Description

I’m recommending a workout/merger arb deal, which has a high probability of breaking within seven months—sounds crazy, right? This is one of the most compelling merger arbs deals I’ve seen in my career, based on downside risk (fundamental) vs. upside skew. This asymmetric bet has the possibility of being a “home run” if the deal gets approved by the global regulatory bodies, and if it gets taken out for $95- a 44%+ annualized return at current prices. If the deal breaks, investors get to own the largest premier global video game creator at a discount to its less profitable peer group, and a discount to its own historical valuation.

In my view, this opportunity is available due to the uniqueness of the deal; this is a massive cash deal ($68.7B) that Microsoft is attempting to close on 06/30/23. The deal is so large the Merger Arb community is not able to really impact the pricing from the market swings- and for many directional institutional investors, any investment in Activision is frowned upon due to style drift. On top of this, the Arb community has recently had a De-Risking event related to a few deals- particularly Rogers Corporation/Dupont cash deal, which was a 2% spread prior to deal closure which completely blew out. Rogers Corp lost almost -60% overnight once Dupont formally scraped the deal due to a regulatory tie-up with the State Administration for Market Regulation in China. The other deal of concern was Yamana Gold/Gold Fields Ltd a stock deal for CAD $9.16B; this is one of the rare instances where the acquirer lost a deal to 2 joint bidding parties (Agnico Eagle & Pan American Silver Corp.). Gold Fields terminated its deal to acquire Yamana stating it would pay the $300M break fee, Gold Fields (the short side of the arb trade) then rallied > 75% from the lows as the arb community scrambled to exit the trade. Some select merger arb funds (& PODs) involved in these 2 deals lost more than an entire year of PnL within a one-month window, causing widespread merger arb de-risking into an arb market with spreads already around multi-year peaks.

So, Activision Blizzard has essentially been a stock in no-man’s land since inception of this deal, and a lot of that has to do with the extended deal duration. The merger is already in its 324th day since the announcement, and likely has another 6-7 months on top of this—a rarity for typical M&A transactions. However, now it is significantly more beneficial to the shareholders as deal step-ups start at $500m for each hurdle period. In the next 132 days, the deal, if not yet closed, ATVI will have an incremental $1B increase for a total deal break fee of $3B. Something that was not a component during the first 365 days of this deal, and a feature that I believe speeds up the deal process prior to the drop-dead date.

Currently, the market is ascribing only a 37.2% deal probability that Activision Blizzard/Microsoft closes by 06/30/23. What’s fascinating about this very low probability is that the probabilities are more closely aligned with a coin flip, to say, a 60% probability this closes. The reason I say that is because there have been indications that Microsoft will pursue Activision in the courts if the FTC sues over the deal. And just within the last few days, Microsoft announced a deal concession on its biggest title, Call of Duty (CoD), offering Sony Playstation a 10-year guaranteed access deal (also on all other platforms) and same day release as available on Xbox. This is important because Sony has been the biggest opponent to this deal from a competition standpoint, and most vocal to the U.S. FTC on the merits of competition.

Like anything, timing is cruitical for a decent IRR on this workout; tomorrow (12/08/2022), there is a closed-door meeting with Lina Khan on Activision Blizzard/Microsoft, which is quite interesting because the deal is approaching some significant milestones.  If the outcome of tomorrow’s private meeting is that the FTC will sue, I think ATVI probably trades down to $70-72. If there is no definitive announcement of a lawsuit, I think that is a big positive and could trade short-term closer to $80. If somehow the FTC is of the view that this deal is likely to get approval, I think ATVI will be trading significantly tighter likely between $85-90.

Downside Risk

While there is a high probability of a deal break, it appears that the actual fundamental value of a standalone Activision Blizzard is likely at current valuations and even higher, given the strong release window coming in 2023. With Activision’s recent release of Overwatch 2 (> 35m users now), and upcoming releases of Call of Duty, World of Warcraft, and Diablo 4 franchises in 2023 consensus estimates have topline revenue growth of almost 19% in 2023 alone, the biggest YoY gain since 2009 (excluding the pandemic pull forward).

While my base case is a fundamental value range of $65-75 for ATVI, on a deal break, it is likely to have more short-term downside due to arb funds blowing out the position. Most arb funds have limits on how long they can hold a deal after a break- some, only weeks, while others, a little more flexibility in terms of months. I think on a deal break, ATVI could wick down to the low $60s, potentially below $60; but in my view, that would be short-lived. If this is a deal that breaks after 07/18/23, that would be an additional $3.80 per share in cash, plus almost $14 per share in cash on the balance sheet (including marketable securities), in addition to a half year of FCF in the books (another $1.4B of cash or ~ $1.80 per share). One could easily see cash on the balance sheet of ~ $18.50* per share (including tax on break fee) by the end of July on a $60 stock in an extreme downside scenario.

Current Price Implied Valuation (DB post 07/18/23):

2023e EPS of $3.84 (consensus)

Cash Adjusted EV of ~ $45,000*/$3,095 = 14.5x 2023 Adjusted EPS

Fundamental Base Case:

2023e EPS of $3.84 (consensus) 13x (adjusted for cash*) = ~ $69

·         Assumes that Blizzard debuts Diablo 4 in ‘23

·         Continued execution on mobile

·         F/D share count used 789m

Fundamental Upside Case:

2023e EPS of $4.30 (adjusted for cash*) 18x multiple = ~ $97.30

·         Assumes that Blizzard debuts Diablo 4 in ‘23

·         Continued execution on mobile

·         CoD > expectations, WoW > expectations, and continued traction w/ Overwatch 2

·         F/D share count 789m

Fundamental Bear Case:

2023e EPS of $3.25 (adjusted for cash*) 12x multiple = $58

·         Disappointing performance on all new releases

·         Poor traction on mobile games, especially Candy Crush

·         Trades at below trough multiples

Comps:

Overall, this is one of the more unique merger arb deals I’ve seen in the past decade, and it is rare not just in terms of the deal size (cash deal), duration, annualized gross spread, but in terms of the quality of the Activision Blizzard business. This is one of the rare occasions where the target is a best of breed video game creator with the largest scale and highest historical margins in the gaming segment. If one has a fundamental view that Activision should trade at a healthy premium to its peer group, there is little to no (fundamental) downside to the name from these valuations. If this is a successful merger and Microsoft manages to appease the regulators, this is a 44% annualized rate of return from these levels with very limited downside, as stated above.

Catalyst

• Deal Approval
• Further progress fundamentally with key titles, CoD, WoW, Overwatch 2, and Diablo
• A large buyback post deal break
• Multiple re-rating in 2023 on improving fundamentals