On Tuesday, January 18th, software giant Microsoft (MSFT) agreed to buy videogame maker Activision Blizzard (ATVI), for US$ 68.7 billion in cash. The deal takes place against a backdrop of accusations of sexual harassment at Activision under CEO Bobby Kotick, which led a group of investors to seek his ouster late last year.
The agreement is the largest takeover attempt in Microsoft’s history, and the largest video game deal ever. This acquisition will make Microsoft the world’s third-largest video game firm, behind Tencent and Sony. Morningstar senior equity analyst Neil Macker expects this deal will spur more activity in the space, with Meta, Tencent and Sony being potential buyers and any large studio as a potential target, including EA, Take-Two, Ubisoft, and even Roblox. But while all the attention might be good news for the sector, some shareholders wonder what will happen about the social and governance issues at Activision Blizzard.
The CEO will stay on, both Microsoft and Activision say, but Macker does not expect Kotick will remain in that position for more than a few months after closing. And the Wall Street Journal is already reporting that Kotick is headed toward the exit.
The Theoretical Cost of Sexual Harassment…
Microsoft will surely be on the lookout for sexual harassment and gender discrimination at Activision Blizzard during the transition to ensure the success of the merger, said Leslie Norton, Editorial Director of Sustainability at Morningstar. “Human capital management problems are a big red flag for investors,” she added.
In a November 2021 paper called ‘Employee Sexual Harassment Reviews and Firm Value’, authors Shiu-Yik Au of the University of Manitoba’s Asper School of Business, Ming Dong of York University’s Schulich School of Business, and Andreanne Tremblay of Université Laval - Département de Finance et Assurance investigated whether a measure of sexual harassment (a so-called SH score) constructed by performing textual analysis of online job reviews contains value-relevant information that affects firm performance. They found that firms in the extreme quantiles of sexual harassment exhibit significant productivity and performance reductions in terms of profitability, labour costs, and future stock performance.
“Firms with a top 2% SH score experience a decline of 4% in return on assets, a decline of 11% in return on equity, and an increase of 7% in labor costs during a five-year period around the year of high-sexual harassment identification, and earn a value-weighted risk-adjusted stock return of -13% in the one-year period after high-sexual harassment identification. These results indicate that sexual harassment has a highly detrimental effect on firm value, and employee voluntary reporting can be a valid disclosure mechanism when firms are disincentivized to reveal bad news,” they note.
…But What About Activision Blizzard?
Activision Blizzard, maker of hit games like Call of Duty and Candy Crush, has been plagued in recent times by sexual harassment complaints, which led a group of investors to seek to oust CEO Bobby Kotick in November 2021, stating that “a month of turmoil has made board failure indisputable.”
In a recent special report, "Without Changes, ESG Issues Will Hamper Activision Blizzard," Morningstar’s Macker argued that replacing Kotick was the cleanest path to unlocking the value in the firm’s shares. Kotick and the board seem to have headed off expulsion with the Microsoft deal.
In 2021, the year that the sexual harassment information was made public, shares of Activision Blizzard lost 26.81%. By contrast, on the day of the Microsoft announcement the shares were up 26.3%. According to a Fox Business estimate, Kotick, who owns over 4 million shares of Activision Blizzard, netted over US$70 million intraday, bringing the total value of his holdings to about US$338 million.
“It is disappointing that a company like Microsoft would move forward with a takeover bid at Activision without acknowledging – let alone addressing – the serious allegations that have been made about a ‘frat boy culture; serious governance lapses, and sexual misconduct.’ With the eye-popping price-tag that Microsoft is offering, investors have to wonder whether governance failures and allegations of sexual harassment and misconduct have been priced in,” said Anthony Schein, Director of Shareholder Advocacy at investor advocacy group SHARE (Shareholder Association for Research and Education) – and one of the signatories of the letter asking to oust Kotick.
Microsoft no doubt has a thorough understanding of the effects a toxic work environment can have on a business, and, like Macker, must believe that sidelining Kotick will solve the problem. Though the company issued press release says that Kotick will continue to run the company until the deal closes, Macker views this announcement as “…a concession to close the deal and (he doesn’t) expect Kotick will remain in that position for more than a few months after closing.” The deal is expected to close in 2023, meaning Kotick could remain in charge for at least another year.
Investors Have Been Active at Activision Blizzard
According to research by Jackie Cook, Morningstar’s Director of Stewardship, in 2020, Kotick took home US$155 million in pay, making him the second- highest paid S&P 500 CEO - the US$125m jump over 2019 more than compensating him for his US$875k salary cut at the beginning of the pandemic. In what amounts to a shareholder revolt in say-on-pay voting terms, only 54% of shareholders supported this advisory vote in 2021.
“In our outreach to Activision Blizzard, we flagged the toxic culture that employees raised, yes, but also talked about other issues that the firm needs to address in order to foster deep routed change at the company. Primary among them was the CEO pay package, which we believe was too high, and as a result, we voted against it,” said Michela Gregory, Director of ESG Services at NEI Investments, another signatory of the October letter.
To NEI, this deal highlights more questions that both Microsoft and Activision Blizzard will have to answer. “We want to see explicit statements on the nature of due diligence conducted by Microsoft around the toxic culture at Activision Blizzard, and we need a better understanding of Microsoft’s strategy around these issues,” she added. She further added that she wouldn’t be surprised to see continued investor advocacy around these issues, which could surface in the form of shareholder resolutions at the company’s annual general meeting.
In fact, in November 2021, Microsoft itself faced a shareholder motion, filed by Arjuna Capital, on its governance of sexual harassment allegations. A full 78% of shareholders voted in support of the resolution, defeating the board, which had recommended shareholders cast their votes ‘Against.’
What All This Means for Activision’s Valuation
Morningstar senior equity analyst Neil Macker views Microsoft’s US$95 offer as fair, given his US$92 fair value estimate for Activision Blizzard.
“We expect that regulators will heavily scrutinize the deal, given the recent anti-Big Tech fervour on both sides of the aisle in Washington. Microsoft expects the acquisition won’t close until fiscal 2023, implying that it agrees with our view on the level of regulatory oversight. However, we think the deal will be approved in the end as Microsoft is competing with other large foreign firms and will keep the Xbox platform open to third-party publishers. We are leaving our Activision Blizzard’s fair value estimate unchanged, balancing our stand-alone valuation, the value of US$95 roughly a year from now, the potential for regulatory intervention, and the possibility of a higher offer from another suitor,” Macker said.
