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In this article, I will run you through my DCF model on Electronic Arts (EA) and then triangulate the result with a review of the fundamentals against those of Activision Blizzard (ATVI) and Microsoft (MSFT). I find that the last two are meaningfully undervalued and will outperform the broader market when the economy hits full employment. Improving median income will result in greater discretionary consumer expenditures, which will, in turn, buoy up the video game industry.

First, let's begin with an assumption about the top-line. EA finished FY2011 with $3.6B in revenue, which represented around a 1.8% decline off of the preceding year. The year before that, the company experienced double-digit negative growth. Thus, while losses are being curtailed, the growth story isn't looking bright. I optimistically model revenue trending from 1% to 6% over the next half decade or so.

Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I forecast cost of goods sold as 42% of revenue versus 29% for SG&A, 32.5% for R&D, and 2.3% for capex. Taxes have been nonexistent, since the company has been bleeding money.

We then need to factor in net increases in working capital. I model this as -0.5% over the explicitly projected time period. As it stands based on this model, EA has negative free cash flow. Around $230M worth of negative free cash flow in 2017 will happen if the company does tap into its value drivers.

All of this falls within the context of strong momentum:

Our results reflect a great performance by Battlefield 3, Star Wars: The Old Republic, our entire EA SPORTS lineup, especially FIFA and a nice boost from our digital games and services.

This was the kind of quarter a CEO loves to report. It is one which generated our highest operating cash flow in 31 quarters and reaffirms our strategy of creating big hits, digital revenue streams that extend the revenue, profitability and consumer engagement in our brands. We gained share in packaged goods in both North America and Europe on the strength of 2 titles, each of which sold more than 10 million units, Battlefield 3 and FIFA 12. We were the #1 publisher on high-definition systems worldwide for all of calendar year 2011.

From a multiples perspective, however, safer stocks Microsoft and Activision appear more attractive. Activision trades at a respective 13.3x and 11.4x past and forward earnings versus 11.8x and 10.7x for Microsoft. Assuming a multiple of 16x and a conservative 2013 EPS of $1.05, the stock would hit $16.80 for 37.7% upside. I am optimistic that investor fear over World of Warcraft will dissipate when consumer expenditures rise across the industry.

Microsoft is perhaps even more attractive. What attracts me to the company is that it has much more synergistic value than what the market appreciates. From Xbox 360 to software to Internet Explorer and Office Suite, Microsoft is one of the most well diversified companies at the current moment. Unlike many mature companies that struggle with growth, Microsoft has not become a mess of a conglomerate. Rather, it has created several segments that can coherently work together ("can" being the key word.) The shift over to cloud computing represents a significant catalyst for Microsoft to capitalize off of this opportunity. A multiple of just 14x and a conservative 2013 EPS of $3 would send the shares soaring nearly 30%. In light of this upside, I strongly recommend investing in Microsoft.

Source: Avoid Bleeding Electronic Arts For Microsoft, Activision