Growth Stocks: Microsoft

Microsoft (MSFT.US) needed a deal like this to further its metaverse ambitions with a mega-consumer-oriented footprint across Activision's gaming franchises. The amount of $68.7 billion is not small, but it is an amount adjusted to the valuation of the company. So it follows that Microsoft probably didn't overpay, given the weakness in Activision's stock recently.

In this sense, Microsoft has closed a great agreement that should transform its ambitions of the metaverse of video games.

The announcement by Microsoft Corporation (MSFT.US) to buy Activision Blizzard, Inc. (ATVI.US) for nearly $69 billion in an all-cash deal had a huge impact on the market. Once approved by regulators, it could be the biggest deal in the entertainment industry since the Disney-Fox (DIS.US) merger. Not surprisingly, Main Street and investors praise Microsoft for this deal. They believe it would strengthen Microsoft's grip on building its metaverse ambitions and fill an obvious gap in the mobile gaming market that is missing from its Xbox consoles.

While we largely agree with the strategic intent of the deal, it is a big outlay, representing slightly more than a year's free cash flow (FCF). It also required Microsoft to hand over more than half of its $131 billion cash balance and short-term investments by the end of the next quarter. However, this deal is a must for Microsoft.

The company needs a deal of this magnitude to increase its competitiveness in the consumer gaming segment, where NVIDIA Corporation (NVDA.US) and Meta Platforms, Inc. (FB.US) have gained significant traction. Even Amazon (AMZN.US) and Alphabet (GOOGL.US) (GOOGC.US) have a huge consumer presence that Microsoft seems to lack as it focuses on the business front.

So the deal is truly huge and it will be transformative if Microsoft approves of it and executes it with aplomb. The synergies of its Xbox franchise and ATVI's global gaming IP and diversified platform extend far beyond gaming. CEO Satya Nadella & Team needs to gain widespread adoption on the consumer front to strengthen his metaverse ambitions. Since the deal would see Microsoft Gaming become the third-largest video game company by game revenue, Microsoft will no longer look outside the industry.

The agreement seems valued correctly

NTM EV/Revenue ATVI

The deal assumes an implied enterprise value of $67.6 billion, resulting in an implied NTM EV/R revenue of 7.8x. It is 18-19% above its average 3-year NTM earnings multiple and its average 5-year income multiple. Therefore, we believe that the deal seems fair and the premium (up to $95 per share) is not excessive. Microsoft appears to have capitalized on weakness in ATVI's stock to land a blockbuster deal.

Activision profitability margins
S&P Capital IQ

Activision revenue and YoY change
S&P Capital IQ

Microsoft is also entering a solidly profitable global video game business. ATVI's business saw a perceptible slowdown in 2021. However, that's consistent with the global trend for video games, which saw significant pandemic-induced growth in 2020. Google and Newzoo reported that the global video game market saw a decline from $178 billion in 2020 to $176 billion in 2021. However, the market is expected to resume upward momentum, reaching $219 billion by 2024.

Activision revenue by platform
Company filings

Therefore, Microsoft may have shrewdly positioned itself to acquire ATVI's well-diversified platform. While King's (Candy Crush) continues to be ATVI's leading game in the mobile gaming market, Activision's list of “AAA” game franchises is diversified across the gaming ecosystem, as seen above. However, mobile gaming remains Activision's main revenue driver. We believe it has also attracted Microsoft's interest in capturing its ecosystem, led by mobile devices.

Microsoft really needs a solid foothold in mobile gaming and cloud gaming

The mobile gaming and cloud gaming segments are expected to continue to grow faster than the overall gaming market. Sensor Tower estimates that App Store consumer game spending (AAPL) will grow at a CAGR of 10% between 2020 and 2525, reaching $78 billion. Additionally, it also estimates that consumers will spend on games on Google Play to reach $60 billion by 2025, at a CAGR of 13.4%. Furthermore, Newzoo estimates that cloud gaming will see rapid growth in the coming years, reaching $6.5 billion by 2024, from just $669 million in 2020. That would represent an incredible CAGR of 76.5%. Microsoft has become the world leader in Cloud SaaS (Software as a Service). However, its foothold in mobile gaming is still a fledgling endeavor.

Microsoft gaming revenue (FQ)
Earnings report

Microsoft Gaming Revenue (LTM)
Earnings report

Additionally, Microsoft's video game revenue has been on a consistent upward trend (see above). It has increased at a CAGR of 19% over the last two years, despite the fact that the global video game market declined slightly. Therefore, we believe that Microsoft has entered this acquisition with an advantageous negotiating position. Along with Activision's inability to find buyers after Microsoft showed initial interest, we believe it also forced the hand of Activision CEO Bobby Kotick, as reported by Bloomberg (edited):

“Activision tried to find other interested parties. Those included Meta Platforms Inc. (FB) and at least one other big company. But no other serious interest materialized. Realizing Activision's misgivings, Microsoft backed down, telling the game publisher that it was still interested in being a partner and working to sell more Activision titles on Xbox. Ultimately, Activision came back to the negotiating table, and teams from both companies worked through the holidays to close the deal".

Activision Combined MAUs (Monthly Active Users)
ATVI IR

However, we think that Microsoft really needed this deal. There is little doubt about the appeal of ATVI's global video game IP and strong profitability, which would likely boost its EPS when the deal is completed (likely in Microsoft's FY23).

However, we believe Microsoft is also going after Activision's combined Monthly Active Users (MAUs) which totaled nearly 400 million in its FQ3. Notably, King has also been the key contributor to his MAU, reaching almost 250 million in FQ3. It even peaked at 273M in FQ1'20. For Microsoft to build the full experience for its metaverse ambitions, the company's earnings on Xbox are simply not enough. The company needs access to a vast number of active gamers, given the critical importance of gaming to building the metaverse. It's an area where Microsoft has been significantly behind NVIDIA, Meta Platforms, and Apple. It is also behind Amazon and Alphabet, which have consumer goods businesses. Bloomberg tech columnist Tae Kim also questioned the timing and size of the deal. In particular, he commented:

"Some analysts estimated that the last GTA and the last Red Dead cost between $300 million and $500 million each. Yes, a company could have financed more than 140 blockbuster AAA titles with that money (which Microsoft paid)."

So we think Microsoft is going after that massive base of MAUs that ATVI has built, especially on King. That's much harder to build in the first place. Even Facebook Gaming VP of Meta Platforms and Horizon Vivek Sharma praised Microsoft for the deal. In particular, he added that Microsoft has a weak footprint that hasn't gained enough momentum, making the deal critical to expanding its gaming ambitions. Sharma articulated (edited):

“Let's go back to other reasons why MSFT bought ATVI. THE CONSUMERS. Overall, MSFT is still an amazing company. But consumer attraction to MSFT other than Xbox has weakened significantly in recent years. So let's not overlook King! The 250+ million people King has on mobile are a HUGE asset. MSFT games have suffered greatly, as have all of us on iOS in particular. With King, MSFT gets a viable gaming presence that could tie into Game Pass and extend to Cloud Gaming. Other than Xbox, is MSFT known to be a consumer company? Relevance is fading fast. With a stronger Xbox ecosystem, MSFT has at least a fighting chance for relevance. Direct sales from Xbox->PC->Devices->Windows is the only viable consumer hook, especially for young people.”

Conclusion: So is now a good time to buy Microsoft?

The deal is expected to close in FY23, pending regulatory approval in multiple jurisdictions. Many analyst houses see a probability of more than 80% that the deal will be successful. Given the size of Microsoft's video game business even after the deal in relation to the global video game market. While consensus estimates have not reflected agreement (rightfully so), the Microsoft ecosystem has been greatly strengthened. The company can more than afford to pay cash, given its strong free cash flow (FCF) generating capacity and cash position. The opportunity to take over Activision couldn't have come at a better time, given its weak stock price and the temporary slowdown in the global gaming market in 2021.

Technical analysis

Although the action has come to mark a fall of 9% since the news of the purchase and due to the influence of the current tensions. This situation only emphasizes the great historical opportunity offered by this correction. The company has only traded below its EMA200 at very specific times in its history, most recently the start of the pandemic in March 2020, the 2018 trade war, or the 2016 oil shock (green arrows on the chart) .

source: xStation

Therefore, current prices, even taking the latest highs as a reference, have suffered a lesser correction than that seen in the corrections of the events discussed above. While the future that lies ahead in the video game sector and specifically in the metaverse, they put Microsoft as a reference along with other companies such as FB, NVDA, AAPL or GOOGL.

Microsoft will publish its earnings report today, Thursday, January 25, at the close of the american session.

Dario Garcia, EFA
XTB Spain