Activision Stock: Greatest Deal Of The Video Game Industry (NASDAQ:ATVI)

The video game industry is simply evolving. The old days were the video game companies based their financial strength and potential almost solely on the brick and mortar sales of their pipeline of game releases are long gone. The introduction of various new business models such as games as a service, games as a subscription, downloadable content, microtransactions, and others have enabled video game companies to enter a new stage of youth while enabling gaming to be perceived as a driving growth force for companies.

At the very top of the mountain lies Activision Blizzard (NASDAQ:ATVI), a true veteran of the industry and one of the greatest video game companies in existence. Due to a terrible and unfortunate sequence of events, investors have had a brief opportunity to acquire a position in the gaming industry giant at pandemic-era attractive valuations.

That train has passed earlier today as it was announced that Microsoft (NASDAQ:MSFT) will be acquiring the video game veteran in a $68.7 billion all-stock deal. The deal creates two different investment opportunities. The obvious merger arbitrage opportunity will most likely be already closed at the time when this article is published, but a much more interesting opportunity arises in the upcoming years for Microsoft.

Microsoft has been looking for ways to better establish its games as a subscription model for years now, and this is only the latest step in the plan. The company already has a giant advantage over any potential competition with it already owning one of the two biggest gaming consoles, as well as owning Microsoft OS. This deal simply put generates value on top of value for Microsoft and most likely is building a moat that is going to last for decades.

The scandal that gave birth to the chance

Last year, on July 20th, California’s Department of Fair Employment has filed a lawsuit against Activision Blizzard for collecting “numerous complaints about unlawful harassment, discrimination, and retaliation” at the company. Senior management of the company has claimed to be aware of the entire situation, trying to push things under the rug, according to various news reports.

Employees of the company have claimed the existence of a “frat boy” culture with female employees at the company subjected to constant sexual harassment, discrimination, and retaliation, as well as lower pay and lower opportunity levels than their male peers.

Due to the scandal, many important executives and developers have stepped down, including Blizzard co-head Jen Oneal, Overwatch 2 executive producer Chacko Sonny, the chief legal officer Claire Hart, and many others. The list of resignations most notably excludes the current CEO, Bobby Kotick.

Due to the turn of events and the subsequent backlash of the public, the stock price has been hit hard in the markets. The stock sold as low as $57.29 per share, only to rebound recently back to its current price, $65.39 per share. The stock price is currently down 27.4% since last year. At the time of writing, after the deal announcement all of this has changed with the price surging to more than $90 per share. Again, a brilliant example of a contrarian value investment that turned out brilliantly.

The gaming industry as a whole

It remains difficult to understand the true potential of Activision Blizzard without understanding the course the gaming industry is taking. It is likely that many people in charge of managing large sums of money today have a very different view on gaming and the game culture compared to the new generations. Game culture is simply living through a significant shift and is becoming more mainstream by the day. The acceptance of gaming as a normal and no longer looked down upon trend is evidenced in data.

Newzoo has reported the global games market will generate close to $175 billion in 2021, and it is on a road to surpassing $200 billion in 2023, despite the slight hiccup it has experienced during last year. At that time, an estimated 2.9 billion players worldwide are expected.

An important takeaway here is that the mobile gaming segment has already taken more than a 50% share of the market, a point that will come useful later in the article. Mobile gaming as of today is valued at $90.7 billion. The vast majority of mobile gamers are what can be considered “casual gamers”.

Naavik has a different view on things. They claim that NewZoo’s model ignores several key segments outside of gaming content and virtual goods purchases. Excluded categories include other forms of content and IP sales, but more importantly the sales of any gaming hardware and equipment as well as gaming software such as streaming services, gamer communication, game engines, and other items.

After incorporating gaming-specific hardware and software (development tools, engines, etc.) as well as complementary markets (streaming, esports, etc.), the total market size projection is set at $335.5 billion in 2021. Interestingly enough, both estimates are beating linear TV as a market segment.

The video game industry is simply evolving. The old days were the video game companies based their financial strength and potential almost solely on the brick and mortar sales of their pipeline of game releases are long gone. The introduction of various new business models such as games as a service, games as a subscription, downloadable content, microtransactions, and others have enabled video game companies to enter a new stage of youth while enabling gaming to be perceived as a driving growth force for companies.

What Activision brings to the Microsoft portfolio?

Activision Blizzard is an American video game company that was founded in 2008 in its current form and is based in Santa Monica, California. It develops and distributes content and services on video game consoles, personal computers, and mobile devices, including subscription, full-game, and in-game sales, as well as by licensing software to third-party or related-party companies that distribute Activision and Blizzard products.

The company currently includes five business units: Activision Publishing, Blizzard Entertainment, King, Major League Gaming, and Activision Blizzard Studios. The key IP the company holds include Call of Duty, World of Warcraft, Diablo, Hearthstone, Overwatch, Candy Crush, and others.

The big gun of the company is the Call of Duty franchise, which has been created all the way back in 2003. It is most likely the best-known first-person shooter franchise in history, becoming almost synonymous with the genre. The newest game, Call of Duty Vanguard, which is set to release next year is going to be the 21st installment of the franchise, not counting ports, remasters, and expansions. The entire franchise still generates almost 119 MAU as of today.

In an interesting sequence of events back in 2007, Activision merged with Blizzard creating the giant we know today. Blizzard expanded the IP portfolio and brought much-needed exposure to the strategy games genre, as well as the then-popular MMO genre. The crown gem of the genre was World of Warcraft, which is turning 18 years old this year. Even as such, the game remains a huge success and a driving force for the company yielding almost 5 million active subscribers.

The newest and brightest success story from the studios is Overwatch, a multiplayer arena shooter game this year with a successor on its way. World of Warcraft, probably the greatest success story from Blizzard is a franchise that is turning 18 years old today. Even as such, the game remains a huge success and a driving force for the company yielding almost 5 million active subscribers.

There are two main issues with the Activision Blizzard game portfolio. First, as some might have guessed up until this point, almost all the main and most well-known franchises are decades old. Even Overwatch which is considered a new addition to the portfolio is a 6-year-old project. The second issue facing the company is the degrading relationship between the company and the gaming community. A strong focus on financials has seen many problematic decisions made throughout the years that resulted in the core gaming base growing apart from the game franchises, which significantly damaged the company’s reputation.

One of the more famous incidents occurred during the Blizzcon event, which is an annual gaming convention held by Blizzard Entertainment to promote its major franchises. After years of consumers waiting for the company to revive its legendary Diablo franchise, things took a turn for the worse when it was announced on stage that they will be transferring the franchise over to mobile. Now it is a rare achievement to get humiliated in a room full of your fans, which is exactly what infamously happened back in 2018.

In short, the great franchises Activision Blizzard held no longer command the same respect, while the relationship with the gaming audience is strained at best. This represents a more important issue in my mind than the temporary headwinds created over the last couple of months. Again, the average investor might not feel the need to care much about this since the numbers are in fact telling a different story, but it is still wise to consider the decay of the franchises which are going to have an impact in the future, as well as what kind of an impact on business in the long term is expected from the decaying relationship with the customer base.

Management was quick to realize the potential of mobile gaming, which has seen an unprecedented expansion throughout the years. The company acquired the mobile game developer King Digital in a $5.9 billion acquisition six years ago. The segment is in many ways much less demanding and is considered the “lowest tier” of gaming. However, the numbers do tell a story for themselves. The deal has paid itself off tenfold, allowing the company a very lucrative venture into the mobile gaming world, which remains successful even today.

What does Microsoft get?

Microsoft has been the first company to realize the true potential of the games as a subscription model. Following the enormous success that Netflix (NASDAQ:NFLX) had in the video subscription platform, management hoped to replicate a similar model and establish itself as the game subscription platform. If we go back to the $180 billion market estimate, we can conclude that this is a significant growth opportunity for Microsoft. The business is scalable and integrates well into everything the company has already to offer.

Further to the point, Microsoft already has a giant advantage over any potential competition with it being the company that already owns one of the two biggest gaming consoles, as well as owning Microsoft OS, giving it effective control over what many would call the only real PC gaming platform. We can already see in the merger presentation that management is bringing this aspect into focus.

A key aspect of this strategy is acquiring established game studios. Microsoft already had several well-known studios under its umbrella, but the effort has been pushed in the last couple of years. The purchase of Activision Blizzard is not the first or the last acquisition Microsoft is making.

The studio acquisitions create value for Microsoft in two different ways. First, they enable the company to push out games directly to its subscription service. This is a huge incentive for the average gamer. Instead of paying for tens of different games a year, it is much easier to simply maintain a subscription. The logic is simple here, the more studios and IPs they own, the lower is the incentive for the average gamer to pay anyone else than Microsoft.

The second value generator is the contribution to the console wars. Microsoft has been embattled with Sony (NYSE:SONY) in the latest and greatest saga of the console wars. Its XBOX platform has been crossing swords with the rivals Sony Playstation. The last generation of console wars ended with Sony taking the lead, something that Microsoft is desperately looking to change in the current generation of consoles.

In a similar manner in which movies and TV shows could be made exclusively available on certain streaming platforms, games are often made “Xbox” or “Playstation” exclusives, meaning the developer enters a deal with a hardware company for the product to be available to purchase only on their platforms. Now, it doesn’t take much to conclude that if Microsoft owns both the development studio and the platform, the title would not be available for PlayStation users. The big question is, will titles such as Call of Duty, Overwatch, and many others become PC and XBOX exclusives? So this deal does not generate value only in terms of the subscription service revenue and game sales but indirectly adds to the console sales as well.

What if the deal falls apart?

With a deal as large as impactful as this one, there are almost definitely going to be some issues along the way. However, even if I do believe the deal will go through in the end, it is important to take a look at Activision as a stand-alone company.

As per the latest quarterly filing, we can see that the company is finding itself in a very favorable financial situation. As it stands, Activision Blizzard has $3.6 billion in total debt, which is generally looking somewhat insignificant considering the size of the company. Furthermore, due to their enormous $10 billion strong cash position, they have a negative net debt standing at $6.39 billion. In other words, they are sitting on a huge pile of cash.

They are facing some $2.01 billion in current liabilities and $7.02 billion in total liabilities, which are being outweighed by $23.97 billion in total assets. All are signs of a strong and healthy balance sheet. The net debt/EBITDA ratio is a negative x1.98 for 2021, which seems to further drive the point to the strength of the balance sheet.

The company has ended 2020 with $8.08 billion in revenue and little more than $3.02 billion in EBITDA. The company has been a steady success story in terms of its top and bottom lines growth. The success story only continued as the company plans to beat its 2020 results, generating more than $9 billion in revenue and close to $3.5 billion in EBITDA in the last twelve months.

We can also conclude that the company is slowly transforming itself into a dividend-paying company. Even though Activision remains to be far from an attractive stock for income-oriented investors, it is difficult not to mention that they have grown their dividend by 176% in the last year, which is a 10.7 CAGR. As of today, that amounts to a 0.71% dividend yield, given the current stock price of $66.53 per share. For now, the dividend remains a token one, but the next decade can see the company reenvisioning itself, especially with the rise of subscription services and similar monthly-based passive revenue.

Activision and the rest of the video game industry

In the light of the acquisition, we might want to take a look at the rest of the competitors and how Activision compares directly. The numbers might not be telling everything here. Still, it is interesting to take a look at how attractive Activision is after losing almost one-third of its market cap in the previous year.

We can see that Activision was trading at what we might refer to as very attractive valuations including an NTM P/E of x17.94 and an NTM Price/Free Cash Flow of x15.85. The market cap prior to the merger was set at $51.82 billion, which clearly indicates we are discussing a market leader in the space, even after the scandals and the price drop that followed. Thanks due to the large cash positions, the Total Enterprise Value was set to only 45.43B. With everything that has happened, Activision does seem to be the far most attractively valued out of the bunch.

Electronic Arts (NASDAQ:EA) is probably the closest direct competitor that can be used when discussing Activision. EA is the owner of popular franchises like FIFA, Battlefield, Apex Legends, The Sims, Madden NFL, Need for Speed, Titanfall, and others. EA is currently valued at a $37.30 billion market cap. Unlike Activision, it does not have a strong net cash position, and the TEV is set at $37.53 billion. It sells at a similar NTM P/E of x18.04 as well as an NTM Price/Free Cash Flow of x19.68. It commands an x4.75 NTM TEV/REV and an x12.43 NTM TEV/EBITDA. Again, in my view, it does come down to the IPs they own, which are difficult to put into numbers, but both companies are relatively similar in valuations.

Ubisoft Entertainment (OTCPK:UBSFY) is at a much smaller scale compared to Activision. Ubisoft is the maker of franchises like Assassins Creed, Watch Dogs, Far Cry, and others. It is valued at $6.04 billion, with a TEV of $6.7 billion. It is selling for an NTM P/E of x17.33, as well as an NTM Price/Free Cash Flow of x145.97.

Take-Two Interactive (NASDAQ:TTWO) is the owner of franchises like GTA, Red Dead, NBA 2K, Mafia, and others. It is valued at a $19.43 billion market cap. It is the only one out of the competition that has a similar strong cash position. As a result, TEV is set only to $17.37 billion. It is selling for somewhat of a warranted premium at x32.34 NTM P/E and an x19.34 NTM Price/Free Cash Flow.

CD Projekt (OTCPK:OTGLF) is a Polish-based game industry giant. It is the maker of video games such as The Witcher or Cyberpunk 2077. Possibly due to a recent release of the latter game the company does seem to be on the higher side of the valuations. However, the $4.79 billion market cap indicates that a lot of growth is possible, while TEV of $4.55 billion again suggests that they don’t have the same strong cash position as Activision. The NTM P/E of x42.15, as well as an NTM Price/Free Cash Flow of x31.18, again point to the price premium, possibly unwarranted in my view.

The direct comparison does conclude that the selloff has created a great investment opportunity for potential investors looking to exploit temporary headwinds that are set against Activision. All of this now obviously changes. Still, it is important to keep in mind that even as a stand-alone company, when taking both the strength of the portfolios and the fundamentals into consideration, Activision does seem to have been the best deal in town up until this point. However, that now changes, since if the deal does fall apart, acquiring Activision on $80-90 per share is in fact paying a strong premium for the company compared to the rest industry.

Final thoughts and conclusions

Today has been a great day for both Activision Blizzard and Microsoft shareholders. The announced deal is a huge value generator for both companies. As far as Activision Blizzard shareholders are concerned, if they believe in the deal and Activision’s future as part of the Microsoft gaming segment, they can elect to keep the shares and wait, with $95 per share they are getting a deal as good as any. Otherwise, they can sell and take home a huge win. It was extremely unlikely that in light of everything that has happened, Activision would be getting close to $85 per share anytime soon.

As far as Microsoft’s shareholders are concerned, today has brought one of the best deals in decades. The deal is a tremendous value generator which impact is going to be felt throughout the years. This is especially true when compared to something like the ludicrous $26.2 billion LinkedIn acquisition. The deal might give birth to Microsoft finally becoming the Netflix of gaming, driving immense growth for its Game Pass platform. Furthermore, it indirectly benefits its console segment, with Xbox looking more and more likely to blow away Playstation.