Pro Strategy: 'Grand Theft Auto' stock is a steal

Published Fri, Mar 18 201611:21 AM EDT

Editor's note: Pro Strategy is a column on how to use the strategies of the smartest minds on Wall Street to generate quality investment ideas. Take-Two is one of the most controversial and heavily shorted stocks in the market. Is it a one-trick pony or are the skeptics missing a secular paradigm shift? Using legendary hedge fund manager Stephen Mandel's investing framework may give us the answer. The Lone Pine Capital founder is considered among hedge fund investors to be one of smartest fundamental growth managers in the industry. "I think Steve is one of the very unique individuals in our business who is both a great analyst and a great portfolio manager. Most are great at one or the other, but Steve is world class in both areas," said Mark Yusko, CEO of Morgan Creek Capital Management, an alternative investment firm. Mandel honed his craft as the consumer analyst for Julian Robertson's Tiger Management. The firm has $26 billion of assets under management, according to a source. Here's CNBC Pro's analysis, using Mandel's paradigm: For his long investments, the hedge fund manager looks for companies with a solid return on capital, good cash flow, a prudent balance sheet, competitive barriers and a strong management team, according to a Lone Pine investor presentation. For his shorts, Mandel aims to avoid private equity targets, while seeking out the competitively challenged, fads and falling knives where financial results will be much worse than consensus. In addition to the stock-specific characteristics, he focuses on finding the winners and losers of big secular investment themes. Mandel wrote about the market-share shifts due to the growth in Internet disruptors the last five years. In an October investor letter, he said: "Internet disruptors are capturing a significant portion of the economics in a number of vertical markets (advertising, video gaming, media, retailing, travel), building significant moats around their businesses and putting tremendous pressure on the business models of incumbents." So let's look at how Take-Two fits this framework. Take-Two is one of the most shorted stocks in the market, far more so than its main competitors. Sixteen percent of the company's float is shorted, which ranks in the top 10 percent of all stocks in North America, compared with 6 percent for Electronic Arts and 2 percent for Activision Blizzard , according to the latest stock loan data from Markit. The traditional bear story on Take-Two is it is a one-trick pony with "Grand Theft Auto" and should be faded after every GTA release. However, the company was able to build a strong stable of non-GTA intellectual properties, such as "Red Dead," "Bioshock," "NBA 2K," "Civilization" and "Borderlands" series, and now has 11 different franchises with over 5 million units in sales. Take-Two dominates "open world" style gaming with several of its franchises and that is turning out to be a good area. The open world game category increased its console gaming market share from 8 percent in 2008 to 33 percent in 2015, according to Ubisoft's analysis. Console gaming is a component of a growing global video game market that market research firm IDG says will expand from $80 billion in 2015 to $91 billion in 2018. Due to the success of multiple game franchises, the company was able to generate strong cash flow and ended 2015 with a balance sheet of over $1.2 billion in cash versus about $150 million at the beginning of the previous console cycle, according to the company. On top of the improving financials and expansion of product breadth, the most overlooked aspect of the company is the competitive moat surrounding a new recurring multiplayer Internet-enabled business in the vein of Lone Pine's secular disruptor investment theme. Previously the GTA life cycle was consumers would buy the game, play the single-player story, maybe buy more story-based downloadable content and then move on. That all changed with "Grand Theft Auto V." GTA V has sold over 60 million units since 2013, three times more than what analysts expected before its launch. A big reason it did so well is that gamers got addicted to the multiplayer component GTA Online and therefore didn't trade it in. Take-Two for the first time focused significant resources on building out a multiplayer online virtual world. The company then sold virtual currency, called micro-transactions, for real money to GTA Online players. So gamers could buy new vehicles, apartments and clothing. And the profit margin on creating such virtual items is very high for the publisher. GTA Online is now generating hundreds of millions of recurring revenue for Take-Two, lowering the volatility of the boom and bust cycle in the traditional model. The success has stunned industry analysts. "Consumers remain highly engaged with the vast open world of 'Grand Theft Auto Online,' which achieved its best week ever for both revenue and active players during this holiday season, more than two years after launch," Take-Two's CEO Strauss Zelnick said on the Feb. 3 earnings call, according to a Factset transcript. Read More Pro Uncut: Full interview with Jeff Ubben What if there is another GTA Online success story right around the corner? Its next biggest open world franchise, "Red Dead Redemption," is regarded by many as the best game of the last console generation and is the second most important nonsports Take-Two franchise. So their moat around this type of gaming is getting larger. Given the popularity of GTA Online and how closely the "Red Dead" series followed the GTA paradigms in the past, it's clear Take-Two's Rockstar studio will do a similar online offering for the next "Red Dead" game. It features an Old West setting instead of a modern urban city. Regarding timing, the release period between GTV IV and GTA V was five years. The first "Red Dead" game was out in 2004 and the sequel was published in 2010. Given the popularity of the series and the approximately five- to six-year development cycle, everyone expects the next "Red Dead" game in the immediate future. "It's been two and a half years since Rockstar last released a new game (GTA V), and most in the industry believe that their next release will indeed be a sequel to Red Dead Redemption," Kotaku gaming journalist Jason Schreier wrote in an email. "Not based on any inside info, but there's a very good chance they'll announce the game this year, maybe around E3 (June) time, and release it this fall or next spring." When asked specifically about a new "Red Dead" game, a Take-Two company spokesman said: "We haven't made any announcements with respect to our successful 'Red Dead' series, which has sold-in over 19 million units worldwide, including over 14 million units of 'Red Dead Redemption.'" Uncertainty around the timing of the next version of the game causes Wall Street to understate long-term earnings. In a note to clients in February, MKM Partners' Eric Handler said the release of a "Red Dead" sequel would boost Take-Two earnings per share over $3, which would be more than 50 percent higher than current Wall Street estimates. Since Take-Two's current valuation has the same high teens forward earnings multiple as its main competitors using estimates where many don't include "Red Dead" upside, therein lies the opportunity. So if the sequel is announced with a release date of this year or early next year, the market will get visibility on the earnings power of another open world game and recurring GTA Online-like offering. With a pretty good probability of an announcement and game release soon and Take-Two's dominant competitive position in the open-world online genre solidified, the market will likely re-rate the share price much higher. Read More Pro Strategy: Fitbit may outrun the shorts

A screen from Red Dead Redemption by Take-Two.

Source: Take-Two

Editor's note: Pro Strategy is a column on how to use the strategies of the smartest minds on Wall Street to generate quality investment ideas.

Take-Two is one of the most controversial and heavily shorted stocks in the market. Is it a one-trick pony or are the skeptics missing a secular paradigm shift? Using legendary hedge fund manager Stephen Mandel's investing framework may give us the answer.

The Lone Pine Capital founder is considered among hedge fund investors to be one of smartest fundamental growth managers in the industry.

"I think Steve is one of the very unique individuals in our business who is both a great analyst and a great portfolio manager. Most are great at one or the other, but Steve is world class in both areas," said Mark Yusko, CEO of Morgan Creek Capital Management, an alternative investment firm.

Mandel honed his craft as the consumer analyst for Julian Robertson's Tiger Management. The firm has $26 billion of assets under management, according to a source.

Here's CNBC Pro's analysis, using Mandel's paradigm:

For his long investments, the hedge fund manager looks for companies with a solid return on capital, good cash flow, a prudent balance sheet, competitive barriers and a strong management team, according to a Lone Pine investor presentation.