Will the Biggest Tech Merger of All Time Go Through?

We're in trench warfare, as Activision CEO Bobby Kotick and Microsoft's Satya Nadella get cross-examined in the Microsoft-Activision merger trial.

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I’ve spent the past few days listening to the Federal Trade Commission’s litigation over the largest tech acquisition of all time, Microsoft’s $69 billion purchase of gaming giant Activision, which makes video games like Call of Duty, Diablo, and Candy Crush. Today, Activision CEO Bobby Kotick and Microsoft CEO Satya Nadella testified in the trial, and under cross-examination, offered what I thought were significant concessions that prove the government’s case.

Still, the Federal Trade Commission is facing serious headwinds, including a judge whose son works for Microsoft. This case, for a deal that should never have gotten out of the board room, is a good look at the hurdles, and opportunities, in addressing big tech.

"The idea is to create a moat that nobody else can attack." - Microsoft exec Matt Booty

This morning on CNBC, David Faber told a story of solidarity within big business, discussing Microsoft’s attempted acquisition of video game giant Activision. “Microsoft,” he said, “is, in a sense, fighting a bigger war in terms of what policy's going to look like and the prospects against the FTC for other companies trying to do deals.” Wall Street is obsessed with this merger, because it is part of what has settled into trench warfare between Biden antitrust enforcers and monopolists across the economy.

Today was a big day for the trial, because both Activision CEO Bobby Kotick and Microsoft CEO Satya Nadella testified. And what their testimony, particularly Kotick’s, revealed, is that there’s a significant philosophical question at the heart of this trial. In fact, I think there’s a reasonable chance that Kotick no longer wants to sell Activision to Microsoft, and may have actually tried to sabotage the deal.

Beyond the Console Wars

Ok, let’s talk about the FTC’s case, and what they need to prove. The basic argument that the FTC is making is that Microsoft is buying Activision so it can take popular games, most notably Call of Duty, away from its rivals. In doing so, it will be able to monopolize a series of gaming markets by forcing users to play on Microsoft platforms. Most gamers think this means that Microsoft wants to privilege its own Xbox consoe over Sony’s Playstation, and make it so that you have to buy an Xbox to play Xbox-exclusive games.

This move, to deny a key input to a rival, is known as foreclosure. And it’s part of the claim from the FTC. But this case isn’t just about Sony and console markets, it’s about the future, and in particular what video gaming will look like in a few years, when the technology for gaming is radically different. To understand that requires looking at a different industry that went through a similar transition: Hollywood.

The transition to streaming is not a technology story, it’s a political and legal one. Everyone knew movies and TV would be delivered over the internet, the question was always what the market structure would look like. Streaming is just another way to distribute content, similar to TV networks and movie theaters. Traditionally the distributors in Hollywood have been powerful, but stayed mostly out of the content game, buying their content from content makers. With streaming, would Hollywood remain an industry with lots of independent producers who sold to distributors? Or would the distributors demand to own everything themselves? The answer, as it turns out, was the latter. Hollywood vertically integrated, with streamers both making and distributing their own content. For a time it looks competitive, because there are multiple streamers, but it’s a group of giants fighting with each other, instead of a vibrant set of content creators selling into an open market.

I’ve written a lot about this transition, noting that the consolidation in the industry has been devastating to both consumers and studios themselves. In The Slow Death of Hollywood, in 2019, I showed that the vertical integration - the combination of production and distribution - excluded creative independent producers from making good TV shows and movies. The destruction of Hollywood seemed unlikely four years ago, when Marvel movies were riding high and streaming services kept being launched to what looked like the benefit of consumers.

Netflix led the way, but Disney’s super cheap Disney Plus came into the market, as did HBO, Peacock, Hulu, and others. Consumers got used to not going to theaters, but so what? What a bonanza! Look at all this great TV! Fast forward a few years later, and now writers, directors, executives, and shareholders all realize streaming is an awful business. Netflix and Disney have massively raised prices on streaming. Meanwhile, the Marvel movies aren't working anymore, but there is no way to get new creative content into the market. Hollywood is vertically integrated and there are high barriers to entry to selling into a streaming service. The industry is in crisis.

What happened in Hollywood is now happening in video gaming. Sony and Microsoft have both been locking up video game exclusives for some time, as well as buying game publishers across the board. Vertical integration, at least partial, has been going on for some time. So this merger is really an inflection point where we can return to a more open market, or make it a Godzilla vs Mothra style conflict among vertically integrated giants.

And that’s why this fight is about more than consoles. The FTC’s claim is about two other markets. The first is subscription services, notably Xbox Game Pass, which is a library of games subscribers can play for one Netflix-style fee. Microsoft has been underpricing this service to attract subscribers, and one result is that gamers love it, just like consumers originally loved Netflix and Disney Plus. I mean, who doesn’t like a free lunch? The second market is cloud gaming, which is the ability to play games without a console where the processing happens on the cloud. There are a variety of competitors in this market, such as Nvidia GeForce Now to PlayStation Plus Premium and Amazon Luna. But cloud gaming is a bit like streaming was in 2005. Sure there was YouTube, but Netflix, being able to watch streamed movies with no problems, was aways off.

Microsoft’s case is as follows. Transforming the industry will be good for consumers, and withholding the games it acquires from Activision to force gamers to buy its consoles or subscription service doesn’t make sense. It would forego money if it does so. Moreover, Microsoft has a small share in video gaming, when you combine mobile games with PC and console games. Microsoft has lost the console wars to market leader Sony, with its Playstation dominance and network of exclusive games. Finally, Microsoft alleges, the FTC’s market definitions are silly. There’s no such thing as workable cloud gaming, and subscription services are not a separate market from consoles. So why would this merger lessen competition?

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Did the Activision CEO Sabotage his Own Merger?

The problem, for Microsoft, is the evidence and testimony has not supported their basic argument. The most important moment, in my view, came today, when Activision CEO Bobby Kotick was asked by the FTC about whether Activision would put its games a subscription service, like Microsoft Game Pass or Sony’s Playstation Plus. He was absolutely adamant that he would never allow that long-term. Asked what Microsoft would have to pay him to make it worthwhile, he said that he “could not imagine” a commercially worthwhile package for Activision to put its games on a subscription service. And the reason, he offered, is that he lives in LA, and he’s seen what these bundles have done to Hollywood studios. Multi-game subscription services are, in his words, “value destructive.” Kotick, in other words, knows that independent video game makers have no future in a world of vertically integrated streaming services any more than independent producers are succeeding in Hollywood today.

This commentary was absolutely devastating. And it was consistent with other evidence. Sony Playstation chief Jim Ryan testified to that effect yesterday, saying “I talked to all publishers they unanimously do not like Game Pass, because its value destructive.” And Microsoft internal documents, as well as plenty other evidence (such as an internally discussed proposal to buy Sega), confirmed that the software giant is trying to monopolize, and is more than willing to lose money to make content on Xbox Game Pass exclusive.

The reason Kotick's testimony was bad for the merger is because this is a philosophical fight between two industry structures, and Kotick endorsed the FTC’s view. Microsoft’s case is that they will not foreclose on content, and they will give all necessary agreements to rival platforms and subscription services, because they are trying to show they will not exclude competitors from the market. Somehow Microsoft says they'll have a Netflix-style service, but also keep it open to new rivals.

Kotick directly contradicted this narrative. Putting important games on a subscription service like Game Pass or Sony’s service structurally changes the video gaming market the same way that vertically integrated streaming has structurally changed Hollywood. Independent video game producers like Activision would lose in that vertically integrated model because there would be higher barriers to entry. You couldn’t just make a game and sell it, you’d have to get a streaming giant to buy your game and give you compensation. (It would also make it harder to start a game streaming service, because you’d need to get content from vertically integrated giants who both stream and own content.)

That’s what Kotick meant when he said the merger would be net value destructive, it would ruin gaming the way streaming has ruined Hollywood studios. The FTC's case isn't that the deal is bad for the industry, but that Microsoft would have an incentive to use Activision content to promote its own platform, aka subscription and cloud service, at the expense of rivals. Kotick came very close to admitting that is true.

This case is philosophically about whether consumers would prefer a vertically integrated Netflix-like monopoly bundle where Microsoft picks and chooses which game makers win and lose. Right now they do, because Game Pass is cross-subsidized by Microsoft's other revenue and the alternative – Sony – acts like a pig. But Kotick understands that an industry structure with a few vertically integrated giants who exclude all rivals will ultimately lead to a bad deal for consumers and independent game makers. It would be bad for Activision profits, unless Activision is part of Microsoft. And that’s why he’s for the merger, but disagrees with Microsoft’s strategy. Is that enough evidence? Unclear. But it’s certainly evidence, and not good for the merger.

Moreover, Microsoft's case is that streaming, subscriptions and consoles are all in the same market. Kotick's testimony indicated they are not, any more than movie theater releases and streaming releases are in the same market. (What studios have figured out after destroying their own business by subsidizing streaming is that releasing on a streaming service isn't the same thing as releasing in theaters or pay TV. Think Top Gun 2, which would not have been a big deal had it been a streaming only release.)

The Downsides of CEO Puffery

Microsoft CEO Satya Nadella’s testimony was less impactful, but still important. A key part of Microsoft’s strategy is to deny that cloud gaming is a real thing, but the FTC confronted him with his own words bragging to investors about how Microsoft is leading in cloud gaming. (There was a lot more evidence that cloud gaming works, such as executives from rival firms like Nvidia testifying that they are making large bets on such services.) Moreover, the FTC asked Nadella why his own self-assessment indicates that Microsoft exceeded its goals on Xbox consoles leading the market. His response to exceeding the Xbox goal on his job review was “yeah, we set it low." It’s hard for Microsoft to deny there’s a cloud gaming market when Microsoft itself is claiming internally and externally that it is leading said market.

Nadella wasn’t very impressive, but then, he doesn’t really care about video games, his passion is search and AI, and Microsoft is just too big for him to focus on every part of the firm. Kotick, however, was impressive. He was relaxed, soft-spoken, smart, knowledgeable arrogant, and mean. I do not think his poor testimony was an accident, because if this deal falls apart, Activision gets a $3 billion break-up fee. And then he gets to remain the boss of a highly profitable video game company, with the ability to engineer his own merger spree. On the other hand, as the FTC revealed, if this deal does go through, he’ll make $400 million. So that’s not bad either.

All Rise: A Conflicted Judge Gets to Run the Economy

The wild card here is, as usual, the judge, a Biden appointee named Jacqueline Scott Corley. Corley was quiet for much of the trial. She asked some questions, expressing doubt about the FTC’s economic expert’s market definition, which isn’t good for the government. But she also clearly understood the meaning of Kotick’s admission on subscription services, asking him why he would go through with the merger if he knew it would result in bad strategy. (He said he was doing what his shareholders wanted.) Corley was almost wholly quiet when Nadella testified, which was weird. And at the beginning of this trial, noted that her son works for Microsoft, which is an outrageous conflict of interest.

If you talk with most observers, the general consensus is that Microsoft will win this case, and close its deal with Activision, despite the anger at big tech and the U.K.’s opposition to the deal. There are a few reasons for this. Sony is not liked in the industry, so a lot of gamers think it’s absurd for the government to trying to block Microsoft from buying Activision and competing with Sony. That said, most of Sony’s bad acts, like making games exclusive, are a result of a legal framework that the FTC is trying to attack with this case. And that means that if you don’t like Sony, you should support this case.

There are a few other reasons for the conventional wisdom. In nearly every merger case, it rarely seems like the government has *proved* that a merger will be problematic, and it’s easy to paint every challenge as a conspiracy to attack business. That’s because it’s impossible to have enough evidence to guarantee something will happen in the future. Congress understood this dynamic, which is why the Clayton Act says “may substantially lessen competition.” The law is about probabilities, not certainties, essentially a well-supported guess. But that’s hard to square with most civil litigation in general, which is usually about proving what happened in the past with some degree of certainty, not litigating what might happen in the future.

Antitrust enforcers are also unpopular where they ply their trade, in the judiciary and the elite corporate and political worlds. Yes there’s a broad public dislike of corporate power, but in specific forums where these fights take place, the dominant crown is an elite crust of actors - economists, reporters, observers, lawyers, and hedge fund analysts - who mock any attempt to satisfy the law or public anger.

Ultimately, the conventional wisdom here is coming from people like CNBC’s David Faber. They are hoping that Microsoft wins. And if it does, the thinking goes, eventually Lina Khan and Jonathan Kanter will give up, and Wall Street can go back to its centralizing ways. This isn’t a remotely accurate analysis of the situation, it’s just wishful thinking. (Indeed, another significant event happened this week that I’ll write about soon, which is the government doing something to get much smarter about understanding mergers.)

More to the point, if you look at the actual case, the Federal Trade Commission has proved that the Microsoft acquisition of Activision is about monopolizing various video gaming markets. But even if the FTC loses, it won’t stop the momentum for addressing corporate power. After all, if a conflicted judge rules in favor of the largest tech acquisition of all time despite ample evidence the merger is intended to monopolize, and the purchase is by the original big tech giant Microsoft, then there’s going to be a momentary period of jeering. But the blowback will be severe.

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cheers,

Matt Stoller

P.S. For all you antitrust lawyers, there’s a job opening at the FTC to run a new anti-competitive practices division. usajobs.gov/job/732195400