- Turnaround success story with "hidden", unappreciated improvements.
- Industry-leading portfolio of games, well positioned to win going forward.
- Cheap valuation.
I am long Take-Two Interactive Software, Inc (NASDAQ:TTWO). In this article, I will condense my research to concisely and, hopefully, convincingly explain to you why TTWO is an attractive investment opportunity and why I picked TTWO as my investment of choice over Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI).
First, the Risks
TTWO, like EA and ATVI, is a pure-play video game company that develops and publishes video games on a variety of platforms, but primarily for console (PlayStation, Xbox, and Wii) and PC platforms. Video game development and publishing is a high-risk business due to two factors: 1) skyrocketing development costs and 2) concentration of revenue and profits around hit games.
As games increase in complexity and graphics, the cost of developing them naturally increases. Therefore, game developers could no longer afford to simultaneously develop a multitude of games and hope for the best. The winning strategy now is to be selective, hope for a hit, and milk it for all its worth. In addition (or perhaps consequently), industry revenue and profits are increasingly coming from hit games. For example, according to ATVI's 2013 10-K, despite a y/y 7% decrease in retail sales in North America and Europe for the overall industry, sales of the industry's top five titles grew 20% in 2013.
TTWO is highly dependent its Grand Theft Auto ("GTA"), Borderland, Red Dead, and NBA franchises. EA is highly dependent on its Battle Field, FIFA, Madden, and other sport franchises. And for such a large company, ATVI generates 80% of its FY13 revenue from only 3 franchises: Call of Duty, Skylanders, and Warcraft. If any of these key franchises fail, the parent company will experience serious problems. This is particularly true for TTWO with 72.2% of the Company's net revenue for the nine months ended December 31, 2013 coming for GTA products.
In addition, these key franchises are developed by key talents. For example, GTA is developed by Rockstar North, a studio within the Rockstar label, which is owned by TTWO. The titles mentioned above are also primarily distributed through a handful of stores for two primary consoles (PlayStation and Xbox) and the PC. So, as you can see, there is a lot of concentration going on the gaming industry.
I believe risk can be managed by appropriately sizing your bet, but if you can't stomach this kind risk at any size, then you should skip the rest of the article and definitely skip investing in TTWO.
If you only look at the superficial financial results of the past decade, you would think TTWO is in a terrible business. You're right, it was. However, I believe the fundamental business reality of TTWO is materially different now then it was 5 or 10 years ago.
From 2001 through 2005, TTWO was pretty much a one-trick pony and was riding high on the unexpected success of GTA 3, GTA Vice City, and GTA San Andreas. I'm not sure how the Rockstar team did it, but they some how managed to produce three smash hits back to back to back. Then the company hit a wall in 2006, posting a loss of $185 million, nearly wiping out all the profits from 2003 through 2005.
The Company was also managed by unethical and reckless management and was plagued with legal challenges. In 2002, the company restated 7 quarters of financial results and in 2003 the CEO was convicted of falsifying business records. Then there was the insider-trading lawsuits, copycat violence lawsuits, "Hot Coffee" incident related fines and lawsuits. If you want the gritty details, check out Item 3 of TTWO's 2007 and 2003 10-Ks.
All of this was fine and dandy until the Company posted that huge loss in 2006 and found itself a few steps away from financial ruin. This led to a shareholder revolt in early 2007. The revolt lead to the replacement of the CEO as well as 5 out of 6 board members. Most importantly, Strauss Zelnick, a media turnaround specialist, became Chairman and later the CEO. In my opinion, the new board and executive team was the most important catalyst in turning the dysfunctional company into what it is today - a professionally run company.
Change #1: Resolving Legal Issues
TTWO in 2007 was one of the most legally besieged companies I have ever came across. At the time, there was no less than 11 different lawsuits and government investigation going on at the same time (some were probably consolidated, but who is counting at 7?). If you look at Item 3 of the 2013 10-K, you will see 0 outstanding legal challenges. In my opinion, this is a huge accomplishment and reflects the professionalism of current management. No doubt management can now better focus on growing the business.
Change #2: Financial Stability
In 2007, TTWO's cash position stood at $78 million with $18 million in long-term debt, and a negative Operating Cash Flow $64 million. This is clearly the opposite of being in good financial health. New management immediately went to work to stabilize the Company. First, TTWO entered into credit agreement to borrow up to $140 million as act of prudence, although it was never drawn. To finance its growth, the company issued convertible bonds at attractive rates (which was probably prudent at the time of issuance but now looks terrible in hindsight after the stock has rallied).
As of 12/31/2013, TTWO's cash position stood at $972 million with long-term debt at $449 million and $0 short-term debt. With net cash of ~$520 million, almost 1/3 of its current market capitalization, TTWO has never been in better financial condition.
Putting the company on a stable financial footing is another accomplishment that should not be underestimated. Now TTWO has plenty of dry powder to expand its business either organically and/or through acquisitions.
Change #3: "Hidden" Organic Growth
So in FY2007 TTWO generated about a $1.0 billion in sales in FY20013 it generated about $1.2 billion in sales - big deal, right? Wrong! In FY2007, distribution, a terrible business to be in, took up 29.5% of sales. Management divested its distribution business over the years so in FY2013, distribution contributed to 0% of sales. Ah-ha, core business actually grew from $700 million to $1.2 billion!
Change #4: Better Portfolio
This change is what drove change #3. Since 2007, TTWO has strengthened its portfolio by adding new IP and strengthening its existing IP. In 2013, Metacritic ranked TTWO as the best major game publisher in 2013. Since there are too many titles to untangle, I'll just highlight a few key developments below.
- Added Borderland franchise, which is one of the most critically acclaimed and highly rated game franchise of all time. Borderlands sold 4 - 5 million copies since its 2009 launch and Borderlands 2 sold over 8.5 million copies since its 2012 launch.
- Purchased WWE franchise from bankrupt THQ and launched WWE 2K14 in FY2014. I don't have my hands on sales data, but it received decent reviews and, most importantly, have a loyal WWE fan base.
- Acquired Mafia 2 from Illusion Softworks in 2008. This wasn't a smash hit, but it received decent reviews and has a fan base.
Expanding Existing IPs:
- GTA 5 broke all records by selling $1 billion in three days after its September 2013 launch. As of 3Q14, GTA 5 sold over 32.5 million copies. Here is a nice chart of GTA sales records.
- GTA Online was launched in FY2014, a huge step for TTWO in entering the online gaming space. GTA Online had some execution problems so no one should think this is a game changer in the short-run. However, I view this is a big learning opportunity and a step in the right direction.
- Red Dead Redemption, the second title in the Red Dead franchise, sold 12.5 million copies one year after its 2010 launch. This far outpaced the first title, Red Dead Revolver, which launched in 2004 and sold only 920 thousand copies in six years after its launch.
- Multiple older titles were released on mobile platforms.
- Exploring the freemium model in Asia with FY2013 launch of NBA 2K Online in China and Pro Baseball 2K in Korea.
TTWO's portfolio has always been its competitive advantage and I believe this competitive advantage is stronger than ever. At the expense of margins (TTWO has the worst gross margins among its peers), TTWO has always delivered the highest quality products. Recently, both EA and ATVI's flagship franchises have received poor reviews. There are too many to list here, but it is instructive to go to Amazon.com to look at the reviews of the following titles:
- TTWO's flagship Grand Theft Auto 5, Red Dead Redemption, and Borderlands 2 (all 4.5 stars with raving user and critical reviews).
- EA's flagship Battlefield 4 (panned), Titanfall (overhyped, panned by fans), and FIFA 14 (decent reviews at 4 stars, but nothing to write home about).
- ATVI's Call of Duty Ghost (panned by fans), World of Warcraft & Expansions (reviews are mixed, but the game was originally launched in 2004 and subscriptions are going downhill fast!), and Skylanders (the only one out of its three flagship franchise that is receiving good reviews).
As of 4/27/2014, TTWO's Enterprise Value / 3-year average EBIT is ~10x. (I'm using 3-year averages because of TTWO's lumpy earnings makes a single year less meaningful.) This compares to EA's 141x and ATVI's ~10x.
Why Not ATVI or EA?
Since the focus of this article is not on ATVI and EA, I will go through the reasons why I am not bullish on these stocks quickly. If there is demand, I may follow up with another article.
ATVI isn't an expensive stock, but given its dependence on a rapidly dying World of Warcraft franchise and its "release once a year" Call of Duty Franchise (with deteriorating reviews from its 2011 to 2012 to 2013 releases), I don't see a bright future. ATVI is now way too reliant on too few titles for a company of its size. If the upcoming Destiny isn't as successful as WoW, revenues will suffer immensely. Furthermore, it is always inherently more risky and expensive to launch new franchises. However, ATVI's CEO is veteran deal maker and talented capitalist, so who knows what will happen.
EA, on the other hand, is simply not making any money for investors. The company has a history of terrible capital allocation (bad acquisitions, large investments in adjacent businesses that has yet to bear fruits, etc.), is killing the quality of its key franchises, and its current CEO is new and unproven. Besides EA's strong hold on spots gaming, there isn't much to be hopeful about.
Given TTWO's cheap valuation and favorable market position, I believe TTWO is the best positioned to win in the video game development and publishing space. With a strong balance sheet, no legal headaches, and a portfolio of critically acclaimed games, there are many ways for TTWO to grow going forward. Opportunities include: 1) building out international distribution (particularly in Asia), 2) increase its digital revenue (micro transactions, DLCs, direct digital distribution, in-game advertising, etc.), and 3) taking advantage of the growth of mobile to monetize older titles.
I believe the biggest opportunity for TTWO is to simply monetize its GTA, Red Dead, and Borderland franchises on par with ATVI's monetization if its Skylander, WoW, and Call of Duty Franchises. I don't expect the same scale with TTWO's games because its three key titles are much more similar with each other than ATVI's three key titles, but margins could be vastly improved and new ways of monetization could be explored. TTWO also has other titles that received very positive critical reviews but has yet to achieve "franchise" status (e.g. L.A. Noire, among others) - I believe current management has the ability to develop these into franchises.
What do you think? Please leave your comments below. If you enjoyed my article, follow me for future articles. Thanks for reading!