Welcome to the December 2020 newsletter for the Waterhouse VC Fund.
The Fund specialises in gambling assets and businesses that are related to the gambling industry. The industry is under-researched by most mainstream fund managers. We aim to leverage our unique expertise and existing assets to generate yield and capital growth for investors over the long-term.
Since inception in August 2019, the Waterhouse VC Fund has achieved a total return of 1,001.25% ($11.01 unit price), as at 30 November 2020.
Lower barriers to entry, but incumbents still dominate
Over time, the barriers to entry in the video game industry have become lower and lower. Developing and publishing a video game played by millions of gamers is no longer limited to the biggest companies, but accessible to small and even solo game publishers.
The biggest driver of this trend is the increasing utility of ‘game engines’, which are packages of software tools for creating, running and monetising video games. You can think of these as Adobe Photoshop, but for editing games. Developers import graphics and then add logic to each graphic, like the in-game laws of physics, lighting and sounds, then export the final product to platforms like Apple iOS or Xbox.
The decline of retail storefronts and rise of new digital storefronts is another tailwind for the smaller publishers, who can reach the masses through Apple’s App Store for mobile, Steam for PC, and Xbox Game Pass for console.
So if the barriers to creating and publishing video games have never been lower, why is the Fund invested in incumbents like Tencent, Ubisoft and the subject of this month’s newsletter, Take-Two Interactive? In short, it’s because the barriers to success have never been higher. Publishing a game has become easier, but creating and supporting a longstanding, profitable franchise that gamers love is an entirely separate challenge.
Take-Two Interactive is known for its Grand Theft Auto (“GTA”), NBA 2K and Red Dead Redemption franchises, among others. GTA is an open-world action adventure game. The latest instalment of the franchise is described by Take-Two Interactive CEO Strauss Zelnick as “one of the most successful and iconic experiences in all of entertainment”. It’s hard to disagree, having sold over 135m units over the last 7 years and earning a cumulative US$6bn in net sales.
Budgets for each new game in a flagship franchise like GTA regularly exceeds US$100m, making it hard for smaller publishers to compete on the overall gaming experience. For example, the latest GTA was initially published in 2013 and has survived multiple generations of consoles and is still going strong into 2021. Given publishers can monetise their games beyond the initial purchase, by releasing further content for games over time and facilitating in-game microtransactions, the returns for creating the best games are even higher. Investment in content is rewarded with longer game play, which leads to more spending over time. It’s a virtuous cycle that rewards the biggest and best publishers. Even with gaming itself getting more of the consumer’s time, the market share of the top titles continues to grow.
Moats around sports franchises
Another core pillar of the Take-Two Interactive portfolio is NBA 2K, the official NBA basketball simulation game, which is released each year. The franchise has delivered consistent double-digit revenue growth through both audience and in-game spend expansion over the past decade, helping the title overtake EA’s Madden as the best-selling sports title in the US since 2016, even though the NFL has 5x the peak season TV viewership.
We believe sports gaming has some of the highest barriers to entry. Take-Two negotiates the licensing agreement with the NBA every seven years, with the last agreement worth US$1.1bn. While the deal is not exclusive, competitors need to at least have very deep pockets to earn the right to play, and then the expertise to create a blockbuster sports game year after year. Competitor EA has re-launched their own NBA series on multiple occasions, but it continues to flop against the incumbent NBA 2K.
Investment thesis
Take-Two’s management’s long-term strategy is to grow by releasing five major titles every year, supported by increased in-game monetisation. We like the optionality embedded in their game pipeline over the next five years, given the company has demonstrated they can produce hits even beyond the core franchises, such as:
Borderlands (role-playing shooter game, which has sold-in over 57 million units)
Civilization (PC strategy game, which has sold-in over 52 million units and expanded in Asia through ‘Civilization Online’)
BioShock (narrative-driven shooter game, which has sold-in over 34 million units)
Take-Two’s CEO Strauss Zelnick has occupied the role for 13 years. His remuneration is directly tied to the successful launches of new IP and increased offerings of existing IP, and has demonstrated commitment to quality over meeting short-term targets. Subsidiary studios earn 15-20% profit share on their respective productions, aligning incentives throughout the organisation. This focus has driven in-game spend by +38% CAGR since 2013 and group net bookings by +11% CAGR since 2010.
Take-Two generated US$715m of operating cash flow in FY19 and fully funds game development through operating cash flow - a luxury afforded by few.
Take-Two fulfils many of our investment criteria: strong balance sheet (with around US$2bn of net cash), irreplaceable assets, and a management team that’s aligned with shareholders. Given COVID-19 tailwinds around indoor entertainment and community-based gameplay (e.g. group missions in GTA), we think Take-Two will continue to generate significant top and bottom-line growth. Considering its balance sheet, high quality long-term assets and earnings profile, Take-Two trades at an attractive valuation of around 20X forward EV/EBITDA and 5X forward EV/Sales.
For wholesale investors that want to follow gaming’s global growth, please follow us for updates on Twitter @waterhousevc.
Please note the above information in relation to Take-Two Interactive is based on publicly available information in relation to each of them and should not be considered nor construed as financial product advice. The Fund currently has a position in Take-Two Interactive. The information provided in this document is general information only and does not constitute investment or other advice. Readers should consult and rely on professional investment advice specific to their individual circumstances.