Take-Two Is Now Being Priced As A Call Option On GTA 6

This article was originally published on this site

It’s undeniable that Take-Two Interactive (TTWO) is a fantastic gaming company. However, I believe it’s relatively pricey by now. It recently got downgraded due to its seemingly lofty valuation. I consider that TTWO isn’t grossly overvalued. But since its 2019 March lows, the stock has risen 46.9%. So, a good deal of its upside has been realized already. Besides, 2020 isn’t very exciting for TTWO’s pipeline. Thus, I believe TTWO’s valuation now hinges on being a call option on GTA 6. This is why I believe TTWO is a viable investment, as long as TTWO doesn’t push GTA 6’s release date past 2021.

Source: TTWO’s investor presentation.

Timing GTA 6’s release date

So far, GTA 6 hasn’t been officially announced yet. Therefore, there’s still much uncertainty surrounding TTWO’s crown jewel. In my view, since GTA 6 wasn’t revealed during last years’ E3, then it’s unlikely it’ll be released in 2020. I estimate that TTWO will probably announce GTA 6 a year in advance to its official release date. This way, they can build the hype around the next installment of its most significant IP. Therefore, I think the subsequent GTA will likely be a next-gen console game. After all, the new generation of consoles should be released later this year.

I now anticipate that TTWO will focus on developing GTA 6 as a next-gen game. Also, I expect the game will become the star of this new gaming super-cycle. Consequently, TTWO will likely grow significantly as a result, which would justify its current premium. This is why I think the market seems to be pricing GTA 6’s release before the end of 2021.

Source: TTWO’s fiscal Q2 2020 10-Q.

Historically, TTWO has acted similarly to previous GTA installments. You see, GTA V was also initially the main attraction of the current generation of consoles (released back in 2013). For context, since GTA V’s release in September 2013, TTWO has risen a whopping 607%. This vastly outperformed the S&P 500, which only increased by 85% over the same period.

Source. Yahoo Finance. TTWO’s stock performance since GTA V’s release compared to the S&P 500.

Even seven years later, GTA remains a significant contributor to TTWO’s revenues. This shows how vital GTA V is for TTWO and also how much of a cultural success was GTA V. Moreover, since then, TTWO has doubled down on GTA V through DLC’s and microtransactions. This has been a winning strategy due to 1) creating recurring streams of revenues, and 2) strengthening its fan base’s loyalty.

Source: TTWO’s fiscal Q2 2020 10-Q.

TTWO doesn’t breakdown this type of recurrent revenue for investors. However, most of TTWO’s recent outperformance was due to GTA V’s stronger than expected results. This means GTA V must continue to be a significant portion of TTWO’s revenues. I feel it’s probably reasonable to assume that 40% to 60% of TTWO’s recurrent revenues come from GTA V. Naturally, we can’t know for sure, but I think it makes sense due to GTA’s historical performance. The remaining revenue streams come probably from NBA 2K and RDR2 online. So, I’m comfortable with these assumptions.

From “volatile” to “recurrent”

I think this gives us valuable insights into TTWO’s future. You see, historically, TTWO’s revenues have been relatively volatile because they tend to fluctuate in tandem with the releases of major titles (such as GTA V). However, now its sales are quickly becoming much more consistent due to microtransactions and virtual currencies. Moreover, these revenues have higher margins. Currently, these recurrent revenues account for 42% of TTWO’s total sales. But, more importantly, these repetitive sales have impressive growth. For context, TTWO’s 2019 recurrent revenues increased by 42% and should grow another 25% in 2020.

Over time, I expect an ever-increasing portion of TTWO’s revenues to be recurrent. As TTWO investors, this would be a game-changer because it would significantly reduce TTWO’s revenue volatility. This, in turn, would also improve TTWO’s risk profile. Thus, I think this would translate into a higher valuation multiple for TTWO over time as well. So, to me, TTWO’s long-term prospects are as strong as they’ve ever been.

TTWO undoubtedly trades at a premium

However, TTWO currently trades at a relatively high valuation. TTWO’s forward PE of 26 implies it’s pricing in 26%+ growth over the long term. I obtain this figure assuming a PEG ratio of 1, which is generally used as a benchmark for fair value. However, in reality, TTWO’s earnings are expected to remain flat YoY during 2020. Hence, TTWO’s short-term results aren’t enough to justify its premium.

Source: Analyst consensus on TTWO.

So, I think the market is pricing in GTA 6’s release before the end of 2021. This is despite the game not being officially in TTWO’s “pipeline.” Moreover, typically these types of AAA titles get released during the fourth quarter to benefit from the holidays. Hence, I expect GTA 6 to be published in Q4 2021. This is why I now mostly consider TTWO as a call option on GTA 6 until 2021, but without the decay. Thus, in my opinion, TTWO currently offers a compelling risk-reward proposition.

A GTA 6 release before 2022 would signal further upside potential

Naturally, I think GTA 6 will most likely be an outstanding success, which would fully justify TTWO’s current valuation. After all, TTWO has consistently hit home runs on every significant GTA title. Also, I think GTA 6’s success will be unprecedented because the gaming market tends to heat up whenever new consoles are released. And finally, gamers will likely purchase GTA 6 mostly digitally and incur many microtransactions, which have higher margins. So, I think all of these tailwinds give TTWO considerable upside potential.

However, despite TTWO’s fantastic long-term prospects, its short-term outlook is boring by comparison. According to TTWO’s guidance, during 2020, there won’t be any new releases on par with RDR2 or GTA 6. And recurrent revenues by themselves won’t deliver any meaningful overall growth. Thus, I believe TTWO’s premium is due to the stock being priced as a call option on GTA 6. But the problem with this investment thesis is that TTWO will likely be “dead money” until GTA 6 is officially announced.

Source: TIKR. The figure shows TTWO’s financial performance since GTA V’s 2013 release.

Nevertheless, I still think the way to play TTWO is to continue holding it regardless. Thus, as time goes by, the odds of GTA 6 being announced increase proportionally, and with it, TTWO’s intrinsic value. Therefore, trying to time TTWO should be ultimately detrimental, even though it’s probable that during 2020 it’ll be “dead money.” On the flip side, investors risk TTWO delaying GTA 6’s release date further than 2021. If this happened, TTWO would be “dead money” for another year, which wouldn’t justify its current valuation.

Conclusion

If you anticipate a GTA 6 release before 2022, then holding TTWO makes sense. However, if you think GTA 6 will take longer than that, then there are far better places to invest in the meantime. My take is that it’d be a massive blunder for TTWO to wait beyond 2021 to release GTA 6. After all, time is money. By 2021, GTA V will be a 9-year-old title, which won’t be enough to justify TTWO’s current valuation. So, I hope TTWO announces GTA 6 later this year and releases it in Q4 2021. In my view, this would adequately compensate for TTWO’s current premium. I think this will be the case, which is why I remain long-term bullish, but short-term neutral until GTA 6 is officially announced.

Thank you for reading and good luck.

Disclosure: I am/we are long TTWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.