Take-Two Still Offering Twists And Turns

By Stephen D. Simpson, CFA | May 31, 2011 AAA

Volatility can be both boon and bane to investors. Traders certainly love it, and savvy value investors learn to appreciate it for the discounts it can create. On the other hand, volatility based on inconstant underlying financial performance makes valuation more difficult and does no favors to the mental health of those who would prefer to be long-term shareholders.

For better or worse, Take-Two Interactive (Nasdaq:TTWO) continues to be a volatile company. While the company has certainly made progress towards more consistent financial performance, progress towards a goal is not the same as achieving that goal. Take-Two may still offer investors the potential for above-average capital gains, but prospective buyers have to ask themselves if they can handle the uncertainty that will go with the possible profits.

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A Sweet and Sour End to the Fiscal Year
Take-Two recently decided to change its fiscal year, and the March quarter now represents the end of the company's fiscal year. For the quarter, Take-Two announced that revenue fell 22% to $182 million. Though that certainly does not sound all that impressive, that $182 million is considerably more than analysts expected, as the averaged estimate called for $148 million and the high-end estimate was $170 million. Sales were not driven by any major releases; rather, the company's revenue came from its catalog. To that end, this is an encouraging sign - if the legacy business can produce better revenue, that's a big step towards a more consistent financial performance. (For more, see Power Up Your Portfolio With Video Game Stocks.)

Profitably was also a mixed bag. On one hand, a lower gross margin and a reversal of a year-ago operating profit into a loss are not reasons for celebration. On the other hand, the expectations were for a meaningfully worse result, so the relative performance was good.

Ironing out a Few Questions
Take-Two also resolved two issues that had likely been hanging over the stock to some extent. First, the company announced that it had renewed its deal with the principle figures at Rockstar Games (the developer of Grand Theft Auto and Red Dead Redemption). The terms were "substantially similar" to the prior deal, and this should reassure investors about the company's ability to continue producing attractive new games. (For more, see Gaming Industry In Desperate Battle.)

The company also announced that it renewed its agreement with senior management. Although I don't think there was ever really any serious concern that existing management would walk away, investors may nevertheless be irked at the higher compensation terms being granted to senior management.

More of the Same - Waiting on Big Titles
Take-Two may be making progress towards a more sustainable model, but the reality is that big releases still matter. To that end, it will be well worth watching to see how popular the newly-released "LA Noire" proves to be. It is also worth seeing what happens with the NBA and its labor situation - the company recently extended its deal with the NBA and Take-Two has been doing a good job of grabbing share from Electronic Arts (Nasdaq:ERTS) in sports titles, but a stoppage of play in the league could be a problem.

It would also likely do Take-Two some good to try to diversify its business a bit more. The company gets a very large percentage of its revenue from the Microsoft (Nasdaq:MSFT) and Sony (NYSE:SNE) platforms, but little from PCs and Nintendo (Nasdaq:NTDOY-PK). While it may be true that Electronic Arts and Activision (Nasdaq:ATVI) are not making money hand over fist in those lines, diversification still has its benefits. At the same time, it is worth wondering if any gaming software company will make a bigger push into games for products like smartphones and tablets. Nokia's (NYSE:NOK) N-Gage may have been a disaster years ago, but that does not mean there isn't profit potential in apps for these newer devices.

The Bottom Line
Maybe it sounds obvious, but Take-Two's valuation really does revolve around to what extent the company's revenue and cash flow production become more consistent. Games are an increasingly high-risk/high-reward proposition, but there is still growth to be had here. For investors who can stomach the likely volatility, these shares look attractive on a three-year basis. (For more, see Has Take-Two Found A New Path?)

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