Monday, June 16, 2008

Activision and Vivendi Pending Nuptuals: Merger Watch Edition


The mailman dropped a 500 page gift on my doorstep this afternoon, the Activision proxy statement for the special meeting to approve the Activision/Vivendi merger. From the first press release Activision made it very clear they were merging with Blizzard and they would not let all the other stuff (the thing we call Sierra) get in the way. The prospectus makes it even more clear, retells the already published nice story of the on again off again courtship, brass balls poker play by Bobby and provides some interesting clues about the new company's future.

In typical Activision style, the document does not mince words. Right on the cover it is made clear Activision is merging with Vivdendi Games for its "portfolio of leading franchises, including Blizzard Entertainment, Inc.'s World of Warcraft." No other franchises are mentioned, with good reason. While Vivendi is the owner of some of the most beloved and best known franchises in the game business - Crash Bandicoot, Spyro the Dragon, SWAT and other great library properties - they never turned them into products people wanted. The risk factors section highlights the point, noting WOW accounted for 62%, 77% and a whopping 85% of Vivendi's revenue in the years ending in 2005, 2006 and 2007, respectively. The percentage is not solely attributable to WOW's market leading growth. Sadly, even Blizzard's growth could not keep up with Sierra's decline. While Blizzard's direct operating margin grew 80% from 2005 to 2006 and 43% from 2006 to 2007, Sierra's losses increased 140% and 62% respectively. Vivendi says it was because of the difficulties suffered by all the publishers in the console transition, but Allen & Company, Activision's banker compared the once market leading Vivendi to pre Phil Harrison Atari, Majesco and SCI Entertainment for purposes of their upside valuation opinion. Not exactly the market leaders. The downside opinion calculated only the carrying costs until shut down.

The ten page background section tells the tawdry tale of the courtship of the two companies. The already published report tells the story of the commencement of discussions in December 2006 and multiple break downs until agreement occurred in December 2007. The interesting part of the discussions occurred in September of 2007. Activision had been doing due diligence on Vivendi for a number of months. The only matters material enough to mention in this description were the subscription and churn rates for WOW, and they are mentioned a lot. After receiving sufficient comfort, the parties started discussing the business combination. This went on from July to September 14th, when Bobby called Bruce to tell him there were too many issues and the deal would not go through. He called off the discussions. Three days later, Bobby attended a "previously scheduled" dinner with Mike Morhaime and other members of Blizzard's management. Bobby told Mike about how important it was for Blizzard management to remain the same - in the new company for which discussions had ended - but didn't really talk about other points of the deal. Three days later, Bobby called Bruce's boss and started discussions again. The key point of the discussion was management of the new entity, which will be Bobby as President and CEO, Brian Kelly as Co-Chairman and Rene Penisso as Chairman. Mike Morhaime will be President and CEO of Blizzard and Bruce, will assume the newly created role of Chief Corporate Officer.

This was a long winded way of my saying, looks like Vivendi sold Blizzard. Sure it's a merger, but the merger is based on a relative valuation of the companies, Sierra was assigned little or no value, and based on the downside valuation it was considered an expense. Activision would not do the deal until they were assured Blizzard management was secured, and when the time came to do the deal, they did it with the parent company. This is interesting to me because rumors were flying a few years ago of Vivendi being on the block. More rumors circulated about offers rejected because they only included Blizzard, not Sierra. Approaches were also made for Sierra alone, and they were rejected. Pursuant to this deal, it looks like they are selling Blizzard alone, and throwing in Sierra as a parting gift.

The course of a year also bestowed a great benefit on the company. After the discussions broke down in June, Bobby restarted them in July with a counter proposal. He proposed an increase in the tender offer by 1 billion dollars, with a commitment to use USD 2.4 billion from the proceeds of Vivendi's share purchase, Vivendi to cover the next USD 700 million from additional shares sold to Vivendi, and the final USD 400 million would be funded through an Activision credit facility. Months later, a price of $27.50 was set for the tender offer, a 45.2% premium over the trading price on the date of acceptance. If the tender offer was completed for the maximum number of shares, Vivendi would end up with 68% of the new company, partially subsidized by Activision, and Activision would have USD 4.028 billion less cash. Because the offer price is significantly lower than the current trading price, the tender offer will likely not be accepted, Bobby will hold on to his cash, and Vivendi will end up with only 52% of the company, a significant ownership swing. Bobby is not the sole direct beneficiary, but it certainly benefits the existing shareholders he represents. In hindsight, it looks like Vivendi was sitting on a straight flush when they called Bobby, who was holding a royal flush.

There is a bit of a tip off going forward. Not really a huge surprise, but an interesting acknowledgement. Activision makes it clear they are merging to get into the on-line subscription business. The merger makes them not only a player, but THE player. They are already profiting significantly from COD 4 add ons and Guitar Hero songs. This revenue is recognized upon payment by the consumer. At the end of the year, they will be introducing a new type of product with different rules for recognition. One of the notes to the financial section, and a comment in the risk factors indicates a change in accounting practices for certain titles. Starting with Enemy Territory: Quake Wars, they will start to recognize revenue for titles which have "online functionality that constitutes a more-than-inconsequential separate service deliverable in addition to the product, principally because of its importance to game play." They view the service period as six months and will recognize revenue over the period, rather than on sale. They go into detail about Quake Wars, and mention they will be analyzing these products in the future. I am confident the Blizzard infrastructure will color the analysis. Blizzard will enable them to enter into not only the Quake Wars FPS market, but perhaps the free to play microtransaction and other markets which require on going, online support.

Finally, the biggest benefit outside WOW - Doug Morris joins the board. Doug is the head of Universal Music Group and together with Jimmy Iovine, grew it into the biggest music company in the world. He also got the USD 1 per Zune concession out of Microsoft and went toe to toe with Steve Jobs. Doug's participation and connection to the company will certainly enhance Activision's existing Guitar Hero business as well as its recently announced "sounds like" Rock Band product. This should give EA cause for concern.

Bobby explained Activision is not the soul sucker EA is, and there is no doubt he will be hands off on Blizzard, the interesting action will be newly appointed CCO's Bruce Hack's integration of the rest of the stuff.






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