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It has been fascinating to see the process of Electronic Arts (ERTS) coming to the realization that they got their bets dead wrong, and to see how they've adjusted strategy in the wake of new information (read: a Nintendo (OTCPK:NTDOY) Wii home-run and a Sony (SNE) PS3 disappointment).

Since my first post, when I interpreted the Internet dialogue around the prospects for the consoles for which EA was developing games, EA has shed $8 in share price and $3 billion in market value. Both posts contained data from the Internet that were sharply negative on EA's prospects given its lofty valuation, with the thesis derived from the data coming to fruition.

I'd first like to give a little recap of my data-driven position in the earlier posts, and then to present new data to bring readers up-to-date. Bottom line: EA has a lot more work to do in order to keep its profit engine going, posing significant risks to investors considering EA as a vehicle to capitalize on the boom in the console market. Reading between the lines, EA's recent earnings call showed an increasing emphasis on game development for the the Wii and DS platforms while soft-pedaling on their view of demand for the PS3. This is rational and is supported by the data. But are they too late? As I've said previously when discussing EA: buyer beware.

From my November 21 post:

Make no mistake: EA is a game-creating machine. A techno-behemoth making big-headline games for the Big Three: Microsoft (MSFT), Sony and Nintendo. But at $58 per share and 43x earnings I would be afraid - very afraid. What was once a company able to focus on harvesting its category-leading franchise is now under siege: high development costs, uncertain platform plays and lofty equity valuation. While EA has deftly navigated the vagaries of the fickle gaming marketplace, it is now facing a competitive landscape unlike any other it has seen in the recent past. Ergo, this is one complex business encountering an array of complex market and business risks. This is not a scenario that makes me terribly comfortable as an equity investor. For a little more insight, read on.

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So if EA continues its emphasis on Sony it is clearly exposed to the degree of adoption (and supply) of new PS3 consoles. If PS3 flops then what? EA will need to identify and milk another future cash cow. They could look to Microsoft’s Xbox 360, with a current installed base approaching 10 million by Dec 31. Not exactly the 100 million installed user base of PS2, but not too shabby nonetheless. However, if the situation evolves such that the Nintendo Wii becomes the rising star, EA may be in trouble. FYI, the French company Ubisoft has lined up nine titles for Nintendo including that exclusive to the Wii: Red Steel.

Ninendo has forecasted up to 4 million units shipped worldwide and with sharply lower development costs than Xbox and PS3: $5-$8 million per title for the Wii vs. the $15-$20 million for Xbox 360/PS3 platforms. This makes the Wii far more attractive (and less risky) for both developers and publishers. If EA sticks to their PS3/Xbox 360 strategy, they may miss the boat on Nintendo, spending too much in development costs while missing what looks to be a home run console in the Wii. This could dent the next several quarters of EA’s earnings, painting a pretty ugly picture for the stock price going forward.

ea logoFrom my December 7 post:

And so it goes. The Wii is a happening, plain and simple, and its fallout is being felt across the gaming landscape. I have written about Sony quite a bit in the past, and have also penned a post about EA, both of which ran on Wallstrip. The general take in my pieces is that Sony screwed up massively by mismanaging its supply chain as well as consumer expectations, particularly as it relates to the blue laser diodes required for both its PS3 and CD/DVD consoles and its ability to meet stated delivery targets. Further, I had articulated that EA was missing the boat by not placing more resources behind the Wii console, choosing to keep most of its bets along the PS2/PS3 and Microsoft Xbox 360 platforms. Well, what I had hypothesized about appears to being coming to fruition.

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The internet conversation has been an incredibly good predictor of the actual outcomes for Nintendo, EA and Sony. While the game is certainly not over, it is pretty amazing to consider how directionally correct all of these online experts and users have been. While Wall Street analysts often have some good insights, they can't possibly replicate the global community brain shared by those who can tap into it efficiently. And this gets to the post I authored a few days ago about next generation search. But I'll keep you posted on the Sony-Nintendo-EA situation. It is sure to be a wild ride.

So now you have some context.

The 2/1/07 EA Earnings Call: Whole Lotta Shakin' Goin' On

And if I were Larry Probst and Warren Jenson, I would have been shaking, too. These guys should be in politics given the subtle undertones lacing their statements. It takes a Ouija board to really get the bottom of what they're thinking. But hey, luckily I've got one and based on the data here is my read. First up, Warren Jenson, CFO and CAO, when discussing new games for the Wii, from the transcribed earnings call:

So, by the end of this fiscal year, we will have six titles in the market which other than Ubisoft, we will be most prolific publisher on the Wii Platform through March. And you can expect to see us ship a number in the low to mid-teens next year in fiscal '08 on both the Wii Platform and on NDS.

Translation: "We screwed up our handicapping in the console wars and are working like hell to catch up given the wild (and unexpected) success of the Wii. Remember, guys, we bought that studio in Utah specifically devoted to developing games for the Wii, we are keeping up the pressure to catch up with Ubisoft. And hey, while we missed the boat early we are getting on now. After all, we are EA." Does this sound right to you? Now it's Larry Probst's turn, CEO of EA:

With regards to the price change that the question that we would refer to Sony, looking at the early January results, the trends on the PS3 are good, its selling through at a comfortable clip, again you have to recall that this is a price point, it is much higher than the PS2. So when you are setting expectations looking at a PS2 for example, you would expect that the PS3 would be a bit slower in terms of its ramp, but we were confident that on the full year number it will be good.

Translation: "Man, that PS3 has screwed the pooch and is killing us. Can you believe nobody in Japan wants it? We have 25 titles lined up - thankfully they can be dual-purposed for PS3 and Xbox 360 - since development costs are a fortune and PS3 is a disappointment. At least Microsoft has this gaming thing going ok. I'm only saying I think PS3 can do 6-7 million units because of the goodwill I need to preserve with Sony given the massive installed base of PS2 users." So, in a nutshell, PS3 is expensive, is selling poorly, but he's saying it will pick up because, well, what else is he going to say on his earnings call?

Boy, am I glad I'm not a member of EA management having to answer a bunch of questions at a time like this. You know why? Because they have no freaking idea what is going to happen with PS3, a bet that has already been made. And what they do know is that Wii is kicking butt, and that they have to run like hell to turn chicken shit into chicken salad. And they are behind. And they are EA. This isn't good.

And Now on the Demand Side

Evidence abounds that regardless of EA and Sony's contentions, that PS3 is available in abundance while the Wii continues to be in short supply. Further, word on the Internet is that Sony is under pressure to lower prices given slack demand, arising from competition on the low end from Nintendo and on the high end from Microsoft. Neither of these trends bode particularly well for our friends at EA.

From GameDaily:

Japan: Wii Outselling PS3 3-to-1

Say it with me now: Wiiiiiiii! If Nintendo's new console can keep up its current pace, it'll dominate the market just as the Nintendo DS has. Lately, the new system has been outselling Sony's PS3 in the land of the rising sun by close to a 3-to-1 margin.

The Japanese love the Nintendo DS and it's starting to look like that love may be translating nicely to Nintendo's new console as well. According to the latest data from Enterbrain, publisher of Japanese magazine Famitsu, the Wii has outsold the PlayStation 3 by a margin of nearly three-to-one in the month of January. Enterbrain's figures show that Nintendo sold about 405,000 Wii units last month, while Sony sold around 148,000 units of the PS3.

Life-to-date in Japan Nintendo has sold through 1.4 million Wii units compared to the PS3's 614,000 units.

All this talk of Sony being outpaced by the competition has once again fueled the idea that a price cut on the PS3 may be coming sooner than we all think. "There could be a price cut for the PS3 by the end of the year, and more software titles will hit the market. I expect the PS3 to be doing better after a while," said Enterbrain President Hirokazu Hamamura, according to Reuters.

However, he then added, "Of course, the Wii will keep running ahead all the while."

Concomitant with Enterbrain's data, Japan's other major video game data source, Media Create, shows that in the most recent weekly chart the disparity between PS3 and Wii sales is even greater. 83,754 Wii consoles were sold compared to just 19,996 PS3s. The Xbox 360, as usual in Japan, trailed behind with 7,365 units.

From Kotaku:

I've gotten several emails now from unidentified Toys R Us employees regarding the availability of Wiis and DS Lites in their stores. It seems that (once again) a company wide email has gone out telling employees to hold on to any shipments of the Nintendo consoles that come in in preparation for a release on February 11.

I don't agree with this kind of mass hoarding and I find it aggravating that this has become a pattern now for most major retailers. What is the point? They are still going to sell them whether they put them out today or next week. It seems a little shady to tell Grandma that there are no DS Lites for her precious grandbaby's birthday when there's a big pile of them sitting in the back. I think at this point we can dispense with the forced line waiting and just get the consoles into the hands of the people who really want them.

From Post-Gazette.com:

WHERE IS Wii? Who would have thought, given all the publicity surrounding the PlayStation 3's arrival last fall, that the Nintendo Wii would be the must-have console of the new year? A month after Christmas, it's still hard to find a Wii, and crowds are still lining up in front of electronics stores every time a new shipment is promised. On eBay, Wiis are still being auctioned off for around $500, double the console's list price. It's even tough to track down Wii controllers, since most of us who have been able to buy a console are stocking up on extra "Wiimotes" so the whole family can play.

Meanwhile, Sony's PS3 is pretty easy to buy. The Web sites for GameStop, Circuit City and other nationwide retailers have it for sale, and eBay auctions are starting lower than the $600 list price for the 60-gigabyte model. Several electronics store clerks have told me that buyers have been returning unopened PS3s after realizing they weren't going to make any money selling them on eBay. Serves them right.

From DarkJedi's Blog:

News around the Internet is saying that Sony is about to lower the prices for their latest attempt at a console, The PlayStation 3 (even though it is not the easiest item to lower the prices on). Already the console is a big expense for Sony’s finances, but a price cut may be a way to get back into the game. However, recently the pricetag for the PlayStation 3 in Europe reached retailers ahead of the European launch in late march - and let me be the first the say that they are staggering! This should indicate to Microsoft that they have a good chance at beaten the air out of Sony once again by competing directly on the price.

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The game is already on between the two contender for HD gaming on the next-gen consoles and cost-efficiency is an important factor. Both Sony and Microsoft knows that improving the manufacturing process is the key to gaining some better margins - especially if the competitor lowers prices and you need to follow suit… For this reason the battle for reaching the 65 nm. manufacturing process is ON! Microsoft is well in the lead and has been since they started a year before Sony with their launch. They hold the key, both in terms of price and in terms of game titles! Sony is struggling to get exclusive titles, especially titles that could prove that the PlayStation 3 is a more powerful machine than the XBox360. Meanwhile Microsoft can sit back and wait on Sony to try and lower prices, which they would immediately meet with lowering prices on the XBox360 or making good-valued bundles, like they did during the Christmas sales. It isn’t funny being Sony these days!

So what does this all mean? PS3 demand is weaker than expected, Wii demand is greater than expected, and PS3 console pricing is coming under pressure do to the fact that, well, people simply don't get the value proposition.

So What Does this all Mean to EA? Back to Mr. Jenson

Another tidbit from the 2/1/07 earnings call:

I can speak about it generally -- we have single franchise teams that are approaching each of these businesses. And when we look at the PS3 and the 360, the development of those two platforms is more alike and has more asset sharing than when you look your current genre or the Wii, for example. Just given the architecture, the systems, the multiple processors, the high definition graphics etcetera. So we do see that that will continue in the future where there will continue to be 360, PS3 development being mostly the same. We will do some things on one versus the other to optimize and to make them better, but on the Wii and the current-gen stuff that still continues to be a different type of development.

Translation: "Yeah, we've got 25 titles going for the PS3 and Xbox 360. We're amortizing development costs over both platforms. No more exclusives for Sony. If PS3 craps out, we'll quickly shift resources. We still rock at development and still have a chance to come up with some unique games for the Wii that give us a competitive advantage relative to both Ubisoft and Nintendo's in-house studio. Developement for the Wii is much cheaper. It's less risky. And we have to do it." Mr. Jenson is a good CFO - he's hedging. What else is EA going to do at this point? They are stuck between a rock and a hard place.

So Sony - Whatcha' Gonna Do About It?

As referenced in my earlier EA posts, there is huge risk in being a console game developer. It is somewhat simliar to being a venture capitalist, handicapping your odds and spreading bets across a complicated and shifting landscape. Back the wrong consoles, you've squandered millions in development costs without the anticipated payoff. Back the right console, you've got a potential gravy train for years. In the case of PS3, early failures have sharply increased the risks of development, raising the stakes for those who might consider creating games for the platform. Further, the cost of developing games for the PS3 platform is 2-3x that of the Wii, further upping the stakes. It is in the wake of this unfriendly development environment that Sony has taken some drastic action.

From Igniq.com:

With third-party developers beginning to shy away from PlayStation 3 exclusive titles, Sony’s done the best thing it probably can to ensure its “super computer’s” powers are fully tapped by upcoming game releases.

The company has appointed Ken Kutaragi as the part-time executive director of a new venture with Namco Bandai. Dubbed Cellius, the project is meant to create PS3 titles that will take full advantage of the console’s powers and give it an edge in the waging war with Nintendo and Microsoft.

The move comes only a few short weeks after Sony named him chairman of Sony Computer Entertainment.

With Kutaragi being considered the father of the PlayStation, the move could very well assure that must-have game titles begin to hit store shelves in the very near future.

As the popularity of the PS3 flounders, this move is very much needed to make the console stand out against its competition. While the high price of the PS3 certainly isn’t helping it, the fact there aren’t a whole lot of impressive games out for it yet is a real killer in the face of Microsoft exclusive titles like Halo and Lost Planet and Wii’s quirky party games.

As a PS3 owner, who happens to think Sony really screwed up with its handling of this console’s release, it is my sincere hope something turns around soon to really make this console shine.

Oof. And the story just keeps getting uglier.

From PS3CENTER.NET:

It seems that more PlayStation 3 exclusive games are headed over to Microsoft’s camp and the Xbox 360 console.

Sony better start doing some serious damage control if they do not want to fall behind to quickly as it appears that more exclusives on Sony’s PlayStation 3 console may be jumping ship and headed over to the rival Microsoft Xbox 360 console. The first heavily rumored game that will only see the light of day on the Xbox 360 is that of a next-generation version of Killer Instinct, the classic fighting game developed and created by Microsoft owned Rare.

Another game which was originally a PlayStation 3 exclusive for quite some time but now appears to be going the way of the Xbox 360 as well is Sega’s Virtua Fighter 5. The game will make an appearance on the Xbox 360 as well as the PS3.

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It seems that Sony is losing more and more exclusives in a next-generation of consoles where development costs are very high and having a game exclusive to one particular console runs the risk of losing sales and profits which could lead to some financial disasters for game publishers. 2007 should be a very interesting year with the console wars as Sony and Microsoft keep on budding heads with Microsoft maintaining a lead in North America for now…

Sony: "I Know What I'm Going to Do - Deny There's A Problem"

Lesson #1 in crisis management: admit you have a problem, and clearly describe how you intend on addressing the problem. Sony's reaction in the midst of crisis: denial. Clearly a sub-optimal response that only reinforces the fact that their culture is seriously broken.

From TECH.BLORGE.com:

Sony US spokesperson, Dave Karraker, has dismissed the Wii as an “impulse buy”, even as his own company blames the PlayStation 3 for its profit slide, and all indications are that the PlayStation 3 is way behind the Wii in terms of sales and buzz.

In an interview with the New York Times, Karraker said that because the PlayStation 3 was much more powerful than the Wii, it did not belong in the same category.

“Wii could be considered an impulse buy more than anything else,” he declared.

Karraker’s theory is that newcomers are buying the Wii, while the PlayStation 3 is attracting hardcore gamers. He also told the New York Times that Sony was selling out the 100,000 PlayStation 3s it was sending to the US every week.

Let’s put Karraker’s comments in context.

Nintendo has sold more than 1.1 million Wiis in the US since its launch, while Sony has sold around 700,000 PlayStation 3s.

Given that the PlayStation 2 sold more than 105 million units around the world, and is the most popular games console of all time, it is highly unlikely that Sony is purposely pursuing a niche marketing strategy.

To me it sounds like a PR hack trying to put a positive spin on a situation, which is anything but positive for Sony. I guess that’s what he’s paid to do.

So what exactly is Mr. Karraker's point? That sticking one's head in the sand is the best way to make problems go away? This kind of attitude is neither doing Sony nor its partners - i.e., EA - any favors. Wake up, guys. This is a beautiful example of partnership in reverse.

Microsoft: "Things Aren't Going So Great Over Here As Well"

As bad as Sony and the PS3 are doing, Microsoft has also had to downscale their volume expectations for Xbox 360 in the face of stiffened pricing and the dramatic success of the Wii.

From MercuryNews.com:

Microsoft reduced its expectations for sales of Xbox 360 consoles by June 30, targeting 12 million units sold worldwide now instead of its earlier forecast of 13 million to 15 million. The company said it is now targeting profitability in its strategy.

The days of giveaways are over? This reminds me of the usual dilemma for a console maker. Ship a lot of units, or make a lot of money. In some ways, they go together. They need to move a lot of consoles in order to create the chance for profits from game sales later on. But if you ship too many consoles too early, you lose a lot of money on the hardware. You can dig a hole that you never get out of, as when Microsoft lost $3.8 billion on the first Xbox.

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Clearly, the PlayStation 3 isn't taking away sales, as it is still in short supply and is even starting to accumulate on shelves. If you look at the Wii's momentum, it's threatening. If it continues, you can see that it's only a matter of time before Nintendo's installed base will grow bigger than the Xbox 360s. Moore says he has great admiration for what Nintendo has done.

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Microsoft's downsizing of its expectations should be viewed in context of Nintendo's continued confidence. Nintendo announced yesterday that it sold 3.2 million Wii consoles by the end of Dec. 31. That was a far stronger showing than either Sony or Microsoft had with their first-season launches. Nintendo missed its 4 million unit target, but still expects to hit 6 million worldwide by March 31. The DS and software are selling so well that Nintendo has already hit its 1-year profit goal in the first nine months of its fiscal year.

With PS3 in extremis and Xbox 360 volume targets down by 10-15%, EA better get its Nintendo strategy right - or else. Even at $50 EA is trading at a massive P/E, one that certainly warrants scrutiny given the near and medium-term risks to their growth prospects.

And a Final Note

From TheStreet.com:

Nintendo's Wii is a hit.

But more Wii consoles in the hands of consumers during the holiday season did not necessarily translate into gains for third-party publishers, many of which are scrambling to profit from the Wii's success.

The Wii sold more than 3.1 million units as of January, but the bestseller for the platform has been Nintendo's own title Legend of Zelda: Twilight Princess.

That compares with slightly more than 1 million PS3 units sold since its November launch, and Madden NFL 07 for the PS3, which brought in the big bucks for Electronic Arts.

"Nintendo has always dominated with games on their platform," says Brian O'Rourke, an analyst with the industry research firm In-Stat. "If you go back to all Nintendo platforms, two-thirds of software sales have been Nintendo-developed games, while with Microsoft and Sony just a third comes from first-party games."

Still, winners on the Wii platform are likely to be THQ (THQI) and Activision (ATVI), say analysts, with Electronic Arts facing the greatest challenge, though EA is probably trying hardest to win.

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A beneficiary of Wii's success could be THQ.

The company has shipped more than 3 million units of its best-selling game Cars, based on the Disney/Pixar movie, for the Wii and Xbox 360. In total, Cars has sold 7 million units.

Also, THQ shipped 1 million units each of its Nickelodeon titles Avatar and SpongeBob SquarePants for the Wii.

THQ's gross margins for the third quarter rose 66%, 110 basis points over the prior-year quarter, primarily because of higher average selling prices for the Wii, DS platforms and the Xbox 360, said CFO Ed Zinser during the company's earnings call.

"For THQ, the Wii has a bigger impact," says Pidgeon. "THQ has always avoided direct competition with top publishers by going after a niche, and with Wii they have found success."

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THQ plans to have 11 Wii titles scheduled for release in 2008. "We are very bullish on the Wii and the DS and we think that our product lineup maps very well to both those platforms," says Brian Farrell, CEO of THQ. "I think you should think of the Wii as incrementally more positive to us than the PS3."

Meanwhile, analysts say that EA had been too optimistic about the success of PS3. For the PS3 launch in the third quarter, EA shipped four of its more popular games: Madden NFL, Need for Speed: Carbon, Fight Night Round 3 and Tiger Woods PGA Tour, but chose to bring only two of those to the Wii.

The Redwood City, Calif.-based market leader among video-game publishers is now trying to ramp up development on Nintendo systems.

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In the fourth quarter, said Jenson, EA plans to have four titles for the Wii, three for the PS3 and five for the 360.

Also, EA in December acquired Headgate Studios of Salt Lake City, Utah, which has been exclusively developing titles for the Wii platform.

"We are redirecting some other resources toward Wii and the DS," said Electronic Arts CEO Larry Probst. "By the end of this fiscal year, we will have six titles in the market -- which, other than Ubisoft -- will make us the most prolific publisher on the Wii platform through March."

Probst also said that EA is likely to ship "a number in the low to mid-teens" in fiscal 2008, on both the Wii and DS.

The lower cost of game development for the Wii has also given smaller publishers an opportunity to make games for the platform, says Pidgeon.

Creating a game for Sony's PlayStation 2, for instance, could cost anywhere from $10 million to $15 million, and take 18 months to two years.

But with the Wii, the investments are lower -- there are fewer complexities -- enabling smaller companies, such as independent Japanese publisher Capcom, to create games for the platform.

"You have to look at the Wii as a new platform, so you can't just port stuff from the PS3 to the Xbox 360 to the Wii, though that's the EA way," says Pidgeon.

"Companies that do differentiate between the platforms will have the edge because they can write for the platform," he adds.

That pretty much sums it up.

Conclusion

Truth be told, I, or rather the Internet, had it right from the get-go. EA has been riding the PS2 gravy train which has boosted its earnings, bolstered its coffers and provided the resources to become the dominant player in the gaming space. Problem is, you place your bets and sometimes you win, sometimes you lose, and sometimes you are good at managing your risks. I'd say EA is now trying to manage risks after they have become reality, kind of like buying health insurance after you've been diagnosed with a terminal illness. Ergo: the cost of insurance is high.

The costs of catch-up are significant, whether they manifest themselves in higher costs (such as those required to buy the development shop Headgate or to bring in new development talent to code for the Wii) or lost profits (due to the time between when they could have been selling Wii games and when they'll actually be able to sell Wii games - and every month that goes buy results in a compounded loss of revenue). EA will still be able to milk PS2 for a while, and Xbox 360 profits will continue to roll in. This will buy them time to get their Nintendo (DS and Wii) strategy right. But this will invariably cause a dent in their lofty P/E, much to the chagrin of current investors.

But don't be surprised. You could have seen this coming. Just listen.

ERTS 1-yr chart:

erts

Source: EA: Microsoft, Sony, We Have a Problem