Activision Blizzard $ATVI: An Attractive Arbitrage Opportunity
If you don’t know, Activision is a giant gaming company and thus I thought that it was only right to slide gaming slang into this pitch. So if you’re not a gamer, pull up Urban Dictionary or click the links to look up the gaming terms and dive into the analysis!
Activision stock ($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. If the deal does not go through, the stock still has amazing financials and is strategically positioned to grow within a booming industry.
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.
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.
- 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 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.
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? I personally think the acquisition will go through and I believe the likelihood of that happening is higher than the 60% used in this analysis. Let me know your thoughts and questions below!
Interesting read here! I can appreciate a lot of your points in this write up, however I disagree with the assessment that the possibility of the deal being stopped by authorities is “slim.”
Microsoft has been on a buying frenzy in recent times, with the purchases of Mojang, Zenimax etc. Monopolization of an industry is seldom a good thing, and I believe the US Federal Trade Commission and the UK Market Competition and Authority are aware of this risk as well. Companies as large as Microsoft often “promise” and “intend” many things. I believe that the authorities responsible for the approval understand that a corporations “promise” doesn’t carry a lot of weight. Companies don’t spend billions of dollars to keep the status quo the same.
I am putting my bet on the authorities to stop this deal, preventing the further monopolization of the gaming industry. Curious to hear what others think.
@investmentnewb Microsoft definitely has been on a buying frenzy, especially with their last big deal with Bethesda. But, when compared to the biggest game companies out there, they are the fourth biggest and don't look to be much of a concern as far as monopolization goes. I talked about this a little bit in the post, but I'll dive into some more detail here.
Chinese tech giant Tencent (owns Riot Games, PUBG, and a majority of Super Cell) has a gaming division that made the most revenue out of all the game companies in 2021 with around $26 billion in USD. Sony's gaming division was the second largest with about $24 billion in revenue. Third was Apple at $15.3 billion (this obviously is mostly from app store games, but that is still a huge portion of the market value and is worth considering).
Microsoft came in fourth at around $15 billion. If the deal goes through, Activision's revenues would boost Microsoft's gaming revenue to about $24 billion, putting them in a tight race with Sony for third place.
To add to that point, Microsoft's gamepass subscriber base passed 25 million users this year. That number pales in comparison to Sony's Playstation Plus membership which passed 47 million users last year.
This deal would make three very large and very competitive gaming companies where one is not the clear leader. Better competition from the big players, in my opinion, would grow the industry, push for more innovation in technology and games, encourage more pricing competition, and it would be something that the regulators would welcome.
When doing arbitrage, it doesn't really matter what the company is doing since the alpha or beta made on the trade is pretty binary (it closes or it doesn't). The probability of it happening is based on 3 factors, the price prior to the announcement, the current price, and the deal price. At current levels, the market is not pricing in a 60% chance of deal completion, it's actually less. Closer to 40%. As far as the trade goes, it's best to take a position on opposite legs of the trade to hedge yourself (i.e. long acquiree and short acquiror or vice versa). the only reason buffet is long ATVI is cause he thought it was punished too much from all the scandals and thought it was a good bargain price in the $50/$60s. Guess he just got lucky with the buyout.
As far as the value of the company if the deal falls apart, doubt $ATVI will be at fault so let's assume that $MSFT is the one to pay breakup. ATVI has held up well so far this year only because of the deal, otherwise, it would have entered the trash can like other tech and gaming stocks and with video game hardware and accessories declining, ATVI could very well drop well below the $60 range to make up for it (think recent $KSS or $TWTR deals once they were dropped. Each subsequently was sent down DDs).
Equity risk and tied up capital for a ~25% upside can ruin your IRR so structuring the trade with options opens up equity while allowing your to achieve DDs IRR and a decent ROI if deal close/not close by July 2023. I outline all this in my trade idea from April.
Would love your thoughts on it since it seems you've also dived into this deal.
Hey @paulcerro! I know the company and macros don’t matter when doing an arbitrage deal, but I also mention that I would hold this company long term even if the acquisition failed. I think the company is in a great position within a growing industry and would be a great long term hold, regardless of the workplace issues that currently threaten performance.
If the deal fell through, given the fundamentals and the termination fee, I don’t think the stock would fall back below the $60s, if it did I believe it would only do so for a short time.
I do like your plan for using options to boost the IRR and limit risk, awesome right up on your part! I wish I had seen it before doing my research and writing for this post 😂
One thing I think Microsoft has understood from very early on with the original xbox, is the value in the gaming industry. It's an industry that continues to expand and turn from a small niche of people to reaching every household. I love the use of 'gaming' slang as well. Great job.
@amgome17 Thanks for reading! The gaming industry is huge and growing, and Microsoft is smart to have capitalized on it all these years. There are 3 billion people in the world today that regularly game on one platform or another. And that number is only going to grow. Microsoft is very strategic with the direction that they've taken xbox, gamepass, and now xcloud to make gaming very accessible and make their system a crucial point in many house's living rooms.
I love the write up Dollars! Always insightful and informative - keep up the great work 🤝🏻
Love the write up! Very thorough and informative. Do you think Bobby Kotick will stay as CEO of Activision if the acquisition goes through?
Great analysis! I feel like this is a great topic to touch in and shed some light on! I do think the merger will go through but I’m curious to see what will happen after. I do think that this merger will continue to push the industry forward and create new innovative games. The amount of time and money that goes into these games is huge and the resources that Microsoft has at their disposal is a great opportunity for game creators with a story to tell. That being said it does scare me a little. With so many acquisitions that Microsoft has been making it is more clear than it ever has that the large studios have a strong monopoly on the industry. Some of my favorite games have been the ones that small studios with a limited budget crate. The only issue is that many of them never get to see the light of day when their in the shadow of these massive monopolized studios and games.
@dale_squater_crypto love your comment, I think it touches on kind of the same ideas of @investmentnewb comment and brings me to an area of the industry that I didn’t really touch on in the post.
The acquisition will bring a TON more competition into the blockbuster video game arena, however I do not think that it will hurt the indie game industry a lot, maybe only a little. As a gamer, I’ve noticed within the last decade or so that indie games or small have really broken off into a genre of their own and have really shined bright.
Take Super Hot, Among Us, Fall Guys, Rocket League, Hades (one of my favorites), and a huge number of horror games for example. Those games are hugely popular and have a made a decent chunk of change. Indie games also have had an awesome critical in run in recent years with some of the more popular ones winning some pretty acclaimed awards.
There’s definitely room for both big names and small names in the industry and I think Microsoft has actually done a good job of showcasing that through their acquired Xbox studios like Mojang, Inexile, and Undead Labs by letting them have creative control of their IPs.
Hey Conor! Yeah it’s great to find another platform to meet likeminded investors - came over from twitter 🤝🏻
Detailed write up, sir. I like the company as well. I do think the acquisition will go through and all the shareholders will get a nice payout when it closes
@scorebdinvestor I think the acquisition will go through as well, if it doesn't I highly doubt it will be terminated on Activision's end which means they have a stellar year with the termination fee paid to them and I get to hold onto an awesome gaming stock 😍 Win win for me!
Good pick and I agree with your thesis that the stock is mispriced.
You might not expect it, but in merger arb the largest deals in absolute $ terms are typically the most mispriced to the downside - too cheap.
This is because many merger arb funds typically equally risk-weight (or also known as equal VaR-weighting) their portfolio, which ends up in a portfolio that looks much closer to equal weighted than market cap-weighted or deal size-weighted.
Thus, you tend to have a dynamic where there's as much risk capital chasing $ATVI ($60bn) as $TWTR ($30bn) as $MGI ($1bn). Since funds can't take on a 60x size position in ATVI as they can MGI from a risk perspective, smaller deals tend to be more accurately priced on factors to do with the probability the deal closes, while there is simply not enough merger arb dedicated capital in the market to tighten the spread on the largest deals to accurately reflect the probability the deal closes.
Buffett (of course) knows this, and I believe that's why we see him consistently playing in the largest merger arb opportunities in the market, from Bayer/Monsanto a few years ago to Microsoft/Activison today.
@dividenddollars I do not. That's just from personal experience from my days as a PM at BlackRock where we ran a merger arb strategy and corroborated through discussions with industry contacts.
I suppose it would be simple enough to do a statistical study on this if you had access to the data, which sadly I do not any more.
I've had my eyes on $ATVI for a while now, you helped make up my mind though! Love all the language used as well, lol!
I want to buy this now, as a gamer I like their products, and I give almost every new one a try. Even if I end up only playing for a month I know a lot of people who will keep playing until the next installment releases. With all the in game content to buy now, i'm sure this is very lucrative. Didn't know King was such a big acquisition for them too, that's great.
Side notes: didn't know they were behind mlg, thats nice.
Please make a new guitar hero🙏
@seasnar I’m in the same boat as you! $ATVI has a knack for making sticky consumers. WoW is huge with a subscription cash flow, their shooters are huge with regular releases and expansion, their mobile games are huge with ads driven by free-to-play bonuses, they do very well as seen by their heap of cash and strong revenues. I’m very glad you liked the article and had no clue Activision owned guitar hero 😂 it would be amazing if they revitalized that franchise 🔥
Love the list of best to worst case scenarios. Allows the reader to make an informed decision. You hit on all the salient points. The use of gamer lingo with accompanying links was appreciated. Also, the article was easy to read and understand - even by a reader with limited understanding and experience in the investment world.
Great write-up! I think your right and the deal will go through and push up the stock price!
This is a really exciting opportunity, fantastic insight on the move! Historically Microsoft has a lot of success with their acquisitions compared to other companies, excited to see how this integrates into their current business operations. I could for see some future Blizzard Xbox exclusives, which would likely cause Play Station to make a similar game changing maneuver in order to compete.