Electronic Arts Earnings Preview: Guidance Will Drive Price Action

Electronic Arts (ERTS) will report fiscal 2Q07 results today after the close. Our pre-earnings notes:

• Results will be positively impacted by strong environment. We believe U.S. video game software sales grew more than 20% in 3Q06 to about $1.225 billion. With some of the biggest sellers during the quarter, we expect EA to be a beneficiary of strong demand. We look for a 2% increase in sales to $689 million, EBITDA losses of $80 million and GAAP EPS losses of $0.26. Consensus estimates are for revenue of $673 million and GAAP EPS losses of $0.21, and guidance was for revenue of $635 million to $685 million and GAAP EPS losses between $0.28 and $0.22.

• EA's fiscal 2Q07 top line is likely to exceed expectations. EA's results will be underpinned by the releases of NCAA Football 07 in July and Madden NFL 07 in August. Together, we estimate these titles sold over 5 million copies. The Godfather, Lord of the Rings, Battle for Middle Earth II, NBA Live 07, and NHL 07 also made substantial contributions to sales. Whisper number puts fiscal 2Q07 sales at $750 million, and as high as $800 million, which seems a little too aggressive to us. If EA fails to outperform expectations, investors are likely to be disappointed.

• Outlook for fiscal 3Q07 will be primary driver of price action. While EA is likely to beat fiscal 2Q07 sales estimates, the outlook for fiscal 3Q07 is more obscure. We are currently forecasting fiscal 3Q07 sales of $1.2 billion, which is in line with consensus, and would represent a 5% decline from last year. There seems to be an emerging consensus that there is probably little upside, and the potential for some downside, to this number. The end result will largely be determined by the success or shortcomings of titles on next-gen consoles.

• We think ERTS has fully priced in the recovery in video game sales. Shares of ERTS were up about 30% in 3Q06, as investors took accelerated retail sales as a signal the cycle has bottomed out. We think they are now fully valued. EA is the leader in an industry that is poised for a cyclical upturn, but EA's valuation is rich throughout the foreseeable future. We think investors would like to play EA for the video game cycle, but downside risk to fiscal 3Q07 makes entry at this point dicey. We would look for a pullback or greater visibility into fiscal 2008 before getting more aggressive.

• Our $55 price target assumes nearly $1 billion in FCF in 2009. We value shares of ERTS at 18.2x 2009 FCF of $1 billion discounted at 10.5%. We can get to $1 billion in FCF in 2009 on aggressive assumptions for the next console cycle, but sustaining growth beyond the cycle is speculative. Shares of ERTS are currently trading at roughly 3.9x calendar 2007E revenue, 28.8x 2007E EBITDA, a 2007E P/E of 51.6x and 28.0x 2007E FCF.

• We would view investment in ERTS as moderately risky. We caution investors that adverse market conditions may arise during the next-gen hardware transition as more focus and resources are spent on preparing for the next cycle. A change in market demand, a decline in software pricing, setbacks in the release and supply of next-gen hardware, as well as delays in the release of software provide substantial risk to our forecasts and projections.

ERTS 1-yr chart: