Rich Polk
2021 – Microsoft and Activision Execute a Merger Agreement
In the wake of a tumultuous summer replete with sexual misconduct scandals, a lawsuit from a California regulatory agency and a deflating stock price down almost 40%, another nail was on the brink of being driven into the Activision (NASDAQ:NASDAQ:ATVI) coffin by November, 2021. Microsoft (NASDAQ:NASDAQ:MSFT) gaming head Phil Spencer, as reported by The Verge on November 18, 2021, was “evaluating all aspects” of their Activision relationship and, “deeply troubled by the horrific events and actions” that took place at the company. Activision was embroiled in allegations that the firm cultivated a culture of constant sexual harassment, and more shockingly, that the cultural rot extended all the way to Founder / CEO Bobby Kotick. Phil Spencer had previously publicly pledged to combat the toxicity in gaming culture and the possibility of one Activision’s largest partners altering their business relationship catalyzed an incremental 10% share price drop over the following week ending December 10, 2021, to $58. Reality, as revealed by regulatory filings, couldn’t have been further from the media speculation. Less than 24 hours after the ominous Verge article, Phil Spencer had a telephone conversation with Activision Founder and CEO, Bobby Kotick, where he expressed Microsoft’s interest in purchasing the entirety of Activision at a premium. Two months later the largest deal in the history of not only gaming, but all of technology, was signed confirming Microsoft’s all cash offer of $95 per share, or $69 billion.
The transaction will cement Microsoft’s position as the third largest gaming company globally by revenues (behind Tencent and Sony), with exposure throughout the value-chain, strength in mobile and possibly the best intellectual property suite in the industry. Activision shares popped 26% on the January 18th, announcement to $82 and have since gradually deflated to the mid $70s.
At the current share price of $76.88, a 24% percent arbitrage opportunity exists with the deal expected to close by the end of June, 2023. The current market price only ascribes a 51% probability that the deal closes at the original terms set out in the merger agreement. The oversized spread is driven by a combination of the market overestimating the competency of Biden’s antitrust team, dismissing the horizontal competitive landscape in gaming and forgetting that Microsoft has never failed to acquire a target in its corporate history. It doesn’t hurt that Warren Buffett, who started his career in merger arbitrage, purchased 9.5% of Activision stock. Per my analysis, a more realistic probability that the deal closes is 80%, which would imply a share price of $86.50 (12.5% above today’s prices).
Reaction to The Deal and the Evolution of Antitrust Enforcement
On March 31, 2022, Senators Elizabeth Warren, Bernie Sanders, Sheldon Whitehouse and Cory Booker penned a joint letter to Federal Trade Commission Chairwoman Lina Khan excoriating Activision’s “frat boy culture” and Microsoft’s anti-union history as undermining the rights and dignity of workers. The Senators urged the FTC to oppose the deal on the grounds it will have an anticompetitive impact on labor. These contentions are a logical stretch and attribute powers to the FTC outside the established purview of antitrust law. Lina Khan issued an official response on June 9, 2022 to qualm the Senators’ concerns and confirm that the agency was scrutinizing the deal.
The Senators’ objections are purposefully outside the established purview of antitrust legislation because the current crop of regulators passionately believe that purview should be expanded. Jonathan Kanter, current Assistant Attorney General of the United States, expressed the view during his keynote at the Georgetown Antitrust Law symposium in September, 2022,
On the other hand, merger enforcement has become disconnected from the competitive realities of our economy. It has become a sometimes-artificial exercise. We focus too much on a small handful of models for predicting price effects, and lose sight of the competition actually at stake. We obsess in all cases about market definition, when in many situations direct evidence can help us assess the potential for harm. Competition varies, and our framework must adapt accordingly.
Kanter doesn’t want to be constrained by sets of arduous formulas and tricky market definitions. He longs for a world where he can unilaterally apply his well informed judgement to merger transactions and block future wrongs from being inflicted upon society. His vision for antitrust enforcement is shared by media darling Lina Khan, a known critic of big tech, who came to prominence at Yale Law by writing a paper describing how modern antitrust law failed to check Amazon’s growing and predatory power. Despite the grandiose pronouncements and countless FDR references, the Khan / Kanter model of antitrust enforcement is failing to produce practical results in the form of case wins and legal precedents.
Recent Court Losses
Despite the headlines heralding the new antitrust sheriff in town, little progress has been made on regulating big tech and the United States regulatory agencies have suffered stinging court defeats. Historically, the government only challenged transactions that were certain wins at trial, but regulatory action has become more adventurous of late. The Federal Trade Commission’s own in-house judge determined that Illumina Inc.’s (NASDAQ:ILMN) $7 billion acquisition of early stage cancer firm Grail Inc. was not in violation of antitrust law despite the FTC challenge. The FTC also had its challenge to the Altria (NYSE:MO) / JUUL Labs (big tobacco buying e-cigarette firm) partial acquisition dismissed by an administrative law judge. Most surprisingly, Kanter and the DOJ were defeated in their first merger challenge by Latham Watkins after attempting to block U.S. Sugar’s acquisition of Imperial Sugar. If the U.S. regulators are not competent enough to block transactions in clearly concentrated industries like tobacco and sugar, I’m not inspired by their ability to curtail one of corporate America’s most capable companies, Microsoft.
Horizontal Landscape
From the perspective of Kanter’s much maligned formulas, the Microsoft / Activision transaction doesn’t appear to be overly anticompetitive. The commonly used Herfindalh-Hirschman Index (HHI) is calculated by squaring and summing all of the market shares of industry participants and comparing the totals ex-ante and ex-post. In a pure, single firm monopoly the HHI would equal 10,000, 5,000 in a pure duopoly, 3,333 in a three firm oligopoly and so on. A HHI between 1,500 – 2,500 is considered moderately concentrated and a value above 2,500 is highly concentrated. Per the FTC horizontal merger guidelines, a merger that increases industry concentration by 200 points or more in a highly concentrated market should raise antitrust concerns. The video game industry is highly fragmented with a HHI of 860. The largest player is Tencent with under 20% of the market. After the Activision acquisition, Microsoft would still be smaller than both Tencent and Sony and the HHI would only increase to ~940, representing an 80 point increase in an industry well below moderately concentrated.
UK / EU Regulatory Perspective
UK and European regulators are analyzing the deal through a less orthodox methodology; attempting to forecast where the gaming industry is headed and how the Microsoft / Activision transaction affects that hypothetical competitive landscape. The gaming industry is in a transitional phase, from console-focused buy-to-play arrangements towards cloud gaming and multi-game subscription services. Cloud gaming allows titles to be enjoyed on cheaper, less computationally intensive devices like tablets or mobile phones and many new entrants are competing for gamers, including Amazon Luna, Google Stadia, NVIDIA GeForce, Blacknut and Netflix. Industry experts speculate that the future of gaming will revolve around a strong content catalog, cloud infrastructure and operating system licenses; therefore, Microsoft equipped with Activision’s IP, its Azure cloud computing and Windows OS, could secure a stranglehold over the nascent industry before it even has a chance to develop.
Regulators have raised concerns regarding Microsoft’s market position and incentive to withhold its valuable intellectual property from other console providers like Sony and Nintendo. This fear is well-founded as Microsoft has publicly considered making future game releases from recently acquired studios exclusive to Xbox, most notably Elder Scrolls VI from Bethesda. The UK’s Competition and Markets Authority seems myopically focused on the Call of Duty franchise and its possible impact on Sony’s PlayStation ecosystem. These concerns appear to be overly influenced by Sony’s complaints, and despite Phil Spencer already offering to extend the Call of Duty PlayStation license for 10 years beyond their current agreement, Sony remains unsatisfied. Over 40% of the Call of Duty community exists on PlayStation and I doubt Microsoft wants to alienate a large part of their new gamer-base. Additionally, Microsoft’s gaming strategy explicitly aims to reach gamers regardless of their device. Brazil’s competition regulator recently approved the deal and seemed to not pay much attention to Sony’s complaints, stating the decision was made for Brazilian consumers and “not the defense of particular interests of specific competitors”. The UK Phase II review period has a March 1, 2023, deadline.
In Brussels, the European Commission announced an in-depth investigation into the proposed acquisition on November 8th, 2022. The EU raised similar issues as the UK, but also added that the deal may lessen the competition in PC operating systems. There is a March 23, 2023, deadline for a decision.
Is it sensible to take regulatory action today about a fictional future? Do UK or EU regulatory bodies even have the ability to accurately forecast the future of gaming? It appears that UK regulators are once again demonstrating their elevated sense of self importance (Activision only derives $70 million in revenues from the United Kingdom). I expect Microsoft to be capable of satisfying most regulatory bodies with remedial concessions, which could include formal agreements with competitors to not make Call of Duty exclusive.
Industry Reaction
Outside of Sony, other industry players seem to assume that the merger will be completed and are not particular bothered by the tie-up. Take-Two Interactive CEO Strauss Zelnick recently commented that he has no issues with the deal and most other competitors feel similarly. Considering the anticompetitive effects of the transaction, Zelnick made his view clear, “We don’t really think the competitive landscape is meaningfully affected in the event that the merger goes through.”
FTC Lawsuit
On December 8, 2022, the US Federal Trade Commission voted 3-1 in favor of suing to block the deal. Interestingly, the share price didn’t move much (+/-1%) on the news. The complaint, borrows from the concerns shared by the UK and EU regulators, namely the risk that Microsoft will withhold content from rival console manufacturers. “Sony” was mentioned 20 times and “Nintendo” 26 times in the 23 page complaint. The complaint fails to mention that Microsoft and Nintendo have already reached an agreement to allow Call of Duty on Nintendo devices for 10 years past their current license. The first pre-trial hearing occurred on January, 3, 2023. Biden’s antitrust team is spread thin and will struggle to convince a judge in the face of Microsoft’s generous concessions.
Risks & Conclusion
Despite requiring regulatory approval in several jurisdictions including the United States, European Union, United Kingdom, Australia, Brazil and South Korea, potential action by Microsoft represents a greater threat to the arbitrage. Activision has been missing the guidance provided in its merger agreement by a wide margin and the last three quarters saw revenue growth of -22%, -28% and 14% respectively. Microsoft is buying Activision for its IP and financial performance varying from the Long-Range Plan outlined at the time of the merger agreement is not an out from the deal. Will Microsoft take a finer look at the contract and begin searching for an excuse to renegotiate the purchase price? I doubt it as Microsoft desperately wants to be viewed as a good actor in the space. Additionally, any reduction in the offer would still likely be above the current Activision share price.
Per Microsoft CEO Satya Nadella during a September Bloomberg TV interview, ”Of course, any acquisition of this size will go through scrutiny, but we feel very, very confident that we’ll come out”.
Bobby Kotick reiterated his view on the transaction with a statement accompanying Activision’s third quarter results on November 7, 2022, “We continue to expect that our transaction will close in Microsoft’s current fiscal year ending June 2023.”
Should this deal break, Activision has cash and investments on its balance sheet of $13.60 per share and Microsoft has agreed to pay a breakup fee of $3.83 per share. Additionally, Activision has an impressive slate of new content including Overwatch 2, Diablo 4, COD Warzone 2, COD Warzone mobile and others. The pre-announcement price is roughly $65 per share. Many investment banks have recently upgraded their stand-alone valuation of Activision to $80-$85 per share. Assuming a drop to $65 per share if the deal breaks due to arb funds indiscriminately selling positions, upside is ~24% and downside is ~15% or roughly 3 to 2. There is also a chance the deal timeline is drawn out an additional 6 months until the end of 2023 and should this occur, I think the current market price of Activision more than compensates for that risk.
I am still considering a long position in Activision, but the situation seems generally attractive.
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