We have written about Take-Two Interactive (Nasdaq: TTWO) on a number of occasions in the past (here, here and here), given that the stock has been in the Montaka portfolio since the inception of the fund. This article will explore what initially drew us to TTWO, as well as how things have panned out with the business relative to our expectations.
1) Business model shift
In recent times TTWO’s business model has undergone a transformation. There has been an increasing trend towards alternate routes for monetizing video games, with a growing proportion of TTWO’s revenues coming from what are called microtransactions. Microtransactions refer to in-game purchases of virtual currency, and other in-game items and services. This marks an important departure from the way consumers have typically transacted with video game publishers.
The business model of a gaming company has traditionally been as follows: (i) develop a video game; (ii) sell that video game to consumers; and (iii) repeat steps (i) and (ii). There are obvious risks here, given the need to keep churning out hit titles. Large costs are incurred in developing video games, and any gaming titles that flop can lead to reported losses for publishers. Microtransactions and other forms of recurrent consumer spend have been the means through which companies such as TTWO have prolonged the useful lives of their video game franchises, in effect reducing the risk of new titles failing to get traction with gamers.
The Montaka team identified this trend early on, and our interest was piqued by the extraordinarily attractive economics of recurrent consumer spending. These are high margin revenue streams that carry extremely high incremental returns. For example, the incremental cost of selling an additional unit of virtual currency is zero, with all of the revenue falling through to the bottom line. At the same time, our view was that the market was failing to price in the favorable economics of these nascent revenue streams, and we subsequently loaded up on the stock.
In other words, TTWO’s share price back at the inception of Montaka implied that the market was not giving due credit to the fundamental change in TTWO’s business model. Games were shifting from packaged discs that were sold in one-off transactions, toward platforms that could be used to create additional high-margin content that could extend gamer engagement.
2) Games becoming platforms, with improved monetization
The Grand Theft Auto (‘GTA’) franchise is perhaps the best example of TTWO using additional content to increase engagement. GTA V was released in September 2013, yet the recurrent consumer spending for GTA Online has grown every year since its release. They in fact reached record levels in the year ended March-2017, over 3 years since the game’s initial launch. The below chart shows total revenue for the Grand Theft Auto franchise, with a notable continuation of revenue from GTA V years after the initial 2013 release.
GTA can be thought of as a platform for developing additional content. However, an important caveat is that only high quality gaming content is capable of keeping gamers interested and engaged enough for them to open up their wallets and spend on in-game items. But with that said, TTWO arguably has the highest quality video game content available measured by Metacritic scores, unit sales, and the levels of recurrent consumer spend. As such TTWO has achieved a remarkable pivot toward these coveted revenue streams, with recurrent consumer spend as a proportion of TTWO’s total revenues increasing from 7.5 percent in FY14 to around 26 percent in FY17.
3) Positive business developments masked by accounting and volatile release cycle
Every investment thesis should involve a variant perception that can be articulated. Said differently, what elements of our analysis were being missed by the market and why? We believe that there were two key factors that made TTWO a difficult business to value, thus creating an opportunity: (i) the lumpiness of game releases and the distorting effect of the 2013 GTA V release; and (ii) deferral of revenues leading to reported losses.
TTWO has traditionally released GTA titles at 4-5 year intervals. In the periods during which a GTA game is released, there is usually an enormous spike in revenue, followed by a sharp decline in the following period. For example, in FY14, when GTA V was released, TTWO’s revenues increased 94% year-on-year, and they subsequently declined by -54% in FY15. This makes it enormously difficult to forecast TTWO’s business in traditional 1 year intervals, and we thus think of the business in 5-6 year blocks, with each block period including a new GTA release.
Another important aspect of the business is that in the interim periods between these blockbuster GTA launches TTWO must incur costs to develop a game, but it could be years until TTWO receives any revenue from launching the game. For this reason, of the past eight fiscal years, TTWO has reported net losses in five of them. Due to these GAAP net losses, TTWO isn’t a company that’s likely to screen cheaply; quant screens are likely to completely miss the nuanced dynamics of TTWO’s game release schedule.
Furthermore, the way that recurrent consumer spending is accounted for has exacerbated the abovementioned issue of timing mismatches in recognizing revenues and costs, as well as created a divergence between cash received for microtransactions and the accounting revenues recognized. For example, if a gamer purchases $100 worth of virtual currency, TTWO receives $100 of cash. However, the accounting standards require TTWO to defer this revenue and recognize it over the “useful life” of a game. This obfuscates the economic reality of these transactions, and the Montaka team make adjustments to revenues and earnings to account for these deferred revenues. Absent a thorough investigation of TTWO’s regulatory filings to understand both the accounting conventions used by the company as well as the economics of these in-game revenue streams, it is easy to see why the market was delayed in recognizing the shift that was underway at TTWO.
The TTWO stock price has increased by over 180% since the inception of the Montaka Global Fund, equating to a more than 70% annualized return. This stock has provided pleasing returns for our investors.
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.