Analyst takes Take-Two to task

While Take-Two executives yesterday basked in the afterglow of Grand Theft Auto IV's 8.5 million copies sold, not everyone was thrilled with their performance. In a note to investors today, Pacific Crest Securities analyst Evan Wilson laid into Take-Two management, saying GTA developer Rockstar Games has made them look better than they actually are.

"Rockstar has supported this organization for too long and it is right to spend every dollar that it can get from Take-Two for keeping the business alive," Wilson wrote. "Unfortunately, management appears to be doing the same thing without it being nearly as deserved."

The management Wilson refers to is the group that first took control of the company in a March 2007 investor coup. Led by current Take-Two chairman Strauss Zelnick, that group rose to power promising to address five crucial shortcomings of the previous administration. They wanted to lower the company's cost structure, make the sports division profitable, sell off non-core business divisions, improve the green-lighting process to release more games on time and on budget, and resolve the wealth of legal issues inherited from the old regime.

Wilson ran down management's performance (or lack thereof) on each of those fronts. Starting with the cost structure, he noted that the publisher expects operating expenses to be up 23 percent for the year, when it originally told investors they would be the same as last year.

"At the same time as its cost structure is deteriorating, management is telling investors that it is the most efficient organization in the business," Wilson said. "That simply is not true. Management talks about having a lean sales, marketing, and corporate infrastructure behind its development talent. We disagree with this as well."

By Take-Two's own figures, sales and marketing expenses combined with general and administrative expenses are eating up more than 20 percent of the company's revenue this year. Wilson compared that to the totals of fellow US publishers Activision, Electronic Arts, and THQ, which Pacific Crest estimates account for 16.2, 19.2, and 18.2 percent of their respective revenues.

Regarding the sports business, prior to yesterday's earnings report, Take-Two's management stated it would have the division profitable this year.

"That dream just ended with management finally admitting sports would not be profitable," Wilson said, "although the loss is still 'manageable.' Management attributes this to a lower-than-expected attach rate on consoles. For the layperson, this means that Take-Two management has not owned up to the fact that it is not the hardware manufacturer's fault that its sports games have not sold."

As for making release dates more reliably, Wilson pointed out that Grand Theft Auto IV, Mafia II, Civilization Revolutions, Manhunt 2, LA: Noire, Borderlands, Midnight Club: Los Angeles, and more had all been publicly delayed since new management took over.

"If it appears that virtually every major game has been delayed, you would be correct," Wilson said.

Wilson was somewhat more conciliatory in assessing Take-Two's remaining areas of improvement, noting that it sold off peripheral maker JoyTech (though it can't find a buyer for distribution arm Jack of All Games), and that it had resolved some outstanding legal issues. As of the company's last 10-K filing, Wilson noted that the "Legal Proceedings" section of the document was down to just three pages.

While the publisher's stock price was trading up slightly earlier today, Wilson warned that its success could be fleeting.

"It is starting to appear that the company is back to where it started," Wilson said. "After the success of Grand Theft Auto [IV], it will be looking at a bloated cost infrastructure relative to its revenue opportunity, which will likely be further muted by game delays and underperformance."

As for the pending EA offer to acquire Take-Two, Wilson again questioned the Grand Theft Auto publisher's hesitance to accept a deal, especially since Pacific Crest estimates the ZelnickMedia management team stands to rake in $80 million in the event of a sale at the initially offered $26-per-share level. (EA has since lowered its offer to $25.74 per share due to possible dilution of Take-Two stock.)

"We believe that the risk of EA dropping its bid for [Take-Two] is greater than the reward of EA coming back with a modestly higher bid," Wilson wrote, "and we continue to recommend that investors take profits. EA's $25.74 offer is more than fair, in our view."