If you've read any of my prior articles (article, here and here), you'll know that I enjoy following the video game industry - perhaps in a little too much depth on occasion. This article will stick to the basics, Q3 earnings. Electronic Arts (EA) announces Wednesday, January 30th, after the bell.
The consensus is at $1.29B revenue and $.56 EPS, near the midpoint of guidance that ranged from $1.25B-$1.35B and $.50-$.60, respectively. I expect revenue a bit lighter at $1.27B and a penny beat on EPS at $.57 - the result of a higher digital mix that drives gross margin to 65% (100bps above guidance). The shift in mix could also affect full-year guidance, most likely raising the digital contribution (currently at $1.6B-$1.65B) and - less likely but possibly - lowering the publishing contribution (currently at $2.35B-$2.45B). Gross margin, guided to 64%, could also tick up.
The story for the release should be the ongoing digital growth, which I project at 24% YoY lapping a FY Q3 that included record digital download revenue from the releases of Battlefield 3 and Star Wars: The Old Republic (absent those profitable downloads I estimate YoY growth of 48%). The holiday quarter will lend further credibility to EA's digital growth story, despite the Star Wars failure, and is likely more impressive because of it.
Below, find my projected Q3 statement of operations.
|Non-GAAP Income Statement $ in millions (CY)||Q4 12|
|Cost of revenue||444.0|
|Marketing and sales||196.6|
|General and administrative||86.3|
|Research and development||291.8|
|Total operating expenses||574.6|
|Operating income (loss)||249.9|
|Interest and other income (expense), net||0.0|
|Income (loss) before income taxes||249.9|
|Provision for (benefit from) income taxes||70.0|
|Non-GAAP Net income (loss)||179.9|
|Non-GAAP earnings (loss) per share|
Revenues for this segment are derived from the sale of physical games at retail. I project sales of $763M, down 38% YoY, and the lowest Q4 segment total in the past five years. As mentioned above, Q3 13 is lapping a Q3 12 that included the mega-hit Battlefield 3, and there are no comparable releases this year.
1. New Titles: EA released just two AAA titles in the quarter (also the lowest number in five years): Medal of Honor: Warfighter and Need For Speed: Most Wanted. The former, whose prior version sold ~5M units, flopped and will likely top out at ~2M units. The latter was a relative success and will probably exceed 3M units. I say relative success because the annual franchise, which sold 6M units as recently as FY 10, sold only 3.5M units in FY 12 - thus the precipitous decline was halted. Together, I model 5M units at $45 wholesale, or $225M.
2. FIFA 13: I discuss the FIFA franchise in more depth in a prior article, and there indicated FIFA 13 was tracking 35% ahead of FIFA 12 in early December. That gap has since narrowed to 15-20%, but this remains a significant win for EA and would mean total units in the 14M range (I believe the long-term tails will be similar). The title sold-through ~11M units by year-end, and I model 13M units sold-in since its late September release - 5M in Q3 - or $225M at $45 wholesale. EA reported marginally less than 8M sold-in for FY Q2 12 (for FIFA 12), and a similar launch ramp this year justifies my prediction.
3. Madden 13: Like FIFA, I discussed this franchise in a prior article and indicated the current title was tracking 16% higher than its predecessor. That gap has narrowed to 5-10%, with 4.8M units sold-through by year-end. The faster sell-through rate, however, brings forward revenues. I model 5M units sold-in by year-end - 1.5M in Q3 - or $67.5M at $45 wholesale.
4. Catalogue: EA defines catalogue sales as revenues from units released in prior quarters, which would technically include FIFA and Madden. I have excluded those titles from this forecast section. Major drivers of catalogue revenue for Q3 include Battlefield 3, NCAA 13, and NHL 13, while less significant contributors run the gamut from Mass Effect 3 to Dead Space 2. I model an additional $245M in catalogue sales. This puts catalogue revenues inclusive of FIFA and Madden at $537.5M, which would exceed catalogue revenues of ~$420M in each of Q3 12 (estimated by me) and Q3 11 (reported by EA) by 28%.
Much of the publishing forecast will depend on the timing of FIFA/Madden sell-in and, to a lesser extent, the strength of the older catalogue. A 28% increase in this combined group is only justified if FIFA/Madden sell-in together is ~2-3M units higher than in each of the two prior years. I'm relatively confident in this happening because I expect management to bring forward revenues where possible (a hindsight model of Q2 suggests that the units will be available) and count on the slate of Q4 releases (e.g. Crysis, Dead Space, Army of Two and SimCity) to perform. There may also be a marginal benefit from a reduced slate of titles industry-wide, which should increase the shelf-length of EA's recognizable brands (e.g. NCAA, Mass Effect).
A comment on methodology may be worthwhile. Sell-through numbers were taken from vgchartz.com, and historical sell-in numbers were disclosed by EA. I don't have access to vgchartz' estimation methodology, but I've found reported sales to accurately reflect sell-through data disclosed by publishers after the fact. Additionally, vgchartz, from what I've been able to gather, does not track digital sales. For example, a search of units sold on the iOS platform returns a grand total of zero. DLC is similarly absent (unless it was released as a standalone disc). This has an important effect on titles that sell well on digital platforms, namely the PC, but increasingly consoles as well. The units modeled above are my projections for sell-in during the quarter. My forecasting process uses sell-through numbers as a baseline and estimates sell-in based on company announcements, historical sales figures and/or an inventory margin.
Revenues for this segment are derived from four sub-segments. I project sales of $466M, up 24% YoY and, more impressively, 48% sequentially. I will be very interested in the results for these sub-segments, as each reflects a unique niche of EA's digital strategy. Note that a more comprehensive description of these sub-segments is contained in a prior article.
1. Full Game Downloads: I project sales of $70M, a 32% YoY decline but quarterly growth of 84%. Revenues in this segment are generally driven by releases of popular PC games, which are then downloaded digitally through EA's Origin service or a third-party distributor. FY Q3 12 included the release of Star Wars (PC only) and Battlefield 3, which led to a 442% spike in YoY revenue to $103M. EA suggested that 40% of the ~2M Star Wars units sold-through in Q3 12 were sold via Origin, which gets you to $45-50M in non-recurring revenues in Q3 13. Battlefield 3 also sold 1.5M copies on the PC, and a not insignificant percentage of those sales will have been digital downloads. If we assume $60M-$65M in non-recurring revenue in Q3 12, that leaves ~$40M, which would have the projected $70M figure in Q3 13 represent a substantial 75% increase both YoY and quarterly. Supporting this increase are Origin's rapidly expanding user base (reported at 30M users - compared to 11M six months before - and 70 independent developers last call), increasing consumer acceptance of digital downloads (particularly on consoles), and the truncated digital release regime. To this last point, starting in October PlayStation offered digital downloads day and date (or immediately if launched prior to October), while Xbox shortened its six month delay to three months (EA is taking advantage of both opportunities). Titles like Madden, NCAA and FIFA were available for download during the holiday season on both platforms, and both Medal of Honor and Need for Speed were available on PlayStation.
2. Extra Content: I project sales of $185M, a 50% YoY increase and quarterly growth of 62%. This is EA's micro-transaction and DLC segment, and it is difficult to pin down specific numbers. FIFA will be a major contributor, as will the Sims franchise, Madden and EA's various browser games. Star Wars, which went free-to-play in November, could also be a factor. YoY growth in each of the last four quarters has alternated between 30%+ and 80%+. While this sort of sustained growth is unsustainable in the long-run, at these lower revenue levels and given EA's aggressive expansion (both geographically and brand-wise), 50% YoY seems reasonable.
3. Subscriptions, Advertising and Other: I project sales of $94M, a 40% YoY increase and quarterly growth of 27%. This sub-segment balances the effect of the Star Wars subscriber count (known to have declined significantly) with the impact of any holiday sales bump - both for Star Wars and across the segment broadly. The Star Wars subscriber count will be reflected in the quarterly trend, as subscription revenues should not have been recognized in December 2011 (a free month was included with purchase). YoY Q3 growth from FY 11 to FY 12 was 14%. Assuming the same this year get you to $76M. Sequential growth from Q2 12 to Q3 12 was 34%, suggesting a $99M figure. I sided closer to the sequential trend, as I think any continued decline of Star Wars subscriber count into early Q3 is minimal (I bet the majority left in Q2) will be offset by a pick-up driven by the free-to-play conversion. At last count in early August, Star Wars subscribers were "over 500,000." I believe my projection assumes somewhere in the 400,000 range.
4. Mobile / Handheld: I project sales of $118M, a 40% YoY increase and quarterly growth of 34%. Like the Extra Content segment, transparency is hard to come by. The 40% YoY growth projection is greater than in prior quarters, but I believe justified by the rapid growth in the smartphone/tablet business ($66M last quarter up 128% YoY), and the slowing decline of the feature phone business ($23M last quarter down 12% YoY). Last I checked, the smartphone/tablet industry was growing 40+% YoY. I expect EA's brands to maintain market share. The sequential bump in FY 12 from Q2 to Q3 - approximately 30% - also suggests a number close to my $118M forecast.
As I mentioned above, a $466M digital number would mean 48% YoY growth excluding the impact of the year ago Star Wars and Battlefield downloads. It also sets EA up for full-year digital growth upwards of 40% ($1.7B+ vs. the current guide of $1.6B-$1.65B), notwithstanding the Star Wars headwind.
Below, find historical and Q3 projections for digital segment growth.
|EA Digital Rev by Type||Q4 10||Q1 11||Q2 11||Q3 11||Q4 11||Q1 12||Q2 12||Q3 12||Q4 12E|
|Full game DL||19||34||32||26||103||60||33||38||70|
I have gross margin at 65%, 100bps above guidance and reflective of the digital strength, particularly in full-game downloads. Operating expenses of $575M are in line with sequential and historical trends, as well as management's guide below $600M.
I don't expect that too many will care to dispute specific unit and segment numbers above, although I hope to have convinced that the methodology is sound. Here is the forecast cheat sheet in bullet form.
1. Publishing revenues projected to decline 38% YoY due to a lack of AAA titles released (just 2 in fact - one of which flopped), but strong sales of FIFA and, to a lesser extent, Madden will prevent a disastrous quarter. Upside to this forecast is minimal, as I expect management to bring forward revenues where possible and count on Q4 releases to perform.
2. Digital revenues projected to increase 24% YoY, below the 45% and 55% rates of the prior two quarters, but up 48% sequentially. Q3 13 laps a difficult Q3 12 comp that included ~$60M in non-recurring revenues - without these revenues YoY growth is 48%. Major growth drivers are digital downloads ex- both Star Wars and Battlefield (both on Origin and through third-party platforms), ongoing free-to-play initiatives and smartphone/tablet games. The downside risk to this forecast is a relatively surprising slowdown in one or more sub-segments caused by as yet unknown factors (unknown because digital sales transparency is limited in the current research environment). The upside is across the growth drivers listed.
3. Overall gross margin is projected to be 65%, 100bps above guidance and a consequence of the strong digital share. Operating expenses are below $600M, distribution revenue is projected at $40M, and net income comes in at $180M.
Some additional thoughts and numbers worthy of mention are as follows:
1. Over the past several quarters, EA has tended to beat consensus by a penny or five - another slight beat will mean very little, while a slight miss could raise eyebrows.
2. Top line above the $1.3B guidance midpoint (and above $1.29B consensus) bodes very well for digital growth and should be viewed quite positively, while a slight miss is likely shrugged off.
3. Notwithstanding either of the above, another downward shift in top or bottom line guidance will dominate the discussion, unless that shift is the direct result of accelerating publishing declines and digital continues its outperformance.
4. Look for digital revenues of at least $440M as the baseline for continued robust digital growth.
5. Perhaps surprisingly for those familiar with its story, I think a Star Wars update could offer some upside to the stock.
To summarize, I predict an EPS beat, slight revenue miss, and robust digital growth (which might lead to a raise of the full-year digital guide).
Revenue: $1.27B vs. $1.29B consensus
EPS: $.57 vs. $.56 consensus
Guidance: Greater than marginal chance of a digital segment guidance raise
Disclosure: I am long EA.