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.
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 m