Take-Two Interactive (TTWO) took a tumble back in early December after it filed an 8-K disclosing a worse than expected Q4 loss and lowered guidance for fiscal 2010. The shares quickly shed almost 35% of their value as the market promptly digested the news, prompting Carl Icahn to accumulate 9% of the company at a price between $7.79-$8.18 (per his 12/17 13D). Icahn also purchased some OTC calls expiring at the end of 2011 and was subsequently joined by Phil Falcone as a passive buyer, who picked up around 7% of shares. The most likely possibility is that Icahn is betting on consolidation in the industry and plans to push management to sell the company to unlock the buried value in its Rockstar Games unit, makers of the popular Grand Theft Auto (GTA) series. ActivisionBlizzard or Electronic Arts would be logical buyers and have sufficient resources to launch a bid; names in the broader entertainment space could also be tempted but with the disastrous history of gaming acquisitions that seems a more distant possibility. With the nosedive shares took in early December, valuations likely reached a point where the company could be purchased at a price only slightly higher than what its premier franchise is worth alone.
TTWO have struggled mightily in recent years, consistently demonstrating an inability to manage the product development cycle. A bloated cost structure and persistent delays have rendered the company unprofitable except in years when it has delivered a major release in its premier GTA franchise, which is the company’s most profitable. The last GTA game generated almost $800M in sales and the series has been among the most successful video game properties in industry history- 2005’s GTA: San Andreas is still among the top 10 highest selling titles of all time. Outside of GTA, the company has a handful of other proprietary titles as well as 2K Sports, a modestly successful publisher of licensed sports games. A cursory comparison of TTWO’s cost structure to its larger rivals Activision Blizzard (ATVI) and Electronic Arts (ERTS) speaks to some of the company’s problems. Product costs are incurred in production and reflect licensing and royalty fees to hardware makers as well as shipping and distribution costs (note that ERTS doesn’t break out licensing costs separately from product costs).
Back in the summer of 2008, Electronics Arts offered to buy Take-Two for $26/share in an offer that valued the company at around $2 billion. Management refused to negotiate the offer and ERTS hit back with a hostile tender which ultimately failed as management maneuvered to block the bid. At the time, management claimed that the offer was too low and that ERTS were trying to steal the company before its blockbuster GTA 4 was released. Other buyers were rumored to be in the wings with the arb community briefly pricing the shares above $27.15, but as the broader markets unraveled so did talk of a deal. We can roughly get a sense of how this bid valued the company by normalizing 2008 earnings by the average write-off of capitalized development costs over the cycle and by assuming ERTS could cut overhead costs by 10%. Adding a 20% control premium and assigning a 10% discount rate, we get:
Subsequently, TTWO sold its low-margin distribution business (Jack of All Games) at a loss for a total consideration of $36.5M cash in early December 2009, leaving management to focus on fixing the core publishing business. Because of its consistent lack of profitability, valuing TTWO requires some extrapolation and normalization of past results to ascertain its going concern value. Historically, the market has valued TTWO at between .8 and 1.4X revenues. Using the average revenues for the publishing business over a full development cycle (in this case, FY 2005-2009) and valuing the company on a price/sales business implies the following values:
As a consistent money loser, the next logical step is to examine TTWO’s liquidity position. At year end 2009, the company had $102M in cash and $100M remaining on a line of credit, and was burning cash at the rate of $622,000 a day. At this rate, the company would run out of cash in late October of next year. However, 2009 FCF was impacted by a historically large build-up in receivables and significant development delays in a number of titles that were pushed back to 2010. Based on consensus estimates for 2010, we can expect FCF to be around -$100M in 2010, which will give the company around 2 years. Liquidity is then not a substantial concern, barring any hideous product delays, significantly higher than expected costs, or total product launch failures.
In a given year, TTWO typically earn between $700-850M in revenues. In the last year of a GTA release (which was the last profitable year in recent memory) the company earned $1.23 billion in revenues. If we value the company using a 10% discount rate on 2008 earnings, we get a value of around $13. If we assume a buyer could cut overhead costs by 10% and paid a 20% control premium, value could be as high as $20 a share. However, arbitrarily using 2008 as a base year is obviously a less than perfect solution, and we must look at some alternative measures of value to get a sense of what the company is worth.
Spreading the company’s revenues over the length of the game development cycle and deducting normalized costs over the same period gives some idea of how unsustainable their business model is. Development costs need to be cut and unprofitable titles need to be abandoned if the company is to have a hope of producing something resembling a sustainable performance.
Valuing GTA from the perspective of an outside acquirer will allow a sense of how much value the market attributes to the remaining publishing business. Since TTWO break out revenues for GTA, this can be accomplished by estimating the cash flows from the most recent release (GTA IV), which was developed during FY2005-2007 and released during 2008. Interviews with developers suggested that the total cost of the game was around $100M. This analysis conservatively assumes development costs at twice this level and also provides an estimate based on a pro-rata attribution of total development costs over the cycle to the series.
At current trading prices, this would imply the non-GTA publishing business is worth $4-5 a share ($300-400M). If another publisher were to buy the company, shareholders could hope for a price between $15-20 a share, implying 50-100% upside from current prices. As an independent company, TTWO’s going-concern value is far less certain and the shares are unattractive as anything but a consolidation play. However, a buyer here is protected by the GTA franchise, which limits the downside at current prices and places a floor on value of around $8 (assuming the remaining game properties and proprietary technology are largely worthless). In an industry where operating profits need to be constantly reinvested to fund growth capex and keep a steady stream of new titles, franchises are valuable properties that allow developers to cost-effectively produce content . Taking the assumed value of the GTA franchise as a worst case value and assuming there is equal probability of a high or low bid with a 10% required return, we only need a 1/3 chance of a deal going through to realize positive expected value. Industry consolidation was ongoing pre-LEH and with Icahn in position shareholders have a decent shot at monetizing the value buried underneath TTWO’s cost structure. The case for a deal is made stronger by the fact that TTWO are controlled by ZelnickMedia, an investor run by former BMG CEO Strauss Zelnick. While Zelnick and cohort Ben Feder rejected the 2008 deal, they might jump at the chance to take a cash-out given the way things have gone in the past year. Even without a deal, on a revenues basis the company would probably be priced more towards $13-15 in a better market for game publishers.
At the price Icahn and Harbinger paid, the risk-reward relationship is compelling. The shares rallied strongly the Friday before Christmas, reducing the margin of safety to a value-oriented buyer, but the opportunity remains for those with interest in the space.
disclosure: bleichröder is long TTWO