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Microsoft's Stock Is About to Get Cheaper Thanks to the Activision Blizzard Deal. Should You Buy?

Motley Fool - Mon Oct 23, 2023

After nearly two years, Microsoft (NASDAQ: MSFT) has finally closed its deal to buy Activision Blizzard. While Microsoft had to make multiple concessions and jump through many regulatory hoops to make it happen, the deal is done. Now, Activision Blizzard will be incorporated into Microsoft, which will add to Microsoft's top and bottom line.

While Microsoft has been a great stock over the past few years, it has gotten expensive from a valuation perspective. Now that Microsoft has put some of its cash hoard to work, is it at a buying point? Let's find out.

Activision will only be a small part of Microsoft

At the end of the fourth quarter of fiscal year 2023 (ending June 30), Microsoft had more than $111 billion on its balance sheet in cash and equivalents. That's quite a bit just sitting around, but with the $68.7 billion deal with Activision, it has now put a significant chunk of that to work.

But how much business did Microsoft pay for?

Over the past 12 months, Activision generated $8.7 billion in revenue and $2.2 billion in profits. That values the stock at 7.9 times sales and 31 times earnings. Considering that Microsoft trades for 12 times sales and 34 times earnings, Microsoft actually purchased Activision for less than it costs for it to repurchase its own shares.

That's a great value proposition, especially considering what this acquisition brings to the table.

Activision's profit margin was a strong 25% pre-merger. After the merger, many roles can be consolidated, improving the margins of the newly integrated business segment. Additionally, Microsoft can flex some of its resources to help with product development, making this merger a win-win for both companies.

But does that make Microsoft stock a buy now? After all, the stock was quite pricey before the merger.

Microsoft trades at a hefty premium to the market

With Microsoft already generating $212 billion in revenue and $72 billion in profits, Activision's portfolio won't add a ton to Microsoft's business. Revenue and earnings would have increased by 4% and 3%, respectively, if Activision Blizzard had been fully integrated over the past year.

That translates to the valuations decreasing by that much as well. So even though Microsoft's stock is technically getting cheaper, it isn't by much.

Does that mean investors should avoid Microsoft stock? I wouldn't necessarily say yes.

Microsoft's stock is expensive compared to its tech stock peers, and next year isn't looking much better. Microsoft trades at 30 times forward earnings, a 50% premium compared to the S&P 500's forward price-to-earnings (P/E) ratio of 20. That's a hefty premium for any stock, particularly one that's only expected to grow revenue by 11% during fiscal year 2024.

Furthermore, with interest rates as high as they are, companies can easily generate a 4% return on cash sitting around: 4% of $68.7 billion (the buyout price) is $2.7 billion, more than Activision generated in profits over the past 12 months. As a result, some investors may question whether that money was best spent on purchasing Activision. But because this deal originated in the low interest rate environment of early 2022, this wasn't a consideration at the time, although it is the reality now.

Even though Microsoft has significant artificial intelligence (AI) investments, a growing cloud computing business, and now a powerhouse gaming creation wing, I still think Microsoft's stock is overvalued. Other stocks are growing faster and priced cheaper than Microsoft, and they should be considered before Microsoft.

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Keithen Drury has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft. The Motley Fool has a disclosure policy.

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