Microsoft: Price Target Upgrade On Acquisition Of Activision

Summary

• Following the announced Microsoft acquisition of Activision Blizzard, we determined the outlook of Activision based on its upcoming game releases, deriving a forward 5-yr average revenue growth of 13%.
• We believe that $Microsoft(MSFT)$ could leverage Activision’s massive active user base for its Game Pass subscription services with an estimated $484 mln in synergies for 2023.
• In terms of its financial impact, we see the deal supported by Microsoft’s massive cash pile, contributing 4% to top-line revenue.
• We raise our price target on $Microsoft(MSFT)$ , and in conjunction with the recent price decline, view a strong buying opportunity for the company's shares.

Jean-Luc Ichard/iStock Editorial via Getty Images

In our previousanalysison Microsoft, Inc. $(MSFT))$, we analyzed and determined its growth drivers beyond 2021 through its cloud segment, driven by the expected rise in data volumes globally benefitting its cloud growth outlook. Moreover, we highlighted the launch of its Windows 11 operating system and projected its market share to remain steady through 2024 based on unit shipment and average pricing growth. Lastly, we looked into its productivity software segment and projected its growth to increase by double digits over the next 3 years based on the forecasted increase in Microsoft's global IT market share.

This time, we covered the plannedacquisitionof Activision Blizzard ($(ATVI))$ for $68.7 bln expected to be completed in an all-cash transaction.

We analyzed Activision's game franchises by comparing them against competitors in terms of ranking by sales across device platforms including PC and mobile. We then determined the growth outlook for the company by examining its planned game releases across all devices.

Furthermore, we examined the company's Xbox installed base and game pass subscribers as well as compared it with Activision's total active players across its games already on Xbox to determine the potential revenue synergies for Xbox through cross-selling opportunities.

Moreover, we determined the impact of the acquisition on Microsoft's financials by examining its financial position to support the deal and the impact of the acquisition on its margins as a combined company, and the revenue contributions from Activision. Reflecting the impact of the deal, we upgrade our rating on Microsoft to a Strong Buy.

Activision Top Gaming Franchises

Following the acquisition of Activision Blizzard, Microsoft wouldgainthe gaming franchises of the company. According to Activision'sannual report, the company's top 3 franchises which are Call of Duty, Candy Crush and Warcraft account for 82% of total revenues in 2021. To illustrate the scale of these gaming franchises, we compiled the top-grossing gaming franchises by HowChoo based on the gaming company that owns the franchises to obtain the share of top gaming franchises.

HowChoo, Khaveen Investments

Based on the chart, Nintendo (OTCPK:$(NTDOY)$) and Electronic Arts ($(EA)$) have the highest share of top-grossing gaming franchises including Pokemon, Super Mario, Star Wars and FIFA. In third place, Activision's top franchises include Call of Duty, Warcraft and Candy Crush. In comparison, Microsoft has a significantly lower share than Activision. Thus, we believe Microsoft stands to benefits from the deal by acquiring major gaming franchises by Activision. The map below shows the ecosystem of gaming companies including Microsoft with Activision subsidiaries.

Source:Reddit

Moreover, we projected the growth outlook of Activision's revenue based on its segments. In 2022, the company is planning toreleaseseveral new titles to its franchises including Call of Duty: Modern Warfare 2 as well as contentexpansionsto World of Wordcraft and Candy Crush. Beyond that, the company is expected to release another Call of Duty title in2023and 2024 (Modern Warzone 2 and Black Ops) while Overwatch 2 and Diablo IV had beendelayed.

To project the Activision segment, we first derived an average unit sales of top Call of Duty games and the average cost per game. Then, we projected its Call of Duty Mobile revenues based on user and revenue per user growth on a 2-year average to derive the total Activision segment revenue forecast. Additionally, we forecasted Blizzard and King's segments based on a 5-year average user and revenue per user growth.

* c = a x b

f = d x e

i = g x h

l = j x k

Source: Activision,Active Player, Khaveen Investments

In total, we expect Microsoft to benefit from the acquisition of Activision gaming franchises and projected a strong outlook for its revenue growth with several key upcoming gaming title releases and content expansions.

Opportunity to Leverage Activision Massive User Base

Furthermore, according to Microsoft, the acquisition boosts its "Game Pass portfolio with plans to launch Activision Blizzard games into Game Pass". Its Xbox Game Pass is a subscription plan with hundreds of games for customers across Xbox and PC devices. In terms of market share, Xbox is thethird-largest gaming console player in the market trailing behind Nintendo and Sony.

To estimate the potential synergies with the deal, we first broke down Activision's monthly active users into Consoles, PC and Mobile and Other in 2021 based on its revenue breakdown disclosure from its annual report. Then, we further broke down its Console MAU into Nintendo, Sony and Xbox users based on the gaming console market share. From that, we applied the forecasted market 2-year CAGR of each console unit sales forSony(SONY) PlayStation andXboxand a 2-year historical unit sales CAGR forNintendoto forecast the total console MAU. Further, we forecasted thePCand Mobile MAU based on market forecasts to obtain the total MAU.

As the Xbox Game Pass is for PC and Xbox, we summed up our PC and Xbox MAU forecasts to get the target MAU for Microsoft. This represents the potential MAU that we believe Microsoft could derive synergies from with Activision. Following that, we calculated the difference between its target MAU and Game Pass subscriptions which we forecasted to grow based on its 2021 growth rate prorated on a 3-year basis. Finally, we derived the synergies based on the average Game Passcostof $11.66 according to Microsoft's website.

* c = a + b

f = (c - e)/3 + d

Source: Activision,Statista, Nintendo, Khaveen Investments

All in all, we believe that the acquisition provides Microsoft with the opportunity to leverage the massive active gamer base across its gaming franchises. Through its Game Pass, we see it potentially cross selling its subscriptions with Activision's user base in PC and Xbox and derive synergies.

Acquisition Impact on Financials

According to its investor presentation, the transaction isexpectedto be completed by FY2023 for a cashconsiderationof $68.7 bln inclusive of Activision's net cash which we calculate to be $3.4 bln. The chart below shows the financial position of Microsoft with a cash balance of $130.3 bln and cash to debt ratio of 0.7x in 2021. Based on the company's healthy financial position, we expect the company to be able to support the deal with its massive cash balance and strong cash generation abilities.

Microsoft, Khaveen Investments Source: Microsoft, Khaveen Investments

Source: Microsoft, Khaveen Investments

With regards to the impact on its margins, we combined both companies' gross and net margins to determine the post-acquisition margins. Compared to Microsoft, Activision had higher gross margins but lower net margins. Thus, we calculated the combined company's gross margins which show a small increase, and a decrease to its net margins without accounting for synergies.

Source: Activision, Microsoft, Khaveen Investments

While the combined company post-acquisition shows little change in its margins, we see the acquisition providing an impact on Microsoft's revenues. Based on our forecast of its revenue from our previous analysis and our projections for Activision, we estimated the acquisition to contribute 4% of revenues in 2023.

Source: Activision, Microsoft, Khaveen Investments

Overall, based on Microsoft's healthy financial position, we believe the company should be able to proceed with the deal without a significant impact on its financial position with its massive cash balance. In terms of the impact on its margins, both companies have similar profit margins and our calculation of the combined company shows little change to the company's margins excluding synergies.

Risks: Regulatory Approval

Besides Activision, Microsoft's previousacquisitionsin gaming companies include ZeniMax Media and Bethesda in 2020 which highlights its acquisitions strategy. According to Activision, the deal is subject to regulatory approval and is expected to close in Microsoft's FY2023. We believe this highlights a risk of the deal not going through should antitrust regulators clamp down on the deal.

That said, to determine the likelihood of the deal going through, we calculated the HHI index of the gaming market which is a measure of market competitiveness used by government bodies as discussedpreviouslyin our analysis on Nvidia (NVDA). For the Other category, we assumed the share to be weighted equally and divided it by 3.

Source:T4. Khaveen Investments

Based on the results, we find the gaming market to be not concentrated with a score below 1,000 in both pre-and post-acquisition scenarios with an increase of only 71. Thus, we believe this indicates the low likelihood of the deal being challenged by regulators.

Source:OpenTextBC

Valuation

Based on our previous analysis on Microsoft, we updated our revenue projections with the full year 2021 results and factored in Activision's revenue contribution in the table below.

Source: Microsoft. Khaveen Investments

We valued the company with a DCF analysis as we expect the company's cash flows to remain positive. The terminal value is based on the perpetual growth rate assumption based on its discount rate (9%) less the growth forecast in 2031 (6.7%).

Based on a discount rate of 9% (company's WACC), our model shows its shares are undervalued by 56%.

Khaveen Investments Source: Khaveen Investments

Verdict

Following the announcement of Microsoft's acquisition in Activision Blizzard for $68.9 bln, we analysed Activision's top gaming franchises including Call of Duty, Warcraft and Candy Crush and projected its revenue growth outlook based on its upcoming game and content expansion releases at a 5-year average of 13%. Moreover, we believe the company could leverage Activision's massive monthly active user base for its Xbox Game Pass and estimated revenue synergies of $484 mln in 2023 based on the difference between its subscriber base and Activision's user base. Finally, we examined the acquisition in terms of the financial impact on the company. With a massive cash pile, we see Microsoft comfortably support the deal and expect a neutral impact on its margins excluding synergies. In terms of revenue contribution, we estimated the deal to result in a revenue contribution of 4% to Microsoft's 2023 revenues. Overall, we rate Microsoft as aStrong Buywith an upgraded target price of$440.36.

Source: Seeking Alpha