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EA Versus Take-Two: How The Takeover Works

Posted by Kotaku US Edition at 3:00 AM on April 17, 2008

When it comes to Electronic Arts' takeover bid for Take-Two, we've heard nothing but silence for the past few weeks. In fact, it looks like business as usual for both companies; while EA's been utterly quiet on the topic, Take-Two has announced an executive hire and an Asian expansion as if nothing were going on.

But tomorrow, Take-Two is set to hold its regularly-scheduled annual meeting for its shareholders, where they can hear from the executives and vote on internal matters. And although this may look like just another routine affair, it might become clear on Thursday night whether EA's bid is likely to succeed— or whether it will end up dead in the water.

Not so clear on what's going on? Hit the jump for the whole story, including the anatomy of a takeover, possible outcomes, the reasons behind Take-Two's resistance, and more.

 

Neither Take-Two nor EA were immediately available for comment, so to understand what's going on here, let's recap the story so far. On February 19th, EA CEO John Riccitiello sent a letter to Take-Two board chairman Strauss Zelnick, proposing to acquire the company at a price of $US 26 per share. Almost immediately, Zelnick rejected the bid, claiming it "substantially undervalued" Take-Two, and said he wouldn't be willing to discuss a merger between the two companies until after the release of Grand Theft Auto IV.

At that time, Riccitiello urged Zelnck to discuss the matter with him privately — promising he'd take the bid public unless Zelnick agreed. Zelnick did not, and EA's acquisition bid went public on February 25th. Again, Zelnick refused to enter discussions with Riccitiello, promising he'd do so on or after April 30th, claiming he didn't want to jeopardize GTA IV's release with any major transactions — and suggesting that the release would add greater value to Take-Two's stock than EA was giving it credit for.

But analyst Michael Pachter is just one of many in his field who believe that investors are already aware of the value of GTA, and that Take-Two's share price reflects that. "I've put in print a dozen times that I think this game will sell 9 million [units] this fiscal year, and 9 million next fiscal year," he explained to Kotaku. "And I say it, and guys like [Janco Partners analyst] Mike Hickey say it... there are some 30 analysts who cover Take-Two. And I don't think anybody has an estimate below 14 million."

In other words, the release of GTA IV wouldn't change a thing for Take-Two — and yet the board continued to hold out. Faced with Zelnick's resistance, the next step for EA was to go hostile. In this type of scenario, the bidding partner bypasses the board to try and buy shares directly from the company's investors. Any share can be sold — and if EA gets more than 50 percent of the existing shares in Take-Two, they gain control of the company. On March 13th, EA formally announced that offer to the investors. And Take-Two, of course, urged its shareholders not to sell, warning that EA's offer just wasn't good enough. They stressed this again on the 26th.

Pachter doesn't see much merit in Take-Two's unhappiness with the offer value. "The point is that last year, and the year before, they didn't have GTA and they lost a buttload of money," he says. "Take Two loves to brag about all their franchises, but the fact is they have 3 Christmases in a row — '06, '07, and '08 — where they lost money. No other video game company lost money in 3 Christmas quarters in a row in history... If you can't make money at Christmas, you are not the 'best video game company in the world.'"

But Take-Two's been sticking to its guns. Kotaku also got input from Lazard Capital Markets analyst Colin Sebastian, who explained, "When analysts tell you that on one hand [EA's offer] undervalues the company, they're looking at just this year's number, which looks very strong just given that GTA is in the year, because that's a very profitable title. It's a very big year for Rockstar and Take-Two. But if you were to normalize over the past few years, they were losing money. There's another method of valuing the company that's looking at it over a period of time — and it doesn't look like an inexpensive acquisition, if you will."

Added Sebastian, "I would agree with Michael; I personally think that... aside from GTA, I think Take-Two has yet to demonstrate a consistent track record for generating profits, although some of the moves they've made... appear [to be] on the right track. But from the point of of EA it's certainly a risk, because Take-Two has been losing money. The problem is, the longer you wait, the less GTA revenue a potential acquirer could get. EA obviously wants as much GTA in their fiscal year as they can get, and as time goes by, they get less."

So time is of the essence. Why then, doesn't EA just offer more money for Take-Two to try and seal this deal quickly? Pachter explains that EA doesn't need to — they've already offered "substantially more" than the company is worth. Moreover, Zelnick won't negotiate with Riccitiello right now. In fact, Zelnick said that, since EA went public with the bid against his wishes, he'll no longer cooperate with EA by allowing them access to any of the company's information that might help generate a different dollar value.

Pachter compares it to demanding more money for your house without letting potential buyers inside to look at it — and he's baffled by the situation. "I don't get why Take-Two management was not willing to privately meet with EA and discuss a possible combination at a price that is in everybody's best interest. Take-Two management... have repeatedly said that $26 is an unfair, inadequate price. Then why aren't they willing to go sit down with EA, explain why $26 is not a fair price and why some number above that is a more fair price, and at least hear EA explain about whether they're willing to go higher or not? If you don't explain to EA why they should pay more... they're not just going to volunteer to pay more... Riccitiello tried for a couple months to be friendly, and Strauss is the one who was hostile."

In fact, Take-Two has tried to explain, in the information it's released to its investors, but the explanation seems to contain a little bit of fuzzy math. When we talked to Pachter, he helped us parse out what it all meant: "First of all, all analyst estimates on Take-Two are before tax . Because Take-Two lost so much money they don't pay taxes — they pay, like, 3 percent. When you don't make profits to offset losses, you don't pay taxes. But Take-Two is using analyst estimates.... to compare [themselves] to Activision, Ubisoft, THQ and EA... and their analyst estimates are all after-tax. If you're EA and you buy Take-Two — you suddenly pay tax on all Take Two's income, because EA doesn't have big losses... So now is it an inadequate offer?"

Moreover, Pachter points out that Take-Two's stock rose after the EA offer went public — and it's only thanks to that that Take-Two might compare, value-wise, to THQ, who is in "turnaround mode," but not to Activision or Ubisoft, who Pachter says are "kicking ass."

So all signs suggest that the excuses Take-Two have made for why they aren't dealing with EA don't really hold water. So could it be that Take-Two management has a completely different reason for rejecting the offer? Not because it's too cheap, and not because of GTA IV, but because the management might have something else to lose?

Not an offer from another buyer; though Take-Two has said it was entertaining other discussions, no one has stepped up. "If Take-Two was waiting for a white knight... we haven't seen evidence of that happening," Sebastian notes.

Take-Two's SEC filings reveal something interesting. On February 14th, the company management effectively tripled the management fee that Strauss Zelnick's ZelnickMedia receives from $US 62,500 to $US 208,333 — that's per month. Zelnick's management company is also getting a bumped up annual bonus: from $US 750,000 to $US 2,500,000 per year. The real big deal here, though, is the 600,000 shares of common stock that the management also gets as part of the same compensation boost.

Executives often get large stock packages that are supposed to help motivate them to raise the value of the company's stock through their management decisions. But if ZelnickMedia loses control of the company, there's no point in him having such a package. And the filing on the compensation boost makes it plain: In the event of a "change of control" — in other words, if EA's bid succeeds — ZelnickMedia won't get those shares.

So it sure looks like this isn't necessarily about GTA, the value of the stock, or the timing of the offer — except as it inconveniences ZelnickMedia's attempt to make itself a little richer."That's obviously a cynical interpretation of events," says Sebastian. "Not to say it's not true... it's hard to think that it's a pure coincidence."

Kotaku wasn't the only outlet to note the odd, potentially unethical timing of the rejection, either — MarketWatch's Herb Greene is generally credited with exposing the information. Additionally, EA's Jeff Brown disapproved to the LA Times, "If Strauss Zelnick keeps telling people he's a Boy Scout, someone should ask him what merit badge he expects to get for this."

Moreover, Take-Two has taken an extreme measure to try and block the hostile takeover by implementing what's called a "poison pill." The board adopted a measure that says that anybody who buys more than 20 percent of the company's shares after April 7th — in other words, EA — is limited in the number of votes they get in the company. In other words, if EA wins the company, they wouldn't be able to control it.

At the time, Take-Two also moved their annual meeting ahead to April 17th so that it would take place after the April 11th deadline for EA's bid. EA responded by simply revising the offer, extending it until April 18th — and also adding a condition for the offer that would effectively invalidate the poison pill.

We asked Pachter about the poison pill, and he told us that it's a normal thing that happens in hostile takeover situations — but it might not be a major obstacle. "In the history of the U.S., there's never been a poison pill that's actually been implemented," he says. "They're just a pain in the arse obstacle that exists to force EA to sit down and meet with the management of the target company."

Take-Two's investors could vote down the poison pill by deciding that it doesn't apply to this transaction. So right now, the fate of the EA-Take-Two merger is in the investors' hands.

And who are Take-Two's investors? Since its largest investors, Fidelity and Oppenheimer, sold big chunks of their ownership, Pachter doesn't believe that any one person owns more than 5 percent of the company at the moment. Sebastian also believes that interpretation is consistent with the public filings. Instead, Take-Two investors are likely a large group of arbitrageurs: people who buy a stock and then flip it quickly when its value increases. Instead of investors who hold stock for the long-term, these guys make their money through frequent, small gains.

There's a chance that the arbitrageurs may ask EA to raise their offer before they agree to vote down the poison pill — in that way, the pill acts as an inconvenience that could squeeze more money out of EA. But Pachter's almost certain that, if that's the case, then the arbitrageurs have already spoken to EA on their demands — and that EA has probably already agreed to them. Pachter suggests that might be the reason for all the silence on EA's end since the hostile bid was announced: they don't need to say anything. They don't need to brag; they've already won.

Predicts Pachter, "My guess is somebody.... will float a shareholder proposal, a resolution, that the poison pill not apply to this transaction. If that passes — which means more than 50 percent vote — then that tells you the next day, more than 50 percent will tender their shares to EA." And if fewer than 50 percent support a work-around for the poison pill? EA walks.

Take-Two announced today, though, that nobody had submitted any shareholder proposals. And because of the time period that proposals were allowed to be collected, none of the people who have bought Take-Two stock since the bid was announced have a say in the meeting — even though current patterns suggest this could be 50 percent or more of the company's shareholders.

So how might those latecomers — those who might have bought in in anticipation of a sale to EA — get their way, if they can't vote in the meeting? They could convene their own shareholder meeting, explains Pachter, after Take-Two's. As of right now, though, Take-Two's stock is trading just above the almighty $US 26 number — and Pachter surmises this could mean that the arbitrageurs holding the stock have faith that the EA deal will be accomplished.

Lazard's Sebastian has a more moderate view of what might go down at Thursday's meeting: "I think we'll find out how many shares have been tendered, and as of the last... I think there were 500 shares that have been tendered to EA. So it's almost nil — and probably because people want to know what the alternatives are. If you're Take-Two management, your options are to sell to EA — or go back to where you were, [a share price of] $US 15-17." According to Sebastian, Take-Two must convince its shareholders it has a plan to raise the stock price over $US 26. "It'll be up to shareholders to decide," he says.

What about that Asian expansion Take-Two just announced? "It doesn't hurt the valuation," says Sebastian. "A long-term strategic plan for building out [into] Asia is important. But I think it's too transparent... you can't just hire somebody and suddenly your company is worth 20 percent more. That's a little too transparent."

Pachter believes the merger would be in the best interest of both game developers and gamers, resulting in "more games, less crap." Games like Midnight Club, for example, would join a rotation with games like Burnout, meaning more selection and more frequent releases of high-quality titles. And the Rockstar mainstays wouldn't suffer, Pachter suggests. "GTA is not ever going to be different. EA's not going to mess up the formula. And I think, internally at Take-Two, a lot of those people are going to breathe a sigh of relief," Pachter says of the possible merger. "Sid Meier, Ken Levine — those guys are gonna love EA, because EA's gonna pump out more copies of their game."

Either way, we could see a turning point in this long battle as early as Friday morning, following decisions to be made at the Thursday evening meeting. At the very least, by EA's Friday deadline, it will have to revise its bid or let it go. Will it be a victory for EA, or will they walk? Let's see what the investors say.

[The full archive of the public disclosures by Take-Two and EA contained in this article can be found at Take-Two's investor relations site, at Electronic Arts' investor relations site, and at the SEC's public archive of filings on the matter.]

Tags: acquisitions | analysts | ea | take 2 interactive

 

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