Buy Activision After FTC Blocks The Microsoft Deal

Paul Franke profile picture
Paul Franke
18.07K Followers

Summary

  • The odds of U.S. government regulators blocking the Microsoft/Activision Blizzard merger are quite high.
  • Activision's long-term valuation could improve dramatically with a failed deal, breakup cash payment from Microsoft, and lower stock quote.
  • Any significant decline in the share quote, caused by the proposed transaction falling apart, may present a solid buying opportunity.

Pro football players Golden Tate and Joey Bosa play Call of Duty: Infinite Warfare Sabotage DLC from Houston

Mike Coppola/Getty Images Entertainment

I have been explaining to investors that the odds of the U.S. Federal Trade Commission approving the proposed Microsoft (MSFT) + Activision Blizzard Inc. (NASDAQ:ATVI) merger are lower than most expect. I also suggested the morning of the announced transaction would be the high-water mark for ATVI's price (it reached $90+ in the premarket) as Wall Street digested the difficult antitrust environment for Big Tech players after Democrats took control of Washington politics in 2021.

With a current quote of $79 vs. a bid value of $95 in cash for each ATVI share ($69 billion in total), experienced analysts and investors are not quite sure the transaction will be completed. I personally place the odds of a final takeover approval by U.S. regulators under 50%, perhaps closer to 25%.

It has been reported a deal breakup fee of up to $3 billion will be paid to Activision if the FTC and Department of Justice refuse to allow another Big Tech merger that would necessarily consolidate the gaming industry and reduce competition. So, here’s what I project will transpire, and how I plan to take advantage of a failed bid situation.

2-Year ATVI Chart

2-Year ATVI Chart, StockCharts

Good Chance FTC Says No

Seeking Alpha author Kevin Mackie posted an excellent piece last week here, going through all the blocked merger deals since 2021 from the DOJ and FTC. The current 16% price discount vs. the offer bid is clear testament by itself to investor fears that the MSFT/ATVI transaction will not be completed.

A February 1st Seeking Alpha recap of a Bloomberg article summarized some of the regulatory hurdles for the transaction,

The review of Microsoft's blockbuster deal to acquire Activision Blizzard will be up to the Federal Trade Commission and not the Justice Department … a discouraging sign for the deal's prospects.

That's because the FTC under Lina Khan - previously a vocal critic of big tech - has acknowledged taking an aggressive stance against dealmaking.

In recent years the FTC and DOJ have come to agreements about dividing responsibilities to review antitrust concerns over major deals. And the FTC has sued to block two big ones so far: Nvidia's deal to buy Arm Ltd., and Lockheed Martin's proposed purchase of Aerojet Rocketdyne Holdings.

The review will examine the combination of Activision Blizzard's robust game portfolio with Microsoft's hardware, and consider whether Microsoft could hurt rivals by limiting access to Activision's biggest games (these would include the annual best-seller Call of Duty series as well as World of Warcraft).

More bad news came out last week, when it was revealed the FTC made a request for additional information from the companies, restarting the clock on its review process. It would appear from this development a quick approval is not in the cards, and may be the biggest signal yet the deal will not be approved in the end.

ATVI Q3 2021 Earnings Presentation

Q3 2021 Earnings Presentation

Potential Sell-Off Creates Opportunity

What happens if the government says the deal cannot proceed? With thousands of investors and arbitrage players betting on the merger transaction, a rejection of the combination would definitely hurt demand for Activision shares. I am thinking the immediate stock price reaction might be a drop under $70 per share as merger arbitrage players sell en masse, to a level closer to its $65 quote before the Microsoft offer was made public.

However, the $3 billion breakup windfall would be a welcome development for a standalone Activision setup. This sum is equal to or better than a record year of operating income. Below is a chart of already super-high gross margins on sales, looking at the manufacturing expense for games vs. revenues generated. I am graphing a comparison over three years vs. a list of major gaming peers and competitors. The biggest names in the field include Electronic Arts (EA), Take-Two (TTWO), Microsoft, Sony (SONY), Nintendo (OTCPK:NTDOF) (OTCPK:NTDOY), NetEase (NTES), Roku (ROKU), Roblox (RBLX), and Zynga (ZNGA).

ATVI vs peers

YCharts

A second chart highlights the existing low liability to asset financial setup for the business. The company today runs one of the stronger balance sheets in the gaming industry. At the end of December, Activision Blizzard held $10.4 billion in cash and $12.5 billion in total current assets vs. just $3.6 billion in debt and $7.5 billion in total liabilities.

ATVI peers

YCharts

A large cash infusion would also jump earnings well above current estimates. A cash payment from Microsoft in the $2-3 billion range would effectively allow the company to repay most of its debt.

ATVI earnings estimates

Seeking Alpha Table - March 28th, 2022

Lower Quote = Better Valuation

In addition to nicely improved income and cash flow numbers, enterprise value calculations would decline for owners in a positive way from fewer net liabilities, with the huge cash windfall. All told, the decent current valuation picture could become something of a bargain buy idea if the stock quote falls and the extra cash is quickly put to good use.

I have drawn 10-year charts of price to trailing sales, free cash flow, and book value, with decade median averages of each fundamental valuation ratio. Again, a lower price will reduce each calculation close to or below long-term averages, while ongoing free cash flow is pumped with the extra unallocated capital payment from Microsoft.

ATVI PS ratio

YCharts

ATVI price to FCF

YCharts

ATVI price to book value

YCharts

Future earnings yields would also find their way higher vs. current estimates. Below is a projection of 1-year earnings yield, measured against peers and competitors. A deal breakup fee and lower stock quote could easily propel ATVI’s after-tax income yield well above 6% for smart investors on a failed transaction development.

ATVI vs peers

YCharts

Finally, Activision’s enterprise value total could fall from $61 billion using today’s setup to something closer to $50 billion on a blocked merger and sub-$70 common equity quote. Such a scenario would put EV to EBITDA readings under 12x, which have proven the low-water mark for a valuation several times since 2016.

ATVI EV to EBITDA

YCharts

Plus, a potential 12x multiple would compare quite favorably with the gaming-only companies available to retail investors. Below is the current graph of EV to EBITDA for peers.

ATVI vs peers

YCharts

Final Thoughts

Activision CEO Bobby Kotick has been under fire because of employee working-condition complaints. A failed deal may be enough of a blow to owners that a leadership change could be pushed by remaining stakeholders.

A refreshed management lineup, better working conditions for women and minorities, a company flush with cash, a low valuation, and a top position in the rapidly-growing gaming industry could open a terrific buying opportunity.

That’s why I am watching the regulatory saga closely. Without more information on final approval, alongside an inflated price on the deal math (somewhat above-normal valuation) with limited upside to Microsoft’s $95 bid, I am not very interested in either owning or shorting Activision Blizzard shares. I have a Neutral rating, with a wait-and-see outlook.

Assuming a management reshuffle will follow the FTC/DOJ decision to block this deal, a $2-3 billion breakup fee is due, and I can purchase shares under $70, a Buy rating could be approaching in the spring or summer months.

This article was written by

Paul Franke profile picture
18.07K Followers
Nationally ranked stock picker for 30 years. Victory Formation and Bottom Fishing Club quant-sort pioneer.....Paul Franke is a private investor and speculator with 36 years of trading experience. Mr. Franke was Editor and Publisher of the Maverick Investor® newsletter during the 1990s, widely quoted by CNBC®, Barron’s®, the Washington Post® and Investor’s Business Daily®. Paul was consistently ranked among top investment advisors nationally for stock market and commodity macro views by Timer Digest® during the 1990s. Mr. Franke was ranked #1 in the Motley Fool® CAPS stock picking contest during parts of 2008 and 2009, out of 60,000+ portfolios. Mr. Franke was Director of Research at Quantemonics Investing® from 2010-13, running several model portfolios on the Covestor.com mirror platform (including the least volatile, lowest beta, fully-invested equity portfolio on the site). As of August 2022, he was ranked in the Top 5% of bloggers by TipRanks® for stock picking performance on positions held one year. A contrarian stock picking style, along with daily algorithm analysis of fundamental and technical data have been developed into a system for finding stocks, named the “Victory Formation.” Supply/demand imbalances signaled by specific stock price and volume movements are a critical part of this formula for success. Mr. Franke suggests investors use 10% or 20% stop-loss levels on individual choices and a diversified approach of owning at least 50 well-positioned favorites to achieve regular stock market outperformance. The short sale of securities in overvalued, weak momentum stocks as pair trades and hedges is also a part of the Victory Formation long/short portfolio design. "Bottom Fishing Club" articles focus on deep-value candidates or stocks experiencing a major reversal in technical momentum to the upside. "Volume Breakout Report" articles discuss positive trend changes backed by strong price and volume trading action.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This writing is for educational and informational purposes only. All opinions expressed herein are not investment recommendations, and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity and is not a registered investment advisor. The author recommends investors consult a qualified investment advisor before making any trade. Any projections, market outlooks or estimates herein are forward looking statements and are based upon certain assumptions and should not be construed to be indicative of actual events that will occur. This article is not an investment research report, but an opinion written at a point in time. The author's opinions expressed herein address only a small cross-section of data related to an investment in securities mentioned. Any analysis presented is based on incomplete information, and is limited in scope and accuracy. The information and data in this article are obtained from sources believed to be reliable, but their accuracy and completeness are not guaranteed. The author expressly disclaims all liability for errors and omissions in the service and for the use or interpretation by others of information contained herein. Any and all opinions, estimates, and conclusions are based on the author's best judgment at the time of publication, and are subject to change without notice. The author undertakes no obligation to correct, update or revise the information in this document or to otherwise provide any additional materials. Past performance is no guarantee of future returns.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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