Microsoft’s Activision Merger Is History’s Biggest Tech Deal. The Stocks to Play It.

The transaction, which has widespread ramifications for the videogame industry, will pose a substantial test of the Biden administration’s increasingly tough stance on mergers and acquisitions, and tech transactions in particular.

From a Microsoft perspective, the deal looks brilliant. The company’s stock rose on the news, despite the large outlay of cash involved. The price tag represents less than 3% of Microsoft’s $2.3 trillion market value. As Moody’s pointed out this past week, Microsoft has $137 billion in cash on its balance sheet and is likely to generate $50 billion in free cash flow in the current fiscal year.

The deal won’t require financing, it won’t affect Microsoft’s stock repurchase program, and it won’t come close to endangering the company’s nearly 1% dividend yield. Also, Wall Street isn’t worried about the price, at less than seven times Activision’s forward sales, well below Microsoft’s own price-to-sales multiple of 12 times. Lastly, the $95-per-share cost is still well below Activision’s year-ago high of $104.

Microsoft said the deal, expected to close before June 2023, would provide an immediate boost to adjusted profits.

For Activision Blizzard investors, Microsoft’s offer is a lifeline. The company, and stock, have been mired in a sexual harassment scandal that triggered calls for CEO Bobby Kotick to resign. While Kotick will stay on as Activision’s chief through the close of the deal, it has been widely reported that he is likely to step down after that, a key step in cleaning up the issue. Microsoft declined to comment on Kotick’s future.

And yet Activision shareholders haven’t quite embraced the deal. At a recent $82, Activision shares are trading at a 14% discount to Microsoft’s offer. That implies just a 60% chance of the deal going through, Barron’s calculates, thanks to the inevitable scrutiny from regulators in Washington.

The merger would make Microsoft the world’s third-largest gaming company by revenue, trailing just Sony Group (SONY) and China’s Tencent Holdings (700.Hong Kong). Sony makes the PlayStation console, the primary rival to Microsoft’s Xbox.

The acquisition is, in part, Microsoft’s effort to gain ground on Sony in the console battle. With Activision, Microsoft would get control of the hugely popular Call of Duty first-person shooter franchise, which accounted for two of the three best-selling games on PlayStation in 2021, according to research firm NPD Group.

Microsoft also gets World of Warcraft, the proto-metaverse sword-and-sorcery multiplayer game, the role-playing game Diablo, and the multiplayer first-person shooter Overwatch. It also brings Candy Crush, still one of the most popular mobile games. (Activision bought Candy Crush publisher King Digital for $5.9 billion in 2016.)

Ultimately, the deal ticks every box for Microsoft: It enhances its position in mobile games, expands its already formidable position in the still-emerging metaverse, provides new games to include in its Xbox Game Pass subscription program, and gives it the option to pull popular games away from rival PlayStation.

All reasons for investors to like the deal—and for regulators to take a close look. App store platforms are already getting tough treatment from regulators across the world, and Microsoft could find itself in a similar position if it were to remove Call of Duty or other Activision games from the PlayStation.

Exclusives have long helped to sell consoles, and Microsoft and Sony keep some of their best games in-house. Even so, Microsoft might be forced to defuse potential antitrust issues by committing to keep Activision games on the PlayStation.

The company declined to comment on the exclusivity issue.

The bigger risk for Microsoft is if the federal government decides to make an example of the merger on the grounds that tech giants are big enough and shouldn’t be allowed to get bigger. If the government goes that route, Microsoft would have to decide whether to defend the linkup in court, as AT&T (T) and Time Warner did successfully in 2017.

Investors already see the competitive risk to Microsoft’s rivals. Sony shares tumbled 11% last week after the Activision move was announced. If Sony’s business is pressured, it could, in turn, be forced to make a deal of its own.

That speculation sparked a rally in shares of Electronic Arts (EA) Take-Two Interactive (TTWO), Paris-based Ubisoft (UBI.France) and Japan-based publishers Capcom (9697.Japan) and Square Enix Holdings (9684.Japan). They all rose on the week, despite the broad selloff in tech stocks.

For investors, there are multiple ways to play the merger. Anyone convinced the deal will go through can buy Activision shares. But there’s plenty of risk, and the potential reward is capped by the deal price, limiting upside to about 15%. That trade is best left to the risk arbitrageurs.

Investors can also bet on the potential of additional consolidation by buying shares of takeover candidates like EA, Take-Two, and the other game publishers that rallied this past week. Shares of mobile videogame maker Zynga (ZNGA) soared earlier this month after Take-Two said it was buying the company for $12.7 billion.

But the better, less speculative bet is Microsoft itself. The stock has been a laggard over the past few months, but seems well-positioned for double-digit earnings growth as far as the eye can see.

Sony also looks attractive here—the gaming industry is on fire, the stock has been discounted, and the threat to its business from a Microsoft-Activision merger seems a little overblown.

Meanwhile, all eyes are on how Washington reacts to the deal. For President Biden, the Federal Trade Commission, and the Justice Department, it’s game on.

Write to Eric J. Savitz at [email protected]