Microsoft Brings a Cannon to a Knife Fight

Microsoft is buying Activision in a $69 billion deal to reshape video gaming. Meanwhile, government antitrust enforcers are gearing up to stop mergers just like this.

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Today I’m writing about two merger-related announcements. The first is Microsoft’s proposed $69 billion acquisition of Activision, which verges on being a ‘mega-merger’ with the goal of reshaping the video game industry. The second is a major proposal by government antitrust enforcers Lina Khan and Jonathan Kanter, who are seeking to limit such acquisitions.

Also, tomorrow, there’s a huge moment in the politics of antitrust. The Senate Judiciary Committee will be actually voting on antitrust-related legislation. I wrote up my expectations in this piece, Fear and Loathing in the Silicon Valley C-Suite.

Microsoft CEO Icarus Gates poses for his firm photo.

“A partnership with Microsoft is like a Nazi non-aggression pact. It just means you’re next.” —Anonymous partner of Bill Gates

“Sony shares fell more than 12% in Tokyo on Wednesday after Microsoft announced plans to buy Activision. Investors likely fear rising competition to Sony’s PlayStation division as well as the potential for Microsoft to pull some popular games from the Japanese entertainment giant’s platforms.”. - CNBC, today

The best way to think about Microsoft, the monopolist of the 1990s turned cuddly corporate teddy bear of the 2010s, is as a character in two different classic parables. The first is the story of Icarus, an ancient Greek story about a boy who was given wings fashioned of wax and feathers by his father, but was warned not to fly too high. Giddy with the act of flight, however, Icarus flew too close to the sun and had his wings melt, then falling into the sea and drowning.

Microsoft founder Bill Gates certainly had the hubris of Icarus, and his downfall - and that of Microsoft - was as spectacular. From his upbringing in Seattle to a wealthy family with rare access to computing resources in the 1970s, Gates was perfectly fashioned for an ascent in the software business. It wasn’t just the wealth and training; Gates’s mother served on the United Way board with IBM CEO John Opel, who referred to the young Bill as “Mary Gates’ boy“ before his firm handed Microsoft the contract to make the operating system for the nascent personal computer.

Gates ran Microsoft with a ruthless understanding of the relationship of software and market power, and within 15 years, Microsoft devoured a long list of software firms, everyone from Lotus to Wordperfect. IBM, once a jewel of American innovation, was pillaged by Lou Gerstner, a McKinsey management consultant turned CEO.

Almost everything that big tech is doing today, from copycatting rivals to establishment platform dominance to tying products together to predatory rebating, Gates did, turning his small but prosperous software company into the biggest firm in the world in a little over a decade. For instance, to get access to personal financial data, Microsoft sought to acquire Intuit in 1995. In 1997 Microsoft official Nathan Myhrvold talked about how the firm’s plan was to take a ‘vig’ - a mobster term for a share - off every transaction online. Gates was so overt that Microsoft in the 1990s had a meeting with venture capitalists where firm executives explained where they could invest, and what parts of the internet it would reserve for itself.

But mobster-like behavior towards other rich people was too much for even the Clinton administration, rooted as it was in Al Gore’s Silicon Valley connections, and Icarus’s wings began to melt. Antitrust enforcers blocked the purchase of Intuit, and then put Gates on the stand in the late 1990s. In a trial splashed across the front pages for months, Microsoft was sued and found guilty of antitrust violations for giving away Internet Explorer as part of a bundle with Microsoft Windows, and otherwise trying to “cut off the air supply to” Gates’s competitor, Netscape.

The trial was a brutal embarrassment for Gates, made more so by his contempt for enforcers. He had called one Federal Trade Commissioner a “Communist,” and told BusinessWeek that “the worst that could come of this is that I could fall down on the steps of the FTC, hit my head, and kill myself.” But when the Antitrust Division legal team took a deposition of Gates for three days straight, he came off as mean-spirited, deceptive, and argumentative. Microsoft lost, and was nearly split up. Microsoft took on a whiff of criminality. Gates’s wings melted.

Parable two is a story of redemption, Microsoft as the prodigal child. This one started with the founding of the Gates Foundation, a giant pot of money established in 2000 to buy what only the super-wealthy can afford, nation-state levels global power. During this period, the disgraced Gates established health nonprofits and gave to institutions like the World Health Organization, fighting malaria and choosing to advocate for prosaic but critical tools, like better toilets for the poor. Gates and Warren Buffett created ‘the giving pledge,’ encouraging billionaires to give away half their money. Obama even gave Gates the Presidential Medal of Freedom in 2016, lauding Gates’s “impatient optimism that, together, we can remake the world as it should.” Chastened and humbled, Microsoft in the early 2000s didn’t crush a little upstart named Google.

Gradually, people mostly forgave that Microsoft had been a monopolist, especially as Google turned from a cool little startup to a big bad wolf in its own right. During the House Antitrust Subcommittee investigations in 2020, Microsoft didn’t come in for scrutiny, and the new nice cuddly Microsoft has even been lobbying for stronger antitrust rules around app stores. The firm now has a smooth President, Brad Smith, a lawyer, and an even smoother CEO, Satya Nadella. It was a redemption story (Jeff Epstein cameo notwithstanding). Gates had admitted that his life solely seeking profit was morally empty, and had pledged himself to the goodness of mankind. Society accepted the prodigal child, and accepted him - and Microsoft - back into the household.

The redemption story has obscured some key details. When Microsoft chose not to crush Google in the early 2000s, it was because it was under an antitrust consent decree. More importantly, the firm never actually lost its monopoly rents. Microsoft still has durable market power in key segments of the software industry, garnering roughly $20B a year from its operating system Windows and $35B a year from Office. Operating systems and spreadsheets/word processors should be commodified by now, 35 years after they went mainstream. That Microsoft is still making insane margins - and the software is in some ways less user-friendly than it used to be - suggests that there is not real competition here.

Still, Microsoft doesn’t seem to be the same threat level of, say, Google or Amazon. Unlike the rest of big tech, Microsoft isn’t really terrifying any major industries outside of technology. Its newest line of business, the Azure cloud, is insanely profitable, but it isn’t, say, destroying the newspaper industry. But Microsoft is still cutting off the air supply to its competitors, like in the cybersecurity area (see the post-script to this piece), or when it used predatory pricing against Slack, which had to sell to Salesforce as a result of it not being able to cross-subsidize its business with monopoly streams of revenue.

And this brings me to Microsoft’s proposed acquisition of gaming firm Activision for $69 billion, a large merger, though when compared to the size of Microsoft, something quite piddly, at 2-3% of its market cap. Since Nadella and Smith took over from Gates, Microsoft has been a merger powerhouse. It acquired 15 firms just last year, in everything from cybersecurity to cloud computing to online advertising to video games. It has been on a buy-out tear in every division, including games. Microsoft has something like 30 game studios. Meanwhile, Activision itself is a gaming roll-up, it has since the 1990s acquired about 25 game studios, coming together with gaming giant Blizzard in 2008. Microsoft-Activision would be a merger of mergers.

Activision has important gaming franchises, like Call of Duty, Candy Crush, Warcraft and Tony Hawk. With this purchase, Microsoft will be the third biggest gaming firm in the world, controlling the X-Box console platform and a lot of game development and intellectual property (as well as Activision’s in-game advertising business line). The key strategic rationale behind this deal is to build up a walled garden for Microsoft’s gaming division, which runs a Netflix-style subscription service called Game Pass. Game Pass, at $14.99/month with likely heavy subsidies by Microsoft, is a very good deal for gamers, and developers, or at least, it is right now. Last year, Microsoft bought Bethesda Softworks, a gaming studio, and is adding its stable games to the Microsoft ecosystem. Bethesda now does exclusives for Microsoft, and it is likely that Activision games will eventually offer some exclusives as well. The idea here is to battle with Sony, which is the second biggest gaming firm with its PlayStation platform, over control of key titles.

Gamers very much dislike Activision, which is run by a CEO named Bobby Kotick, who apparently did not want to sell. The firm had stopped innovating, and was just milking its cash cows. Meanwhile, Kotick presided over sexual misconduct scandals involving alleged rapes, which crushed the stock price of the firm. One upside to the merger is that Kotick will leave if the deal goes through. Don’t cry for Bobby, though because his golden parachute is something on the order of $293 million. Kotick, unsurprisingly, was a terrible manager, and many in the gaming community are overjoyed that someone else is going to be running such an important game publisher.

So for a variety of reasons, it’s likely that game developers and gamers will immediately have a better experience because of the takeover. For all of these reasons, the deal doesn’t seem that threatening. For instance, Republican Congressman Ken Buck, who is spearheading the attack on big tech, was mollified.

Rep. Ken Buck @RepKenBuck

This acquisition still has to go through a legal review by the Federal Trade Commission and the Department of Justice, but the assurances I've received from Microsoft are encouraging.

The New York Times @nytimes

Breaking News: Microsoft agreed to buy the video game maker Activision Blizzard for $68.7 billion, its largest takeover ever and a big bet on the metaverse. https://t.co/dDofndd8yW

Still, just because consumers will like it now doesn’t mean it’s a good deal. This could again be Microsoft engaging in predatory pricing, or charging below cost with the intent of acquiring pricing power by driving rivals out of the market. Microsoft’s X-Box Marketing boss Aaron Greenberg basically admitted that the firm doesn’t make money on its Game Pass service. Certainly Wall Street seems to see the deal as anti-competitive, as Microsoft’s gaming competitor Sony stock got crushed in Japan, declining by 12%, or roughly $20 billion in market capitalization. One game consultant explained why this deal is such a threat to Sony.

Dr. Serkan Toto / Kantan Games Inc. @serkantoto

About Game Pass, we should be aware that: 🏢 Microsoft is a US$1.5 TRILLION company, one of the biggest on earth 💰US$390 million in revenue DAILY 💸 US$120 million net profit DAILY As far as "Netflix for gaming" goes, Microsoft overall can bring cannons to a knife fight. https://t.co/rcnkrlyB4n

In tech markets, predatory pricing often comes with bundling of products. That’s what Microsoft is sort of doing with Teams, it’s what it did with Internet Explorer, and it’s what could happen with its gaming subscription, X-Box platform, and growing game publishing empire.

One can imagine how Microsoft would want this to end up, because Microsoft, while it is trying to push the idea that it is platform-agnostic, has a track record. It has already tried to restrict its users from sharing games, before being pushed back. Last year, the firm sought to raise prices on its X-Box Live Gold subscription service, but didn’t have enough market power to force it through.

The goal here is the vertical integration of the industry into a series of walled gardens, similar to the transformation of Hollywood from studios separated from TV networks and movie theaters, to a Hollywood of streaming giants where production and distribution are contained by the same dominant firms. Such an arrangement looked great at first, with Netflix having oodles of content, and Disney coming into the market with a very low price product. Prices, though, are going up, and now talent and independent studios are being squeezed out.

It’s not entirely clear, however, that movies are a great analogy for games. “Most people don't play a new game every week,” one person in the industry told me, “instead they come back to the same game over and over.” So it would be hard to put the really popular games behind Game Pass because those games will not be as profitable. Then again, profit in gaming doesn’t matter to Microsoft, the amounts involved are almost a rounding error for its balance sheet. A firm with multiple super profitable lines of business has bottomless amounts of capital to throw at the problem, which is why Sony’s stock tanked. Sony has a knife, Microsoft has a cannon, plus whatever else it wants to buy with its trillions.

What will happen with this merger? Wall Street is making two bets. The first is that the gaming industry will transform into a set of competing walled gardens. Mergers and acquisitions elsewhere in the industry are heating up, with Cowen analyst Doug Creutz noting gaming publishers “carry a lot more strategic value than was being acknowledged by the market.” Sony, he said, “might have to consider chasing their own blockbuster acquisition, in order to enhance its own exclusive portfolio,” perhaps Electronic Arts, which makes a host of popular games, including the popular Madden football franchise.

The second bet is that the deal doesn’t go through. The stock price of Activision skyrocketed on news of Microsoft’s offer, but interestingly, though the offer was for $95/share, shares of Activision are trading in a range between $82-83. That means there’s substantial doubt that antitrust enforcers let it go through. In addition, Microsoft must pay a $3 billion break-up fee if the deal fails, which is something that Activision would only negotiate if the firm felt strongly that antitrust was a real risk.

And this brings me to the final point, which is the other big merger-related news yesterday. In an important announcement, Federal Trade Commission Chair Lina Khan and Assistant Attorney General for Antitrust Jonathan Kanter announced they will be revising merger guidelines. This is an important development, and I’m going to go into it in a separate newsletter. But the point here is that this could potentially change the game for a merger like the Microsoft-Activision combination.

Both Khan and Kanter are eager to find a new way to evaluate mergers outside of narrow analyses that involves market share and price effects. Kanter isn’t as well-known as Khan, being more of a behind-the-scenes practicing antitrust attorney, rather than a star academic. (One of his clients was, ironically, Microsoft). In many ways, though, what Kanter said was more aggressive. In particular, he attacked the bedrock concept behind merger enforcement, the notion that there are clean categories of mergers, like ‘horizontal’ in which firms buy rivals, versus ‘vertical’ in which firms buy upstream or downstream companies.

Microsoft’s purchase of Activision would not normally raise much of a fuss in antitrust circles, because there are still competitors in the game publishing market. As Microsoft gaming head Phil Spencer noted, the firm will be number three in gaming, and gaming is “not a place where Microsoft has a unique capability.” But that’s only under the old antitrust framework. As Kanter noted, with digital markets, and stacks of products creating ecosystems that have lock-in, such a narrow lens doesn’t make sense.

That broader lens is how the Microsoft-Activision acquisition will be judged, and it’s why Wall Street isn’t sure the merger will go through. Icarus might have gotten himself a new pair of wings, and is giddy to fly again.

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Thanks for reading.

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cheers,

Matt