Electronic Arts: Strong Stock Price Reaction, But The Best Is Yet To Come

May. 7.14 | About: Electronic Arts (EA)


In line with our scenario, significant revenue upside is starting to materialize at video game makers, thanks to healthy next-gen console sales.

EA's operating leverage is impressive, with earnings significantly above consensus.

In our view, the group is on track to get back to its previous margin highs (26% vs. 18% in 2014).

Taking into account both the revenue and margin upside potential (c.35%), we remain bullish on the stock, as the valuation (18x 2015 EPS) does not reflect EA's earnings power.

Impressive revenue momentum

In our March article, we said that strong PS4 (and Xbox One) shipments suggested that revenue upside at video game makers was more and more likely in 2014 and 2015, our assumption standing at 5-10%+ upside.

We had a first taste of this last night, with both Activision (NASDAQ:ATVI) and Electronic Arts (NASDAQ:EA) reporting March quarter revenue 12% above consensus (admittedly, the beat at Activision was mainly driven by online PC games) and EA guiding for June quarter revenue of $700m, 10% ahead of the Street.

Despite the significant beats, both companies remained quite cautious when guiding revenues for the full year, with Activision raising its top line target by less than 2% and EA guiding only in line with consensus. There's no reason to be disappointed, in our view, as we are still early in the year, while the video games business is traditionally back-end loaded. Activision and EA will probably set more aggressive revenue targets when their visibility improves on the second part of the year, and specifically on the Christmas quarter.

In all, we stick to our view that Activision and EA are well on track to exceed revenue expectations this year by close to 10%.

Margins can probably exceed previous highs

We have been more bullish on EA than on Activision, as we considered that this revenue upside would spark a much higher operating leverage at EA. And indeed, EA delivered an impressive EPS beat in Q4 (EPS of $0.48 vs. consensus $0.11), as the FY operating margin stood close to 18% vs. expectations of 14%, and guided for FY15 EPS 22% above consensus.

The impressive opex discipline the group has been displaying in the last quarters is now paying off. This, combined with an improving revenue momentum and a rising percentage of highly profitable digital revenues could enable EA to exceed its previous margin highs (26% in 2004), in our view. Analysts have upgraded this morning their forecasts, and are now expecting margins of 20% and 21% respectively in 2015 and 2016.

This suggests a margin upside around 25%, if EA gets back to a 26% margin.

Taking into account both the revenue and the margin upside (around 35%), we remain bullish on the stock, as the valuation does not reflect, in our view, EA's earnings power. After the strong stock price reaction and estimates upgrades, EA is trading at 18x 2015 EPS, while earnings growth is expected well above 20%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.