Activision Presents The Ultimate Fan Experience, Call Of Duty XP 2016

Rich Polk/Getty Images Entertainment

Rich Polk/Getty Images Entertainment
Gaming is a growth industry, but in recent months, sales have not performed too well due to consumers shifting their spending towards outdoor activities, travel, etc. as the pandemic is coming to an end. This, combined with interest rate headwinds, has hurt the stocks of gaming companies. Activision Blizzard, Inc. (NASDAQ:ATVI) has performed better than its peers due to the fact that its acquisition by Microsoft (MSFT) is still in play. It seems likely that this takeover will close eventually, which should result in ample upside potential for ATVI’s shares.
Activision Blizzard, Inc. has agreed to be taken over by Microsoft in an all-cash deal that values the company at $68.7 billion. This pencils out to $95 per share, which was well above the share price at the time of the takeover announcement in January.
Today, ATVI is trading for $77 per share, which represents a discount of 19% versus the takeover price. In other words, ATVI would climb by 23.4% if it were to trade at the exact takeover price. That’s a relatively large discount compared to the agreed-upon takeover price, which is explained by several factors. First, the takeover closing eventually is not a certainty. In fact, there are some regulatory hurdles that might prevent MSFT from being able to acquire Activision Blizzard. Some senators, for example, have called for a close review of the takeover by the FTC, with the explanation for this request being that Microsoft and Activision Blizzard (allegedly) have a history of treating their workers poorly.
On top of that, the timing of the transaction is not known. Since interest rates have been climbing and with inflation running at a four-decade high, the time value of money has become more important. CNBC reports that the deal supposedly will close prior to July 2023, so around a year from now. Just factoring in the current rate of inflation, a high-single-digit discount compared to the deal price would thus make sense, even if it was a certainty that the deal will close. Since that is not certain, some additional risk premium is factored into the current share price, which explains why ATVI is trading significantly below the price Microsoft has agreed to pay for Activision’s shares.
Overall, I do believe that there is still a solid likelihood that the deal will close eventually, despite some calls for a close review. There might be some concessions, however, such as change in management due to ATVI’s misconduct in the past. But since Microsoft would still not be dominant in the gaming space even if the takeover closes, there isn’t really a good reason to block the deal completely I think.
Activision Blizzard is one of the largest gaming companies in the world. Its franchises include important assets such as Call of Duty, World of Warcraft/Warcraft, Diablo, and so on. It also owns a vast mobile games business that is quite profitable, even though most of those games use a freemium model where users can play for free and only have to pay for some extras. Candy Crush, one of the mobile games Activision Blizzard owns, has been the best-performing game franchise (in terms of revenue generation) in the US App Store for 19 quarters in a row.
During the most recent quarter, Activision Blizzard generated revenue of $1.77 billion, which was down more than 20% versus the previous year’s quarter. A decline was expected, but not at this magnitude, which is why ATVI missed top-line estimates by $30 million. A revenue decline is not really surprising, as ATVI and its peers benefitted a lot from the stay-at-home environment over the previous two years. This led to a tough comparison to Q1 2021 when the pandemic was much more of a tailwind still. With consumers seeking outdoor experiences as the pandemic is coming to an end, gaming and other stay-at-home activities are taking a backseat. This trend has also been visible in Netflix’s (NFLX) weak subscriber numbers this year, for example.
Eventually, Activision Blizzard and the gaming industry as a whole should get back to growth, however, especially once the strong pandemic years have been lapped. More and more people around the world see gaming as a hobby, and price increases and growing monetization should allow the industry to record compelling long-term growth. This forecast sees gaming revenue growing by 9% a year between 2021 and 2030, which indicates that ATVI’s rather weak Q1 results are likely an outlier — at least as long as the company executes well. With its strong brand and established player base, I believe that it is unlikely that Activision Blizzard will not grow its business over time as the market it addresses continues to expand.
Not surprisingly, ATVI’s net bookings were down during the quarter as well, due to the same tough comparison to the pandemic-impacted quarter in the previous year. Despite these headwinds, ATVI still generated solid cash flows of around $640 million for the quarter, or around $2.5 billion annualized. When we also account for ATVI’s cash balance of $11 billion, Activision Blizzard seems like a pretty healthy company from a financial perspective.
Activision Blizzard is forecasted to generate earnings per share of $2.91 this year, with that estimate having dropped by a pretty large 20% over the last three months. Due to the earnings miss in Q1, downward revisions are pretty logical, of course. The forecasted profits for the current year place ATVI at an earnings multiple of 27 at current prices, which represents a clear premium relative to how ATVI’s peers are valued:

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Data by YCharts

While Activision Blizzard used to trade in the middle of the pack when compared to Electronic Arts (EA) and Take-Two Interactive (TTWO), it has now become the most expensive among these three major gaming companies. That is, of course, explained by the fact that it mostly trades based on the takeover price Microsoft will be paying, instead of trading on fundamentals. Its peers have pulled back significantly in recent months due to tough comparisons and also due to the Nasdaq pullback we have seen over that time frame. This means that Activision Blizzard’s shareholders have seen their investment value preserved pretty well in recent months while other gaming stocks underperformed. But at the same time, the rather high valuation means that ATVI would likely drop quite a lot in case the takeover falls through due to any reason. I do believe that’s unlikely, but if that were to happen, ATVI could easily fall by 20%+ and it would still not be a cheap stock.
In the long run, gaming is a solid growth industry. But in 2022, Activision Blizzard and its peers will likely not report strong results, as consumers suffer from inflation and since discretionary spending should get shifted towards not-at-home activities, such as travel, going out, and so on.
It is likely that Activision Blizzard’s takeover by Microsoft will close over the next year or so, which will lead to a solid 20%+ gain for those continuing to hold shares. At the same time, there is some risk that the merger falls through. This would likely result in a steep sell-off for ATVI, in line with what its peers have experienced in recent months.
Despite ATVI being a fundamentally very healthy company with strong brands and world-class franchises, investing today is more of an arbitrage play than fundamental investing. I have argued in the past that selling at the time of the share price pop when the takeover was announced was a good idea. Those that want to use this as an arbitrage play can continue to hold shares until the takeover closes, of course.
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If you want to reach out, you can send a direct message here on Seeking Alpha, or an email to jonathandavidweber@gmail.com.

Disclosure:
I work together with Darren McCammon on his Marketplace Service Cash Flow Kingdown.

Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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.

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