Take-Two Interactive Software, Inc. (TTWO) Earnings Call Transcript & Summary

Good morning, everyone, and thanks for joining our next session here at the UBS Global TMT conference. I want to apologize and thank everyone for their patience today. I know we've had a lot of issues with the webcast and the video. So as a result of those issues, we're going to conduct this as a audio webcast of a conversation that Strauss Zelnick and I will have about Take-Two Interactive. Hopefully, we will have those issues sorted out by this afternoon. But again, my apologies on behalf of everyone at UBS, and my apologies to Strauss that we're going to do this via audio instead of video, but this is great. I'm looking forward to this. This is the opportunity to talk to Strauss Zelnick, Chairman and CEO of Take-Two Interactive on all things going on with Take-Two in the video game industry.

Strauss, I want to just kick it off, maybe big picture. It's obviously been a very strange year, very trying year in a lot of ways. Maybe you can just give us your perspective on what's going on at Take-Two, how you reacted to the COVID-19 environment, and how you and everyone else at the company are doing as we put an end to 2020 in the coming weeks?

Well, look, I mean, it's not our nature ever to take victory laps no matter what happens. We get up every day recognizing that whatever has gone well is in the past, and we need to create our success going forward always. And particularly in these times, I think it's important to start by recognizing what an incredibly difficult year it has been for people personally, professionally, economically, and concerns continue with financial benefits coming to an end, at least at the moment for many; hunger in the U.S. at record levels. All of these things are deeply troubling, and we are not unmindful of them. That said, we have been extraordinarily fortunate. So first, in terms of the steps we took when it became clear that there was a pandemic upon us that was in early March, we were fortunate that our IT group is very forward-thinking and very focused on disaster recovery. In fact, they had a work-from-home day planned for early March. And it turns out that, that became working from home and within a week of that planned day, we had 6,500 colleagues all around the world working effectively from home. They've been immensely productive. We had only one title slip as a result of the pandemic, that was Kerbal Space Program 2, which has slipped into fiscal '23. And that was because a lot of the work was being done in China at that time, and China at that time was completely shut down. Other than that, not only have our titles been on time, but they've been really excellent. And our colleagues remain highly focused on doing great work, highly productive, one might argue too productive because, of course, we can do all of our work on computer. That's basically the way our company works. And we can track productivity. It's exceedingly high. I mean we have to really encourage people to take time off, and morale is strong. We've also been able to create production bubbles for our motion capture work that are a bit more expensive, but not materially so and safe and effective. In terms of what the marketplace has done since then, it's no secret that sheltering at home had a beneficial impact on demand for all forms of entertainment and specifically and disproportionately for interactive entertainment. According to Activate, a leading media consultancy, aggregate demand for interactive entertainment was up somewhere between 30% and 40%. Of course, our numbers are up much more than that. Activate also expects demand to continue post-pandemic. They expect about a 14% lift versus pre-pandemic. We'll see if that occurs, we are not projecting that. But that's been translated into extraordinary results for our company. So at a time of terrible privation and loss for many, we're grateful to have succeeded mightily.

Thanks for that perspective, Strauss. Maybe zooming out and putting aside COVID-19 for 1 minute, just getting your perspective on where we are in the evolution of the industry. When we think about where the industry is going over the long term, the way in which games are distributed, the way in which games are played, the way in which monetization happens, what's your worldview of how you see the broader interactive entertainment space evolving in the coming years at such an interesting juncture?

Well, it's always tempting to believe that what's going on now is what will always go on. But of course, what's truly constant is change. I think these are early days yet for the interactive entertainment business. I think in the 1880s, the Head of the U.S. Patent Office said something to the effect of, we're not going to be very busy going forward because everything that could be invented, has been invented. There are many people who believe that the glory days of the media and communications business have already come and gone. There are some people who believe that the glory days specifically of digitally-driven media businesses may have come and gone. I think we're on the threshold of massive growth driven by technology and media and communications, and that the next 30 or 40 years are going to be most exciting yet. Specifically with regard to interactive entertainment. This is still a nascent business. It's about 35 years old. And our average consumer is 37 or 38 years old. And people consume for the rest of their lives, that wish, that entertainment that they fell in love with when they were 17. So every year that goes by, our cohort grows as new people come into the business, and our older consumers stay with us, but they're not so old that they're leaving the earth. So I think that math tells you that our cohort should grow for the next 20 or 25 years, giving us massive industry tailwinds. Now what does that mean for us specifically? It's always better to operate with tailwinds, but we still have to make great gains. And if we fail to execute, tailwinds will not help us. So ultimately, it's an execution game. It's very nice to have the backdrop of massive growth. In terms of the specific question you raised about, what does the business look like, I'm guessing that the business in 10 years looks very different than it does today in the same way that it looks very different today than it did 10 years ago when there was no mobile business and no recurrent consumer spending. And I can't quite say what that will involve. But I think what you're going to see is, first, technology will allow us to -- our creative folks to do things they've never been able to do before, including make games that look exactly like live action. What we do now looks a lot like live action but it's still animation. In 10 years, you'll have the option if you want to make things that look completely realistic, all done inside a computer. Never mind all the other advances that technology will enable. I also think that as more and more consumers realize what interactive entertainment allows, which is an incredibly robust entertainment experience with all the normal attributes of an electronic entertainment experience. So characters, stories, graphics. However, we add this concept of Gameplay and then you overlay it against the social aspects, your ability to play often in an online world with other people, to talk to those people, interact with them, even though they're halfway across the globe. So you get to not only consume great entertainment, you get to consume it with other people and have a social experience at the same time. And of course, the consumption of entertainment has always been a social experience. It is rarely a solitary experience. So all of those things lead me to believe that there'll be massive moves in our business, many of which we can't entirely predict, massive growth in the business, and there'll be a lot of dynamic opportunity, both in terms of what we can do creatively and what we can do on the business side to exploit that creativity.

So you touched upon a lot in there. And I do want to maybe go down a couple of those topics idiosyncratically. But maybe just one as to a shift that's going on right now because we have new next generation consoles being sold to consumers in the market. Every console cycle seems to have different themes and different narratives. How are you positioning Take-Two to take advantage of what some of the partners in the industry on the hardware side are putting into the hands of consumers?

We're just trying to make the best entertainment that anyone could possibly make. We've already launched 2 titles for next-gen consoles, NBA 2K21 and Borderlands 3. And we're incredibly excited about what new technology will enable us to do, not only on these consoles, but in the PC format, which always tracks the same technical gains. Anything that makes the experience better. So quicker load times, better graphics, better memory, anything enhances -- potentially enhances the consumer experience. And a better consumer experience will obviously cause people to consume more of them.

And then the moves you made with respect to pricing on NBA 2K, can you just help us better understand the thought process behind raising the upfront price of the product? And how you think investors should analyze the ability to have pricing power broadly in the business model going out over the next couple of years?

Well, U.S. frontline prices have been the lowest on earth among developed countries for quite sometime. And the last time there was any kind of frontline price increase, I think was 2005 or thereabouts. In the meantime, production costs have gone up 200% to 300%. But obviously, consumers don't particularly care about what it costs us to make a product. They do care about the quality. And when you're delivering a new title built from the ground up in NBA 2K21 for next-gen, I think consumers understood that, that was a costly and risky endeavor and that it merited a higher frontline price. We wouldn't normally talk about pricing that would occur for future releases. That will be announced when the time comes. But I think in that instance, the price increase was merited, and I think consumers largely were okay with that.

Great. And one thing we've seen also emerge is free-to-play as a format of gameplay and go-to-market strategy for the industry. What's your own perspective on what you've seen in terms of titles positioning for free-to-play as a means of initially giving consumers an element of exposure to content and then driving engagement and monetization over the long term.

Well, look, we have free-to-play titles in our company. I think free-to-play represents less than 10% of our net bookings but close to that. But we have titles like NBA 2K Online in China, Monster Legends, Dragon City, Word Life, Tasty Town World Chef, The WWE Supercard game, the NBA 2K companion app and others. So it's a meaningful part of our business. We also have online multiplayer world attached to games. So they look very much, once you're in them, like free-to-play businesses. As you know, I think, as we've talked about it, we vastly increased our pipeline. We expect to bring something like 93 titles to market in the next 5 years, something like double of what we were doing 5 years ago, and 26 of those 93 titles are expected to be free-to-play. So clearly, we believe in the business. I would observe, though, the ratios are lower in the business. And obviously, risk profiles are different while your upfront production costs and your upfront marketing costs may be lower than AAA console title. Depending on what you're up to, they may not be that much lower. And of course, your basic return is in no way guaranteed. Then apply to that a much lower hit ratio than our core console business. And the good news is that in success, free-to-play title can do really, really, really well. The other news is that in failure, especially if you're spending more on production and marketing, that can create a real problem. So it's a balancing act. And there are only a handful of huge free-to-play stand-alone titles out there, the Fortnites and Apex Legends of the world and others. So we're cautiously optimistic about the future of stand-alone free-to-play. We also know there's still a great continued opportunity within what has historically, for the past 5, 6, 7 years, has been our business model, which is an exceedingly strong frontline release for which people pay, followed by incremental opportunities for the consumer to engage and along with that, monetization opportunities.

Great. A few years back, you acquired Social Point. We've seen mobile as a form of play continue to grow at an above average rate within the broader industry. Can you talk a little bit about that acquisition? Why -- what you've learned from it? And how you think about positioning some of your key titles, either to have mobile elements of them over time or to continue to think about mobile-only games as part of your broader portfolio?

Well, I sort of talked about it a bit just now. We relate to the party, frankly, on mobile. When we took over the company, which was a few years before the dawn of mobile businesses, we had a significant array of issues on our hands, and we didn't have much investment capital either, and so we had a focus on the core business, and we did, and that worked out, as you know, quite well. So we acquired Social Point in an effort to enter the mobile business in a bigger way and build it, and that's gone very well indeed. We still have the hits that the company had at the time. I just mentioned some of them, but they have new hits in the marketplace, including Word Life. And then, of course, more recently, we added on to that part of the business by acquiring Playdots for about $200 million, a significant amount of which was in stock, and that allows us to bring the highly successful titles that they have, including 2 dots into our firm. They have titles in development at the Playdot division. We have numerous new titles in development at Social Point. And as I mentioned earlier, if you get it right, a mobile free-to-play title can be very, very active and can actually deliver superb results. However, the hit ratios are low. However, on the other hand, again, production costs are quite a bit lower. We think that there's a great future for free-to-play mobile in our business, and we're investing accordingly. Whether that means we take owned IP that currently is expressed on console and take it to mobile remains to be seen. I would observe that the biggest hits in mobile remain native to the platform, not IT that came from elsewhere. There are some great exceptions, whether it's the Kardashian title that Glu did or Call of Duty Mobile. So certainly, there may be an opportunity to take existing IP that our labels have and put out a new game that is a mobile version of that IP, and we would in no way roll it out. That would be driven by our labels. That would be driven by the creative passion of our teams. And I'd be surprised if we don't try some of that in the coming years. But again, I think, creating something brand-new that is native to mobile is probably where you're going to see the biggest hits come from.

Great. Maybe talk a little bit about you as a company have spoken a lot about the pipeline of games that you have in terms of the sheer depth you plan on bringing to market in the next couple of years. Can you just talk a little bit about how you and the management team are working together to sort of align resources, make sure you're bringing all of that content to market. How does owned and operated content or your private division work against your broader goals of bringing as much content as you plan to over the over the next sort of 5 years?

Well, we have many years now of an approach through our creative and business operations that continues. Our labels have enormous creative autonomy. We meet with them at least quarterly to go through all of the productions. In that process, we make sure that everyone is comfortable with the investments we're making and the progress we're making on those investments. And in certain instances, we determine as a group not to pursue certain projects. Obviously, in other instances, we'll put new projects into production. That process works well because, as you know, we have an exceedingly high hit ratio. So the proof of the effectiveness of that process is just how well you're doing. You mentioned sort of capital allocation. Capital is not our problem. I think our cash balance in the last quarter was around $2.4 billion. We're a cash flow positive company. We expect to generate unrestricted operating cash flow this year around $650 million. So in our business, and this is true of our big competitors also, not all of them, but most of them, cash isn't the issue. The issue is the rare resource you have to allocate is creative talent. We, like our biggest competitors, have plenty of open slots. We're always looking for the best and the brightest. So we can't just lie and keep up and fill those open slots. And that is our bottleneck for increasing further our production capacity, which is why we've hired so many developers in the past years. And that obviously has been a big part of our headcount growth and much, much less so, our administrative fixed overhead. So I feel very good about where we're at now. I think we found a nice balance of this setup. We've doubled our production capacity and expect to bring 93 titles to market in the next 5 years. I think that's good. That's already very ambitious. And I don't see us increasing that scale for a while. And we'll see how this turns out.

And then probably the #1 question we get a lot from investors is not on the growth side, but more on the return on capital and the margin side for the industry. I think most investors believe the industry is, over the medium to long term, headed for solidly higher margins. Can you just help us understand how you're framing the long-term for margins for Take-Two? What roles sort of scale and continuing mix shift in the business are in terms of elements of achieving those longer-term goals?

Yes. And let me just stop short of sounding too promotional because it's really not my goal to sound that way. The business is trending more to digital distribution. I think in our last quarter, something like 70% of our units were digitally delivered; 99% of the PC format, of course, is digitally delivered; our catalog is largely digitally delivered. And I've been saying for years that I expect the business to become a digitally delivered business. When we sell products digitally, of course, we have higher margins, both in percentages and in dollars per unit sold, and that obviously drops directly to the bottom line and increases our operating margins. The other effect on operating margins would be, obviously, how well you're doing because a flop is going to have a negative gross margin. The more hits you have, the better your gross margins naturally. With scale, if you don't increase your fixed overhead, if you maintain your gross margins, and those are 2 ifs that matter, you'll increase your operating margins. So we are still meaningfully smaller than our 2 biggest third-party competitors. And as a result, there's more pressure on our operating margins, although we've done very well on operating margins of late because of the success we've had. As we grow scale, and it's our goal to grow scale, in fact, we are projecting to have $3.15 billion to $3.25 billion in net bookings this year, operating margins, again, holding still your hit ratio, should continue to grow. So we're optimistic about where our operating margins will grow. But that too will be reliant upon and subject to our ability to create hits.

Understood. I want to come back to some of the points you made about the broader industry evolution that we're sort of undergoing. Because I think a lot of these various nuances of where the industry might pivot in the future years is another key area investors would like to focus on. First, I wanted to talk about subscription models. So you have a number of companies now that are sort of beginning the process of trying to maybe change the way in which the consumer pays in which case games are monetized. What's your own experience been so far with some of the subscription models that have either been talked about or launched by some of the distributors and how you think about that as an element of broader sort of industry reach and industry monetization over the long term?

Well, obviously, it's a topic that people raise a lot. Our view is that any business model, first and foremost, has to reflect what consumers want. And I'm not convinced that consumers want a subscription in interactive entertainment as opposed to the ability to selectively buy what they want and not buy things they don't want. In the case of linear entertainment, subscriptions have worked really well because companies like Netflix and then more recently, Disney and HBO offer a broad array of titles to consumers who consume 150 hours a month of linear entertainment, and that's more than 100 different properties. Well, if you can get access to what's available by paying for 2, 3, 4 subscriptions in a month and churn in and out as necessary, that's a really great deal compared to what cable bills used to look like, even if you add on some kind of basic skinny bundle and add on your cost of access. In the case of interactive entertainment, consumers consume an average of 45 hours a month in the U.S., not 150, and that may be 1, 2 or 3 titles, not 100 titles. So it may not make sense to pay for 1, 2 or 3 titles effectively every month by subscribing. And therefore, I'm not convinced that the interactive entertainment subscription program is the be all and end all from a consumer point of view. Equally from the producer's point of view, if you take everything that you're making for frontline and turned it into a subscription and then you get some small sliver of the value because, obviously, subscriptions need to aggregate a lot of different companies' products, that can be a very bad trade. And we've experimented with frontline subscription a couple of times for an array of reasons with business partners. And there is no doubt, because our properties are highly rated and successful, that we've had an economic detriment with regard to the kind of the value created by a frontline title being available day-and-date on subscription versus one that's available later on. So where we're interested and happy to participate is in subscriptions where it naturally falls within title's life cycle, which means you're in catalog and/or perhaps deep catalog land, it may make sense to have a subscription offering. It makes much less sense with regard to frontline, in our opinion. But we'll see how it pencils out. Ultimately, the consumer will decide, and we'll have to see where the consumer is.

Along the same lines, another one of these, will the industry, won't the industry chicken-or-egg sort of debate is around streaming services and moving to that is a distribution model. Maybe 2-part question. Sort of a broader question of how you see the distribution model evolving over the medium-to-long-term from what traditionally has been where we were in the last couple of years to where maybe the industry is heading with higher bandwidth consumption and faster in-home bandwidth speeds versus your own experience with some of those services in the recent past when you've made some of your intellectual property available to partner with those companies.

Well, I mean, it's sort of interesting to riff on the topic, but it really doesn't matter to us. I mean, broader distribution is always a good thing. We're happy to try out any new kinds of distribution methods as long as they deliver great quality at the right price and as long as they're secure and appropriate, as long as the underlying business models make sense. And therefore, we have been supportive. We were supportive and are supportive of Stadia, and we'll be happy to support other services as well, again, with those caveats. But ultimately, I'm not sure that streaming services really transform our marketplace. I don't know why they would. I mean all they do on a really good day, and I mean -- by a good day, I mean when there's no latency, we're not -- we haven't had that good day yet. But on a really good day, what do they do? They alleviate the need to buy something and download it and take that time, okay? And they alleviate the need to buy a dedicated machine, console, PC or the like. You could just have your phone or a tablet and have a controller and you're off to the races. So you've reduced some of the friction of getting the consumer to your intellectual property, and that's always a good thing. But I'm not sure it's a game changer only because the implication of being a game changer is that there's some massive audience out there that really wanted to consume our games, by the way, and pay for them. Somehow we're allergic to buying the the console necessary or the PC necessary to play them before. I don't know how big that marketplace is, that subset of -- as the consumer open to buy the games, on the one hand, doesn't have the consumer open to buy or appetite to buy the console. And I've said this before, that's my concern. That no way references skepticism about whether it can occur. I have no doubt the technological barriers will be removed and that high quality, low latency streaming will exist. I'm just not sure it will be a game changer for us, although, again, broader distribution is always a good thing.

Understood. And maybe one more on sort of a bigger industry question we get a fair bit. We've seen a lot of moving pieces on the M&A front. In the recent past, distributors continuing to look at buying and partnering with content, people getting into mobile, people thinking about scale. How do you think about M&A as a tool in your toolbox in terms of building scale, capabilities? And where do you think the industry is headed? I think the question remain good over the time, is it going to be like traditional media where forms of content and distribution increasingly marry up with each other? Or do you see more separation than necessarily partnership or ownership? So just a bigger picture question on industry structure and then maybe your own approach to allocating capital behind industry consolidation.

Well, years ago, I projected that there would be more consolidation than actually occurred. So I say this with some trepidation, but I do believe that as the business matures, as the successful companies get more successful and bigger, their appetite for growth and scale for the reasons that I said, the opportunity to build operating margins, which is what investors want, will lead to selective consolidation, and you've seen that. Zynga did a whole bunch of deals, Microsoft bought Bethesda for $7.5 billion. In recent months, we closed the acquisition of Playdots, and we announced that we have an agreement with the Board of Codemasters for them to recommend that we purchased that company for just shy of $1 billion in cash and stock, probably in the first quarter of calendar '21. So you've certainly seen some consolidation, and I expect more to continue because as entertainment businesses become more mainstream, become more successful, typically what happens is the better companies get bigger, and the bigger companies get better and therefore, bigger again, and part of their growth plan becomes consolidation. When I started in this business many years ago, Crystal Dynamics in the '90s, there were billion little companies and only a couple of big ones. And when I took over Take-Two 14 years ago, roughly, there were 8, 9, 10, 11 meaningful third-party players. And now that's significantly fewer. And I think you're going to see it drill down to what always happens in the entertainment business, which is there'll be 5 meaningful creators of content. They will be the majors. And there probably won't be more than that. Sitting here today in terms of the ones that matter, depending on how you look at it, I'd say Tencent is #1, and then you have Activision, EA and ourselves. And then there are others who are significantly smaller, but certainly meaningful. And I do think that, that -- you may see some consolidation occur as all of us seek to acquire great intellectual property or great teams or great tools or all of the above. In terms of how we allocate capital, and we've said this forever, so for those of you who followed us, forgive me, we have 3 uses of our capital, the first to support organic growth. That's been the biggest part of our story. When we took over the company, I think we had net revenue of around $700 million. And I already mentioned what net bookings should be this fiscal year, $3.15 billion to $3.25 billion. Most of that was driven by organic growth. We would like to continue to invest in that story because it's very efficient when you do it right. We also returned a good deal of capital to our shareholders through buybacks. We do so selectively and opportunistically. We have done so and done so in a meaningful way. And then, of course, when appropriate, we've shown a willingness to acquire enterprises as long as the deal is accretive or quickly accretive, and that's super important to us. And so far, knock wood, we've been disciplined enough that we haven't yet made a mistake, and I'm hopeful that we'll be able to continue. We did just announce the biggest acquisition that we will have ever done with Codemasters, and assuming that closes, that will be quite meaningful to us. But we have plenty of dry powder going forward.

Great. Thanks so much for that on both M&A and on capital allocation. Maybe 2 more questions in the last few minutes we have to wrap up. First, how would you characterize the traction of your efforts in China today? How do you think about the broader opportunity globally for the interactive entertainment sector? And then more specifically, how should we think about NBA 2K online in China and what that presents as an opportunity to you?

There's a lot there for the speed round. I've made no secret of the fact that I'm a big believer in Asia, generally in China specifically. I believe that we'll continue to have great opportunity in China. I'm cautiously optimistic that the Chinese government will feel that opening up to western entertainment is not only not a bad thing, but is probably a good thing for their population. And right now, Asia represents, I think, around 8% of our net bookings, and we have expectations that, that will grow. Obviously, if China were truly open, if approvals became very easy as they are elsewhere as restrictions around how you can conduct business there were reduced, China by itself could be a much bigger market than the U.S. for our business just because of the size of the middle class and because of how avid the Chinese population is with regard to interactive entertainment. So we remain very excited about geographical growth for our company, particularly growth in Asia. And that's not just China, that's throughout the region. In terms of the future of NBA 2K online, that continues to be a great story, I think, in the quarter, was up about 13%. We have now 50 million registered users. We remain the #1 PC online sports title in China. So I feel really good about what that looks like. I think I covered all your questions there.

You did. Maybe I'll just sneak one more in since you did that very efficiently. Just on eSports, obviously, you've got a play on eSports with the announcements you've made around NBA. I was curious if you had any update on your latest thoughts on NBA and eSports. And broadly, how you see eSports evolving across your portfolio, especially with how much intellectual property you're bringing to the market in the next half decade plus?

Well, I believe that eSports are robust as the consumer side of the equation is, still will end up being in its maturity a business that matters for sort of 4 or 5 titles, not 40 or 50 titles. eSports are built organically. The entire market still only about $1 billion. Most of that goes to one title, which isn't ours. We're very excited about the NBA 2K league because we think it's such a natural for eSports, and consumers agree it's grown rapidly. Our third season was great. We're heading into our fourth. And we've seen massive increases in viewership and engagement, but it's still a small business, both broadly for the industry and for Take-Two specifically. So I don't think you want to underwrite to it as something material for us anytime soon. But over the long haul, I see it as an embedded call option for the business. I don't expect that we'll be launching other eSports businesses, but they could grow up organically if the title grabs an audience. That's what happened with League of Legends, it could happen for us, too. But I don't -- again, it's not going to happen for our full release schedule or anyone else's.

Fair enough. Well, I think we're running right up against time, Strauss. I want to first thank you for being part of the conference this year. This is the first time you've been part of the UBS TMT Conference. I really appreciate you making yourself available. I also want to wish you and your family a happy set of holidays in the coming weeks and look forward to catching up in the new year.

Thanks so much. Thanks for having me, and we'll talk soon.

Great. Take care. Thanks, everyone, for joining today.