By Burt Helm It's official: Take-Two Interactive Software (TTWO) got burned in the third quarter by the controversy surrounding "Hot Coffee," the sexually explicit mini-game embedded in one of its best-selling titles. While the maker of the Grand Theft Auto computer-game series beat its own lowered earnings forecasts, Take-Two missed analysts' expectations.
Sales were $169.9 million, short of the $175.6 million estimate on Wall Street, figures released after the market close Sept. 7 showed. Take-Two posted a loss of 41 cents a share, wider than the analysts' consensus of 38 cents, and pared its profit outlook for the rest of the year. The main reason: An abrupt halt in sales of Grand Theft Auto: San Andreas and the cost of reimbursing retailers for some 800,000 units after the Entertainment Software Ratings Board (ESRB) slapped an "Adults Only" rating on the bestseller.
FEDS' ATTENTION. Despite the weak earnings, Take-Two executives are relieved. After spending over a month missing from store shelves, recoded copies of the PC and Xbox versions of Grand Theft Auto: San Andreas are set to return with the previous rating of "M," for mature. "This should end" the concerns over the rating, says Take-Two Chief Executive Paul Eibeler.
It has been a rough summer for Take-Two. Amid the Adults Only rating and a rebuke from Congress, stores ranging from Wal-Mart (WMT) to specialty chains like GameStop pulled the game from shelves, and Take-Two slashed its third-quarter sales forecast to $160 million from $170 million. A still-fuming U.S. House of Representatives, in an overwhelming vote, asked the Federal Trade Commission to investigate whether Take-Two had "intentionally deceived" the ESRB, demanding that "the Commission should apply the toughest of penalties" if it discovered intentional deception by Take-Two.
The FTC probe is ongoing, but investors shouldn't be too bothered. Recent FTC settlements related to deceptive products have all amounted to less than $1 million. For a company with an estimated cash position of $280 million by October, and San Andreas profit of roughly $168 million, according to Smith Barney, that's insignificant. Even if the FTC mandates that Take-Two must reimburse any game buyers who decide to return San Andreas, it's unlikely that a large percentage of them will take up the offer.
"IN NO-MAN'S LAND." Yet as the "Hot Coffee" furor settles, last quarter's results point to the even bigger challenge facing Take-Two. Life without Grand Theft Auto can be very hard. And with no major GTA sequel on the immediate horizon, the gamemaker needs to diversify fast. Nearly 21% of its 2004 revenue came from San Andreas -- a game released in October of that year. The next two best-selling games also hailed from the GTA series, while the fourth-best, Max Payne 2, made up a measly 3.2% of the total.
Take-Two plans to debut a smaller version of the game, Grand Theft Auto: Liberty City Stories, this fall for Sony's Playstation Portable device. Still, without widespread ownership of Playstation Portables, that title will have a tough time rivaling the sales of a full multiplatform launch on widely owned consoles such as the Xbox or Playstation 2.
Some analysts foresee Take-Two sailing straight into the doldrums. "Take-Two is in no-man's land" wrote Bank of America analyst Gary Cooper in an Aug. 15 report on the holiday gaming season.
IFFY MODEL. Take-Two is grappling with the same challenge facing the rest of the industry: how to create a wide array of games that bring returns year after year. Yet Take-Two finds the going harder than rivals like Electronic Arts (ERTS). Take-Two, which has traditionally given its Rockstar label a wide berth to create games on its own schedule with few restrictions, has created wildly innovative games like GTA, but hasn't had a steady, reliable source of revenue quarter-to-quarter.
Electronic Arts, on the other hand, does a better job of annualizing revenue. Recent successes include The Sims series, with its continual expansion packs and sequels, an almost-yearly release of James Bond-themed games, and a Madden NFL series out year after year. Take-Two has had blockbuster success with the Grand Theft Auto games and some success with a series of racing games called Midnight Club, but little else.
"Take-Two has created a very risky business model," says Elizabeth Osur, an analyst at Citigroup's (C) Smith Barney. "They look at [the freedom] they give development studios as a competitive strength -- but game titles get delayed, and it's not clear that management has control over the schedule of new releases."
LOSING THIS ROUND? To its credit, Take-Two is making efforts to diversify and start generating less risky sources of income. Last year, it ventured into sports games by acquiring Kush Games and Pivotal Games, the two developers that made Sega's 2k series in football, basketball, and baseball. It also acquired the developer that makes the No. 1 tennis game, Top Spin.
"The most inviting part of the sports business is that it's a natural driver" of revenue every season, says Eibeler. Take-Two has also acquired rights to publish the next iteration of two popular PC franchises -- Civilization IV and Elder Scrolls IV: Oblivion.
Yet some analysts take issue with Take-Two's venture into sports. It entered the market last July with low-price games and the intention of grabbing market share from the leader in sports games -- EA. But it woke a sleeping giant. In December, EA struck back by locking up exclusive rights to use National Football League teams and player names. In response, Take-Two reached an exclusive pact with Major League Baseball to produce video games.
While terms of neither deal were disclosed, it's a costly proposition for Take-Two, which is about one-tenth the size of Electronic Arts. Baseball games are also a much smaller market -- about one-fourth the size of football, according to the NPD Group.
LITTLE ROOM. "I think Take-Two overpaid on that deal," says Jonathan Rudy, an analyst at Standard & Poor's. With the release of Microsoft's (MSFT) Xbox 360, Take-Two will begin charging full price for sports titles for use on the consoles, Eibeler announced Wednesday. That could remove Take-Two's main competitive advantage.
Plus, the majority of the games Take-Two has pinned its highest hopes on in the coming year are either licensed titles, like the sports games, or are being made through partnerships with outside studios, like Civilization IV, and Elder Scrolls IV: Oblivion. Eibeler acknowledges those are less profitable than games developed in-house. "The margins are significantly lower, but the risk is significantly lower, too," he says. "There are real tough business goals we are working to meet here."
Eibeler wouldn't say whether a new GTA title would be out by the end of 2006. For now, lacking a stable of home-grown blockbusters and confronting steep competition from EA in sports games, Take-Two will need to keep falling back on its GTA mainstay.
Helm is a reporter for BusinessWeek Online in New York