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shares are down about 17% over the past couple of days. The video-game maker is the focus of a grand jury subpoena and recently settled a Federal Trade Commission investigation.
However, the company's valuable
Grand Theft Auto
franchise should benefit from the current video-game console rollout, and we are adding Take-Two to our radar screen for possible inclusion in the model portfolio on a pullback closer to $7.50 a share. Take-Two closed Wednesday at $10.71, down 14 cents.
After the close Monday, Take-Two announced it had received a grand jury subpoena from the New York County district attorney's office. The subpoena seeks documents regarding the knowledge of officers and directors in the creation, inclusion and programming of hidden scenes in
GTA: San Andreas
. Specifically, the district attorney's office is investigating the company's involvement in the inclusion of explicit sexual scenes in the game, which Take-Two already has admitted were created by its own programmers. In addition, the district attorney's office is investigating compensation documents of former officers and information related to past acquisitions and earnings results.
In January, the chairman of the company's audit committee, Barbara Kaczynski, resigned and filed a letter with the
Securities and Exchange Commission
outlining concerns about the FTC investigation and previous SEC inquiries into the company's management. As we learned from covering Calpine during its bankruptcy in late 2005, the resignation of any member on an audit committee is a red flag for investors because it can indicate internal conflicts over accounting policies and corporate governance.
As a result of the legal problems and possible internal conflicts, Take-Two is no stranger to adversity and is already a favorite of savvy short-sellers who are betting on the stock's demise. The major themes cited by short-sellers relate to the company's dependence on
for revenue, because its other games -- such as the 2K sports titles-- are not as popular. Also, the company's potential corporate governance issues pose a risk.
However, shares are down some 61% from their 52-week high and could be close to a bottom. The video-game industry is approaching a potential boom this holiday season for several reasons.
will unveil its highly anticipated PlayStation 3 video-game console in November to benefit from a sales ramp into the holiday season. And the Xbox 360 console from
, which has been on the market for a few months, will see an increase in shipments later this year as Sony and Microsoft battle it out for video-game supremacy.
Take-Two will unveil the fourth edition of
in September 2007, right when penetration of new consoles in the market is reaching critical mass. Anticipation of this release could create a strong catalyst for shares in the coming year. In addition, the company will release
for the Xbox 360 and Sony PlayStation 3 simultaneously, as opposed to past releases that favored an initial launch with just Sony.
As a result, we believe Take-Two, while poorly run and scandal-ridden, can't be ignored with the stock now trading near the single digits. Although an anecdotal measure, consider the fact that
GTA: San Andreas
received 4.5 stars out of 5 from 871 Amazon reviewers. And according to Web site gamasutra.com,
GTA: Liberty City Stories
for the PlayStation Portable device is the top-selling video game of the year. Take-Two's
franchise is a valuable asset that, at some point, could be attractive to an acquirer or private-equity firm.
With respect to the legal risk, it is worth noting that
is already rated "adults only," which is the strictest rating a video game can receive. Given the game's violent nature and focus on bloodshed and death, we don't expect a big user backlash due to the inclusion of explicit sex scenes. In fact,
could see a surge in popularity as a result of this news as the headlines serve as free marketing for the company. We expect anticipation of the next installment to pick up in 2007 when retailers such as
begin to take pre-orders, with investor enthusiasm quick to follow. In fact, the game should be a top seller in the 2007 holiday season, as it has been in past holiday seasons. Take-Two shares rallied 100% from 2002 through 2004 on the heels of success with
GTA: Vice City
and the introduction of
GTA: San Andreas
in 2004, and a similar rally could occur in this case.
A comparison of Take-Two's valuation with that of peers such as
shows that Take-Two trades at a significant discount to the group, at just 0.7 times 2007 analyst revenue estimates on an enterprise value basis, according to data compiled by Capital IQ. The peer group trades at 2.2 times 2007 consensus revenue estimates for 2007 with Electronic Arts,
and THQ all changing hands at better than three times the Street's 2007 revenue forecasts.
We also compared Take-Two's current operating metrics such as EBITDA (earnings before interest, taxes, depreciation and amortization) margins with its results in past video-game console cycles to determine how much the company could potentially earn at the peak of the current video-game cycle, which is likely to occur in late 2007 and heading into 2008. We believe the company can expand its EBITDA margin from the current level below 5%, to as high as 15% to 20% by 2008, and generate close to $1 a share in earnings. On this basis, we believe shares compare quite favorably with peers'.
Even so, we are going to remain on the sidelines for now as we await more clarity on the ongoing investigation by the New York County district attorney and attempt to assess what, if any, impact this development has on sales trends. However, a drop in the share price closer to the $7.50 level would create a more compelling risk/reward scenario in the near term, leading us to consider taking action for the model portfolio.
William Gabrielski is a research analyst at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabrielski welcomes your feedback;
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