Commentary

Game Over: Whoever Gets Take-Two Wins

Electronic Arts' continued pursuit of Take-Two Interactive would not be surprising, given the strength of the "Grand Theft Auto" video game franchise. But the real winner would be Strauss Zelnick, who bet two years ago that the troubled independent games publisher would be a value play.

Take-Two has been in a turnaround mode since Zelnick Media acquired it. It's expected to become profitable this year on the sale of more than 10 million copies of its only notable game, "Grand Theft Auto," for Microsoft Xbox and Sony PlayStation. Zelnick told me earlier this year there are no plans to buy other video game assets. EA's latest $2 billion cash offer, or $26 a share--quickly rejected by Take-Two--paves the way for what analysts say could be an improved offer, as much as $30 a share, to close the deal.

Having also rejected an earlier bid from EA, Take-Two said it would resume sale talks with EA after the April 29 release of "Grand Theft Auto IV," which is sure to increase the company's value. EA's latest offer represents a 64% premium to the trailing price of Take-Two, which traded up by more than 50% Monday on the news. Last year, Take-Two lost an estimated $138 million on nearly $1 billion in revenues.

Although Viacom and News Corp. have been dancing around the edges of the video game market, they are not expected to engage in a bidding war for Take-Two. It is the kind of profitable flip Zelnick Media was betting on when it acquired Take-Two. While this could come to a head at Take-Two's annual shareholder's meeting this spring, EA is up against the deadline for recommending its own alternative slate of directors for the company's board. Zelnick Media heads a consortium of shareholders controlling 46% of Take-Two stock that replaced the company's board and top management amid financial, legal and operating issues. Zelnick now is executive chairman. The run at Take-Two, like Microsoft's unsolicited bid to take over Yahoo, is indicative of a swell of hostile plays for undervalued properties in the absence of aggressive private-equity buyers.

What's interesting is what the situation reveals about EA and video game' competition in general. Activision's "Guitar Hero" and Wii's participatory games have taken video games to a new level of interactivity that "Grand Theft Auto" and EA's popular sports titles don't include. Advertising, social networking and even wagering are bringing new, lucrative dimensions to the business that has rendered more stable growth than nearly any other media and entertainment sector. Video games' unique connectivity to consumers provides many more ways to generate revenues. In an extensive sector report, Goldman Sachs analyst Mark Wienkes estimates that operating margins will increase to an average 15% from 10%. New revenue opportunities could add as much as $5 billion to the domestic video games market by 2010, coming from in-game advertising, e-commerce, social-networking and broader digital distribution of games.

EA's move into mobile and online games and away from console-dependent games positions it to take advantage of these new interactive-based revenue opportunities. Domestic video game software revenue exceeded consensus by growing 11% in January, although unit sales were down 7% driven by "Call of Duty 4," "Wii Play," "Guitar Hero 3," "Super Mario Galaxy" and "Rock Band." Game engagement and advancement is becoming more significant as "longer, deeper, broader console cycles" introduce new revenue streams, Wienkes said.

Still, EA's stock traded down Monday--reflecting short-term investor concerns about related risks, including Take-Two's dependence on primarily a single franchise, as well as executive scandals and poor financial performance prior to Zelnick's acquisition. That could result in challenging due diligence of Take-Two by any buyer. Assuming no synergies, Wienkes said a Take-Two transaction would be "mildly dilutive" to EA's 2009 fiscal year earnings. Although EA plans to release 10 new game titles this year, "Battlefield: Bad Company" and "Mercenaries 2: World in Flames" have been delayed.

In making a play for Take-Two, EA itself could be skirting the grip of unwanted takeover with a $16 billion market cap and a stagnating stock price in the face of a more formidable rival resulting from Vivendi's $18 billion merger with Activision. The new Activision Blizzard will match EA's projected annual sales of $4 billion, analysts say. EA last year acquired VG Studios for $860 million and its two smaller game developers BioWare Corp. and Pandemic Studios. Analysts say EA needs more creative blood, not just the limited appeal of Grand Theft Auto. John Riccitiello, who took over as EA's chief executive a year ago, is aggressively restructuring the company. In a letter to Zelnick, Riccitiello noted that Take-Two is facing a host of threats that--with or without an EA combination--will likely lead to Take-Two's eventual sale.

There is every promise that things will get more interesting before being resolved. Street.com reports that Take-Two did not disclose EA's earlier offer this month. Instead, it filed with the Security and Exchange Commission to considerably increase the monthly salaries, annual bonuses and stock options for its top management, which also are the leading executives for Zelnick Media. Street.com said management can vest their new options if Take-Two is acquired within three years, acting as a hedge of sorts to an unsolicited deal.

That kind of intrigue and creativity should be integrated into the fantasy play on which the long-term fortunes of EA and Take-Two depend.

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