EA And Activision Beat Expectations As Digital Revolution Continues

| About: Electronic Arts (EA)


EA and Activision beat market expectations for the March quarter with strong performances from core franchises and expansion into the digital domain.

Digital expansion is a priority for both Electronic Arts and Activision as they head into the new era of gaming.

The popularity of new consoles suggests that a sales revival is likely around the corner, and both EA and Activision have strong lineups to capitalize on that trend.

Gaming giants Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI) beat market expectations for the March quarter of 2014 with strong performances from core franchises and expansion in the digital domain. [1] Electronic Arts' stock jumped more than 15% after the company beat its revenue guidance for the quarter by $114 million, or 15%. The company's performance was helped by strong demand for digital offerings, particularly its Ultimate Team services for sports-based Madden and FIFA franchises. EA earned over 45% of its Non-GAAP net revenue from digital streams including extra-downloadable content (DLC), full game downloads, mobile games and in-game advertising and subscriptions. An increased contribution from digital streams allowed for margin expansion; EA's fiscal fourth quarter gross margin was 77.4%, compared to the 74.3% figure observed last year and the company's guidance of 71%. The operating margin increased from 26% to 31%.

Activision, on the other hand, earned 68% of its revenues from digital channels, allowing it to report a record high operating margin of 31%. The latest edition of the company's flagship franchise, Call of Duty: Ghosts, was the highest selling game for the recently launched eighth generation Microsoft and Sony consoles. Activision's innovative toys-to-life franchise Skylanders also continued to perform well. [2]

Our $21 price estimate for Activision's stock implies a premium of 15% to the current market price.

Digital Expansion

Digital expansion is a priority for both Electronic Arts and Activision as they head into the new era of gaming. For Electronic Arts, the main stream is DLC, accounting for nearly half of the digital revenues earned by the company. Revenues from this stream increased 8% in the March quarter, with growth in Ultimate Team services and FIFA Online 3. Ultimate Team services accounted for 10% of the company's revenue for the fiscal year. Full game downloads for First Person Shooting (FPS) games Battlefield 4 and Titanfall led to a 13% increase in the stream, which accounted for 20% of the fiscal Q4 digital revenues. Revenues from the mobile stream also increased 21%, but those from the subscriptions and in-game advertising stream fell 64%. This decline was primarily due to the timing of the company's accounting of Battlefield Premium revenue.

Management expects digital streams to account for half of EA's income in FY 2015. Revenues from these streams increased from $296 million in 2010 to $1.4 billion in 2013 and accounted for almost 40% of the company's income in 2013. We expect the company to maintain its focus on digital expansion in the coming years.

Activision's digital income was driven by Call of Duty: Ghosts and Skylanders SWAP Force, which were the 2 top games in North America and Europe. Skylanders is an innovative franchise, which requires gamers to purchase physical models of the franchise's characters for the user to access the character. Activision has sold over 175 million toys since the launch of the franchise, generating over $2 billion in revenues. The company has also announced the next installment in the Skylanders franchise, Skylanders: Trap Team, which will be launched in October. The game will allow gamers to capture characters on-screen in a "magical crystal trap" and then play with these characters.

Activision continued to lose subscribers for its massively multiplayer online role-playing game (MMORPG) World of Warcraft. The franchise was once a cash cow for Activision, accounting for nearly $1 billion in annual revenues, reaching a peak of 12 million subscribers in 2010. However, competition from free-to-play titles led to a decline in the subscriber base, which fell to 7.6 million subscribers at the end of the March quarter. Activision is trying to revive interest in the franchise through expansion packs. Mists of Pandaria sold 2.7 million copies on the first day of its release in 2012 and helped sustain interest for some time, but failed to arrest the slide. This year, Activision plans to launch another expansion pack, Warlords of Draenor. Despite Activision's best efforts, we expect a continuing decline in World of Warcraft subscribers through the decade.

The Battle For Market Share In The Next Console Cycle

Since its launch last year, the PlayStation 4 has sold over 7 million units worldwide while Microsoft has reported 5 million unit sales for the Xbox One. While the consoles have been popular, software sales are lagging behind. Research group NPD reported that software sales for March were down 28% from the prior year's mark. [3] The popularity of the new consoles suggests that a sales revival is likely around the corner, and both EA and Activision have strong lineups to capitalize. While EA's exclusive licensing agreements with sports governing bodies such as FIFA and the NFL will allow it to maintain dominance in the sports genre, it is also looking to expand in the FPS genre, which accounted for 20% of the video game market in 2013. [4]. The company successfully launched Titanfall this quarter. However, EA is cutting back on the number of titles launched per year. In 2010, it launched 56 titles, but cut back to just 24 in 2013. The company is cutting back further and has decided not to release an NCAA Football based game and a Need for Speed game this year.

Activision will launch its much-anticipated title Destiny in September 2014. The company has suggested a budget of $500 million for developing and promoting the game and expects to develop it into a $1 billion franchise. Activision will also launch the next edition of Call of Duty, Advanced Warfare, in November. The Call of Duty franchise is currently the leader in the FPS genre, accounting for nearly 60% of genre sales in 2013. We expect the franchise to maintain that share in the FPS genre.

Disclosure: None.