This story is, in essence, at least six months old. Even this blogger penned a post over six months ago titled "EA: Why Didn't Wii Focus on Nintendo?" The interesting thing is that I was going out on a limb back in November when I was calling Electronic Arts (ERTS) to the mat, back when it's stock price was $58 and it was trading at 43x earnings. Fast-forward to today: the stock is trading at $48, having dropped 17% from my original post. One of the principal reasons: stagnant revenue growth, skyrocketing development costs. Why? Having to ramp up development for yet another platform, but one that will be absolutely vital to its growth prospects in the near and medium-term: Nintendo's (OTCPK:NTDOY) Wii.
So this is what the Mercury News had to say about EA yesterday:
Some analysts and investors are beginning to question this upbeat outlook. The biggest problem: the surprising early dominance of Nintendo's Wii in the latest round of the console wars. It's no coincidence, they say, that EA emerged as the top game maker at a time when Sony's PlayStations dominated the game console market. The threat that the Wii now poses to Sony's dominance is bound to affect EA as well, they say.
EA officials blame the company's recent problems on the complexity of the transition. Not only has the company been developing games for about 11 different platforms during the transition, but there also are multiple emerging opportunities in the industry, from the growing market for games in Asia to in-game advertising to games for mobile phones, said company spokesman Jeff Brown.
While EA was late to recognize the potential of the Wii and Nintendo's DS handheld, it's been ramping up its development efforts for both, Brown said. Meanwhile, the company has also been investing in many of those new areas of the game business, he said.
In some ways, EA's troubles aren't unexpected. The transition to new generations of game hardware usually are troublesome for software vendors. That's because they typically invest in developing games for the new consoles long before sales of the machines take off.
But this time, analysts and game makers expected an easier time. Companies such as EA promised to continue to develop games for outgoing platforms longer than they had in the previous industry cycle. Sales from those games as well as for two new handheld systems, Nintendo's DS and Sony's PlayStation Portable, were supposed to help bridge the gap during the shift from older to newer generations of game consoles.
But things didn't work out as expected. Sony's PSP saw limited demand. Although games for Sony's older PlayStation 2 continued to sell, development costs for the new consoles skyrocketed, eating into company profits. And when the new consoles arrived, fewer than expected made their way into consumers' hands because of supply problems, demand problems or both.
For the industry, the result has been a longer than expected transition. For EA, it's meant that sales have grown at an annualized rate of just 1.5 percent over the last three years, its research and development costs have more than doubled during that time period, and its profit has fallen by more than half.
Now compare this to what I had written on November 21, 2006. DId these risks of backing the legacy leaders ever come home to roost, or what?!
However, when a platform technology shift happens (roughly every five years), game developers encounter a rough patch and need to increase diversification by making fewer titles across more platforms. They then wait for the fall-out and watch for the winners to emerge, after which point they revert back to the original operating model. While this is a business that has the capacity to mint cash, it also has the capacity to result in a lot of dry wells. Clearly not a business for the meek.
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.
Ok, ok, so I called this one (or, rather, the internet did). But what about Ubisoft, that company that was well ahead of the pack in putting its chips in with Nintendo and the Wii? They just reported blow-out earnings today. Among the big winners in their current product portfolio? Red Steel, exclusively for the Wii, as mentioned in my post above.
As I have noted before, game development is akin to trading, where bet distribution and bet sizing are key to winning. And in the case of EA, while they are working dutifully at playing catch-up, they find themselves deep, deep in the hole with a declining pile of chips in front of them. EA has won before and I am sure they'll win again, but theirs is a tough row to hoe. And it takes time. A. Long. Time.
ERTS 1-yr chart: