TAKE TWO INTERACTIVE SOFTWARE INC annual report, FY2014

Business context and reporting period

Take-Two Interactive Software, Inc. filed this Form 10-K for the fiscal year ended March 31, 2014. The filing also reports the fourth fiscal quarter ended March 31, 2014; the metadata’s “2013 Q4” does not match the filing period. Take-Two develops and publishes games through Rockstar Games and 2K. Results are highly dependent on a small number of major releases, particularly the Grand Theft Auto franchise.

Financial performance and liquidity

Fourth-quarter revenue was $195.2 million and net loss was $30.8 million, compared with revenue of $299.5 million and net income of $22.5 million in the prior-year quarter. The fiscal third quarter generated $1,863.9 million of revenue and $578.4 million of net income, principally reflecting Grand Theft Auto V sales.

• Margins and expenses: Annual gross margin declined 1.3 percentage points to 39.8%, mainly because of increased internal royalties associated with Grand Theft Auto. Operating expenses fell to 22.2% of revenue from 40.7%, despite increasing in dollars by 5.6%.
• Cash and liquidity: Cash and cash equivalents were $935.4 million at year-end, versus $402.5 million a year earlier; working capital was $924.6 million. The balance sheet also included $193.8 million of restricted cash, primarily for royalty obligations. Management said cash, expected operating cash flow, and revolver availability were expected to cover requirements for at least 12 months.
• Debt: Long-term debt carrying value was $454.0 million. The company had $537.5 million aggregate principal amount of convertible notes outstanding ($250 million due 2016 and $287.5 million due 2018); carrying value differs from principal due to accounting discounts. There were no revolver borrowings and $63.6 million was available under the credit facility. The company reported compliance with debt covenants.
• Other balance-sheet metrics: Total assets were $1,799.6 million, total liabilities $997.8 million, and stockholders’ equity $801.8 million.

Material changes versus the prior comparable period

• Revenue rose 93.5%, driven primarily by approximately $1,481.5 million of higher Grand Theft Auto franchise sales, principally Grand Theft Auto V. Higher WWE 2K and NBA 2K sales also contributed; declines in several prior-year releases, including Borderlands 2, Max Payne 3 and BioShock Infinite, partly offset growth.
• The company moved from a net loss to substantial profitability. The improvement reflected the revenue increase and operating expenses declining as a share of revenue.
• Operating cash flow improved by $704.8 million, supported by Grand Theft Auto V cash generation and collection of receivables associated with the prior year’s BioShock Infinite release.
• Digital online revenue increased 45.2% to $372.0 million, while its share of total revenue declined to 15.8% from 21.1%, as physical sales grew faster. International revenue rose to 53.5% of the total from 41.5%; console revenue share increased to 91.4% from 80.4%.
• Cash generation was partly offset by $276.8 million in share repurchases, $166.0 million paid to extinguish the 4.375% convertible notes, and $55.7 million to terminate related warrant transactions. The company issued $287.5 million principal amount of 1.00% convertible notes.

Outlook, commentary, risks and unusual items

Management emphasized franchise development, sequels, digital add-on content, microtransactions, online play, mobile offerings, and international expansion. The announced pipeline included Borderlands: The Pre-Sequel, Evolve, Sid Meier’s Civilization: Beyond Earth and NBA 2K15, generally expected in fall 2014; the filing does not provide a clear numerical financial forecast for the coming year. Management expected digital delivery to become a larger part of the business over the long term.

• Concentration and release risk: Grand Theft Auto generated 68.9% of FY 2014 revenue; the ten leading franchises together accounted for 98.3%. Hit-driven sales and release timing create significant earnings volatility.
• Customer and channel exposure: The five largest customers represented 39.4% of revenue; GameStop alone represented 18.4%. Five customers accounted for 68.3% of gross receivables at year-end. Platform owners also control access, approval and online distribution terms.
• Platform and business-model transition: Console platforms generated 91.4% of revenue. The transition to new consoles may raise development costs and reduce demand for older-platform titles; mobile and online initiatives may not recover their investment.
• Unusual costs and accounting items: Software development cost and license impairment was $52.9 million, compared with $9.4 million in FY 2013. The company recorded a $9.0 million debt-extinguishment loss and $78.1 million of stock-based compensation expense. The deferred-tax valuation allowance decreased by $92.1 million, primarily reflecting use of net operating loss carryforwards.
• Taxes, commitments and contingencies: Gross unrecognized tax benefits, including interest and penalties, were $24.9 million. Contractual obligations totaled $936.3 million, including $537.5 million of convertible-note principal. Routine litigation was described as not material, though losses exceeding accrued amounts were considered reasonably possible.
• Other risks: Management identified foreign exchange exposure, product returns and price concessions, used-game competition, cybersecurity and service availability, intellectual-property protection, ratings and content restrictions, and dependence on key creative and management personnel. No cash dividends were expected in the foreseeable future.

Important facts for investors to verify

1. Confirm the durability of Grand Theft Auto V and online-related sales, given franchise concentration and the unusually large FY 2014 release-driven contribution.
2. Review the subsequent performance and cash-flow implications of the announced product pipeline and next-generation console transition.
3. Reconcile convertible-note principal, carrying values, conversion dilution and the timing of maturities with future repurchase and financing plans.
4. Assess the quality and accessibility of liquidity, including restricted cash, foreign-held cash, working-capital movements and revolver availability.
5. Examine the assumptions behind software-cost capitalization and impairment, returns and price-concession reserves, tax assets and uncertain tax positions.
6. Monitor retailer and platform concentration, currency exposure, and the company’s ability to grow digital revenue while preserving margins.