Take-Two Interactive Stock (TTWO), Despite the tough holiday sales, it’s not a value trap

We’ve been following Take-Two Interactive for (NASDAQ:TTWOOver the past twelve months, we have both purchased and sold shares. We are generally bullish on the company because we expect future games to be released and that game franchises will continue to thrive. This translates into investment returns. Recent Although headline estimates were below consensus expectations, we expect the stock to trend higher in the coming year. When discussing upside potential in our investment thesis for TTWO stock, we provide conservative estimates for FY ’23 – FY ’25 results.

Take-Two Interactive’s earnings call revealed some serious issues that we attempt to address constructively in our responseary research report. The following key points are at a high-level: 1) Zynga transaction costs ($12.7 billion) will likely take longer to resolve and impact profitability metrics. 2) The cost associated with mobile game Development is dependent on the development of native videogame titles. 3) There will be some short-term charges tied to Zynga’s transaction. 4) Reduced operating expenses of approximately $50 million per year, mainly through the sale of general and administrative expenses rather than the layoff of in-house game developers.

We expect that the narrative will improve with the addition of mobile games titles and the announcements of next-generation franchises. However, this is not the case immediately. TTWO lost -4% during after-hours trading on Monday, February 6, 2023. Over the following week, the stock rallied to $111 (ending February 10, 2023), recovering much of the selling that had occurred after the earnings announcement. The stock trades at the exact same level it traded before the earnings announcement, which caused some confusion among investors and traders.

Management was a little less open to discussing next-generation console platforms like Xbox Series X or PlayStation 5, but they did discuss monetization of pre-released games. While we appreciate the fact they can continue to monetize GTA V as well, it is worth noting that the franchise has deteriorated over time and reduced the revenue contribution from core Rock Star games franchises. The inclusion of Take-Two’s NBA2K23 being the only product with an annual refresh cadence (hence the revenue contribution skewing towards the sports title). Given the weakness in the mobile game console market, we are concerned about the potential growth headwinds.

Management indicated that the company would be releasing an updated on game release and game schedule in May 2023. Expectations should decrease with Grand Theft Auto 6’s launch. The earnings call was not geared towards Grand Theft Auto 6 but instead focused on GTA V sales and GTA Online shipments. The original release was in 2013 but the game has been extended by adding DLCs to online content.

We rate TTWO at Buy with a $130 price target, and anticipate +17% upside from the time of writing, as we value the stock at 22.5x FY ‘25 earnings. The prospects for improving the game console cycle, weak holiday sales and low expectations about game release slate make this stock look undervalued. As we enter the transitional year, we expect the company to generate faster growth rates. We are conservative in our valuation of the stock. To arrive at our price estimate, we use more conservatism in the model and anticipate lower revenue and diluted earnings than other analysts.

The Take-Two gaming console cycle is at its lowest point, shocking shareholders

We’re not surprised management missed its own financial guidance as results were fairly weak for hardware, and hardware related shipments for game consoles. This was mainly due to chip shortages and scalpers buying consoles on the primary or secondary markets. The pandemic also played a part in keeping the PlayStation 5 & Xbox Series X out the hands of consumers.

These trends are expected to slow down as we move into 2023. We see a shortage of chips in the channel which indicates that the current 7nm-generation console generation’s aging tech should be able take advantage of increased capacity when the smartphone cycle moves towards 5nm or 3nm manufacturing.

Hence, we expect all the accompanying components like memory, storage, processors and graphics inclusive of wireless modem will be in abundant capacity as console’s primary competitor for parts, high-end desktop GPUs and smartphones start to transition towards 5nm and even 3nm orders over at TSMC. Upcoming AMD Zen Core 4 architecture shifts more MPUs (microprocessor units) to TSMC’s (TSM) 5nm+ second-gen process (AMD Socket AM5). The utilization rate for 7nm manufacturing is declining significantly, signaling the start of a large volume ramp-up for current generation consoles. Both the first- and second-gen 5nm production processes will shift significant amounts of production away form older gen 7nm manufacturing. The remaining capacity will be taken by game consoles, resulting in a supply/demand balance and retail pricing at $499 for Xbox Series X and PlayStation 5 respectively.

Figure 1. Installation of the Game Console Base

We’re at a point where Xbox Series S & X shipments, and PlayStation 5 shipments total 57.2 million units, which is quite low at this point in the cycle (3rd holiday launch year). Typically games get more exciting at this point in the console hardware cycle (at least that’s the hoped for outcome). We believe that the availability of next-gen install base plays a significant role in the timing of key game titles’ release.

Furthermore, we expect the company’s launch of certain titles to sustain financial results like NBA 2K24 to play a major role in reducing some uncertainty tied to financial results given the annual release cadence of sports titles. Investors may need to press the panic button if the core game title is not included in the line up for the coming year.

That being said, we’re early in the game console cycle, and we anticipate that as the gamer base builds up, and AAA titles launch from TTWO we can get a bit more optimistic on financial results. We’re probably off by 3-months or so before we can build any real excitement in the stock.

TTWO earnings summary headline figures and guidance

Take-Two Interactive reported Q3 GAAP EPS of -$0.91 and missed consensus expectation by $.07, as consensus estimates implies GAAP EPS of -$0.84 for Q3 ‘23 results. Revenue of $1.41 Billion was also reported by the company. This growth was 56.1% year over year, but was mainly driven by Zynga acquisitions. TTWO was $40 million short of analysts’ expectations. Analysts had expected the company to report $1.37 trillion in sales.

We could imagine TTWO improving on financial results, but given the cost of launching various mobile and game console titles we’re not exactly certain when the company will transition back towards profitability given the addition of acquisition related impact, and the skew towards AAA game title launches having substantial revenue impact on holiday quarter sales.

We hope there’s more hiding for the upcoming Winter launch of 2023, but we’re not exactly certain what’s in store for the game developer by end of 2023. This reduces our optimism regarding the management guidance for the full year, which seems to be limited to another quarter, or Q4 results, reported sometime in May 2023 (approximate). We expect that TTWO will be able to establish some momentum in its shareholder narrative before the start of its next fiscal-year. This is after the E3 gaming conference, which took place June 2023, where experts and gamers from the game industry met to discuss future games.

In Q3’ 23, TTWO reported that digital sales mix for consoles increased from 63% to 69% y/y and that the bookings mix for game segments were as follows: 46% Zynga, 36% 2K, 17% Rockstar Games, 1% Private Division labeled games. The increased mobile mix might be difficult to swallow, but we anticipate other Rockstar titles will launch at some point in time and 2K titles will also. We expect the mix contribution to vary. But commentary on release suggests that most of the momentum is in mobile gaming, unless the game consoles are released and the game console shipment begins to match consumer demand.

Additionally, the company provided outlook for the full fiscal 2023. The revenue outlook was $5.24 to $5.29 billion, and total opex ranged from $3.4 billion up to $3.41 billion. (This report is usually published in May, but can be reported in June or May depending on the date TTWO announces earnings). Management team stated that operating expenses could be reduced by $50 million annually, however they expect a smaller number of layoffs due to the different nature of the game publishing and big tech industries. The company will also report a GAAP net loss range between -$704 million and -721 millions, or -$4.40 – -$4.50 per share. earnings per share.

David Karnovsky, an analyst with JPMorgan, stated that holiday spending trends were particularly low for video game publishers, in line with other game publisher commentary.

Messaging from TTWO was similar to EA and UBI, with management commenting that consumers – especially over the holiday period – were more discerning with their spending, shifting allocations to the largest franchises and discounted catalog, and away from smaller and in some cases critically acclaimed new releases (e.g. Marvel’s Midnight Suns, which launched in the post Black Friday discount window). Inflationally, some of the softness was extended into RCS for core console/PC games, even despite strong engagement.

The holiday game title shipments suffered from the same weakness as big tech companies last week. We expect that this quarter’s pessimism will continue to echo the sentiment that Hollywood has been doomed lately. This is especially true for the creative output. We hope to provide some insight into our financial model, and how we arrived at Take-Two Interactive’s recommendation and price target.

Take-Two Financial Model Discussion & Overview

Figure 2. Take-Two Financial Model

We expect the company to report mostly in-line the commentary from the earnings calls, possibly at the low end of the guidance range.

We forecast revenue of $5.24 billion and non-GAAP diluted EPS of $3.58 for FY ‘23, which compares to consensus estimates of $5.22 billion and non-GAAP diluted EPS of $3.56. There are not many surprises in the comments about expense reduction. If anything, it is mostly assumed that there will be cost synergies associated with an acquisition. This rarely happens. We anticipate a growing narrative related to new game releases and the eventual release AAA titles games for the current console cycle to raise our estimates.

Given the somewhat limited visibility of revenue, and non-GAAP diluted EPS earnings, we estimate +10% revenue growth for FY ‘24, and +30% revenue growth for FY ‘25. We expect the release of new games for consoles and the mass production of many mobile games to boost earnings. Analysts anticipate a dramatic sales increase of +40%- +60% in FY’25, tied to a major title release. However, we are more conservative due to the uncertainty surrounding the timing of major game releases.

Furthermore, we value the stock using a combination of 34x P/E, 19x EV/EBITDA, 4x Sales to arrive at an average FY ‘25 value of $166 and then discounted to PV using the firm’s WACC of 8.2% to arrive at our $130 price target for the next 12-months. The stock will have a +77% upside from current levels due to the disappointing earnings results. Expectations have been reset to the point that any announcement about future games would actually make the stock move up.

Take-Two Interactive is a quick summary of investment thesis

The next few quarters will be impacted by the weakening of near-term results. We expect announcements at E3 to assist with the transition of core games franchises, and to reaffirm a positive shareholder narrative in order to keep bulls on board. We also expect to see limited success in transitioning console games from mobile titles. Mobile-only franchises are the best mobile games.

We believe TTWO is more appealing to value-oriented investors, who will not be influenced by quarterly earnings results. Although the weakness in financial outlook may seem exaggerated, we believe that some investors prefer to remain on the sidelines.

The new reality of higher inflation will be reflected in the wider economy, which we expect to see a general adjustment. We believe that the sentiment will improve as we enter the summer of 2023. Furthermore, TTWO likely recovers by June as the stock is expected to announce a number of new games at E3 2023, and we think it’s a make or break year for game publishers as the release of new games is the only pressure reliever for what has been a rough Q4’22 for game sales.

We recommend TTWO at Buy, to our readers because it’s heavily undervalued and because we anticipate +17% upside to the stock given the conservative inputs of our model when compared to other estimates from other analysts that cover the stock. The stock could reach $130. This is conservative, but it’s still well below the peak of $200 in February 2021. Value investors can also benefit from the transitional narrative if they are able to keep up with the stock.