Activision Inventory: Engaging Arbitrage Alternative (NASDAQ:ATVI)

On January 18, 2022, Microsoft (MSFT) introduced its acquisition of Activision (NASDAQ:ATVI) for $95 per share in an all-cash transaction. ATVI’s share value continues to hover round ~$80 as traders stay skeptical about whether or not the regulators will approve the transaction and uncertainty relating to the upcoming shareholder vote.

Based mostly on an anti-trust assessment evaluation, I consider the FTC will ultimately approve the transaction. Draw back threat stays capped even when the FTC approval doesn’t pan out, making ATVI a sexy merger arbitrage alternative with an ~18% upside inside 14 months.

Vertical Or Horizontal Merger?

Given the dimensions of the transaction, the extra request for data from FTC is inevitable. The FTC will then assess whether or not the acquisition is a vertical or horizontal merger. The previous refers to an acquisition of an organization offering a special service (normally a part of the availability chain) from the acquirer, whereas the latter refers to an acquisition of a direct competitor.

Vertical Merger

Vertical mergers had remained unchallenged for over twenty years until lately. There have been three mergers challenged: Illumina-Grail, NVIDIA-ARM and Lockheed Martin-Aerojet Rocketdyne. The primary was consummated and is at the moment present process courtroom proceedings. Whereas the latter two offers had been deserted. The explanation cited for disapproval of all three mergers was constant, being {that a} sole provider of essential downstream enter was being acquired.

There was a consensus that the FTC will view the merger as a vertical merger. The explanations are (i) MSFT’s key revenue-generating segments stay the Workplace and Home windows companies and (ii) Xbox being a platform with gaming content material as a downstream enter.

Provided that ATVI doesn’t present “essential” gaming content material inputs, FTC can have a tough time denying the merger if it views it as a vertical one. Additional, there’s a multitude of profitable media content material consolidation priority in assist of an MSFT-ATVI merger (assume Disney-Fox, Discovery-WarnerMedia and Amazon-MGM).

Customers might be harmed and competitors stifled if MSFT was to transform common titles like Name of Obligation to Xbox exclusives. Nonetheless, MSFT has confirmed that not less than Name of Obligation will stay obtainable on the PlayStation platform. As such, there stays no cause for FTC to disclaim this merger from a vertical merger standpoint.

Horizontal Merger

It may be argued that the merger is a horizontal one given MSFT’s presence within the sport publishing house with video games like Halo, Minecraft, Forza and Gears of Struggle. This presence has since expanded with the acquisition of ZeniMax Media (owns The Elder Scrolls and Fallout IPs amongst others).

The FTC might be following the Horizontal Merger Tips printed in 2010. These tips concentrate on the adversarial aggressive impact on prospects be it pricing, high quality, selection, service or innovation. The proof of such adversarial aggressive impact might be (i) priority of adversarial aggressive impact, (ii) lack of a considerable head-to-head competitor, (iii) elimination of a “maverick” and (iv) change in market focus.

Priority of adversarial aggressive impact

The FTC will assessment the historic impression of current mergers, entries, expansions or exits within the video gaming market or comparable markets to find out the aggressive impression of the merger. There’s restricted historic priority within the business for acquisitions of ATVI’s dimension. The closest is Tencent buying a majority of Supercell for $8.6 billion. This acquisition didn’t immediate any value enhance, as a substitute, the costs of digital items went down.

An identical priority that the FTC might reference could be the Disney-Fox merger. Each mergers are comparable by way of the acquisition dimension and being within the leisure content material class. The Disney-Fox merger ended up as a plus for shoppers. They had been in a position to benefit from the big library of Disney-Fox content material supplied through Disney Plus at a lower cost level than Netflix.

Given the above precedences had a optimistic impression on shoppers, the FTC will discover it difficult to disclaim the merger on such grounds.

Lack of a considerable head-to-head competitor

MSFT and ATVI are rivals for certain, particularly within the first-person participant shooter (“FPS”) style. Nonetheless, it could be difficult to argue that they’re substantial head-to-head rivals given the large vary of common alternate options. These alternate options, which can be found on each consoles and PC, are priced as little as free within the case of Fortnite, Apex Legends and Staff Fortress 2.

Elimination of a “maverick”

A “maverick” is a agency that disrupts the business be it by new know-how, enterprise mannequin or resisting value will increase. Elimination of such a agency will seemingly result in an adversarial aggressive impression given its disruptive impact on the business.

ATVI has not purchased something new to the desk lately. It has caught to its tried and examined franchises – Name of Obligation, Sweet Crush and World of Warcraft. There have been incremental gameplay enhancements, however innovation remained missing. The enterprise mannequin has remained the identical and it has been following the normal gaming pricing mannequin. It will be truthful to say that ATVI has not been a disruptive firm within the gaming business for an extended whereas. As such, no “maverick” is being eradicated on this merger.

Change in market focus

If any, this might be the almost definitely cited cause by the FTC to disclaim a merger. Whereas making an attempt to find out the change in market focus, how the market is outlined issues. FTC has denied mergers on grounds of elevated focus in a narrowly outlined market. A distinguished instance is the 1997 Staples-Workplace Depot merger, the mixed firm would solely management 6-8 % of the general workplace merchandise market (barely vital share). Nonetheless, the choose blocked the merger in acceptance of FTC’s “workplace provide superstores” market definition. The merger try was once more blocked in 2015 utilizing “B-to-B workplace provide” market definition.

Desk 1: Market share of prime 50 video games on PlayStation & Xbox printed by Sony, MSFT & ATVI (measured in time performed in March 2022)

If one was to slender the market to video games on PlayStation and Xbox solely, the rise in market focus by the merger is 5.5%. The market share analysis in Desk 1 highlights the fragmented nature of the market. Even a longtime big participant like ATVI holds solely about ~10% of the market. A mixed ATVI-MSFT market share of ~16% is nowhere near holding monopolistic energy.

Desk 2: Market share of prime FPS video games on PlayStation & Xbox printed by Sony, MSFT & ATVI (measured in time performed in March 2022)

If one was to slender the market additional right down to the first-person shooter (“FPS”) style on PlayStation and Xbox solely, the rise in market focus is lower than 3% (Halo collection). As per Desk 2, ATVI does have a domineering market share within the FPS style. However, MSFT has a restricted presence on this style because the Halo collection is simply obtainable on Xbox and its reputation stays far behind that of Name of Obligation.

Each market share evaluation highlights that there might be a restricted enhance in market focus. Thereby, a problem by FTC on such grounds might be unlikely to cross muster.

Why The Enormous Unfold?

There are two key uncertainties behind the large unfold: (i) the necessity for a majority shareholder vote and (ii) altering merger regulatory atmosphere.

Shareholder vote

Shareholders might vote to reject the merger. It’s normally led by activist traders with vital stakes within the firm. Given there has not been any activist opposition so far and solely a easy majority is required, I consider the vote will cross with no problem.

Altering regulatory requirement

The FTC has acknowledged that it will likely be reviewing supplies not coated within the tips corresponding to client knowledge entry, impression on the sport developer labor market and impression on mistreated workers. Given the office harassment issues at ATVI, FTC will seemingly focus its consideration on labor points.

Recreation publishing studios have traditionally been recognized to have poor working situations with compelled time beyond regulation, poisonous tradition and low pay. The business has been in a position to get away with it as labor provide far outstrips demand. I extremely doubt the MSFT-ATVI acquisition will change that business labor dynamics.

I might say that MSFT has among the higher office tradition within the business. Studying from its errors of extreme involvement in Lionhead Studios (developer of the Fable collection), MSFT has since taken a hands-off method to acquired studios. This has labored effectively in lots of circumstances with few complaints heard. One in every of its acquired builders, Playground Studio, was even named among the best locations to work.

Nonetheless, MSFT additionally has its share of office points in one in every of its studios, Undead Labs. The office points appear to have come about as a result of departure of its founder. However MSFT has since taken corrective actions in pushing out the concerned HR government and investing in variety and inclusion.

MSFT’s emphasis on office tradition can be evident in giving up on working with an acclaimed studio, Moon Studios (developer of the favored Ori collection), as a consequence of poisonous office tradition. One in every of its key executives, Bonnie Ross, Head of 343 Industries (developer of Halo Collection post-MSFT’s cut up with Bungie), has been instrumental in driving variety within the gaming business.

I consider MSFT is well-positioned to right the poisonous office tradition at ATVI, which is probably going the explanation why it went forward with the acquisition. ATVI below MSFT will almost definitely be a significantly better working atmosphere for present sport builders. With that in thoughts, I discover little cause why the FTC ought to cease this acquisition.

Draw back Capped

Determine 1: ATVI DCF Valuation (submit failed acquisition)

Based mostly on analysts’ free money movement projections, a conservative discounted money movement valuation as per Determine 1 will yield a value goal of US$82. The valuation accounts for a $3 billion payout by MSFT ought to the acquisition fail as a consequence of antitrust points.

The share value will tumble submit the information of a failed acquisition seemingly as a lot as 13% to $69 (ATVI’s pre-acquisition value of $65 + $4 in money termination payment paid out per share). Nonetheless, ATVI stays a enterprise with robust IPs that can proceed to generate robust money movement. Its share value will ultimately get well from the one-off failed acquisition shock and commerce at its intrinsic worth of US$82.

Nonetheless, if an investor is unwilling to attend for the corporate to commerce at its intrinsic worth, a low 13% draw back likelihood versus a excessive 18% upside likelihood stays a sexy risk-to-reward profile.

Timeline

Given the dimensions of the transaction, the events expect the conclusion of the merger by June 18, 2023 (last extension deadline). MSFT might be on the hook for US$2-3 billion ought to the merger be terminated as a consequence of antitrust points.

The particular shareholder assembly to resolve whether or not to proceed with the merger might be held on April 28. A majority vote is required else the merger settlement might be terminated.

Within the meantime, MSFT/ATVI might be compiling and submitting the data as requested by the FTC. In keeping with the steering, the FTC has 30 days to assessment the submitted supplies. However the FTC has been recognized to take far longer, which can seemingly be the case for such a distinguished merger. My projection is the approval will are available Q1 2023.

Conclusion

It’s simple that there’s threat concerned else a ramification is not going to exist. Nonetheless, on this particular case, it appears the market has drastically overestimated the dangers resulting in a sexy arbitrage situation.