This article is authored by MOI Global instructor Hunter Hayes, Vice President and Portfolio Manager at Intrepid Capital Management, based in Florida.
Take-Two Interactive Software (TTWO) is a popular video game publisher with a wide moat, substantial growth opportunities, and excellent management. The company owns or licenses the intellectual property behind some of the best-selling entertainment series’ of all time, including Grand Theft Auto, Red Dead Redemption, and NBA 2K. The company has a $12.5 billion market cap, but its $1.6 billion of net cash on the balance sheet give it an enterprise value of under $11 billion. The stock currently trades hands for around $110 per share which I view as an attractive discount for a company with $15/share of cash and the potential to generate $10/share of FCF in the next few years. Below is a brief summary of my investment thesis, which I will elaborate on during my presentation at the Wide-Moat Investing Summit.
Investors sometimes eschew entertainment publishers that rely on a limited number of content releases because of the inconsistency of cash flows. Although cash flow generation has been lumpy for TTWO in the past, the company has steadily grown recurrent consumer spending (RCS) as a percentage of net bookings over the past several years. One can think of RCS as the video game equivalent of same store sales. I believe this shift will help smooth out earnings and free cash flow going forward.
RCS is generated through something that video game publishers call microtransactions, which can be further segmented into virtual currency, add-on content, and in-game purchases. For the uninitiated, these microtransactions are essentially additional content that a gamer purchases after initially buying a video game. The types of virtual content vary – it could be a new mission, a new character, or even a virtual outfit for your favorite digital avatar. Regardless, the margins on RCS purchases are phenomenal since there is very little incremental cost associated with virtual content.
RCS also keeps gamers engaged well past the initial release of a game. Consider Grand Theft Auto V, which over its lifetime has sold nearly 110 million copies making it one of the best-selling entertainment products of all time. Over five years after its initial release, it is still one of the most played titles in the world and generated over half a billion dollars in revenue for TTWO during fiscal year 2019 (TTWO has a 3/31 fiscal year end). Five years of relevance for a single title is a long time in the video game world.
Rockstar Games, the TTWO-owned studio that publishes Grand Theft Auto, has kept the title relevant by regularly releasing new content, characters, and missions (microtransactions) that gamers pay extra to access. This creates a nice engagement loop – as gamers spend more time and money on a game, they become more attached to the game’s ecosystem. They also develop social, online relationships with other gamers that leads to increased engagement. To put it into context, many players spend over a hundred hours a month playing just one title.
The success of Grand Theft Auto isn’t a one-time fluke, either. Red Dead Redemption 2 is a more recent title that Rockstar Games published last October. It has already sold 24 million units which is a staggering number for a video game in such a short span of time. TTWO recently brought Red Dead Online, the multiplayer version of Red Dead Redemption 2, out of beta and announced on the company’s last earnings call that “Red Dead Online is performing better than Grand Theft Auto Online did at the same stage of the game.” Between the Grand Theft Auto and Red Dead Redemption franchises, TTWO had almost 90 million active, unique player accounts in fiscal year 2019. If Red Dead Redemption Online achieves even a portion of the engagement and longevity that Grand Theft Auto Online has, that number should grow, and it would be a significant boost to TTWO’s bottom line for years to come.
A misconception that’s recently gained steam is that with the entry of large companies like Google/Apple/Amazon as well as existing publishers like Epic Games, the creator of the free-to-play sensation Fortnite, there will be increased competition for publishers like TTWO. While it’s likely true that competition will increase on the hardware and distribution side, I would argue there has never been a better time to be a premium publisher of traditional video game content.
The barriers to entry for publishers of AAA-titles, which TTWO is, are very high. Titles like Grand Theft Auto V cost nearly $300 million dollars to create. Past that initial, steep entry cost, the most important input for a successful game is talented developers. Assembling a team with a cohesive vision takes years. Then there’s the actual time to develop the game, which for a AAA-title can range from 2-7 additional years. Beyond that, there’s huge execution risk as many games by first-time studios flop. Additionally, if a large company was poaching video game developers for a massive new project, it’s likely that competitors would take notice. From our conversations with TTWO and others in the publishing space, there hasn’t been any large-scale poaching occurring. Hence, I think it’s much more likely that Google/Apple/Amazon acquire established publishers rather than build out the capability to publish from the ground up. Video game publishers are expensive acquisition targets, with most deals occurring north of 20x EBITDA. TTWO stock, which is still nearly 20% below its 52-week high, currently trades for 15x trailing 12 months EBITDA.
As for the rise of free-to-play games like Epic’s Fortnite, I would point out that TTWO’s sales and engagement numbers haven’t been negatively affected, as demonstrated by the recent success of Red Dead Redemption 2 and the consistent gamer engagement with TTWO’s other stalwart titles. Although gaming has changed over the past several years, the most important ingredient for a successful publisher is still quality. TTWO has consistently exhibited its commitment to high-quality content which, regardless of the monetization model, should continue to generate demand from gamers.
The video game space has grown rapidly over the past few years and shows no signs of slowing down. Over the past five years alone, sales for gaming software has grown at a CAGR in the low teens. The Entertainment Software Association estimates there are 2.4 billion gamers in the world and that 60% of Americans play video games daily. Opportunities like eSports, cloud streaming, and expanding broadband penetration around the world should contribute to the continued growth. Alongside that macro backdrop, there are also more specific opportunities for TTWO. Global expansion of the company’s intellectual property, growth in the mobile category, and increased operating margins with scale are some of the low hanging fruit. FCF to the firm over the trailing 12 months at TTWO was $529 million. I estimate it will eclipse $1 billion in the next five years.
Lastly, I think management at TTWO is superb. The company is led by Strauss Zelnick who has done a great job running the company since joining as executive chairman in 2007 and taking over as CEO in 2011. Strauss is a veteran in the entertainment industry and gives TTWO’s publishing studios the flexibility to create at their own pace. This has created longer droughts between game releases compared to some of the other publicly traded publishers, but it has also resulted in TTWO’s games carrying some of the highest ratings and surviving longer than other studio’s titles. With RCS becoming a larger component of overall net bookings, I believe the longer cycle times between releases will become less important for cash flow generation going forward.
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About The Author: Hunter Hayes
Hunter Hayes is a Portfolio Manager at Intrepid Capital Management. Prior to joining Intrepid Capital, he was an Associate on the High Yield team at Eaton Vance and a Consultant at Deloitte Advisory. Mr. Hayes graduated from Auburn University with a BS BA degree in Finance and a BM degree in Piano Performance. Besides his passion for value investing, Hunter is also an avid runner and recently finished his first Boston Marathon.
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