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Electronic Arts Inc. (NASDAQ:EA)

February 26, 2013 4:20 pm ET

Executives

Rajat Taneja - Global Chief Technology Officer and Executive Vice President

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

Analysts

John Egbert - Morgan Stanley, Research Division

John Egbert - Morgan Stanley, Research Division

It's good. Hi, so I'm John Egbert. I work on Scott Devitt's Internet team. And today, we have Blake Jorgensen and Rajat Taneja?

Rajat Taneja

Taneja.

John Egbert - Morgan Stanley, Research Division

Before we start, please note that all important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures, or you can also find them at the registration desk.

So it's my pleasure to welcome Blake and Rajat who serve as CFO and CTO of Electronic Arts. It's great to have you guys. So prior to joining EA in September last year, Mr. Jorgensen served as Executive Vice President and Chief Financial Officer of Levi Strauss & Co. Prior to that, he was Chief Financial Officer at Yahoo! Inc. and before joining Yahoo!, he cofounded Thomas Weisel Partners.

Mr. Taneja joined EA in October 2011 as CTO to drive critical technology decisions and investments for EA on a global basis. Before joining EA, Mr. Taneja spent 15 years at Microsoft where he recently led the division responsible for the development and deployment of all commerce and transaction technologies across Microsoft's Connected Services, including Xbox LIVE.

John Egbert - Morgan Stanley, Research Division

So, to start, I think the most topical thing on most investors' minds is the launch of PlayStation 4 or the announcement of PlayStation 4 last week. Rajat, could you tell us your thoughts on the announced system?

Rajat Taneja

Sure, absolutely. We are excited about Sony's news and the launch of the next generation of consoles. At EA, we have never been as prepared or more ready for the start of a new console cycle. The console technology itself is a gigantic leap for our industry. Any which way you look at the specifications, it is a step function over what exists today. I won't go into the nitty-gritty of every component, but if you look at it in an aggregate basis, the new consoles are between 8 and 10x the power of the current generation. So what does this mean to a company like EA? It means really 3 things: First, we no longer have to constrain our games or ration, compute or graphics or memory or bandwidth. We can let the games really flourish, 1080p, 60 frames a second, character physics on a much broader canvas, color saturation, lighting, particle effects. There will be a level of gameplay experience that is unprecedented, not been imagined before. So it's going to create playing conditions for our gamers that'll be just phenomenal. The second thing is that the gaming -- the architecture of the consoles is based on standard PC components and technologies. So our own investments in our back end engine like Frostbite, our libraries, our tools will very smoothly run on this and make it easier for us to innovate to the new console technologies themselves. What used to take months in the past will now take days to do. Lastly, the connected and sharing capabilities of the new console actually fits very directly with our strategy and the secular trends that we're embracing of multiplayer gaming, connected gaming, social gaming and helps us accelerate those features into our games. We are seeing this really gives us new ways to approach our existing IPs like Battlefield and FIFA, and we're already beginning to use these learnings on new IPs that we are building for this new console generation.

John Egbert - Morgan Stanley, Research Division

Great. Can you tell us some of the biggest challenges and as well as opportunities that you'll face during this console transition?

Rajat Taneja

Well, the challenge, as in any transition like this, is keeping in concert the developments on the hardware and the drivers from the console makers and our own tools and technologies and in the games. So it's like 3 trains are moving at the same time and we have to connect together and hit a lock. So the normal engineering dependencies between those moving parts are the biggest challenges currently. The opportunities, themselves, are really phenomenal. The secular trends that have emerged and led to the growth of our industry in a massive way from about 200 million to nearly 2 billion consumers will accelerate dramatically with these new technologies. The ability to have cross-device play, to have persistence in the cloud and continue the gameplay from the console, to the PC, to a phone or a browser will be much easier. The ability to take new business models, open it up internationally will also be accelerated with this.

Blake J. Jorgensen

In the past, console transition, which a lot of people may have lived through, is the challenge we had at EA was we had 85-plus titles, and we now have 15 core titles. We didn't have the technology backbone that Rajat's team has built nor did we have the strength of the engines in which our core games are built on like Frostbite. And so now, having that allows us a much smoother transition. We've messaged to the Street that we think that's, at worst case, $100 million delta off of our R&D expenses and most likely we'll be able to moderate that through some cutbacks in other areas. And a big focus that we've had in the organization for the last year on trying to make sure we're developing for gen 4. And then last but not least, assuming that Sony and Microsoft are more aligned in their timing -- last time they weren't, that made it more difficult for a transition and ran the costs up.

John Egbert - Morgan Stanley, Research Division

Okay. You talked about the $100 million delta. Could you maybe talk about what the R&D requirements would be maybe just on a given title? How much more it might take on the new console?

Blake J. Jorgensen

Yes, so we won't do all titles at once. We'll stage them over time. And the biggest titles we've been working on are ready for the past year for the gen 4 transition. So on any one title, it might be 5% to 10% increases in costs. But the real opportunity comes with the ability to expand what you can do in that title. And I think in the past, it's been a constraint. Now, it's allowing people to do more and so overall you might see larger titles and larger costs because of the capability that you can deal with. But we'll also see larger revenue streams, we believe, because of the excitement around some of those big titles.

John Egbert - Morgan Stanley, Research Division

Okay. Would you, and you may or may not be able to comment, but would you expect to see some kind of pricing increase with this next generation, because I know each kind of console generation has gone up about $10 on average per title to compensate?

Blake J. Jorgensen

I think, typically, at the start of a cycle, you've seen the pricing raise, say, to $69 for a core piece of software. And then over the life of those, that's drifted down to introduction price, typically now around $59. We haven't yet set pricing on our gen 4s, but you probably see a similar trend to that during the start of the next cycle.

John Egbert - Morgan Stanley, Research Division

Okay, great. So, Rajat, at last year's E3, you presented your strategy on building up back-end infrastructure tied mainly to movement to digital. Can you provide us an update on your progress?

Rajat Taneja

Absolutely. When it comes to the platform, it's one of the most significant infrastructure initiatives in the history of our company. When we think about the platform, we think about it as the digital operating layer for all our games to enable connected experiences across all the devices on which our games work. So it's everything from identity to commerce to game services to our data infrastructure and data pipeline. And it's all about the physical infrastructure underneath that, our servers and our data centers, routers and switches. The effort we began a year ago has been proceeding with phenomenal speed. It's beating all our internal milestones. We are saving more than we had expected to. We are doing it faster than we had originally thought we would. And we are enabling capabilities at a faster pace than we thought we would in the roadmap we had initially set out last year. Let me give you a couple examples of where we are saving some money and where some of the new technologies are bearing fruit. We began an effort last year to identify our 275 million registered users and the 2.5 billion game sessions we run a month more ubiquitously across all their experiences with us. So we began to create a single identity for our gamers no matter where they're logged in to our network. Just last week, we have now released code into production that allows our games to integrate and begin to do that, and as you can imagine, the kinds of experiences we can create for our gamers with that in place. We also began a complete rewrite of our back-end data infrastructure. We generate somewhere in the neighborhood of 50 terabytes of gameplay and gamer data every single day. And so the way we ingest, process and make sense of the data and do both predictive and adoptive analytics in the game and around the game required us to rethink our entire back-end infrastructure and we have adjust released that as well in beginning to merge all our different data islands. We have made a lot of progress in enabling persistence of gameplay, and we are making steady progress in improving the infrastructure uptime and resilience and availability. We still have a lot more to do, but we are very pleased with where we are right now. When it comes to cost, we have also made a lot of headway. I'll give you a couple of examples. Just by bringing together our commerce engines into one single engine for the company, we are beginning to get a lot of efficiencies in the processing costs we have. For example, for Origin transactions that take place through our Origin website, by bringing it in-house and merging it with the same engine that we've created for the rest of the company, we're going to save more than 50% of the cost per transaction basis as it goes live. Our data centers, which were pretty much custom-built for every game and were based on a legacy architecture, we are modernizing it by using virtualization. We are using sharing of compute. We are sharing a lot of resources through the public and private clouds. And we're already seeing a lot of material benefits to our data center costs with the efforts that have gone into place and over the coming -- coming year. And last but not the least, just the reengineering of our data pipeline where we collect the telemetry data and we process it, we are saving 50% of the cost of storage of the data by moving to more scale-out architectures using technologies like Hadoop as opposed to more traditional big iron data warehouses. We still need that for some parts for our platform, but for most of it, we are moving to a much more scalable commodity-type of hardware infrastructure.

John Egbert - Morgan Stanley, Research Division

Okay, great. So with all of that data, it seems like you have a ton of information collected on gamers. So with the focus on big data with a lot of companies these days, how do you think you can use that data to your advantage?

Rajat Taneja

We have so much of insight into both the gameplay and the game itself because of the telemetry we have done that a lot of our focus has been to try to get the right data at the right time. So instead of just getting inundated with a lot of big data and big, bigger, biggest mentality, we're trying to get the right data at the right time and more, in real-time, begin to take action from the data. So we are applying techniques like machine learning, adaptive and predictive algorithms in line to the gameplay so we can customize offers and promotions. We can message appropriately to the gamer inside the game. We can understand their preferences from one game and move it to the other game. We don't need for them to have multiple sign-ons. We can have a far better experience for them with the data analytics platform that we are now releasing and putting into place for all our games.

Blake J. Jorgensen

Fundamentally, you should be able to see lower marketing and sales expenses over time as we have direct connectivity to our core gamers. So in FIFA, for example, we can help people move from just being a FIFA player on the core console game into a FIFA Ultimate Team player. We can help them understand the benefits of that without having to put a TV commercial up or a magazine ad in place or even through search marketing. We can have that one-on-one direct conversation with them. And the customers, they want that and they are excited by it when we engage with them that way.

John Egbert - Morgan Stanley, Research Division

Okay, great. So shifting gears a little bit towards financials. Blake, during your last earnings call, we noted that you came short a little on revenue guidance, but were able to hit the top end of your EPS guidance, which seemed like it was partially due to higher gross margins, but also significant expense control. Can investors expect to see further operating margin improvements, especially while you're undergoing this console transition?

Blake J. Jorgensen

Yes, I think, as Rajat just said, we're dramatically changing how we thought historically about how we operate the business. There's no secret that our operating margins have been below Activision, our core competitor, for many years. Part of that's been driven by the fact that we had too many titles and too much complexity, and we didn't have a unified back-end of the business and part of it's been we've been more focused on promoting and growing many titles versus a few really big titles. FIFA is now a $1 billion-plus business. Battlefield's similar. It allows us some latitude that we may not have had in the past. We're working very hard, as Rajat said, on gross margin. Our gross margin has gone from 55% in our fiscal 2010 to this year we'll finish in the 65% to 66% range. Rajat and I believe we still got another 3 or 4 points to go on that to really drive the business. And some of that's just through the natural transition into more of a digital world as we move from shipping physical disks. Beyond gross margin, there's a firm belief that we can build more leverage into our R&D line by continuing to consolidate the number of properties we're building and to build those properties off of consistent platforms. And then the marketing and sales consolidation, we've traditionally been a studio-based organization, which is essentially a bunch of silos. We're trying to break some of those silos down and integrate more of those operations. For example, just today, we're in the process of starting to move the electronic -- the digital marketing component into our global sales organization and marketing organization. So we'll have one marketing team, not multiple marketing teams. There's more of that to come and we believe all of that will give us a lot of operating margin expansion that we haven't seen historically.

John Egbert - Morgan Stanley, Research Division

Okay. Can we talk a little bit about your capital allocation strategy? You've done a number of big M&A deals in the past. Do you think that EA will continue to evaluate large M&A deals going forward, especially in the digital space?

Blake J. Jorgensen

Call me a traditionalist, but I'm kind of a cash flow guy. I'd like to see more cash flow. I think many people in this room probably would like to see more cash flow. Part of operating the company for more cash flow means being just ruthless on all the acquisitions. Now, I'm sure a lot of people were arguing a few years ago that we were behind in social and we chased a few social acquisitions and those will pan out fine for us. I don't think they might be as big a hits as we were all hoping for, but they're not going to be disastrous. PopCap, for example, got some really great IP in the form of Plants vs. Zombies and Bejeweled, and we'll leverage that across all the different platforms that we have. But I think we want to be very focused on building the business that we have today. We've seen what we can create out of something like a Battlefield or a FIFA, and we think there's a lot more opportunity to go on that. I'm also a big believer that you want to return cash to shareholders, and I think the management team is -- and the Board understands that as well and wants to do that through share repurchases and other fashions over time and we want to make sure that we're staying very focused on it.

John Egbert - Morgan Stanley, Research Division

Okay. So in the digital space, what are some of the key challenges that you guys face in progressing more towards digital? And also, is there a chance in the near future we could go completely digital and what are the hurdles to that?

Rajat Taneja

So we think of digital in 2 ways. I think you're alluding to the digital distribution of the game itself. And certainly, there are those consumers who prefer to go to a store and buy the box physically and have the experience of browsing and seeing what the store offers. But there are those who would prefer to get the software more digitally. And in the past, some of the challenges were around the size of the download and the gating factors of bandwidth and connectivity and just the sheer amount of time it would take to do that. We're already seeing with the PlayStation 4 announcement the back-end processing capabilities that will make that a little bit easier to happen while you're playing other games. So certainly, that will add to those consumers who'd prefer to receive their bips digitally. But the other way to think about digital is the gameplay itself. Once you get the bips, what do you do with it. As I mentioned earlier, on a typical month last year, we ran in the neighborhood of 2.5 billion game sessions a month. So most of the gameplay has become digital, connected. You're playing with somebody else, you're playing with friends or you're playing with a community. You're taking part in challenges. You are having cross-device experiences. You're finishing a game, for example, in the console and continuing pieces of a game on the phone or on your PC. So we are seeing a lot more of an opportunity in the connected always-on gaming, which is, in fact, the essence of digital as you look forward, where social and core gaming comes together.

John Egbert - Morgan Stanley, Research Division

Okay. So digital has seemed to help the worldwide video game market grow despite declines in consoles overall. It seems like it's been a bright spot for you. Can you talk about how your expertise in console gaming helps you become a huge player in digital outside of just your acquisitions that got your foot in the door.

Rajat Taneja

Yes, I can start and maybe, Blake, you can continue. When we think about the game, first and foremost, it's about the consumer experience and ensuring that they engage with the game in the most entertaining manner. And if you look at Battlefield and the gaming capabilities that span both the console and the PC, if you look at FIFA and the FIFA Ultimate Team, and the SPORTS Club, it goes across all our devices. So our experience with console focused around the consumers' experiences around the game itself. It taught us a lot of lessons on how we have to build the underlying infrastructure and how the game technology should evolve to work its scale and what are the other capabilities the game needs to run in a digital environment. For example, identity. How does the data analytic system feedback, and for wide customizations, what happens to the game services that are shared, for example, lobbies and leaderboards and chat and messaging and so on. And those are the same sorts of experiences that you're bringing to bear when you build a pure Facebook game or a mobile game itself. And in the same vein, for some markets, as gaming becomes so large in emerging markets and in China and in other -- India, Brazil, et cetera, we're able to take the core of the game and build it for that market in the right manner, as we have seen with FIFA Online and other games.

Blake J. Jorgensen

I'd say that there's kind of a span of benefits here. On one end of the benefit span, it's in pure digital distribution. If we're not going into a physical retail channel, as Rajat said, we're not shipping a disk, we're also not having to price protect that in the channel. Traditionally, when we put something into the channel, we got about $0.15 on every $1 to make sure we keep that channel clean over time. That goes away completely. So it's margin right there alone. I think the next piece of the puzzle is really how you engage with your customers and you engage across mediums and lengthen the life of any one piece of software. We'll sell $150-ish million worth of Battlefield 3, which was a piece of software that was brought out 1.5 years ago. Some of that's through expansion packs, which are all digital, very high margin. And some of that is through the additional sale of the Battlefield game, because people see the expansion packs and they want to go back and buy the game, becoming a bigger and bigger piece of the business to be able to extend off of it and helps drive margins in that way. And build a community around the game, a true social community around a game versus simply buying the game, playing it a few times and then putting it aside. All that, we think, helps our argue for a greater margin over time and more profitability in the business.

John Egbert - Morgan Stanley, Research Division

Okay. Can we talk a little bit about how much of your digital revenue today is derived from extensions of your console games, so digital goods for those games, versus, like, pure play, perhaps mobile games, for example, or social games?

Blake J. Jorgensen

Yes, so the digital business is broken up into a couple of pieces. One is pure digital downloads of full games. So someone buys Battlefield and downloads it onto their PC or their console. That business goes up and down based on the title. So in a Battlefield quarter, you're going to have a lot of that business. We had a lot of that 1.5 years ago, less so this quarter because of that comparison. The next and much bigger piece is microtransactions within games. And so to the extent that, as Rajat said, we're building into all of our games the ability to pay for things along the way, either to get to a higher level to buy a new character, to buy a truck, a gun, whatever it might be, and consumers are enjoying and embracing that way of the business. We've got to have a very strong back-end to make sure that we can operate a business like that. If you're doing microtransactions and you're processing credit cards for every one of those microtransactions, you'll get eaten alive. And so Rajat's team has built an amazing back-end to be able to manage that and manage it much more profitably. We've outsourced a lot of that stuff, historically. We're bringing that all in-house now. The other piece of that puzzle is the mobile business itself. Playing games on a tablet or a mobile phone, smartphone, that business has evolved very quickly. It's become a very large part of our business and it's either an extension of existing franchises or new franchises. So The Simpsons, for example, is a free-to-play game, leverages, obviously, The Simpsons TV show, and you pay all along the way. Last quarter, we did over $25 million in Simpsons business alone. So there's an opportunity there, probably smaller opportunity on a per title basis than something like a FIFA or a Battlefield. But, as Rajat said, it's a place that's actually growing internationally as well for us so it helps to extend our business into Asia, which has not been a big console market over time.

John Egbert - Morgan Stanley, Research Division

Okay. So just one more for me and then we'll open up to questions. So you mentioned The Simpsons. I follow that digital space a lot more closely than in the console side. And I remember The Simpsons coming out and having a lot of people try to play the game and then I think you had to pull it because technical issues. Can you maybe talk about how you overcame that because a lot of companies have that happen and the game is a wash. But you guys bounced back and made it the top grossing game on iOS and other platforms after those early hiccups.

Rajat Taneja

Absolutely. The Simpsons Tapped Out was -- the launch of that game was a character-building exercise for us and...

Blake J. Jorgensen

Nice way of saying he got a lot of late-night phone calls.

Rajat Taneja

Yes, we partnered very closely with Gracie Films and with FOX and with our engineering teams and the studios to really learn from what happened over there. And we had a couple of mistakes in the launch. One was we didn't cater to the sort of demand that game would generate. So our infrastructure itself was not geared for the kinds of daily active users and, more importantly, the concurrency of usage that would take place. So there has been a lot of learnings we've had in not just making sure that we build the right infrastructure for every game, but how do we handle elasticity and spikes of gameplay and share those resources, compute resources, storage resources, database resources, across our entire surface area of our data centers, and we are making architectural changes on the very fundamental level around that. We also learned a lot about the way we launch our games, the way we test them and the way we get ready to launch the games. And we've created, for all our games, an infrastructure now where we run it through its paces for several weeks before it goes live to focus on scale, to focus on performance and reliability, to stress it and to see all the impacts that would happen in gameplay at the level of demand that we are now expecting to get.

John Egbert - Morgan Stanley, Research Division

Okay, great. So any questions in the audience? Yes, right over here.

Question-and-Answer Session

Unknown Analyst

I was wondering if -- the PS4 announcement, they spent a lot of time talking about downloadable games. I was wondering if you guys had any thoughts on whether that instead of, like, not just microtransactions, but it's like the main format of delivery of that, if that's going to happen, you think, on the next gen? And then, you guys weren't at the launch event. You didn't announce any games there. Is that indicative of the main investment on that platform really coming in 2014 and '15 versus this year?

Blake J. Jorgensen

Yes, let me address the second part first and that is -- no, that's not indicative at all. I think it's more about timing of our own slate, as well as trying to maintain a good balance of power with all the parties out there and choosing when to unveil certain pieces of software. I'd say between now and E3, you're going to see a lot of stuff from us and we just choose, on our marketing cadence, as to when to start to announce stuff. At the end of the day, we're very excited about Sony's platform. We think there's a huge opportunity. It's a great, as Rajat said, the technical power on the platform is going to allow us to do a substantial amount of things that we've never done before. I've seen the new Battlefield and it is stunning. I mean, it is just amazing what the imagination of the game developers are allowed to do with that much power. At the end of the day, we do think there's going to be more digital business and digital download business. But a lot of it will depend on when we release titles, when Sony and Microsoft choose to release titles. And in no way do we want to see the retail channel disappear. We think that's an important part of the overall industry and we want to keep that -- keep that a vibrant channel for us long term as well. So it's balancing all of those. But without a doubt, you're going to see more digital business and particularly more digital components of the gameplay allowed because the ease of it will be much better and the storage capability better.

John Egbert - Morgan Stanley, Research Division

I think we've got one more over here.

Unknown Analyst

You guys aptly pointed out the success you've had with FIFA and Battlefield and also some of the additional opportunities you have continue to growing those franchises. If I holistically think about the profit buckets in EA over a multi-year period, understanding that there's lumpiness, what portion of the aggregate profits do you think those 2 franchises will represent, including digital aspects of those games and so forth, versus other buckets, say, digital mobile games being a second bucket and then the rest of the console business and associated digital content being the third bucket? How should I think of those 3 relative buckets in terms of profit contribution over a multi-year period?

Blake J. Jorgensen

Yes, I think, clearly, the larger franchises are going to be inordinate in terms of the size of the profitability. One of the secrets that our competition has had is having 2 very large properties and we clearly are focused on how do we build our cost structure so it is -- allows us to have margin expansion by having 2 big properties like that. I think, for us, the counterbalance is we want to make sure we're having a business that's derisked in some way and that means new IP and building existing -- off of existing IP as well. So having franchises like Madden and NCAA, or Dragon Age or Crysis or Dead Space are also very important in our business. It will not be or may never be the size of a Battlefield or a FIFA, but it's nice to have $400 million, $500 million, $300 million-plus franchises bouncing around as well. The challenge we've had historically is balancing the costs. And we need to continually focus on how do we do we keep our costs down, how do we use more new methods of marketing to bring our marketing costs down, so we some real leverage in the business, not just slim the titles down without leverage. So that's our goal.

Unknown Analyst

Is it fair to say that if you're successful, those 2 franchises will be more than 1/2 of your profits on a multi-year period?

Blake J. Jorgensen

I wouldn't want to speculate on that, but certainly they're going to be the largest part of the total, just because having $1 billion-plus properties make a huge difference.

John Egbert - Morgan Stanley, Research Division

All right. Well, I think that's probably all we have time for. But thank you both so much.

Blake J. Jorgensen

Thank you very much.

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