Over the last five years, video games have been one of the hottest industries to invest in, especially when you compare the stocks to some well-known tech companies.

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There's a simple explanation for these gains. Video game companies are no longer one-hit wonders that rely on sales of physical game discs. The big three U.S.-based video game companies -- Electronic Arts, Activision Blizzard, and Take-Two Interactive (TTWO 0.94%) -- are generating more revenue from higher-margin digital sales of games and content, which gamers can download directly to their consoles.

More importantly, game companies have shifted to a new business strategy of selling additional content that can be purchased in-game long after a game's release. Add-on content extends the replayability of a game and has provided game companies more money-making opportunities throughout the year, as opposed to relying on blockbuster game releases ahead of the holiday season to generate the bulk of annual revenue.

Previously, I reviewed how this new strategy has benefited Activision Blizzard and Electronic Arts. In this article, I'll examine Take-Two.

Overhead view of men's hands holding video game controllers while playing a game.

Image source: Getty Images.

Growth of digital revenue is opening new doors

As digital revenue has grown, Take-Two has been able to earn more consistent annual profit based on its cash generated from operations, which is reported on a company's cash flow statement and shows the actual amount of cash a company receives and spends over a given time period.

Metric 2017 2016 2015 2014 2013 2012 2011
Digital revenue as a percentage of total revenue 52% 49% 37% 18% 22% 13% 9%
Cash from operations $331 million $261 million $213 million $700 million ($5 million) ($85 million) $135 million

Data sources: Earnings releases and 10-K SEC filings. Fiscal years shown. 

Sales of digital content cost relatively little to produce compared to the cost of manufacturing physical copies of games on discs, so the bigger digital revenue gets as a percentage of annual revenue, the further margins will expand, boosting the bottom line and providing Take-Two more cash to invest in growth opportunities.

There are a few key components that make up what's reported as digital revenue. One is full-game downloading. Gamers are starting to follow the lead of their PC counterparts by purchasing full games directly over console. This trend is still in the early stages. About 25% of Take-Two's game sales are downloaded direct to console, as opposed to being purchased at a retailer.

Another component of digital revenue is in-game content, such as virtual currency in NBA 2K and Grand Theft Auto Online-- the two biggest drivers of in-game purchasing over the last few years. In many games that get released these days, players can buy additional content updates for about the cost of a fancy coffee and it immediately extends the life of the game several weeks or months.

A third component helping to grow digital revenue is mobile gaming. EA, Activision, and Take-Two have all been investing more in this fast-growing segment of the industry. Like its peers, Take-Two has released mobile versions for a few of its top-selling console franchises. Earlier this year it took a bigger step into the mobile gaming space when it acquired Social Point for $250 million.

Cash is piling up fast

The Social Point acquisition perfectly illustrates how digital revenue growth has transformed Take-Two into a stronger, more profitable company. Without the extra cash Take-Two generated over the last few years following the strong contribution to digital sales of Grand Theft Auto Online, Take-Two probably wouldn't have been in position to make that acquisition.

Metric 2017 2014 2011
Total cash on balance sheet $1.4 billion $935 million $280 million
Long-term debt $252 million $454 million $107 million

Data source: 10-K SEC filings. Fiscal years shown.

An acquisition of Social Point's size would have taken a bigger bite out of Take-Two's balance sheet a few years ago. Take-Two had less than $500 million in net cash in fiscal 2014 after subtracting debt. But with $1.4 billion of cash at the end of fiscal 2017 and very little debt, a $250 million acquisition is easily affordable for Take-Two -- all thanks to greater amounts of cash flowing into the company's coffers.

The shift to a digital distribution strategy has transformed Take-Two from a money loser to a cash-generating machine. In addition to acquisitions, management now has more cash to invest in the development of new game franchises, as well as potential share repurchases and dividends.