Thread by @PandaValue

Panda Value is long $TTWO.

With it I meet my yearly goal of investing in a high-quality undervalued compounder

Needless to say, $TTWO has fantastic IP led by Grand Theft Auto & NBA 2k. It is led by a wonderful capital allocator in Strauss Zelnick.

Earnings are materially understated, making the stock look optically expensive. Let's peel back this onion.

First, $TTWO has been delaying new game launches so that the new gen of consoles gain critical mass.

More importantly, they are investing ~$500M annually to develop new games. They tout a ~90+ game pipeline. Admittedly there is some noise is that 90 figure. Nevertheless, these games will hit the market between now and YE 2025.

Of the $500M annual spend, $300M hits the income statement as R&D. This is spend attributable to the first 10-20% of game development. It is true growth spending masking profitability.

Accompanying these game launches in increased corporate and marketing costs. $TTWO has to bulk up this muscle prior to game launches (obviously) so it hits the PnL well before they see the benefits.

Additionally, $TTWO has added a massive amount of developers. Operating expenses are yet again elevated to support their onboarding and their work product. Not to mention the learning / productivity curve associated with new hires.

All told, if I normalize their operating structure and ramp down their R&D spend to grow in line with the industry. I get $6.00 to $6.50 of normalized earnings, or 22x-24x earnings (ex. cash).

$TTWO margins will further benefit in 3 meaningful ways. 1) increased scale should bring margin expansion and you can allocate those corporate expenses across more and more units.

2) an increasing amount of digital versus physical sales, which are higher margin

3) an increasing amount of monetization via microtransactions, which is even higher margin.

I also fully expect take rates to decrease materially over time.

Should take rates decline to 15% (higher than Epic and Microsoft 360 stores), it could potentially add another ~$4 of earnings power to $TTWO.

There is also a meaningful advertising opportunity, which would be very high margin. You see it already in NBA 2k. This is yet another kicker.

For simplicity purposes, let's say that would be $10 of earnings power, which means $TTWO would be trading at 14x earnings (ex cash).

There is significant downside protection in a potential buyout as many would love to own the asset.

With ~$25 per share of net cash, the balance sheet is rock solid.

Zelnick has proven to be a good capital allocator. If anything, you can fault him for being too conservative.

Growth is a bit hard to nail down. They are going to get a huge pop when GTA VI is released. That said, the industry is expected to grow 5% annually. $TTWO should easily outpace that given their pipeline.

I suspect they will also accelerate their growth rate buying smaller studios (as they have done of late). I do think growth will slow from the historical rate, but 7-10% (ex GTA VI) doesn't seem too far fetched.

To recap, you are paying 22x for a fantastic asset that is growing ~8% that will benefit from margin expansion that has bolt-on M&A opportunities, run by a great allocator with a net cash balance sheet. Check, check, check, and check.

You have a huge upside kicker in reduced take rates, which seems highly likely that you are getting for free. There is also a massive advertising opportunity. You also have very strong industry tailwinds that should persist for the foreseeable future.

It is for these reasons $TTWO is a 7% position and I feel I've met my yearly objective of finding an undervalued compounder.

Special thanks to the following:

@bizalmanac @FrancoOlivera @cap_zay @analogcap @clubmaliboo @PrefShares @MordorCapital @the10thmanbb @davidkaye

#HouseofStrauss