The $69 billion merger between Microsoft and Activision Blizzard is one big step closer to completion. Earlier this month, a federal judge in California struck down the Federal Trade Commission’s attempt to block the deal ahead of its July 18 deadline. As a sign of confidence that it can close the deal, the two companies extended the acquisition contract’s deadline to Oct. 18 to allow more time to win regulatory approval in the U.K., which has yet to give a thumbs up on the merger.
The potential completion of the Microsoft-Activision deal just became a catalyst for Electronic Arts (EA 0.17%). Shares of Take-Two Interactive and Electronic Arts were moving higher after the news. Here’s why Electronic Arts stock looks particularly appealing right now.
Why EA could be a top buyout target
EA trades at a substantial discount to Activision. While the latter currently trades at a price-to-sales (P/S) ratio of 9, EA’s P/S ratio of 5 looks cheap. A buyout offer for EA would undoubtedly come at a substantial premium to its current share price.
There are key similarities between these companies, but EA’s recurring revenue stream from its annual sports releases Madden and EA Sports FC (formerly known as FIFA) would be attractive to larger companies involved in video games, including Amazon, which owns the popular game streaming site Twitch and also has exclusive broadcast rights to Thursday Night Football on Prime Video.
Microsoft wants Activision Blizzard for its best-selling franchises Call of Duty, Diablo, and World of Warcraft, as well as the ability to leverage Activision’s army of game creators to bring more games to mobile platforms.
Across all its games on console, mobile, and PC, Activision ended the first quarter with 356 million monthly active users. It generated $2.4 billion in free cash flow on $8.7 billion of revenue over the trailing-12-month period through June. Activision got a major boost from the recent release of Diablo IV.
Likewise, EA boasts nearly 700 million players across its games. EA hasn’t reported its June-quarter financial results yet, but it generated $1.3 billion in free cash flow on $7.4 billion of revenue over the trailing-12-month period through March, with sales from FIFA, Madden, Apex Legends, and The Sims 4 the primary drivers.
Madden and EA Sports FC would be very valuable in the right hands. Management considers the revenue from sports to be recurring in nature, since these franchises have dedicated players who will buy the new version of the game every year.
More acquisition activity is a catalyst
Whether EA becomes a buyout target or not, consolidation within the highly fragmented video game industry will continue regardless of the outcome of the Microsoft-Activision deal. This is a growth opportunity for the leading game companies to grow their player bases worldwide and spread more revenue across their top franchises to achieve higher margins.
The video game industry is valued at $347 billion, according to Statista. This makes the leading game producers like Activision Blizzard and Electronic Arts look tiny by comparison, and this is why merger activity has been heating up in recent years.
In 2021, EA acquired mobile game maker Glu Mobile and a leading producer of racing games, Codemasters, for a combined $3.2 billion. Last year, Take-Two acquired Words with Friends owner Zynga for roughly $13 billion.
Should you buy EA stock?
Considering EA’s discounted valuation and valuable revenue streams from sports titles, the Madden owner appears undervalued.
However, EA hasn’t generated much revenue growth in recent years outside acquiring new studios. While its stock beat the market’s return for most of the last decade, it has underperformed over the last few years. But that could change.
Good things will happen for patient investors. EA has valuable gaming brands that generate healthy free cash flows and command a sizable audience. After losing the license to FIFA, EA is using the rebranding of the franchise to EA Sports FC as an opportunity to build on the game’s popularity with new in-game features.
Considering these qualities, Wall Street will likely revalue the stock at a higher P/S multiple once the Microsoft-Activision merger closes, so buying a small position in this top video game stock now could be a profitable move.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. John Ballard has positions in Amazon.com and Take-Two Interactive Software. The Motley Fool has positions in and recommends Activision Blizzard, Amazon.com, Microsoft, and Take-Two Interactive Software. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.