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Why Take Two must accept EA's offer

Why Take Two must accept EA's offer
We disagree with both thoughts.

In our view, EA is serious when it said that it reserves to withdraw its offer, and that Take-Two will not be worth as much in the future as it is today. As we consider the possible benefits to EA from a combination, it is clear that EA would be able to pay much more for Take-Two. However, we think that the “right” purchase price is determined in light of the next best alternative for investors. We believe that the next best alternative value is well below EA’s $26 offer, and think that EA can reinforce this point by withdrawing its offer.

Take-Two doesn’t really have any other options. If a second bidder doesn’t surface (we think a second bid is extremely unlikely), Take-Two has no real leverage. We don’t think it is credible for management to ask shareholders to trust them to grow the business and earnings to the point where a $26 share price is warranted at today’s multiples.

Synergies
We think that EA plans to combine Take-Two’s sports business with its own, and will likely generate around $300 million in incremental revenue from sports. This figure is derived by adding Take-Two’s sports revenues (expected to be around $220 million in 2008) plus around $40 – 50 million in higher pricing on EA’s other $1.25 billion in sports revenue, plus around $20 – 30 million in higher revenues from more focused marketing. We believe that by combining sports businesses, EA will be able to maintain sports pricing past the holidays, where in the past, it has discounted sports games before Christmas due to competition from Take-Two.

We also think that there are tremendous synergies to be gained from consolidation outside of sports. Take-Two has several valuable franchises, including Civilization, Bioshock, Midnight Club, Max Payne, and of course, Grand Theft Auto. In addition, the company has developed games that we consider more “one off” hits, like Mafia, Manhunt, Red Dead Revolver, Bully, Carnival Games and Table Tennis. We think that some combination of these games can be produced each year, with the first five “franchises” produced on a two-year or three-year cycle, and with the other games produced every three years. We estimate that these games (excluding Grand Theft Auto) would generate approximately $150 million in annual predictable revenues.

Grand Theft Auto is a case study in and of itself. The game could likely be released every two years, but its success and profitability will depend upon whether the creative talent responsible for the first four versions is retained, and upon the price commanded by this talent for their contribution. We think that ownership of the intellectual property and game engines would allow EA to make the game itself and generate around $150 million every other year without contribution from Rockstar North. With the current creative team in place, it is more likely that the game will generate closer to $600 million every other year.

Value to EA

Taking the revenue estimates in the preceding section, EA is positioned to generate significant operating profit. If it captures $300 million in incremental sports revenues, it will likely capture around $150 million in incremental operating profit. This figure is calculated by burdening the sports games with $50 million for the Major League Baseball license, $20 million for other sports league royalties, $20 million in incremental R&D spending, plus $60 million in console manufacturers’ royalties.

The $150 million from non-GTA games will likely carry an operating profit of at least 35%, as the intellectual property is wholly owned. This figure presumes that EA will pay the teams responsible for these games a disproportionately large bonus, as the historical contribution margin for EA typically approaches 50% on wholly-owned intellectual property. Thus, we expect EA to generate an incremental $50 million in operating profit from non-GTA games.

That leaves us with Grand Theft Auto. If EA is unable to reach an accord with the Housers (founders of Rockstar) or with the Rockstar North studio, we envision that EA would choose to release a game entitled Grand Theft Auto and using the existing engine, and could generate $150 million every two years at a 50% operating profit. Should the company be able to reach a satisfactory arrangement with Rockstar North, we expect that the game would generate closer to $600 million every two years at somewhere around a 30% operating profit (presuming an “internal royalty” of 20%). Thus, the expected range of operating profits from Grand Theft Auto is between $75 – 180 million every two years, or $35 – 90 million annually.

Adding this all together results in operating profit contribution of $235 – 290 million annually. We think that these figures are conservative, and do not reflect brand extensions, mobile phone game revenues, or growth of the existing brands. Should EA be able to grow the assumed $525 – 750 million annual revenue stream in the future, each $100 million of incremental revenue should generate around $40 million in incremental operating profit.

The cost of this revenue is foregone interest on the $2 billion purchase price. We estimate EA’s average interest rate on deposits to be 4.5%, so the foregone interest is $90 million annually. We therefore believe that EA should generate incremental operating profit of somewhere between $145 – 200 million annually, with potential for growth of around $30 – 40 million annually. This suggests that EA would value the net Take-Two operating profit stream at around 15x, and would be willing to pay as much as $2.6 billion. Stated another way, EA would likely be willing to pay 10x gross operating profit of $235 – 290 million, or around $2.6 billion.

Value to A Third Party

Unfortunately (for Take-Two), fair market value is not determined by an asset’s intrinsic value. Rather, it should be determined by the price that would be paid by a willing buyer to a willing seller, with neither under any compulsion to act. In the case of Take-Two, we believe that a “fair” price is an amount that is higher than its next best alternative.

It is clear that the market valued Take-Two at around $1.3 billion last Friday (based upon the stock’s closing price), so the “fair” price would be the price that is just above what another willing purchaser would pay. We have already established that a 15x multiple on net operating profit or a 10x multiple on gross operating profit is likely a fair value. So we must determine the likely price to be paid by a third party bidder.

Based upon Take-Two’s guidance, the company expects pro forma EPS of between $1.30 – 1.50 in FY:08. At the high end of this range, Take-Two expects operating profit of around $117 million ($1.50/share x 78 million shares). At a 10x multiple, a third party would be willing to pay no more than $1.2 billion. EA’s offer amounts to 17x this figure, which Take-Two’s press release characterized as “a significant discount to its public peers”. In fact, public peer Activision trades at 14.7x its operating income (on an EV/operating income basis), while public peer THQ trades at barely 7x (even after today’s runup in value). It is true that public peer EA trades at around 27x its operating income (on an EV/operating income basis), but EA’s share price contemplates that the
company will double its earnings over the next two years based upon company guidance. At its analyst day, EA projected operating income of $1.5 billion in FY:11, so its EV/operating income at yesterday’s closing price is closer to 8x. Public peer Ubisoft trades at a multiple of 23x, so Take-Two management is right that the EA offer is a discount to one of its public peers.

We think that a third party would have difficulty determining whether Take-Two will be able to deliver $117 million in operating profits, or whether this figure is sustainable in future years. We note that the decline in EA’s stock today suggests that investors are concerned about whether the Rockstar North team will remain after a change in control, and we believe that similar concerns will be raised among prospective purchasers contemplating a fight with EA.

In conclusion, we just don’t see any public company stepping up and offering more than EA’s $2 billion offer. In order to make a higher offer work, a third party would have to accept Take-Two’s guidance as a sustainable figure, and would have to have faith that Take-Two management could grow this figure dramatically in future years. We think that execution risk makes it unlikely that any third party would bet on future growth, and do not see a competing bid at these levels.

Why EA Will Win

In its SEC filing on February 15, Take-Two’s board adopted an amended by law that provides that nominations for the Take-Two board of directors must be submitted by February 25. We believe that EA will keep its options open, and will nominate a slate of directors to be approved by shareholders at Take-Two’s annual meeting, expected some time before June 30. In our view, EA has likely purchased some Take-Two stock on the open market, and we believe that EA management is speaking with Take-Two investors this week to convince them that the EA offer is a fair one.

It is likely that Take-Two has a poison pill that could obviate a hostile takeover. If EA chooses to make a hostile bid, it would therefore likely be prevented from succeeding. However, we think that the EA offer presents a value far above the likely second place offer, and do not believe that a second offer will materialize.

EA has the advantage of a strategic reason (sports) for purchasing Take-Two. No other party has the same advantage, and the acquisition of Take-Two makes another purchaser subject to head-to-head competition with EA. No other party can pay as much as EA, and should another bidder enter the fray, they would subject themselves to potential “buyer’s remorse” if they bid too high and EA withdraws from the bidding. We don’t see this happening.

Of course, shareholders can take the assurance of Take-Two management to heart that it will work diligently to build value. However, based upon the closing price last Friday, shareholders apparently weren’t convinced of this potential until the EA offer surfaced. Should EA withdraw its offer, we think that Take-Two shares will decline in value dramatically, probably to $20 or so (factoring in a premium for the potential that EA’s bid will resurface.

Why EA Will Walk
EA has no real choice other than to withdraw its bid if shareholders do not accept $26/share. We think that the company may choose to offer a small increase, perhaps $1 – 2/share more, in order to complete a friendly takeover. However, we don’t see the company dramatically increasing its bid over the near term. In the absence of a hostile bid, we think that EA will cool its heels and walk.

We think that the real urgency of the EA bid is to avoid competition from Take-Two sports titles scheduled for release later in the year. By our math, each year that the companies compete in sports costs EA $150 million in operating profit. If Take-Two shareholders do not accept an EA bid and close the transaction before Take-Two releases its fall sports lineup, EA will have lost $150 million in opportunity cost. Thus, the clock is ticking. If the offer appears unacceptable to shareholders, we think EA will withdraw it, and we expect EA to compete more aggressively in sports, by cutting price dramatically. By our reckoning, EA could cut pricing on its basketball and hockey games by as much as $30, incurring pain, but causing Take-Two’s operating profits to be halved for the fiscal year. We think that such a strategy will force Take-Two back to the bargaining table.

Why Take-Two Will Accept EA’s Bid
Take-Two doesn’t really have any other options. If a second bidder doesn’t surface (we think a second bid is extremely unlikely), Take-Two has no real leverage. We don’t think it is credible for management to ask shareholders to trust them to grow the business and earnings to the point where a $26 share price is warranted at today’s multiples. We base this assessment on the EV/adjusted net income multiples for EA (around 12x FY:11 adjusted net income, implying around 17x the discounted present value), Activision (around 22x FY:08 adjusted net income, with price support from the pending Vivendi tender), THQ (around 10x consensus FY:09 adjusted net income), and Ubisoft (around 25x consensus FY:09 adjusted net income). The average of these “peers” is a forward multiple of 18.5x, so if we were to value TTWO at the peer average, the company would have to demonstrate after-tax net income earnings power of $1.40/share. This figure reflects EPS growth of around 35% above the implied $1.05 after-tax EPS suggested by the high end of company guidance for the year, and requires significantly more “turnaround” than management has committed to thus far.

Why Shareholders Should Accept EA’s Offer
We think that EA has two choices: beat ‘em or join ‘em. They are attempting to offer a conciliatory gesture first, preferring to avoid the pain of a price war in sports without at least trying to acquire Take-Two. Should shareholders reject EA’s offer, we expect the offer to be withdrawn, and expect to see EA compete aggressively and attempt to limit Take-Two’s profit potential from its sports business. If this occurs, we think that the $1.50 pro forma pre-tax EPS guidance could well slip to something below $1.00 per share.

Next, we think that EA will ultimately seek to disrupt continuity of the Grand Theft Auto franchise by attempting to engage the Housers and key Rockstar personnel upon the expiration of their contracts in February 2009. Should EA not complete an acquisition in time to eliminate duplication and competition in its sports business, its next best alternative is to try to “hire” key Rockstar personnel and engage them in creating an open world, mature-themed game to compete directly with Grand Theft Auto. This strategy has been successfully implemented by Activision through its recruitment of both the Infinity Ward and Spark Unlimited teams, and the ultimate development of the Call of Duty franchise. We expect to see EA (or another publisher, such as Activision) attempt the same thing with the creators of Grand Theft Auto.

In our view, the Rockstar North team is as valuable as any studio in the video game business. After the price paid for Pandemic and BioWare (around $860 million), the Rockstar North team must at least consider testing the market value of their future services. We think that both EA and Activision will be interested in attracting talent such as this, and think that both companies’ managements would be derelict in their duty if they failed to pursue the best in the business when their contracts expire.

We envision that EA will withdraw its offer if not accepted, and likely will resurface with a lower offer at some point later in the year. In the meantime, we expect the company to prepare for battle, and we don’t see Take-Two winning any prospective battle.

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