U.K. Throws A Wrench Into Microsoft-Activision Deal: Time To Reevaluate

Activision (NASDAQ:ATVI) shares tumbled as the UK blocked its deal with Microsoft (MSFT) based on competition concerns. I previously wrote I expected it to be a good merger arb mostly based on the vertical nature of this merger. Microsoft's Vice Chair and President Brad Smith has said the company remains "fully committed" to the deal and will appeal. This should now go to the Competition Appeal Tribunal, or "CAT." In line with U.S. and European regulators, the U.K. regulator has been more aggressive in blocking deals in the past few years. I'm not entirely opposed to that general trend but that's another story for another day. I do think sometimes decisions are overly aggressive and in my opinion this is one of them.

Unfortunately, the CMA appeals aren't often successful (in this article there's a statistic of 70%). It's not like the entire process is repeated with a higher authority. In this case, Microsoft probably has to show somehow that the procedure wasn't executed properly (seems unlikely) or that the decision was irrational on the part of CMA (I think they have a shot here). But then when the decision is found to be irrational, there's a do-over with the CMA again.

The CMA basically killed this deal because it fears Microsoft, its position in cloud gaming. They didn't like the remedies Microsoft proposed. Here are the problems with blocking the merger on these grounds:

1) cloud gaming is currently a tiny market as a percentage of the gaming market. 2) Cloud gaming is only just starting to grow and anything can happen. A potential "substantial lessening of competition" is a big future maybe. 3) Therefore, if Microsoft isn't allowed to buy ATVI, any future decisions should apply to other mergers. 4) Microsoft's perceived competitive advantage is heavily supported by the CMA by arguing Microsoft has its own cloud infrastructure in Azure. However, this seems to disregard that just because you're doing something in-house it doesn't mean there's no cost to it. Here's an interesting paragraph by the CMA in its decision:

We are concerned that making Activision's titles exclusive to Microsoft's cloud gaming service would harm competition, particularly since our view is that Microsoft already holds a strong position in this market by virtue of its unparalleled advantages through its ownership of Windows, its cloud infrastructure, and its existing catalogue of first party titles. There are a few 16 emerging rivals with their own respective strengths, such as Amazon (AMZN), Sony (SONY), and Nvidia (NVDA), but none seem to be as well positioned as Microsoft in this market. We consider that Google's recent decision to shut down its own cloud gaming service, Stadia, shows that merely having some strengths relevant to cloud gaming is not enough to guarantee a platform's success. The evidence also indicates that there are significant barriers to entry and expansion, including the cost of cloud infrastructure, the cost of acquiring content, and the need for economies of scale in order to drive down costs. Since Microsoft already appears to face limited competitive constraints from current and potential rivals, we are concerned that withholding Activision's content from rival cloud gaming platforms is particularly likely to harm competition now and in the foreseeable future. 70. On this basis, we found that the Merger may be expected to result in an SLC in cloud gaming services in the UK, as a result of vertical effects in the form of input foreclosure.

You can read the entire decision here.

It's my view that Microsoft can still get this over the finish line but there's no doubt this hurts the odds really badly. The only reason the stock is down only 8.76% is that there may be some truth to the idea that ATVI's downside isn't that bad if the deal were to break. Because basically it's now more likely the deal doesn't go through than it is to go through. I'm not sure about the exact odds but this now seems 60%-80% likely to somehow get blocked whether it's in the U.S. , Europe or in the U.K. My argument last article was basically:

...my argument is: 1) The spread is wide, 2) the downside may not be all that bad, and 3) it's a vertical merger. It's a simple argument, but that doesn't mean it can't hold up...

To be completely honest I don't love that the stock is down only ~8%. I think it should be down a bit further. I'm not sure arbs are exiting en-masse already. Given where the price went and the current state of affairs I think it's wise to either cut down/sell an Activision position and re-evaluate to enter back in at a slightly lower price. The EU could further damage the case soon while there are limited gains to be had if the EU lets it pass.

The economics also are damaged somewhat because it's now taking quite a bit longer for this to close. I can now more easily see this run until November 2023.

Holding Activision also puts you in a tricky situation in a macro sense. If the economy remains strong and there's no recession the upside remains capped because of the merger overhang (you have the "risk" of getting taken out), and if the economy does badly while inflation remains high (barring interest rate cuts) there's a lot of downside as ATVI is a high multiple stock. That's mitigated a bit by the "out" you would have if the merger passed against the odds. However, all taken together I don't love this risk profile. Unless I tremendously misunderstand the odds ATVI has of fighting the CMA decision I think this is now a sell. If the stock declines a lot more (let's say another 7%-10% down), I'll be a lot more interested again.