Grand Theft Auto IV, developed by Rockstar North and published by Rockstar Games

Yesterday, the stock price of Take-Two Interactive fell after the company announced a fourth quarter loss of $15 million (up from a loss off $7.1 million a year ago) even though its revenue of $323 million (up from $293 million a year earlier) was greater than expected. What's interesting is that in early November, according to Bloomberg, Zelnick all but declared Take-Two recession-proof, stating "With entertainment products, if there’s something you must have, typically consumers are going to buy it....So far, we’re not seeing any negative influence of the overall economy on sales of our titles.” Yesterday, however, Zelnick was siging a different tune. "We too are influenced by a very difficult set of economic conditions and the world looks a lot worse than it did just a couple of months ago," he admitted.

The news wasn't all bad, however. For the entire fiscal year, Take-Two is projecting a profit. And the best news of all was that the core staff of the studio that's primarily responsible for those profits--Rockstar Games' Dan Houser, Sam Houser, Leslie Benzies and unnamed others--has signed new contracts with Take-Two through the year 2012. More interesting, however, than the fact that the new deal would be "primarily based on a profit sharing agreement," was the following paragraph:

In addition, Take-Two has agreed to fund the future development of certain new intellectual property to be owned by a newly formed company controlled by key Rockstar Games team members and published exclusively by Take-Two.

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In other words, the Housers and their inner circle retain creative control of the franchises they've created, including Grand Theft Auto. They received a rich new deal. And they will also be able to create brand-new franchises for a separate company that they control--note that the release doesn't specify who owns the company, so Take-Two could have a stake in it--with those new games being funded and distributed by Take-Two. We were impressed when Bungie got to keep its name upon departing from Microsoft during the Flight of the Killer B's, but this strikes us as a far better and shrewder deal, with the Housers and company having the best of both worlds: they get to strike out on their own without ceding control of the house that they built.

For further analysis, we turned to Wedbush Morgan analyst, Michael Pachter. Here's what he had to say:

How would you assess Take-Two's refusal of Electronic Arts' offer considering that both companies' stock prices have taken a beating?

We have to be fair to Take-Two, and say that nobody anticipated the steep decline in the markets. Until after market today, Take-Two was actually performing better than the other videogame publishers, down far less than the market and than the others. I think that prior to the meltdown, Take-Two management thought that EA would be back with a higher offer. After EA began to experience problems of their own, it became clear that they wouldn't be back to the table. So with 20-20 hindsight, it's easy to say Take-Two made a huge mistake. At the time, I think that Take-Two management genuinely believed that EA or some other firm would come up with a higher offer.

Why is Take-Two losing money despite its year-over-year revenue growth?

Take-Two is losing money because it is still overly dependent upon profits from Grand Theft Auto. The game sold $710 million in the fiscal year, and conservatively threw off 30 percent operating profit (a normal "blockbuster" throws off over 50 percent operating profit, but I'm assuming that the Rockstar revenue share was 20 percent). That equates to $213 million of operating profit. Yet, the company generated only $177 million in overall operating profit. That means that the rest of the business lost $36 million. This is apparent when you look at guidance for the coming year, when GTA revenues will likely be closer to $250 million. In the coming year, $250 million of GTA would throw off $75 million of operating profit, and the company is guiding to around $15 million overall operating profit, meaning that everything else still loses money.

The problem here is that they have one phenomenal franchise, and a handful of "good" games, plus a lot of losers (Don King's Prizefighter, Top Spin, Bully Scholarship Edition, sports in general). Next year, they have a similar lineup, with Bioshock 2 as the "good" game, offsetting the profitable Carnival Games from last year.

Rockstar's top brass was undoubtedly already earning royalties for sales of its games. What is likely the difference between that and the new "profit sharing arrangement" with its parent company, Take-Two?

Strauss said "win-win", suggesting that Take-Two wins by keeping the talent, and the Rockstar guys win by making more money. My guess is that the old deal involved a royalty equal to 15 percent of revenues (I used 20 percent above to make the math easy), and the new deal is for a substantially higher percentage of profits. If profit (before royalty) is 50 percent, the team would have to get 30 percent of profits to break even (30 percent x 50 percent = 15 percent of sales). So they likely are getting something closer to 40 percent of profits. Every incremental dollar earned by the Rockstar team is an incremental dollar NOT earned by Take-Two, so the company is worth less going forward.

Strauss Zelnick runs Take-Two, but he's also the founder of ZelnickMedia and the private equity fund ZM Capital. Sam Houser, Dan Houser and other "key Rockstar Games team members" run Rockstar, but they're now also owners of this as-yet-unnamed new game developer. Am I correct to see parallels in this arrangement? What are the advantages and pitfalls in these kinds of deals, both Zelnick's with Take-Two and the Housers et al. with Rockstar?

The real interesting feature is the new company "controlled" by Rockstar employees. This suggests that all NEW Rockstar intellectual property will be owned by the employees, with Take-Two getting a minority stake in profits. So games like Max Payne, Red Dead Revolver, Bully and Manhunt (all "invented" on Rockstar's watch) will continue to be owned by Take-Two, but all NEW IP will be owned by the new company. Thus, Take-Two's growth prospects are limited, given that the old franchises will eventually fade, and the new franchises are controlled by a third party.

I'm not sure that there are parallels with ZelnickMedia--don't know much about them.

Why are so many publishers struggling even as the overall videogame sector is showing continued growth?