The early raving success of Grand Theft Auto V and the launch of the new generation of gaming consoles (PlayStation 4 and Xbox 1) are just a couple of reasons to think Take Two's growth story that started in the beginning of the year is just starting. This article will take a fundamental look at the gaming developer, analyze its upcoming growth prospects, and determine its viability as an investment.
Take-Two Interactive (TTWO) is a well-known consumer electronic developer, with a consistent track record of releasing cutting edge and critically acclaimed games on an almost annual basis. Through its wholly owned labels, including 2K, Rockstar Games, and Irrational Games, Take-Two has established itself as a premier designer of games for console platforms -- Microsoft's (MSFT) Xbox line, Sony's (SNE) PlayStation line, and Nintendo's (OTCPK:NTDOY) Wii line - as well as PC, tablets, smartphones, and handheld gaming systems.
Take-Two has 2 main subsidiaries, the first being Rockstar Games. Rockstar's offerings are almost always internally developed and typical contain free to explore, open world settings where the player has the ability to take whatever path he or she so desires. The games include Grand Theft Auto, L.A. Noire, Red Dead, and Midnight Club. Most recently, Grand Theft Auto V was hailed the fastest selling video game in history, shattering previously held records by GTA IV and Call of Duty: Black Ops by passing the one billion dollar mark in only 3 days.
2K is the second of Take-Two's major subsidiaries and is known for products spanning a wide variety of gaming genres, including sports, RPGs, shooters, strategy, and action/adventure games. 2K's offerings have been both internally and externally developed and include franchises that have become major hits such as the Borderlands, BioShock, and Sid Meier's Civilization, as well as the NBA 2K, NHL 2K, and MLB 2K series. In addition, 2K Online - which is aimed primarily at the Chinese market - has been a provider of a rather consistent subscriber base.
Take-Two operates internationally, with segmentation percentages remaining relatively stable over the past three years. Europe's make-up of the company's revenues has decreased as revenues from the region has declined 10% since 2011 despite the company posting an overall revenue growth of 7% over the same time period. The rest of the regions - U.S., Canada & Latin America, and Asia Pacific - have grown at rates of 12%, 58%, and 7% respectively since 2011.
When breaking down Take-Two by its gaming segments - Console, PC & Other, and Handheld - we can see that the tablet/smartphone segment's (which include PCs) share of the company's revenue contribution has nearly doubled since 2011. Console growth has remained relatively flat over the same period, while handheld devices have seen a 58% decline, a trend that is likely to continue. Expect console gaming to regain traction in revenue contribution over the next couple of years as the next generation consoles are released in time for 2013's holiday season. In addition, as smartphone/tablet penetration increases in emerging countries, especially China, look for mobile revenue contribution to increase as well.
Now let's take a look at a breakdown of the distribution of Take-Two's content. Below, we can see a massive shift from Physical Retail to Digital distribution - a trend that we have seen for a while now, and one that has been scaring the likes of brick-and-motor retailers such as GameStop (GME) and Best Buy (BBY). With the move towards digital distribution, other avenues of revenue generation, such as downloadable add-on content, have boosted per-player spending. With the continued success of 2K Online, the release of GTA V, the expected release of GTA Online (~2013Q4), and the next generation's offerings including NBA 2K14, MLB 2K14, and Borderlands, the revenue generation stemming from Take-Two's monetization of digital content will only improve.
Taking a look at executive compensation, below is a short term view of Take-Two's top two executives' compensation compared to revenue and EPS growth. In the spotlight are Chairman Strauss Zelnick and President Karl Slatoff. It would appear that both Zelnik's and Slatoff's compensation is predominantly tied to company performance, particularly EPS growth.
Now we can get to my favorite part of my articles - an analysis of a company's financial standing and fundamental health. Take-Two has historically kept itself it relatively strong financial standing. Recently however, the company has tacked on a large amount of debt - Take-Two's long term debt total is now approximately $335M, up from $70M in 2008. The good news is that the company's cash balance has also increased -- $403M now, up from $280M in 2008. Debt-to-Equity and Debt-to-Capital ratios have contracted over the past few years, but barring any significant capital expenditures, I expect a level-off - if not a decline - in the company's debt balance. Below is a snapshot of Take-Two's historical and forecasted ratios and growth rates. (Please note, this is based on fiscal not calendar year information.)
To give you a breakdown of my valuation let me first show you my model's income statement for Take-Two:
Like in most of my articles, I'm going to break down my 2 primary valuation methods:
1) Intrinsic Value (IV) refers to how much the stock is worth by projecting future EPS and/or DPS growth. The IV is theoretically what the company's price would be in a fully rational market where stocks trade at exactly the amount they are worth and multiples, such as the P/E, moved at a relatively stable rate. Therefore, stocks do not necessarily have to trade at the IV. The IV is calculated by forecasting 4 to 5 years into the future, then discounted back at the present value. Thus, the IV places a higher emphasis on companies that are estimated to have sustainable earnings and/or dividend growth.
2) Target Price (TP) refers to what we believe a stock will sell at given a particularly time frame - such as a 12-month TP. The TP may differ from the IV as it could be higher or lower due to investor perception and/or less than efficient markets. Theoretically, at some point within the long term (4-5 years), the long-term Target Price will equal the long-term Intrinsic Value. The TP does not take into account a company's long-term growth potential, but is likely a more accurate depiction of a company's stock price in the more immediate term. Theoretically, a TP multiple, such as P/E, will be higher than an IV multiple, as company's growth tend to slow over time.
Now that we can get down to the numbers, let's take a look at the P/E Multiple Analysis for Take-Two.
The only lines you need to consider in the above exhibit are the two "My Estimate" rows. The first of these two rows calculates the Intrinsic Value, while the second calculates the Target Price. The TP multiple is comprised from several different factors of information: 5-year historical high and lows (I take out abnormally high and low values), consensus estimates, and a slew of ratings that I personally assign to the company - financial standing, growth prospects, industry outlook, management grades, and profitability.
These factors all combine to generate the "Modified P/E ratio" which is 13.7x. This is what I believe the stock should trade at, not necessarily where it will trade. Usually, the next step would be to take into consideration a company's historical P/E trend, but due to the high volatility of Take-Two's P/E multiple over the past 5 years, it is not practicable to factor historical growth trends into this particular calculation. In addition, I take into consideration the average of the P/E multiples of a company's peers or the industry P/E (which I calculate to be 17.7x). Therefore, after combining the "Modified P/E" and the peer P/E I am left with a final P/E ratio of 15.7x. This becomes my TP's P/E multiple. You can see a visual of the process in the chart below.
The last step of this method is to calculate the IV P/E multiple. The IV P/E is the TP P/E discounted at the company's Weighted Average Cost of Capital, or the WACC, which I will go over in the next section. The discount process results in an IV P/E multiple of 14.8x. Think of this as what the mean P/E multiple would theoretically be (based on an initial P/E multiple of 12.7x) for Take-Two over the next 5 years. Just as a company's growth should theoretically decline over its lifetime, so should its P/E multiple (which is often viewed as a reflection of growth).
Therefore, my Target Price is calculated by using the P/E multiple of 15.7x my 2014E EPS of $1.68 - giving Take-Two a valuation of $26.
The Intrinsic Value calculation is a little bit more complicated, but it boils down into applying the P/E multiple of 14.8x to forecasted EPS (DPS would also be included, except in this case there is no DPS) that run through 2017 - which results in a valuation of $24. In a very similar manner to a Free Cash Flow Analysis (which I will go over next), this is what I believe Take-Two's per share value is when considering future earnings growth.
Before we get into the Free Cash Flow valuation, let's take a look at a breakdown of the WACC. Given that Take-Two is comprised of ~36% debt, which has an average coupon rate of approximately 1.8%, Take-Two manages a very low and highly favorable WACC of 6.5%. Note that the Beta is calculated by taking the covariance of Take-Two and the S&P 500 over the past 5 years.
Free Cash Flow Analysis
The Free Cash Flow analysis plays out almost identical to that of the IV P/E analysis. It would be highly unlikely for revenues to grow at a stable rate over 10 years due to the cyclical nature of the industry, but I attempt to normalize the growth over the time period. In addition, I use a long term growth rate of 2% -- which is approximately the average growth rate of the U.S. GDP over the past 5 years. By forecasting free cash flows out to 2022 and including a terminal value calculation, I estimate that Take-Two has a per share value of $25. The fact that all three valuation methods (FCF, IV P/E, and TP P/E) produce very similar results gives me extra confidence that the valuations are definitely viable. As $25 is the average price between the 3 valuation methods, I feel that this is a good price target to set and represented a 45% upside to Take Two's current price.
After taking into consideration the considerable amount of quality offerings coming down the company's product pipeline, continuing revenue generation from already released products, great fundamentals, and a management team highly aligned with optimizing performance, Take-Two Interactive is a fantastic investment in a highly exciting industry.