TheChek News Flow

The Takeaway

• Microsoft’s gaming revenue growth fell below targets in fiscal 2024

• Rival gaming studios are reluctant to put games onto Game Pass

• Activision has been slow to migrate to Azure

In 2021, Microsoft CEO Satya Nadella faced a choice involving the company’s Xbox and cloud gaming business. The company could either acquire major game studios to drive more subscriptions to its nascent Game Pass subscription service. Or it could wind down its games business entirely, Nadella told two people at the time.

Nadella took the first path, acquiring Elder Scrolls maker Bethesda Studios for $7 billion in 2021 and Call of Duty maker Activision Blizzard for $75.4 billion in the fall of 2023. So far, the returns on the investments appear unimpressive: In the year to June, Microsoft’s gaming business revenue grew 5.8%, well below the 11% target set for the purpose of calculating part of Nadella’s compensation, according to securities filings. (That growth excludes revenue of Activision since its acquisition but includes Game Pass).

Gaming was the only section of his pay evaluation that fell short of Microsoft’s goals. Meanwhile, in the three months ending Sept. 30, Microsoft indicated that its gaming division didn’t grow at all without the first-time contribution of Activision revenue in the quarter.

For many investors, Microsoft’s performance in gaming ranks is likely less important than its progress in artificial intelligence. Questions about whether the company’s big investment in new data centers will generate a return have weighed on investors’ minds and are likely the major reason why the stock rose only 12% last year, well below the number for every other big tech firm.

Even so, given the sheer amount Microsoft has spent on gaming expansion—the Activision purchase was its biggest ever—the outcome of Nadella’s gaming bet is important in the long run.

“Seventy billion dollars is not a pittance—it’s a lot of cash. They might lose money in the short term, which is fine, as long as they can prove that in the long run Game Pass is a solid source of recurring revenue,” said Wedbush analyst Michael Pachter.

Uncharted Territory

Microsoft first launched its Game Pass subscription service in 2017. It charges customers $12 to $20 per month to access a library of PC and Xbox games from any device.

By launching the service, Microsoft is forging into uncharted territory. The company hopes to prove a business model that is now omnipresent in movies and television streaming can also prove successful in videogames.

Big gaming firms, like Activision, have historically been reluctant to put their games on an all-you-can-play subscription service, worried they would make less money than they do by selling games outright at $60 to $70 apiece. Buying Activision allowed Microsoft to change that dynamic.

Since then, however, several leading game studios have resisted Microsoft’s pitch that they should put their titles on Game Pass in exchange for fees that Microsoft offers to pay to the gaming studios, according to people familiar with the discussions.

“I just think the majority of the game market doesn’t really want a game pass” like the one Microsoft is offering, said Gus Zinn, a portfolio manager of the Macquarie Science and Technology Fund, which holds roughly $400 million in Microsoft stock and has kept its Microsoft position roughly flat over the past year.

Microsoft also hoped the Activision deal would attract game developers to rent its Azure cloud servers. But Activision wasn’t using Azure prior to the deal, and it still rents servers from Google Cloud and Amazon Web Services while primarily relying on its own servers for development, according to someone with direct knowledge of the situation and another person briefed on it.

Pushing a New Business Model

Between launch and 2021, the number of Game Pass subscribers grew to 18 million, Microsoft reported. Since 2022, Microsoft has stopped regularly reporting annual numbers, although it said in February last year that Game Pass had grown 36% since 2022 to 34 million subscribers.

Before completing the Activision acquisition, Microsoft targeted having over 100 million Game Pass subscribers by 2030, meaning it would have to triple its current subscriber base in five years—or grow at a rate of 40% annually, which would be faster than its rate of growth every year since 2020.

The company previously included Game Pass growth as one of the metrics that determined CEO Satya Nadella’s pay package, but it eliminated that provision in October 2023 after it failed to meet Game Pass growth targets in the prior two years.

When reached for comment, a Microsoft spokesperson referred to Nadella’s remarks to shareholders in October that Game Pass had set a “new revenue record” in the quarter prior and that a record number of people had signed up for Game Pass on the day Microsoft published Activision’s new Call of Duty: Black Ops 6 title.

Some shareholders say Activision’s contribution won’t matter much as long as Microsoft generates growth in other areas like cloud and artificial intelligence software sales.

“[Activision] has been disappointing,” said Denny Fish, a Janus Henderson Investors portfolio manager who oversees two funds that included a total of more than $800 million in Microsoft stock as of November. “It’s also a business that had some degree of consistency over, like, a three- to five-year period but was highly volatile from year to year, because you’re so dependent on the big releases like Call of Duty.”

However, Microsoft’s heavy spending on data centers for AI is a bigger drag on its stock price than the Activision deal, Fish said.