Take-Two's Steamy Scenes: a Wash?

Analysts differ on the long-term damage of the sex-scene controversy.
Author:
Publish date:

A sex-scene controversy has tarnished

Take-Two Interactive's

(TTWO) - Get Report

reputation and threatens to sully current-quarter earnings, but investors differ on the longer-term meaning for the company -- and its stock price.

An assortment of major retailers on Wednesday and Thursday said they would pull the game from shelves in reaction to a change in the rating of

Grand Theft Auto: San Andreas

from "mature" to "adults only." While this crimping of distribution could hit sales, the company might actually benefit from the publicity, ameliorating some of the effect.

With Take-Two shares already trading at a discount to those of the company's peers (the stock was recently at $25.53), the downside may be limited. But the news certainly didn't help, and the upside for the stock might be limited as well, thanks to broader issues.

"I think this is just really a neutral event. I don't look at it as a bad thing or a buying opportunity," says Norm Conley, a portfolio manager for JAG Advisors and a contributor to

TheStreet.com's

sister site,

RealMoney.com

. Noting that Take-Two is no stranger to controversy, thanks to its "edgy" games, Conley, whose firm is long Take-Two, adds, "This is part of being a shareholder in Take-Two, this sort of thing."

The sort of thing that got Take-Two in trouble is a

series of sexually explicit scenes found within

San Andreas

, the top-selling game last year. Players don't see the scenes in the game as shipped, but they can unlock them by using software code available over the Internet.

After an investigation into the matter, the Entertainment Software Rating Board changed its rating on the game. As a result, Take-Two will stop producing the game, recall any copies of the current version that retailers wanted to return, and ship a new version later this year that blocks access to the sex scenes.

Take-Two predicted that earnings would come in 30 cents to 40 cents lower than expected because of the moves it will make, because of retailers' expected response.

That response came quickly on Wednesday and Thursday. Citing company policies that prohibit the sale of "adult only" rated titles, major video-game retailers including

Wal-Mart

(WMT) - Get Report

,

GameStop

(GME) - Get Report

,

Best Buy

(BBY) - Get Report

and

Circuit City

(CC) - Get Report

all said they would pull

San Andreas

from their store shelves.

"If the major channels of distribution are blocking you, that's a problem," says Steve Monticelli, president of Mosaic Investments, who has no position in Take-Two.

The market seemed to agree, as Take-Two shares plummeted immediately following Take-Two's announcement after the bell Wednesday. But the stock recovered much of the lost ground in the regular session on Thursday, ending the day off less than 5% from Wednesday's close -- or up more than 6% from its nadir in the after-hours session.

However, a bigger problem is that retailers may be unwilling to give the company the benefit of the doubt next time around, Monticelli says. Even if they do, parents who might otherwise have bought the game for their kids may be wary of doing so.

"If parents are aware of it -- and I think they will be -- they'll say 'no.' That's the damage," Monticelli says. "I would guess this is going to hurt them beyond the current quarter."

A key indicator of the long-term fallout could be sales of

Grand Theft Auto: Liberty City Stories

, a special version of the game designed for the PlayStation Portable that is due out later this year. The game has been expected to be a big part of Take-Two's revenue and earnings this year.

"Parents before might have said, 'I'll buy it for you.' Now they might not," says Joe Spiegel, a portfolio manager at Dalek Capital, who has no position in Take-Two. "That's the risk."

But other developments signaled that the sales fallout may not be as bad as Monticelli and other observers might think.

Many retailers who dropped the game said they would carry the revised game when released. And two notable retailers --

Amazon.com

(AMZN) - Get Report

and

Electronics Boutique

(ELBO)

-- said they planned to continue to sell the now "adults only" version of

San Andreas

, albeit after a temporary pause to relabel the game with the new rating.

Indeed, as of Thursday afternoon, the PC, Xbox and PlayStation 2 versions of the game were ranked No. 3, No. 4 and No. 6 among the best-selling products in Amazon's electronics store.

"I hate to say it, but I suspect that the 'adults only' rating, particularly for people over the age of 17, may actually increase sales," says Conley, noting the aphorism that "any publicity is good publicity."

Still, Monticelli argues that the controversy is likely to revive investor concerns about Take-Two's management. The company replaced much of its senior executives in recent years after an accounting scandal that led to a

Securities and Exchange Commission

investigation that the company recently settled.

Take-Two executives were likely unaware of the hidden content in

San Andreas

, Monticelli says, but that doesn't make them innocent.

"What this shows is the lack of control that exists," Monticelli says. "The stock has always traded at a discount to its peer group because of issues like this."

But other investors were less ready to criticize management for the controversy. The practice of embedding hidden content in games and other software has a long history and is "endemic" in the industry, says Spiegel. Take-Two's previous management was "shaky," Spiegel acknowledges, but that -- or the sex scene scandal -- shouldn't reflect poorly on the current executive team.

"They've done such a good job to clean themselves up," Spiegel says. "I've got nothing but the highest respect and admiration for them."

So, where does that leave the stock? Spiegel says the shares would have been a "wonderful" buying opportunity if they'd dropped into the low-$20s. But at the current level, they are probably fairly priced, given the updated earnings outlook.

But those earnings numbers could be in doubt, Monticelli says. The key will be how quickly Take-Two can come out with the new sex-scene-free version of the game -- and how willing retailers are going to be to carry it.

"I could be wrong, but I don't see that as a slam-dunk," he says.