We think that it is important to point out that U.S. industry software sales have grown by over 58% from the November 2005 – January 2006 period through the November 2007 – January 2008 period, while Take-Two’s publishing revenues have declined by almost 23%. This is clearly a company that is losing market share, and as we review the lineup for the balance of 2008 and 2009, we see more of the same type of games we have seen over the last three years. The company’s sports lineup continues to underperform, generating only $32 million of sales (26% of publishing revenues) for the key holiday period. This figure calls into question whether Take-Two can deliver sports revenues of $250 million for FY:08, as management implied in a prior earnings call.
As we look at Take-Two’s lineup, we see GTA IV, and several games that look much like Take-Two games from past years. We are fans of Midnight Club, but question the decision to delay the game’s launch into the competitive Burnout and Need for Speed window as ill-advised. We also note that the Q4:08 launch of Midnight Club will mark 3 1⁄2 years between versions of the game, highlighting Take-Two’s failure to “sequelize” its key franchises on a regular basis. In commenting about the company’s broad portfolio of franchises, its Chairman mentioned games like Max Payne (last released at the end of 2003), Red Dead Revolver (last released in May 2004) and Mafia (last released in January 2004). We note that only a Mafia sequel has been announced, and it is scheduled for 2009 release, meaning that (unless management surprises us) sequels to these key franchises will require five or more years of development. It is true that management mentioned a “Rockstar sequel” some time in 2009, and we assume that this is Red Dead Revolver, based upon the display of a trailer at Sony’s May 2006 E3 event.
Instead of delivering these “franchises”, Take-Two management has promised us games like Top Spin 3, Don King Presents: Prizefighter, and Carnival Games: Mini-Golf. These games appear to us very much like the Manhunt, BIGS, All-Pro Football, Ghost Rider and Fantastic Four games of last year, when the company generated a net operating loss of more than $100 million. We think games like Civilization Revolution and Midnight Club Los Angeles will perform quite well in FY:08, but are reminded that games like Bioshock, The Darkness and Carnival Games performed quite well in FY:07.
So in the final analysis, FY:08 looks just like FY:07, with one glaring exception: GTA IV.
Now, we must admit that this is a whale of an exception. We estimate that GTA IV is likely to sell over 9 million units during the fiscal year, and think that the company will likely ship 6 million units in its first week, and will sell 3⁄4 of that amount in a brief period of time. The performance of GTA IV will thus be responsible for more than 100% of Take-Two’s earnings for the year, and the game is likely to mask the underperformance of the rest of Take-Two’s portfolio. We think that GTA IV will generate around $450 million of the company’s expected $1,073 million publishing revenue this year, and will generate an operating profit of around 30%, or $135 million. At the high end of company guidance, Take-Two will generate operating income of around $130 million, meaning that the game is responsible for 103% of overall company operating profit.
Management repeatedly mentioned GTA IV “downloadable content” during the call. We expect this content to be well received, but note that Take-Two has received a $50 million cash advance for two installments, and has booked $25 million in deferred revenue for the first installment. This suggests to us that the company will recognize earnings, but no cash, from the first installment until its overall revenues exceed $35 million (assuming Microsoft retains 30% of total revenues). This implies that Take-Two will have to generate over 2 million downloads (assuming a $15 per download price) on the Xbox 360 before it sees any more cash from this content. We expect around 6 million copies of GTA IV to be sold to Xbox 360 owners, and believe that around 65% of Xbox 360 owners are Xbox Live members, so the company has to sell a download to 50% of its addressable market in order to generate cash from the first download. This is possible, but not highly likely.
In summary, Take-Two is pretty much the same company it was over the past three years, but has the good fortune to have GTA IV coming out next month. The game will mask recurring problems from the rest of the company’s operations, and calls into question the value of the rest of Take-Two’s business. At the high end of guidance, Take-Two will approach breakeven in FY:08 from the rest of its lineup, with GTA IV likely to generate lower revenues in FY:09. This suggests to us that the rest of Take-Two’s lineup will be even more important, if the company is to grow earnings in FY:09. We see nothing in the lineup for FY:09 that is any more exciting than this year’s rest of lineup or than last year’s rest of lineup.
This leads us to the conclusion that shareholders should jump at Electronic Arts’ “proposal” to purchase the company for $26 per share in cash. At the high end of guidance, EA’s offer reflects an EV/EBITDA valuation of 15.4x. At this same valuation, Activision would trade at $25.88; THQI would trade at $34.71; and Electronic Arts would trade at $43.68. Given that all three companies have generated profits for the last two years while Take-Two has not, we think that EA’s offer valuing Take-Two at the same valuation it and Activision receive is extremely generous. THQ trades at barely 50% of this same valuation, given investor concerns about the company’s licensed portfolio. We find Take-Two management’s statement that the EA offer reflects a “significant discount to its peers” as disingenuous at worst, and misinformed at best.
We noted in the preceding paragraph that EA has a “proposal”. The company’s proposal consists of a recitation of its two offers for Take-Two, and recounts the two rejections it has received from Take-Two’s management and board. At present, there is no tangible offer for shareholders to accept, which may have precipitated the sale by Take-Two’s two largest shareholders of a significant portion of their holdings, representing around 22% of outstanding shares. The absence of any recent 5% filings, coupled with the stock price dropping below $25, suggests to us that a large number of shares are in the hands of arbitrageurs, and indicates that a firm offer at $26 would be accepted by shareholders, even if rejected by management.
So what happens next? We envision a very proud EA making a firm offer of $26 for Take-Two shares. We expect that in order to save face, Take-Two management will withdraw its demand that any discussions wait until after the launch of GTA IV (conveniently scheduled 19 days after the impending shareholder vote on additional stock compensation for ZelnickMedia), and we think that management will engage in discussions with EA. We think that EA prefers to complete a friendly deal, and think that it is possible that Take-Two management can convince EA of the extent to which EA may have undervalued Take-Two shares, and believe that as a conciliatory gesture, EA management may be prepared to increase its likely $26 offer to somewhere close to $27. Again, we think investors will jump at the offer.
We expect that all of this will transpire within the next few weeks, and are confident that an offer will be presented prior to Take-Two’s scheduled annual meeting on April 10. EA’s “proposal” makes clear that its offer applies to all outstanding shares as of last month, and does not include any additional stock that may be paid to ZelnickMedia. In other words, should shareholders approve the grant of restricted stock proposed by Take-Two’s board, the grant would be funded by reducing the share price to be paid by EA. If roughly half of the stock vests on change of control, this would reduce EA’s final offer by around $0.25. We don’t expect shareholders to approve the restricted stock grant, but stranger things have happened.
We reiterate our HOLD rating on Take-Two and our $26 price target. We think a deal is highly likely to come to fruition in the next few weeks, and think that Take-Two shareholders should expect a $26 offer. Depending upon the stance taken by Take-Two management, this offer (or something slightly higher) will either be accepted, or we believe EA will walk. Should EA withdraw the offer and abandon its pursuit of Take-Two, we will re-evaluate our rating and price target.