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#1: Microsoft’s Acquisition of Activision Blizzard Faces its First Major Roadblock

Microsoft and Activision Blizzard have had a tumultuous week. The first major event was Microsoft’s earnings, which came out after the close on April 25th. Shares rose by as much as 9% after hours, after revenue and earnings beat expectations. This was coupled with a strong forecast for the next quarter, with strength in the cloud business that includes Microsoft Azure. The company also trumpeted their recent AI moves, which was met with a positive investor reaction despite resulting CapEx increases. Gaming beat expectations off of strong services growth, but hardware sales plunged 30% as the Xbox Series X/S lost share against the PS5.

Less than a day later, before U.S. markets opened on Wednesday, the U.K.’s Competition and Markets Authority (CMA) announced its final decision on Microsoft’s acquisition of Activision Blizzard. The CMA stated that their concerns, which were initially raised in February around cloud gaming monopolization, were not adequately addressed, and the deal would not be approved. Given the global nature of the deal, a block from any major market regulator would result in its failure. It also increases the likelihood of the FTC blocking the deal in the U.S. on these same grounds, as it shares many of the CMA’s concerns and both countries’ regulatory bodies enjoy strong ties. 

To allay some concerns over the health of the business, Activision Blizzard pulled forward their FY 2023 Q1 results by one day, from April 27th to April 26th. It’s unclear whether the company had advanced knowledge of the CMA’s decision, but the press release was issued during market hours at 10:39 AM EST. GAAP revenue for the quarter grew 35% from 2022 Q1, while EPS grew by 86%. These are against soft comparables given the challenges the gaming sector faced last year, and individual challenges within Activision Blizzard due to company-specific issues such as game delays. Notably, revenue is also marginally higher than Q1 2021, at $2.38 billion versus $2.28 billion, while EPS is materially higher at $1.09 versus $0.79.

Contributing to the upbeat quarter was broad-based bookings growth in the company’s five core properties: Call of Duty, Candy Crush, Warcraft, Overwatch, and Diablo. Mobile was a bright spot as Candy Crush and Call of Duty Mobile saw net bookings grow double digits year over year. Guidance for Q2 calls for >10% revenue growth, >30% net bookings growth, and operating income growth of >40%. These are all organic given the lack of M&A over the period. As we noted last week, next quarter’s optimism is due to the Diablo IV launch, which has had three successful beta weekends thus far. 

Activision Blizzard also reaffirmed that a new Call of Duty premium release would be coming later this year, likely in the fourth quarter when new entries in the series typically launch. Previous reporting indicating that the Call of Duty series would skip 2023 on its premium release schedule ultimately proved either incorrect or too early, as Activision is now reportedly planning a follow-up to last year’s Modern Warfare 2. 

Activision did not provide detailed results — including an earnings presentation, conference call, or financial guidance — in light of the ongoing acquisition, as has been the case since the merger announcement. CEO Bobby Kotick also used the report to restate the company's commitment to the Microsoft acquisition, saying they “will work aggressively with Microsoft to reverse [the decision] on appeal.” The last formal earnings release was on November 2nd, 2021, covering FY 2021 Q3 earnings. 

The upbeat earnings and remarks from Kotick were not enough to stop the stock from sliding. ATVI fell -11.5% on April 26th, its worst performance since November 9th, 2018, when shares fell -12.4% after Q3 earnings were reported. While still higher than the pre-deal price, indicating that investors believe a deal may still be possible, the stock now trails the offer price by 19%. Note that it is difficult to gauge what portion of the move was due to earnings and what was due to the CMA decision, as both events happened concurrently.

Investors may have also keyed in on the MAU decline across the portfolio. The monthly active users for Activision Blizzard games declined from 389 million in Q4 2022 to 368 million in Q1 2023. This is slightly lower than Q1 2022, but sharply lower than the 435 million MAUs two years ago in Q1 2021. This info was burrowed at the very end of the press release, but is a material disclosure that could affect profitability going forward. So far, a rise in average spending per user has blunted the effect of the decline in player count, but an economic downturn could rapidly upend this dynamic. The losses were concentrated in the Blizzard segment, where users fell by 40%, a metric reflective of Diablo Immortal’s eroding popularity.

The decision was a blow to large gaming companies, which saw their deal premiums erode. The other two gaming constituents in the S&P 500, Take-Two Interactive (TTWO) and Electronic Arts (EA), fell -4.3% and -3.4% on Wednesday, respectively. Ubisoft interestingly remained unaffected, perhaps because the company is already trading at extremely low historical valuations. Outside of gaming, investors who bought ATVI for merger arbitrage are also affected. Berkshire Hathaway has a sizable $4 billion stake in the company, as Warren Buffett believed the deal was very likely to go through.

Microsoft maintained much of its after-hours move post-earnings and rose 7.2%. While it would rank as one of the largest M&A deals of all time, the $69 billion sum owed by Microsoft were the deal to close would equate to about 3% of its market cap. Furthermore, the deal value was struck in January 2022, when tech valuations were much loftier than they are now. Investors may actually prefer that the acquisition doesn’t close and Microsoft pays the $3 billion break-up fee, rather than close a deal for a company worth materially less today than a year ago. 

Sony was a beneficiary of the CMA decision, with the NYSE-listed ADR jumping 3.4% on Wednesday. The company has aggressively lobbied global regulators, including the FTC and the CMA. Despite the lead Sony enjoys over Microsoft in the ninth generation of consoles, the company has successfully persuaded regulators that the acquisition is monopolistic and anticompetitive because of the threat it poses to PlayStation and others. 

Sony’s lead over Microsoft in unit sales was evident this quarter. Sony’s earnings, which came out on Friday before the market opened, showed console sales triple from the same time last year. Part of this was due to comparables being easier following the console shortage, but the company managed to beat its FY 2022 forecast by 1.1 million units. 

Microsoft, on the other hand, suffered a 30% decline in hardware, while Games Pass subscriptions notched a new record, albeit with slowing growth. Quarterly revenue was just shy of $1 billion while users across first-party software now exceed 500 million. The success of Xbox Games Pass represents a competitive advantage for Microsoft. PS Plus has a larger install base but a lower introductory price point, as many gamers subscribe just to be able to play online rather than, like Game Pass, access to a library of downloadable titles as is the case for the PS Plus Extra and Premium tiers. Adding additional titles to Game Pass is vital for Microsoft, as it reduces churn for the service while giving the company flexibility to raise prices going forward.

The CMA’s decision appears misguided. The 418-page report is primarily focused on the competitive landscape of “cloud gaming.” But it appears the CMA is conflating gaming subscription services with cloud gaming, which involves streaming games without a console or PC directly to a screen, tablet, or smartphone. In reality, very few subscribers utilize Xbox Games Pass for its cloud gaming component, which is still in beta. The report redacts the names of the competitors that have raised issues with the acquisition, but it is clear Sony is the primary complainant, while more recent disclosures point to Google as another. 

The CMA also said the cloud gaming market was “growing.” This is an ambitious declaration, given that Google’s cloud offering Stadia was discontinued just two years after launching. NewZoo’s 2022 report on the size of the market estimates that just 32 million people, or 1% of total gamers, payed for a cloud gaming service in 2022. Revenue is also estimated to be $2.4 billion. 

Even if these numbers are growing, it will be years before the industry becomes a double digit percentage of the overall gaming market. The fact that a “60-70% market share” is seen as problematic is also concerning, given this unfairly segregates gaming from other software. For example, Google has 89% search engine market share worldwide. Microsoft’s Windows has about a 75% market share worldwide, versus competitors like MacOS and ChromeOS. Gaming is a much, much smaller market than the search engine ad business.

Were the acquisition to fail on appeal, Microsoft could still try and carve out a gaming subsidiary exclusive to the U.K.. This is much more difficult than it seems given how integrated the gaming services market is. Furthermore, this would require the EU and FTC to also approve the deal, with minimal divestitures. Any additional roadblocks would spell the end of the Activision Blizzard takeover, the closing of which is all but ensured to be postponed past 2023. 

Gaming as a whole makes up a fraction (albeit important) of the story for the world’s second largest company by market capitalization. The acquisition will give Microsoft a fighting chance against displacing Sony’s hegemony on first-party exclusives, which is why Sony has fought so vehemently to block it. Before the deal was announced, Activision stock was under pressure due to game delays and corporate culture issues. The recent earnings are reassuring that the company could stand on its own, but the MAU trends, particularly in the Activision segment due to the Call of Duty franchise, are concerning. 

In the immediate term, expect ATVI to retreat to its pre-deal December 2021 price in the $50-60 range if the acquisition is called off entirely. The $3 billion break-up fee would represent a high single-digit percentage of the company’s market cap, and would probably result in shares trading at the higher end of this range. 

#2: Modern Times Group Keeps Getting Leaner

Swedish video game developer and publisher Modern Times Group reported earnings on April 26th. Net sales declined by 4% year over year, from SEK 1,357 million ($132 million) to MSEK 1,306 ($127 million) as reported. In constant currency terms, sales fell by 11%. Adjusted EBITDA fell from SEK 342 million to SEK 263 million. Note that these adjustments include M&A transaction costs and non-recurring bonuses, both of which were sizable in Q1 2022. On a reported basis, EBITDA actually rose slightly from SEK 239 million to SEK 245 million. There were no material acquisitions and divestments in the quarter. 

MTG stock fell about 1% after the release, and closed the week flat amid a broad rally in tech. The main contributor to the revenue decline was the Strategy & Simulation franchise. This segment is managed by mobile developer subsidiary InnoGames, and includes legacy games Forge of Empires and Elvenar, and newer titles Rise of Cultures and Sunrise Village. Racing was the other big detractor, as subsidiary Hutch’s F1 Clash suffered from the seasonality associated with the Formula 1 season.

Barring additional corporate changes, FY 2022 is the last year including any revenue outside of gaming. The past forty years have seen Modern Times Group change substantially in structure, to the point where the current company would be unrecognizable a decade ago. To understand MTG’s prospects, it’s important to see how things have evolved since the company’s inception.

In the mid to late 1980s, Scandinavian countries opened up their airwaves to non-state-run operators for the first time. This resulted in the entry of Swedish digital entertainment and investing conglomerate Kinnevik into the space, launching the TV3 station, the first commercial station in Sweden. Kinnevik’s TV & Media division grew rapidly, launching new offerings in Scandinavia with high market penetration. Eventually, Kinnevik expanded beyond paid TV into terrestrial channels within the Baltic states. 

In 1995 the division was incorporated as MTG. The group expanded rapidly throughout the 1990s and 2000s, buying assets in the Balkans, expanding beyond television into radio and print media, and even into sports betting with the minority stake purchase of BET24 in 2005. MTG launched one of the first video streaming services catering to the Nordics in 2007, Viasat on Demand (now Viaplay).

While still making acquisitions within TV post-GFC, activity slowed down significantly. MTG remain net sellers of their expansive media portfolio to this day, choosing instead to focus on gaming. In 2015, the company purchased 74% of Turtle Entertainment, the owner of the ESL brand and the world’s largest esports company at the time. MTG was still a media conglomerate, but gaming and esports became a sizable part of the portfolio.

Then in November that year, MTG acquired Swedish esports tournament series Dreamhack, further expanding its esports reach. October 2016 was marked by the acquisition of a 35% minority stake in German gaming developer InnoGames, a stake that has been increased over time and today amounts to 68%. In June 2017, web gaming portal Kongregate was acquired. In the meantime, all of the non-gaming holdings were slowly sold off, culminating in the split of the remaining assets into a separate entity, Nordic Entertainment Group in 2018 (today Viaplay Group). 

Today MTG is a pure-play gaming software company centered around InnoGames. Other studios include Ninja Kiwi, the developers of the popular Bloons Series, PlaySimple, a mobile games studio in India, and Hutch, a mobile studio making exclusively racing games. ESL and Dreamhack were merged in September 2020, and subsequently sold to Saudi-led Savvy Games Group in January 2022 for $1 billion, a month marked by a torrent of gaming M&A. With a 37% IRR and 655% cash-on-cash return, the deal was a windfall for MTG.

InnoGames is getting leaner too. After challenging performance in 2022, the company underwent layoffs this April which resulted in 75 employees being let go, or around 20% of the total headcount. Revenue started to decline in April and slid through November, though has recently begun to rebound slightly. This was primarily due to Forge of Empires, which comprises much of InnoGames’ revenue. The game has been out for over ten years since its browser-based release in 2012. It was later released on iOS in 2014 and Android in 2015. 

Over the last two years, Forge of Empires has grossed about $87 million in IAP revenue, which is around 70% of InnoGames’ total for the period. In March 2023 the app constituted 62% of revenue. This concentration must continue to decline to reduce the outsized influence of Forge of Empires. In normal times, the studio would diversify by ramping up UA spend on its other apps, but Apple’s IDFA changes have made targeting much more challenging. MTG disclosed that UA spend was lower at InnoGames this year, which was offset by higher spending at PlaySimple. 

MTG still has a lot of money on the balance sheet relative to its size, with SEK 4,019 million ($390 million) in cash and equivalents. When MTG purchased a majority stake in InnoGames in 2016, it valued the studio at $300 million. With the proliferation of mobile games studios throughout Europe and Turkey, the company would have no shortage of targets to purchase outright or at least buy a majority stake in. 

After spending years trimming off fat and becoming a lean gaming company, it is time for MTG to become a net buyer again. 40% of the proceeds from the ESL sale were already returned to shareholders, mainly in the form of buybacks, but there is still a lot of cash left. The company should narrow its scope and remain exclusively in the gaming software space, but with additional assets that can diversify its concentration with InnoGames’ Forge of Empires and a select few other apps. 

Top Movers

• For the week ending April 28th, 2023: the average return for gaming companies tracked by Naavik with a market capitalization exceeding $500 million was 1.1%. The S&P 500 returned 50.9% and the Nasdaq-100 returned 1.9%.
• Swedish gaming conglomerate Embracer Group surged by 21.5% after the UK CMA’s announcement that the Microsoft - Activision Blizzard deal would be blocked in the country. The market perceived the news as positive for Embracer, given the company is not under the same regulatory scrutiny as gaming giants. Embracer should still be able to execute its acquisition strategy without engaging in bidding wars with its more regulated competitors.
• Roblox continued to slide, falling by -12.5% and adding to the -10.9% decline from the prior week. These losses come after the company reported its March 2023 key metrics, which showed DAUs down sequentially and average bookings flat from March 2022. after reporting its March 2023 key metrics. DAUs were 66.2 million, up 26% year-over-year but down -1.6% from February. Roblox will not publish a monthly key metrics report going forward. 

Most Notable Strategic Investments

• Esports betting platform Rivalry raised $7.3 million in a private placement from bookmaker Pinnacle. The placement was announced concurrently with Rivalry’s latest earnings report. The platform swung to profitability in Q4 2022, and based on preliminary results appears to be profitable in Q1 2023 as well. Betting volume increased as large tournaments for games like Dota 2, CS:GO, and League of Legends were held. Over 90% of Rivalry’s revenue comes from esports, but the company is planning on expanding into traditional sports betting and other products. The funds will also be used for geographic expansion, as the Isle of Man company received licenses to operate in Ontario and Australia last year. (Link)
• Starbreeze Studios, the developers of Payday 2, are raising $43.6 million in a rights offering of Class A and Class B stock. One-third of the funds are earmarked for debt repayment to strengthen the balance sheet. The company noted that most of its developers are currently occupied with Payday 3, and as the game finalizes its development, resources can be allocated towards new games. Starbreeze also plans on expanding its third-party publishing operations; the last games published by the studio were in 2018. (Link)

Most Notable Venture Financings

• Mobile gaming studio Cosmic Lounge raised $4.4 million in a seed round led by Transcend Fund. The studio is led by mobile veterans with experience at EA, King, Rovio, and Next Games. Cosmic Lounge specializes in the puzzle genre and is looking to use AI to revolutionize the industry via its proprietary Puzzle Engine. The company has six co-founders, and based on job postings on the website, is looking to double its headcount. (Link)
• CharacterBank, a Japanese studio focused on AR, VR, and XR, raised $2.5 million in a Series A round. Investors in the round included NetEase Games and SMBC Venture Capital, among other Japanese funds. Since 2019, CharacterBank has launched three games, and plans on releasing about one title per year. Its VR game RUINSMAGUS was selected by Meta as one of the best action games on Quest in 2022. The company plans on using the proceeds to boost hiring. (Link)
• Vitar Games, an Icelandic studio of four based out of Reykjavik, raised $0.55 million in a seed round. The company is behind WW1 management strategy game Dig In, which will be released on Steam Early Access later this year. The company plans on using the funding to further development of its debut game.

Other News

• Days after the U.K.’s CMA decided against Microsoft in the acquisition of Activision Blizzard, Microsoft signed yet another 10-year cloud gaming deal, this time with Nware. Similar to its other deals, the European cloud gaming service would be able to stream Xbox games to its end users. Microsoft has signed these deals to curb regulators’ fears that the tremendous amounts of IP from the Activision Blizzard deal would become first-party exclusive. These remedies were rejected by the CMA however as not covering enough ground. (Link)
• Razer and Roblox signed a partnership that would see the peripheral maker’s products bundled with in-game codes for Roblox. The BlackWidow V3 keyboard, Orochi V2 mouse, and Barracuda X headset all have a corresponding Roblox edition, which allows for players to redeem the item as a virtual cosmetic for their character. Razer has inked many co-branded partnerships with various brands, but the foray represents the first for Roblox. (Link)
• NetEase announced the creation of a new internal studio called Anchor Point Studios. Based out of Barcelona with a secondary location in Seattle, the studio plans on scaling rapidly and hiring up to 100 employees. Anchor Point will specialize in action-adventure games for console and PC. Taking the reins of the operation is Paul Ehreth, who was previously a director at Smilegate Barcelona. (Link)

A big thanks to Mario Stefanidis, CFA for writing this update! If Naavik can be of help as you build or fund games, please reach out.