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Pachter: Why EA Will Win The Take-Two Takeover

In his latest note to investors, Wedbush Morgan's Michael Pachter has provided an in-depth analysis of why EA will win its takeover bid for rival publisher Take-Two, despite the latter's insistence that the $2 billion offer undervalues the company -- full
In his latest note to investors, Wedbush Morgan's Michael Pachter has provided an in-depth analysis of why EA will win its takeover bid for rival publisher Take-Two, despite the latter's insistence that the $2 billion offer undervalues the company. In EA's own call with investors, CEO John Riccitiello insisted that if EA can't acquire Take-Two, nobody else can. "EA is unique in being the best acquirer of this asset," he said. "We have the strongest infrastructure... the strongest management. A lot of people have speculated that a media company might come in... This is a company where, unless I hear anything to the contrary, it would be my belief that the Zelnick media crew wouldn't go with the transaction... They'd find themselves in a tough situation. We're the most likely acquirer. Our label structure is unique, and this makes us the best possible home for their studios." While Pachter has already offered his reasons as to why the $2 billion bid is 'more than adequate,' his latest notes break down the deal even further, and are offered in full below: Why EA Will Win "In its SEC filing on February 15, Take-Two's board adopted an amended by law that provides that nominations for the Take-Two board of directors must be submitted by February 25. We believe that EA will keep its options open, and will nominate a slate of directors to be approved by shareholders at Take-Two's annual meeting, expected some time before June 30. In our view, EA has likely purchased some Take-Two stock on the open market, and we believe that EA management is speaking with Take-Two investors this week to convince them that the EA offer is a fair one. It is likely that Take-Two has a poison pill that could obviate a hostile takeover. If EA chooses to make a hostile bid, it would therefore likely be prevented from succeeding. However, we think that the EA offer presents a value far above the likely second place offer, and do not believe that a second offer will materialize. EA has the advantage of a strategic reason (sports) for purchasing Take-Two. No other party has the same advantage, and the acquisition of Take-Two makes another purchaser subject to head-to-head competition with EA. No other party can pay as much as EA, and should another bidder enter the fray, they would subject themselves to potential "buyer's remorse" if they bid too high and EA withdraws from the bidding. We don't see this happening. Of course, shareholders can take the assurance of Take-Two management to heart that it will work diligently to build value. However, based upon the closing price last Friday, shareholders apparently weren't convinced of this potential until the EA offer surfaced. Should EA withdraw its offer, we think that Take-Two shares will decline in value dramatically, probably to $20 or so (factoring in a premium for the potential that EA's bid will resurface. Why EA Will Walk EA has no real choice other than to withdraw its bid if shareholders do not accept $26/share. We think that the company may choose to offer a small increase, perhaps $1 - 2/share more, in order to complete a friendly takeover. However, we don't see the company dramatically increasing its bid over the near term. In the absence of a hostile bid, we think that EA will cool its heels and walk. We think that the real urgency of the EA bid is to avoid competition from Take-Two sports titles scheduled for release later in the year. By our math, each year that the companies compete in sports costs EA $150 million in operating profit. If Take-Two shareholders do not accept an EA bid and close the transaction before Take-Two releases its fall sports lineup, EA will have lost $150 million in opportunity cost. Thus, the clock is ticking. If the offer appears unacceptable to shareholders, we think EA will withdraw it, and we expect EA to compete more aggressively in sports, by cutting price dramatically. By our reckoning, EA could cut pricing on its basketball and hockey games by as much as $30, incurring pain, but causing Take-Two's operating profits to be halved for the fiscal year. We think that such a strategy will force Take-Two back to the bargaining table. Why Take-Two Will Accept EA's Bid Take-Two doesn't really have any other options. If a second bidder doesn't surface (we think a second bid is extremely unlikely), Take-Two has no real leverage. We don't think it is credible for management to ask shareholders to trust them to grow the business and earnings to the point where a $26 share price is warranted at today's multiples. We base this assessment on the EV/adjusted net income multiples for EA (around 12x FY:11 adjusted net income, implying around 17x the discounted present value), Activision (around 22x FY:08 adjusted net income, with price support from the pending Vivendi tender), THQ (around 10x consensus FY:09 adjusted net income), and Ubisoft (around 25x consensus FY:09 adjusted net income). The average of these "peers" is a forward multiple of 18.5x, so if we were to value TTWO at the peer average, the company would have to demonstrate after-tax net income earnings power of $1.40/share. This figure reflects EPS growth of around 35% above the implied $1.05 after-tax EPS suggested by the high end of company guidance for the year, and requires significantly more "turnaround" than management has committed to thus far. Why Shareholders Should Accept EA's Offer We think that EA has two choices: beat 'em or join 'em. They are attempting to offer a conciliatory gesture first, preferring to avoid the pain of a price war in sports without at least trying to acquire Take-Two. Should shareholders reject EA's offer, we expect the offer to be withdrawn, and expect to see EA compete aggressively and attempt to limit Take-Two's profit potential from its sports business. [...] Next, we think that EA will ultimately seek to disrupt continuity of the Grand Theft Auto franchise by attempting to engage the Housers and key Rockstar personnel upon the expiration of their contracts in February 2009. Should EA not complete an acquisition in time to eliminate duplication and competition in its sports business, its next best alternative is to try to "hire" key Rockstar personnel and engage them in creating an open world, mature-themed game to compete directly with Grand Theft Auto. This strategy has been successfully implemented by Activision through its recruitment of both the Infinity Ward and Spark Unlimited teams, and the ultimate development of the Call of Duty franchise. We expect to see EA (or another publisher, such as Activision) attempt the same thing with the creators of Grand Theft Auto. In our view, the Rockstar North team is as valuable as any studio in the video game business. After the price paid for Pandemic and BioWare (around $860 million), the Rockstar North team must at least consider testing the market value of their future services. We think that both EA and Activision will be interested in attracting talent such as this, and think that both companies' managements would be derelict in their duty if they failed to pursue the best in the business when their contracts expire. We envision that EA will withdraw its offer if not accepted, and likely will resurface with a lower offer at some point later in the year. In the meantime, we expect the company to prepare for battle, and we don't see Take-Two winning any prospective battle."

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