Activision Blizzard; Market Cap: $25.52bn (as of 06/11/2015)
King Digital Entertainment; Market Cap: $5.55bn (as of 06/11/2015)

 

Introduction

On November 2, Activision Blizzard agreed to acquire for $5.9b King Digital Entertainment, one of the major players of the mobile gaming industry with its popular Candy Crush Saga. The move would position Activision Blizzard as a global leader in interactive entertainment across mobile, console and PC platforms, with a combined global network of more than half a billion monthly active users.

 

About Activision Blizzard

Activision Blizzard is headquartered in Santa Monica, California, and is a worldwide developer and publisher of online, personal computer, console, mobile and tablet games. The company acquired itself in October 2013 from the French group Vivendi for $8.2bn and since then has performed particularly well gaining market share in the gaming industry.

Activision Blizzard currently operates through three business lines: Activision Publishing, Blizzard Entertainment and Activision Blizzard Distributions. Activision Publishing develops and sells software products for video games (Call of Duty is the most famous franchise) which operate on the most common consoles systems like Xbox, Nintendo and Sony PS. Blizzard Entertainment is instead mainly engaged in the subscription-based online role-playing game category, mostly through its World of Warcraft franchise, which it develops, markets, and sells together with many other online strategy games for the PC, mobile and tablet platforms. The last operating segment is Activision Blizzard Distribution, representing the distribution channel of the company.

Activision Blizzard has the following revenue structure:

– Product revenues, including sales of physical products and digital full-game downloads. They have been historically the biggest source of revenues for the Santa Monica-based company, accounting for 61% of 2014 revenues.

– Subscription revenues, mostly derived from World of Warcraft, which although free for the first month requires users to enter into a subscription agreement for future access.

– Licensing revenues, third-party licensees in Russia, China and Taiwan distribute and host certain Blizzard games in their countries under license agreements, for which they pay the company a royalty.

– Other revenues, which mainly include sales of virtual goods.

Given this stand-alone revenue base, the acquisition seems to be the most transformative for Activision since its $18.9bn combination in 2008 with Blizzard, at that time owned by Vivendi Game. In fact, after the acquisition of King Digital, product revenues will only account for 39% of combined sales (excluding synergies), making subscription and other revenues much more relevant and thus diversifying further its product portfolio.

 

King Digital: from the IPO to Activision

King Digital Entertainment, headquartered in London, develops and publishes games that can be played on its King.com and Royalgames.com websites, Facebook and mobile platforms such as iOS and Android.

The company went public in March 2014 but, as BSIC previously discussed in a dedicated article, the IPO has not been successful because the stock experienced a sharp decline in the first days of trading and has not reached its $22.5 IPO price ever since. The main reason of the poor performance was attributed to the strong dependence of the company’s revenues to Candy Crush Saga (73% in Q3 2013). In these two years, the company developed new games reaching a better product portfolio diversification and was also able to partially offset the decline of Candy Crush Saga revenues, which now account for 40% of total gross revenues of the third quarter of 2015. In addition to the well-known Candy Crush Saga, which was first launched on Facebook and smartphones in 2012, the Company’s games portfolio includes the Candy Crush Soda Saga, Farm Heroes Saga, Pet Rescue Saga and Bubble Witch 2 Saga.

Despite Monthly Active Users (MAU) have been growing in all the previous quarters, revenues started to decline after peaking in the first quarter of 2014, driving down both earnings growth and stock performance. It is worth noting that only 2.2% of MAU generate revenues for the company and the main concern is that while MAU are still growing, the number of Monthly Unique Payers is declining rapidly: they were 13m in Q3 2013 but they fell to only 6.8m in Q3 2015. This sharp decline has been offset by a growth in the spending per user, which peaked in Q2 2015 but that now is unfortunately declining.

Despite the recent trends described above, the company is still very profitable as margins are particularly high and constant (Ebitda margin is steadily within the range of 40-45%) even with declining revenues, signaling that the company is able to operate with limited operating risk, as it has reduced costs in almost the same proportion as revenues.

 

Deal Structure

Activision Blizzard has committed to pay $5.9bn in cash for King Digital Entertainment valuing the shares of the developer of Candy Crush at $18, or approximately a 20% premium on the price of the trading day preceding the deal announcement. The US-based company is planning to finance the acquisition through $3.6bn in offshore cash and $2.3bn in debt provided by Goldman Sachs and Bank of America Merrill Lynch at an interest rate of 3.25%.

After the acquisition, King Digital Entertainment will operate independently as an operating unit of Activision Blizzard under the guidance of its current management team, whose members have already signed long term contractual commitments.

Undoubtedly, the peculiarity of this transaction is that King’s shareholders will not receive any share of Activision Blizzard but only cash. The explanation could be twofold: on the one hand Activision might have opted for this type of financing because is trying to spend its offshore cash, on the other the company might consider its stocks undervalued and therefore thinks that a share deal would be too expensive. Nevertheless, as stocks of Activision are trading approximately 100% over the price of one year ago, the former motivation seems the most reliable: the rationale would be in fact to avoid paying those taxes related with bringing this cash to the United States.

 

A Call of.. Candy

Behind the Activision’s $5.9bn acquisition one can find several straightforward motivations. Firstly, the move strengthens Activision’s position as the largest publisher in the interactive entertainment business with a combined portfolio encompassing 10 of the world’s most iconic interactive entertainment franchises and over half a billion monthly active users across diverse demographics in 196 countries. Financially speaking the numbers look meaningful and impressive: with combined revenues of $6.8bn and profits of $1.41bn, Activision Blizzard will become the most profitable standalone company of the industry. Furthermore, the deal will be accretive, as it will increase the EPS of Activision by 30% mainly thanks to the King’s Ebit margin, which is higher (32% vs 26%).

Nevertheless, the most interesting part of the story comes into play when one realizes that with the buyout, Activision is able to address one of its few areas of weakness: mobile. Although Activision’s franchises—which in addition to Call of Duty and World of Warcraft, also include Destiny, Guitar Hero, and Skylanders—are strong and with a stable client-base, recently the Santa Monica-based company has faced a growing threat as the mobile gaming industry has vertiginously acquired market shares. In fact, dollars spent on mobile in 2015 account for 20% of those spent on gaming and are expected to grow by 50% in the next four years: given this context, the Activision Blizzard’s weak embrace of the mobile gaming was considered a backward-looking strategy. As a consequence, the acquisition of King Digital allows Activision to gain not only a 467m customer base, but also a successful management team which might help the company exploit its own franchises. Furthermore, Activision hopes to exploit economies of scale and scope by cross-promoting content among its players and strengthen its position in the emerging markets for which its current products are often too expensive.

Looking now at the price paid for the London-based company one should assess that it is undoubtedly high when considered in absolute value, also because it involves a 100% cash transaction in contrast with the recent stream of stock-financed acquisitions aimed at capturing the buoyant valuation of equities. Still, several mitigating circumstances can provide a convincing explanation of Activision’s choice: it would involve an accretive use of Activision’s offshore cash balance and avoid paying taxes that would have been incurred by repatriating it to the US; also the implied multiple of ~6.4x E2015 Adjusted EBITDA is far lower than the average multiple paid for many similar tech transactions; finally the 20% premium paid on the trading day before the announcement share price looks downsized when compared to the IPO price of $22.5, suggesting that also the timing of the acquisition for Activision seems optimal.

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Concerns over the transaction

Still the doubts that last year surrounded the above-mentioned weak King Digital’s IPO inevitably affect the current transaction: (i) the company’s rigid, although decreasing, financial dependence on the Candy Crush Saga, (ii) its inability to launch another Candy Crush Saga-sized hit, and (iii) the increase of competition from many mobile gaming companies which try to replicate the success of King Digital. These concerns worry the market and Activision’s shareholders. In fact, Activision’s the stock price lose over 6% in the last trading day after the initial rally that followed the announcement.

Moreover, it’s also worth noting that the arrival of social networks and smartphones heavily affected the gaming industry and it is quite difficult to state what will be the successful business model for next years. There are other segments of gaming industry which are growing fast: Virtual Reality, in which Facebook and Sony made heavy investments and Esports where players compete in organized tournaments which could be a potential platform for advertisers. These could be threats for Activision and King, given that the barriers to exit in mobile gaming industry do not play a significant role.

The success of the deal is conditional on the approval of King Digital Entertainment’s shareholders and of the relevant antitrust authorities. Goldman Sachs and Bank of America Merrill Lynch advised Activision Blizzard on the deal, while King Digital was advised by J.P. Morgan.

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