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Electronic Arts Inc. (NASDAQ:EA)

February 12, 2013 1:20 pm ET

Executives

Blake J. Jorgensen - Chief Financial Officer and Executive Vice President

Analysts

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Brian Karimzad - Goldman Sachs Group Inc., Research Division

All right. Good morning, everybody. This is Brian Karimzad from Goldman Sachs Research continuing the mini-video-game track here. And it's my pleasure to introduce our next guest back to this conference, Blake Jorgensen, Chief Financial Officer of EA. Blake, welcome

Blake J. Jorgensen

Thank you. Thanks for having me. Appreciate it.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Sure.

Question-and-Answer Session

Brian Karimzad - Goldman Sachs Group Inc., Research Division

You bring fresh eyes to EA. And so why don't you help us understand what motivated you about the opportunity now that you spent some time inside and what opportunities do you see for EA after that assessment?

Blake J. Jorgensen

It's good. I joined in September of this past year. It's a good career opportunity for me because it's a great combination of consumer and technology, which I've had both sides of the equation. I looked at EA and said here's a company that's got an amazing set of IP, incredible track record and yet still a lot of opportunities to fix and improve the business. And at the same time, going through a console transition, great opportunity to get to see what it looks like as the software side of that business grows in the transition. So big potential and I think the chance to really be involved with a great team. The management team there is fantastic. Everyone works really well together. And I've found that everything I saw from the outside coming in has been true, and I'm excited about it.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Excellent. So how about that new console? I mean it's probably the #1 question you get in meetings is how we can think about the cost base for you. You've thrown a couple of figures, I think, out there to help us frame it. But refresh us on that and if you have any new color to add now that, at least, it appears from the outside to be fairly certain we're going to get something within the next 18 months, if not 2 things in the next 18 months.

Blake J. Jorgensen

Yes. So obviously, there are some things I can't say about the timing just because we're under NDA with the producers. But I do think what we've seen, we're very optimistic about. And I think the most important question on people's mind is well, what's the cost to go through that transition? I'd look at it a couple of ways. One way is that historical transitions have been bumpy for a few reasons. One reason has been that a lot of companies had too many titles. We had way too many titles in the last transition, and the more titles you have, the more expensive it is to convert them from one generation to the next. And we're much more focused now. We've got a core group of 10 to 15 titles. We'll stage those in terms of the transition and so manage those costs through that. Our goal is to keep the cost increase for R&D under $100 million. And that's probably -- some of that's in this year, some of it's in '14 and some of it will be in our fiscal year '15. I think the other issue in the past has been what happens to pricing with the existing consoles, and what we're trying to do is be receptive to where pricing ends up. We don't think it'll be as dramatic, and I think the benefit we have now is we've got some very large franchises that are more tied to sports calendars and won't be impacted by some of the pricing issues. The reality is, is that fiscal year '14 will still be a fairly large gen 3 fiscal year, if there's a console business that comes in at the tail end of the year, mainly because a lot of our titles are built around sports calendars. And so a FIFA, a Madden, an NCAA, an NHL title all come out aligned with the sports calendar. And if a next-gen console doesn't come out until next Christmas, most people won't wait, they'll want to be involved in getting those titles early because their friends are all playing those titles and because they're being played on current-generation consoles. I think important to remember is that next-gen consoles will most likely not be backwards-compatible, as they have been in the past -- as they have not been backwards-compatible in the past. And if you're multiplayer on a game, you'll most likely not be able to play with someone on a different generation. And so if you're a FIFA player and the soccer season's starting in August and all your friends are playing FIFA, you're going to want to be on the same box that they're on. And so if they all go out and buy a gen 4 box, if it comes out at Christmas, then you'll most likely do it. If they all hold on and continue to play on their generation, you'll probably not see that box purchase until after the soccer season's over. And I think that works for us in both positive in both ways, right? It helps us continue to sell gen 3 products, and it will help us sell gen 4 product as that cycle finally gets into place.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. And I know you can't get too deep on this, but you mentioned that you're kind of phasing some of your existing franchises. Is the fair way to think about it is, I mean, there are a couple of them, like Battlefield, that are currently produced for a very high-end PC spec. And so fair to say that those are pretty close to what would be needed for this new generation, in terms of fidelity and things like that size of a team?

Blake J. Jorgensen

Yes. So we've always been moving Battlefield well out on the spec because of the huge PC-embedded base of that business. And so moving from a gen 3 to a gen 4 is not a huge uptick in cost. The other key advantage for us is we've been building those type of titles all in Frostbite, which is our proprietary engine. And moving Frostbite up to gen 4 was a big task, but once you've done that, you now can do that across multiple titles as long as they're using a Frostbite engine. And so that's something that's been going on over the last year. The early look on some of that product's, I think, spectacular, and it'll be interesting to see how it plays out as it ultimately gets finished.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. What about just generally on the return threshold for a console game franchise and what's appropriate? It's not actually clear to me whether something that's just modestly profitable is acceptable to the organization. Because, and we've had these conversations in the past, right, FIFA and Battlefield are the largest dollar profit contributors in terms of franchises, and then the rest of your top 10 are profitable, but not nearly as much on a dollar basis, maybe not even percentage basis. Do you think you'll see a more significant profit threshold as you consider which franchises to move to the new generation and develop new ones?

Blake J. Jorgensen

Yes. I mean, I think, in general, one of the problems we've had historically is managing the operating costs and aligning that better with where the sales potential is. We still have, I think, marketing expenses that are too high. We need to continually focus on how we use more methods for marketing with our consumer base, where we're connected versus just spending marketing on traditional advertising. We have millions of players in FIFA Ultimate Team or Battlefield Premium. We're connected with those players almost every day through their gameplay. We need to use that connection to better bring down our marketing expenses. I think, at the same time, we're also focused on how do we have bigger, fewer titles. That's been a journey this company's been on for a long time. You want to always keep new IP in the mix so you don't lose the potential for future growth. But at the same time, we're trying to figure out how do we make sure that all of those titles, even if they're smaller titles, are really driving the profit. A couple of the key measures for us, we're focused on gross margin. It's really driven -- has been driven up by the digital transition over time, and we're going to continue to keep coming back to trying to push more digital product. A typical digital margin is in the 80s versus a packaged goods margin in the 50s. You don't have any price protection in the channel or promotional expenses. The marketing expenses, we believe, can be lower. All that yields a gross margin that, for the total company, probably can be in the high-60s and maybe even in the low-70s. We're right now bouncing around the 65%, 67% range. That, in combination with the marketing expenses and keeping our overhead down, I think allows us to get some margin expansion over time and trying to be really careful that we don't have too many small titles that even if they're profitable, they're adding more to the overhead component. The other piece of the puzzle that's important to us is wholly-owned IP, and the more wholly-owned IP we can develop, the better off we are. It's been great to have the NFL or FIFA along the lines with us, but obviously, we're sharing some of the profits with those guys, and so we want to be careful. They're really big properties where we're able to continue to build our own IP.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. And then, I guess, drilling a little bit more on the marketing side. I mean, used to be you were spending about 300 basis points less on a similar revenue base than you are today. And obviously, your mix has changed, and the smartphone and social games are a whole different character of marketing associated with them. How much room do you think you have there? I know you're not going to give a target, but...

Blake J. Jorgensen

Yes, I think we -- there's definitely a couple of points out there. I want to resist giving a target or giving guidance too soon in the year. But at the end of the day, what's gone on is our business went from a traditional packaged-goods-only business. It's now packaged goods and digital, mobile, free-to-play, subscription. And as you can imagine, in any organization where you've gone from one business model to many, you get organizational creep. And so we've got marketing and R&D and, for that matter, finance and HR and everything everywhere in the organization, it expands as you get new business models. Then on top of it, you add acquisitions, and you get some expansion as well. And so part of what we need to do is more organizational rationalization, which will help bring down expenses in specific areas. Marketing people do what they do. They spend money on marketing, and so when you have 3 organizations doing it, they'll typically spend 3x as much as if you have 1. And so part of our focus has really got to be on how do we get organizational alignment first and then drive down the cost through that activity. At the same time, it's a hit-driven business, right? And so marketing's critical. We're not going to stop marketing. It's key, it's been key for our competitors. But we do look around, and we see that we probably can spend less than we're spending today.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. So last time you had a buyback program it was, at least to us, unexpectedly cut off with the PopCap acquisition and funding that. What's your view of the importance of a very consistent cash return for EA versus being opportunistic on the acquisition front?

Blake J. Jorgensen

Yes, I mean, I think there's sort of 2 components to the question. First is we're going to be, I think, very careful on acquisitions going forward. That's not to say that -- it's easy to say that in the rearview mirror some of the acquisitions we did in the past may not have been as good as we thought. I'm sure everybody in this room was pushing the company to do something in social because everyone thought that's where the game business was going. Obviously, different view today than a few years ago. The good news is that most of the acquisitions we've done historically, we've designed them to have a cash payment and an earn-out. And if they haven't performed, they're obviously not getting the earn-out, and so it brings the overall cost of the deal down. But we're going to try to be very careful on acquisitions. I'm a big believer in cash flow. I think we've got to focus on cash flow. One of our weaknesses compared to Activision is we don't generate as much cash flow as they do, and we've got to focus on how we build that number up. If you've got the cash flow, obviously, I'm also a big believer that shareholders are interested in cash flow because they'd like to get some return, and that might be in the form of a share buyback. Maybe someday, we would consider a dividend, I don't know. But at the end of the day, it's all about how do we get cash back to shareholders. Our view is establish a buyback program and then stay fairly consistent with it. Like most of everybody, I think, in this room knows, buyback programs are typically built around a grid and around share price. So as the share price goes up, you're going to buy less stock. We've bought a lot of stock. We've bought about $250 million on our $500 million buyback up through the last 2 quarters. But because the stock price has come up a little bit, obviously, we won't buy back quite as much stock because we see it's less of a deal. Now I don't want anyone in this room to take that as an example to go sell the stock to bring the price back down so we'll buy back some more. But at the end of the day, it'll be balanced around what we view as the appropriate buyback. And over time, we'll change that grid. I'd like to continue to have a buyback in place and just keep a consistent view about buying back stock when possible and when it's prudent for the investors.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. I guess you touched on this a little bit, but with the last console transition, I mean you mentioned there was too much title supply going into it. What are some of the other challenges you guys faced and what have you learned as you head into this one?

Blake J. Jorgensen

Yes, I think the whole pricing in the current generation market we're paying a lot of attention to. I think there was activity in the last -- as I look back through the last-generation console transition, there was a lot of movement on not just the actual console prices coming down, but also where, for example, Sony had quite a few titles, they brought the price of those titles down as well, feeling that one or the other would drive volumes through the channel in the tail end of the transition. I don't think that's as big of an issue now, but we're clearly going to watch that carefully. I think we're a little more isolated to that because of the sports calendar associated with our properties and the constant desire to be part of that sports calendar playing, along with the actual sports as they are going through the season. But we're very cautious of watching pricing and watching what goes on and try to maintain good economics this year. Because the reality is no matter what, this coming fiscal year will be mostly a gen 3 year for us, right. Even if a lot of boxes get out into the marketplace, it'll take some time for that embedded base to build up. And so we're focused more on the benefit that we have a strong FIFA business, that we'll have Battlefield coming out this year. Both of those are going to be big positive comps for us even in a tougher retail market.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. And I guess just generally, as you talk to your consumers, do you research, I mean, this fragmented environment. Why do you think people will be receptive to a higher grade of console and the innovation you're building? On the one sense, it seems like the most successful innovation in games in recent years has frankly been on the network effect side just of it, as opposed to the fidelity and what the technology can deliver in terms of graphics and what are consumers telling you?

Blake J. Jorgensen

Yes, I mean, it's -- no one's really seen yet -- I mean, we have internally, but no one externally has really seen what the look and feel will be like on the new consoles. So I'll reserve judgment other than to say that I think people are going to be pretty excited. I do think, once again without describing the new consoles, you got to assume they're going to be highly integrated into the living room and the house, and there'll be a lot of capability for interaction. I think the console makers have seen what the typical gameplay is today. It's very different than 5 years ago or 10 years ago. It was typically single gameplay, not dual gameplay or multi-game players. So there's going to be some connectivity potential around that to make the game much more exciting. I think as well you're going to see a lot more integration between tablets, phones and the consoles over time. You're going to see people playing on glass at the same time they're playing on the console, and there's going to be some exciting innovations around that. And I think it's going to be an extension of moving from what's in the living room to what's outside the house. Even though it might not be playing on the console, it's connected to the console in some way. So today, for example, FIFA. Our FIFA Ultimate Team business is a great example of where the business can go. So people are playing FIFA at night with their friends connected in a multiplayer mode. They then, the next morning, are downloading scores onto their handheld device, as they may be on the bus to work or the subway or in the car, and then they're interacting with their friends and trading players during the day. And then at the end of the day, they may be scheduling another game that they're going to play that night with their friends. And all along the way, we're either doing micro-transactions or just simply staying connected to the customer, and that's a huge opportunity for extension beyond what was traditionally a gameplay. So I think there's a -- you're going to see more of that, and the new boxes are going to be much more tied to that capability. I remind people look at whatever the device they're using in the room right now and I guarantee, virtually, none of those existed 2 years ago, let alone, 7 years ago. So you've got to imagine 7 years is a long time in technology. We're going to probably see some pretty exciting things when it comes to the new consoles.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Right. What about on the smartphone side? So between what you've reported and a couple others out there, there's been some inflection on the revenue scale side of these things. What about the margin potential? It seems a lot of the successful stuff is on the license side, so there's a hit there in acquisition cost for customers. I mean, maybe I'm wrong, I get the impression it's a bit of an auction out there for getting customers. Help us understand what's going on there. And do you see an opportunity 3, 5 years that these things could be higher-margin businesses than what we're seeing?

Blake J. Jorgensen

Yes. Those are really good points. I mean, today, I think the consumer's trying lots of different things, and some people are getting connected to a certain game and they're playing that a lot. The acquisition costs -- so when you look at the app store and you realize there are hundreds and hundreds of thousands of games, breaking through that noise requires either a really unique IP, really expensive customer acquisition or possibly some shared IP with a third party. In the case of The Simpsons, for example, Tapped Out, which is one of the largest games on the iOS platform, and it's now coming out on the Android platform, using the Simpsons as a draw has been a big plus to us. So even though we obviously have to share some of economics with Gracie/Fox, at the end of the day, it's still a very profitable game for us because the acquisition costs are relatively low. If you've got shared IP or big fees you've got to pay and you got to do acquisition costs, it's probably not a very good economic model. And so we're trying to either develop it off of our own IP, like a Plants vs. Zombies or a Bejeweled or do it with IP that's very well known, like The Simpsons, as a great combo. I think the last piece of it is doing something that's spectacular and different than others. So I encourage people in the next couple of weeks, when it comes available, to download Real Racing onto their tablet or phone, do it from a landline or from a high-speed line, don't do it off your phone because it's a big honking piece of software. But what you'll see is a racing experience where you use the tablet as a steering wheel. And while that's been done before, this is a level that I don't -- it's console quality that I think people are going to be blown away at. And the reason I bring it up is I think it helps show people where the business is going versus the traditional business, which was much more of a hunt-and-peck kind of game on a tablet and more old fashioned.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Well, I guess, on that, one other point that gets brought up to me quite a bit to me is you look at some of the more heavily monetized stuff on the smartphone and even a lesser extent, onto the PC platform, is stuff aimed at the mid-core gamer. A lot of it tends to be role-playing fantasies, as opposed to, say, a racing game. Why hasn't EA had a bigger presence there, given the large base of players you have in that demographic? And kind of what are some of the efforts we should look forward to?

Blake J. Jorgensen

Yes, I mean, I think I'll say frankly, we were probably distracted by some of the social, trying to port things over to social or build social. We were not alone in that. I think as we now move towards more the mobile platform, you'll see more of that, an extension off of some of the big franchises we have, like The Sims, or newer franchises, like the PopCap franchises around Plants vs. Zombies. So you'll see some more of that mid-tier game that's really built for the iOS and Android platforms versus the Facebook platform. And are we a little late there? Sure, we're probably late. But I think a lot of people were because we were all chasing Facebook. But I do think moving what have traditionally been either PC games or console games onto the mobile platforms, you're going to see a quality level that shines relative to some of the stuff that is out in the market today.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

And how quickly have you been able to scale down your efforts on the Facebook platform? Or is it kind of more to come that we should...

Blake J. Jorgensen

Yes. No, I think we've scaled it down pretty quickly. I think the tough part is development time on a new platform takes a while. And at the same time, Android didn't exist a couple of years ago. And so we've been -- we went deep in iOS, and now we're building out the Android capability alongside of that. It just takes time to -- you can't take an organization and overnight, just move them from Facebook to iOS to Android. It's a slower moving process. But you'll see, over the next 12 to 18 months, a lot of new titles coming out, very much trying to move all the iOS titles that we've been successful on onto Android as a first step and then introduce some new IP along the way through things like Plants vs. Zombies and others.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. We have about 5 minutes left. So I'm going to open it up to audience questions before I move forward.

Unknown Analyst

Have you considered, long term, switching to a kind of subscription model for your titles instead of -- have you considered switching to a subscription model going forward instead of selling individual games?

Blake J. Jorgensen

Yes. So we have some free-to-play and some subscription models alongside of the core game models. I think we want to have a balanced model across the board. So Star Wars has started as a subscription model. It is now a free-to-play model, but you can choose to either do a subscription or free-to-play. And in some cases, people have gone in as a free-to-play and realized that their micro-transactions are actually greater than a subscription cost, and they've converted over to subscription. I think there are -- the trend for subscription models over time is going down, and free-to-play trends are going up. But the economics that I just described with the Star Wars property, we may see some of that balance out over time. We've also looked at historically and we'll continue to do more of this through, for example, our Origin channel, where we might offer a subscription to a group of sports. We have those sports ticket concept, right, yes, and we're looking at other ways to do that. And one of the big benefits we have is we have a great catalog. And so how do we leverage that catalog of games through more activity, particularly as the digital download component is easier to be able to move games to people or not or even longer term, allows them to play the games in a cloud-type structure. And so I think you'll see more of that over time.

Unknown Attendee

My name is Lupee Volum [ph]. I'm a venture investor out of Boston. And interesting conversation I had with one of the guys who invested in Rovio early on, it was something like their 40th game, and so their ability to execute is what allowed them to create this success and sort of the probability of that. Can you talk a little bit about how your model of engineering games has changed with the app store and with mobile games? Are you focusing on producing more games faster? And how does that affect the strategy moving forward?

Blake J. Jorgensen

Yes. I mean clearly, the time and effort -- dollar efforts that you're going to put into some of the mobile games is going to be less. I think we're still -- we're coming from our DNA is a console-game maker, and so we're going to always be focused on the higher-end gaming experience. Real Racing is a great example of that, where it's a higher-end game versus a very quick throw-it-up, expected to have a 6-month life and then go onto something else. I think we're looking for ways to try to bring people into a gaming community independent of how they get there and keep them engaged in that community over time. That doesn't mean that we won't have some more, what I would call lighter or more consumer-friendly, easier games to play that are played on handhelds, but I don't think we're going to completely transition down to where some of the game makers are today. I think the other dynamics that I mentioned earlier is it's tough to break through. And so while I think Angry Birds, somehow or other broke through, who in this room would have predicted that, probably? It's just those things hit and so, because you can't predict those things. It's trying to work off of IP that either you've built over time and you know consumers resonate with or IP that they recognize from a different medium, so Simpsons is a great example there. But we're going to continue to see these little businesses that come out of nowhere and generate spectacular short-term returns because they've been able to build off of some -- but can they turn that into a long-term franchise? Tougher to say.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

So onto used game market, I mean do you view this kind of healthy used game market as at all beneficial to EA? And I know you've tried some authentication things in the past, I mean you even have some today to a degree, but what have you learned from those [indiscernible]?

Blake J. Jorgensen

Yes, it's a great question. It's a tough one because it's kind of one of these classic double-edged swords. In one way, the used game business has been critical for the health of the retail channel. And having a healthy retail channel is an important thing for us, right? I mean, the business will probably never be 100% digital. Bandwidths are a constraint and will continue to be a constraint for many years to come, which hold back the ability to do full digital downloads of some games. And so at the end of the day -- and storage capacity, right? Storage, I mean, unless you've got a giant storage server in your house keeping hundreds of games can get -- can tax to your storage capacity. And so having a healthy retail channel out there, like GameStop or Best Buy or others, is important. And to the extent that used games is important to them, I think that's a positive. Obviously, would we like to sell everything at full price and not have a used game market? Sure. But I think a used game market's a little bit like a -- any other kind of market where it creates liquidity, and the fact is that liquidity benefits us in some fashion, right? So if someone goes in and trades in a game, there's a good chance they're going to buy another one of our games. And so if there's a liquid market, I think that, that's not a bad thing at all. I can't really comment on where the next-generation boxes are going to be relative to used games. I will say that the trend in the business is to have that always-on connectivity and connect with the customer. And to the extent that the software identifies a certain customer is going to create some issues going down the road in the used game market. But I do believe that the consumer likes it, and it's been good for the retail channel.

Brian Karimzad - Goldman Sachs Group Inc., Research Division

Okay. We're about out of time here, so I'll wrap it up. Blake, thank you very much for joining us.

Blake J. Jorgensen

Appreciate everybody's time. Thank you.

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