For the past year, the video game industry has been intensely focused on one topic: Microsoft's (MSFT 1.65%) proposed buyout of Activision Blizzard (ATVI) for $75 billion. The deal -- which could end up being one of the largest in corporate finance history -- is under review by regulators in the United States, United Kingdom, and European Union for potential anti-competitive or anti-consumer issues.
With a current spread to the closing deal price of 12.4%, merger arbitrage investors are making bets that the deal will get approved sometime soon, with Microsoft expecting the decision to be finalized at some point this summer.
A lot of analysts are spending their time trying to figure out whether government regulators will approve this deal. But is Activision Blizzard stock a buy regardless of a confirmed deal? I think it might be.
A resurgence at Blizzard + mobile expansion
Activision Blizzard's business was in a tough spot last year when Microsoft proposed to purchase the company. It had just released its most disappointing Call of Duty (its No. 1 franchise by far) title in years. It had declining user trends for its live service Call of Duty: Warzone, and kept seeing delays for titles from its formerly renowned Blizzard studio.
Blizzard has also been in a tough position for years due to allegations of sexual assault harassment among its workforce. This came to a head in the middle of 2021, causing the corporate executives to finally try to fix things. Given all these problems, it is no surprise to see Activision Blizzard's free cash flow (the best metric for measuring profitability) not much higher than it was in 2017.
ATVI Free Cash Flow data by YCharts
Today, even with the distractions of the buyout, Activision's business has made a 180-degree turn. Its newest Call of Duty title, Modern Warfare II -- which launched a few months ago -- is setting purchase records for the franchise, and the company is preparing to release another iteration in the series later this year. Blizzard has also finally started releasing new games, with Overwatch 2 coming out in October 2022 and the highly anticipated Diablo IV set to release this June.
Within the mobile category, Diablo Immortal was released to a solid reception, and Call of Duty: Mobile is routinely one of the top-grossing games on the App Store. Don't forget about Candy Crush, either. The top-grossing mobile game around the world is owned by Activision's subsidiary King and has shown consistent growth for the company in recent years.
Because of these successes, Activision Blizzard management thinks free cash flow is going to be materially higher a few years from now. Even in early 2022, the company was forecasting free cash flow to hit $3.4 billion in 2023 and $3.9 billion by 2026 (according to its merger documents). Now, with the recent success of new game releases, it is likely Activision could hit $4 billion in annual cash flow in a few years. At its current market cap of $66 billion, that gives the stock a forward price-to-free cash flow (P/FCF) of 16.5, which feels reasonable versus the market average of around 20.
The deal is likely to close regardless
Even if Activision Blizzard's stock is set up to do fine without a deal, I think it is likely this deal will close and current shareholders will get a cool 10%+ return within a half-year.
Why? First, Microsoft's Xbox division is a clear laggard in the console/PC gaming market, with PlayStation and the Nintendo Switch much more popular among console players and Steam way ahead in PC users. This isn't a dominant platform trying to monopolize content distribution, but a struggling ecosystem trying to find a way to catch up with the market leaders.
Second, there is no need to worry about Microsoft making popular franchises like Call of Duty exclusive to Xbox. The company signed 10-year agreements with every major distributor except PlayStation (it has offered a deal, but Sony will not sign) to keep Call of Duty widely available for consumers. The U.K. regulators were worried about making Call of Duty exclusive on Xbox, but recently said that it would be commercially untenable for Xbox to make Call of Duty exclusive given new evidence the regulators received on industry and consumer trends. This is bullish for acquisition approval.
Third, Xbox has virtually zero presence in the gigantic mobile games market as a games distributor. Apple and Android have a duopoly in this space, which may limit competition. As a part of this merger, Microsoft wants to launch its own mobile games store and use its Activision Blizzard properties as a way to help kick-start this new initiative. From a mobile perspective, the deal could actually end up being competition-enhancing, which could greatly appease regulators.
It is still possible -- but, I think, unlikely -- that the Microsoft acquisition of Activision Blizzard won't get approved. However, whatever happens, I think investors will earn positive returns if they buy shares today.
