- Strong PS4 shipments suggest that revenue upside at video game makers is more and more likely in 2014 & 2015 (+5-10%).
- This rising confidence in the revenue outlook is likely to feed margin expansion expectations, specifically at EA which is expected to show off a significant operating leverage following recent restructuring.
- Assuming a >20% operating margin within 3 years (in line with previous cycle peak margins), we get to a 20-30% EPS upside for the stock.
Since our early January call, Electronic Arts (NASDAQ:EA) has delivered an impressive 30% performance and we believe there is more to come. The company will obviously benefit from a healthy game software market even if its product lineup is less impressive than some of its peers in the current fiscal year (but remember, Star Wars games coming in FY15/16). More importantly, EA is expected to show off a significant operating leverage in this new cycle following recent restructuring. This is likely to spark strong EPS upside and make EA a better pick than Activision (NASDAQ:ATVI), which offers limited room for margin improvement (its margin already stands at impressive levels, >30%).
Following an impressive launch in November-December, next-generation consoles numbers continue to surprise, with Sony (NYSE:SNE) recently announcing that global sales of the PS4 had passed 6m, well ahead of its 5m target. Interestingly, the PS4 tie ratio (number of games sold for every console purchased) stood at a comfortable 2.3 level, pointing to a healthy game software market on the machine.
Even if it is still early in the new cycle and even if we attribute some of the PS4 performance to market share gains at the expense of Microsoft's (NASDAQ:MSFT) Xbox One, this could suggest some upside (+5-10%) for the video games software market in 2014 and 2015. Most of the revenue upside is likely to materialize in the second part of the year as in the very short-term (FQ4 and FQ1), sales of "old generation" games (PS3 and Xbox 360) are expected to continue to decline fast and to weigh on the revenue momentum of Activision, EA and peers. Admittedly, the release of new blockbusters (Titanfall by EA in March, Watch Dogs by Ubisoft (OTCPK:UBSFY) in May) could mitigate this and could be a source of short-term upside.
This rising confidence in the revenue outlook is likely to feed margin expansion expectations and positive EPS revisions in coming quarters, specifically at EA. Indeed, EA has displayed an impressive opex discipline and restructuring effort in the last quarters, leading to an estimated 14% operating margin for FY13/14; well above the 8-10% reported in previous years. This margin strength, achieved during the console transition year which is traditionally the toughest year for video game makers, suggests that EA is well prepared to deliver significant margin expansion in the new cycle when revenue growth accelerates.
The Street expects EA to deliver a 17% margin in FY16/17. This is a nice improvement vs. the 14% expected in FY13/14, but we tend to believe that consensus is still on the conservative side, given that EA disappointed many times in previous years. Taking into account the above-mentioned revenue upside and margin strength in the trough and EA's operating margins in the previous cycle peak (21% in 2005 and 26% in 2004), we believe that EA is set to deliver a >20% margin within 3 years and that the Street will have no choice than to revise upwards.
In all, we are confident in a 20-30% EPS upside (at least) and continue to believe that EA's valuation levels are not demanding (19x 2014/15 EPS for EA) in view of EPS growth >20% in coming years.