Why So Serious? The Most Important Business Deal Of The Year
Seven Reasons Why Microsoft and Activision Blizzard wanted each other.
Heya! Welcome to Refined Insights, - I know,new name!- the newsletter where I discuss the most important trends happening today with a bias towards emerging economies and emerging industries. I generally do not release newsletters on Saturday- this is a special exception. As always, thank you for sharing, reading, subscribing, and liking. It really means a lot. So, let’s get straight into it.
Accounting: a complicated inconvenience companies handsomely reward so as to convince outsiders they are richer than they actually are.
Microsoft's acquisition of Activision Blizzard, last week, for roughly 70 billion dollars is, despite the fact that we are not done with ten percent of 2022 yet, certainly the largest acquisition of the year.
It is also:
The largest acquisition of the decade.
the largest acquisition in Microsoft's History.
The largest acquisition in Gaming History.
the largest acquisition in Tech History.
The last part is significant. The Big Five Tech Companies ( Apple, Microsoft, Amazon, Meta, and Google) have not reached their dizzying heights by mere effort alone, but by the infusion of capital. Lots and lots of capital. In 2010 and 2011, Google was buying a company every week..
Technology companies are generally discreet with their splurging: no press releases, no thorough disclosures, and in many cases, no mention of the purchase price.
This secrecy helps to conceal that monopolistic behaviour, much more than radical innovation, is central to their success.
Nevertheless, I tallied up the total costs of Google’s over 100 acquisitions during that period. It amounted to a lump sum of 14.6 billion dollars. That’s a sizable amount, especially when you consider it is probably closer to twenty billion dollars since many of these acquisitions did not have their costs attached.
But it is also a mere twenty percent of what Microsoft shelled out for Activision blizzard. Google's most rapacious era has been outmatched by a single acquisition five times over. Microsoft has just reminded everyone of who the Original Hulk is.
The deal is not just historic against the context of the past. It is meaningful in what it portends for the future. And in between memory and conjecture, it has significant value for the present. Because we live in an era where today is undervalued and tomorrow is overvalued, most of the rounds that made the internet last week hailed the deal through metaverse-tinted glasses.
It is true that a sophisticated universe of illusion is a pivotal reason in why Microsoft was willing to significantly overpay for Activision Blizzard. But it was not the pivotal reason in why Microsoft was willing to buy in the first place.
This newsletter series will thus be segmented into three parts:
Part 1 will deal with the manysided importance of Activision Blizzard to Microsoft's present-day strategy.
part 2 will discuss the often prophesied but deeply misunderstood value of Activision Blizzard to Microsoft’s Metaverse strategy for the future.
Finally, part 3 will analyse the current problems of antitrust law in America & Europe, the reasons why the merger will eventually be approved, and the fundamental reforms antitrust law badly needs.
In this particular newsletter, we will be concerned with only Part 1 of that triad. After reading this, I hope you will understand:
Why Microsoft was so eager to buy that they paid 45 percent more than Activision Blizzard's total market value.
Why Activision Blizzard was not as eager to sell as people have wrongly assumed.
The massive potential of the acquisition for both parties in the here and now.
The social and economic forces that made the deal attractive.
The implications for the industry at large.
The Benefits of The Deal For Activision Blizzard
Nothing in The Game is an Accident - Neil Strauss.
Microsoft paid 45 percent extra for Activision Blizzard. They handed over 95 dollars per share for shares that were at the time trading for 65 dollars. It takes only basic addition to see that Microsoft paid far more than it could or should have.
For the shrewdest company on earth, bar possibly Amazon and Koch Industries, such an exorbitant purchase looks like an absurd decision. At best, it looks like Microsoft got hit with merger curse, a statistically observed tendency for companies to overpay for acquisitions and mergers due to unwarranted optimism about the scale, or sometimes even the existence, of potential benefits.
If you think this is the case, you are seriously mistaken. To understand why, we have to take a deep look at Activision Blizzard's revealing annual shareholder reports:
Manufacturing Royalty Costs.
Page 13 of Activision Blizzard's 2020 annual shareholder reports reads with a faint whiff of unhappiness:
Microsoft, Sony, and Nintendo generally specify or control the manufacturing and assembly of finished products and license their hardware technologies to us. In return, we pay an applicable royalty per unit once the manufacturer fills the product order, even if the units do not ultimately sell.
As it makes clear, Activision Blizzard does not manufacture its own consoles or the other hardware products required for its game franchises. That honour goes instead to the Big Three Gaming companies: Microsoft, Sony, and Nintendo, a concentrated monopoly of gaming hardware. You don't expend so much effort into becoming a monopoly just so you can charge consumers a fair price. Duh!
To confirm this, we need only take a look at Activision Blizzard's consolidated statement of operations:
Product Costs
2019 - 656 million dollars.
2020 - 705 million dollars.
Yearly increase in costs: 49 million dollars.
Game Operations and distribution costs.
2019 - 965 million dollars.
2020 - 1.131 billion dollars.
Yearly increase in costs: 166 million dollars.
These numbers largely represent the amounts Activision Blizzard pays the Big Three gaming companies to produce consoles and other hardware for its games.
The yearly increases in product and distribution costs is not a general trend across Activision Blizzard's business operations. Costs in several other aspects of the company's operations have been falling:
Software Royalties and Intellectual Property Costs for Product Sales
2019 - 269 million dollars
2020 - 240 million dollars
Yearly Decrease in costs: 29 million costs
Software Royalties and Intellectual Property Costs for subscription and other in-game revenues:
2019 - 233 million dollars.
2020 - 155 million dollars.
Yearly Decrease in costs: 78 million dollars.
Restructuring and Related Costs:
2019 - 132 million dollars
2020 - 94 million dollars.
Yearly Decrease in costs: 38 million dollars.
It is clear that the major reason costs are rising for product and distribution are because these costs are dictated by the Big Three gaming monopoly. The rising costs are not replicated in other areas of Activision Blizzard's business. In fact, costs are falling everywhere else
Activision Blizzard has an even bigger problem. Hardware units required for their games are manufactured according to reasonable estimates of consumer demand. Or in less business speak, Activision Blizzard has to guess. When those guesses fail to come true, the outcomes can be costly.
When Activision Blizzard makes a new game, it must enter into contracts with the hardware monopoly for gaming hardware. If the company predicts the game will have a great reception, it may demand for hundreds of thousands of consoles.
There’s a catch: if the game meets less than favourable consumer reception, and this happens often, Activision Blizzard will still have to pay for all the consoles ordered and designed to specification. A failed game can cost Activision millions of dollars. Those losses will not prevent the company from paying royalty fees in full.
You see, the gaming industry has a feedback problem. Games cost a lot of money, effort, and time to produce. Let’s zero in on effort. Tech companies, for instance, have a reputation for minimizing head count and hiring only super smart, super skilled developers. Google stated in its shareholder reports that it has 27, 169 software engineers.
That's enough engineers for two thousand, four hundred, and sixty-nine football teams. It’s a lot.
Until you find out the company has 139, 995 workers in total, which is more than enough for the first team of every professional football team in existence. Google’s key employee class represents less than twenty percent of its total headcount.
Compare that with Activision Blizzard, in which 61 percent of its total workforce are gaming developers.
The figure and associated costs are likely to keep rising because of the ever increasing demand for sophistication and realism among the gaming population.
In this regard, the gaming industry is similar to the pharmaceutical industry which also commits years and even decades of capital and effort to release new drugs.
However, the pharma industry knows that the drug once released will meet ready comsumer demand because most people don't turn their backs at what can be the difference between life and death. They only have to worry about whether other pharma companies release before they do.
With the gaming industry, none of this is the case. Gamers don't have the existential incentives sick people do. Activision Blizzard can literally waste years of effort, time, and capital into putting a product out there that nobody eventually likes. Paying for all the manufacturing royalties on top of these losses is understandably a sore spot for Activision Blizzard's management.
Microsoft's purchase of the company can't fix the feedback problem. That's intrinsic to the gaming industry. But the acquisition can largely eliminate manufacturing royalty Costs.
Microsoft does not have to pay royalty costs to Microsoft - subsidiaries can buy from other subsidiaries but consolidated costs don't increase.
More importantly, Microsoft is not just a different kettle of fish to Activision. It is a white shark in the gaming industry. Sony and Nintendo, the other two monopolies, will find it very difficult to dictate higher prices for their hardware now.
Fees For Platform Access.
Before the deal, Activision Blizzard used to be screwed here on two sides.
Item 1A, Page 21, of their annual shareholder reports summarizes the problem with characteristic whininess.
On one hand, console manufacturers and platforms, the big three, charge overpriced fees to allow Activision access to sell its games.
On the other hand, digital platforms like Google and Apple playstores extract large rents for distributing Activision Blizzard's products. Both playstores, for example, have made substantial revenues from hosting Candy Crush Saga, one of Activision's most successful products.
Again, the benefits of the acquisition are the same as before: Microsoft's platform fees are taken out of the equation and Microsoft has much more bargaining power to negotiate more profitable terms of service for blizzard's offerings.
Indeed, Microsoft retains the real threat of withholding these games altogether and rendering them exclusive on the Xbox One platform. Although, for reasons I will discuss in the third segment of this newsletter, Microsoft won't make this move.
3. Capital For Diversification.
Microsoft made history with the acquisition. But its accountants were surely like 'what's all the fuss about?’ If Microsoft began tomorrow with Activision’s market value, Bill Gates and co. would reach for a suicide prevention helpline.
The cost of the purchase was just around three percent of Microsoft's market value. Microsoft didn't even need to sweeten the deal with shares.
Activision Blizzard is not so wealthy. 90% of the company's consolidated revenue comes from just three mega successful products: The Call of Duty franchise, the World of Warcraft, and Candy Crush Saga.
For reasons outlined earlier, gaming is a pareto-model business. Only a few of a gaming developer's products will have the right combination of luck, timing, skill, and capital to attract a large fanbase.
Because multiplayer games have inbuilt network effects, the long tail of the gaming industry can be expensively, needlessly long. Most gamers just play games that most gamers are already playing. The good news for game developers like Activision is you only have to be right once. The bad news is if consumer demand declines for the prized jewel, it can take the entire company down with it.
Activision has been making efforts to change that by diversifying into digital gaming, where the benefits of cheaper production come with the side effect of exposure to intense competition. It has also been dipping its feet into cloud based game streaming, new products and games, and of course, the metaverse.
Microsoft already owns Azure, the second largest cloud provider in the planet. In addition, it has boatloads of capital to support Activision's foray into the other two domains.
The Benefits of The Deal For Microsoft.
Microsoft's Xbox Products Are Not Generally Loved.
In the top fifty best selling games of all time, and excluding games purchased by Microsoft like Minecraft, the Xbox Gaming Studio has made a grand total contribution of zero. This is since its launch in 2001. It has failed in all of 21 years to redeem that unflattering record.
Gamers prefer the Sony and Nintendo libraries of content and combine this with a strong derision towards the Xbox One. Activision Blizzard has no such likability problems. It boasts five games in the top fifty and is bettered only by Nintendo's ultrasuccessful game studio.
There are other similar enticements. Microsoft's Gamepass is a subscription service selling in two tiers for full access to exclusive Xbox gaming content.
A GamePass subscription for as low as ten dollars would guarantee unlimited downloads and installations from a library of gaming content.
It's a very sweet deal, but consumers keep refusing to take the bait. Gamepass currently has 25 million subscribers out of three billion active gamers in the world. Its share of the entire gaming market is less than 1 percent. So, it’s no surprise that Gamepass is effectively a dud.
Microsoft's head of gaming strategy, Phil Spencer, recently admitted that Gamepass does not make any profits.
It's not hard to see why: the first law of subscription is that having tons of content don’t matter if people don't want them enough to pay for access.
The funny irony is subscription is actually a superb monetization model for the gaming industry, as opposed to say media and film. Media and film have their own share of blockbusters, but beyond that, everyone has different tastes. We may have all seen The Avengers and Harry Potter but I have seen Brooklyn while you probably enjoy stuff like I know What You Did Last Summer (I really hope not but it happens).
If Netflix wanted to sign us all up, they would have to create and purchase content that addressed this diversity in taste.
Movies additionally lack renewable value. Few people rewatch their favourite movie ten times, not to mention a hundred or a thousand times. A gamer, on the other hand, can play the exact same game a hundred times in a day. All of this means owning the few most popular games is enough to have a very successful gaming subscription service.
Microsoft is keenly aware of this. To Gamepass' measly 25 million subscribers, Activision has 400 million active users monthly. To the Xbox's revulsion among the gaming community, Activision brings a basket of adored content. If the cards are played right, it has the potential of a match made in subscription heaven.
5.) COVID-19
The pandemic was hell for airlines, awful for restaurants, bad for hotels, good for pharmaceuticals, splendid for billionaires, and excellent for the burgeoning nft-crypto-smart contract industry.
But it was heaven, absolute heaven, for gaming companies. People found themselves, sitting at home, often cut off from friends and family, with absolutely nothing to do for months on end. We also found out that after three weeks, watching COVID-19 cases go up ceases to stimulate.
So we turned to protecting the environment, reforming our institutions, connecting with loved ones, getting fit, and making wise financial investments all with the benefit of unprecedented free time?
Well, some people did. But who am I kidding? We turned to games.
Fact: The gaming industry grew more in the pandemic than it did in the last five years preceding it.
More Interesting Fact: it was already the fastest growing industry in content in those five years and one of the fastest growing industries in the world overall.
The accounting firm Price Waterhouse Coopers published a report verifying that the gaming industry had gained ten percent revenue growth in 2020.
The COVID-19 Simon Kucher Global Gaming Study was even more startling. The authors, Lisa Jaeger, Nick Zarb, and Alex Davis, classified the gaming population into four categories:
a.) Non Gamers - people who play games for less than an hour a week.
b.) Casual Gamers - people who play games for one to five hours each week.
c.) Gamers - people who play games for five to twenty hours a week.
d. Serious Gamers: people who play games for more than twenty hours each week.
The study predicted that not only was spending on games expected to stay elevated at a 21 percent from pre-pandemic levels but the population of the latter two categories increased permanently by nine percent.
Seventeen percent of non gamers and casual gamers became gamers and serious gamers in the pandemic. This is how the gaming industry grew by ten percent while the global economy shrank by half that number.
These high levels of retention should surprise no one because gaming has been confirmed in several peer reviewed studies to be potentially more addictive than cannabis.
Its addictive reputation is so promising that there are strong calls to regulate gaming. The Chinese government, never one to shy from telling families what to do, has already placed strict regulations on gaming and screen time for children.
You know you have made it as an addiction when communists and republicans want to control your use.
Many who picked up a console or a digital game in 2020 may have cut back on engagement but few stopped for good. And it's only about to get better for the industry. With Doordash & Instacart promising to cut out everyone's last routine exercise left - grocery shopping, with Amazon still doing its thing, and with remote work accelerating, an increasing number of people will spend more time at home.
Spending huge chunks of time at home is a boon for an industry that still needs you sitting on a couch for hours.
6.) Activision Was Severely Undervalued.
Microsoft has been scratching an M&A itch for some time now. It eyed up TikTok as its shiny new bride before TikTok eventually rejected one sugardaddy (Microsoft) for another sugardaddy (Oracle).
Discord came next, but the social media platform was a foregone non-conclusion from the beginning. Any mentions of a Discord acquisition would likely have triggered the full force and fury of a DOJ and FTC, who are still yet to approve Microsoft's proposed acquisition of Nuance, a drastically smaller company.
In between rejection and regret, Microsoft snapped up Bethseda Softworks, a relatively successful gaming development company, for 7.4 billion dollars.
On the other side of the divide, Activision Blizzard had been getting its employees in the news. As a general rule, if a company's employees are in the news, it's not for a good reason. The gaming industry is a cauldron of sexism and gender inequality. Activision Blizzard was just the worst of a bad bunch. When the company got sued in July by the California Department of Fair Housing and Employment on grounds of sexual misconduct, sexual harrasment, and widespread discrimination, its share price tumbled by 27 percent.
Blizzard didn't help its case by refusing to take punitive action against its CEO, Brian Kotick, who had been heavily implicated in the disgrace. And so, when Microsoft finally cast its lustful eye again on the gaming industry, there was Activision Blizzard, a diamond that had been industriously burying itself in the mud.
Buying Activision was a move that could still have happened regardless, but losing a lot of its value in the last six months certainly made it a cheaper and more attractive marriage.
7.) A Final And Inconspicuous Reason.
Reading a complete set of annual shareholder reports is exhausting. You are literally trying to figure out the truth from a document designed to deter you from figuring out the truth.
However, something strange caught my eye on my final perusal. Tucked away inconspicuously in page 36 is a rather laconic paragraph:
On January 27, 2021, our Board of Directors authorized a share repurchase program under which we are authorized to purchase up to $ 4 billion dollars of our common stock during the two-year period from February 14, 2021, until the earlier of February 13, 2023… To date, we have not repurchased any shares under this program.
On January 31, 2019, Our Board of Directors authorized a share repurchase program under which we are authorized to purchase up to $1.5 billion dollars of our common stock during the two-year period from February 14, 2019, until the earlier of February 13, 2021… To date, we have not repurchased any shares under this program.
For the uninitiated, a share buyback is a successful attempt by a company to repurchase some of its shares either by making private offers to select shareholders or buying them on the open market.
Investors and shareholders generally like to see share buybacks. To know why, it's important to understand that all investors, whether or not they believe in charts, fundamentals, cowry beads, fraudulent advice, or some other investing strategy, pay attention to two key metrics:
ROA.
P/E ratio.
A high ROA is generally a sign of a profitable industry meeting competent management. If you invested 1 million dollars in a venture and received 200,000 for the first year, that's a pretty good ROA of 20 percent.
On the other hand, when the Price to Earnings ratio is low, it usually means the company is not dramatically overvalued. Buying an undervalued stock means it's more possible to make more money. It should also justifiably give the investor more confidence that he's buying actual value. This is not often the case but it’s important to keep the peace today.
There are several ways for a public company to have low P/E and high ROA. One of the easiest ways is through a share buyback. For an elementary demonstration, check this out.
Share buybacks can happen for a multitude of reasons:
Trim excess ownership. Especially when stocks have been granted generously as incentives to employees.
Provide better returns to investors, since capital gains, unlike dividends, are not only taxed at a lower rate but are only as of the moment taxed when realized, that is, when the stocks are sold
To signal faith from the management that the stock is undervalued.
To juice up the stock's attractiveness to the unsuspecting.
So far, so good. Just a regular day at Wall Street. The important thing to remember is a share buyback proposal is a strong vote of confidence. The company is basically saying ' we will have a better return on our cash by buying back our assets than by doing anything else with our money. And we are willing to take on more ownership to prove it."
Which is why that paragraph is curious. Twice in the space of two years, the Board of Directors had enough confidence to approve a substantial share buyback proposal for the combined sum of 5.5 billion dollars. And yet, at both times, no share, not a single one, was eventually repurchased.
So, it's Sherlock Holmes time. Were Activision shares undervalued? Yes. It’s easy to forget though that they were even more undervalued in the last six months for reasons which had nothing to do with the fundamentals of the company. Yet, no shares were repurchased during that period, an action that might have restored some of its market value. None of the other reasons really add up as well.
If something doesn't fit with your expectations, the problem is often your expectations. In this case, there is a fifth reason stock buybacks are so popular- they insulate the company from takeovers and mergers. Buying back significant proportions of the company's shares reduces the number of shares left outstanding for outsider investors to pounce on. It also increases the share price, making the shares left on the market more expensive.
There has been a flurry of acquisitions in the gaming industry. Meta alone went on a gaming buying spree last year, including purchasing the hit VR fitness app, Supernatural.
Phil Spencer, Microsoft's new head of gaming strategy, reports that discussions began late last year. We have no reason to doubt the veracity of those reports.
However, Activision Blizzard's management were fully aware they were sitting on gaming gold and must have anticipated that in the current acquisition-prone environment, an acquisition was coming from somewhere.
It is quite likely that they initiated a stock repurchase program because they were waiting for an acquisition, and when one eventually came, they made sure to secure what they considered full value.
This is why Microsoft met Activision Blizzard's demands so quickly: they were prepared to overpay not just out of a desire to avoid another failure but because meeting the full valuation of Blizzard's Management was evidently something the company was unwilling to compromise on. Blizzard sold itself out of disaster, but it made certain to charge full price for its own salvation. If I didn't know better, I would say it sounds exactly like a broke pretty girl adding discretionary expenses to the list.
In parts 2 and 3, we will delve deeper into what the acquisition means for the metaverse and for antitrust policy going forwards.
Until then, Stay Cool.