• As expected EA's results were much higher than estimates. What was striking was that EA also came in ahead of the whisper number and raised its outlook for the rest of the year. We believe this shows a high level of confidence on the part of EA in its fall lineup and is likely to cause the stock to rally today. We are raising our price target to $58 to reflect an improved outlook for fiscal 2007; however, we think shares of ERTS are fully valued and would not chase them as we see few near-term catalysts to drive them higher.
• EA benefited from a resurgence in demand for video games. EA reported fiscal 2Q07 revenue of $784 million, up $109 million, or 16%, from a year ago, versus our estimate of $689 million. Gross profits rose 14% to $445 million, while operating expenses rose 26% to $431 million, for operating income of $14 million versus $49 million a year ago. GAAP EPS were $0.07 versus our estimate for losses of $0.26, and compares to $0.16 a year ago. Non-GAAP EPS were $0.21 versus $0.15 a year ago.
• Strong fiscal 2Q07 results were driven by key sports franchises. EA released 43 SKU in fiscal 2Q07, up from 37 SKU a year ago. Results for the quarter were driven by the company's core sports franchises, which saw a higher sell through than a year ago. Madden NFL 07 sold five million units and NCAA Football 07 sold over two million units, FIFA 07 sold two million units overseas, and NBA Live 07 sold over one million units. Other high volume titles included Tiger Woods PGA TOUR 07, NHL 07, and The Godfather.
• Following fiscal 2Q07's strength EA raised its outlook for fiscal 3Q07. Fiscal 3Q07 revenue is now expected to be $1.2 billion to $1.3 billion, or roughly $100 million higher than we had been expecting. GAAP EPS are expected to be $0.33 to $0.43 ($0.50 to $0.60 non-GAAP). EA expects to release 41 SKU in fiscal 3Q07, compared to 49 a year ago with results to be driven by four PS3 launch titles, two Wii launch titles, and four titles for Xbox 360 as well as three titles for the DS and five titles for the PSP.
• Increased guidance reflects high degree of confidence in line up. We believe EA's increase in guidance for fiscal 3Q07 reflects a high degree of confidence that it can meet or beat its forecast. There is little rationale for EA to step out on limb, as any miss will likely be a result of delays or disappointing volumes for next-gen consoles, which EA has little control over. However, given the recent outperformance of the sector, it may not be enough to meet guidance as expectations get dialed higher and higher.
• We are raising our price target to $58 but reiterating our HOLD rating. We value ERTS at 19.0x 2009 FCF of $1 billion discounted at 10.3%. We can get to $1 billion in FCF in 2009 on aggressive assumptions for the next console cycle, but we think sustaining growth beyond the cycle is speculative, and it is unclear to us that EA's investments in other forms of interactive gaming, such as the MMOG space will generate as high a return as its core business.
• We would view investment in ERTS as moderately risky. The primary risk to our neutral thesis is that ERTS will continue to rise as investors search an overbought market for the illusive growth idea. Given the sky-hi valuation of the stock this is likely to put shareholders in a position where the slightest disappointment puts pressure on the stock, and we think that there are a host of scenarios this holiday season which could translate to disappointment.
ERTS 1-yr chart: