This, week Microsoft (MSFT) announced its plans to acquire Activision Blizzard (ATVI) in an all-cash offer for $68.7 billion. Including Activision’s net cash position of $6.4 billion, the deal is valued at $95 per share.
The deal is expected to close sometime in 2023 after regulatory approval. Activision has a number of strong gaming brands including Call of Duty, Candy Crush, Warcraft, Overwatch, Diablo etc.
Microsoft can realize synergies and also expand into mobile gaming through this deal, which is why it is offering more than 20x Activision’s trailing 12 month EBITDA ($3.4 billion). I am bullish on Activision stock in the near term, and neutral on Microsoft.
Activision has almost 400 million monthly players across its games. Microsoft’s core motivation for this deal comes from the fact that gaming content (creative software) is more powerful than better hardware from a margin and growth point of view. With operating margins above 30%, Microsoft will want to expand its Gaming segment as much as possible.
As the deal gets closer, traders will be looking to capitalize on the spread between Activision’s trading price (currently $82) and the acquisition price of $95 per share.
If the deal closes successfully once regulators approve the transaction traders could capitalize on 16% returns on the trade. Hedge funds will consult ex-senior bankers and M&A lawyers who will be responsible for looking at the risks of the deal falling through.
It’s up to them to appropriately determine what regulators, shareholders, closing conditions factors might result in deal failure. This is known as “Deal Closing Probability.”
Most important is regulator-based issues, including anti-trust concerns such as monopolistic factors that give one corporation in an industry too much power.
Microsoft has been acquiring video game developers for several years, however the most recent deal is significantly larger than any previous video game developer.
Merger Arbitrage
The reason Activision Blizzard hasn’t traded up to $95 per share after the deal was announced is because that’s what the market deems the risk spread of the deal falling through.
As the deal gets closer and closer, the trading price should begin trading closer to $95 per share because the closer in time we get to a completion date the higher the probability that the deal will successfully close.
Particularly on the date that regulatory approval gets announced, shares are likely to move higher. If the deal is successful, investors will have their shares purchased from their custodian for $95 per share upon closing.
Downside Risk
The downside is that regulators may refuse the deal or other factors results in the deal breaking. If this happens, the sell-off will be just as dramatic as the rally when the acquisition was announced, however now it’s in the opposite direction. The DOJ can also block the deal if it isn’t satisfied with additional information not originally disclosed.
In the case of Microsoft, regulators might not like the idea that the Xbox manufacturer is purchasing one of the biggest video game publishers in the world. Microsoft may turn future games from the existing franchises into Xbox-exclusive games.
The question is whether or not Microsoft can get past regulators who may be against the idea of Activision franchises being made exclusively for Xbox, which puts limitations on industry consumers who already have a PS5.
The size of this deal does pose more risks, as more careful consideration is needed by the FTC. Furthermore, the deal can fall through for other reasons such as poor company performance leading up to completion, or financing issues.
According to Accelerate, between 2011-19, 94% of announced M&A deals in the U.S. closed successfully, with 87% of the announced deals closing with the same terms. So, overall there is a high probability that the Microsoft-Activision deal will close in 2023.
Activision Blizzard Performance
Looking at Activision Blizzard’s performance we can see growing gamers across most franchises.
In the last 12 months, Activision generated over $9 billion in revenue, this is significantly higher than $6.6 billion from 2016. Of course the pandemic has aided this increase in gaming demand, however the growing global trend for gaming is expected to continue.
Over the last 12 months, Activision has achieved a 15.6% return on capital (ROC). Over the last five years, ROC has been above 10% in every year except for in 2017.
Activision has a very healthy balance sheet with only $3.6 billion in debt and $10 billion in cash and equivalents. It also has a current ratio of 5x, meaning it can pay its current liabilities five times over with all its liquid assets.
Microsoft earns a Strong Buy consensus rating, based on 27 Buys and one Hold assigned. The average Microsoft price target of $373.88 suggests 24% upside potential.
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