Description

Activision is a dramatically different story than when it was written up 6 months ago by cablebeach.  However, trading at almost the same price, I still think it is a great investment from here.  Either Microsoft successfully acquires the company for $95 in ~15 months and you make a very respectable double digit IRR in a very tough environment to find safe double digit returns, or the FTC scuttles the deal and you end up owning one of the premier videogame companies right into its next product super cycle.  Either way it looks like you will win.

What happened since the last write-up?  

1. In November, because of the well-publicized sexual harassment problems at Blizzard and turnover at the top as a result, it was announced that Overwatch 2 and Diablo IV would be delayed until at least 2023. 

2. Bobby Kotick almost got canceled. Since the sexual harassment issues at Blizzard there has been an endless stream of press about the company, its past inadequate workplace policies, and how Kotick turned a blind eye to it all. There was an active campaign among Blizzard employees to have Kotick removed.  While it looks like there was no direct wrongdoing on Kotick’s part, in the world we live in, being at the top of a company that has issues is enough.  

3. Microsoft sensed an opportunity and used the weak stock price and controversy to approach Activision about a merger and reached an agreement on January 18th to acquire the company for $95 per share in cash.

4. In February, Activision said it would delay the release of the next Call of Duty game to 2023.

Because this is mostly a merger arb play for the time being, I’ll focus on the deal details a little bit.

• Offer:  Cash offer at $95/share.  Microsoft is a pretty decent credit (one of 2 companies with a AAA credit rating).
• Termination Fee:  $2.27 bil from ATVI to MSFT if ATVI takes a superior offer, doesn’t get shareholder/board approval, or fails to close.
• Reverse Termination Fee:  $2.0 bil before Jan 18, 2023, $2.5 bil from Jan 18-Apr 18, $3.0 bil after April 18,2023 from MSFT to ATVI if the deal gets scuttled by antitrust or MSFT fails to close.
• Timeline: The deal is expected to close by July 18, 2023 as that is the latest date considered by the merger agreement.  The companies guided to a mid 2023 closing when they announced the deal, so it seems like they are planning on a lot of antitrust scrutiny.

Obviously, antitrust is the key issue here and the market seems to be pricing in a huge amount of risk (the spread implies only a 48% chance of the deal happening).  I’m hard pressed to see how MSFT could have too big of a problem if the market is defined as the video game market.  That’s a roughly $180 billion market depending on who you believe.  Microsoft’s video game revenue (and this includes hardware) was $16 billion last year.  Activision’s was $8.8 billion.  So combined they would have 13% market share.  Pretty hard to call that a monopoly.  Now the regulators may force Microsoft to promise to continue licensing games on other platforms like Playstation and Nintendo, but I can’t see them having a leg to stand on in terms of quashing the deal altogether.  Microsoft and their team of lawyers knew this deal would get heavy scrutiny, they are prepared for it.

I think by far the most likely outcome is that the deal goes through as planned.  However, if the deal doesn’t go through, I think you will end up making more money in the end.

Reasons to love the core business if the deal breaks:

1. Dominant Franchises - Call of Duty, Overwatch, Candy Crush, World of Warcraft.  Video games have become like the movies (think Star Wars, Avengers, etc.).  The dominant franchises can put out sequel after sequel and print money and Activision owns several of the best franchises of all time.

2. Early Lead in E-Sports - Activision to my knowledge has the best effort in the emerging esports market.  For Overwatch and Call of Duty they have very organized leagues with franchises for various cities.  Eventually, E-Sports has the potential to be a market as large as other professional sports and Activision is an early mover in the space.

3. Product Delays Should Make Earnings Very Strong - One needs to go no further than the proxy from MSFT merger to see that the plan is for earnings to ramp very significantly from here as some of the delayed games are released:

So if these numbers are to be believed and we apply a reasonable 20x multiple to GAAP 2024 earnings (most of the street still looks at EPS ex SBC)  which is what people will be looking at after the deal breaks it still implies a $90 stock.  If it gets the kind of multiple EA and TTWO get on adjusted EPS the stock could easily be $120+ at this time. 

4. Bobby Kotick - This may not be PC, but Bobby Kotick is an amazing capital allocator.  He basically stole Blizzard from the morons at Vivendi.  He took a near bankrupt Activision and built it into one of the great videogame businesses of all time.  An example of this excellent capital allocation is Guitar Hero.  It was a huge game and hugely popular.  But, the music rights got very expensive.  When Bobby couldn’t make money anymore the franchise got canceled.  Capital allocation 101, but few people have the guts to cancel a popular game that doesn’t make money anymore.  Obviously, there were sexual harassment problems at Blizzard.  However, most of the egregious issues were 10 years ago and you are telling me that you didn’t expect problems like that at a developer making shoot ‘em up games 10 years ago?  The world has changed a lot in a decade. I think Bobby has learned his lesson on this issue and will take it seriously if the MSFT deal doesn’t end up happening.  I firmly believe that Kotick is much more of an asset to the business than a liability.

Bottom-line, Activision to me looks like a heads, MSFT acquires it at $95, or tails, it stays independent and I own it right into the next product cycle and probably see a valuation well in excess of $95.  Either way I think someone owning it from here over the next couple of years is likely to win.

Catalyst

MSFT closes the deal or earnings from the next product cycle kick in.