E CONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.T HIS REPORT WAS SUPERVISED BY

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THIS REPORT WAS PREPARED BY FRANCISCO MARTINS A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE

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 Around 94% of Take-Two Interactive Software’s net revenues have been generated by its five top titles in FY2016. This increasing trend of generating revenues from a selected number of IPs is expected to continue in the long-term. This represents a strength of Take-Two, due to the robustness of their IP portfolio – with games such as GTA, NBA 2K, Read Dead Redemption – that is expected to generate value without producing market saturation.

 According to Euromonitor Passport’s data, the video game

software market is expected to grow at a real CAGR of 5.95% between 2016 and 2020. Additionally, the average purchaser of video games, as reported by ESA, has 38 years old, whereas players report playing on average for 13 years. This represents an opportunity for Take-Two that is expected to steadily increase revenues from their current core IP portfolio, that also benefits from a lower development risk.

 Take-Two cost structure is excessively heavy, when compared with Activision, EA and Ubisoft’s average. In fact, over the past 5 years, and excluding non-cash expenses, non-recurring items, or expenses that might generate future value, such as R&D and Selling and Marketing, Take-Two had an average cost structure that amounted to approximately 75% of net revenue, compared with competition’s 41%. If Selling and Marketing costs were considered as a pure expense, with no future value added, then the cost structure would average 92.5% of revenue versus competition’s 60%.

 Newzoo estimates that the global ESports market will grow at a nominal CAGR of 32.3% for the next 3 years, in which the fan base will generate an increasing amount of revenue, as the market matures. Considering Take-Two failures to tap into this high growth market, with both Evolve and BattleBorn IPs falling short of expectations, there is a lack of positioning towards this segment, which poses a threat to Take-Two future growth, as competition is expected to get tougher.

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[email protected]

Recommendation: HOLD

Vs Previous Recommendation None

Price Target FY18: $53.44

Vs Previous Price Target None

Price (as of 5-Jan-17) $49.36

Source: Yahoo Finance

52-week range ($) 31.36-50.19

Market Cap ($m) 4,762.418

Expected Outstanding Shares (m) 92.731

Source: Bloomberg Data and Forecasts

Source: Bloomberg Data

(Values in $

millions) 2016 2017F 2018F

Revenues $1,413,698 $1,721,150 $2,290,569

EBITDA $17,972 $24,927 $124,417

Net Profit $-8,302 $-13,979 $53,227

EPS $-0.10 $-0.15 $0.57

R&D $119,807 $135,145 $133,910

Deferred

Revenues $582,484 $713,179 $1,049,960

Non-current Deferred Revenues

$216,319 $201,557 $261,961

Source: Company Reported Values (2016) and Forecasts

Company description

Take-Two Interactive Software is a video game publisher, currently quoted on Nasdaq. The company is known in the market for its successful video game franchises, such as Grand Theft Auto, Read Dead Redemption and NBA 2K, for example.

Risk of Missing the Growth Wave

Take-Two Cost Structure Straining Profitability

0.0 1.0 2.0 3.0 4.0 5.0 6.0 jan /0 1 n o v/0 1 se t/ 0 2 jul/ 0 3 m a i/0 4 m a r/ 0 5 jan /0 6 n o v/0 6 se t/ 0 7 jul/ 0 8 m a i/0 9 m a r/ 1 0 jan /1 1 n o v/1 1 se t/ 1 2 jul/ 1 3 m a i/1 4 m a r/ 1 5 jan /1 6 Cummulative Returns

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TAKE-TWO INTERACTIVE SOFTWARE COMPANY REPORT

List of Abbreviations Used

BSA – Business Software Association CAGR – Compounded Annual Growth Rate CCC – Cash Conversion Cycle

CoD – Call of Duty (Activision IP) COGS – Cost of Goods Sold DLC – Downloadable Content EA – Electronic Arts

EGDF – European Games Developer Federation ESA – Entertainment Software Association

ESAC – Entertainment Software Association of Canada ESIC – ESport Integrity Coalition

ESN – European Security Network EV – Enterprise Value

FIFA – Fédération Internationale de Football Association FTW – For the Win (ESports team)

FY – Fiscal Year

GTA – Grand Theft Auto (TTIS IP) IP – Intellectual Property

ISFE – Interactive Software Association of Europe MLG – Major League Gaming (Acquired by Activision) PES – Pro Evolution Soccer (Konami IP)

RDR – Read Dead Redemption (TTIS IP) RSP – Retail Selling Price

TTIS – Take-Two Interactive Software VR – Virtual Reality

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Executive summary

After the shareholder’s takeover that replaced the company’s board members, including CEO and Chairman, in 2007, the new management team, supported by Zelnick Media, has been focusing on strengthening the company’s IP portfolio, while avoiding market saturation.

The adopted strategic approach has increased the weight of Take-Two’s top titles on net revenues from 27% by FY2007 to around 94% by FY2016, while

increasing average commercial sales from $831 million between FY2001 and FY2007 to an average of $1.39 billion between FY2008 and FY2016.

Nonetheless, Take-Two’s ambitions of tapping into the ESports high growth segment, with a forecasted nominal CAGR of 32.3% for the next 3 years according to Newzoo’s research, fell short, with both Evolve and BattleBorn IPs underperforming market and management’s expectations.

In addition, without an announcement of a new IP coming to boost growth expectations, future value is expected to be generated by Take-Two’s current IP portfolio. Nevertheless, Take-Two IP portfolio is robust, which is a reflection of its adopted strategic approach towards long-term methodical releases, instead of generating market saturation with frequent releases of the same IP, an approach practiced by competition that is already facing decreasing revenues from

sequels, whereas Take-Two’s Grand Theft Auto and Read Dead Redemption core sequels always outperformed the past release.

Unfortunately, Take-Two has a heavier cost structure than most competitors, a cost structure that has been taking, on average and for the past 5 fiscal years, approximately 75% of Net Revenues, whereas competition cost structure takes, on average and for the same period, 41%. This main difference in cost structure results from Take-Two’s Rockstar studio benefiting from an Internal Royalty Program, a caption that increased dramatically in size after the release of GTA V in FY2014, which was a success. From FY2011 to FY2013, this caption weighted on average 5% of net revenue while between FY2014 to FY2016 it grew to an average of 25%. Additionally, this Internal Royalties cost caption is expected to remain persistent in size, considering the upcoming Rockstar’s Read Dead Redemption 2, to be released in FY2018. Consequently, this burdensome cost structure is a major weakness of Take-Two when compared with competition’s.

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The Video Game Industry

In the past few years, video game publishers and developers had seen their businesses changing dramatically, as some market innovations disrupted their operations.

Euromonitor International data, that resorts to several reliable information sources including trade associations, governmental and company sources, pointed that the worldwide Video Games Software market size in US dollars, with 2015´s constant prices and fixed exchange rates, is 85,3 billion, by 2016, and is expected to grow up to 107,5 billion, by 2020, thus locking a real 5.95% CAGR. On the other hand, the Video Games Hardware market size, with the same settings as mentioned before, is currently 21,8 billion and is expected to grow at a real 2.33% CAGR between 2016 and 2020.

Since the entrance of the new-generation consoles, such as the Playstation3 and the Xbox360, a shift towards digital distribution started taking place. By delivering online copies of their games, video game publishers enjoy from lower product costs which boosts profitability margins, since the value chain gets significantly shortened when compared with the previous, traditional, value chain, where companies were dependent on distributors and retailers to deliver their products to the final consumer. Hence, profitability started to increase after the growth of the installed console hardware base, change in consumers purchase behaviors towards digital and reorganization of the top 4 market players business model.

In fact, most of the expected industry’s growth is still being driven by this change towards digital distribution. Regarding non-mobile games, where AAA titles are included, most companies rely on consoles sales to get their returns back, as the PC segment potential is undermined by software piracy. In 2015, BSA estimated

Source: Ubisoft H1 Earnings Presentation

Video Game Software Market: 2016

Total Size – $85,3 Bn

By segment: Consoles – $30,9 Bn PC – $30,3 Bn Mobile – $20,4 Bn

By geography:

Asia Pacific – $38.9 Bn USA – $20.9 Bn Europe – $17.7 Bn Latin America – $3 Bn Canada – $1.8 Bn

Further Notes: - Data in US dollars

- Data in constant prices and fixed exchange rates

- PC segment includes F2P games - Mobile segment includes browser based games

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that the worldwide rate of unlicensed PC software installations was 39%, representing a total of $52,2 billion lost to piracy. Nevertheless, most of piracy comes from underdeveloped countries, achieving a rate of 64% in the BRIC and 61% in Asia Pacific countries, whereas in developed countries the piracy rate is lower, about 29% for the European Union, 24% in Canada and 17% in the USA. Although there is reported piracy on console games, since hackers are often talented and organized in groups, the amount of lost value is much lower, as console piracy carries the risk of turning the harware obsolete. This fact also highlights the major differences between the Asia Pacific and Western markets, as most market players need to adapt their positioning towards F2P gaming in order to both avoid software piracy and reach consumers.

On the other hand, mobile gaming has been seen as a major hot topic, but where companies face challenges to capture value. In fact, the mobile market is

extremelly competitive, and firms often monetize their games through

microtransactions. Certainly, most mobile games are often offered in a freemium model, where the game is free-to-play but has additional and personalized paid content. Some current examples are Pokémon GO, developed by Niantic in partnership with Nintendo, and Supercell’s Clash Royale and Clash of Clans.

Still, a report published by the European Games Developer Federation in 2015, states that the video game market has been growing exponentially, with two-digit growth, over the last years and is currently the most dynamic entertainment market, with the “ability to overcome cultural and linguistic barriers”. The same report supports the idea of shortening the value chain by connecting software developers directly to consumers through digital distribution channels. By removing unecessary intermediaries, the maximum potential growth would be achieved. This trend towards digital distribution is expected to continue in the

Software piracy is absorbing most of the PC segment value

This is also the reason why a part of players support having a

gaming PC and “free” (pirated)

games, rather than paying for a console, paying for the

subscription fee to play online and pay for each individual game

There were already cases in which the pirated version of a game arrived before the official releasing date of the title. Which poses serious threats to the PC gaming market

Free to Play (F2P) games with microtransactions, represented by in-game purchases of additional content (DLC) distributed digitally, emerged in the PC segment as a response to software piracy

Shortened Value Chain Arising from Digital Distribution

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long-term with market players benefitting from lower product costs, as revenues originated by digitally distributed content increase in weight.

Moreover, there has been an increased market awareness on the size and long-term opportunities that the video game industry is able to deliver. The

emmergence of ESports, competitive gaiming with several professional teams competing to be the champions of a certain league, is also boosting growth opportunities in the sector.

On the one hand, it can be observed a boom in the teams dedicated to ESports, both independently created such FNATIC and FTW, amoung others, or

developed within traditional sports clubs, such as Manchester City, Valencia, Shalke 04 and Sporting. This boom of professional teams dedicated to ESports is boosting the development of local leagues and tournaments, the creation of official regulation bodies such as ESIC, and the ackowledgment of ESport players as official atlhetes by some countries such as the USA, France and Russia.

On the other hand, a new market infrastrucutre to support the ESports audience growth is already in-place, with streaming platforms such as Twitch and Youtube capturing most of the viewers. Nonetheless, traditional media is also adapting to this new trend with channels such as Fox Sports, BBC and ESPN starting to broadcast major competitions. Even Facebook is allowing for live streaming to be directly present on their social network, to increase the time spent of viewers inside the platform. All this screen time given to ESports has value for companies such as Coca-Cola, Intel, Samsung and Vodafone, amoung others, that see a way to advertise their products using new and less invasive media channels. Additionaly, Newzoo report on the global ESports market states that the enthusiast audience will grow approximatelly 37% between 2016 and 2019, whereas the occasional viewers will grow 32%. From the total audience, about 44% will be from Asia-Pacific, 25% from Europe and 19% form North America and Mexico. Additionaly, ESports revenues generated by Media Rights, Merchandise & Tickets, Online Advertising, Partnerships and Additional Game Publisher Investment are expected to grow from $463 Million by 2016 to $1072 Million by 2019, representing a nominal CAGR of 32.3% for the next 3 years. Nonetheless, it is important to highlight that revenue generated by ESports fans still falls behind the revenue generated by traditional sports fans. By 2016, it is estimated, by the same report, that, on average, an ESports fan generates $3.5 of annual revenue, when compared to a basketball, a NBA and a NFL fan, that generate $15, $20 and $60 of annual revenue, respectively. Although the annual revenues generated by ESports fans is rather low when compared with other An ESports fan still doesn’t

generate the same amount of annual revenue as some traditional sports fans.

Nonetheless, it is core to notice that this market is still at its early-stages, whereas traditional sports market is already mature

The high growth potential of the video game industry and the value that it is expected to create alerted European institutions and some governments that are now supporting this market

development.

Both UK and Canada provide tax incentives to video game developers, for example.

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traditional sports, it is important to notice that the ESports market is still in a growing phase, whereas the traditional sports market is already mature and perhaps declining.

New technologies are constantly making their way to the market, which also offers opportunities to video game developers and publishers.

One example of a new potential technology that is expected to drive growth in the market is the Virtual Reality (VR). Due to the high quality content that the video game industry is delivering to the market, in which video games also deliver cinematic experiences, the emergence of VR seems achievable and is desired by customers. The VR is expected to enhance the user’s experience even beyond, thus having the potential to attract current non-gamers. Nevertheless, and due to the competitiveness of the video game market, it is still uncertain if companies will be able to capture a premium from the implementation of such technology in their games.

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Regarding the social component of the Video game Industry, ESA reported that the average age of the most frequent game purchaser is now 38 years,

compared to 35 years in 2012. Additionally, gamers have been playing video games for 13 years, on average, however this value may still be understated due to the proportion of young and new gamers on the sample size that end up driving the average downwards. This fact highlights the persistency of the gamer population consumption of content, which might also explain the impressive growth rate that the Video game Industry has been achieving inside the Entertainment Industry.

Market Players

As it was mentioned before, the video game market is highly competitive as “the start-up costs for game development are cheaper now than ever before” (Reagan Miller, 2014). In fact, there are already high quality game engines, such as the Unity3D, Unreal Engine 4 and CryEngine completely free to developers and, in some cases, free of royalties. Thus, it is relatively easy to become an Indie developer publishing for the PC segment, as a developed game can be published and distributed through Steam online distribution platform.

Nonetheless, there is a catch here, although it is easy to become a video game developer, it is hard to become part of the blockbuster game industry - triple-A developer - such as the major public companies in the market. In fact, publishing for consoles requires licences and special permissions from the companies that own the video game consoles. Hence, it is core to understand that there are increasing barriers to entry on this development segment, despite being easy to enter the market in the non triple-A segment, where developers often publish for the PC and Mobile segments.Therefore, the first layer of market players

emerges, the video game hardware developers. This layer can be better characterized by an oligopoly between Sony, Microsoft and Nintendo, that developed the PlayStation, Xbox and Nintendo Wii, respectively, that account for 80% of the total video game hardware market, approximately. Of course, it is important to notice that Nintendo ‘s Wii has been facing an annual decrease in market share. Despite Nintendo’s upcoming console Switch having the chance to boost their influence in the video game console market, it is important to notice the long-term trend of failures that Nintendo faced, with major video game publishers stopping to launch content on Nintendo’s home consoles, as their specs continue to lag on quality, when compared with Sony’s or Microsoft’s home consoles. Euromonitor Passport’s 2015 data suggests that PlayStation captures approximately 43% of the whole video game hardware market (consoles and non-consoles). Microsoft’s Xbox captures 22% and Nintendo captures 15%,

The video game consoles market is characterized by an oligopoly,

with Sony’s PlayStation capturing most of the market share

Increasing barriers to enter in the triple-A video game development segment

$2 000 $4 000 $6 000 $8 000 $10 000 $12 000 $14 000 $16 000 $18 000

0% 10% 20% 30% 40% 50% 60% 70%

2008 2009 2010 2011 2012 2013 2014 2015

Source: Euromonitor Data $ Million

Video Game Console Manufacturers' Market Share

and Market Dimension

Nintendo Microsoft Sony

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approximately. Considering the home-console segment alone, them the market shares would be 58%, 33% and 9%, for PlayStation, Xbox and Wii, respectively. Furthermore, these huge console manufacturers, and focusing more on Sony and Microsoft, have their own gaming software development teams, thus ending up competing within the video game software segment. In fact, both Sony and Microsoft can better schedule product launches so that other publisher’s video games do not compete over video game sales against their own, exclusively developed, gaming software.

On a second layer of market players, we can find pure video game developers and publishers, such as the US based Activision Blizzard, Electronic Arts and Take-Two Interactive Software, and the EU based Ubisoft, among others. In terms of market capitalization, both Activision and Electronic Arts are the biggest pure video game developers and publishers, having a $27,45 billion market capitalization and expected to achieve $6,4 billion in net revenue and Electronic Arts having a market capitalization of $23,43 billion market capitalization with approximately $4,4 billion in net revenue for their FY2016, that ended in March. These four pure video game publishers account for approximately 12% of the video game software market by 2015, according to Euromonitor’s data.

From the graph, to the left, it can be observed the generated revenues of core paid franchises. Both WoW and CoD belong to Activision, representing a high percentage of its total revenues; the FIFA game belongs to EA, a very robust title that already exists for 23 years; Assassin’s Creed is an historical action-based open-world franchise with 9 released sequels that belongs to Ubisoft and GTA is TTIS’ crown jewel, despite being released, on average, once each 7 years.

On the other hand, after 2008, there was a surge of F2P games on the digital PC segment. These market players are privately held, or in case of Riot, developer of League of Legends, are held by a conglomerate. Hence, it isn’t possible to extract more accurate data on their operations.

Finally, on a third layer, we have video game developers and publishers which have other business units with different assets requirements or that belong to conglomerates or holdings. Here we can include most of Japanese video game developers and publishers, such as Bandai Namco, Capcom, Square Enix Holdings, Konami Holdings and Sega. These players often include amusement facilities, resorts and gambling machine games as part of their operations. Therefore, and despite being market players, these players have different net working capital and invested capital requirements and thus should not be considered as equals with the pure video game publishers.

$1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 Million

Reported Net Revenues

Activision Electronic Arts Ubisoft Take-Two Interactive

$,250 $,500 $,750 $1,000 $1,250 $1,500 $1,750 $2,000 Million

Source: Euromonitor Data

Core non-F2P Games

World of Warcraft Call of Duty

FIFA Assassin's Creed

Grand Theft Auto

$,250 $,500 $,750 $1,000 $1,250 $1,500 $1,750 $2,000 Million

Source: Euromonitor Data Core PC F2P Games

CrossFire

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

Market Multiples

Taking the layer of pure video game publishers, including EA, Activision, Ubisoft and TTIS, it was interesting to evaluate at which multiples they were currently trading in the market.

These ratios were later taken to evaluate upper and lower bounds for TTIS and expected FY2018 share price, with everything else constant.

In this case, it is key to notice that, for video game companies, R&D is a source of future value. Also, one of the key main assets of a publisher is human capital, which is not present on a company’s balance sheet. A good and expert team is able to deliver better content in a lower amount of time, that’s why most

companies report being dependent on key developers or management staff members to assure the business’ continuing success. Therefore, other

approaches based on the number of full-time employees were adopted to try to capture the firm’s value. It is assumed however, that the top market players have developed and harsh HR recruitment processes to capture the most talented teams, thus being a source of comparison as a multiple.

From the market multiples, there is an obvious difference between US based publishers and the Europe based publisher. Unfortunately, there isn’t another pure European video game developer, besides Ubisoft, with a significant size to support this analysis. Nonetheless, Ubisoft trades at significant lower multiples in ratios that link value to its operations results or even to the R&D expenses. On the other hand, it is essential to notice that Ubisoft has an abnormal number of employees for its EV. Activision has an EV approximately 9x higher than Ubisoft and employs 9,000 full-time workers, whereas Ubisoft employs 10,545 full-time workers. This fact may also explain why Ubisoft is trading at significantly lower multiples at some key items, thus it will be treated as an outlier for these items, excluding the “Last FY Price/ Sales” item, in the multiples valuation.

Multiples Analysis TTIS EA Activision Ubisoft Average (Adjusted)

Equity Value /Book Value 7.3 7.0 3.8 3.6 5.4

EV/EBITDA 23.1 19.5 16.3 6.3 19.6

EV/R&D 29.4 19.2 45.7 7.4 31.4

Other Approaches

Thousand Sales per Employee** $516 $538 $543 $135 $532 Last FY Price/Sales*** 2.32 4.66 6.05 2.65 3.21****

* Ubisoft is not included due to the disparity between ratios. It was treated as being an outlier ** Ubisoft is not included as it has an abnormal high number of employees for its size *** Sales data and Enterprise Value (EV) in thousands

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Take-Two Interactive Software

Take-Two Interactive Software (TTIS) is a North American company, traded on Nasdaq, that focuses on the development, publishing and marketing of

interactive entertainment software, Video Games.

Its two wholly-owned labels, Rockstar Games and 2K, each composed by several studios, are responsible for the development and publishing of new game

franchises, which are later delivered by physical retail, digital download or other distribution platforms such as cloud streaming services and online platforms. The company built its fame on a successful portfolio of gaming franchises, such as the Grand Theft Auto (GTA), Read Dead Redemption (RDR), NBA2K,

Borderlands and Civilization, among others. Additionally, they have been striving to expand their portfolio of successful Intellectual Property (IPs) by launching two titles outside their zone of comfort, such as Evolve, in February 2015, that is now a free-to-play multiplayer online-based game and BattleBorn, in May 2016, which despite not being free-to-play, is also a multiplayer online-based game. It is important to highlight that, it was the first time that this company entered the Multiplayer Online Battle Arena (MOBA) gaming genre (compatible with the high growth ESports segment) despite these games still being mixed with First Person Shooter (FPS) features, a fact that turns the genre classification harder to make.

Overview of the Past

Take-Two Interactive Software was founded in 1993 by Ryan Brant that opted by growing the business through mergers and acquisitions. By 1998, TTIS acquires BMG Interactive, naming it Rockstar Games, one of the core labels of the company that delivers high valued IPs such as GTA and RDR franchises.

Additionaly, and by 2005, TTIS acquired several studios such as Visual Concepts and Kush Games that were then merged to form TTIS’s second core label, 2K Games.

At this stage, the management engaged in a strategy to develop and distribute several non-core franchises on an almost yearly basis. This lead to their top ten titles representing on average, and between 2001 and 2007, 42.9% of their reported net revenues, being 2007 the year in which the top 10 titles had the lowest weight on total net sales, about 26.6%.

As consequence, the firm’s results were not satisfactory to shareholders that saw an opportunity to take over and replace the board members and the CEO, in March 2007. This take-over was fueled by a group of institutional investors that

$,500 $1,000 $1,500 $2,000 $2,500 $3,000

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Source: Adjusted Reported Values Million Top Series Weight on Net Sales

Non-Current Deferred Revenues Deferred Revenues

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accounted for 46% of the company’s shares, including ZelnickMedia, a media investment and management firm, and other institutions such as SAC Capital, Oppenheimer Funds and D.E. Shaw Valence Portfolios, amoung others. After the take over, TTIS establised an executive services management contract with ZelnickMedia in which TTIS would pay both a management fee and a

performance fee based on a set of core thresholds that should be achieved with new operations. Still in 2007, Strauss Zelnick, the founder of Zelnick Media, is nominated the chairman of TTIS with his co-founder Ben Feder being appointed CEO.

After the take over, the new management team restructured operations so that several cost reductions were to be attained, a fact that would, most probably, increase TTIS’s efficiency and long-term profitability – yet to be verified.

Highlight of Possible Conflicts of Interest

As it was mentioned before, TTIS has a management agreement with Zelnick Media, a relationship that started after the takeover and is expected to continue in the long-term.

Their current management agreement, that will be in place between 2014 and 2019, placed an annual management fee of $2,970 thousand and a bonus component up to $4,752 thousand subject to no annual growth. Additionally, Zelnick was granted $3,850 thousand on time-based awards and $4,750

thousand on performance-based awards given in the form of restricted stock that gets vested on an annual basis.

A significant part of Zelnick Media compensation is given in the form of restricted stock, which can be seen as a future call on the firm’s stock, since the restricted stock is assigned at a fair value price but, at the time it gets vested, it might represent a higher or lower value than the assigned one at the time of the grant. In the valuation of call options, it is known that dividends contribute negativelly for the value of the option, as the stock price gets adjusted after the payment of dividends. In this case, and considering the amount of excess cash that the company has currently on hands, it might seem that Zelnick Media is avoiding to distribute the cash, arguing that they will use the cash to boost long-term growth, in order to expand the potential payout they will get from the restricted stock award.

On the other hand, it is important to highlight that the founder of Zelnick Media, Strauss Zelnick is both Chairman and CEO of TTIS, which usually leads to troublesome corporate government failures. Additionally, and despite the annual reports defending that the board is independent, it is clear that Zelnick Media

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exercises much influence on the company’s operations. This fact may lead to decisions being taken in the best interest of Zelnick Media and not in the best interest of shareholders.

Lastly, besides TTIS, only Ubisoft has a corporate governance structure where the Chairman is also the CEO. However, Ubisoft corporate governance structure resembles a family business where top management posts are filled with familiy members - the Chairman and CEO is the founder of Ubisoft and all Vice

Presidents are brothers – which can explain why Ubisoft trades at lower multiples. In contrast, both Activision and EA have a corporate governance structure where the Chairman is not the CEO and where the board is not filled with partners – in the case of TTIS – or family members – in the case of Ubisoft.

Adopted strategy

The new top management team is focused on outputing quality, with extended development cycles for their core IPs, over quantity, launching core IPs on a almost annual basis. This strategy opposes the one that was being followed prior to the takeover, mentioned above, and thus is viewed as being appropriate to achieve long-term success.

By focusing on quality, the probability of the emergence of a new hit-title gets higher, however at the expense of longer development cycles and, thus, higher development costs.

Supporting a focus on quality over quantity is rather easy to present, although quality should be defined as the willigness of customers to purchase TTIS content at a higher price than the next best alternative.

Product quality, in this case, can be somewhat measured by the scores games achieve in the market. These scores are attributed by several game reviewers, such as IGN, Gamer Network and Gamespot, amoung many others, and later collected by Metacritic that presents a final average score. If we measure overall product quality with this average score than it could be highlighted that Rockstar Games Studio deliver better quality games than 2K Games Studio. In fact, Rockstar games had an average score of 81 compared with 2K’s games that had an average score of 73, in a scale of 0 to 100 and a sample of 98 and 186 games respectively. Rockstar never got a negative game score but 2K Games had two negative scores, below 50, after the takeover. Moreover, and from the same data sample, it can be seen that Rockstar tends to launch a much higher percentage of titles with a positive score, higher than 75, than 2K Games that has a higher weight of mixed reviews, with a score ranging between 50 and 74.

TTIS quality focus made their top game titles starting to

concentrate an increasing share of total revenues. From 27% in FY2007 to over 90% from FY2012 onwards

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Rockstar Games 2K Games

Source: Metacritic

TTIS Labels: Game Developed Score

Structure

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Therefore, and despite the management’s focus of delivering high quality content to the market, betting on this trait as their competitive advantage, there is still a lack of perception of quality on 2K Label’s developed games, as they often struggle to achieve such a level of sales that Rockstar games do.

Company

’s current competitive context



Volume of Sales

Currently, TTIS is competing in size with two big titans, Activision Blizzard and Electronic Arts. These publishers have a market capitalization 6 to almost 7 times higher than TTIS and benefit from a steadier volume of sales.

It is important to avoid jumping to wrong conclusions regarding the source of more stable volume of sales. In fact, most of it is originated from different

strategic approaches. Both Activision and EA, opt by launching new titles of their IPs on a yearly basis, often compromising perceived quality or introducing minor updates from the previous title to the new one. Some examples of franchises that receive annual updates are the Activision’s Call of Duty, able to generate over $10 billion in sales over 10 years, and the EA’s sports series, such as FIFA, and shooter series, Battlefield. On the other hand, TTIS strategy consists on avoiding market saturation, represented by recurrent decreasing sales from sequels of the same IP, thus aiming to eternalize their IPs, by assuring they outperform the past sequel in terms of sales or keep a relatively stable, and assured, level of sales from the current fan base. The concept of avoiding market saturation from their IP portfolio was stated by TTIS’s CEO Strauss Zelnick.

Nonetheless, and despite the possible market saturation originated from annual releases of the same IP, it is necessary to perceive the different levels of market risk that each IP bears. For example, some IPs related to sports, such as FIFA, Madden NFL and NBA2K that have official licenses from the respective sports federations, can be viewed as low-risk cash-cow titles, as consumers are willing to purchase the new updated title with minor gameplay updates, just to have access to the new team squads, equipment or other league updates.

Contrastingly, there are titles that do not benefit directly from such features, such as most TTIS’s IPs. For example, TTIS’s GTA V recurrent consumer spending remains robust after 3 years since the game’s launch. The popularity of the series is allowing TTIS to expand the product lifecycle of its IPs, without having to expand its operations’ size. On a recent conference at the MKM Partners

Entertainment, TTIS’s CEO stated that they would have to double the

development teams to deliver their franchises on an annual basis, which could

There are different strategic approaches adopted in the video game market. The most

contrasting ones can be summarized by:

1) Annual Releases Pros:

- More frequently generated cash-flows

- Faster and leaner development cycles Cons:

- May lead to market saturation

- Quality problems are often highlighted by players

2) Long-term Methodical Releases

Pros:

- Capture both old fan base and new players

- Often enjoys an extended lifecycle

- Implements new technology

with significant gameplay improvements

Cons:

- Infrequent and usually bulky cash-flows at time of release

- Volatile results at times of no significant release

- More expensive development cycles

$0 $200 $400 $600 $800 $1 000 $1 200 $1 400 Million

Source: Euromonitor Data Robustness of Sport Titles with

Official Licences

(16)

burnout their franchises due to market saturation. Instead, they are focused on creating new IPs so that they achieve a steady level of revenues “without burning out their franchises”.

Ubisoft, on the other hand, claims that they are able to deliver “open-world games” on a consistent annual basis - games similar to TTIS’s GTA V open-world experience despite having a different theme. Nonetheless, there were releases, for example of their Assassins Creed IP, that underperformed, thus supporting market fears on decreasing revenues from sequels of the same IP. Furthermore, Activision’s latest CoD: Infinity Warfare had disappointing sales due to perceived market saturation that made investors concerned on the future of the franchise. Activision lost about 18% of its value over the past 3 months as a direct result of its annual release strategy of CoD titles, whereas GTA sequels, for example, always outperformed the past release results – at least after the TTIS’ change in strategy towards long-term methodical releases of their non-sport IPs. This fact supports the more long-term approach of TTIS that is successfully avoiding market saturation of its already established IP portfolio.



Exposure to High Growth Segments

–

ESports & VR

The ESports segment has been seen by major video game publishers as a strategic segment to achieve growth. Here, Riot’s F2P League of Legends is one of the major market player, since its MOBA genre allows for competitive gaming to emerge. Activision was also able to enter this segment successfully with its acquisition of MLG in 2015 and release of Overwatch in May 2016 that generated almost $590 Million until November of the same year. Furthermore, EA’s FIFA franchise is also being a focus on ESports, despite not having the same MOBA genre as the former mentioned franchises.

Regarding ESports, TTIS lags most industry players. In fact, TTIS´s efforts to enter this market fell short, with both Evolve and BattleBorn IPs having mixed reviews and lack of adherence. It is true that both GTA V and upcoming RDR2 have an online component, but this online feature is not considered to be included in the ESports category, thus not benefitting from the ESports potential growth. Nonetheless, TTIS’ sports games, such as WWE2K and NBA2K, might have the potential to tap into this segment, if they are able to mimic FIFA’s approach to ESports, despite being implausible, at the moment.

In terms of VR, TTIS is taking a conservative approach by waiting to see whether is just a seasonal trend or a disruptive technology that will change the standards of gaming. However, there are still titles that benefit not being in VR, thus Strauss Zelnick is more focused on “delighting customers” with cinematic quality video

BattleBorn game failed to tap into the high growth ESports market

Strauss Zelnick stated that ESports have been mostly a commercial opportunity for League of Legends, and not much for anyone else

$,500 $1,000 $1,500 $2,000 Million

Source: Euromonitor Data League of Legends Leading the

ESports Market

FIFA

(17)

games. Nevertheless, a VR experience was released for TTIS’ NBA2K17, which is perceived as being a form of test to the potential of the VR market, considering the still low levels of console VR installed hardware base – presented before.



Shareholder structure

A significant portion of TTIS common stock is held by major institutional

investors, that account for 52% of the outstanding shares, and mutual funds that account for 15.3% of the outstanding shares.

The major institutional shareholders are the BlackRock Trust Company, the Vanguard Group, Citadel LCC and AJO,LP that hold 9.4%, 7.6%, 5.9% and 5.8%, respectively. Strauss Zelnick, TTIS’ Chairman and CEO, and Karl Slatoff, TTIS’ President, hold together 3.6% of the outstanding shares, in approximately equal parts.

It is interesting to notice, that most of the institutional investors that fuelled the takeover at 2007, do not participate in the ownership structure anymore, or currently hold a tiny percentage of the outstanding shares. For some reason, ZelnickMedia does not directly belong to the ownership structure as an

institutional investor, but they still have the right to buy 2mn shares until 2017, as it was already mentioned, a participation that would represent approximately 2% of the outstanding shares.

Financials

Cost Structure

In relation to the cost structure, TTIS’s COGS as percentage of net revenue is, on average 62.5%, when compared with the main competition’s, Activision, EA and Ubisoft, average of 32.8%, between FY2011 and FY2016. The fact that Ubisoft operates with a volume of sales similar to TTIS, highlights that the cost structure disadvantage might not only be originated by fixed costs, thus pointing to a TTIS’ inefficiency of operations problem. Unfortunately, most of the selected competition do not disclose their COGS with the same detail as TTIS, which turns comparison between TTIS and competition harder to perform on a more detailed level.

Nonetheless, due to the already mentioned trend towards digital distribution, which allows market players to avoid unnecessary costs related with inventory management, shipping and packaging, it can be observed an overall reduction of the product costs as percentage of net revenue over time. In the last fiscal year, FY2015 for Activision and FY2016 for TTIS, EA and Ubisoft, digital sales

0% 5% 10% 15% 20% 25% 30% 35% 40%

Source: Reported Reported Values and Forecast for Activision FY2016 Product Costs as % Net

Revenue

EA Activision TTIS

0% 10% 20% 30% 40% 50% 60% 70% 80%

Source: Reported Values and Forecast for Activision FY2016

COGS as % Net Revenue

(18)

weighted on average 48% of total net revenue, with Ubisoft having the lowest amount of digitally generated sales, about 32% and TTIS having 49% of total net revenue coming from digital sales, including recurrent consumer spending. Therefore, this decrease in product costs weight on revenues trend is expected to continue as market players’ digital sales weight on total sales increases.

Still on COGS composition, TTIS’ internal royalties weight on the cost structure registered a huge increase, which is attributable to Rockstar’s Internal Royalty Program and GTA V success - a Rockstar’s production. This employee compensation structure is straining the firm’s capacity to achieve a leaner cost structure closer to the selected competition average, as shown before, despite incentivizing employees to deliver high quality content. Additionally, the high weight of Internal Royalties on the cost structure is expected to continue in the long-term, considering the upcoming Rockstar’s RDR2 title to be released by FY2018 and future GTA titles that are expected to be released. In fact, it is doubtful that this cost caption will suffer a revision due to the relevance of the veteran staff that composes the Rockstar Label, as TTIS reports having

dependency on key staff members. Finally, it is core to highlight that TTIS is the only player that reports having an Internal Royalty Program that benefits developers who supported the development of a specific title. This is, neither Activision and EA, nor Ubisoft report having such cost, which explains most of the cost disadvantage that TTIS has versus competition.

Then, by considering both COGS and operating expenses as percentage of net revenues, it can be observed that the firm has been struggling to keep expenses below the generated revenues. Nonetheless, it is important to notice that

Depreciation and Amortization expenses do not constitute a cash expense, that Business Reorganization items are non-recurrent and that both R&D and Selling and Marketing are expected to generate future value, hence should be

considered as an investment and capitalized.

Even so, TTIS has a heavier General and Administrative costs as percentage of reported net revenues, with an average of 12.2% of net revenues compared with the comparables’ average of 8.2%, between FY2011 and FY2016. Thus, the firm has an average COGS and General and Administrative expenses that amounts to approximately 75% of Net Revenue, compared with competition’s 41%.

Regarding expenses that might generate future value, R&D and Selling and Marketing expenses, TTIS spends, on average, 7.3% and 17.5% of net revenue compared with the competition’s average of 26.2% and 18.6% respectively, between FY2011 and FY2016.

TTIS major weakness is its heavy cost structure as percentage of net revenues

Competitors report having much leaner cost structures

0% 10% 20% 30% 40% 50% 60% 70% 80%

Source: Reported Values Components of TTIS' COGS as

% of Net Revenue

Licences Internal Royalties

Software Development Costs & Royalties Product Costs

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: Reported Values Components of OPEX as %

Net Revenue

(19)

If Selling and Marketing is not considered to be an investment, but rather an immediate expense with no future benefits, then TTIS’ cost structure takes, on average, 92.5% of total Net Revenue when compared with the competitions’ average of roughly 60% of total Net Revenue.

To conclude, Take-Two is facing efficiency problems as the result of a more burdensome cost structure. A problem that is absorbing most of the margins that the company could realise on its robust IP portfolio on a more frequent basis, instead of having to wait for core releases, such as the GTA and RDR series to report positive earnings. This is a serious weakness of TTIS and poses a long-term threat for TTIS’ operations, as restructuring operations is costly.

Deferred Revenues as the New Standard

First, deferred revenues are represented by an advanced payment in cash for services or products that are going to be delivered in the future, payment that results from the firm’s operations. Despite being recorded as a liability, since the firm as to comply with the delivery of the promised service or product, the reality is that firms receive the cash today and only need to report it to the income statement by the time they deliver the service effectively.

In the video game industry context, deferred revenues started to emerge as a result of online gaming, licencing and exclusivity arrangements. The online component of the game, present in most market players’ published games, cannot be dissociated from the game and priced separately, creating the necessity to adopt some revenue recognition standards.

On the one hand, as firms are required to supply game servers for players to enjoy the online features of the game, to develop updates, to correct bugs or expand in-game features, the online feature ends up being considered as a service delivered over time.

On the other hand, recurrent consumer spending in the form of virtual currency, currency used to purchase in-game content, is only recognized when the player expends that money effectively in-game. TTIS’ has several games that enjoy from the virtual money feature, such as GTA V, NBA2K and other mobile applications, while being expected to implement similar monetizing features in future titles as recurrent consumer spending corresponds to TTIS’ fastest growing revenue item, growing at an impressive 53.4% nominal CAGR since 2013 and totalling approximately $361.4 million in FY2016.

Recurrent Consumer Spending has had a nominal CAGR of 53.4% since 2013 and is expected to continue with high growth levels in the short-term.

0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

Source: Reported Values and Forecast for Activision FY2016

General and Administrative Expenses as % Net Revenue

(20)

Therefore, firms record a part of effective sales as being deferred and recognize those components on a monthly basis. For example, TTIS recognizes GTA V deferred revenue on a 36 months’ period.

Deferred revenues ended up boosting market players’ cash conversion cycles, since they receive up-front for the online service they are going to deliver to the players. Here, in the CCC analysis, the adjustment was made by subtracting the amount of deferred revenues from the reported trade receivables.

As it can be seen, deferred revenues are reducing the CCC of companies that operate in the video game industry, thus reducing net working capital

requirements for video game publishers. Take-Two benefitted a lot from the addition of the online component to their IP portfolio, where both GTA and NBA 2K franchises were responsible for the significant increase in reported deferred revenues, and decrease of the CCC towards and below the industry average.

Net Debt

By the end of TTIS’s FY2016, the company reported having approximately $1.3 billion in cash and equivalents and short-term investments. Due to the high liquid nature of short-term investments - bank-time deposits for example – these are considered to be excess cash, in this equity research.

By taking FY2016 data, one could evaluate that the company’s net debt as percentage of its enterprise value would be approximately -21%, highlighting that the company has a lot of excess cash on its financial structure. Some market competitors, such as EA, Ubisoft and Activision before and a little bit after merging with Blizzard, also opted out, on average, to hold significant amounts of excess cash on their balance sheets turning net debt as percentage of enterprise Take-Two Interactive 2011 2012 2013 2014 2015 2016 Average Inventories $24,529 $23,528 $26,348 $29,999 $24,916 $17,970

Average Trade Receivables $79,176 $64,626 $117,316 $121,370 $135,502 $193,194

Average Deferred Revenues $12,689 $13,649 $20,392 $53,121 $363,337 $723,077

Average Trade Payables $51,033 $51,417 $63,307 $48,192 $27,621 $34,619

Average Inventory Days 13 16 13 8 11 8

Average Collection Days 21 23 29 11 -77 -137

Average Payable Days 27 36 32 12 13 16

Cash Conversion Cycle 7 3 11 6 -78 -144

Industry Average

Average Inventory Days 26 25 23 20 18 17

Average Collection Days -24 -25 -27 -38 -59 -66

Average Payable Days 69 68 62 59 52 72 Cash Conversion Cycle -67 -67 -66 -77 -93 -120

(21)

value negative. Nonetheless, EA and TTIS are the only pure publishers that had consistently opted for a negative net debt financing structure.

The reasoning behind sticking with a small or negative leverage levels can be explained by the competitive landscape behind the video game industry. First, major market players are the ones that already launched a successful “hit” title that filled the company’s balance sheet with cash. Since the release of a “hit” title is unpredictable, due to market preferences, it would be naive to leverage operations up as an immediate response to a successful franchise, since the firm would be exposed to a higher level of cash-flow volatility beyond the volatility that it can face from revenues generated from future sequels of the same franchise. Second, big video game publishers often acquire other studios or, in the case of Activision, ESports Leagues, that create synergies with their operations. Usually, a target for acquisition needs to have at least one of the following traits,

according to Strauss Zelnick: “high quality IP, a creative team that is tied to that IP, and new tech”. As acquisitions require cash to be settled, it seems plausible for market players to keep those amounts of excess cash on their balance sheets, so that they are able to capture the deal without having to leverage up or resort to the equity market, which is expensive.

Until now, TTIS hasn’t presented a consistent pay-out plan to shareholders, nor has presented future plans to engage in inorganic growth. In fact, it never paid out dividends and only distributes cash to shareholders with irregular share repurchases. This research will assume distribution of cash to shareholders based on forecasted cash-flow conditions, in order to avoid accumulation of excess cash much beyond the forecasted financing structure, where the firm will continue to follow a negative net debt strategy, here assumed to reach an average of -25% of net debt as percentage of the firm enterprise value. Finally, and regarding debt structure, the firm usually chooses to contract convertible debt, instead of regular debt. This way they are able to pay lower interest rates while avoiding, if debt is converted, paying the principal back to debtholders.

Valuation

Defining Bounds

–

Multiples Valuation

(22)

Taking on expected diluted values with the new expected value of outstanding shares by FY2018 of 92,731 thousand, the lower bound of TTIS share price is $37.63, if we take a EV/EBITDA approach, this multiple is more focused on the firm’s core operations, thus being more aligned with the firm generated value. Also, the average stock price using these multiples would be $50.78.

Finally, an upper bound of $56.73 per share would be achieved if an R&D multiple valuation approach was taken. This value is expected to be more appropriate as R&D is considered to be a source of future value.

Adopted Approach

–

DCF Model

To compute the firm’s EV, a DCF model was applied. Here the forecasting, that ends up comprising a total of 26 years, was divided into two main parts. The first part, used to capture the value generated by a video game publisher, such as TTIS, is represented by a product pipeline approach with a total of 21 years, from FY2017 to FY2037. Here, and based on Euromonitor’s data, revenues from four main franchises – GTA, RDR, NBA2K and Bioshock - and from recurrent consumer spending were considered as future sources of value. Still, an adjustment caption was introduced to minimize the error resulting from not including TTIS remaining IPs, despite being important to highlight that both BattleBorn and Evolve IPs are failing to generate significant value, for example. In the product pipeline approach, the NBA 2K franchise is assumed to maintain its annual releases, Bioshock having a 2-year period between releases, and both GTA and RDR having a 7-year period between releases, that starts immediately after the last release. Additionally, the forecasted commercial revenues are estimated by analysing past market-shares of the selected titles, denominated in RSP, and forecasting them in the future, while respecting the product lifecycle until the next forecasted release. Nonetheless, due to the long-term development cycles of both GTA and RDR franchises, there was a low amount of market-share historical information to support forecasts, thus constituting a limitation of the valuation model. For NBA 2K and Bioshock franchises, there wasn’t lack of historical data since these franchises are released on a more frequent basis.

Multiples Analysis Average (Adjusted) TTIS Enterprise Value TTIS Price per Share

Equity Value /Book Value 5.44 $ 3,733,492 $ 51.59

EV/EBITDA 19.61 $ 2,439,336 $ 37.63

EV/R&D 31.44 $ 4,210,475 $ 56.73

Other Approaches

Sales/Employee $532

Price/Sales 3.2

Result $ 4,251,190 $ 57.17

*Values in thousands except per share data

Human capital has a lot of value for video game publishers as a good team can deliver

outstanding content

Considering that some annual video game franchises already exist for 23 years, such as EA’s

FIFA, it is reasonable to assume that TTIS successful NBA 2K title will exist for 21 years with annual releases

Time Between Releases: NBA 2K – 1 Year

(23)

Recurrent consumer spending, however, is forecasted using past reported data and average growth rates. Nonetheless, it is assumed that this caption will reach a commercial sales concentration point, after an initial high growth period. Thus, its growth rate decreases over time towards a long-term growth rate.

The second part, comprising the last 5 years, from FY2038 to FY2042, is considered to be an adjustment to steady-state period. In fact, the perpetual growth rate started being applied to the video game expected market size since FY2029. However, the product pipeline approach continued to be applied, in order to capture the company’s focus to generate value from its IP portfolio. Additionally, as the firm has both current and non-current deferred revenues, there is the need of an adjustment period before the company reaches an actual steady-state with operational cash-flows growing at the perpetual growth rate. This is the main reason why the forecasting period was extended to such length, since it assures that the company has effectively reached a steady-state where the perpetuity formula can be applied.



Market Portfolio and Unlevered Beta

As most investors’ portfolios are internationally diversified, the considered market portfolio was the MSCI World.

Most market players operate with significant low or even negative amounts of net debt

Due to deferred revenues, it was necessary to expand the forecast period to assure the firm would reach a steady-state before applying the perpetuity formula

Source: Bloomberg Data and Other

Fields TTWO US Equity EA US Equity ATVI US Equity UBI FP Equity

Levered Beta (MSCI;2011) 1.00 0.52 0.78 0.83

Average Return 27.5% 32.7% 25.8% 30.3%

St.Dev 33.3% 34.4% 25.3% 38.8%

Expected MSCI World Market Return 7.31% Risk-Free Rate (US 10Y; November 30th) 2.38%

Market Risk Premium 4.02%

Sample Size 128

Take-Two Interactive Electronic Arts Activision Ubisoft

Levered Beta (MSCI;2011) 1.00 0.52 0.78 0.83

Upper Bound (95% CI) 1.06 0.58 0.83 0.90

Lower Bound (95% CI) 0.95 0.46 0.74 0.76

Values in Thousands $

Equity Value $ 4,261,349 $ 23,911,462 $ 27,208,918 $ 4,041,312 Net Debt $ -743,353 $ -2,596,080 $ 2,341,280 $ 76,264 Assuming 2% of sales as Operating Cash

EV $ 3,517,996 $ 21,315,382 $ 29,550,198 $ 4,117,576

Net Debt / EV -21% -12% 8% 2%

Equity/EV 121% 112% 92% 98%

Long-Term Credit Raiting Baa3 Baa2 Baa2 Baa3

Beta Debt 0.1 0.1 0.1 0.1

Unlevered Beta 1.20 0.58 0.73 0.82

Upper Bound (95% CI) 1.27 0.64 0.77 0.88

Lower Bound (95% CI) 1.13 0.51 0.69 0.75

US Publishers Publishers

Average 0.83 0.83

Average Upper Bound 0.89 0.89

(24)

Using long-term monthly data on the MSCI World returns, since January 1986, and Fama-French short-term risk-free rate, for the same period, a market risk premium of 4.02% was derived. Additionally, the 10 year US bond yield was considered as the risk-free rate, a rate of 2.38% by the end of November. Then, approximately 5 years of monthly returns data was taken for the selected pure publishers market players, such as Activision, EA, Ubisoft and TTIS, returns that were later compared with the market portfolio.

Regarding the long-term credit rating, not all companies had their debt rated, which was a limitation. To offset the limitation, Bloomberg’s 1-Year probability of default was taken for these players, and later compared in order to imply what their debt ratings would be. In the end, S.Schaefer and I.Strebulaev average debt betas by debt rating were used to delever each company’s beta.

It can be observed that TTIS’ unlevered beta is much higher than the competitions’, this can be explained by TTIS heavier cost structure as was already mentioned before. Nonetheless, and to conclude, after averaging the relevant players’ unlevered betas, a final unlevered beta of 0.83 was adopted to be later used to access TTIS’ appropriate discount rate.



WACC

After achieving the appropriate unlevered beta, it was then time to relever it according to the expected TTIS’ capital structure.

As it was already mentioned before, it is assumed in this research and based on data, that TTIS will continue to pursuit a negative net debt structure, achieving -25% approximately. This fact generates a levered beta 0.68 for the company which then is translated into a cost of equity of 5.1% approximately.

On the other hand, with a debt beta of 0.1, based on its debt rating and S.Schaefer and I.Strebulaev 2009 working paper, the firm’s cost of debt is approximately 2.9%.

Finally, taking the operating tax rate of approximately 31.4%, the cost of equity, the cost of debt and the expected financing structure, we end up with a WACC around 5.9% to be used to discount the company’s free cash flows.

Risk-Free Rate = 2.38%

Market Risk Premium = 4.02%

Operating Tax Rate = 31.4% Net Debt / EV = -25% Rd = 2.9%

(25)



Perpetual Growth Rate

The growth rate to be applied to the perpetuity formula, was estimated by forecasting each TTIS reported selling region’s1_{expected real GDP growth and} expected weight of the video game industry on their total real GDP.

Passport’s data supplied both the expected real GDP growth rates up to 2030, rates that were used to compute the real CAGR, and the expected video game industry weight on each region’s GDP by FY2018, the year of the target stock price. The final industry weight by 2030 is based on forecasts, where the video game industry is assumed to grow at the same pace of the GDP after 2020. After computing each region’s real perpetual growth rate, there was the need to adjust it to better represent TTIS growth in perpetuity. For example, in this research, the Asia Pacific weight on the total net revenues was forecasted to reach 9.6% by FY2030, compared with the reported 8.5% in FY2016.

Considering that the expected real growth rate of the Asia Pacific Video Game Software market is much higher than the expected real growth rate of the EU and US, 6% versus 2% and 2.2%, respectively, it is often naively assumed that the weight of the Asia Pacific on TTIS’ net revenues should increase more

significantly over time, and reach a value beyond the forecasted 9.6%.

The reasoning behind this more modest increase in Asia Pacific weight on total net revenues is explained by the different consumer preferences between the exposed geographies. In fact, TTIS’ home-gaming positioning is more directed towards the paid PC and console games segment, as it was explained before, whereas the Asia Pacific home-gaming revenues are mostly generated by F2P PC games, in contrast with the competitive western landscape that derives its home-gaming revenues almost equally from the three presented segments.

1

Asia Pacific, Europe, USA and Canada & Latin America

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 F2030

Europe + USA 88.5% 88.2% 88.3% 86.0% 86.5% 84.2% 85.5% 85.0% 87.3% 84.4% 83.0%

Asia Pacific 5.7% 6.2% 6.2% 5.1% 7.2% 7.5% 7.3% 7.6% 6.5% 8.5% 9.6%

Canada & Latin America 5.8% 5.6% 5.6% 8.9% 6.3% 8.3% 7.2% 7.4% 6.2% 7.1% 7.4%

Reported and Forecasted Geography Weight on TTIS’ Net Revenues

41%

20% 20% 19% 50%

16% 13% 21% 65%

33%

1% 2% Mobile Games Free-to-play PC Games Paid PC Games Paid Console Games

Source: SuperData Segment Weight on each Region's Generated Revenues (2016)