Take-Two: Cheap Got Cheaper

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About: Take-Two Interactive Software, Inc. (TTWO), Includes: ATVI, EA
by: Edgar Torres H
Summary

TTWO has sold off roughly 35% from its highs, mainly in sympathy with the rest of the gaming sector, rather than something specific to TTWO.

TTWO's fundamentals have actually improved since RDR2 sales were better than expected.

The disparity between fair value and TTWO's current share price is too good to pass up at this point.

In my view, buying TTWO below $100 is going to prove very lucrative for investors over the long term.

Take-Two interactive (NASDAQ: TTWO) is such a fantastic stock, yet it has sold off. This type of fluctuations always fascinates me because it wasn't too long ago that investors were happy and glad to pay up almost 30% more for the same company. In fact, at the time the market was making new all-time highs, the Fed was raising rates, and there were a lot of uncertainties in the world (as always). Still, investors were happy and optimistic at that time.

Did cheap get cheaper?

Back in late October 2018, I argued that even when Take-Two was trading at $110-$120 it offered investors a good value. Still, the stock dropped another 20-25%. This was mainly due to the market-wide meltdown during 2018's fourth quarter.

Still, for me, TTWO is one of those stocks that you have to buy for the long term when the market offers you a deal you can’t refuse. That’s the beauty of the stock market. Sometimes it gets rational, and it provides you an even better deal a few months later. If you look at it just from an objective perspective, the fundamentals of Take-Two Interactive have not deteriorated by 35%+ (measured from all-time highs) as the share price might suggest. TTWO has been sold off because of "fears" and "uncertainties".

Quite to the contrary, TTWO released Red Dead Redemption 2 which was an absolute success with gamers. Analysts were expecting roughly 15.5 million copies sold during its first year. To me, this was ludicrous as even on the low end of any reasonable analysis, RDR2 looked extremely promising (I used GTA V and RDR1 as benchmarks). I forecasted that RDR2 would sell at least 18 million copies during its first year. Still, TTWO managed to shatter that forecast as well and has sold more than 23 million copies so far. Overall, it fell in line with what I was expecting, but it's worth noting that it destroyed analysts' forecasts.

If RDR2’s sells 30% of its total inventory during its first year and achieves only 60% of GTA V’s total sales, then that would imply about 18 million RDR2 copies sold during its first year (100 million x 60% x 30%). However, imagine if RDR2 is 80% as good as GTA V was. That would imply a whopping 24 million RDR2 copies sold. It would completely shatter analysts' expectations. – Edgar Torres H, Seeking Alpha.

In my view, TTWO's fundamentals still justify a $150 valuation (you can read my valuation in the linked article). After all, if anything, the company's fundamentals had only strengthened since October 2018 when it started selling off. Cheap got cheaper, but that's good for smart investors with enough courage to pull the trigger.

Numbers don’t lie

That argument alone could make a case for Take-Two Interactive being a good investment at this point. I don't think TTWO was ever overvalued. I believe it offered a reasonable upside for investors even at $130-$140 (given the current market circumstances at the time). However, now the Fed has signaled that it won't keep raising rates for the foreseeable future. Furthermore, people are even talking about the possibility of negative interest rates at some point. If you take those assumptions seriously then purchasing Take-Two Interactive shares right now it's a no-brainer – from a valuation perspective.

Of course, this is a necessary assumption that might or might not be right in the end. It's reasonable to think that the Fed almost crashed the market in October 2018, and then it saved it on January 2019 when it backtracked its hawkish statements. In general, a dovish Fed will always be favorable for stock prices (the reverse is equally valid), and TTWO won't be the exception. Still, TTWO is now 35% cheaper, which put differently, it now offers 57% more upside, and it's 57% safer (see the example below).

Pullbacks can be very profitable for long-term investors.

TTWO relative valuation thoughts

I genuinely believe that this is one of those opportunities that come by once in a while. At a 17 forward PE ratio TTWO appears undervalued given its forecasted growth of 23%. This would result in a PEG ratio of 0.74, which by itself places it well below the rest of the market. For example, the S&P 500 (as measured by SPY) trades at a PE ratio of 16.5 and is expected to grow at 7.61% until 2020. This would imply a market PEG ratio of 2.16! Hence, TTWO is the better deal by this metric.

Today's market conditions are unique. I wouldn't say this market is "normal". Right now some people are arguing that the bull market ended in 2018 after it dropped below the arbitrary 20% threshold, and there are others who claim that January’s sharp recovery means that the bull market still lives. So it is difficult to say whether or not we're in a bull or bear market right now. One thing's for sure though. You're getting more value as an investor in TTWO now than what the market is offering everywhere else on average (as measured by the SPY’s PEG ratio).

This is why I recently purchased Take-Two Interactive under $90. I think anything below $100 per share is a steal. I was waiting for it to drop a little bit more, but now it’s just too good to pass up. Still, if the current market optimism fades and there's another market-wide pull back, then I will gladly buy more shares at a lower price. Because, as I previously mentioned, nothing has fundamentally changed regarding the company's fundamentals.

Source: TTWO’s online microtransactions. I’m a happy shareholder who enjoys selling in-game content to gamers.

Addressing the big elephant in the room

Nevertheless, I do want to take the opportunity to discuss something that maybe many investors are focusing on right now. The current battle royale trend has captured many gamers and companies by surprise. It is a very addictive game mode, and I think there's a lot of money to be made there for companies. However, investors need to make a clear distinction between the type of games that Take-Two Interactive develops and videogames from other companies (like EA or ATVI for example) that compete with titles like Fortnite or Apex Legends.

TTWO has been sold off roughly 35% from its highs, mainly in sympathy to the rest of the gaming sector, rather than something specific to TTWO. TTWO

Battle Royale statistics: A huge gaming trend that won’t hurt TTWO, but will actually help it boost profits. RDR2 also has a well-received battle royale game mode, and GTA 6 will likely eventually offer a great battle royale experience there as well.

The difference between Red Dead Redemption or GTA V and Fortnite cannot be understated. It is almost like the difference between selling wine and selling soda. In one, you can completely immerse yourself, and there's a depth of taste and flavor that you can appreciate, while the other one will quench your thirst with sugary water.

I believe that Take-Two Interactive’s games are like wine or scotch. RDR2 or GTA V allows gamers to immerse themselves in a world completely different than their lives. Players who purchase RDR2 are looking for a completely different experience than players who play for free Apex Legends or Fortnite. TTWO's games are unique and offer different experiences to gamers. This is why I don't think that Apex Legends or Fortnite are a threat to TTWO's games.

However, Electronic Arts and Activision Blizzard do have exposure to the battle royale genre. Those two companies will likely see their profits hurt due to Fortnite. Thus, investors are rightfully worried about these trends there. But Take-Two Interactive is an entirely different animal in my opinion.

Regardless, it seems that traders are selling off TTWO in sympathy with EA and ATVI. This creates an opportunity for investors who recognize this and can snap shares cheaply at these levels.

Two profit pillars: RDR2 and GTA V will easily sustain TTWO until the eventual release of GTA 6, which should be another huge success. This will drive growth for years to come.

Conclusion

The market, by nature, will always fluctuate, and sometimes it will go in your favor and sometimes against you. Savvy investors make great stock picks in terrific companies at attractive prices, and when the stock goes against them, they add more. Thus, I think that a simple “buy and hold” strategy of Take-Two Interactive at these levels should outperform the market over the long term.

It is currently undervalued (according to the PEG ratio and relative to the market) and oversold in sympathy for circumstances that don’t affect the company directly. In my view, this offers an opportunity for investors willing to buy the fear in an otherwise fantastic video game company. I do not know what the future holds, but I do know that in the past this strategy has worked consistently for investors. Hence, my money is on TTWO for the long term at these price levels. It's genuinely a fantastic investment opportunity at this point.

Thank you for reading and good luck.

Disclosure: I am/we are long TTWO. 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.