Take-Two Stock: Well Positioned For High Growth (NASDAQ:TTWO)

Investment Thesis

At this point, it is obvious that the pandemic pulled a lot of gaming demand forward. We’re now seeing a reversal of that trend. Sales related to gaming recently sank to the lowest they’ve been since February of 2020.

However, I believe Take-Two Interactive Software, Inc. (NASDAQ:TTWO) is an underappreciated stock that could have significant upside over the next few years. The company has stable revenue streams and is aggressively expanding its product pipeline. I feel there may be further downside in the short term, but I’m bullish on the company’s long-term growth.

Recurrent Consumer Spending

Increasing incremental revenue is an important part of Take-Two’s growth story. For many years, the industry has been dependent on single purchases of products. This made gaming companies very dependent on “hit” games to drive revenue.

Take-Two has managed to transition its business into more stable revenue streams. One of these streams is the company’s sports titles, such as the WWE 2K and NBA 2K series. These games regularly release new installments with updated content and predictable consumer purchases.

The other is the release of extra content and subscriptions for existing games. Take-Two calls this additional revenue “recurrent consumer spending.” Take-Two is well positioned to take advantage of this revenue stream. The company owns some of the most popular franchises in gaming history. Many players are willing to pay lots of money for extra content in these games.

Over the past six years, Take-Two’s RCS has grown significantly. The incremental revenue stream has increased at an incredible 30% CAGR. RCS now generates more revenue than direct sales of games.

I believe this gives some added security to Take-Two’s top line. A lot of gaming stocks have recently pulled back due to reduced purchasing. However, Take-Two creates games that users continue to play for years after release. I believe these types of products will see the smallest declines and fastest recoveries.

To be clear, I think the company will likely experience growth headwinds. But I’m confident this won’t hurt Take-Two over the long term.

Product Pipeline

Take-Two is aggressively expanding its product pipeline. The company plans to release 69 titles over the next three years. 75% of these are slated for 2024 and 2025.

Gaming companies like Take-Two have high upfront costs to develop their products. The company’s operating costs will have to grow significantly to develop this huge portfolio of games. This will create a serious headwind for the company’s profitability over the next year or two.

But a lot of Take-Two’s franchises drive multiple transactions and repeated engagement from their customers. Grand Theft Auto and Red Dead Redemption generate solid revenue even years after their latest installments.

In the short term, this will likely result in higher operating costs and reduced profitability. However, I think this positions Take-Two very well for the long term. Many of these new games will generate revenue for years after their release. This revenue will have high profit margins because development is largely finished.

Expansion into Mobile

I believe Take-Two’s expansion into mobile gaming is its last key growth driver. Take-Two started providing information on its mobile segment in its last 10-K. Over the past two years, the company has more than doubled its revenue from this segment.

A lot of this growth has been driven by acquisitions. Since May of 2019, Take-Two has acquired 10 different studios in the gaming space. Many of these acquisitions add to Take-Two’s intellectual property portfolio, especially its mobile segment.

I think that another aim of this strategy is to quickly recruit talent. These companies can assist Take-Two in bringing its key franchises to mobile. Rockstar Games and 2K own many of the most popular franchises in the gaming industry. Mobile represents a huge market for Take-Two to drive extra revenue and engagement.

Zynga Acquisition

This brings us to Take-Two’s acquisition of Zynga. The acquisition is the most important development in Take-Two’s recent history. The economics of the transaction don’t seem great at first. Zynga only made a little over 2.8 billion in revenue over its final fiscal year. The mobile games company managed to generate some positive free cash flow. However, high stock-based compensation expenses and many acquisitions made the business unprofitable.

At the announced acquisition price of 12.7 billion, Take-Two paid 4.5 times EV/S and above 65 times EV/FCF for Zynga. This was a very expensive acquisition on a purely financial basis.

But what Take-Two gets out of this deal is a significant amount of data and expertise in developing and monetizing mobile games. On its Q3 2022 earnings call, Take-Two’s management said that the combined companies will have a customer database of over a billion users.

Zynga can help port Take-Two’s key franchises to mobile platforms. Then, the two companies can work together to effectively monetize these new offerings. On the Q3 earnings call, Take-Two’s CEO said that the company had identified cost and revenue synergies of as much as $600 million. I believe all these combined advantages may justify the price.

Valuation

It’s difficult for me to put a direct price target on the company at the current moment. I’m waiting for Take-Two’s next earnings call to see the company’s guidance. I want to hear how Take-Two is integrating Zynga into their operations.

Instead, I’m going to check my thesis by working backwards. Take-Two is currently valued at about 20 times forward earnings. That’s about what I’d be willing to pay for a company growing earnings at a high single digit rate. I believe that Take-Two’s robust content pipeline can increase its earnings by over 15% across the next few years.

The company’s sports titles are experiencing solid growth. The most recent NBA 2K game sold over 10 million units. Important releases such as the next Grand Theft Auto installment should bring in billions of dollars of revenue on launch.

I’m waiting for more insight on the company’s next earnings report. In general, I think Take-Two is fairly valued in the worst case.

Final Verdict

I like Take-Two’s strategy and I’m bullish on their long-term prospects. However, profitability will likely take some time to improve. The broader environment is also not very favorable for video game spending. I think shares can fall further from here. For these reasons I would start a small position and scale up over time.