Analyst: Rockstar Deal Could Steal Take-Two's Thunder

Take-Two managed to retain key Rockstar talent with a substantially compelling deal, but will it help or hurt Take-Two in the long run? The loss of that talent would have been a major blow to Take-Two, a company that has always categorized its unique developers as a major selling point to its shareholders. The company kept founders Sam and Dan Houser and Grand Theft Auto producer Leslie Benzies by offering them profit sharing, and the opportunity to create and control their own IP in a separate company. Analyzing the deal, Wedbush Morgan analyst Michael Pachter says Take-Two showed "sound judgment" in extending the contract of these employees. In evaluating the particulars of the new contract, Pachter speculates that it results in a significant earnings boost for these Rockstar employees. "While we completely endorse the shift in bonus from a revenue-based to a profit-based formula, it is clear to us that the employees would not have accepted the new arrangement unless they were confident that their overall compensation would increase," Pachter said. "Thus, we think that the profit split is substantial." How substantial? Pachter explains: "In our view, the old arrangement called for an internal royalty of around 15 percent of Rockstar revenues, which likely generated an operating profit (before internal royalty) of 50 percent." "Under the new deal, we can only conclude that the employees expect to earn more. If we’re right about the 50 percent operating margin, the new deal would have to provide at least a 30 percent profit share (30% x 50% = 15%) for the Rockstar employees to remain whole. We suspect that the new deal offers something closer to 35 – 40% of profits." But Pachter notes that the real leverage in the arrangement lies in its second clause -- the controlling interest in what's effectively a new company and the IP it generates. "We speculate that the term 'controlling interest' means that Rockstar employees will own at least 51 percent of the stock of the new entity," Pachter concludes. "We envision a scenario where Take-Two will fund game development, and will be entitled to first-dollar payback of its development outlay before the new entity will be entitled to any revenue." Pachter compares this to Electronic Arts' EA Partners model, and says that as publisher, Take-Two receives 30 percent of revenues with a minimum 12 percent marketing commitment, leading to profits of about 12 percent. Under Pachter's assumed model, after adjustments on the remaining 70 percent, those profits would then be split among the shareholders of the Rockstar employees' new entity. "This arrangement makes sense for Take-Two, insofar as it will continue to earn something from the labors of its key employees," says Pachter. "Similarly, it makes sense for the Rockstar employees, as it gives them greater control and greater ownership of their creations." The downside, Pachter thinks, is that Take-Two may be under-resourced in IP that Rockstar creates. Grand Theft Auto may be what Pachter calls the "flagship brand," but Rockstar has created several other IP over the years including Midnight Club, Manhunt, Bully and Red Dead Revolver. "Going forward, we expect no new Rockstar IP to be owned by Take-Two, and ultimately, we expect the value of the company’s existing brands to fade," says Pachter -- and according to the analyst, this means that a "substantial shift" in value could occur away from Take-Two and in favor of Rockstar. Recently, on the company's quarterly results call to investors, Board chairman Strauss Zelnick aimed to stress that this would not be the case: "The bulk of [Rockstar's] activities will be related to what they've done before," he said. "The key activity is the ongoing activity." Pachter concludes, "Of course, the contract is only for three years, and it’s possible that nothing more will happen than another installment of Grand Theft Auto."