"Grand Theft Auto" Comes to "FarmVille" as Take-Two Buys Zynga

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This video was recorded on Jan. 10, 2022.

Shares of Lululemon Athletica (LULU -1.26%) fall as the retailer lowers expectations for its next quarterly report. Asit Sharma analyzes those stories, the latest innovation from Deere & Co.(DE -0.14%), and why he's focusing on both capital-light and capital-heavy businesses this upcoming earnings season.

Later in the show, Ricky Mulvey talks with Maria Gallagher about how trading costs can still affect investors in a world where the cost of executing a trade is $0.

Chris Hill: Today on Motley Fool Money, a closer look at trading costs, and what do you get when you cross FarmVille with Grand Theft Auto? That's coming up right now.

I'm Chris Hill, joined by Motley Fool Senior Analyst, Asit Sharma. Thanks for being here.

Asit Sharma: Chris, thank you for having me.

Hill: We've also got a warning in the retail industry and yet another self-driving vehicle. But we're going to start with the deal of the day. Take-Two Interactive (TTWO 0.42%) is buying Zynga in a cash and stock deal worth $12.7 billion. Take-Two has a number of gaming brands under its umbrella, probably best known for things like Grand Theft Auto and BioShock. Zynga, probably still best known for FarmVille, but it's a mobile company and that's a fast-growing segment within the gaming industry. Interesting to me that Zynga apparently didn't go shopping themselves around. Take-Two Interactive came knocking at their door, and technically Zynga's still has 45 days to shop for a higher price. But for now, let's just assume that this deal is going to go through. Do you think that Take-Two Interactive is paying too much? Because when you look at shares of Take-Two falling a bit today, that seems to be the reaction on Wall Street. They're paying too much for Zynga.

Sharma: Chris, I don't think they're paying too much. I think that Wall Street is taken aback just by that premium of what, 60, 64% to the closing price of Zynga on the last trading day? So it looks expensive that the question when you see that kind of gain is, oh wow, why did you pay that much? But Wall Street has awarded Zynga with a lower multiple over time than Take-Two Interactive has received. If you compare their forward multiples, just take their enterprise value to their EBITDA or earnings before interest, taxes, depreciation, and amortization, Zynga trades at a discount of something like 50 percent to Take-Two Interactive give or take the month. What this means is that the management of Take-Two Interactive says, "Yes, we can afford to give enough here so that shareholders and the board feels good about it on Zynga side. Then we can capitalize and start working on some of these synergies." So they are looking ahead. The current shareholder of Take-Two Interactive wants to know, "Did you pay a fair price?" 

Management of Take-Two Interactive wants to know, "Hey, what can we get out of these two companies if we combine them and look forward?" They've mentioned a $100 million in cost synergies over the next couple of years. But they've also mentioned about half a billion dollars in revenue synergies, that is, being able to combine these two platforms. I think it's a good deal for Take-Two Interactive because as its leader in the PC and console gaming space, they really haven't been able to crack that mobile market to the degree you might have expected them to. But this gives them that instant entry into that space. For me, I foresee overtime being able to transition some of these great titles on Take-Two's side into the mobile formats. That's very powerful. The last thing I'll say before asking for your perspective is that this is an annuity business to me, this software gaming business. Over time, titles that you think would whither away and fade, they've got this staying power. It's almost like you have to keep acquiring in this business. Both companies are serial acquirers of smaller studios and technologies. This is just par for the course for a company like Take-Two that wants to keep growing at scale. It's pretty big already with a market cap, I think, of somewhere of north of 16 billion bucks.

Hill: Well, one of the points you made earlier is, Zynga just has never gotten the respect on Wall Street that some of the other video game companies have. This is a hits business, and in the case of Take-Two Interactive, they have more hits. I think it's a fair criticism of Zynga that they never really had a second act to FarmVille. If they had more hits, even close to FarmVille, then maybe we'd be talking about a different situation here. But to your other point, there is something to be said for the management at Take-Two Interactive saying, "We want to get this deal done quickly. If we take a hit in the short-term because some people think we're overpaying, the flip side of that is its not being dragged out." Because I think if you're a shareholder of either company, you don't want to see something like this really get drawn out over a long period of time. 

We were talking way before we started recording, this is something that obviously has a direct impact on these two groups of shareholders. But whatever company you're a shareholder of, there's a chance that you're going to wake up one morning and the news is going to be a stock in your portfolio just got acquired. What are a couple of questions that, in this case Zynga shareholders, but in the future, any shareholder should be asking? What are a couple of questions people should ask when they find themselves in this situation and they have to decide for themselves, "Do I want to be a shareholder of this new company?" Because this is a cash and stock deal; Zynga shareholders get some cash, but then they are also going to get some Take-Two Interactive stock. Maybe they want to keep it, maybe they don't.

Sharma: Often at times, a growth investor will see such an acquisition as the end of the road. You bought a stock, you had high expectations. Let's say that you've purchased Zynga in the last five years and you believed management's narrative about its attempts to rejuvenate the business, to purchase smaller companies, and rekindle that growth. I should pause here and say, Chris, we're probably giving short shrift to those Words With Friends fans. They're probably wondering why we haven't called them out yet. They have a couple of other well known titles. Zynga does.

Hill: Fair.

Sharma: It's not all FarmVille, but it sometimes seems like that. The knee-jerk reaction probably is, "OK. I'm going to sale the shares, either I sale beforehand or I wait until the deal is done and then get out of this new entity." But I think it's a good practice to figure out, "The company that acquired, what do I know about it and where might it be going?" Easiest place to get that is to look at the most recent earnings call transcript where you hear management talk about their financial performance and their strategy. You can get a pretty good bird's eye view in most cases just by reading that last earnings transcript. Then if you've got the acumen for it or if you've got the time, patience, you can dig in a little further. Sometimes it's worth hanging on and just trying to understand, "Wow, OK, if the management of this company purchased my company, they seem very enthusiastic about it. What does it mean for the new entity?" Sometimes I've just let things run and benefited from it. But I think that's the first order of business, is to step in the shoes of the acquiring company, figure out why they wanted the company you owned and where they're going, and if you believe that story.

Hill: Shares of Lululemon Athletica down six percent today after the company warned, fourth-quarter results are going to come in at the low end of their estimates. Lululemon is dealing with not enough staff and as a result, shortening the store hours. How do I put this? This really doesn't look good. So soon after the holidays, particularly when you think back to the end of last year, Asit, and management was pretty bullish about the start they had to the holiday season. We're a couple of months away from the actual earnings report coming out, so this is one of those situations where I'm not suggesting that people who own shares of the stock need to run out and sell immediately, but I will say that we've got a couple of months before their earnings report comes out and this could get worse before it gets better.

Sharma: You could. I mean, there are actually a few weeks left, 21 odd days left in their quarter. So they still have time in this fiscal year that they're talking about. You're right, Chris, I distinctly remember. I follow, I'm a fan of it. Management was very positive about this start to this last quarter. They were looking forward to a strong holiday season. They weren't really focused on omicron at that point. This was several weeks ago. I'm not sure anyone picked up for many companies toward the end of the year. So I'm willing to spot them some blindsidedness there. They did talk about, during that call, the problems they were having with their supply chain. But also, on the flip side of the coin, they mentioned that they were dealing with those issues. I can see the shortened store hours as something that would be a curve ball that management didn't foresee at the time. 

One always wonders, "Is there some of just you not meeting expectations for your holiday sales that's wrapped into this or maybe we're looking at a convenient excuse?" I don't think that's the case here. I think Lululemon's management is a very operationally focused team and they don't tend to whitewash things or to sell a story to investors. I'm looking at this more as a stumble, "Guys, maybe you should have seen this coming or not been so optimistic." But at the same time, if we go back to that same call, they were also adjusting this forward sales of their mirror business. That is the connected fitness company that they purchased, has been doing well, but now it's starting to slow down. Maybe they have taken one hit after another unexpectedly, but they're trying to get it out now, which is good. I mean, if you've seen that that writing is on the wall, get out in front of investors, don't wait till that next quarter report. I'm not sure quite what I make of this as a longtime fan of the business, I think their brand is very strong. But yes, it's given me pause this morning.

Hill: Yeah, and to your point, this is a management team that appears to be very straight shooters when it comes to talking about their business. They've been clear in the past when things haven't gone as well for the Mirror acquisition as they had hoped, and certainly as their shareholders had hoped. You look at the stock, it's down from its highs, it's basically, I was going to say it's flat over the past 12 months, but with the drop today, let's just say it's 6% underwater over the past 12 months. Do you look at the stock as being particularly expensive right now? Because they really have done a better-than-expected job of growing this business. There was a good stretch of time when they were starting out that people thought nobody is going to continue to pay these prices. Yoga pants are not a luxury item. No one is going to be able to sustain this as a business and they have defied expectations in that regard. So if you look at the stock down from its highs, if it doesn't appear expensive, this could be a good entry point.

Sharma: You're getting a business in Lululemon that manages to grow its comparable sales double-digits as a matter of course. Even if you account for some of the slowdown in 2020 and easy comparisons, they've been doing this for several quarters and I think they're capable of doing that for several quarters still. Part of this is because they are expanding internationally, part of it is because they've mastered the game of selling high-tech athleisure wear and understanding where the trends are going. I feel that this is a high-quality company in this retail space. It's a tough space, as we both know. I mean, you're competing against companies like Nike on some fronts. It's not a space that is very kind to companies that can't execute. 

This is the one thing I like about Lululemon, that they are able to consistently execute in just a mathematical part of their business, which is that store expansion, they are still opening new stores, also managing their inventory, just the pace of introduction of new products. I think all-in-all, yes, if you look at this company, it's well off its highs. It's a high-growth company for this sector, which again, I don't need to remind anyone. Usually the typical compay's growing less than 10% a year and then this company has lately been growing in excess of 25%. I think it's worth a look at. As for whether it's expensive, I'm holding back thoughts of that until we see where interest rates are going this year. I can have a totally different answer a few months from now.

Hill: Fair enough. Earnings season kicks off later this week with the big banks. I want to get to what you're watching. But before that real quick, you brought something to my attention because last week on the show, we talked about CES, some of the news coming out of the trade show. Increasingly, some of the most important announcements have been in the automotive industry and along those same lines. You pointed out some news, the self-driving tractor. John Deere, one of the go-to brands in the agriculture industry, they came out with a self-driving tractor that they're putting into production this fall and I have to say I like the fact that they were very clear about the fact that they're not going from 0-60 in one fell swoop here. They've been methodically improving the technology over time, but coming this fall, self-driving tractors.

Sharma: I love it. This gives me more time to hang out on Zoom with you while my tractor is running in the field, Chris. Well, this is just the way they presented actually because it's essentially an app controlled self driving vehicle, autonomous vehicle. The farmer will get notifications via app if let's say an animal has come in front of the tractor. The story that I read on The Verge says that the AI layer can distinguish between flock of birds or maybe a larger animal, something that the farmer would have to pay attention to. Now this isn't a completely robotic experience. There is a team of outsourced contractors that act like a call center. If they see an obstacle in the course, then there's some human intervention to alert the farmer. But it does illustrate the principle that technology is pervasive everywhere and if we think that it's only focused in the highest flying companies like Tesla, innovation in this space is going around everywhere. I should say though, moving one big piece of heavy equipment linearly in a field is a lot different than trying to teach a car how to drive, let's say in New York City. Still I'm impressed though. Your thoughts.

Hill: I'll just close with this. For anyone listening who is thinking, "What do I care about this?" Well, if you are an investor who likes market-beating stocks, you might want to take a look at John Deere because over the last one, five, and 10 years, Deere is a stock that has solidly beaten the market. Before we move along, one thing you are watching this earnings season. It could be a company, it could be a group, an industry. What are you going to be watching this season?

Sharma: Chris, I think I'm going to be watching to groups of companies. One, our capital light high flier companies. As you and I were discussing the notes, and you suggested software-as-a-service company is a great group to follow. Because if they're still delivering the type of customer growth and net dollar retention so selling this to the same customers and incorporating churn, but selling more of their products, it will reaffirm my personal thesis that you have to stay focused five years ahead, buy those quality companies that you like now. Yes, so many of them are getting beat up, but that doesn't mean that you stop investing. You invest now, plant that seed for what will mature and ripen five years down the road. That's one group that I am looking forward to. 

The other is like a whole suite of companies that are the complete opposite, the capital heavy companies, the companies with the lower gross margins, those that are bellwethers for the U.S. economy. We talk about these companies like UniFirst, the big retailers like Home Depot. I'm going to be taking a pulse on various sectors of the economy just by how these companies are doing. Because, again, if they are able to have fairly strong results, it means that they are exercising their purchasing power, whether it's a manufacturing firm or a big box retailer of do-it-yourself equipment. In that scenario then, inflation is not so scary to me because I understand that the economy itself is rebounding from a really stagnant and difficult period in 2020. We're just now starting to see that acceleration. You have to expect inflation when an economy picks up steam. There is a certain scenario in which, look, it's not all that bad. I know this a scary time for many investors, but funnily enough, it's the big industrial companies, the big retailers that will tell us that it's OK to be comfortable with investing in them and the other side, those capital-light high-flying growth companies.

Hill: Asit Sharma, great talking to you. Thanks for being here.

Sharma: Always fun to be here. Thanks so much, Chris.

Hill: Over the past 20 years, a number of trends have benefited individual investors. Maybe at the top of that list is the fact that with many brokerages, the cost of executing a trade is zero dollars. Why should trading costs matter in a world where trading stocks is free? For more, here's Ricky Mulvey.

Ricky Mulvey: I'm Ricky Mulvey and this is the Long View where we look at historical events and trends to see how that history affects us today as investors. Joining me now is Maria Gallagher. We're talking about trading costs. Maria, I guess what is the point of talking about trading costs when for most of us stock trading is something that is completely free?

Maria Gallagher: I think it's important to understand well the history of what led us to zero trading costs. As we know, not everything is free, nothing is really free. So understanding really what those commissions end up looking like on the other side. I think zooming out and seeing it all together is really important for us as investors.

Mulvey: This is something that has always existed, these costs, whether they are apparent or they are inherent. Back in London when people would have to buy and sell these paper shares, it's hard to believe, in these coffee shops and sometimes that was free. It was frictionless because you would find a seller for your share of stock or you would go to a coffee house and you'd find a broker who is willing to take it. That created something we know now is the spread.

Gallagher: There's this thing called the spread and you can make money in two ways. You can make money for commission, you can make money with the spreads. Cutting the spread was not really a slow-moving process. Spreads on the Dow Jones stocks were around 0.6% for sustained periods around 1910 and the 1920s. They were at similar levels in the 1950s and the 1980s. They were at this level for quite a long time and we've been having this conversation for a while now. For most of the 20th century, trading costs actually rose.

Mulvey: That was because, at the time, the New York Stock Exchange really acted as what some would call a quasi cartel. They had these very specific rates that the brokers had to set for trading costs and they were not happy to let that go.

Gallagher: The cost was typically a percentage of the value of the shares traded. When we were talking about reforms, the New Deal reformers didn't really want to touch those minimum commissions. They were scared that the removal would spark dangerous speculation in the stock market. We all talked about fear a lot and that was really pervasive in the way the New York Stock Exchange cartel acted. In contrast to spreads average proportional commissions on the New York Stock Exchange, stocks climbed steadily to high of almost 1%. So you had high commissions and pretty standard spreads trading as well for the New York Stock Exchange.

Mulvey: The New York Stock Exchange was able to really enforce this. Because if you wanted to trade either as a broker or principal at the New York Stock Exchange, you could only trade there, you couldn't go to these outside markets. They really had a firm grip on these trading costs. But then something happened in the mid-20th century, which is that institutional investors started making up more and more of these trades. It wasn't just something like a wealthy trader was coming in and finding a broker and these institutional investors wanted a little bit of a deal if they were going to pay for their stock trades.

Gallagher: What we saw is in the 1960s, the Justice Department and Antitrust Division, they knew what was happening. They tried to urge the New York Stock Exchange to abandon its attachment to these fixed commissions. We had someone named Robert Hack, he was the New York Stock Exchange president, their price fixing ended in 1975 on May Day after he spent many years trying to really hammer home that this was a dangerous practice. We have him to thank for really starting to push toward the end of this cartel.

Mulvey: At first, he was against it because what they had started to notice is these institutional investors would come in, they would pay the fee, but then they would camouflage how these fees would get redirected, "Hey, my buddy did some equity research for this. Let's send some of that money his way." Upwards of 70% of these fixed fees were getting redirected. It created this whole mess that they realized they needed to break something. In 1975, as you said Maria, there was May Day and the first winners of this weren't the small investors. Again, the winners tended to be these institutional investors and brokerage fees for them declined as much as 50% in the days of deregulation. Wealthy investors saw some benefits as well, but it took a long time for the small investors to start to see the benefits of the deregulation.

Gallagher: Small investors initially actually saw their rates going up. This was mainly because the big brokerage houses had no interest in arguing over fees at that small of a trade.

Mulvey: But then slowly and slowly, you started seeing these discount brokerages come in which realized, "Hey, maybe we can make a little bit of money charging a little bit for a trade. Then the small investors are going to be able to be on our platform and we're not going to give them advice, we're just going to charge them for the trade." The most famous of course being E*Trade, they had those commercials with dancing chimpanzees and toddlers on mobile phones. This is something where, if you look at the 90s commercials on YouTube, it is insane that those things got put on television. They said, "Hey, Morgan Stanley. We know that those jacked up fees are an entitlement for you, so we're going to make a lot of fun of it."

Gallagher: We see that e-trade was launched in 1982. E*Trade charged about $40.95 commission for most New York Stock Exchange market orders in '98. Fidelity charge the same amount, but only if you had $100,000 or more in your account or traded more than 12 times a year. Some brokerages also charged more for investors to place limit order about five dollars. You saw those fees really changing in the '90s.

Mulvey: They start to come down, but it was still expensive. There's the famous, in the economics and the investing world, there is a very famous paper, it's called "Trading is Hazardous to your Wealth." They found that the more trades that small investors made, the worst that they tended to perform. They said that was because of essentially behavioral biases and also because of trading costs. They found that in the year 2000, the average round trip trade of about $1,000 cost 3% in commissions and 1% in the bid-ask spread. But, as you said Maria, there's more competition there. Eventually, this created a race to zero where trading became free because of the introduction of Robinhood in 2015. Now you have this whole generation of investors who came up expecting free trading for stocks.

Gallagher: Yeah. I'm one of those investors. I started with some $5 trades and then within a couple of years, we're at zero dollar trades and I love it. Robinhood currently has $81 billion in assets under custody, which is far less than places like E*Trade which has $600 billion, TD Ameritrade which has $1.3 trillion, Charles Schwab with $3.8 trillion. But trades move prices.

Mulvey: Yeah because that's what ultimately determines is who are the buyers and who are the sellers. The people on Robinhood tend to be a little bit more active, which is what those old suits at the New York Stock Exchange were worried about in the first place. Robinhood, of course, they offer free trading, but trading isn't free. How do they make money? It's through this thing called order flow, which is that when you place an order on a trading app like Robinhood, they may sell that information to market makers who come in and then give you the order of providing liquidity and then making money in the middle between buyer and seller in these very quick, computerized, automated processes.

Gallagher: Another way as well, stock trading is free at most of these major discount brokerages, it's now also a foot in the door for other services. You have them saying, "We saw you opened your new IRA, do you want some life insurance? Would you like a loan so you can buy even more stocks that you see?" These ancillary services as well are part of these platforms.

Mulvey: You become a marketing lead. How delightful. This trading is free and it's still expensive. Now the real cost for a lot of investors is essentially act as an investor, not a trader. There's been some research done, particularly on Robinhood, about these events called herding events, which is where a bunch of traders, investors, pile onto a rapidly gaining or losing stock. On Robinhood, they have this list called the top movers. This is where a lot of traders, investors act like traders, and end up losing money because the price shoots up originally. Then there's this sugar high that cools off, and then the stock goes down. People aren't going to investments or companies because they think it's a great stock, they're going because they're seeing it on this top movers list.

Gallagher: Usually, it's counted as days when the number of Robinhood users who owned a stock grows by a 1,000 users, and 50% from the previous day. These stocks posted abnormally large gains on the day of herding, averaging 14% for regular herding event and 42% for an extreme herding event. The next day, however, returns turned significantly negative and we're still down 5%, 9% respectively after 20 days. You're seeing a lot of this behavioral bias when it comes into herding events.

Mulvey: There's other biases that you'd have to contend with when trading is free. You can pick pretty much what ever you want. One of the ones I really see myself having to deal with and avoid is loss of version.

Gallagher: Yes. Loss aversion's are really big when I feel it as well. Behavioral economist, Daniel Kahneman, would say loss looms larger than gains. What that means is really that the intensity of losing $10 is greater than the intensity of winning $10 on an absolute basis. You really tend to focus on your losses and really discount your gains in a really meaningful way which can be very dangerous for investors.

Mulvey: What we're finding now is that transaction fees are back for trading, but it's not necessarily for stocks now, it's for cryptocurrencies. For example, if you sell $100 of Ethereum on Coinbase, well, that may subject you to about a 3% transaction fee. They also have these taker and maker fees and that's even if you're on the Coinbase pro accounts. You're seeing expensive trading again, it's not with stocks though, it's with these cryptocurrencies.

Gallagher: Yeah. You have other platforms that offer lower fees or you can pay for premium subscriptions that lower fees. Different coins have different gas fees, which is something that as a transaction fees that coin traders pay miners. As we see with this new area, when you look at the history of trading, you're going to have that beginning of trading costs again in this new asset class, in this new area.

Mulvey: That's tough for me, I think as an investor because that's supposed to be the promise of a lot of these cryptocurrencies in the blockchain which is, "Hey, we are going to deregulate it and break out a lot of those fees." Well, we're still in the early innings, so you're seeing a lot of those fees there. I think the point of all of this though is that while trading for a lot of these more common stocks is free, it's maybe something you shouldn't treat like it is free. That's the Long View. Joining me is Maria Gallagher. This segment is produced by Dan Boyd.

Hill: That's all for today. But coming up tomorrow, Alison Southwick and Robert Brokamp will be here with a few tips on increasing your net worth in the next five years. As always, people on the program may have interest in the stocks they talk about. The Motley Fool may have formal recommendations for or against. Don't buy yourselves stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.