The idiom "what goes up must come down" does not necessarily translate to financial markets. After all, many companies continually accumulate value due to a real increases in productivity decades into their maturity.
Sometimes, this old saying is just common sense. Reaching a 52-week high share price of 24.49 and closing at 24.32 on Friday, video game publisher Electronic Arts (EA) is the short-seller's piñata
that keeps growing fatter. This price is more than double its 52-week low of $10.77, and the growth prospects are simply not there to support that.
Expecting a miracle
EA has been profitable for approximately one year, but earnings have remained lukewarm.
click to enlarge images
At the astronomical P/E of 79.39, where exactly is the supposed growth that the market is betting on? The first answer you will get is mobile games that have only recently comprised a large portion of video game sales. Second and third are digital sales from its Origin platform and potential breakthrough franchises respectively.
Origin is EA's digital distribution platform, and is the main competitor of the privately held Valve Corporation's Steam. Steam is the current juggernaut of PC gaming, with a clear majority in the digital distribution market. EA has room to grow here, but as of now, there is very little reason to believe that this will be case. Gamers just do not like Origin as a platform, and it lacks the impulse buying allure that Steam has with its regular sales of up to an 80% discount on the price of games. EA's head of Origin, David DeMartini, has specifically denied that similar sales will happen on Origin, stating that large discounts "devalue" intellectual properties. Mr. DeMartini is confusing price and value, and Origin will not capture market share and will not be liked by game consumers until there is considerably change in the philosophy of Origin.
Looking backwards, there is no reason to trust that EA-owned casual game developers PopCap or Chillingo will bring the company into the mobile promised land that their outrageous P/E predicts. Consider EA's management style when it comes to developers, a style notorious for the buying, the squandering and ultimately the retiring of respected video game developers. A high-profile example of this waste is with EA BioWare's Star Wars: The Old Republic. A 200 million dollar massively-multiplayer game, it is the most expensive video game in history, and shortly after release lost so many subscribers that the game was forced to go free-to-play to retain players, not to mention the surge of layoffs the game caused. This is part of EA's grand strategy; EA must stay liquid enough to buy companies and franchises that it thinks it can grow, and this is corroborated with a debt to equity of 24.66%, notably higher than the industry average of 15.27%.
More recently we saw another wave of layoffs in April, resulting in 10% of EA's staff losing their jobs. This was as the result of a refocus towards mobile, but might also be a measure to inflate its next earnings report due to its occurrence early in the quarter. During the same month, EA announced the retirement of its largest social titles on facebook, The Sims Social, SimCity Social and Pet Society. All of these games were shut down last month, indicating that EA was very much touched by a crash of web-based social games and sealing off one more possible path to growth.
The uninspiring state of the industry
Total consumer spending in video games has dropped to 2013's lowest in May, with June's report expected to be even lower, according to industry research firm NPD. Not only that, but predictions state that 2013 will have the weakest video game sales since 2001, with April and May 2013 sales 25% lower than April and May 2012. While we must factor in the transition to a new generation of consoles causing gamers to save their cash, when comparing to previous generational seams, this is unprecedented. 2005 actually brought a 600 million increase in total industry revenues to 10.5 billion dollars, and only one of the three seventh generation consoles was out in 2005, and even then for barely more than a month.
To find where EA is in this mess, take a look at its competitor, Activision Blizzard, Inc (ATVI). While beleaguered by the same industry torpor, ATVI is a more profitable and more reliably profitable than EA. It is the owner of two of the most profitable franchises in video game history: World of Warcraft and Call of Duty. While World of Warcraft total subscribers is in decline, every new annual installment of the Call of Duty franchise has broken the record for the largest video game launch of all time, including its own previously broken records. There doesn't seem to be an end to this ever-growing, multi-billion dollar cash cow, yet ATVI sits at a modest P/E of 14.24 and debt, with the industry average at. So what, you might be wondering, does EA have?
EA's consistent money makers have been its EA Sports franchises, with titles such as FIFA and Madden NFL that are highly profitable through the thick and thin. While this could comfort the EA investor, the growth prospect glorified by the share price is simply not present. The founder of Electronic Arts himself has admitted that the console market is shrinking - and EA sports games are strictly a console phenomenon.
Directly competing with Call of Duty, EA has the Battlefield franchise. EA's flagship first-person shooter has co-opted some of its competitor's attributes, not only with similar gameplay mechanics and style, but also a faster development-release cycle between installments of the series. I expect the upcoming installments to generate a lot of money, but nothing that we can't already see in black and white with EA's earnings reports - and copying a success is hoping for a chance at second place.
A potential new blockbuster by EA, Titanfall, was revealed early in 2013. Gamers received it very well, indicating that it may be a major player first-person shooter. The problem with this is that its fate is married to the Xbox One, which is an upcoming console that was not well received by gamers - Microsoft (MSFT) had to backpedal on a majority of the console's features due to overwhelming backlash from the gaming community, a backlash that is still evident in pre-order data when compared to the Playstation 4. Titles that gamers were long awaiting are Mirror's Edge 2 and Battlefront were also announced, the latter of which was secured when EA obtained exclusive rights to develop Star Wars games for consoles and PC, leading to a share price jump in May, despite Disney (DIS) retaining the rights to make mobile and social games in the Star Wars universe on mobile devices and the web.
EA is indeed a company built on franchises, so investors need to realize that there just are not enough franchises to go around in EA in the market that EA itself admits is shrinking. If EA does manage to reposition itself with one foot in the traditional video game market and the other in mobile games, these expensive intellectual properties are not being fully leveraged. Indeed, when entering the mobile gaming world, EA faces disadvantages due to the lack of barriers to entry that protects it from competition in the traditional gaming world. Games made by much smaller, leaner and more focused mobile developers are can compete and be gigantic successes. The massive marketing budgets of traditional games cannot solve this, since casual gamers are less engaged and are fickler with their tastes.
The same logic applies to building a franchise on mobile platforms; you need an engaged and loyal fanbase. Gaining exclusive rights of famous intellectual properties such as the aforementioned Star Wars on mobile platforms could happen, but it probably won't, just as Disney retained its rights. The rationale is simple: mobile games don't require the comparative advantage of a large, dedicated video game publishing company. Disney and every other owner of an internationally known IP can comfortably hold on to rights to these franchises and develop them in-house or contract a small developer.
Electronic Arts' share price is currently a house built on a foundation of too much optimism. Its upcoming quarterly results on July 28th will probably be show increased earnings, but much of this will be due to short term factors rather than productive long term investment that might actually demand such a share price. Its core products will suffer from an industry in slow decline and metamorphosis, and its potential for growth depends on delicate restructuring. The trend may continue to creep up due to market gains, but the current price is not sustainable, with a downside that could bring price to the mid teens. Potential price gain from an earnings report that exceeds expectation is low, as it is already exuberantly priced for such an occasion.