With an adjusted operating margin above 40%, Activision Blizzard (NASDAQ: ATVI) is one of the most profitable companies in the world. In the past four quarters, it generated $ 2.87 billion in free cash flow and ended the first quarter with $ 9.3 billion in cash on its balance sheet.

During the first-quarter earnings call in May, an analyst asked management about its plans for mergers and acquisitions (M&A), especially as Activision peers recently struck deals. Management’s response provided valuable insight into its approach to capital allocation.

Let’s take a look at what they had to say and what investors should expect.

Blizzard Entertainment World of Warcraft: Burning Crusade Classic. Image source: Activision Blizzard.

Activision’s approach to acquisitions

As part of our business strategy, we acquire, make investments or enter into strategic alliances and joint ventures with complementary businesses.

– Activision Blizzard Annual Report 2020

Video game companies of all types and sizes have used acquisitions to expand their content lineup, grow their installed base of active gamers, and attract more talent to create games.

It has been a busy year for negotiations. Last year, Microsoft appeared to kick off with the monster acquisition of ZeniMax Media, owner of Bethesda Softworks, for $ 7.5 billion. Of course, the mobile operator Zynga has been very active over the years, buying small game studios to build its empire in the mobile space. Electronic arts recently made a bold move by buying Codemasters and Glu Mobile for a combined $ 3.2 billion.

Take-Two Interactive just found its niche with a deal to buy mobile game developer Nordeus for $ 385 million.

Activision’s latest acquisition was King Digital Entertainment in 2016 for $ 5.9 billion, and it has spent the past four years paying off the debt that funded that deal. At the end of the first quarter of 2021, Activision had net cash of $ 5.7 billion.

Metric Q1 2021 Q1 2016
Cash and equivalents $ 9.3 billion $ 2.9 billion
Long-term debt $ 3.6 billion $ 5.8 billion

Data source: Activision Blizzard.

So what’s next?

Speaking on the first quarter earnings call, Armin Zerza, Chief Commercial Officer of Activision Blizzard, said:

We have a very good track record of balance and discipline in how we allocate capital through investing in organic business growth, returning capital to shareholders through buyouts and dividends, as well as mergers and strategic acquisitions. … And on mergers and acquisitions in particular, we have completed several transactions that have created significant value.

Let’s look at these transactions.

The 2008 merger between Activision and Blizzard Entertainment significantly increased the company’s free cash flow.

ATVI Free Cash Flow graph showing an increasing trend.

ATVI Free Cash Flow given by YCharts

Again, in 2013, management repurchased $ 5.83 billion in shares held by Vivendi, reducing the total number of shares outstanding, which had the effect of increasing the share price. Since July 25, 2013, when the share buyback was finalized, Activision’s share price has climbed 539%.

ATVI price change graph showing an upward trend.

ATVI given by YCharts

Zerza explained, “We mentioned today that we just celebrated the fifth anniversary of [King’s] the acquisition, which has given us a leadership position in mobile at a valuation that offers significant value for our shareholders. “

The deal was very profitable for Activision Blizzard. In 2020, King achieved operating income of $ 857 million. Comparing that to the purchase price of $ 5.9 billion, that’s a valuation multiple of 6.9, which looks like a good deal.

Another way to look at the value here is to assess the payback period over the purchase price.

As of 2016, King’s cumulative operating profit is $ 3.58 billion, or 60% of Activision’s $ 5.9 billion purchase price. It’s not a bad ROI so far.

This confirms what Zerza mentioned during the Q1 earnings call that the company is looking for big franchises or established technologies, in the case of the popular King. candy Crush franchise, which have growth potential. “And then, of course, we’re looking for an attractive valuation that meets our yield thresholds,” Zerza explained.

The big takeaway

These are great insights into management thinking when it comes to acquisitions. If Activision announces a deal at any point, investors need to ensure that the acquired business fits the culture of Activision and – very importantly – that the deal contributes to Activision’s profitability.

However, Activision may remain on the sidelines when it comes to mergers and acquisitions. Zerza stressed that management can afford to remain disciplined, given the “significant organic growth opportunities” the company has with Activision Blizzard’s game development pipeline.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Questioning an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.