Top video game stocks delivered great returns over the last decade. Take-Two Interactive (TTWO 0.78%) was a standout, with shares soaring nearly 500% in value from 2015 through 2020. But as the economy reopened, video game stocks underperformed. Take-Two is down 13% over the last year, trailing the S&P 500 index return of 13%.
I'm taking advantage of this down period to load up on my top pick in the video game industry. There are several reasons I like gaming stocks as a long-term investment, but Take-Two is my favorite for one reason: It has greater potential to expand profit margin and deliver further outperformance over time. Here's why.
Image source: Getty Images.
Take-Two has waited for this moment
Over the last five years, Electronic Arts and Activision Blizzard have generated an average profit margin between 25% and 30%, respectively. Take-Two's profit margin is just 15%.
When CEO Strauss Zelnick took over the leadership role at Take-Two in 2011, it was management's goal to diversify the company's catalog of titles. The basic idea is to reach more players and spread more revenue over development costs to improve profitability.
However, 11 years ago, Take-Two didn't have the resources to expand its development capacity. In fiscal 2011, Take-Two had a net cash balance of $173 million on the books. Its annual profit was not consistent enough to make the necessary investments to hire more talent and develop more games.
But Take-Two found a great opportunity to grow the business and gain the resources it needed -- the 2013 release of Grand Theft Auto V. After selling more than 160 million units over the last eight years, Take-Two ended fiscal 2021 (ending in March) with $2.7 billion of cash sitting in the bank.
Image source: Take-Two Interactive.
Take-Two is now producing more consistent cash flow due to the success of its top franchises, including Grand Theft Auto, Red Dead Redemption, and NBA 2K.
Over the last five years, Take-Two has been hiring thousands of employees to work on new games in preparation to launch dozens of new titles through fiscal 2024. The company previously disclosed a pipeline of 62 new titles, including 20 mobile releases.
Image source: Take-Two Interactive.
"We continue to position our company to deliver on its long-term pipeline, build scale and gain market share," Zelnick said on the fiscal third-quarter earnings call.
Take-Two hired another 300 developers in the last quarter, including additions from the recent acquisitions of elite3D and Roll7 studios. It is also in the process of acquiring Zynga (ZNGA), which will add nearly 3,000 employees and expand Take-Two's mobile game development capacity.
Take-Two is in the best position to grow profits
"We've been pursuing this since the beginning," Zelnick told analysts during an investor presentation in November.
Management has already guided for 14% annualized growth in bookings (a non-GAAP measure of revenue) over the next three years. If Take-Two can use its greater game diversity to close the margin gap with EA and Activision, investors are looking at even faster growth in profits. In short, there is big return potential in Take-Two shares at the current share price, and that's why Take-Two is high on my buy list right now.
