Take-Two Interactive (NASDAQ:TTWO) has long been a solid video game stock for investors. It returned almost 400% over the last five years, far outpacing the trading performance of Activision Blizzard (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA).
Take-Two's Grand Theft Auto V (released in 2013) has sold 130 million copies. Those stellar sales helped push the company's bottom line into the green, moving from a net loss five years ago to a profit of more than $400 million over the last four quarters.
Still, this video game stock is way behind its peers in terms of profitability, and management is working to narrow that gap. Here are four charts that highlight Take-Two's path to greater profits and why further improvements should lead to even more returns for investors.
Gross margin history
Like its peers, Take-Two has seen a rise in its gross margin over the last 10 years as digital revenue climbed. Digital distribution of games was in the early innings of adoption for console gamers around 2010, but today, more consumers are downloading their games instead of purchasing them in store. In fiscal 2020, digital revenue made up 77% of Take-Two's business.
In its fiscal 2020 annual report, Take-Two explained why there is still more profitability to squeeze out of the digital channel: "We expect online delivery of games and game offerings to continue to grow and to become the primary part of our business over the long term."
Higher margins lead to higher profits
The growth in digital sales has had a significant impact on Take-Two's net income and free cash flow too. Its bottom line was inconsistent a decade ago but is less so today.
Management still sees opportunity to improve its operating margin and fuel more growth in net income and free cash flow. The chart below highlights the large disparity between Take-Two's operating margin and that of its peers.
On Take-Two's fiscal fourth-quarter conference call, CEO Strauss Zelnick discussed the company's plan to scale the business up to achieve a more competitive operating margin. This is part of the reason for the 93 new titles in its development pipeline. Take-Two is on a mission to spread more revenue across its overhead and marketing expenses to improve its profitability from current levels.
This strategy has already worked in Take-Two's favor. Over the last few years, Take-Two has continued to sell millions of copies of hits like Grand Theft Auto V and Red Dead Redemption 2 (2018). Along with the strong sales of core titles, its total operating expenses have dropped as a percentage of revenue, falling from 42.3% in fiscal 2018 to 36.3% in fiscal 2020. That has helped net profit margin jump from 9.7% to 13.1%. This is despite research and development (R&D) expense on new games increasing by 51% over the same time frame.
While investment in the dozens of new games in the pipeline will cause R&D to continue increasing, other operating expenses such as marketing should only rise modestly, as Zelnick explained on the call:
To have competitive operating margins, you need scale with the same level of success of your games, and that's our goal here. But the reason you get those higher operating margins with more net bookings is because you don't build up your fixed overhead, and your fixed overhead would typically include marketing and distribution expenses.
Positioned for outperformance
Take-Two's relatively lower margin profile compared to its peers is why the company's stock trades at a lower price-to-sales (P/S) ratio, even though Take-Two is more expensive on a price-to-earnings basis.
If Take-Two can continue expanding its margins, making its business more profitable, then its P/S valuation will gradually increase. In that light, its stock is positioned to outperform the competition.