Home Deep Analysis Activision Stock: Attractive Arbitrage Opportunity (NASDAQ: ATVI)

Activision Stock: Attractive Arbitrage Opportunity (NASDAQ: ATVI)

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On January 18, 2022, Microsoft (MSFT) announced the acquisition of Activision (NASDAQ: ATV) in an all-cash deal of $95 per share. ATVI shares continue to hover around $80 as investors remain skeptical Regulators will approve the deal and uncertainty about an upcoming shareholder vote.

Based on the antitrust review analysis, I believe the FTC will eventually approve the transaction. Even if the FTC approval doesn’t pan out, downside risks remain limited, making ATVI an attractive merger arbitrage opportunity, up about 18% in 14 months.

Merge vertically or merge horizontally?

Given the size of the transaction, the FTC’s additional requests for information are inevitable. The FTC will then evaluate whether the acquisition is a vertical or horizontal merger. The former refers to acquiring a company that provides a different service (usually part of a supply chain) than the acquirer, while the latter refers to acquiring a direct competitor.

vertical merger

Until recently, vertical mergers have remained unchallenged for more than two decades. Three mergers were challenged: Illumina-Grail, NVIDIA-ARM, and Lockheed Martin-Aerojet Rocketdyne. The first has been completed and court proceedings are currently ongoing. The latter two deals were dropped. All three mergers were rejected for the same reason, namely the acquisition of the only supplier of key downstream inputs.

The FTC has agreed to treat the merger as a vertical merger. The reasons are (i) MSFT’s main revenue generating segment remains the Office and Windows business, and (ii) Xbox is a platform with gaming content as a downstream input.

Given that ATVI does not provide “critical” game content input, it would be hard to deny the merger if the FTC viewed it as a vertical merger. In addition, there are many successful media content integration priorities in support of the MSFT-ATVI merger (think Disney-Fox, Discovery-WarnerMedia, and Amazon-MGM).

If Microsoft converts popular games like Call of Duty into Xbox exclusives, consumers could be hurt and competition stifled. However, Microsoft has confirmed that at least Call of Duty will continue to be available on the PlayStation platform. Therefore, the FTC has no reason to deny the merger from the perspective of a vertical merger.

Horizontal merge

Considering Microsoft’s presence in game publishing, such as Halo, Minecraft, Forza, and Gears of War, it’s also fair to say the merger is horizontal. That influence has since expanded with the acquisition of ZeniMax Media (which owns The Elder Scrolls and Fallout IP, among others).

The FTC will follow the horizontal merger guidelines issued in 2010. These guidelines focus on adverse competitive effects on customers, whether it be pricing, quality, variety, service or innovation. Evidence of such adverse competitive effects would be (i) prioritization of adverse competitive effects, (ii) loss of a large number of positive competitors, (iii) elimination of “mavericks” and (iv) changes in market concentration.

Prioritization of adverse competitive effects

The FTC will examine the historical impact of recent mergers, entries, expansions, or exits in the video game market or similar markets to determine the competitive impact of the merger. The historical priority of acquiring ATVI scale in the industry is limited. The closest is Tencent’s $8.6 billion acquisition of a majority stake in Supercell. The acquisition did not result in a price increase, but a decrease in the price of virtual goods.

A similar priority for the FTC to refer to is the Disney-Fox merger. Both mergers were similar in size of acquisitions and categories of entertainment content. The Disney-Fox merger is ultimately good for consumers. They can enjoy the vast library of Disney-Fox content available through Disney Plus at a lower price than Netflix.

Given the positive impact on consumers of the aforementioned priorities, the FTC will find it challenging to reject a merger on such grounds.

lose a substantial head-to-head competitor

MSFT and ATVI are clear competitors, especially in the first-person shooter (“FPS”) genre. However, given the wide variety of popular alternatives, it’s hard to say they are substantial head-to-head contenders. These alternatives are available on consoles and PC for as little as free in the case of Fortnite, Apex Legends and Team Fortress 2.

Eliminate “mavericks”

“Mavericks” are companies that disrupt industries through new technologies, business models, or resistance to price increases. Given their disruptive effects on the industry, eliminating such companies could have adverse competitive effects.

ATVI has not purchased any new products in recent years. It’s sticking to its tried and true franchises — Call of Duty, Candy Crush, and World of Warcraft. Gameplay has improved, but innovation is still lacking. The business model remains the same and has been following the traditional game pricing model. It’s fair to say that ATVI hasn’t been a disruptive company in the gaming industry for a long time. Therefore, this merger did not eliminate “maverick”.

Changes in market concentration

If anything, that would be the most likely cited reason for the FTC to reject the merger. How the market is defined is important when trying to determine changes in market concentration. The FTC rejected the merger, citing increased concentration in a narrow market. A prominent example was the Staples-Office Depot merger in 1997, in which the combined company would control only 6-8% of the overall office products market (almost no significant share). However, the judge blocked the merger while accepting the FTC’s definition of the “office supply supermarket” market. In 2015, the use of the “B2B office supplies” market definition again blocked merger attempts.

Table 1: Market share of the top 50 games published by Sony, MSFT and ATVI on PlayStation and Xbox (measured by playtime in March 2022)

Market share of the top 50 games on Playstation and Xbox

author research

If the market is narrowed down to games on PlayStation and Xbox only, the combined market concentration increases by 5.5%. The market share study in Table 1 highlights the fragmentation of the market. Even established giants like ATVI only account for about 10% of the market. The combined market share of ATVI-MSFT is about 16%, far from a monopoly.

Table 2: Market share of top FPS games published by Sony, MSFT, and ATVI on PlayStation and Xbox (measured by playtime in March 2022)

Market share of top FPS games on Playstation and Xbox

author research

If the market were to be further narrowed to the first-person shooter (“FPS”) genre only on PlayStation and Xbox, the market concentration would increase by less than 3% (Halo series). According to Table 2, ATVI does have an absolute market share in the FPS category. On the other hand, MSFT has a limited presence in the genre, as the Halo series is only available on Xbox, and its popularity still lags far behind Call of Duty.

Both market share analyses highlight that the growth in market concentration will be limited. Therefore, the FTC’s challenge on such grounds is unlikely to pass.

Why is there a huge spread?

There are two key uncertainties behind the wide spread: (i) the need for a major shareholder vote and (ii) the changing regulatory environment for mergers.

shareholder vote

Shareholders can vote against the merger. It is usually led by activist investors who hold large stakes in the company. Given that no activists have objected so far and that only a simple majority is required, I am confident that the vote will pass without question.

Evolving Regulatory Requirements

The FTC has said it will review material not covered in the guidance, such as consumer data access, the impact on the labor market for game developers, and the impact on abused employees. Given ATVI’s workplace harassment issues, the FTC is likely to focus on labor issues.

Game publishing studios are known for poor working conditions, forced overtime, a toxic culture, and low wages. With labor supply far outstripping demand, the industry got away with it. I highly doubt that the acquisition of MSFT-ATVI will change the industry workforce dynamics.

I would say that Microsoft has some of the better workplace culture in the industry. Learning from the mistakes of being overly involved with Lionhead Studios (developer of the Fable series), MSFT has since taken a hands-off approach to acquired studios. This works well in many cases and complaints are rarely heard. Playground Studio, one of the developers it acquired, was even named one of the best places to work.

Still, MSFT has workplace issues in one of its studios, Undead Labs. Workplace problems appear to have arisen due to the departure of its founder. But Microsoft has since taken corrective action, ousting relevant HR leaders and investing in diversity and inclusion.

MSFT’s emphasis on workplace culture is also reflected in the abandonment of collaboration with renowned studio Moon Studios (developers of the popular Ori series) due to toxic workplace culture. One of its key executives, 343 Industries head Bonnie Ross (who developed the Halo series after MSFT’s spin-off from Bungie) has been instrumental in driving diversity in the gaming industry.

I believe MSFT is well-positioned to correct ATVI’s toxic workplace culture, which may be why it continues to make acquisitions. ATVI, which is owned by MSFT, is likely to provide a better working environment for existing game developers. With that in mind, I can’t find a reason for the FTC to stop this acquisition.

Downside Cap

Figure 1: ATVI DCF Valuation (After Failed Acquisition)

ATVI DCF Valuation

Author Research, Simply Wall St, as of 22 April 2022

Based on analysts’ free cash flow forecasts, a conservative discounted cash flow valuation based on Figure 1 would yield a price target of $82. If the acquisition falls through due to antitrust concerns, the valuation will be paid by MSFT at $3 billion.

Shares will plummet 13% to $69 on news of the failed takeover (ATVI’s pre-acquisition price of $65 + a cash termination fee of $4 per share). However, ATVI remains a business with strong intellectual property that will continue to generate strong cash flow. Its shares will eventually recover from a one-time failed takeover shock and trade at an intrinsic value of $82.

Still, a low 13% downside probability versus a high 18% upside probability is an attractive risk-reward profile if investors are unwilling to wait for the company to trade at its intrinsic value.

timeline

Given the size of the transaction, the parties expect to complete the merger by June 18, 2023, the final extension deadline. If the merger is terminated due to antitrust issues, Microsoft will bear the loss of 2-3 billion US dollars.

An extraordinary general meeting to decide whether to proceed with the merger will be held on April 28. A majority vote is required or the merger agreement will terminate.

At the same time, MSFT/ATVI will prepare and submit information as required by the FTC. Under the guidance, the FTC has 30 days to review submissions. But the FTC has been known to take longer, and that may be the case with such an important merger. My prediction is that approval will come in the first quarter of 2023.

in conclusion

Admittedly, there are risks, otherwise there would be no spreads. In this particular case, however, the market appears to have substantially overestimated the risk leading to an attractive arbitrage scenario.

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