Video gaming is the fastest-growing part of the otherwise depressed technology industry, and no company is hotter right now than New Yorkbased Take-Two Interactive Software. Its secret: technically advanced, fun-to-play games with lots of sex and violence.
Take-Two’s latest entry on the risqué fringe, Grand Theft Auto: Vice City, exploded off the shelves when it was released on October 29, becoming the fastest-selling video game in history. Through December 31, consumers worldwide had snapped up more than 6 million copies at $50 a pop, for roughly $300 million in gross sales. By comparison, just one motion picture, Spider-Man, made more than that in 2002. And analysts say it’s just a matter of time before Vice City, which features a mob flunky running violent missions in 1980s Miami, surpasses Spider-Man‘s $400 million gross. Only four films have ever done better.
“I don’t know what to say -- I’m just blown away,” Edward Williams, video gaming industry analyst at Gerard Klauer Mattison, says of the company’s blockbuster numbers.
For all of its success, though, Take-Two has been about as endearing to the markets as the seedy characters it programs into its games. Over the past two years, Take-Two has issued erroneous earnings statements, demoted its CEO, tossed out most of the rest of its top management and alienated many of the analysts who cover it. The Securities and Exchange Commission is investigating the accounting problems, which surfaced late in 2001 and required a restatement of seven quarters’ earnings, triggering a protracted, three-week halt in the trading of Take-Two’s stock and forcing the company to pay $7.5 million to settle shareholder lawsuits accusing it of issuing misleading financial reports.
All this has tried the patience of analysts and investors; 95 percent of Take-Two shares are held by institutions, including Barclays Bank, J.W. Seligman & Co. and Waddell & Reed Financial. At a price-earnings multiple of 12 in late January, Take-Two’s shares were trading at a deep discount to the 27 multiple of industry front-runner Electronic Arts. And short-sellers are talking trash.
“It’s a junk company with a $1 billion market cap,” carps Marc Cohodes, general partner at New Yorkbased Rocker Partners, who says he’s been shorting Take-Two for the past two years.
“They’ve gained market share and have the hottest games,” UBS Warburg analyst Michael Wallace says, but he cautions, “I’m not recommending the stock, because I don’t know what the outcome will be of the SEC investigation.”
Yet even under that cloud, Take-Two remains well positioned. Currently second in industry revenues behind Electronic Arts, Take-Two has grown from $97 million in sales in 1997, the year it went public, to $794 million in the fiscal year ended October 31. It is projecting $950 million in the current fiscal year, with earnings per share increasing to $2.20 from $1.81. Take-Two’s stock price is up 31 percent over the past year, to $21, while Electronic Arts’ and Activision’s have fallen 18 percent and 47 percent, respectively.
Overall, the sector continues to offer hope to growth-starved investors. Total interactive software sales, which analysts estimate were as much as $7.2 billion last year -- or $2 billion less than domestic movie tickets sold -- will grow 24 percent this year and 17 percent in 2004, predicts Michael Pachter, director of research at Los Angelesbased Wedbush Morgan Securities.
Pachter sees the mature game segment expanding 35 percent annually for the next several years. That’s Take-Two’s niche, and the company has been acquiring development studios, buying and licensing content and staffing up to seize that opportunity. Vice City, the fourth installment and second huge success in the Grand Theft Auto series, is the handiwork of a renowned U.K. software shop, DMA Design, which Take-Two acquired in 1999 from BMG Interactive. DMA’s chief executive, Sam Houser, and chief operating officer, Terry Donovan, renamed the division Rockstar Games, hoping to emulate the hit-making machinery of the music business.
“It’s a cliché, but content is king,” says Kelly Sumner, president of Gathering for Developers, the Take-Two division that publishes games for personal computers. (Sumner had been CEO until last year.)
But strong content won’t much matter unless the company can grow up from a management standpoint, resolve the still-open SEC inquiry and assure investors that its financial house is truly in order. To that end, board members Ryan Brant, the company’s founder and chairman; Oliver Grace, its biggest individual shareholder; and Robert Flug, CEO of New Yorkbased women’s clothing manufacturer SL Danielle, set out to overhaul senior management. By early 2002 COO Larry Muller and CFO James (Chip) David were gone. Brant, Grace and Flug also recruited new directors, including Steve Tisch, the Oscar-winning producer of Forrest Gump, and former BDO Seidman chief executive Richard Roedel, now chairman of the audit committee, to bring to six the number of outsiders on the nine-member board.
“It’s all part of a big program to improve transparency and to have more outside people looking in,” says Grace, a 49-year-old private investor and member of the family that founded W.R. Grace & Co. His 700,000 Take-Two shares, worth some $15 million, represent nearly 2 percent of those outstanding; Brant’s stake is about half as big.
The hands-on directors capped their organizational moves in December by hiring Jeffrey Lapin away from competitor THQ to become Take-Two’s new CEO. He replaced Sumner, whose flagging confidence came out in an interview late last year. “People need to understand what their level is, and maybe I’ve passed mine. I don’t know,” mused Sumner, a shaven-headed Englishman who joined Take-Two in 1997 and ran its international operations before becoming CEO in February 2001. Noting that the company expanded rapidly over two years, from 560 employees to 939, Sumner added, “We’re not going to let the company outgrow management again.”
Says the 46-year-old Lapin, who was THQ’s vice chairman and chief operating officer: “One of my first tasks will be to evaluate the management team. I need to make sure that everyone is in the right slots to run a billion-dollar company.” But Lapin, citing his three years at THQ and in the Starwood Hotels & Resorts organization before that, expects to take the task in stride: “It’s almost a textbook problem [for growth companies], and it’s always easier being the new guy coming in. You don’t have the emotional attachments and loyalties of the guys here.”
TAKE-TWO GOT ITS START IN 1993, JUST AFTER Brant’s December 1992 graduation from the undergraduate program at the University of Pennsylvania’s Wharton School. A gaming enthusiast who as a student developed products for Nintendo Co.'s Game Boy, Brant used money from his father, Peter, a New Yorkarea publisher and real estate magnate, to buy a small development studio, which came with rights to flight-simulator games. For the next few years, Take-Two mainly produced budget-priced game software for PCs and for Sony Corp.'s PlayStation I console.
That set the stage for a 1997 IPO, which raised $8 million. Over the next two years, Take-Two made more than 20 acquisitions, including DMA/Rockstar and Jack of All Games, now the industry’s largest independent distributor. Sales jumped from $13 million in 1996 to $305 million in the fiscal year ended October 1999.
All this gave Take-Two a portfolio of modest-selling games, among them the first two versions of Grand Theft Auto. The company had its breakout success in May 2001 with Max Payne. Similar in feel to the Die Hard action films starring Bruce Willis, the game revolves around a distraught cop avenging the deaths of his family members.
By then, with technology stocks in the doldrums, investors began to pay attention to game companies, particularly to Redwood City, Californiabased Electronic Arts. Today, with hot properties like Madden NFL 2003, EA’s sales are surging. Revenues rose 48 percent in the quarter ended December 31, to $1.2 billion, and the company boasts a market capitalization of $7.5 billion. “Money managers tried to hide out in the video games market, and they doubled their money,” says James Lim, a video gaming analyst at Jefferies & Co. in Los Angeles.
Take-Two became the hot stock after it released Grand Theft Auto III in October 2001. The game became that year’s top seller and laid the groundwork for Vice City a year later.
Take-Two made two strategic bets that paid off big. With its main rivals -- Activision, Electronic Arts and THQ -- concentrating on mainstream categories such as sports and children’s games, Take-Two decided in 1999 to focus its development dollars on harder-edged, mature-content games created specifically for Sony’s PlayStation II platform. The new console, which was introduced in October 2000, sported a 128-bit processor that could render 3-D graphics far more realistically than its 64-bit predecessor.
Take-Two also bet, correctly, that the new machine would grab a dominant market share and that large numbers of PlayStation I users would upgrade to PlayStation II, creating an increasingly mature, affluent and growing population of players. Sony has sold 14 million PlayStation II units in the U.S.; one in nine households has it (the PlayStation I is in one out of three households), and 60 percent of the users are over 18. “Adult males are no longer ashamed to be playing video games,” says Wedbush Morgan’s Pachter.
All is not rosy, to be sure. Game marketers have come under attack from groups like the National Institute on Media and the Family, which campaign against excessive sex and violence. Because of the high visibility of Grand Theft Auto III and Vice City, Take-Two has borne the brunt of recent criticism. It’s easy to see why. After all, a Vice City gamer assumes the role of an underworld goon sent out on missions by a mob boss, committing murder and causing all sorts of mayhem along the way. But Take-Two has some scruples: There is no nudity on the streets of Vice City. And these games carry an M rating, for players 17 and up. “Unlike The Sopranos on HBO, we don’t need nudity, because no one is flipping channels,” says Jamie Leece, president of Gotham Games, one of Take-Two’s publishing labels.
TAKE-TWO HAS BEEN UNABLE TO EXPLAIN AWAY its accounting irregularities so easily.
Prompted by a routine year-end audit, Take-Two announced on December 17, 2001, that it would have to restate earnings for fiscal year 2000 and the first three quarters of fiscal 2001. The timing was dreadful, coinciding with the market frenzy over Enron Corp.'s problems. The company’s stock plummeted $4.72 in one day, to $15.05. A formal SEC investigation and shareholder lawsuits followed.
A month later Take-Two was still struggling to get to the bottom of its accounting irregularities. Short interest in the stock and rumors of management culpability were growing. The company added fuel to the fire after the markets closed on January 22, 2002, saying it would postpone not only its release of fourth-quarter and full-year 2001 earnings, but also a follow-up conference call with analysts. Take-Two officials also asked the Nasdaq Stock Market to begin the trading halt that ultimately dragged on for three weeks.
“We really thought the halt would last a couple of days, but everyone took a deep breath and dug in again,” says Take-Two president Paul Eibeler. “It took much longer to make sure the accounting was 100 percent accurate.”
Eibeler, who took his current post in July 2000 after serving as a consultant to Microsoft Corp. on the launch of its Xbox game hardware, was among the targets of wild rumors about management wrongdoing. “There was one rumor from somebody who said I had called them from jail,” recalls Eibeler. “It was crazy.”
The verdict came from a multimillion-dollar forensic audit by PricewaterhouseCoopers: The company had improperly recognized revenue for games that were returned and later sold again, and some sales booked near the end of quarterly reporting periods, before products had been delivered, should have been carried over into the next. Take-Two also had underreported losses on its 1999 acquisition of Gathering for Developers.
But the dollar impact was relatively minor. Take-Two revised its revenues and net income downward by $4 million and $18.1 million, respectively. Of the $7.5 million cash payout to settle the shareholder suits, insurance covered $6.1 million. When stock trading finally resumed, on February 15, 2002, Take-Two opened at $14 and closed at $18.18.
Analysts remain uneasy, however, mostly because of the ongoing SEC investigation. Neither the agency nor the company will comment on the matter. But Wedbush Morgan analyst Pachter, who is also a lawyer, believes that the probe could lead to civil sanctions, resulting in a fine of up to $1 million. Criminal charges are unlikely because the SEC would have to prove malfeasance by individuals.
In any event, Take-Two can’t count on much good feeling in the analyst community. Researchers have been made wary not only by the earnings restatements but by the fact that the company has changed CFOs three times in as many years. Chip David, previously CFO of Motown Records, held the Take-Two job from July 2000 until he was forced out three weeks after the restatement. David’s successor, Al Pastino, a former Deloitte & Touche auditor, lasted only two months before he quit, citing personal reasons. Stability, of sorts, arrived last February in the person of Karl Winters, who previously served as CFO of United Auto Group and spent ten years in Coopers & Lybrand’s auditing practice.
But even after the earnings restatement, Take-Two failed to repair its relations with the Street. In June, for example, the company raised its guidance for the second half of fiscal 2002, but, in the process, it put out a third-quarter number that was lower than analysts had been expecting. The analysts complained in an earnings call that they had been blindsided, but they got no sympathy from Take-Two’s then-CEO, Sumner, who responded that any mistakes were the analysts’ own fault.
Analysts credit Winters with cleaning up the accounting function by merging the company’s two divisional accounting offices and by upgrading and automating internal audits. The CFO also has beefed up his management team by hiring a treasurer and a chief information officer.
As a result of the high- and midlevel shake-ups, the SEC will find it more difficult to point accusatory fingers at anyone now in key day-to-day management roles. And in Lapin the company has a CEO with stronger operational credentials than predecessor Sumner -- and who doesn’t carry the previous administration’s baggage.
“I hope the SEC looks at it as a positive to have a new person in the top slot who has not been involved in anything that happened,” says Lapin, who began his career as an attorney in Los Angeles and later became president and CEO of Starwood Lodging Trust, now part of Starwood Hotels & Resorts Worldwide, and president of House of Blues Hospitality.
Still, Lapin’s biggest challenge will be coming up with an encore to Vice City. The big rap against Take-Two, says Jefferies analyst Lim, is that it could be a one- or two-hit wonder. “Take-Two now has only two major products -- Grand Theft Auto III and its sequel,” asserts Lim. “Wall Street will turn its cheek until the end of March or so, but then people will ask, ‘What else have you got?’”
Take-Two says that Grand Theft Auto in its various forms contributes 40 percent of net sales, and Max Payne 10 percent. The rest comes from smaller sellers such as Midnight Club, Smuggler’s Run and State of Emergency and from its distribution business. Argues Sumner: “Last year we grew at a 70 percent clip, and Grand Theft Auto III was 30 percent of net income. We’re not a one-trick pony.”
Take-Two intends to accelerate its new-product pipeline, thanks in part to technology advances at Rockstar Games. These include reusable software code that was instrumental in getting Vice City to market just a year after GTA III, about half the normal development time.
For Take-Two, the endgame lies in accumulating intellectual property, both internally and through acquisition. It wants to be positioned for what it sees as inevitable industry consolidation driven by the rising cost of game development. Salaries, royalties and licenses can easily add up to $5 million to produce an elaborate game like Vice City. That’s too much for small publishers, who lack the leverage of a Take-Two in gaining access to scarce retail shelf space.
Take-Two has been gobbling up some of those smaller players: In November it shelled out $28 million in cash plus 235,679 restricted common shares for Carlsbad, Californiabased Angel Studios, now Rockstar San Diego. Also in the past year, Take-Two paid $40 million in cash and stock to Remedy Entertainment for the Max Payne rights, and $3 million in cash and 242,000 shares for Vancouver-based Barking Dogs Studios, which has 50 developers focused on military action games.
Lapin will continue to look at potential deals, but he’s counting mostly on organic growth and an increase in licensed content, especially “kids’ products to round out the portfolio,” he says. “I’d like to see 10 to 20 percent growth over the next several years -- certainly organically and, hopefully, if an M&A deal comes along and makes sense.” For Lapin, and the industry overall, the game is just heating up.
