Expectations were high going into video game publisher Take-Two Interactive Software's (NASDAQ:TTWO) earnings report. The results smashed both expectations and the company's guidance, driven by the record-breaking launch of the long-awaited sequel to Red Dead Redemption. The company even increased its full-year outlook based on the strength of the quarter. In situations like that, investors would normally be cheering, but the stock fell more than 14% in the wake of the company's earnings.

What caused the disconnect? A competitor reported weak results, and Take-Two's guidance for the coming quarter was significantly lower than what analysts were anticipating. The combination has stoked fears that free-to-play title Fortnite, from privately held Epic Games, is taking a toll on the traditional video game industry.

A group of six cowboys on horseback riding against a snowy backdrop in Red Dead Redemption 2

Red Dead Redemption 2 led a "killer" quarter. Image source: Take-Two Interactive Software.

A killer quarter by any measure

Take-Two reported net revenue of $1.249 billion, up 160% year over year. This far exceeded management's forecast of $1.1 billion and $1.15 billion. Net bookings -- which also includes cash paid for virtual items that the company hasn't yet earned -- came in at $1.569 billion, up 140% compared to the prior-year quarter, easily surpassing analysts' consensus estimates for $1.5 billion and the company's guidance of $1.43 billion. 

The strength carried all the way down the financial statement, as profits soared. Operating income of $51.8 million jumped more than fivefold, producing net income of $180 million, an increase of more than 600%. A tax benefit boosted the bottom line to $108.7 million, but even excluding that one-time benefit, net income nearly tripled. Earnings per share increased sevenfold to $1.57, and adjusted earnings per share of $2.90 easily topped expectations of $2.75 per share. 

Backed by strong operational metrics

It wasn't just the strong revenue and earnings that powered Take-Two's quarter. Recurrent consumer spending -- money spent on virtual currency, add-on content, and in-game purchases -- fell to 24% of total revenue from 32% in the prior-year quarter, but this was due to the breakout performance of Red Dead Redemption 2, which skewed the results. Digitally delivered net revenue grew to $594.7 million, more than double year over year, increasing to 48% of total revenue. Digitally delivered net bookings grew 85% year over year to $703.8 million and accounted for 45% of net bookings.

The biggest contributors to the strong growth were Red Dead Redemption 2, NBA 2K19 and NBA 2K18, Grand Theft Auto Online and Grand Theft Auto V, WWE 2K19 and WWE SuperCard, Dragon City and Monster Legends, and Sid Meier's Civilization VIRed Dead Redemption 2 continues to see strong adoption since its release in late October, selling more than 23 million units to date.

"Take-Two is exceedingly well-positioned -- creatively, strategically and financially -- to capitalize on the vast opportunities that will shape the future of our business, and to deliver long-term growth and margin expansion," said Strauss Zelnick, Chairman and CEO of Take-Two.

Check out the latest earnings call transcript for Take-Two.

An animated image of a girl playing a guitar in an ad for "Fortnite."

Image source: Epic Games.

Stoking Fortnite fears?

After such a blowout quarter, you'd think investors would be pleased, but fears regarding growing competition -- particularly from free-to-play titles like Fortnite: Battle Royale and PlayerUnknown's Battlegrounds (PUBG) -- once again surfaced. To help illustrate those fears, let's look at what one of Take-Two's competitors had to say.

Electronic Arts (NASDAQ:EA), one of the larger video game publishers, released disappointing results the night before Take-Two's report, citing "significant challenges," which the company expects to continue into the upcoming quarter. On the conference call to discuss its Q3 results, Electronic Arts CEO Andrew Wilson addressed this, bringing up competition 13 times. While not mentioning Fortnite by name, Wilson said, "This year, battle royale modes became incredibly popular in shooter games," seeking to explain the weak performance of EA's recently released Battlefield V.

The road ahead

For the upcoming quarter, Take-Two is anticipating net revenue in a range of $530 million to $580 million, representing growth of between 18% and 29% year over year, if it achieves those goals. The company is forecasting diluted earnings per share between $0.67 and $0.77, which would be flat to a decline of 13%, respectively, compared to the prior-year quarter. This guidance fell far short of analysts' consensus estimates, which were calling for revenue of $609 million and earnings per share of $0.84. 

Take-Two didn't mention any of the concerns cited by EA and posted a blowout quarter, both in terms of its overall performance and that of Red Dead Redemption 2. The company's guidance was weaker than expected, causing investors -- right or wrong -- to make the connection.