Electronic Arts: Sell-Siders Flee on Lowered 2009 Guidance

I should put it out there that I’m not a contrarian by nature. Sometimes I agree with what the ole’ herd has to say. It just so happens that lately, the sell-side community has been slicing the ball so severely that “zigging when they zag” seems the smartest move.

In many years of covering Electronic Arts (ERTS), I’ve seen several long time periods where the market let EA “stay out past curfew”, allowing the company to trade at P/Es of 50+ and high multiples of book value when cyclical earning periods were near a trough. Their leadership of the video game market was assumed, and the premium remained. Each year, EA would cause grumbling amongst the purists for relying on sequels and franchises, yet each year the company would exceed earnings targets.

What a Difference a Wii Makes

When the Wii came along two years ago, everyone was caught off guard, but most of all Electronic Arts. The company had been stuffing the R&D channel for game development towards what it thought would be the alpha dog platform, Sony’s (SNE) PlayStation 3. Two years in, and the PS3 runs a distant third to the Wii and Microsoft’s (MSFT) Xbox:

Cumulative Units Sold - Worldwide (through 11/08):

• Wii - 40.17 million
• XBOX 360 - 24.9 million
• PS3 - 17.9 million

The rest, as they say, is stock market history - Electronic Arts has failed to do what it's done in every prior console cycle, which is reach a higher level of earnings and a greater market share. Two years after we knew Wii was going to be a game changer, management has yet to steer the ship in the right direction. EA has only seven games in the top 50 sellers for the Wii console..and not a single one is in the top 20.

Bad News Was King Yesterday

After five straight quarters of losses, the pity party was consummated yesterday with a massive sell-off as EA dropped guidance for its Fiscal 2009 (ending March 31), citing poor sales of its holiday lineup and general market malaise. (Eric Savitz had a nice post up on the mass analyst exodus over at his Tech Trader Blog, yesterday). The prior guidance was for revenues of $4.9 to $5.1 billion, and non-GAAP EPS of between $1.00 and $1.40 per share.

Another Apex of Negativity?

In early trading shares were off as much as 17%, and I took the opportunity to add more ERTS shares to the existing Secular Trends Portfolio position @$16.20. EA closed the day still down 12% at $17.00, as volume was truly capitulation worthy at 7x average volumes.

Why did I add to the position? After all, this company has failed to right itself onto the Wii track, has costly licensing deals with the NFL, ESPN, movie studios, etc., and it has failed to produce any bona fide hits in recent years from original, in-house properties.

It’s All About the Fundamentals

The answer is simple valuation, as ERTS shares have gotten to a level I never would have thought possible, no matter how weak the current operating environment. First let’s get grounded on what the equity value really is right now. EA has no debt and over $2 billion in cash & securities, versus a current market cap of $5.45 billion.

Looking over the balance sheet (per the 09/30/08 filings) I see shareholder equity of just over $4 billion, from which I’m happy to yank out all the goodwill and intangibles (totaling $1.4 b) to leave a tangible book of $2.6 billion, or roughly 50% of the entire capitalization.

That leaves just a $3 billion price tag on the entire company, which has a slew of titles that can be repackaged each year with minor tweaks. While operating losses make the whole business look like a wash, the losses are largely due to R&D costs that have ballooned by over $400 million in the past two years.

Also, as we look into calendar 2009, there is revenue sitting on the table & largely expensed already, including the next Harry Potter game (delayed along with the movie) and a Star Wars MMO title that will be the company’s first big foray into the online multiplayer space. EA has also committed tens of millions to online & mobile game distribution, which should drastically cut down on longer-term SG&A costs.

A Secular Trend in High Demand

Video game software growth should come in above 20% this year globally, and the industry is quickly becoming a target for content-starved media companies facing secular declines in old line distribution channels. Disney (DIS) has been mentioned as a possible suitor for EA, but I won’t claim to have the inside track on who will step in, and for what price. But I do feel quite confident that bids or tenders are one the way, and not too far from now. A $3 billion sticker for this company is going to attract a lot of attention, and an acquisition would likely be accretive to a buyer within a year.

Disclosure: Author does not hold positions in the companies mentioned; ERTS shares are held in EpiphanyInvesting Secular Trends Portfolio.

Comments

[vitaminc:]

ERTS's business model is being rendered obsolete by the progression in videogaming industry and you have not yet realized yet.

2008 Dec 12 08:46 AM

[Ryan Barnes:]

Your comments give no information and only state words, and you have not yet realized yet....I'd be happy to hear what will replace the $15 billion revenue that ERTS competes for each year.

2008 Dec 12 09:52 AM