Last week the management of Take-Two Interactive Software, Inc. (TTWO) made an appearance before investors at the UBS Global Media and Communications Conference in New York City. Nearly every slide in the company’s presentation references its “leading” position in the global gaming market….leading products, leading creative team, leading intellectual property. They also claim an iconic brand and a see themselves as “pioneers” redefining electronic games. It sounds like Take-Two management is trying to take the castle and seize the crown in real life. The kings of old knew that keeping the castle requires defense - in short, a good moat.
Many company management teams claim the so-called “moat.” Surely if such a defensive barrier exists against competition, protecting market share and profitability, financial measures should reveal the competitive advantage. What characteristics do such companies have from a financial standpoint?
First and foremost companies with real moats will be more profitable than the rest of their peers, from at least one level if not all profit measures – gross, operating or net. Some analysts argue that it is not enough to be better than the pack. A real moat would deliver net profits in excess of 15% year after year. That is not the case for Take-Two, which has reported losses in two of the last five years - fiscal years 2009 and 2010. Indeed, Take-Two’s gross profits have been on the decline - from 42.4% in fiscal year 2008 to 39.4% in fiscal year 2011. The company reported a loss again in most recently reported six month period ending September 2011. This was due in part the gross margin which sunk even further to 35.2% compared. This compares to an average gross profit margin of 57% for the balance of the industry in the most recent twelve months and 33% for the last five years. No moat here.
Operating and net profits of course, can be a messy and sometime erratic numbers. Free cash flow figures leave out much of noise made by GAAP accounting treatments such as stock compensation expense that leads to sometimes substantial non-cash operating expenses. A widely used “moat benchmark” is consistent generation of free cash flow in excess of 5% of total sales. Did I mention the two years of net losses? In those same years Take-Two operations used cash, leaving negative free cash flow. Indeed, the company has reported positive free cash flow in only two of the last four fiscal years. Operations consumed cash again in the most recently reported six months ending September 2011, largely due to the capitalization of software development costs and licenses. The rate of capitalization has exceeded amortization of development costs in each of the last four years.
Profitability is not the only measure of a protected company. The fact that Take-Two has a considerable investment in intellectual property signals the need to consider asset turnover (Sales / Assets). Here Take-Two shines. While the rest of the industry averages Total Asset Turnover of 0.6, Take-Two consistently delivers turnover between 0.7 and 1.1 times. Perhaps we can allow Take-Two management that “pioneer” accolade even if not quite king.
Strong returns on assets and equity also signal the successfully protected competitive position. Obviously, any year in which there is a loss Return on Assets or Return on Equity will be negative. When profitable, Take-Two delivers stronger than average returns. In fiscal year 2011, return on average assets and return on average equity was 5.4% and 8.9%, respectively, well above of the industry averages of 1.6% ROA and 6.8% ROE.
As impressive as that might be confirming outperformance is not enough. Many analyst would argue for at least 10% ROA and 15% ROE in each of the last five fiscal years to confer “moat” bragging rights. Take-Two did achieve a 10.1% ROA in fiscal year 2008 and may be poised to bring returns back to that level now that the economic turmoil has subsided. Likewise, ROE was 17.9% in the same year and is again above the industry average in fiscal year 2011. Also not meeting the high standards of some analysts, we give Take-Two credit for delivering better returns than most in its sector.
Many companies claim strong competitive positions but do not really have a fully defended position or have not been successful in capitalizing on that strength. While there might be a divergence in viewpoint on the strength of Take-Two’s defense against competition, it is clear the company plans to execute opportunistically in the coming months. In announcing the completion of convertible note offering of $250 million early November 2011, management mentioned acquisitions and strategic investments. In my view, $250 million could buy a very nice moat.
Disclaimer: Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.