Is EA's Bid for Take Two Grand Theft?

About a week ago, Electronic Arts (ERTS) CEO John Riccitiello acknowledged many of EA’s past merger efforts proved disappointments. The post merger integration process, and EA’s style at the time, simply didn’t accommodate the needs of incoming creative talent. Effectively, the company ended up buying existing game titles but doing a poor job of leveraging the human capital behind them to build for the future.

Now, about 7 months after restructuring the company and creating an organizational hierarchy designed to better balance creative development and fiscal accountability, EA is setting out to prove they can acquire assets without stifling (and losing) their creative game development talent.

The first test of the new approach began several months ago with the acquisition of Bioware and Pandemic. The second test began to take shape Sunday.

In a press release, EA made public a proposal to buy struggling game developer Take Two Interactive (TTWO) for approximately $2b in cash. The offer price of $26/share, which was put forth in an open letter to Take Two shareholders, is a 64% premium over the company’s February 15th closing price and a 63% premium over their thirty day moving average. As a cash deal, there are no financing conditions attached to the offer. The only conditions are “usual and customary.”

Take Two has summarily dismissed the offer, along with a prior private offer from EA (at $25/share) as being “highly opportunistic” and occurring at “absolutely the wrong time.” The situation is not unlike Microsoft’s (MSFT) bid for Yahoo (YHOO). Both proposed acquisitions have targeted companies with strong assets but a stock price beaten down amidst competition and market forces. Both target companies are also in the midst of management restructuring and rebuilding (Take Two replaced its board and management in March). The offers are a direct referendum for shareholders to vote their confidence, pro or con, on management’s ability to effectively fix what’s been broken.

In the case of Take Two, these breaks have been substantial. In 2005, the SEC accused then CEO Ryan Brant, two former CFO’s, and the head of sales Robert Blau, with artificially inflating revenue for 2000 and 2001. Brant plead guilty in 2007 to lesser charges of falsifying business records. In March of last year, shareholders revolted and booted five of six board members including then CEO Paul Eibeler. The company has also been closely investigated for their stock option policies and sued for including hidden scenes of an adult nature (a concept now called “Hot Coffee content”) in some of their more risqué games including flagship franchise Grand Theft Auto. A class action suit on this issue, since settled, accused the company of violating consumer fraud statutes and misleading consumers. Financial woes, product delays (Grand Theft Auto IV was originally scheduled for an August 2007 release) and cash flow concerns are also lingering issues.

Since March 2007, when Take Two’s board was replaced by shareholders, the company has been trying to shed the specter of past management and to reassure shareholders they can unlock the value in their deep portfolio of creative assets. EA’s offer takes advantage of the market’s continued uncertainty. It’s also timed to predate the launch, and likely sales surge, associated with the release of their flagship franchise’s next title (Grand Theft Auto IV) in April.

If the deal goes through, it would help bolster EA against the competitive threat posed by the merger of Activision (ATVI) and Vivendi Games.

Like Microsoft/Yahoo, the plotline for this deal, and its eventual resolution, could see many shifts and swings. Here, an essential question is whether the same institutional holders (Oppenheimer Funds, SAC Capital Management, Tudor Investments and others) who installed current management just about a year ago will accept 64% as sufficient premium to move on, or will they trust the team they hired to yield a higher return.

A special website addressing shareholders has been set up.

SOME SIDE NOTES, FACTS AND FIGURES

• Take Two Management Structure
Take Two is currently run under a management agreement by executives from media/entertainment private equity firm Zelnick Media. Ben Feder, the current CEO, a principle at Zelnick Media, was formerly an Executive VP at News Corp. (NWS). Strauss Zelnick, the current chairman, was previously President and CEO of 20th Century Fox and BMG Entertainment (now Sony BMG). On February 15th, their deal was extended for five more years. Under its terms, they each receive a salary of just $1 but a management fee of $208,333 is paid per month to Zelnick Media (it was previously $62.5k). The approximately $2.5m in fees pays for the services of Zelnick, Feder and Karl Slatoff, another partner at Zelnick Media who serves as Take Two’s Executive Vice President. In addition to cash, Zelnick Media also has bonus potential for $2.5m/annually and up to 1.5m shares of restricted stock subject to performance milestones.

• Take Two’s Financial Condition
Take Two reported 4th quarter sales of $292.6m for a net loss of $7.1 m. Non Gaap Net Loss for fiscal 2007 was $81m or $1.13/share. But as of October 31st, 2007, Take Two had only $77.8m in cash or cash equivalents (cash flow issues, and the need for possible financing, have been a major component of ongoing merger rumors). They lost 64 cents a share in the 3rd quarter.

Sales to their 5 largest customers account for 51% or revenue in 2007. Best Buy (BBY), Wal-Mart (WMT) and GameStop (GME) represented about 39% of total revenue. Grand Theft Auto titles accounted for 13.1%, 22.4% of total net revenue for 2007 and 2006 respectively. Delaying Grand Theft Auto 4 from its original August 2007 release date hurt the company’s 2007 earnings.

As of October 31, 2007, they had approximately 1,900 full-time employees, approximately 877 employed outside of the United States.

• Game Franchises
Take Two’s sports division has content licenses with Major League Baseball, professional tennis leagues and the NBA. As part of the EA sports umbrella, (which just expanded its NFL license), the combined entity would take what is already EA’s market leading sports platform and make it even more dominant.

Take Two’s 2K casual gaming group was launched in 2007 and could be a natural compliment to EA’s increased focus on the genre.

A substantial portion of Take Two’s games are developed internally and wholly owned. This increases costs and makes the company somewhat dependent on a small list of titles to offset costs.

2007’s Bioshock, Grand Theft Auto and Carnival Games (Wii) have all proven hits. Bioshock, in fact, was one of the fastest selling titles in gaming history. The next installment of Grand Theft Auto (version IV) is widely expected to be a gaming blockbuster once released.

• Global Footprint
Sales in international markets accounted for approximately 31.3%, 39.4% and 39.8%, respectively, of Take Two revenue for 2007, 2006 and 2005. A combined EA/Take Two could potentially realize substantial gains by combining marketing resources and their assorted international business/sales operations.

• EA Revenue Predictions
In addition to recently expanding their NFL license, experimenting more online, and pursuing dynamic gaming initiatives, EA set significant revenue goals on February 13th. In an announcement delivered to analysts, John Riccitiello put forth a revenue goal of $6b for 2011 with at least $900m coming from digital revenue streams including downloaded content, subscription fees and in-game advertising. The growth in that prediction represents a 71% increase over expected 2008 revenue of approximately $3.5b.