Summary

At its current price, Take-Two Interactive (“TTWO” or “the Company”) represents a compelling opportunity to invest in a company with significant secular tailwinds and a strong margin of safety against permanent capital impairment due to the recurring nature of its cash flow streams originating from its market-leading franchises.  The market continues to view TTWO as a hit-driven video game company even though more and more of its revenues and profits are being derived from its portfolio of evergreen IP.  With category-killing titles that face little to no competition in games such as Grand Theft Auto, NBA 2K, Red Dead Redemption, and Civilization, TTWO has one of the strongest IP portfolios in the video game industry as well as one of the most thoughtful and aligned management teams led by CEO and Chairman Strauss Zelnick.

Though the stock has retreated over 20% from all-time-highs due to short-term concerns around difficult COVID-19 comparisons, we believe this is a prime opportunity to buy a quality company at a reasonable price.  We believe there are sightlines for the stock to double in three to four years as the Company executes on its pipeline of games and continues its transformation towards a “gaming-as-a-service” (GaaS) business model.  Just as important, there is limited downside at the current price, as TTWO has high strategic value to a significant range of potential acquirors. In a “downside” scenario, TTWO’s management team is heavily incentivized to sell the Company and in such a scenario the Company should still be worth $190+/sh.

Description

Take-Two Interactive is one of the largest "AAA" (equivalent to film industry's "blockbuster") game developers in the world, with a portfolio of studios that includes Rockstar Games (Grand Theft Auto, Red Dead Redemption, Max Payne, Bully), 2K (NBA 2K, WWE 2K, Bioshock, Borderlands, Civilization), Private Division (which formed in Dec 2017 that publishes indie games developed by SMID studios), and T2 Mobile Games (develops FTP mobile and social network games). Aside from NBA 2K and WWE 2K, TTWO has primarily focused on publishing high-quality and complex video games that take longer and cost more to develop than games developed by peers.

Key Thesis Points 

1)      Strong secular industry tailwinds

Even prior to the COVID-19 pandemic, video games entertainment had been growing for years. The $208bn global video game industry has been growing at a MSD to HSD clip year after year, and this is expected to continue into the foreseeable future. While the video game industry is already bigger than the global film and music industries combined, there are few signs that this growth will stop anytime soon. Much of this growth is a result of the strong value proposition of video games (cheap, highly engaging entertainment that one can enjoy with their friends), which is driving consumers to spend less time watching TV and increasingly more time on video games (the average American is spending 40% more time on video games since 2012). The trend of increasing video game consumption at the expense of other entertainment activities is likely to continue.[1]

The COVID-19 pandemic turbo-charged the growth of video games and engagement reached a new level, with many more people depending on video games to socialize with their friends and to entertain themselves indoors.  Video games have increasingly becoming the preferred form of entertainment for many people, especially younger generations, which will drive future growth for years to come.

The secular growth of video games should be durable as demographics (i.e. millennials were the first generation to grow up with video games and have largely continued engaging even as they reach middle age) and innovation in distribution technology (i.e. game streaming and faster internet will decrease the barrier for consumer adoption) will continue to increase the population of potential gamers.

2)      High and increasing barriers to entry / “winner-takes-all” industry

AAA video games are very capital-, labor-, and time-intensive to develop, with new AAA titles costing between $100-500mm and 3-7 years to develop and market, with no guarantee of success.  Video game development costs have skyrocketed because of geometric expansion of project complexity and staff.  Not only is processing power / game size scaling at a geometric rate (and thus requiring more complex coding), but the required staff to coordinate and develop a game is also rising geometrically.  For example, a 16-bit game developed in the 1980s would only require 1-4 people and $50-300k of development cost, while a Nintendo 64 game cost on average $1-3mm to develop in the 1990s.  By 2008, a AAA game developed on a PS3 or XBOX 360 cost $20-50mm to develop, which has since ballooned to $100-400mm (with hundreds of people on staff) on the current generation of consoles / PC.  This dynamic has resulted in significantly higher unit break-evens for AAA video games (average unit prices have barely increased over the last 20 years) and thus increasing financial risk for developers, which increases the barriers to entry.  As a result, IP and network effects are becoming more important to the financial success of video games than ever before.  For example, in 2000 four of the top ten best-selling video games were not established franchises.  In comparison, between 2000-2017, there was only one year where more than one of the top 10 selling video games was not an established franchise.  Over the last 10 years, this trend has accelerated as the top 10 console games as a % of total units sold has gone from ~19% in 2008-10 to ~30% in 2018.[2] (Source: Raph Koster, data set of over 250 games and their development cost)

3)      Unmatched IP portfolio with huge pipeline for future growth

TTWO’s reputation for excellence is unmatched in the industry, as it owns three of the most successful video game franchises of all time (GTA, Red Dead, NBA 2K).  The top two rated games (according to Metacritic) for the XBOX 360, XBOX One, PS4, and PS3 are all TTWO franchises, with TTWO claiming 4 of the top 10 highest rated titles for both the Xbox 360 and PS3.

Grand Theft Auto V and its associated Grand Theft Online is the most successful entertainment product of all time (by revenue generated), having generated over $7bn of revenues since its launch 8 years ago in 2013 and continues to generate $800-1bn of revenue a year for TTWO.  Incredibly, Grand Theft Auto V sold 15 million units, which would be a great number for a newly launched game, in TTWO’s FY2021 (ending 3/31/2021) despite it being a 7-year old game.

Looking forward, TTWO has a massive pipeline of games that it plans to launch over the next few years as the Company has been aggressively expanding its developer headcount and building its pipeline.

A major knock on TTWO recently has been the fact that the Company has not released many new titles in FY20-22 and has instead been primarily growing through releasing content for its existing titles.  We believe this is the correct strategy for TTWO for a simple reason: the new generation of video game consoles, PS5 and XBOX Series X/S, have just launched and the install base is currently still very small.  It wouldn’t make sense for TTWO to rush and launch next generation games before the install base of the PS5 and Xbox Series X/S reach critical mass.

A patient, long-term investor who recognizes this fact would conclude that TTWO is likely currently underearning its potential as the Company waits for the next-generation install base to grow.  Unlike other game developers, TTWO emphasizes quality and allows its studios full autonomy in determining when and how a game is released. Take-Two, Rockstar, and 2K have some of the highest Glassdoor employee reviews of any video game developer, and are thus able to attract top notch talent.

While this strategy frustrates short-term investors who want tangible near-term catalysts, long-term investors would recognize that a delay of a few quarters or even years is worth it if the final product is a critical and commercial success.  There is no better evidence of this than the botched launch of 2020’s most hyped game (and supposed competitor to GTA), Cyberpunk 2077, which was rushed to production and was widely panned by critics and gamers.

“We’re kind of unique in that we’ve been saying forever, we don’t believe in annualizing nonsports titles, and we don’t. And we make sure to give all of our studios the time needed to create something that’s absolutely extraordinary. That approach has served us well. We now have 11 franchises that have each had at least one 5 million unit release… I think we have the best collection of owned IP in the business. The only reason that’s the case is because we have the most talented creative folks. We not only allow them to, but we insist that they pursue their passions.” – Strauss Zelnick, 12/15/2020 MKM Partners Conference

4)      Margin expansion and more predictable revenue stream as recurrent consumer spending (“RCS”) becomes a bigger portion of the revenues

A major knock on TTWO historically has been the unpredictability of its gaming releases, which created lumpiness in its revenues / profits.  However, in recent years, TTWO has been significantly increasing the share of “recurrent consumer spending” (RCS) in its revenue base, which are generated through monetization of existing games and not through new game sales.  The growth of “gaming as a service”, which includes downloadable content, in-game microtransactions, and expansion packs makes TTWO less reliant on new game releases and also significantly increases profitability as RCS typically has much higher margins (>60-70%+ gross margins) than new game launches. Indeed, TTWO’s adj. EBITDA margins have expanded by over 1000bps from 2016 to 2021 (from 17.7% to 28.2%) as RCS has gone from 18% of bookings to 64% in FY21.

TTWO’s long-term revenue mix is likely to continue to trend towards more RCS revenue, as each successful launch of a new title in upcoming years will likely lead to development of “follow-on” RCS revenues in the form of downloadable content, in-game microtransactions, and expansion packs.

5)      GTA franchise likely to see a step function change in revenue and profitability in coming years, driving significant earnings growth for TTWO

While GTA VI may still be a couple years away (likely FY24 or 25), we believe the market is underestimating the potential of GTA Online to take a step function up in terms of earnings power.  GTA Online was designed off the 2013 architecture of GTA V, which in turn made the game highly difficult to scale as a platform. TTWO / Rockstar didn’t expect that GTA Online would be as successful as it has been and the game has been updated in piece-meal way, which has limited the Company’s ability to easily develop new content.  We believe this will change significantly as TTWO re-engineers the design of GTA Online and there has been considerable industry chatter that GTA Online will likely become an “ever-green” property once it has been redeveloped for next-generation consoles (standalone GTA Online is launching in CY4Q21 for PS5 + XBOX Series S/X), and will see more frequent content drops and map expansions over time.  There is an opportunity for GTA Online to become a “metaverse” and broaden its appeal to even more gamers and activities.  Even today, GTA Online continues to routinely occupy the #1 most watched Twitch game despite the age of the game, and we believe TTWO will have learned a lot about the game and will incorporate more ways of monetizing / engaging players.   

6)      GAAP accounting obfuscates true earnings power of the Company

Given TTWO’s significant investment in its future pipeline of games, its current “run-rate” earnings are understated due to the significant investments it is making in research and development. TTWO notes in its 10-K that it “capitalizes internally developed software costs, subsequent to establishing technological feasibility of a product.”  These software costs are then amortized through Cost of Goods Sold (COGS) once the game is launched.  However, for games that are in early development (at the discretion of TTWO), R&D expenses flow through the income statement and is netted out against the Company’s current earnings.  This accounting methodology means that the Company’s true earnings are understated and penalized when it is investing heavily in the future pipeline of games.  Consider that for an asset-intensive tangibles-heavy business such as a manufacturer or a retailer, investment in its core tangible assets largely flows through the cash-flow statement and the Company’s current earnings are not being penalized by investments in future growth.  Given TTWO is currently investing $250-300mm+ in its future pipeline through R&D, its “run-rate” EPS is being understated by over $2 per share as “maintenance investments” are already being captured through TTWO’s COGS.

Furthermore, the Company’s heavy investments in its pipeline in FY22 (for games largely to be launched in FY23+) is manifesting itself in a significantly higher overall opex ratio than historical, with management guiding to ~41-42% of opex to bookings ratio in FY22 vs. a historical ratio closer to 31%.  Unless an investor simply believes that these investments are here to stay forever in some structural way and are not investments in growth, the earnings power of TTWO in FY22 is closer to $6.25 per share and perhaps even $8+ / share (once we account for the $200-300mm of R&D still flowing through the income statement).

7)      Highly incentivized management team with a track record of execution

TTWO is led by Strauss Zelnick, Karl Slatoff, and their team at ZelnickMedia. Zelnick stepped into the role of Chairman at TTWO back in 2007 and then CEO in January 2011, when the Company was reeling from an accounting scandal and poor management.  Under Zelnick as CEO, TTWO has transformed itself into a highly cash generative business rich with category-killing IP, and the stock has nearly doubled the annual return of the S&P 500 at 27.5% per year (vs. 14.8% total return CAGR for the S&P 500). Strauss Zelnick has consistently taken the long view with TTWO and is known as a hard-working, efficient, and humble manager who knows how to delegate effectively.

Zelnick is also highly aligned with shareholders as the vast majority (75%) of ZelnickMedia’s performance-based stock awards are tied to relative 2-year TSR performance to the Nasdaq Composite.  Zelnick (through a combination of shares held in several trusts as well as shares held by ZelnickMedia) has roughly $94mm (589k shares) of exposure to TTWO’s share price.

TTWO’s management team has a history of under-promising and overdelivering when it comes to guidance, as the Company typically only underwrites the most conservative of future outcomes (i.e. something that is truly a “floor” for them).  Over the last 5 years, the Company has on average beaten its own initial guidance by 24% and 77%, for bookings and EPS, respectively.

While management is generally very conservative when it comes to its own guidance, recent comments made by management regarding its future highlight that even under conservative lenses, management expects TTWO’s EPS to reach new records within the next few years as its pipeline of games are launched.

“We believe that we’ll achieve sequential growth in fiscal 2023 and establish new record levels of operating results over the next few years” – Strauss Zelnick, 1Q’22 earnings call

8)      Margin of safety as takeout candidate

The video game industry has been undergoing significant consolidation and we believe TTWO would be a prime target if the Company were to put itself up for sale. The ongoing consolidation of the industry is primarily a result of the battle for content as game streaming platforms like Microsoft’s Game Pass, Google’s Stadia, Sony’s PlayStation Now, and Amazon’s Luna compete for subscribers and exclusive content. In more recent months, Netflix made its own big hire that signals the Company is also likely looking to make its own game streaming platform as it recognizes that video games are likely the biggest competitor to its existing business. As we’ve seen in non-interactive entertainment, content becomes king when new channels of distribution are developed. Beyond the streaming platforms, larger publishers like EA or Activision could also be candidates to acquire Take-Two as both have been highly acquisitive and continue to seek scale.

As examples of the consolidation trend, in 2020, Microsoft paid $7.5bn in cash to acquire Zenimax (the parent Company of Bethesda) at an estimated EV / Bookings ratio of ~6x and Codemasters was acquired by EA for ~$1.2bn or roughly 10x EV / Bookings. We believe that Zenimax’s multiple is likely a floor for TTWO as Bethesda has somewhat similar (but inferior content with less RCS capabilities) titles to TTWO’s games even though its last major launch was a flop. This range of multiples implies TTWO would be worth $188 to $300 per share in a sale.

Price Target

To estimate the price target for TTWO, we break down the company into two discrete pieces: GTA and non-GTA revenues. GTA VI will likely be likely be the biggest entertainment launch of all time, and, given that GTA V has sold an average of ~20mm / yr since its inception, we believe it wouldn’t be a stretch to believe that GTA VI will average 30mm unit sales per year in the first 3 years of launch.  We also believe that GTAO will likely get a boost from the launch of GTA VI as Rockstar has been working on a GTA Online standalone game that will likely significantly improve the game’s monetization.  Based on the assumptions above (as well as datapoints taken from our research about the development of the game – including rumors the development of the game will cost ~$500mm+), we estimate that GTA should generate ~$7 of EPS for TTWO alone starting in 2024.

As for the rest of TTWO’s portfolio of games, we conservatively estimate that the portfolio should be able to grow at least 10% / yr, which, given TTWO’s massive pipeline today, should be easily achievable.  We believe that this pipeline should be able to generate ~$5-6 of EPS on a run-rate basis for TTWO, with significant upside if some of the games in the pipeline are extended through RCS.

Combined, we believe that TTWO should be able to achieve a $12+ run-rate EPS in a few years.  In addition, the Company is generating significant FCF (~$22 of net cash per share today + estimated $8 / share of FCF in FY22+23) and we believe will have at least $30 of net cash per share.  Putting a 22x NTM P/E multiple on the Company, we arrive at a $313 per share price target at 12/31/2023.

As mentioned earlier, we believe a downside scenario here would still value TTWO at over $180 per share as the Company is currently trading at below the multiples that Zenimax and Codemasters were acquired for in 2020. Zelnick would be heavily incentivized to sell the Company, should there be missteps along the way in terms of execution. 

Overall, the risk / reward dynamic for TTWO is highly asymmetric for the long-term investor. Investors that are willing to look past the quarterly volatility caused by short-term, catalyst-driven investors are likely buying TTWO today at a significant bargain to its long-term intrinsic value.

Risks

-          Execution – TTWO could always mess up on the execution and it’s certainly had some mixed game launches, with the most recent one being WWE 2K having been cancelled for a year due to poor reviews. Further, it’s arguable that Red Dead Redemption Online has not lived up to its expectations as a potential successor for GTA Online, although we believe that’s likely due to the nature of Red Dead Redemption’s game play (i.e. being a Western-based game in the 1800s).

o   Mitigant: Overall, TTWO’s management team has an exceptional track record with respect to major game launches and will not hesitate to delay releases in order to perfect the game.

-          Free-to-play threat from Fortnite / PUBG / etc. – it’s possible that consumers continue to gravitate towards FTP games like Fortnite, PUBG, DOTA, etc. and immersive open-world games like GTA loses favor

o   Mitigant: These games have been out now for several years, and GTA continues to put up record numbers with record engagement and followership. There are also no real challengers to GTA, Red Dead Redemption, or NBA 2K in their own categories at this point.

-          Regulatory risk in in-game monetization -  the FTC has looked into loot box mechanics (primarily used by NBA 2K) as to whether they are gambling devices and other European countries have forced changes in the way NBA 2K monetizes (moving away from loot boxes) as well.

o   Mitigant: Specific loot box mechanics are a relatively small % of TTWO’s revenues (accounting for <10%) and despite noise around regulations 2 years ago, nothing has come from it in the US since then.  

-          Console video games lose relevance to mobile games – the vast majority of TTWO’s revenues come from console games, which makes it susceptible to platforms like mobile gaming.

o   Mitigant: Judging by the incredibly high and on-going demand for the PS5 and XBOX Series S/X, consoles haven’t lost much relevance. Console games are generally much more complicated and sophisticated than mobile games.