Take Two Interactive (TTWO) is a video game developer with roots in prime marquee franchises such as Max Payne, Civilization, Borderlands and the controversial Grand Theft Auto series.
Over the last five years the company has earned itself a reputation as a powerhouse in creating potent franchises and titles that rivals the production quality of big name Hollywood studios. At the same time the company is no stranger to controversies either, with series such as Grand Theft Auto and Manhunt attracting the media attention of numerous lawsuits and calls for regulation.
We believe that 2013 will be another key year in the company's history and as a result we are picking TTWO as our top pick for this coming year. Let us explore the industry and the company in detail.
The State of the Industry
2012 was an unforgiving year for big budget video game developers. Industry giants Activision Blizzard (ATVI), Electronic Arts (EA), and Take Two Interactive are down over 14%, 32% and 18.5% respectively since the start of the year. This pales in comparison with the price levels from mid-2008, where these names are down around 40%, 70% and 60% respectively.
The industry as a whole over the past few years has seen a radical change since then in game development and delivery. Today, game developers no longer are restricted to the barriers of entry of distribution of yesteryear. With the advent of digital sales venues such as Steam, iTunes, Google Play and other online digital distributors, it has essentially leveled the playing field that developers can now release games to the masses without the box and disc. This in turn has created a massive wave of upstarts, increasing competition to the big budgets.
The success of mobile devices also changed consumer habits in media consumption that casual, mobile games have now become a vibrant and viable component of the once big budget studios environment of the early 2000s. The traditional idea of games needing to be on the big screen is out the window, while having the games on Facebook and on your phone during your morning commute is in. Companies such as Zynga (ZNGA) symbolize these radical changes by going public a year ago with a market cap of over $7 billion dollars.
These casual and mobile titles are also changing the dynamics of pricing. Premier titles from the big budgets developers often cost $60 dollars, perhaps even more, upon release. In contrast, casual mobile often costs <$5 dollars, or even free to download to play. The casuals compensate for this by introducing premium contents for a price, and so far, there has been considerable success in this model.
Analyst prediction has been quite downbeat for the traditional big budget developers such as Take Two. According to data compiled by the industry research group NPD, retail sales is feared to have dropped to six-year lows in 2012, as a result of these environmental changes. This largely explains the drops in share prices of ATVI/EA/TTWO over the past few years.
Our Views on the Future of the Industry
We do not believe that these big budget developers are going the way of the dinosaurs. While the trends certainly pose numerous headwinds for this business model, there are several key developments and trends that will play out in the next 2-3 years:
1) There's more to this "Big Budget - Casual" binary scenario.
We believe that the market reaction in this field is overextended. Currently the forward PE of EA and ATVI are in the low teens and are trading at a massive discount of 30%-40% to their historical ranges. The market has been ratcheting down expectations, while reasonably so, but we feel has overshot.
While casual will no doubt continue to solidify its place in the video game industry, the experience of a big budget title is still very different than one you would experience with a casual/mobile game. We liken this environment to eBay vs. Sotheby's/Christie's, and we feel both markets can and will co-exist.
2) The current hardware cycle
Video game developers are also working in an extended hardware cycle. Premier hardware consoles such as the Xbox 360, released 7 years ago and PlayStation3 over 6 years ago, understandably have limited the boundaries developers are able to push their art.
In the coming year or two we will mostly likely begin to see signs of a new hardware cycle that will trigger new innovations both on performance, and possibly introduce new concepts that will reinvigorate the interest in high production value games and a revival of the big budget developers.
3) Consolidation is becoming increasingly likely, and perhaps, necessary
With the advent of the small independent studios, big budget studios are facing competition unseen in these companies' histories. With equity values of the industry Goliath in multi-year lows, the possibility of making deals is improving.
Consumers are also becoming more sophisticated and demanding in their expectations on the quality of production. Thus, we feel companies will be forced to acquire talent or franchises to maintain relevance in today's marketplace, with buyouts again being the speediest way to achieving that objective.
So Why Take Two Interactive?
Take Two is at the top of its game in 2012-2013. It has been years since the company's release pipeline has been this exciting and we are bullish on several key points:
1) Big title releases
Two major titles that we are keenly focusing on will be released in 2013: Grand Theft Auto 5 and BioShock Infinite.
Grand Theft Auto 5 is the latest release in the highly violent and highly popular crime drama series. Known for its controversies with Senators and lawyers, and the humor/drama unique to the Rockstar Games studio, this title is on the radar as the game to watch for all of 2013. Analyst expectations are high for this title with sales estimates ranging from 18 million copies sold, all the way up to over 25 million copies. This would set launch records for the series and also for the entire company. The game is scheduled to be released Spring FY 2014 (March to June 2013 calendar dates).
BioShock Infinite is another marquee title preparing for launch in 2013. The BioShock series is evolving into another premier franchise for the company and current pre-orders are showing a very promising trend in the series' popularity and relevance with gamers. Analysts are projecting sales of 5 to 6 million copies for this title for 2013. The game is scheduled to be released in February 2013.
Between these two titles we are looking at over 20 million copies sold, or over $1 billion dollars in revenue for the company at $50 each. Combined with other titles in the pipeline and add-ons to established titles, the company is poised to establish 2013 as one of its busiest years.
2) The strength of existing franchises and the ability to create new ones
2012 also marked a year where Take Two Interactive had shown itself to be more than a one-trick pony. Previously thought to be a firm that relies on one key title released every couple of years, the company is likely to post a profit in calendar 2012 on the success of several new titles.
The company has some of the most impressive talent that seems to be able to generate titles that are relevant and of interest to gamers despite the challenging operating environment of the past years. This human capital cannot be understated in ensuring the viability of the business. Credit must be given to management that it is able to maintain the quality of its release.
We also are seeing a transformation in the business strategy to grow the business into the mobile space and overseas. Several new initiatives have been developed to shift more of the business from the traditional single player high production value titles to online multiplayer focusing on social. It has also entered agreements with developers in Asia to broaden its demographic reach. Again, we feel the company is taking the right steps to maintain relevance in the marketplace.
3) Management's ability to manage the portfolio
One key distinction for Take Two Interactive lies in a business strategy CEO Strauss Zelnick has undertaken: Key titles are not annuities. (Zelnick elaborates on this point during a Credit Suisse conference in 2012: Listen here.)
Several other developers such as Activision Blizzard have achieved great success with titles such as Call of Duty and have been releasing new titles aggressively. However in our view, this is leading up to consumer fatigue with certain franchises and could very well threaten the performance of these titles in the years ahead.
Take Two on the other hand has been effective in maintaining consumer interest and anticipation of its intellectual properties by keeping expectations high and interest strong. We like this strategy that prevents dilution of brand value, as well as keeping Take Two's reputation as a premier name in this highly competitive space.
What to Expect in the Next Year
One key risk to the company is the recent tragedy in Connecticut. Talks of regulations and controls have increased over the past month and shares have pulled back from a recent rally as a result. Recent talks have included bans of Grand Theft Auto 5 and far stricter controls over the release of violent video games.
It is our belief that these comments are highly reactive to current events, yet without merit of posing long-term damage to the franchise based on research done by reputable entities in the past on the subject. Thus we do not believe that there will be fundamental legal or regulatory risk to the company. We would go as far as saying that the undertaking of bans and other punitive actions would be unconstitutional (refer to Brown vs. Entertainment Merchant Association.) However, the negative press and attention could dampen sales of TTWO's key releases, both of which are likely to stir up controversy upon release.
Carl Icahn, well known activist investor, and Ken Griffin of Citadel both aggressively increased stakes in Take Two late in 2012. The shares currently trade at $11, putting a $1 billion market cap on the company. Icahn's involvement particularly intrigues us due to his reputation in shaking up management and unlocking company values (note: Current CEO Zelnick was installed by Icahn after an accounting scandal and management issues at the companies in the mid 2000s). We view this as a potential catalyst that could play well with our industry consolidation thesis.
Valuing Take Two
Since the industry is in a cyclical decline it is very difficult for us to use current figures to calculate the company's value. However, at current valuations of $1 billion market cap and our next year sales projection of $1.5 billion, mostly driven by the two key release titles, the stock is trading at under 0.67 next year sales.
Prior to the release of Grand Theft Auto 4 in 2008, Take Two Interactive rejected a buyout from Electronic Arts for $26 a share, all cash. This deal valued TTWO at around $2 billion.
Even if the company is taken out at 1x next year sales at around the $1.5 billion projection (see below), the offer would be at around $17. While it is still far lower than the EA offer, we acknowledge that the industry is in a different place compared with 2008, and we feel that a deal could still occur at these levels. Anything above this figure and we would have a very high confidence level that it will be accepted by the board and public, and we feel encouraged to bet on this thesis.
In our view, Activision Blizzard is the most likely candidate today that would be looking at Take Two Interactive outside of private equity. The company is highly digestible for this industry juggernaut with over 2.9 billion dollars in cash and a balance sheet devoid of debt, thus making the above buyout scenario well within the realms of possibility.
Rumors of private equity firm KKR being involved in the possible takeout of Electronic Arts further suggests other non-gaming company interest in the gaming space, thus further improving the likeliness that there could still be other 3rd-party candidates that could yet come forward with a buyout offer at TTWO that we have yet to anticipate. We would not rule out European and Japanese entities that could be looking at Take Two as a way into the North American gaming space.
We have a $17 target price on the company.
Activision Blizzard's Call of Duty Black Ops 2 has been noted as a key release of 2012. Our thesis suggests that Grand Theft Auto 5 will at least match the performance of this title and most likely exceed it due to the four-year release cycle since the last GTA vs. the one-year cycle since the last release of Call of Duty.
CoD Black Ops 2 hit sales of $1 billion dollars in 15 days, and the game was released in November of 2012. Company execs have compared the title with "Avatar" the movie, which generated $1 billion in 17 days.
The quality of entertainment we feel is similar with GTA5. We are establishing a sales estimate of 18 million copies by the end of 2013 for GTA5.
We strongly believe GTA5 could match these early sales numbers of CoD: BO2, and since we are projecting releases for GTA5 in June of 2012, we also feel the team at Take Two could leverage up on the title and drive up gamer interest yet again in the Christmas season of 2013 with lower price add-ons and new episode content, similar to what it has done for GTA4 in 2008 to keep sales momentum. Our estimate for this title alone could be over $1.2 billion in all of 2013.
BioShock Infinite we estimate to sell around 5.5 million copies for revenue of around $350 million.
Our FY 2014 baseline revenue estimates stands at $1.55 billion dollars. We are basing this figure by simply projecting just GTA5 and BioShock Infinite. We will ignore all other titles to give ourselves a bit of a moat in our projections and thus this is established as our worst-case baseline.
Margins are most likely going to be steady at the 35% level and operating costs at $350 million. This translates to around a $192.5 million profit for FY 2014, or $2.1175 a share. This suggests a forward P/E ratio of 5.2.
Analyst FY 2014 earnings estimate range from $1.45 to $3.18 per share, with a consensus average of $2.29, slightly above our estimates.
We believe the company can outperform our estimates, as several other titles of 2013 are showing strong interest, as well as the new initiatives of online assets and partnerships beginning to bear fruit.
Even if there is no buyout, the company's valuation is very attractive in our opinion. The company has shown this year it can still stay in the green without a big release and we expect this trend to continue. We view these big release years as the cherry on top.
Take Two Interactive might just be that second chance to a life beyond casual the video games industry has been waiting for.
Disclosure: I am long TTWO and may add/revise the position in the next 72 hours.