Take-Two's Q3 Earnings To Offer A 'Triple-Play' In Wake Of Grand Theft Auto V Delay?

| About: Take-Two Interactive (TTWO)

Take-Two (NASDAQ:TTWO) announces FY Q3 results Tuesday, February 5. Notwithstanding the continuing industry-wide slowdown, I'm predicting good results. The consensus is at $365M revenue and $.55 EPS. I expect $392M on the top line and $.73 below. I also think that management may raise full-year guidance, particularly the EPS range, on the back of these results, giving investors an earnings "triple play" (meaning beats on the top and bottom line, along with a raised outlook). Management guided Q3 revenues and EPS at $325M-$375M and $.45-$.60, respectively, and full-year guidance sits at $1.1B-$1.2B and $.00-$.20.

The very recent Grand Theft Auto V release date announcement -- pushing the title from FY Q1 14 until September -- led to a sell-off of ~7% (from ~$13 to ~$12 per share). I wrote the bulk of this earnings analysis last week and, in a moment of apparent prescience, had the following to say about such a possibility:

"I offer a final word of caution related to (what else) the Grand Theft Auto franchise. If something during the earnings call is interpreted in an unfavorable (or even ambiguous) light for TTWO's upcoming GTA V release, I expect that to outweigh anything FY 13 has to offer. I don't have any reason to think this will happen, although it would be nice to have a release date announced."

With that said, TTWO has gotten the bad news out of the way in advance of earnings, which is almost certainly a good thing! Moreover, the reaction to GTA V is understandable from a sentimental perspective, but it says very little about TTWO fundamentally. The company habitually delays games, and the later releases have not portended weak sales (e.g., Red Dead Redemption was delayed over six months). Next week's announcement may offer a short-term opportunity in this regard.

Below, find my projected Q4 statement of operations:

Non-GAAP Income Statement $ in thousands (CY) Q4 12E
Non-GAAP Revenue 391500
Revenue deferrals 7500
GAAP Revenue 384000
Software dev costs/royalties 60000
less stock-based comp 1500
Product costs 105705
plus def rev costs 2500
Licenses 27000
Internal Royalties 2000
Total COGS 195705
Non-GAAP gross profit 195795
% margin 50.0%
Selling and marketing 60000
G&A 32000
Research and development 18000
Depreciation & Amortization 2600
less-stock-based comp 5000
less re-org expense 0
less professional/legal fees 0
Total non-GAAP operating expenses 107600
Non-GAAP operating income (loss) 88195
Interest expense and other 3000
less non-cash interest expense 2000
Income (loss) before income taxes 87195
Provision for (benefit from) income taxes 2000
less non-cash tax expense 450
Loss (income) from discontinued ops 0
plus loss from discontinued ops 0
Non-GAAP Net income (loss) 85645
GAAP Net Income (loss) 71695
Non-GAAP earnings (loss) per share
Diluted* $ 0.73
*diluted EPS unadjusted for conv notes
Diluted Shares 118000

Revenue Drivers:

1. NBA 2K13: TTWO has been the sole player in the NBA category for the last three years. EA attempted to relaunch its NBA Live franchise this fall, but scrapped those plans amidst quality concerns (expect another try this year). 2K has reaped the rewards, selling-through more than 5M units in each of the two previous iterations. The current title, 2K13, is tracking ~30% above 2K12, selling-through 3.5M units in CY Q4. Sell-in should be higher, and I've modeled 4.5M units at a $45 wholesale price ($202.5M). Note that this title released the first week of October, and all sales will hit the top line.

2. Borderlands 2: This sequel has been somewhat of a surprise success, outpacing its predecessor so far (although the original sold-in 6M units over its three-year life). Released September 18, it sold-through 1.8M copies in its first week, and TTWO announced 5M units sold-in as of the end of October. By year-end, 3.9M copies had sold-through. I modeled 4M units in Q2 and 1M units in Q3. At $45 wholesale, that contributes $45M. Note that I have not modeled additional units sold-in after the late October announcement. I do not believe the available sell-through data warrants an increase, and I am also unsure how TTWO defines "sell-in." (i.e., are digital sales included?)

3. XCOM: Enemy Unknown: This strategy shooter is not one of TTWO's established franchises, but has sold-through .9M copies to date, more than likely enough to be profitable. Like NBA2K13, this was released in early October, and all sales will contribute to the quarter. I've modeled 1M units at $45 wholesale, for a contribution of $45M.

Summing these titles gets you to $292.5M, which leaves $99M to reach my revenue projection. Consider the following, which taken together, would need to assume the shortfall:

1. Catalog Sales: TTWO released a box set collector's edition ($60 retail) of its biggest hits in early November -- including GTA IV, Red Dead Redemption, L.A. Noire and Midnight Club -- which merits consideration. Unit sales numbers aren't available, and I did not model these sales explicitly. As is typical, other titles will contribute at reduced prices. Catalog as a percentage of sales was 25% ($57M) and 28% ($81M) in Q1 and Q2, respectively, led by the aforementioned GTA and Red Dead Redemption. Catalog sales were $80M in last year's holiday quarter, benefiting from a Red Dead Redemption "Game of the Year" edition. A similar level this year makes up much of the shortfall.

2. Digital Sales: TTWO will release five DLC (downloadable content) expansion packs at $10 per unit, two each for Max Payne and XCOM, and one for Borderlands. If we expect 10% conversion at installed bases of 2M, .5M and 3M, respectively, the top-line contribution is $8M (I think this is reasonably conservative). Digital sales also include mobile titles and full-game downloads, the latter of which I expect will be led by Borderlands 2, NBA 2K and XCOM (the latter two were available day and date for download on PS3, and 12 weeks post-launch on Xbox). Borderlands 2 and XCOM have also sold well on the PC, which I expand upon below. Digital revenues were 17% of total sales in 1H, and would contribute $67M in Q3 at the same rate (note that a portion of digital sales -- mobile as the exception -- will overlap catalog sales above).

3. Max Payne 3/Spec Ops: The Line/MLB 2K13: These three titles were released in CY 2012, and may offer some marginal benefit given the holiday sales bump. The former two titles were such disappointments, however, that it's questionable whether additional units were sold-in. For what it's worth and as mentioned above, TTWO has continued to roll out DLC for Max Payne 3.

Sell-through numbers were taken from vgchartz.com, and historical sell-in numbers were disclosed by TTWO -- a comment on both. I don't have access to vgchartz's estimation methodology, but I've found reported sales to accurately reflect sell-through data disclosed by publishers after the fact (unadjusted for such publisher releases, of course). Additionally, vgchartz, from what I've been able to gather, does not track digital sales. For example, a search of units sold on the iOS platform returns a grand total of zero. DLC is similarly absent (unless it was released as a standalone disc). This has an important effect on titles that sell well on digital platforms, namely the PC, but increasingly consoles as well.

The units modeled above are my projections for sell-in during the quarter. My forecasting process uses sell-through numbers as a baseline and estimates sell-in based on company announcements, historical sales figures and/or an inventory margin. For example, NBA 2K13 sold-through 3.5M units in the holiday quarter, which is about .9M copies ahead of 2K12 at the same time last year. TTWO has revealed that 2K12 sold-in at least 5M copies during its lifespan, and the company can be reasonably sure that 2K13 will do that at a minimum. As a result, my forecast calls for 4.5M sold-in, which allows for an inventory buffer, but doesn't stuff the channel should there be an unanticipated slowdown. By comparison, TTWO announced 5M copies of Borderlands 2 were sold-in as of the end of October, six weeks after release, and with just 2.9M units sold-through.

Risks To Revenue Forecast:

Risks to the revenue forecast are as follows:

1. Borderlands 2 sold-in significantly more than 4M units in Q2, bringing forward some portion of the 1M unit Q3 projection. The game launched 9/18, and TTWO had 12 days to sell-in additional units from the initial internal projection. Given that the original Borderlands sold-through ~25% slower in its first 10 weeks, I would imagine the initial inventory supply projection was in the 3M range (especially after the Max Payne failure). We do not know, however, how quickly TTWO was able to sell-in additional copies (my 1M estimate is based on strong Q2 results). Ex-catalog sales were $208M in Q2, meaning 4.5M units at $45 wholesale are possible (that assumes nearly zero contribution from MLB, NBA 2K12, Max Payne and Spec Ops).

2. NBA 2K13 sold-in less than the 4.5M units projected. This is self-explanatory, and may reflect cyclical conservatism or Q4 earnings management if it happens.

I believe these risks are mitigated by the following:

1. Digital sales have contributed increasingly to revenues ($58M last quarter vs. $27M a year ago). Borderlands and XCOM sold-through .8M units combined to PC customers by the end of the year, with sales of the latter outpacing PlayStation 3 sales. This PC performance (remember vgchartz reflects physical retail) bodes well for digital download sales, which I have not explicitly modeled (but will not overlap catalog sales for these newer titles). The PC community is well acquainted with downloading games, and anecdotal commentary suggests the download vs. physical sales split for popular titles can be as high as 50/50. Also noteworthy, Borderlands 2, as of January 25, was the top-selling daily download on Xbox Live more than a month after its December 18 release.

2. To the extent that one of Borderlands 2 or NBA 2K13 misses my physical unit expectations, the other could beat by the same amount.

3. Catalog sales have held up well on a sequential basis even as GTA IV and Red Dead Redemption age ($81M last quarter in a tough industry environment), which bodes well for the holiday quarter.

Margin Considerations:

I have gross margin at 50.0%, which is above Q3 guidance in the "upper 40s." If one assumes the mid-point of revenue guidance ($350M), gross margin comes in at 47%. The higher margin is a reflection of COGS leverage on more slowly amortizing software development costs, internal royalties (assumed to be minimal for 2K studio releases) and licenses. This would be the highest quarterly margin in the last 20 quarters, ahead of the holiday quarter last year (46.8%) and the blowout FY Q2 08 when GTA IV released (46.5%). This is not a surprising result. Holiday quarter gross margins have been in the mid-40s each of the last 3 years, driven by relatively low NBA 2K development costs and gradually increasing digital sales. Operating and other expenses reflect either explicit Q3 guidance or are extrapolated from full-year guidance based on historical trends and the product release line-up.

Industry Considerations:

NPD reported overall new physical software sales down 27% for December -- sales for the full year were down 22%. Electronic Arts (NASDAQ:EA) missed significantly on its top line. Why should we expect TTWO to beat the high end of guidance in such a hostile environment? Aside from the analysis above, I offer a few reasons for the unconvinced. Industry mega-hit Call of Duty is tracking 15% below its predecessor (3M units), the new and highly touted Halo title is flat versus its unremarkable predecessor, and there were simply less games released (EA, for example, had only one AAA release in the quarter compared to four in Q1 13). While these are industry-wide issues, they have little effect on TTWO (and may have even contributed to the company's strong quarter as consumers shifted purchases).

Raising Guidance?

Full-year guidance is at $1.1B-$1.2B and $.00-$.20 for non-GAAP revenue and EPS, respectively. With TTWO beating the mid-point of its range by $42M in Q3, there is potential for a raise. Management is bullish on its BioShock: Infinite title (essentially BioShock 3) due in March. Sales of the prior two iterations each hit 3.5M units, with the latest release in early 2010. Customers will be familiar with the title, and pre-orders are tracking ~25% above Borderlands 2 at the same time prior to its release. If sell-in for the quarter hits 4M units, I project full-year EPS at $.23 and revenue of $1.18B. If customer demand for BioShock is even more robust -- and the Q2 and Q3 releases continue to sell well -- guidance could move.

It is worth noting -- particularly in light of the GTA V announcement -- that BioShock has been delayed several times and, in December, was pushed from February to a late March release, which will limit secondary sell-in (and raises issue of further delays). The development studio has also experienced recent defections. This may not affect guidance issued, but is relevant for longer-term investors.


To summarize, I predict revenue and EPS beats with the possibility of an earnings "triple play":

Revenue: $392M vs. $365M consensus

EPS: $.73 vs. $.55 consensus

Guidance: Full-year revenue and EPS ranges have a marginal chance of being raised

TTWO is an interesting company. I hope to offer a more comprehensive article in the coming weeks detailing my outlook for the rest of FY 13 and FY 14 (spoiler: I am somewhat less sanguine than here). For now, February 5 may present an opportunity for traders so inclined.

Disclosure: I 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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