Share tip of the week: adventurous investors should play video games

By Paul Hill Jun 05, 2009

Paul Hill

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Cash-strapped families across the world are swapping nights out for cheaper home entertainment. One beneficiary is Take-Two, a leading US video games developer. It is best known for its blockbuster Grand Theft Auto franchise, which has sold 65 million units to date. But it's no one-trick pony.

The group has diversified into other genres, with updated versions of other 'AAA' titles, including BioShock (an underwater action game) and Red Dead Redemption (a spaghetti western epic) due over the next year.

Take-Two Interactive (Nasdaq: TTWO), rated BUY by Cowen

Take-Two is also well placed to ride out the recession. Players have less money in their pockets, so the industry is polarising into mega-brands at one end and value games at the other. For the latter, Take-Two owns several in-licensed brands including big names in sports (Major League Baseball) and family entertainment (Nickelodeon).

So why are the shares stuck near five-year lows? The company's financials will be much weaker this year than last year due to a temporary hiatus in releasing new hits. This is a worry, but as this is probably the low-point in the cycle; we're still not talking car-crash numbers.

The board has reaffirmed its 2008/2009 guidance of underlying earnings per share (EPS) ranging from nil to 20 cents per share on revenue of $1.05bn to $1.15bn. The balance sheet is also robust, with net cash of $110m as at the end of April.

Take two

Arguably the real reason for Wall Street's indifference is because rival Electronic Arts pulled its $25.74-a-share takeover offer last September. This has led to a 65% drop in the stock, which looks overdone. In fact, activist investor Carl Icahn recently upped his stake to 2.6%.

So what's the business worth? I'd rate it on a through-cycle operating profit (EBITA) multiple of ten. Adjusting for the cash pile, that gives a fair value of $14 a share. But mergers can create big synergies in this industry. By integrating Take-Two's distribution channels and back-office infrastructure with its own, I reckon Electronic Arts could cut around $300m a year of overheads. After being taxed at 35% and discounted back at 12%, that adds $1.6bn to the valuation of the enlarged entity. I think Electronic Arts could probably afford to pay around $21 a share.

There are several potential problems, not least its reliance on the Grand Theft Auto franchise (contributing 46% of 2008 revenues), greater competition and the unpredictability of developing new games. There are also currency issues to consider; North America accounts for 75% of turnover. But with gaming fast becoming a family pastime, Take-Two is a good bet for the adventurous investor.

Recommendation: BUY at $8.23

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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