf space,’ has placed these customers in a better position to negotiate favourable terms of sale. These distributors are in the position of also being Activision’s direct competitors: e.g. Activision sells games through Sony for the PS4 console, but Sony also develops games itself for the PS4 console. In the mobile space; Apple controls all purchases made through it’s store of game add-ons for Activision’s Candy Crush franchise. They are also, in the case of e.g. Apple, sometimes the payment processors. In summary, Activision has pricing power with it’s end customers, but has less power over its distributors.
Durability, Quality & Risks
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Disclosure: the Real Worth Stocks model portfolio has a long position in Activision Blizzard (ATVI).
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