- EA’s recently-announced Access initiative will increase the amount of recurring revenues and the weight of digital revenues within the revenue mix.
- Margins will obviously benefit from this model transition. Ultimately, EA could reach a margin close to 30% (vs. 21.5% expected in FY15), in line with that of Activision.
- The valuation remains a key Buy argument: it's not specifically demanding in view of expected EPS growth and, importantly, does not factor at all a bull case scenario (40% upside).
The Access service is a boon for margins
We believe that Electronic Arts' (NASDAQ:EA) recently-announced Access initiative is another step in the right direction. For $4.99/month or $29.99/year, the service provides Xbox One users access to a library of titles, a 10% discount on EA digital content purchases made via the Xbox Games store, and trial access to new EA games up to 5 days before the release date. For the time being, the service is limited to the Xbox One as Sony (NYSE:SNE) has not accepted it on its PS4 platform. Should Access become a success and spark similar services from other publishers, we believe that Sony could finally consider embracing it.
We see several positives stemming from this initiative. First, EA will better monetize its back catalog considering that, traditionally, the trading of used games does not generate revenues for the publisher.
Second, EA will benefit from an increasing amount of recurring and predictable revenues (subscriptions) in its revenue mix, something that is likely to please investors in a traditionally highly cyclical industry.
Third, the 10% discount on digital content purchases will probably speed up the transition from physical to digital distribution (slightly less than 50% of sales in 2013 according to NPD). This digital expansion will contribute to EA's continued profitability improvement as margins on digital content are well above those on physical games thanks to savings on manufacturing and shipping costs. Activision (NASDAQ:ATVI) is a perfect illustration of this as the group has enjoyed margins above 30% for years thanks to its large exposure to MMORPG (Massively Multiplayer Online Role-Playing Games), which come with subscriptions and digital distribution, while EA has displayed margins well below 20%.
Bull case points to 40% EPS upside
We have been saying for months that EA is not only a top-line story (new video games cycle) but also a tremendous margin recovery opportunity. And indeed, the group has delivered impressive earnings in the last quarters, leading analysts to raise materially their operating margins expectations (21.5% and 23.5% respectively in FY15 and FY16).
After the strong performance year-to-date and EPS upgrades, EA's valuation remains decent in our view at 18.5x 2015 EPS as its earnings growth could be well above 20% thanks to high single digit/double digit revenue growth and significant margin expansion (from the group's impressive opex discipline and rising weight of highly profitable digital revenues in the mix).
Interestingly, if the group delivers on its Access initiative, it will probably be on track to exceed its previous 26% margin high and reach a margin close to 30%, in line with that of Activision. This suggests that in a bull case, EA could still offer around 40% EPS upside (around +10-15% top-line upside, as explained in our previous articles, and +25% margin upside). This is more than sufficient to retain a strong Buy rating on the stock.