Take-Two Interactive Software (NASDAQ:TTWO) took a big step to further distance itself from its reliance on lumpy console revenue with the recent announcement to acquire Social Point, a mobile game developer headquartered in Spain.
Social Point is the maker of two popular mobile games -- Dragon City and Monster Legends -- that have been downloaded more than 180 million times on Apple's iOS and Google's Android mobile platforms.
Terms of the deal
Under the terms of the deal, Take-Two is paying a total of $250 million -- $175 million in cash and the balance in Take-Two stock. Usually, management will issue stock to make an acquisition if the acquiring company's shares are seen as "overvalued," following the logic of receiving more value than you give. In this case, Take-Two management offered stock to give Social Point managers some skin in the game and keep its interests aligned with the combined business.
Leaving that reasoning aside, it seems Take-Two made an even exchange by issuing shares that have seen a big run-up in the last few years and are trading for a higher valuation than what Take-Two paid for the mobile developer. All in all, Take-Two made a good deal.
Take-Two's management expects the deal to be immediately accretive to revenue, earnings, and net cash from operations. In 2016, Social Point generated $90.8 million in revenue, which has grown 29% per year since 2013. The mobile game developer is also profitable, generating $19.9 million in earnings before interest and taxes (EBITDA), which is usually a good proxy for cash flow.
The big opportunity in mobile gaming
With this acquisition, Take-Two is gaining access to the lucrative opportunity of free-to-play mobile gaming and diversifying its revenue stream from the sales of console games. Through the first nine months of fiscal 2017, console revenue was 80% of Take-Two's total revenue.
Given the relatively small amount of revenue Social Point will contribute to Take-Two's existing business, the acquisition will not significantly reduce Take-Two's exposure to console game sales, but it is a step in the right direction.
So, what did management see in this particular mobile game developer?
For starters, Take-Two could afford an acquisition of this size with its cash on hand. In addition, Social Point is a profitable, fast-growing business with a great track record of producing quality games. Its mobile games have greater gameplay depth than other casual games available, something Take-Two management particularly liked when it evaluated the small developer.
Also, Social Point's games have higher conversion rates than those of competitors. It has developed in-house data analytics that show management how to optimize revenue and profits by predicting behavior patterns within hours of a game being downloaded in the app store.
Finally, Social Point has a strong pipeline of new games for the next two years, assuring that Take-Two will harvest more growth and profits from its new mobile subsidiary.
In keeping with management's approach with its existing subsidiaries, Take-Two wants Social Point management to keep doing what they have been doing and grow the business.
Social Point shouldn't have any problem growing since it has a big tailwind at its back. The mobile gaming market has exploded in recent years as smartphone technology continues to advance at a rapid rate, and as developers of mobile games have adapted their business models from a pay-up-front model to a very profitable free-to-play one.
The mobile gaming market generated over $40 billion in revenue in 2016, and this is attracting major game publishers to acquire the small, fast-growing, and profitable app developers that have demonstrated a track record of creating quality games.
Acquisitions an industry trend
Take-Two is following in the footsteps of rival Activision Blizzard's acquisition of King Digital Entertainment a year ago. However, King was a larger swallow for Activision's business than Social Point will be for Take-Two. Activision paid $5.9 billion for King, and it has contributed about $1 billion in cash flow to Activision's 2016 financial results.
Electronic Arts has also entered social and mobile gaming in recent years with the acquisitions of Firemint, Playfish, and PopCap Games, giving EA access to popular mobile games such as Flight Control and Plants vs. Zombies.
The lucrative mobile gaming market offers larger publishers more than diversification away from console revenue, but also other new business models. For example, Activision is currently testing advertising in some of King's titles with plans to more aggressively roll out ads in the next few years.
What to do with all that cash
The growth of high-margin, digital revenue from in-game transactions is drowning the major game publishers in cash. As of the most recent quarter, Take-Two had over $1.4 billion in cash and short-term securities on its balance sheet, and it's generating over $200 million in annual cash from operations, or cash flow.
As traditional game makers seek to further diversify and generate more consistent cash flow, more acquisitions could be in the cards over time for Take-Two, Electronic Arts, and Activision Blizzard.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. John Ballard owns shares of Activision Blizzard. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (C shares), Apple, and Take-Two Interactive. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.