The momentum at Take-Two Interactive Software, Inc (NASDAQ:TTWO) has been kind of like one of its fast-paced games. And, yes, investors have been playing it up. For the year so far, TTWO stock has soared 116% to $106.40. It has actually beat out other hot operators like NVIDIA Corporation (NASDAQ:NVDA), Netflix, Inc. (NASDAQ:NFLX) and Facebook Inc (NASDAQ:FB).
Digital Downloads Have Been Instrumental to TTWO Stock Success
A key part of the success of TTWO stock is that the company has invested heavily in making the transition to digital downloads. True, this seems like a no-brainer, but, then again, it is tough for a legacy company to make big changes.
But they have certainly paid off in a big way for TTWO stock. During the latest quarter, the revenues for digital downloads jumped by 31% to $302.9 million — accounting for a whopping 68% of total new revenues. The growth came from a broad selection of titles, such as NBA 2K17, Grand Theft Auto Online and Grand Theft Auto V, WWE SuperCard and WWE 2K17, and XCOM 2.
This is important since the margins tend to be higher, as middlemen like GameStop Corp. (NYSE:GME) are cut out of the revenue chain and there are also more engaging relationships with customers. In fact, a game can have a prolonged life, as there are ongoing updates with new content.
Quality Over Quantity
But there is something else that’s interesting about TTWO’s strategy — the company does not have a large number of titles (at least compared to other large game developers). This allows for better focus on quality, which is certainly critical as customers have high expectations for games, but also there is less of a chance that highly successful titles will get diluted.
Equally encouraging to TTWO stockholders is that the gaming industry is likely to see continued growth. According to InvestorPlace.com’s Josh Enomoto: “Amazingly, 155 million Americans play video games on a regular basis, or three or more hours per week. Additionally, 80% of households own a video game console. Most importantly, the average video gamer is aged 35, meaning that this demographic has plenty of money to spend. As Millennials spawn more offspring, the gaming culture will become even more integrated.”
All this is great, right? Of course. It’s really not a surprise that TTWO stock has been a big winner this year.
Reasons to Be Concerned About TTWO Stock
Yet, I still think investors need to be wary. First of all, there could be issues with the microtransactions model. This is evident with the recent backlash over Electronic Arts Inc.’s (NASDAQ:EA) Star Wars Battlefront II game. The company made it exceedingly difficult to unlock characters like Darth Vader. Essentially, many players had little choice but to shell out money.
As a result, EA caved in and eliminated the monetization strategy — and that tanked the stock.
Now, it’s not clear what this will mean to the gaming industry. But, going forward, it does seem reasonable that the large companies will show more restraint with their microtransactions, which could weigh on revenue growth.
Next, Take-Two plans to release the next version of its Red Dead franchise, which is expected to hit the markets in early 2018. Generally, the company has done a great job in creating new titles. But nothing is guaranteed either. Let’s face it, the gaming industry can be volatile. As seen with operators like Zynga Inc (NASDAQ:ZNGA), there can be long dry-spells — which lead to horrible stock performances.
If anything, this risk is even more of a threat since much of the good TTWO news has already been baked into the share price. Consider that TTWO’s price-earnings ratio is 63. By comparison, Activision Blizzard, Inc. (NASDAQ:ATVI) trades at a 42 P/E ratio and EA sports a ratio of 28.
Moreover, the growth rate underlying TTWO stock is hardly robust. During the past five years, revenues increased by an average of 16.6% per year. While this is solid, it does not really justify an outsized valuation.
So, for now, TTWO stock is probably one to press the pause button on.
Tom Taulli is the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.