A Long Case For Take-Two Interactive Software, Inc.

| About: Take-Two Interactive (TTWO)

Summary

TTWO has small non-GAAP gross and operating margins relative to peers but shows superior growth potential.

TTWO experienced significant EPS growth following its 2013 release of "Grand Theft Auto V" and expects a similar result with the upcoming installment.

TTWO saw GAAP net revenue from digitally delivered content grow by 53% year-over-year in fiscal 2016 to $698 million, a company record.

By Mathew Jerome and Ryan Christensen

Recommendation: Take-Two Interactive Software, Inc. (NASDAQ: TTWO) seems to be an undervalued video game developer at the present time. The company has small non-GAAP gross and operating margins relative to those of competitors but shows superior growth potential. Given its promising game pipeline and its ability to adapt to a changing industry, expect TTWO stock to continue its upward trend in the coming years.

Company Overview

TTWO is a multinational video game developing and publishing company with two wholly owned labels: 2K Games and Rockstar Games. Its most direct peers include Activision Blizzard (NASDAQ:ATVI), Electronic Arts (NASDAQ:EA), and Ubisoft Entertainment (OTCPK:UBSFY), but it also competes indirectly with console makers Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE), creators of the Xbox One and PlayStation 4, respectively. TTWO offers its products through physical retail, digital download, online platforms, and cloud streaming services. Users enjoy a diverse catalogue that spans many genres, including adventure, role-playing, shooter, sports, and strategy games. TTWO succeeds in the large consumer markets of the United States, United Kingdom, and Japan and continues to pursue other opportunities abroad.

Industry Trend: Live Streaming

As technological innovation continues to advance rapidly, people are becoming increasingly interconnected. TTWO recognizes the power of live streaming within the gaming industry and seeks to cater to the interests of users. The company demonstrated its visionary approach to gaming in 2014, reporting that it received $22 million after cashing out its investment in Twitch, which is now the world's leading social video community for gamers. Given that the Twitch community includes 9.7 million daily active users, there is clearly a widespread fascination with shared gaming experiences. TTWO values connecting with users and continues to stream live events on the Twitch platform.

Bull Case

  • Timely release of Grand Theft Auto VI, leading to boost in revenue
  • Strategic growth and success in profitable Asian markets
  • Securing crucial microtransactions

Bear Case

  • Inability to meet growing demand for mobile gaming
  • Uncharted 4K, HDR, and VR technologies
  • Two-year delay for GTA VI release
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Bull Case-Investment Positives

1. Grand Theft Auto Spurs EPS Growth

Action-adventure franchise Grand Theft Auto is the single greatest profit driver for TTWO. Historically, the company has fared well during periods in which it has released a GTA game. 2013 was no exception. Upon releasing Grand Theft Auto V, TTWO experienced a tremendous spike in earnings per share growth. As of this June, Grand Theft Auto V had sold more than 65 million units, making it the highest-rated title on both Xbox One and PS4. We expect a similar result for fiscal year 2019 with management anticipating the release of the franchise's sixth installment in 2018.

2. Asian Market Presence

TTWO prides itself on being a global corporation and is actively seeking opportunities for expansion in Africa, Asia, and Latin America. CEO Strauss Zelnick is excited about the Asian markets-most notably China and South Korea. Estimates show China accounting for $25 billion, or one-fourth, of the global games market in 2016. With serious money to be made in China both in the present year and in future years, TTWO could dramatically improve its stock price by appealing to more Chinese consumers. TTWO serves as a publisher in Japan and maintains its Asian headquarters in Singapore. We believe these footholds will allow the company to further its influence in the Asian marketplace.

3. Growing Prominence of Digital Purchases

Traditionally, video game developers have relied solely upon the success of physical game releases. This is quickly changing with the introduction of in-game purchases. With the ability to buy virtual goods within a given game, users often pay for more than just the title. In fiscal year 2016, recurrent consumer spending reached its highest level ever and contributed to more than one-fourth of TTWO revenue. GAAP net revenue from digitally delivered content grew 53% year-over-year to $698 million, an all-time high for the company. According to the TTWO 2016 Annual Report, Grand Theft Auto V and Grand Theft Auto Online have exceeded expectations in each quarter since their release. Because microtransactions prolong user engagement and digitally delivered content increases profit margins, we anticipate TTWO becoming even more profitable as digital purchases grow in prominence.

Bear Case-Risk Factors

1. Decline of PC and Console Gaming

The gaming industry as a whole has enjoyed healthy growth, but its structure is shifting rapidly. For the first time ever in 2016, mobile gaming has overtaken PC gaming in total global revenue. Estimates project that mobile gaming will overtake console gaming by 2017. While PC and console gaming are expected to steadily decline, the mobile gaming segment will continue to grow.

Source: Newzoo

Rockstar Games released a mobile version of Grand Theft Auto: Vice City in 2012 for the game's ten-year anniversary. Users appreciated the improvements in the PlayStation 2-to-iOS conversion but criticized the touch controls. The following year, the label made Grand Theft Auto: San Andreas available for mobile devices, whereupon it received an 8.3/10 review from IGN Entertainment. Grand Theft Auto is a key revenue cog for Take-Two, so it is essential for management to develop comparable-quality Grand Theft Auto titles for mobile devices.

2. Uncharted Technologies

4K and HDR televisions are in the early stages of their lifecycle, and console makers are striving to stay on the cutting edge of picture quality. Microsoft recently released the Xbox One S in June. Sony will release the PlayStation 4 Pro in November. Both consoles are able to stream 4K videos, but neither possesses 4K gaming capabilities. Microsoft expects Xbox One Scorpio, the next installment in its console series, to reach retailers in Q4 2017 and offer true 4K gaming. Until then, the plausibility and popularity of 4K gaming remains to be seen.

Virtual reality is another trend adding uncertainty to the gaming industry. Sony just released PlayStation VR, a virtual reality headset companion for the PS4. Microsoft and Oculus Rift plan on releasing their version for the Xbox One in 2017. TTWO faces risk because in-house developers and licensed third-party software developers must account for virtual reality in future game releases. If the VR market proves unfruitful, then the company will have allocated resources in vain. If the VR market takes off, then the company may be prone to budget increases and development delays, as in the case of Grand Theft Auto VI.

3. Uncertain Grand Theft Auto VI Release

TTWO has not formally announced Grand Theft Auto VI, and there is no shortage of speculation on its release date. In our bull case, we anticipate a 2018 release, which would result in a major spike in revenue for fiscal year 2019. However, a more bearish scenario could see the release pushed into 2020 if VR compatibility were to be taken into consideration, delaying the revenue spike until fiscal year 2021. Because TTWO revenue can be volatile surrounding the release of a new Grand Theft Auto title, a two-year postponement would adversely affect revenue during those reporting periods.

Valuation

I. Relative Valuation. The market is placing a premium price on TTWO relative to the industry's average enterprise multiple of 11.95. Since the company is younger than its immediate competitors, we believe TTWO has excellent growth prospects.

Ticker

Company

Year Founded

EV (millions)*

EV/EBITDA

TTWO

Take-Two Interactive Software Inc.

1998

2,489.60

16.31

ATVI

Activision Blizzard Inc.

1979

30,680.60

16.92

EA

Electronic Arts Inc.

1982

17,215.10

15.72

MSFT

Microsoft Corporation

1975

339,982.40

12.68

SNE

Sony Corporation

1946

3,319.10

4.8

Euronext: UBI

Ubisoft Entertainment SA

1986

3,143.60

5.24

Industry Avg.

11.95

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Assumed Multiple

19.6

EV

4453.42

2016 EBITDA

227.3

- Net Debt

-771.7

MV of Equity

5225.12

Diluted Shares Outstanding

83.4

Fair Value: MV/Diluted Shares

62.65

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II. Discounted Cash Flow Analysis. We conducted a six-year discounted cash flow analysis for our bull case. Note that all data used for this analysis came from the Bloomberg Professional service. We made assumptions based on historical data for the purpose of establishing reasonable forecasts.

2016

2017

2018

2019

2020

2021

2022

Sales Revenue

1,413.70

1,574.86

1,754.40

2,631.59

2,931.60

3,265.80

3,331.11

Growth

11.40%

11.40%

50.00%

11.40%

11.40%

2.00%

COGS

813.9

906.68

1,010.05

1,515.07

1,687.79

1,880.20

1,917.80

COGS/Sales

57.57%

57.57%

57.57%

57.57%

57.57%

57.57%

57.57%

Gross Profit

599.8

668.18

744.35

1,116.52

1,243.81

1,385.60

1,413.31

Operating Expenses

372.50

414.97

462.27

693.41

772.45

860.51

877.73

Operating Expenses/Sales

26.35%

26.35%

26.35%

26.35%

26.35%

26.35%

26.35%

EBITDA

227.3

253.21

282.08

423.12

471.35

525.09

535.59

(D&A)

163.43

182.68

203.51

305.26

340.07

378.83

386.41

EBIT

63.87

70.53

78.57

117.85

131.29

146.25

149.18

Tax Rate

35%

35%

35%

35%

35%

35%

35%

(Taxes)

-30

24.68

27.50

41.25

45.95

51.19

52.21

D&A

163.43

182.68

203.51

305.26

340.07

378.83

386.41

D&A/Sales

12%

12%

12%

12%

12%

12%

12%

(MUTF:CAPEX)

37.3

40.95

45.61

68.42

76.22

84.91

86.61

CAPEX/Sales

2.60%

2.60%

2.60%

2.60%

2.60%

2.60%

2.60%

(Increase in NWC[CA-CL])

11.3

12.60

14.04

21.05

23.45

26.13

26.65

Increase in NWC/Sales

0.80%

0.80%

0.80%

0.80%

0.80%

0.80%

0.80%

FCF

208.7

174.98

194.93

292.39

325.73

362.86

370.12

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Assumptions:

Tax Rate

35%

WACC

9%

Perpetuity Growth

2%

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2016 PV of FCF

2017

160.53

2018

164.07

2019

225.78

2020

230.75

2021

235.83

TV of Growing Perpetuity

5,287.40

PV of Growing Perpetuity

3,436.45

EV

4,453.42

Click to enlarge

Appendix

Source: Bloomberg

Source: Bloomberg

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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