Take-Two Interactive: GTA and NBA 2K - [Business Breakdowns, EP.124]

25:12within 12 months of each other. And then you come out with a PC version and then you get triple dipping potentially, right? So it was like actually a perfect storm and a perfect time to release this type of game. Not to mention they were releasing their online services over that time and perfecting it and getting more, getting re -engaged people coming in to try it out again and get hooked on it, right? This time it's a little bit different because we're kind of mid -cycle. And so the install base is a lot lower than it would have been that GTA 4 release. And so they only have a certain amount of hardware units out there to sell into because it's going to be a PS5 and Xbox Series X exclusive.

25:47And so the initial sales are probably in the 25 to 30 million range. And what I worry about is that people get way too high in their expectations. And we won't see another next -gen console for another three years, maybe even four. And so they only have this basically install base to work with until those next -gen consoles come out. And the PC SKU, obviously we don't know, but that likely will be delayed at least a year after the console skew, which is the typical thing. Anyway, so I think people don't want to get ahead of themselves in terms of expectations on the unit sell through. There's only a certain amount of attach rate, maybe 30, 40 % of the existing install base that will buy GTA.

26:23Not everyone is going to buy GTA that has a console. But if I do the math and that it does come out in two years and there's a new console in three years, it wouldn't be the worst setup in terms of replicating what they did before, obviously with a much lower install base overall with consoles. If I'm right in my delay of the game, you may be right. You're off by a year, maybe. Not as ideal, but yes. It's possible that they could wait until a better opportunity to double dip the way they did with the original one with GTA 4. Is there a substantial cost involved with updating the title for the different consoles?

27:02Yes and no. It used to be far more complicated because they were on different architectures. But now that everything's basically a PC, both Microsoft and Sony have come out with consoles that are PC architecture. I don't want to be demoralist on this because it is very complicated, but it's not as complicated as it used to be. And then the PC SKU itself allows them the flexibility of building the game for different levels of hardware. And so that helps as well in terms of engagement and then to iterate on the game itself. When you look at the most recent GTA, just in terms of the upfront sales that they have now, the revenue associated with in -game purchases, what do you think that looks like in terms of the total that they earn from selling the actual title versus the total that they've earned from in -game over time?

27:46The amount of money that they've made on selling the game is far higher over the years. But the recurring revenue, if I were to guess, I would say it's like 70 -30, maybe 60 -40. That's typical. Yeah, you answered my question as to why they don't just give away the game for free and generate the... Oh, wow. That has been a huge source of angst for me, people talking about free -to -play on console like it's going to be the next thing. It's the wrong market to do free -to -play. This is a premium market and you have to compete against premium games. And so, yeah, they have given away for free over the years, but only after they've sold a gajillion units.

28:20It's interesting that the unit price per sale has not gone up substantially. The title would cost in the $60 to $70 range now? The new price being set now is $70. But with something like GTA, they'll have premium SKUs that go for $80, $90, even $100, and people will buy it. And is there any bull case for seeing that number go even higher? As you start to mention those numbers, it's substantially higher than the $50 that I remember paying back in my day, as I'll say. but I would have expected it could possibly be over 100 at this point, given everything that's happened. Where do you think that could be over time?

28:58Is it any bit of a catalyst from a revenue perspective? Yes and no. When you're talking about premium plus type things, where you're buying the game basically in essence for $60 or $70, and then you're adding in a layer of DLC, of currency, etc. People that are going to be really engaged with the GTA online, because only a small portion of the actual audience that buys GTA is involved and engaged GTA Online, right? Again, the free -to -play business model is very small group of people that are actually spending insane amounts of money. So you have to keep that in mind. So those type of SKUs will do well with that audience, but it's a smaller percentage of that audience.

29:34What I'm hoping, again, from a design perspective, what I'm hoping for GTA this time is, first of all, they learn a lot from their last GTA in terms of how to monetize what the content cadence is supposed to be, how to monetize the audience and optimize against the spenders, And then also the technology behind GTA 4 was so bad in terms of load times and all the issues around matchmaking. And it was horrific. The fact that they've made so much money is kind of remarkable. So the new technology with the better hard drive, the SSDs and better load times, hopefully they'll be able to optimize and make it a much better experience and have more mechanics to monetize.

30:09And again, what I'm really hoping for, which I don't think will happen, this would be really bullish for them, is they start to do more pay to win, pay to progress type mechanics, which will send the spend depth much higher. And that'll really leverage the core players to spend more. And that would be a huge boom for them in terms of revenue per user. I know in mobile, a lot of the advertising actually is just the closed loop system. So it's not necessarily advertising for products, it's advertising for other games. I always wondered if the advertising market could exist in the console industry as well, whether it's product placement or something else.

30:46GTA feels like one of those games where you could actually see those things show up, putting aside the mature rating and all the dynamics that go into that. But I'm just curious if that's a business line or a segment that they've ever tapped into. You mentioned why most likely that won't happen because of the mature content. And I don't think Coca -Cola would be really interested in branding with GTA. So those brand placements, probably not. Maybe certain brands. Yeah, there's brands for everything, but fair enough. That makes sense. Advertising actually within console games is something that we've been looking at for decades.

31:19When I was at EA and we actually tried it a few times. Massive, I think, was acquired by Microsoft ages ago to try to take advantage of that. It kind of went away, but now it's coming back in full force. There's a couple of companies that are actually working on building that within games to do banner advertising and other much more. better placed advertising. So we'll see. GTA, I don't know if it's a really great fit. Because the one thing about GTA is you want to be immersed in the world. And by any type of advertising within the game, that pulls you out of the immersion, right? And what's the call to action?

31:50But anyway, there are people much smarter than me working on this type of thing, and we'll see it more and more. But again, the mature nature of GTA makes it a little bit tough. Shifting gears to 2K, I think you outlined the bold case for why that franchise could continue to do well. I'm curious in terms of the license itself with the NBA, is there anything unique there in terms of what that contract costs them, whether it comes up for renewal, how often it comes up for renewal? What are the dynamics behind that? Basketball is an open license. It's not an exclusive with 2K like the NFL was for a while with EA and then FIFA was, but ultimately that went away for EA.

32:26There's no competition out there. EA has been trying to make a new game. And actually, I don't know what is happening with that because supposedly it was supposedly coming out this year. And they said to investors of clients of mine that they're not giving up on it, but it seems like they're giving up on it. So I'm not too worried. I will say this is this is one thing that people don't really quite understand about these licenses. that even though the Take -Two is the licensed store and NBA is the licensee, the reality of it is that 2K actually does a lot for the brand of NBA. Similarly, they did a lot for the FIFA brand in terms of making it as popular as it is, right?

33:05It's more of a partnership than a licensee -licensor relationship. Now, that's not to say that NBA could come at them with insane terms. That's possible. But I think there is a partnership there and I think that's less of a risk. Makes sense. If we just compare those two titles from a margin perspective, profit perspective, however you would think about it, do you think there's drastic differences between those two? And then we can talk about the rest of the catalog after that. I actually don't think so. And the reason I say that is because the type of license or 15 to 20 % that you're giving to the NBA and the Players Association is probably very similar to the percentage you're giving away to Rockstar, right?

33:46So at the end of the day, from an EBIT perspective, I bet they're very, very similar. And what is an ideal EBIT margin for a title? Obviously, there's a lot of moving parts. And I know it's difficult when you have the beginning of the life with the title sales versus the in -game purchases. But how would you even think through that in terms of any type of return metrics, profitability metrics, margin metrics for a title? I would say like 40%, 30 % to 40 % for these type of businesses. But over the life, it gets complicated because the dev costs are so front -voted, right? Capitalized, etc, etc.

34:19But it's probably a higher margin ongoing, but lower margin if you look at it holistically. So 30 to 40%. And then the rest of the console PC portfolio of titles, is there anything else in there that you think is an attractive name that could emerge as a third horse in the race? This is part of my risks with Take -Two as a whole, right? Is that Activision Take -Two in particular just did not do a good job of investing in other studios, right? Whether it's different Rockstar teams or other studios. And so they really don't have much at all other than GTA and 2K at Take -Two. There are other games in the portfolio that are coming, but they're just not going to be profitable, not nearly as profitable as GTA and 2K.

35:05Like if they make money, it'll be surprising. Like Judas is the game from Levine that's coming out. And then finally, we have the Gearbox guys who make Borderlands. And Borderlands has been one of the bigger franchises from Take -Two, but they don't own it, right? They're only a distributor of record. It's really the Gearbox guys, which were acquired by a terrible, terrible, terrible acquisition by Embracer. And so they own that team, but not that franchise. So it's very unclear. And Embracer's collapsing as we speak. So I don't know what the guys at Gearbox are going to do, et cetera. But that could be an interesting game going forward.

35:36But other than that, everything that they're doing doesn't make any sense. They came out with some casual sports strategy, which is some fever dream of some guy in Marin that wanted to make casual sports. That's not the business that we're in. We're in a triple A business. So it never made sense. They had some success with the Lego racing game. But other than that, making a tennis game or making an arcade basketball game, none of this makes any sense, right? This is not the business that we're in. And then the company will keep saying the same bullshit over and over again, that they have like 52 games planned for the next three years, including 17 immersive core games.

36:13It is just nonsense that they keep pushing this narrative, but they don't have the teams to do what they're suggesting. It is just a narrative. That's all it is. And I guess you should keep track of it, but don't expect much contribution from it is the way I would look at it or the way I talk to my clients about it. Putting aside the casual sports games, which it sounds like there's an obvious issue there, but do you think there's other AAA titles that exist within the portfolio that just don't have the marketing budget, what do you think stops them from having another hit game? They don't have any teams.

36:46That's it. They have not built the teams that can build contemporary AAA. They just did not invest in building new game teams that can create contemporary games. That's just full stop. I know with EA, they have a software or some type of design studio that's in -house that can be used by all the different teams. And you can tell me how quality that is versus just pure marketing language. EA did the smart thing. They bought Respawn, right? And they bought that management team and that group. And Vincent Bell, he's an amazing operator and studio leader, which is the hardest roles to fill within these type of organizations.

37:22Like it's really hard to manage creatives, but he has that credibility. He's been down the block a bunch of times and he's created like four or five studios under him that are actually creating AAA content, including the Star Wars game, including the Black Panther game and the Iron Man game. They're working on a Medal of Honor game. That's what Take -Two should have done ages ago, right? But it's too late now. It's really hard to build these type of teams there. So I think EA has been really smart in reinvesting some of their revenue and earnings into building out these teams to build more content, right?

37:50They just don't have the capability that I see within Take -Two to actually do anything. The other thing would have been, which again, they have no control, is that Rockstar creates a second team to help build something with Midnight Club, some with their older IPs, Max Payne or whatever. But that's not happened. They've consolidated to one team as well, like I said earlier. And what does a team look like in terms of size? I'm just curious. Early concept is like 10 to 20, but pre -pro is 50 to 60. And then you go up to full production at like 200. So it evolves over time. But those teams need to be built up and have experience working together and working on games, right, which takes a long time.

38:27So I guess with something like film, we've actually seen the number of titles that are released each year come down quite a bit. And you've seen a removal of a lot of those mid -budget films that used to be made that are no longer made by the studios. And there's various different reasons for that. It sounds like, in your view, from an investment perspective, that's what would make more sense to do here. Do you think that's specific to Take -Two because of the teams? Or do you think that's a broader industry dynamic? Historically, when I was the first at EA, we were building like 30 games a year.

38:59Now, if they do six games, that's a lot. And again, the focus has been on revenue per user, as opposed to tons of games trying to expand the audience. The market matured. Media matures in that way, right? Until new platforms emerge, right? Gaming is no different than even movies and television, which kind of consolidated to a few studios, right? Or to a few networks until Netflix came out. And then that changed the game, right? A new platform came and created much more opportunity. But for games, it's again, it's been like these 200 million users that continue to buy consoles that is the target market.

39:33And the game makers have just consolidated to fewer and fewer franchises. And mobile is evolving in that way too, where it is almost a winner -take -all type thing where certain types of genres are the main revenue drivers of the business. And that's been the way it's been since almost 2014. In mobile, does the margin profile look similar to those 40 % EBIT margins? Unfortunately not, particularly for Zynga, which was acquired by Take -Two. So for individual products that scale, absolutely. So for something like King's Candy Crush, I think they are at 40 % margins. And certain big games do scale in that way.

40:10The problem with Zynga, and I think we'll get into it a little bit, is that, yeah, they bought this company with a gajillion products that some are more profitable than others for sure. But overall, the business, I think, was like a 15 % margin business at best. Talk a little bit about the titles there. Do they have any core IP or crown jewels that sit within that portfolio? And in your mind, how similar will mobile be to console where it is core IP? Or is it a different market where you'll just see recycling and new games tested out more frequently? Well, because game development costs a lot less in mobile, I think there was a lot more opportunities to experiment and throw out there and see what sticks.

40:49But my opinion of mobile has changed now is that user acquisition cost is so expensive. Game development is getting more and more expensive. But you spend more on user acquisition than you do on game development, right? Which is not the case for console. So it is consolidating amongst the big publishers and the big games. And Zynga does have some amazing games that they've acquired over the years. And so those are like the cornerstones of their business in terms of what's generating all the profit and the revenue for that matter. The problem is, is that all those core businesses are falling apart right now because IDFA and all these privacy issues.

41:28And Take -Two bought this company at the peak. It was like the most idiotic acquisition in terms of timing I've ever seen in my career. It was so bad. People in the industry were just like, what is he doing? Why would he ever acquire this company? And I've been covering Zynga since the beginning. And I was really content with what Frank did with the business. But it was clear eight months before the acquisition that they were looking down the barrel of gun of no growth the next like three or four years. And then they get acquired for a premium. It made no sense at the time. But back to your question.

42:00The big franchises that matter for them is Merge Dragons, Empires and Puzzles, and Toon Blast, and Toy Blast, and Golf Rival to some degree. These are all the acquisitions Zynga made over the years that drive the majority of their revenue. And if you look at all of them, they're all down 15 % to 20 % year on year after a shitty year last year. It is Armageddon over at Zynga. The fundamental problem with this is as revenue declines, in order to maintain the profitability, which was shitty to begin with, you start cutting costs, right? And when you start cutting costs, the only thing that you really can cut, once you cut a lot of people, is cut UA.

42:36And the minute you start cutting UA, and this is a UA driven business, then revenue suffers, and then revenue goes down, and then you get in this death spiral. Now, having said all that, I think a lot of that's priced into stock. If you had listened to me a year ago, when this acquisition was announced, I would have told you all this then, and exactly what I said actually happen. But I think everyone's kind of realizing that and no one gives a F, right? All they care about is GTA. And rightfully so to some degree. Hopefully they can stabilize this business, but it's not looking good. I'm curious, just in terms of the acquisition, obviously the price was way out of bounds.

43:12Is it still a valuable asset? You described the death spiral there, which can be incredibly destructive and almost negative value. And you can argue that just the attention that it requires could detract a lot of value. but in your mind, is there value somewhere in that Zenga asset once it stabilizes? No, they gave up 40 % of their company, 40%, right? Whoever was doing spreadsheets and PowerPoints on this thing clearly had no idea what was going on in the mobile game market. There was a reason why it was at $6 before this acquisition. If they had waited three to six months, they would have gotten it for half as much.

43:48The majority of the analysts in the space could have told you that. So I don't know what they were thinking. Really, I have no idea. So is there value? No, it's a declining business. You have to compare this to King, right? And I hate to bring up King on this because King was bought for like 10 times EBIT while Activision was trading at 20 times EBIT. And at that time, Bobby did this absolutely massive multiple arbitrage and it was a genius acquisition at the time. But even after that, the business actually flatlined. It wasn't doing much, but it maintained its profitability, right? So it was this cash cow that they kept on reigning in.

44:22And then on top of that, they ended up growing by doing better live ops and advertising all this stuff. This business has been, Bobby is a freaking genius, right? When it came to this sort of thing. Strauss did the exact opposite. They bought a declining asset with less profitability than their core business and continually declining revenue. So I'm imagining in my head with these McKinsey and JP Morgan guys creating these spreadsheets and these beautiful PowerPoints talking about how this is going to be multiple expanding arbitrage, whatever, and like putting all these fancy graphs up there, but they don't understand the core business.

44:53Apple destroyed it overnight and it's getting worse and worse. And all these core franchises are never going to be able to grow again. And the key thing here is they have absolutely no capability of building new games within Zynga. And this is the critical point is that they do not have extra teams building new stuff. They have no pipeline whatsoever to offset the weaknesses in their core businesses. And so this was all known. It was so obvious. It just kills me. So no, I think this is the biggest problem with this story is that Zynga is going to be this constant albatross around the neck of this company from a profitability and revenue perspective once they consolidate all their P &Ls.

45:28Do you think it makes sense for mobile and console PC publishers to be combined? Are there many synergies that exist between the two? Very, very little. No. I think Strauss had a lot of pressure to get into mobile. And as I said earlier, mobile has become like 50 % of the interactive business and they really had no mobile presence. So I think he was pushed into it without really understanding it. And if you actually listen to Strauss talk all the time, he's always talking about AAA. He doesn't really like these free -to -play mechanics and he doesn't like mobile all that much, similar to the way EA, the CEO of EA, hates mobile, generally speaking.

46:09So anyway, I think he was kind of pressured into building it. And I think a lot of it had to do with the ego. Strauss is always, in my opinion, or people that I talk to say that he always wants to be as big as EA and Activision, right? And without a mobile presence, it's going to be impossible to be at the scale that EA and Activision are, right? Both of which have mobile. This was a way of almost overnight getting into mobile, but it was just the wrong acquisition at the wrong time. Qualitatively checking a box of mobile exposure makes sense. Everything else beyond that, the reality of the situation, point made for sure.

46:38Keeping on the consolidation topic, the acquisitions topic, Microsoft Activision, obviously big headlines. What does that mean for Take -Two? My immediate assumption is it makes them a potential target. How real do you think that is? And in five years from now, will EA and Take -Two be independent? And it's really, really hard to think that EA and Activision will be independent in the next five years. I have to imagine that as I don't want to go down this rabbit hole of this Microsoft Activision, Activision, but if that deal actually goes through, which it looks like it's going to get through, that is open.

47:14Everything's open for acquisition, at least locally, right? One clear thing is that the Chinese will not likely be able to acquire big publishers in the West for obvious reasons. But for people like Amazon, Comcast, Netflix, Apple, Disney, potentially, not probably in the short term, it's open season on gaming companies, right? Now, they're expensive, but could be a strategic pillar for any of these companies. Right now, I think Amazon and Comcast are the ones that are the most potential to do something in this space. I think Amazon's not giving up and Take -Two makes a lot of sense for Amazon.

47:48And Comcast has some interests there as well. Savvy Group is probably the other potential that has deep coffers to buy something like that. And that's that Saudi sovereign wealth fund that acquired Scopely recently. And they're still looking for a traditional publisher for console PC, which could be something like Ubisoft or Take -Two. EA is a little bit different in the sense that majority of their content is licensed, most of their biggest content. So it's a little bit harder. Disney would make a lot of sense for them or Amazon. And the strategic benefit to those buyers, I think with Microsoft Activision, I know it hasn't necessarily been for the strategy, which you would initially think in terms of the Xbox and maybe holding games hostage.

48:30It's quite the opposite, but would be a buyer strategy, someone like an Amazon or a Comcast in terms of acquiring a Take -Two. First of all, getting into the interactive space, which is one of the fastest growing areas of media, generally speaking. It's also leveraging the existing IP from that acquisition to do cross media, which movies and television, which has become more and more popular with the success of Last of Us and The Witcher and numerous others that have done extremely well. And Take -Two has some great IP. Red Dead Redemption would be a great IP for movies and television. Max Payne, Bioshock.

49:07So there's tons of stuff that they could leverage. You've mentioned the valuations are extremely high in terms of potentially impeding a potential acquisition. How do you go about valuing these businesses? And what is industry norm from the investment world in terms of looking at these as a traditional PE? Is there anything unique that they use to come up with valuations? I mean, it's more or less traditional PE stuff. It used to be more of a hit -driven business. So you would take peak earnings, et cetera, and then do some kind of discount on it. And that's kind of what Take -Two has to some degree, because next year, again, if GTA comes out, you consider that one of their peak earnings years.

49:47And so that's kind of what the multiple is based upon right now, or how some of the investors are looking at it. On the flip side, Activision and EA kind of have much more stable earnings. And so they traded an ongoing multiple. And I think that makes the most sense. Or you could take an average over the next three or four years for take two. But they seem to think that they can actually grow after the release of GTA through GTA catalog and online sales and other products in the pipeline. Anyway, that makes it even potentially more valuable. And I think there's actually a method that that could happen.

50:18I guess relative to the market, we said like average market multiple normalized of 15 times earnings. Have these businesses historically basically normalized off of that as the evolution of mobile or maybe not mobile, but in -game purchases allowed for secular multiple expansion? I alluded to that earlier. Historically, the multiple was a lot lower because of the hitch driven business. But now that they are kind of a SaaS business to some degree, their multiple definitely expanded to the 20 to 25 range. And they should. I mean, a lot of this stuff is very predictable. EA has grown FIFA over the last decade every year, some higher than others, but it's still like this ongoing business.

50:59They have this core group of people that are continuing to spend and have complete loyalty. 2K is the same thing. I think we've talked about the risks quite a bit. Zynga being in the death spiral and just being in a constant strain on the business, being one of those things. Anything else that you would point to in terms of key risks here for Take -Two? My biggest worry is that people's expectations on GTA get ahead of themselves. People have to keep in mind that the install base is a lot lower that they're selling into. The total address of the market is smaller. And then there's always the software as a service risk.

51:34There could be burnout. People may not be as interested in going into GTA that they did before, right? Or get all bent out of shape because all the content that they've purchased. I mean, you have to imagine people have collections, hundreds of cars, hundreds of boats, hundreds of motorcycles that they've collected and spent thousands and thousands and thousands of dollars and thousands and thousands of hours collecting. And so now you're asking them to stop, get rid of all of that. And I know it's digital, but it's still considered an asset for these people and start over. That's a tall order.

52:07They have to manage that well. The final thing I would just say is that in order to really see an increase of revenue per user, they have to do a better job of managing the service, the online service. And that's what I'll be watching to see how well and what they do, what mechanics they have, what kind of things that they're doing in order to monetize the audience better so that they get more revenue per user, because they're going to have to do that to offset the big install base of GTA 4. We close these conversations out with lessons or things you could take away from looking at this business and maybe apply to other businesses.

52:43Seems like there's quite a bit here, actually, just in terms of lessons about capital allocation and acquisitions and getting pressured into making those deals. But what would you point to in terms of main lessons that you think you might be able to apply elsewhere? Clearly, you have to focus on the businesses that make up the majority of their earnings. So keep an eye on the big titles, GTA and 2K, similar EA, similar Activision, etc. And then also, you got to keep an eye on the potential downsides of businesses that aren't doing well, like Zynga. And I think you can do that for all of these publishers that are out there.

53:18And then finally, this is still a hit -driven business. Regardless of how mature it gets, there are still things that can surprise you. And so that's what makes this business really interesting from an investment perspective, is because things can come out of nowhere and do extremely well. I mean, something like Fortnite was after two really failed games from Epic. Epic hadn't created a good game, a successful game for like 15 years. 15 years they haven't created the game. And all of a sudden they have the biggest game in the world. That's still possible in this world. And that's what makes this industry really interesting for both mobile and console for that matter.

53:53Always keep that in mind that you have to be keeping track of the buzz and interest along new games that are coming out. Well, Eric, this was a pleasure. Appreciate all of your insights on Take Two specifically at the industry. Thanks for joining us. Thank you. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S .com.