The fiscal 2020 fourth-quarter earnings report that Take-Two Interactive (NASDAQ:TTWO) released on May 20 showed strong momentum building during the early weeks of the COVID-19 shelter-in-place period. The video game company's stock is up 4% year to date and 20% over the past 12 months. 

But while revenue smashed expectations in the quarter that ended March 31, some investors were disappointed with management's guidance for fiscal 2021, which called for total revenue to dip from fiscal 2020's $3.09 billion to somewhere in the $2.63 billion to $2.73 billion range. The shares have fallen by more than 12% since the earnings report was published. 

That guidance might look weak on the surface, but there are a few important things investors need to understand about Take-Two's long-term growth strategy.

Two video game players holding controllers while playing a competitive game.

Image source: Getty Images.

Why video game stocks trade at high valuations

Along with lower revenue guidance, Take-Two is also calling for net cash from operating activities -- management's preferred profitability metric -- to drop from $686 million to about $560 million. Earnings per share are expected to drop from $3.54 to between $2.60 and $2.85. 

Most growth stocks would get hammered over guidance like this, especially given Take-Two's higher valuation of 34 times forward earnings estimates. Even its trailing P/E ratio looks frothy at nearly 40. 

However, investors have largely given video game companies the benefit of the doubt in recent years, and Take-Two is no exception. One reason is that investors are used to them reporting lumpy results from year to year, given that they operate in a business where revenue cycles are often tied to the timing of big releases. 

Overall, video game stocks are usually awarded high price-to-earnings multiples because of the consistent growth in the number of people playing games and the growth in the total money spent on games each year. 

A bar chart showing the annual increase in the value of the video game industry since 2012.

Image source: Newzoo.

Further, Take-Two is generating more of its revenue from in-game spending than it did five years ago. In fiscal 2015, Take-Two generated 18% of its non-GAAP revenue from recurrent consumer spending. In fiscal 2020, that share reached 51%. Higher in-game spending from older titles makes Take-Two less dependent on new game releases to drive year-round sales.

What's baked into this year's guidance

Management blamed the soft outlook for fiscal 2021 on lower expected results from Borderlands 3, Red Dead Redemption 2, and Grand Theft Auto V. Recurrent consumer spending is expected to reach approximately 60% of the business this year. 

Earnings are expected to be down mainly due to higher spending on the development of new games. Take-Two has the deepest pipeline in its history with 93 games planned -- 47 of them from existing franchises. Not all of these will be completed, but many of the planned titles extending existing franchises will likely get released. 

Take-Two's research and development expenses have climbed about 50% over the last three years. R&D as a percentage of total revenue has generally been on an upward path throughout the company's history.

TTWO R&D to Revenue (TTM) Chart

Data by YCharts.

Take-Two ended its fiscal 2020 with an R&D staff of 4,488 employees working on games across all major platforms -- consoles, PCs, and mobile devices. Part of the increase in R&D spending came from its increased headcount, a necessity as the company prepares such a large pipeline of potential new releases. 

The investment in new games will continue to rise, which will put pressure on earnings this year. Because of that, it's possible Take-Two's profitability over the next five years may not reflect its actual earnings potential. Revenue should increase from these new releases, but earnings may not grow at the same rate if the company continues to invest heavily in R&D. That isn't a bad thing, it's just reflective of big investments in the future growth of the business.

But management is not prioritizing revenue growth at the expense of profits. Growing profits is ultimately what this is all about, as CEO Strauss Zelnick explained during the last conference call: 

We already have competitive gross margins, highly competitive gross margins. To have competitive operating margins, you need scale with the same level of success of your games, and that's our goal here.

Take-Two prefers to be cautious with its forecasts

Keep in mind, Take-Two has a history of underpromising and overdelivering. A year ago, the initial forecast for revenue was $2.83 billion with cash from operations expected to be over $430 million. Take-Two's actual fiscal 2020 results were revenue of $3.09 billion and cash from operations of $686 million. 

With digital spending on games across the industry continuing to look strong through April, there is a good chance Take-Two could beat its guidance. Management acknowledged that the recent trend of high in-game spending has continued into the current quarter but hasn't factored any continued strength in player engagement in its outlook beyond it.  

Take-Two's ambitious release schedule is already in full swing with three notable titles in the list for this summer: the sci-fi shooter Disintegration, the remake of Mafia: Triology, and a new sports franchise PGA Tour 2K21.

The bottom line: Take-Two is executing on its long-term growth strategy, which should make it a more valuable company for investors in five years than it is today.