Take-Two Update - Earnings, Zynga, and GTA VI

Implications for returns going forward

Feb 12, 2022

A lot has happened with Take-Two since my deep dive on the company last year, the most important of which was the announcement of a $12.7bn acquisition of Zynga. This is a transformational deal which has changed the investment thesis for a lot of investors. The majority of this article will be focused on evaluating the transaction and the potential implications for returns going forward. I will also cover off on Take-Two’s earnings which were reported this week. Finally, we now officially have confirmation of the development of GTA VI and a strong indication of timing, which may be the single most important catalyst for the stock over the next two years.

EARNINGS UPDATE

On Monday Take-Two reported its Q3’22 results (it has a Mar-YE). This was a strong quarter which more or less confirms that the thesis for the company on a standalone basis is very much intact. i.e. the strength of its three core franchises plus untapped value from its large pipeline of latent IP.

NBA2K: The latest instalment NBA2K 22 hit 8m sales in less than 5 months, putting it on track to top the 14m sales of the prior year’s edition. In addition, daily active users of the online mode hit 1.9m, 10% higher than prior period last year. Essentially, every year the franchise gets stronger
GTA: Almost nine-year old GTA V sold another 5m units in the quarter, after also selling 5m in the prior quarter. It has now reached a staggering 160m lifetime sales. GTA Online’s performance also matched 2020’s record-setting audience size. Rockstar also released the now infamous GTA Trilogy, which with its horrendous glitches and bugs earned a laughable Metacritic score of 49. Management acknowledged that this was a big fumble and something that wouldn’t be repeated. But even this edition managed to sell 10m units according to IGN. The strength of this franchise never ceases to amaze me. Next quarter should also see the release of an enhanced version of GTA V on the new generation consoles
Red Read Redemption: RDR2 sold 4m units in the quarter to reach lifetime unit sales of 43.5m. This was its strongest quarter in quite some time. Red Dead Online continues to do well, and there is an insatiable appetite for new content as evidenced by the #SaveRedDeadOnline campaign on Twitter (Red Dead players feel like that there are not enough updates compared to GTA Online, which is probably right). Overall, player engagement with the franchise appears very strong
Other IP/Pipeline: Several new releases during the quarter including Borderlands 3 Ultimate Edition, and a bunch more planned in the coming quarter including the rebooted WWE2K 22, a new Marvel IP Midnight Suns, and OlliOlli World, the studio of which, Roll7, was acquired by Take-Two during the quarter

All of this amounted to Take-Two beating guidance and market consensus this quarter, and raising its net revenue guidance for the entire year FY22 (Mar-YE) to $3.4bn at the midpoint. This represents 2% growth on last year, which is a good outcome as 2020 was a banner year for Take-Two due to COVID lockdowns (at the start of the year the expectation for FY22 revenue was a decline to $3.14-3.24bn).

Profitability continues to climb as well, driven by increasing share of recurring revenue (as shown above) and digital sales, both of which come with higher margins.

All in all, a reliably sound quarter that sets up a strong finish to the year. Most of the focus of the earnings call Q&A was however on Zynga, and for good reason.

ZYNGA

On January 10th Take-Two announced that it is acquiring mobile game company Zynga for $12.7bn. Take-Two’s market cap is $18bn, so this is a transformational deal for the company, and was the biggest M&A deal in the gaming industry at that point, only to be usurped by Microsoft acquiring Activision for $69bn a week later. The offer price for Zynga was $9.86/share, a huge 64% premium to its last closing price. The funding structure is a mixture of cash and equity:

$4.7bn (35%) in cash, of which $2bn will be cash on balance sheet, and $2.7bn in new bank debt
$8bn (65%) in Take-Two stock, with the issue price of the stock subject to a collar between $156.50 and $181.88

Zynga is one of the largest mobile game companies with a diverse portfolio of casual titles such as FarmVille, Words With Friends, CSR Racing, Merge Dragons!, Golf Rival, Harry Potter: Puzzles & Spells, Toon Blast, Zynga Poker, and a bunch of others. Its original developed games, FarmVille and Zynga Poker, have been turned into long-running ‘forever’ franchises. However, the majority of its games portfolio have come through acquisitions of smaller studios, with the company having completed over twenty deals in the last ten years.

Strategically I can understand the rationale for the deal:

Mobile is the fastest growing segment of the video gaming industry, and Take-Two up until now hasn’t had a meaningful presence in mobile (currently only 10% of revenue). Acquiring Zynga would finally give Take-Two a real presence in this segment, with mobile accounting for about half of its revenue post-transaction
It greatly reduces Take-Two’s concentration to its three key IPs (together about 85% of revenue), which due to their blockbuster nature creates some lumpiness in their earnings. Zynga, with its collection of free-to-play mobile games which are monetised through ongoing in-game microtransactions, delivers fairly steady revenues. Adding Zynga’s recurring revenue streams into the mix will make Take-Two a more predictable business, which may be assessed more favorably in public markets. Arguably Take-Two has had a taste of the beauty of the recurring revenue business model through its success in GTA Online and NBA2K, and wants to build upon this
This acquisition will bring a unified mobile leadership to Take-Two and a structure that supports multiple, autonomous mobile studios. Rolling up Take-Two’s past mobile acquisitions (Social Point, Playdots and Nordeus) under Zynga’s experienced CEO Frank Gibeau makes sense and will be synergistic
There is potentially a significant synergy opportunity from Zynga being able bring some of Take-Two’s IP to mobile. Take-Two would obviously be keen to try to make more money from its franchises, especially recurring revenue dollars, and mobile is an obvious way to do that. There are also other potential synergies from being able to leverage Zynga’s ad platform and data analytics across Take-Two’s portfolio. Management states they have identified revenue synergies of $500m

Firstly, I think that most people are aware that the base rates for large M&A creating value are not great, so I have had to try to put aside my natural skepticism towards these sorts of transactions and evaluate the deal for what it is.

Take-Two CEO Strauss Zelnick is a well respected investor, deal maker and operator, who over the last decade built a lot of trust with the investor community (a large reason for why Take-Two has generally been valued at a premium to its peers). However, given how disciplined he’s been with M&A and capital allocation, the boldness of this deal seems quite uncharacteristic.

People in the industry say that the deal may have been in part due to Take-Two bidding for and losing mobile games company Glu in 2021. This asset would have been much more digestible, but ultimately went to EA for $2.1bn. Although Take-Two has made a series of smaller mobile acquisitions, they don’t have anything of scale similar to EA and Activision’s King. Thus they probably felt like Zynga was one of the last remaining large mobile assets. Take-Two has likely been speaking with Zynga for many years and formed a view on its strategic value some time ago, however with such a huge premium there is definitely a sense of desperation and potentially empire building here.

The north star of this acquisition would be bringing Take-Two’s IP to mobile. However, there are a number of reasons for why I think this will be challenging:

The skillset to make the sorts of games Zynga makes (casual, casino, puzzle games) is very different to what’s required for hardcore and even mid-core games in Take Two’s portfolio. I highly doubt there is any studio at Zynga that would be able to turn Max Payne or GTA into a mobile game, at least not of the same type that looks like the console or PC version
Where Zynga has worked with big IP in the past, like Game of Thrones or Harry Potter, they created slot machine and puzzle games out of them. Maybe there is some potential to turn a mystery game like LA Noire into a mobile puzzle version, but I have trouble seeing Rockstar handing over its IP to anyone at Zynga for such a purpose
Industry insiders say that mobile game creators and AAA developers are culturally very different and in the past have generally not accepted the others’ business models. Integrating two groups of people with different DNA is likely not going to be easy. More so, Take-Two doesn’t really have a track record of integration or cross-collaboration across its labels - all of its studios are run very autonomously
These issues may only be amplified if there is loss of talent on either side as a result of this deal (which there typically is). Some talent will be let go, and some Zynga employees may just want cash out after the long slog they’ve had. The incentive to stay as part of a larger conglomerate may be little

Activision’s $5.9bn acquisition of King in 2016 is a close parallel to this, however King has remained largely unintegrated and contributed little to the cross-over of Activision’s core IP to mobile. While analysts like to point to the success that Activision had with Call of Duty Mobile as a justification for the Zynga deal (reportedly over $1bn of revenue), it’s often missed that it was Tencent who developed the game - King had no role. King did however develop Activision’s Crash Bandicoot for mobile, which was launched last year. The fact that it took five years for a cross-over game to be developed shows that this is something that can’t be banked on.

It is interesting that Take-Two seems to have walked back somewhat on the messaging around the synergy potential from transitioning its IP to mobile. On the deal announcement on 10th January, it was stated front and center as the key revenue synergy item:

“Perhaps most importantly, we have the ability together from both a development and a publishing point of view to optimize the creation of new titles, new titles based on Take-Two's core intellectual property.”
Strauss Zelnick, Zynga M&A announcement call (10 Jan)

However, on the earnings on 7th February, they took a much more measured stance:

“We've identified around $500 million of annual run rate revenue synergies to be achieved in the coming years in the combination with Zynga in addition to $100 million of annual run rate cost synergies. And only a small portion of those synergies on the revenue side are attributable to new releases based on core Take-Two IP”
Strauss Zelnick, Q3’22 Earnings call (7 Feb)

Maybe they’re trying to temper expectations as they realised the challenges of what they were initially selling. But this however makes me wonder what portion of this $500m number is actually realistic.

Zynga does have some merits. The business struggled with various issues post its IPO in 2011, however it has executed a successful turnaround under the helm of EA executive Frank Gibeau who was brought on as CEO in 2016. The key tenets of its turnaround have been acquisitions of independent studios with proven titles, the build out of a scaled live ops strategy and advertising business, increasing its pipeline of new releases, and focusing its publishing efforts on growing its own franchises as well as that of third parties.

In 2021 however, the business was heavily impacted by Apple’s changes to privacy policies, which made it hard for applications to track iPhone users without their consent. Suddenly, player acquisition efforts became more challenging, causing Zynga to lighten up its advertising spend, which led to decelerating revenue performance. According to Ben Thompson, “Zynga, was among the least prepared of the major mobile gaming companies for the changes wrought by Apple’s App Tracking Transparency (ATT) policy, which was introduced with iOS 14 and rolled out over the first half of 2021.”

Which is why Zynga shares have seen a tumultuous performance in the lead up to the Take-Two deal.

To address some of these challenges, Zynga acquired Chartboost, a programmatic advertising platform which leverages machine learning and data science to optimise audience-based targeting. This acquisition is still in the process of being integrated and may certainly help Zynga fix some of its advertising issues as well as create synergies across Take-Two’s portfolio of mobile games. More generally however, I question whether Take-Two management, who lacks mobile experience, really appreciates that Apple’s privacy changes are not some transitory issue but is structural change to the mobile industry that they will have to navigate with Zynga.

Valuation and returns

One could argue that perhaps Take-Two is picking up Zynga on the cheap off a trough price. However, at a 64% premium, the implied multiple is 16.1x fwd EBITDA1, which puts it on par with the valuations of some leading gaming companies. Even though this deal is often compared to Activision’s acquisition of King, King was done at a considerably cheaper 6.6x EBITDA2. King is also arguable a much better asset given the continued dominance of Candy Crush which is now over 10 years old.

Given how significant Zynga will be to the combined entity, it’s important to understand whether this deal is actually value accretive.

The typical metric on which all M&A deals are assessed on is EPS accretion. Running some basic merger maths with some high-level assumptions, as can be seen below the deal is likely to be mildly EPS accretive in the first two years. Notably, I have given them credit for the majority of the announced $100m cost synergies, but have not included any revenue synergies (as described earlier, I am highly skeptical that these can be realized). Also worth noting that the higher the Take-Two stock price is in the lead up to the transaction closure (30-Jun-22), the less shares need to be issued to fund the equity portion of the offer, and thus the more accretive the transaction. The range of issued shares is between 58.5m (at the bottom end of the collar of $156.50) and 50.3m (at the top end of the collar of $181.88). This also makes me wonder whether the subsequent Rockstar announcement on GTA VI was a strategic move to bump up the share price pre-closure (more on this later).

However, EPS is only part of the picture, and is often easy to make accretive. Return on Invested Capital (ROIC) I believe is fundamentally the most important metric in evaluating capital efficiency, and this is what I have attempted to calculate below based on the purchase price and Zynga’s consensus forecast earnings.

As can be seen, even with the inclusion of the full $100m cost synergies and the $500m revenue synergies, the ROIC is at a very low 5-6% range - a reflection of the expensive purchase price relative to earnings. What looks attractive from an EPS perspective doesn’t look that attractive at all from a ROIC perspective. Despite this, the deal would still be mildly NPV positive as the ROIC exceeds the low funding costs of the transaction3.

The big issue I have is that Take-Two on a standalone basis has attractive ROICs in the range of 14-18%, far higher than its peers Activision (10-13%) and EA (8-10%). This is a reflection of its disciplined capital allocation over time, and was one of the key reasons I was drawn to Take-Two in the first place. The inclusion of this large, relatively expensive deal significantly dilutes the overall ROIC of the enlarged entity. As can be seen below, PF ROIC drops to almost almost half of what it was on a standalone basis, and is now at a level below its peers. You would need some serious value creation to get Take-Two back to its pre-Zynga ROIC, well beyond the $500m revenue synergies that’s been advertised.

If we accept that ROIC is a fundamental driver of valuation, we would then expect that going forward Take-Two should see a downward re-rating in its multiple4. As can be seen below, on a Fwd P/E basis it has historically traded at an average of around 30x. This has generally been at a premium to its peers Activision (25x) and EA (23x). Post the Zynga announcement, the stock has seen some downward pressure, and is now trading at about 27x.

While it may be possible that at some point the multiple reverts upwards to its historic range, I think the now inferior ROIC of this enlarged company could see it trade at a discount to its peers. Assuming a 20x fwd P/E and the pro-forma MergeCo EPS as calculated earlier, I get to a $216 share price in FY24. This implies a 12% IRR over the next two years from today’s price. Based on the conservatism of these assumptions, I actually think that this is still a reasonable outcome (my hurdle rate is 10%). Despite the assumed multiple compression and no revenue synergies, the returns still work in small part from the slight EPS accretion from the Zynga deal, but in large part from the growth of Take-Two’s standalone business, which now almost certainly includes the release of GTA VI in FY24/25 - more on this later.

Of course maybe I’m being too conservative - perhaps 20x P/E is too low, and also I’ve assumed no revenue synergies at all. Sensitising both of these variables - EPS and P/E - we get the below return profile.

As shown above, the risk-reward generally skews to the upside, and in order to lose money you need to assume the multiple compresses to 17x (the long-term market average P/E), and my EPS forecast misses by about 15%.

As a final cross-check, the $216 share price derived earlier using the EPS/PE maths generally lines up with the Sum-of-the-Franchise NPV I performed in my original Take-Two deep dive (below). Together, this suggests a fair value for the business in the $200+ range.

Zynga has eroded the Take-Two investment thesis for a lot of investors, myself included. As such, it wouldn’t surprise me if we still see some near-term downward pressure on the stock as investors rotate out. However, despite the fact that I think that Zynga reduces the overall quality of the business, I think there is still reasonable value to be captured with Take-Two over the next few years even under conservative assumptions. This is more so because I believe we now have the major catalyst that could provide medium-term support for the stock and see it appreciate towards its fair value - GTA VI.

GTA VI

In what was probably the worst kept secret in the world, on 4th February Rockstar announced that a new version of GTA is in development. The reaction to this news in terms of fanfare and share price speaks for itself:

In the past, Rockstar officially announced the development of its big games (GTA V and RDR 2) almost exactly two years before their release, which would suggest an FY24/FY25 (i.e. calendar year 2024) release for GTA VI.

The other big clue around timing was in the guidance provided in conjunction with the Zynga M&A announcement. Management guided towards a 14% bookings CAGR for the combined business from FY21 to FY24, which excludes any revenue synergies. We can do some back-of-the-envelope maths to work out what that means for Take-Two projections standalone. A few months ago Zynga indicated a ‘low double-digit’ percentage growth for the ‘foreseeable future’. If we assume for example a 12% CAGR for Zynga until FY24, that would imply a 15% CAGR for Take-Two with $5.5bn of bookings in FY24. This is $0.7bn higher than what the previous broker consensus was for that year, suggesting that everyone’s models are missing something large in FY24. With most brokers previously expecting an FY25 release for GTA VI, this seems to suggest that the game may arrive earlier than anticipated.

One of the analysts on this week’s earnings call did try to get more details on what exactly in the pipeline was driving that outer year revenue, but management of course would not disclose anything. However, I think when we take this together with the Rockstar announcement, we have a strong indication on the timing of the release.

The interesting thing is what happened to Take-Two’s share price in the period leading up their big game releases. Here is GTA V, which was released in October 2013:

With the huge success of GTA V, the run-up ahead of RDR 2 (released on October 2018) was even more dramatic:

Now I’m not suggesting anywhere near the same price moves this time around. The company is now significantly larger and more diversified, plus some expectations have already been built into the share price. However, I think having more certainty around the release of GTA VI and the gradual trickling of information on the game over the next two years will increase the hype cycle. This should at the very least provide support for the stock, and may see it move more towards its fair ($200p/s plus range).

As a reminder of why GTA VI is important, GTA V is the most successful piece of entertainment IP in the world. It has earnt lifetime revenue of almost $10bn5 just on unit sales alone, and is still selling incredibly well to this day. By the time GTA VI is released, it would have been almost 12 years since the last edition, so to say that anticipation is high would be the understatement of the century. Put simply, the release of GTA VI is probably the most important catalyst for Take-Two.

CONCLUSION

To sum up, I think the Zynga transaction has for me eroded the longer-term thesis for Take-Two. I am, however, planning on holding the stock for a while longer, perhaps up to two years or so, as I think there is still reasonable value to be captured even under conservative assumptions. The thesis around the strength of its key IPs continues to hold, but more importantly, the hype cycle around GTA VI could be the important catalyst that sees the stock capture some of this value over the medium term. Selling out now feels like leaving money on the table. Meanwhile, I hope I am wrong about Zynga, and Strauss can show some evidence over the next few years that this is indeed a good piece of capital allocation.

Thank you for reading and hopefully you found the article helpful. I welcome all feedback, good or bad, as it helps me improve and clarifies my thinking. Please leave a comment below or on Twitter (@punchcardinvest).

Punch Card Investor

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