The market is having some heavy betting on whether the Activision Blizzard deal would actually push through. What are the odds that it won’t?

Activision Blizzard (NASDAQ: ATVI) is in limbo while authorities sort through worries about the company’s impending takeover by Microsoft (MSFT).

ATVI shareholders overwhelmingly accepted the terms of the deal in April, but the Federal Trade Commission (FTC) recently launched a lawsuit to block the acquisition due to worries that the merger of the two companies would be anti-competitive.

If the deal is approved, Microsoft will pay $95 per share for ATVI, a 25% increase over the current share price of $76.08.

Following the acquisition announcement on January 19, 2022, ATVI soared rapidly, peaked at roughly $80, and has been trading continuously below $80 since mid-August.

The stock is trading slightly higher than it was immediately prior to the FTC lawsuit notice on December 8th.

The corporation is currently faced with significant legal concerns, including serious sexual harassment and discrimination issues. Simply put, the company culture appears to be dysfunctional.

Microsoft’s acquisition should help to spur fundamental change in the company.

Interestingly, since the potential transaction was publicized, Berkshire Hathaway has increased its holdings in ATVI.

According to the most current Form 13F, Berkshire owned $4.47 billion in ATVI shares as of September 30th.

This gain was not sustainable after experiencing a significant increase in earnings during COVID, as video game sales rose among people with scant entertainment options outside of their homes.

EPS for the first and second quarters of 2022 were much lower than for the corresponding quarters in 2020 and 2021.

The consensus forecast is for earnings to rebound over the following year, with EPS predicted to expand at a rate of 7.4% per year over the next three to five years.

The significance of these forecasts is, of course, dependent on the likelihood of the transaction closing.

I last wrote about ATVI on May 30, 2022, which was approximately 6 months ago, when I raised the company from a hold to a buy.

The shares were trading at $78.20 at the time, compared to $76.08 now. ATVI has announced one quarterly earnings miss (Q2) and one earnings beat since this publication (Q3).

My ATVI upgrading was principally motivated by Microsoft’s impending acquisition for $95 per share.

I got my information about the chances of the deal closing from two sources. The first was the Wall Street analyst consensus perspective, and the second was the market-implied outlook, which is a probabilistic price estimate based on the options market’s consensus opinion.

With a consensus 12-month price forecast of $95.56, Wall Street plainly backed the acquisition going through.

The highest and lowest analyst price targets were $95 and $100, respectively, indicating a very narrow range.

The inferred market view suggested that option purchasers and sellers were, on average, assigning a significantly higher likelihood of the deal closing than the alternative.

A quick explanation is required for readers who are unfamiliar with the market-implied outlook. The market’s consensus estimate of the probability that the stock price will increase above (call option) or fall below (put option) a certain level (the option strike price) between now and when the option expires determines the price of an option on a stock.

It is feasible to create a probabilistic price projection that reconciles the options prices by comparing the prices of call and put options at a range of strike prices, all with the same expiration date.

This is the market’s forecast. I recommend the CFA Institute’s monograph for a more in-depth discussion and background.

I wanted to re-evaluate my rating after more than 6 months and the just publicized FTC complaint.

As I said in my last post, I produced revised market-implied outlooks for Activision and compared them to the Wall Street consensus.

ETrade estimates the Wall Street consensus outlook for Activision by collecting the views of 13 ranking analysts who have given price targets and ratings in the last three months.

The consensus recommendation is a buy, as it has been for the last year, and the consensus 12-month price objective is $92.50, which is 21.7% higher than the current share price but slightly lower than the projected acquisition price.

The analyst price target range is much larger than it was in my last piece, but it is still modest in comparison to most of the stocks I have looked at.

The wider spread suggests a lower level of confidence in the deal’s completion.

Wall Street consensus is that the stock is a buy, with a 12-month price target that is extremely close to Microsoft’s acquisition price.

Since my previous report, the spread between individual analyst price targets has risen, indicating that some analysts now give a lesser probability to the deal closing.

A further consideration, of course, is whether a 21% – 22% gain merits the risks, given the firm’s troubled management and culture, as well as the acquisition’s uncertainties.

ATVI’s Market Expectations

I estimated ATVI’s market-implied prognosis for the 5.9-month period ending June 16, 2023, and the 13-month period ending January 19, 2024, using the prices of call and put options expiring on each of these dates.

I chose these expiration dates to provide a look ahead to the middle of 2023 and for the entire year.

The usual market-implied perspective is represented as a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

The market-implied prognosis until the middle of 2023 is qualitatively similar to the data I estimated in May in that the probability distribution has two distinct peaks.

This, in my opinion, represents two distinct outcomes: one in which the acquisition closes and one in which it does not.

The higher-probability peak corresponds to a return that brings the share price to $91.50, which is a little less than the $95 acquisition price.

The secondary high translates to a -12.5% price return. If the deal appears to be in trouble or is blocked, the options pricing indicates that Activision will decline by anything close to this amount.

This forecast implies that the overall odds favor the deal going through, hence the shares are expected to rise significantly from their current position.

This gives me a positive outlook. The predicted volatility derived from this distribution is 29% (annualized), which is fairly low—particularly for a stock with this level of uncertainty.

According to theory, the market-implied outlook is likely to be negative since investors in general are risk averse and hence pay more than the fair value for downside protection.

However, there is no way to quantify the degree of this bias, or even whether it exists at all.

Given the greater likelihood of a small-magnitude (but high-probability) negative return versus a positive return, the anticipation of a negative bias enhances the bullish interpretation of this view.

The market-implied prognosis for the following 13 months, from now until January 19, 2023, likewise exhibits a bimodal probability distribution, but the likelihood of the deal closing is significantly higher.

The peak probability corresponds to a 25.5% price return, bringing the share price to $95.87.

This forecast implies that the options market consensus significantly favors the transaction being completed at $95 per share at some point in the next year.

The secondary, far lower likelihood peak correlates to a 17.5% price decrease. This is a positive assessment based on the likelihood that the deal will be completed. If it does not, the shares are projected to fall by around 20%.

The calculated volatility from this distribution is 26%. (annualized).

The market suggested outlooks favor Activision being purchased by Microsoft during the next 13 months and the shares rising significantly in the following 6 months. The predicted volatility is fairly low, implying that even if the deal fails, ATVI would not fall drastically.

Summary

Investing in ATVI is a bet on Microsoft’s takeover.

Wall Street analyst consensus is in line with the closure of the purchase, with a buy rating and a consensus 12-month price target that is $2 to $3 lower than the $95 acquisition price.

Individual analyst price target spreads have widened in the last 6 months, indicating that some analysts are allocating a lesser likelihood to the purchase. In contrast, market-implied forecasts place a larger relative probability of the deal closing than in my earlier research.

Aside from the acquisition, the good news is that the consensus forecast for earnings in the future year or so is for a moderate recovery.

Despite recent rumors that the FTC is attempting to stop Microsoft’s acquisition of Activision, Wall Street analysts and the options market remain bullish on the deal.

For a buy recommendation, I look for a projected return that is at least 12 times the expected volatility. Analysts anticipate 20%+ gains, bringing the share price to $95; this is substantially above half of the predicted volatility of 26%-28%.

Taking all of these into consideration, Activision remains an ideal buy in my opinion.

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