Electronic Arts: The Turnaround Is At Hand For This Fallen Angel - Buy On Headline Weakness

| About: Electronic Arts (EA)
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The core video game industry has suffered significant declines in 2012. According to research firm NPD, U.S. sales of physical hardware and software products (excluding PC) are down 30% and 23%, respectively, through November. As other Contributors have noted, the share prices of third-party publishers such as Electronic Arts (NASDAQ:EA) have responded accordingly. EA closed at $13.94 today, down ~30% YTD (off nearly 10% in the wake of the Newtown tragedy). Truth be told, third-party publishers have struggled since the financial crisis. None of EA, Activision (NASDAQ:ATVI), Take Two (NASDAQ:TTWO), or Ubisoft (OTCPK:UBSFY) have recovered from crisis lows. I argue that one of these fallen angels, EA, is finally poised for a turnaround (ex-EA, I use the term "angel" loosely).

The investment thesis for EA is based upon the following five considerations:

  1. EA bet big and bet wrong leading up to the financial crisis, and has been paying for it since (hence the current opportunity);
  2. Lessons learned over the past four years (title reduction, cost control, online/digital importance) will reduce future missteps;
  3. Key franchises (FIFA, Madden, Battlefield) offer sustainable revenues in an industry where "hits" often make or break companies;
  4. Digital revenue streams are significant (40% FY 13E sales), high margin (> 60%), growing (~35% FY 13E) and largely sustainable; and
  5. Fears of cost increases and potential short-term sales drag resulting from the current console transition are overblown.

Betting Wrong Before the Crisis:

At $14 per share, EA's current market cap sits just shy of $4.5B (ATVI = ~$12B). From July 2003 to August 2008, EA shares never dipped below $40 and traded as high as ~$65. After the crash, shares spent the next few years in a range between $15 and $25 before heading to new lows in July of this year (~$11). Why did a company worth $15B a little over four years ago lose (and continually lose while peers marginally recovered) so much of its value?

EA's original growth story coincided with the introduction of the original Xbox and PlayStation 2 in the early 2000s. Revenues grew from $1.3B in 2001 to $3B in 2004, and earnings went from nothing to ~$600M. Revenues then flat-lined at $3B for the next three years, while operating expenses (mainly R&D) ate away at earnings - $76M in 2007. In April 2007, former President John Riccitiello returned from his three-year private equity stint intent on producing growth, substantial growth (a YoY top-line increase of $500M-$700M).

Riccitiello made M&A a core strategic focus, acquiring development studios with expensive intellectual property (BioWare alone cost $800M), betting not just on the success of in-process titles, but future unproven titles. Riccitiello also licensed Hasbro (NASDAQ:HAS) properties to produce "casual" games for the Wii, partnered with MTV (Rock Band) and other publishers to distribute games (a low margin business), and reorganized the company into a "city-state" model intended to increase the flexibility of internal studios.

The new CEO achieved his revenue goals, boosting the top line by ~$600M in FY 08 to $3.7B, but margins collapsed. Gross margins decreased from 60% to 50% YoY and OpEx increased from 60% of revenue to 64% (to be fair, newly adopted accounting standards requiring the deferral of certain online-related revenues aggravated the impact-revenues excluding such impact were ~$4B). EA posted a $454M (GAAP) loss. Riccitiello remained confident, however, promising (non-GAAP) revenues of $5B in FY 09 and a 200bp gross margin improvement (FY 09 guidance was relayed in May 2008). The rest, as we say, is (recent) history. FY 09 revenues came in just above $4B, while total expenses exceeded $5B. Sales in each of the past three years - and anticipated sales for FY 13 - have hovered at the $4B mark (although operating expenses have improved). Profitability (on a GAAP basis) returned for the first time in five years in FY 12 ($77M).

Annual Income Statement $ in millions (FY ending 3/31) 2008 2009 2010 2011 2012
Total net revenue 3665 4212.0 3654.0 3589.0 4143.0
% growth n/a 14.9% -13.2% -1.8% 15.4%
COGS 1805 2127.0 1866.0 1499.0 1598.0
Gross profit 1860.0 2085.0 1788.0 2090.0 2545.0
% gross margin 50.8% 49.5% 48.9% 58.2% 61.4%
Operating expenses:
Marketing and sales 588 691.0 730.0 747.0 853.0
General and administrative 339 332.0 320.0 301.0 375.0
Research and development 1145 1359.0 1229.0 1153.0 1212.0
Amortization of intangibles 34 58.0 53.0 57.0 43.0
Acquisition-related contingent consideration 0 0.0 2.0 -17.0 11.0
Restructuring and other charges 241 472.0 140.0 161.0 16.0
Total operating expenses 2347.0 2912.0 2474.0 2402.0 2510.0
Operating income (loss) -487.0 -827.0 -686.0 -312.0 35.0
% operating margin -13.3% -19.6% -18.8% -8.7% 0.8%
Gains (losses) on strategic investments, net -118 -62.0 -26.0 23.0 -17.0
Interest and other income (expense), net 98 34.0 6.0 10.0 1.0
Taxable income -507.0 -855.0 -706.0 -279.0 19.0
Provision for (benefit from) income taxes -53 233.0 -29.0 -3.0 -58.0
Net income (loss) -454.0 -1088.0 -677.0 -276.0 77.0
% npm -12.4% -25.8% -18.5% -7.7% 1.9%
Net income (loss) per share: .
Basic $ (1.45) $ (3.40) $ (2.08) $ (0.84) $ 0.23
Diluted $ (1.45) $ (3.40) $ (2.08) $ (0.84) $ 0.23

Importantly, EA's dreadful FY 09 and subpar performance since was much less an effect of the financial crisis than one might think. Video game sales in CY 2008 - which included the first three quarters of EA's FY 09 - increased 17% YoY. In CY 2009, sales declined a relatively benign ~10%. EA was not just a victim of poor investment timing, but the company was investing in the wrong titles. An exhaustive survey of such titles is beyond the scope of this article, but failed projects ran the gamut from Wii-focused casual games to core studio IP to EA Sports' NBA Live series. EA was investing in everything just as the market began demanding specialization.

This specialization is a key point. Anyone following the industry over the last few years is aware of publishers' shift to the less titles, more quality format. Analysts often point to two demand-side culprits for this shift: 1) deleveraging consumers forced to be pickier by the financial crisis and 2) the rise of mobile/casual gaming. While these factors are relevant, I think that an equally, if not more, important issue is the rise of online gaming (particularly on consoles) and accompanying robust multiplayer experiences driven by ubiquitous access to broadband internet connections in developed markets. In the pre-online console world, gamers generally bought a game, "beat" it, and moved on to the next game. Even the highest quality single-player games could be played for only so long before repetition fatigue set in. As a result, publishers interested in maximizing profits were concerned with quality, but title variety was essential.

For the past few years, gamers have been blessed with diverse multiplayer experiences across a range of game types (FPS, sports, RPG, etc.). For many, a single game will account for hundreds or thousands of hours of entertainment (take your pick of Call of Duty, Halo, Madden, FIFA, Assassin's Creed, etc.). In this new paradigm, enticing gamers to buy the next iteration of a proven franchise is often difficult enough, while establishing and monetizing unproven titles is next to impossible lacking top-notch reviews, extensive marketing, good timing and a significant multiplayer component. EA is painfully aware of these challenges. The company released 36 primary titles in FY 11, 22 in FY 12 and will release 14 in FY 13 - this is after releasing 55 titles (~150 SKUs) in FY 09.

Lessons Learned:

Riccitiello's FY 08 restructuring plan, which incurred ~$100M in charges, was more of a reorganization to spur growth than a cost-cutting initiative. Subsequent restructuring plans in FY 09, 10, 11 and now 13 were most definitely the latter. After the pre-crisis profligacy, facilities needed to be closed and leases bought out. Employees were laid off and severance paid. Development contracts and licensing agreements were amended or terminated, and related intangible assets were written off. The total cost of the five plans has exceeded $500M to date, with the bulk of charges occurring in FY 08 ($97M), FY 10 ($140M) and FY 11 ($161M). Future expenses under these plans total ~$20M. The result is a leaner company, particularly from a facilities, development and licensing standpoint (headcount since FY 09 is unchanged).

EA Restructuring (in millions) (FY Expenses)
2008 2009 2010 2011 2012 2013**
2008 $ 97 $ 34 $ 10 $ 141
2009 $ 41 $ 14 $ 55
(FY Plan) 2010 $ 116 $ 13 $ 129
2011 $ 148 $ 16 $ 164
2012* $ -
2013 $ 22 $ 22
$ 97 $ 75 $ 140 $ 161 $ 16 $ 22 $ 511
*No plan in FY 12
**Future expenses under all plans expected to be ~$20M

This leanness is reflected in the title reduction. As mentioned above, EA released 36 primary titles in FY 11, but will release only 14 this year. In hindsight, it appears EA was not aggressive enough in focusing the title line-up and eliminating costs. Why were five restructuring plans needed, instead of one or two? Why was it not apparent sooner that only the strongest franchises had a chance at profitability? The realities of the video game development cycle (one to several years), analysts' expectations, company morale and the unprecedented nature of 2012 industry slowdown all played a role - among other factors. I would argue that, given the extent of the build-up, EA has done fairly well undoing the damage.

Annual operating expenses beginning in FY 10 (including ongoing restructuring, amortization of intangibles and acquisition-related consideration) for example, have remained relatively flat in the $2.5B range (down from $2.9B in FY 09), despite investment in digital initiatives. Gross margin increased from 49.5% in FY 09 to 61.4% in FY 12. On a Non-GAAP basis (which can be thought of as sales inclusive of deferred revenue less expenses exclusive of one-off items such as restructuring charges - essentially a measure of operating performance had EA not dug itself such a deep hole to begin with), EA has actually been profitable since FY 10, steadily increasing yearly earnings from $145M to $233M to $284M to my projection of $331M in FY 13.

Non-GAAP Annual Income Statement (FY) 2009 2010 2011 2012 2013E
Net revenue 4086.0 4159.0 3828.0 4186.0 4115.1
Cost of revenue 2073.0 1857.0 1486.0 1544.0 1458.2
Gross profit 2013.0 2302.0 2342.0 2642.0 2656.9
Marketing and sales 671.0 714.0 726.0 827.0 742.8
General and administrative 285.0 273.0 261.0 312.0 340.0
Research and development 1225.0 1119.0 1042.0 1106.0 1114.2
Total operating expenses 2181.0 2106.0 2029.0 2245.0 2197.0
Operating income (loss) -168.0 196.0 313.0 397.0 459.9
Interest and other income (expense), net 34.0 6.0 10.0 -3.0 1.0
Income (loss) before income taxes -134.0 202.0 323.0 394.0 460.9
Provision for (benefit from) income taxes -38.0 57.0 90.0 110.0 129.4
Non-GAAP Net income (loss) -96.0 145.0 233.0 284.0 331.5

While the cost lesson is an important one, EA's greatest lesson learned is the company's recognition of and pivot toward the new gaming paradigm. To succeed in this new world of multiplayer dominance, mobile/casual gaming growth, and digital distribution, publishers must have persistent brands and a blueprint for monetizing those brands beyond traditional retail sales. Among publishers, EA has been an early adopter of such strategies. This early movement, however, has been overshadowed by difficulties in its traditional businesses.

Sustainability of Key Franchises:

An investor will often look at a company like EA and attempt to determine his worst-case scenario. This is especially relevant here given the uncertainty surrounding the video game industry in the year moving forward (and perhaps the broader economy as well). The question becomes, what can I really count on to produce cash flows in the years ahead? For video game publishers in a hit-driven industry, the answer to that question is a function of brands and their competitive moats.

EA's publishing segment, which is its traditional packaged goods video game business, has been under attack for several years. Whether the attacker was a rival, an ill-fated acquisition, or the industry itself, EA struggled to generate growth. Segment revenues were $2.75B in both FY 09 and FY 12. I estimate FY 13 revenues at $2.35B, a 14% decline. The bright side of these challenges is that the company has reduced itself to its most profitable and promising properties.

Non-GAAP Revenue Composition (FY) 2008 2009 2010 2011 2012 2013E
Publishing Packaged Goods and Other 2766.0 2983.0 2781.0 2736.0 2342.0
% growth 7.8% -6.8% -1.6% -14.4%

Three of these properties are top tier franchises: 1) FIFA, 2) Madden and 3) Battlefield. These properties shipped ~30M units in 2012 and likely produced half of the $2.75B in publishing segment revenues (assuming an ASP of ~$45). I address the future prospects of each franchise in turn. Note that unit numbers are primarily derived from vgchartz.com and exclude all digital/mobile sales.

  1. FIFA: FIFA shipped 12.3M units in FY 12 after shipping 9.4M, 10.5M and 12M units in FY 09, 10 and 11. FIFA 13, after 10 weeks of sales through December 1st, was tracking 35% higher than FIFA 12 (on the Xbox and PS3). Even adjusting for an industry trend of increased preorders, this is a significant win for EA. FIFA weekly sales ending December 8th came in relatively in-line with FIFA 12 (420M vs. 395M), showing the continued strength of the release. While these numbers are great in the short term, FIFA's historical annual unit sales numbers are more important, as they indicate long-term sustainability. The franchise has been a leader in online integration (discussed more below), dwarfs its soccer competitors (Pro Evolution Soccer made a small splash several years ago, but its latest iteration has sold a little over 1M units to date), and is exposed to growing emerging markets.
  2. Madden: Madden shipped 5.3M units in FY 12 after shipping 7.8M, 7.4M and 6.5M units in FY 09, 10 and 11. Madden 13, after ten weeks of sales, however, was tracking 16% higher than Madden 12. This puts the latest iteration on track for 6M units, reversing a downward trend of several years. While the recent decline was a concern for EA, much like FIFA, Madden dominates the NFL football category. Competitors have tried and failed to take significant share over the years, and EA is developing an online infrastructure that will make such efforts even more difficult. While the growth prospects here are less apparent than with FIFA, this franchise offers a floor of several million units in annual sales. With the popularity of the NFL, it is difficult to conceive of a world where gamers stop playing football simulation games in significant numbers.
  3. Battlefield: Battlefield 3 shipped 12.1M units in FY 12 after shipping less than 7M units of the previous iteration, Bad Company 2. A sequel has yet to be announced, although I would expect a new version by CY Q1 14 at the latest. The franchise has typically updated every 18-24 months, which indicates a CY Q4 13 release at the outside. The Battlefield franchise, and particularly Battlefield 3, has been a revelation for EA. The game shipped close to another 3M units in FY 13 to date, and online content sales have significantly contributed to digital revenues. In a console FPS segment dominated by Call of Duty and Halo for several years, EA carved out its Battlefield niche through a combination of realistic graphics and a strong multiplayer emphasis. Battlefield's single-player was less well-received, but it mattered little. The online experience was different and engaging enough to justify a separate purchase. Unlike FIFA and Madden, Battlefield has clear competitors - and less of a moat as a result. The franchise also lacks annual releases. In the near term, however, it is difficult to see the brand losing its luster. The next iteration, even if it disappoints, will likely sell more than 10M units (which would represent a 30% decline) on the strength of the last two releases. This result would hurt EA, but the injury would pale in comparison to the harm suffered by ATVI given a similar percentage decline for Call of Duty (or World of Warcraft for the matter).

With licensed titles like FIFA and Madden, an additional risk is maintaining that license (exclusive or otherwise). I do not anticipate many scenarios, however, whereby EA does not aggressively and proactively pursue an extension for these successful titles. Even if such aggression were rebuffed for whatever reason, I wonder how many publishers would be willing to start from scratch on such iconic titles, especially given the online infrastructure EA has built.

I will not address EA's entire catalogue of franchises, but it is worth noting that the company has several "second tier" brands that have survived the wringer of the last several years, consistently sold at least 2M units, and produced at least two iterations. These brands include The Sims (and SimCity), Need For Speed, Mass Effect, Crysis, and Dead Space, with a few others on the cusp (e.g. NCAA Football and Army of Two). I use these criteria and mention these titles to emphasize the relative diversity and sustainability of EA's catalogue. If the titles slated for Q4 13 perform in line with previous releases, I project that EA's publishing segment will produce $2.35B in revenues in a year with only 14 primary releases. A 14% decline YoY, but FY 12 offered 8 more primary releases, one of which was Battlefield 3.

As a whole, the purpose of this section is to illustrate the long-term sustainability and diversity of EA's various franchises (ex digital revenue contributions). In brief, the key points are as follows:

  1. FY 13 more than likely represents a low point for both EA title releases and industry sales, given the transition to next generation consoles in the coming year - the only way to go is up;
  2. Of the top three titles, FIFA and Madden are not going anywhere (both are performing quite well this year) and Battlefield has enough short-term momentum in a competitive shooter category to produce at least one more iteration of blockbuster sales; and
  3. Even with the top three titles representing 50% of publishing revenues, EA has a number of second tier brands capable of absorbing shortfalls in any given year (and the relative share of total revenues for those three titles is closer to 40% when digital sales are added).

Digital Growth:

EA's lack of growth in its traditional business has overshadowed impressive gains on the digital front ("digital" includes mobile). EA was monetizing the feature phone market as early as 2004, and around the same time launched its subscription-based casual games service, Pogo. Riccitiello made digital growth a priority for the company when he returned in 2007 and has delivered-both organically and through acquisitions. Digital revenues totaled $1.23B in FY 12, representing a 5-year CAGR of 36% (FY 07 digital revenues totaled $267M), and I project additional growth of 36% in FY 13 to $1.67B - 40% of company revenues.

Non-GAAP Revenue Composition (FY) 2008 2009 2010 2011 2012 2013E
Digital Net Revenue 342 429.0 570.0 833.0 1227.0 1669.0
% growth 25.4% 32.9% 46.1% 47.3% 36.0%

EA reports four types of digital revenue, and I address each in turn. Similar to the traditional business, I focus on the sustainability of cash flows in the context of the current growth trajectory.

  1. Full Game Downloads: This segment produced revenues of $221M in FY 12, a 135% increase YoY. I project FY 13 revenues to decline 14% to $191M, which is still a two-year CAGR of 43%. This is the smallest of EA's four digital segments but also represents a significant growth opportunity. Revenues are derived from EA's digital distribution service, Origin (which distributes PC - both core and casual - and mobile games), as well as downloads on third-party distribution platforms such as Xbox Live or The App Store. Origin launched in June 2011, superseding a more primitive online distribution platform. The service presently has over 30M registered users (13M mobile) - up sharply from the 11M reported in May 2012 - and 70 independent developers. FY 12 Origin revenues were $150M, an increase driven by downloads of EA's PC-based Star Wars and Battlefield games. While a repeat of this performance will not happen in FY 13 (neither game is an annual release), the advantages associated with establishing a robust digital distribution platform in a gaming world rapidly shifting to digital delivery should be obvious. Commissions to third-party distributors (including physical retail) are avoided, EA can charge independent publishers its own high margin commissions, and an ongoing dialogue is established directly to consumers. In this space, gaming-focused competitors include the market leader Steam (35M users) and GameStop's Impulse. Neither service, of course, has the benefit of EA's brand integration. With regard to distributing on third-party console platforms such as Xbox Live, EA has and will continue to take advantage of consumers' affinity for the convenience of digital purchases. Presently, such purchases consist primarily of catalogue titles, as the industry has yet to shift new releases to the digital format. At some point, new releases will be distributed digitally as well, and margins should benefit (if the reported ~30% royalty rate holds).
  2. Extra Content: This segment produced revenues of $433M in FY 12, a 46% increase YoY. I project FY 13 revenues to increase another 46% to $631M. Extra content is defined as revenues generated from free-to-play platforms as well as downloadable content. Free-to-play platforms include social games on Facebook, EA's Play4free casual games property (now integrated with Origin, but reported in this segment) and international ventures like FIFA Online (targeting the Korean market). Downloadable content includes individual map packs for a game like Battlefield, character customization in Mass Effect, and player pack purchases for FIFA and Madden "Ultimate Team" modes (the gamer acts as a general manager / coach). While revenues for each of these sub-segments (e.g. FIFA Ultimate Team) are not disclosed, EA has disclosed some promising statistics. Total FIFA digital revenue (across all four digital segments, but of which extra content is likely primary) increased 106% to $165M from FIFA 11 to FIFA 12. Total Battlefield 3 digital revenue is expected to exceed $200M by the end of FY 13, compared to $68M for the prior iteration. Across the various free-to-play platforms (which includes all non-subscription-based games - social, casual and mobile), average weekly revenue at the end of Q1 13 was 6.3M, compared to 2.5M a year before. Similar to the Origin digital segment, there remains room for significant growth. While FIFA and Battlefield have monetized online well, both games generated immaterial revenues only a few years ago. Games like Madden, Mass Effect and Need For Speed are still in their digital infancies, which is a good thing for growth. EA is in front of the digital trend and pushing for each of its core franchises to have online monetization capabilities.
  3. Subscriptions, Advertising and Other: This segment produced revenues of $289M in FY 12, a 44% increase YoY. I project FY 13 revenues to increase 53% to $442M. Traditionally, the large producer in this segment is EA's Pogo.com adult casual games (e.g. casino games, board games, card games, etc.) property. Pogo sells annual subscriptions for $50 and EA has reported subscriber numbers as high as 1.8M (in 2010). Non-premium games are supported by advertising. Newer revenue drivers in this category include EA's Star Wars MMO and Battlefield Premium subscription service. The former was launched with much fanfare after several years of development and - while initially garnering upwards of 1.7M subscribers (at $15 per month) - has suffered since. EA refuses to disclose current subscriber numbers and has shifted to a free-to-play model in the last month. The latter has exceeded expectations and is expected to produce $110M in FY 13 revenues, more than offsetting the Star Wars subscriber decline. The growth prospects for this segment are less exciting than the other digital segments. Star Wars pivoting to a free-to-play property is intended to boost subscribers over time, but the history of successful subscription-based MMORPGs is not good (only ATVI's World of Warcraft has thrived). I expect Battlefield Premium and Pogo to generate sustainable revenues into the future, but both services have likely passed their high growth phases.
  4. Mobile / Handheld: This segment produced revenues of $284M in FY 12, a 17% increase YoY. I project FY 13 revenues to increase 43% to $405M on the back of strong growth in smartphone and tablet game sales. EA's mobile segment has exhibited accelerating YoY growth over the last several quarters, as declines from feature phone and handheld sales are offset by smartphone and tablet sales. Some readers may recall EA's Real Racing mobile game being featured at Apple's (NASDAQ:AAPL) September iPhone 5 unveiling. Origin's growth will drive mobile sales and margins in this segment and, much like the extra content segment, EA has a number of recognizable brands either in their mobile infancies or yet to be ported. While mobile titles typically have short life cycles, unpredictable levels of popularity, and suffer from copy cats, the strength of EA's brands lessens such issues substantially. Particularly with regard to tablets, future growth prospects are bright.
EA Digital Rev by Type ((NASDAQ:CY)) Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 Q4 11 Q1 12 Q2 12 Q3 12 Q4 12E Q1 13E
Full game DL 28 23 18 19 34 32 26 103 60 33 38 60 60
% growth 21.4% 39.1% 44.4% 442.1% 76.5% 3.1% 46.2% -41.7% 0.0%
Extra Content 38 53 64 66 113 70 85 123 155 131 114 184.5 201.5
% growth 197.4% 32.1% 32.8% 86.4% 37.2% 87.1% 34.1% 50.0% 30.0%
Subs/Ads/Other 34 58 33 59 51 48 50 67 124 81 74 87.1 200
% growth 50.0% -17.2% 51.5% 13.6% 143.1% 68.8% 48.0% 30.0% 61.3%
Mobile/HH 56 54 51 67 70 59 55 84 86 79 88 117.6 120.4
% growth 25.0% 9.3% 7.8% 25.4% 22.9% 33.9% 60.0% 40.0% 40.0%
Total Digital 156 188 166 211 268 209 216 377 425 324 314 449 582
% growth 71.8% 11.2% 30.1% 78.7% 58.6% 55.0% 45.4% 19.2% 36.9%

Where the previous section described EA's traditional packaged goods business as at its nadir, this section sought to illustrate EA's numerous and largely sustainable digital growth opportunities. Importantly, the majority of this digital growth will be accretive to earnings, either because EA is exploiting an entirely new revenue stream or the digital business will produce higher margins. Of the four segments above, three of the four are positioned for substantial growth, and the Subscriptions segment is not likely to experience a dramatic decline.

Console Transition is Manageable:

EA's share price slide to $11 this summer reflected the terrible industry-wide packaged goods numbers, lackluster Star Wars subscriptions (which lowered guidance) and general uncertainty regarding the transition to next generation consoles. The stock has rebounded to $15 since, a move justified - if not caused - by improved industry packaged good sales (relative to prior months) and EA's continued digital successes (ex Star Wars). Negative sentiment surrounding the console transition remains a concern.

This transition uncertainty persists for two reasons. First, there is a perception that video game sales will drag in the year leading to a transition as consumers delay purchases. I have not sought to confirm or deny this phenomenon by examining the last cycle in detail, and prefer to concede its existence. Granting that, I would ask just how much lower physical video game sales could go after the past year's 23% decline (in the U.S.)? Depending on who you ask, the console transition is one to three years overdue, which suggests some of this fatigue has already set in. Mobile and casual games are widely available in developed markets and have largely converted those who prefer such an experience to core gaming. At this point, publishers are releasing only their best and most profitable titles, and I have explained how this is especially true for EA. In any event, it is much more an issue of timing than lost sales. Release dates may be shifted to accommodate a new console, but consumers will eventually make the purchases.

The second reason the transition is a concern is its effect on development costs. While development costs for individual games vary, sources have reported that the current console generation increased such costs by an average of 5-10x. A game that cost $5M to bring to the Xbox or PlayStation 2 could cost as much as $25-$50M on the Xbox 360 or PlayStation 3. While the 5-10x multiple may be an exaggeration in certain cases, it is not uncommon to hear of game budgets in the $25-50M range. Gross margins and operating expenses at EA during the current cycle seemed to confirm these higher costs. Could we see development costs balloon as high as $250M-$500M?

I think this is unlikely to happen, for a few reasons. As mentioned herein, the profitable business model for the current console generation emphasizes fewer high-quality - and expensive - AAA titles, where as the previous generation thrived on cheaper quantity and variety. Consumers have demanded robust, cutting edge gaming experiences for some time now. It is difficult to see these expectations getting much higher. Moreover, console manufactures themselves, particularly Sony (whose PlayStation 3 did not see the commercial success of the PlayStation 2-many think because it was so difficult to develop for), have incentives to keep development costs within a viable range to maximize licensing fees. TTWO's CEO, in response to a question from a Baird Analyst in the latest earnings call, said he did not anticipate that next generation titles would be a lot more expensive (suggesting that they may actually be easier to make in many instances). The law of large numbers - or just common sense - also militates against substantial increases. Only in health care do costs outpace broader economic growth indefinitely.

Investment Thesis:

Notice what this analysis did not touch on. The bane of the summer, Star Wars, is written off. EA's flagging physical distribution business ($100M projected FY 13 revenues) is ignored. Perhaps most significantly, there is no mention of the "next big thing" - that hit title sure to wow gamers and analysts alike (I see this "hit" driven focus all too often). While hits are great, they are few and difficult to predict, and by that very nature poor reasons to invest (though by all means speculate) in a publisher.

Additionally, I have not talked much about financial ratios, EPS, valuation, price targets, etc. Part of this is to avoid the confusion of GAAP versus non-GAAP results and EA's persistent one-time restructuring charges. Another part of it is the limited usefulness of relative value comparisons (and corresponding price targets) for a company with EA's recent financial results. I recognize, however, that many investors will have questions regarding these issues, and to them I offer the following summary (and table immediately below).

  1. Cash levels (inclusive of short-term investments and marketable securities) sit at $1.3B ($4.17 per share) while long-term debt consists of a sole 2011 .75% $632M convertible note issue (dilution potential of ~20M shares on 315M outstanding);
  2. I expect Non-GAAP EPS of $.53 and $.78 in Q3 and Q4, respectively, and FY 13 EPS of $1.05 (consensus is $1.04);
  3. I expect Non-GAAP FY 13 gross margins of 64.6% (1.5% YoY increase), largely on the back of record 70% margins in Q4, while operating expenses decrease ~2% YoY to $2.2B (with the largest YoY reduction - $85M - coming in marketing and sales);
  4. Digital revenues will increase 36% to $1.67B (driving the margin expansion), while publishing revenues decline 14% to $2.34B, effectively offsetting one another (total revenues come in at $4.1B when distribution is included);
  5. I estimate FY 13 free cash flow (ex restructuring and charge-offs) at $360M, driven by a 15% non-GAAP EBITDA increase to $632M (capex is estimated at $117M - EA is not in a capital intensive business); and
  6. With a market cap of $4.5B, EA is fairly valued if the current FCF level forecasted perpetually at a 10% cost of capital assumes just a 2% growth rate ($360M / (.1 - g) = $4.5B).

Annual Non-GAAP Income Statement $ in millions

2008 2009 2010 2011 2012 2013E
Total net revenue 4020 4086.0 4159.0 3828.0 4186.0 4115.1
% growth n/a 1.6% 1.8% -8.0% 9.4% -1.7%
COGS 1777 2073.0 1857.0 1486.0 1544.0 1458.2
Gross profit 2243.0 2013.0 2302.0 2342.0 2642.0 2656.9
% gross margin 55.8% 49.3% 55.3% 61.2% 63.1% 64.6%
Operating expenses:
Marketing and sales 588 671.0 714.0 726.0 827.0 742.8
General and administrative 339 285.0 273.0 261.0 312.0 340.0
Research and development 1145 1225.0 1119.0 1042.0 1106.0 1114.2
Total operating expenses 2072.0 2181.0 2106.0 2029.0 2245.0 2197.0
OpEx % 51.5% 53.4% 50.6% 53.0% 53.6% 53.4%
Operating income (EBIT) 171.0 -168.0 196.0 313.0 397.0 459.9
Non-cash charges:
Depreciation 117 123 104 102 113
% PPE 33% 23% 20% 18% 21%
Amortization (ex intangibles) 13 10 12 52 59
Non-GAAP EBITDA -37.7 329.2 429.2 551.2 632.1
Less Cash taxes 19 -34 21 -4 37
Less Increase in NWC -264.88 65.38 8.22 -116.44 111
Less Capex 47 306 80 157 117.2
Less Increase in other assets -31 60 -95 105 7
Free Cash Flow n/a 192.2 -68.2 415.0 409.6 359.6
FCF/share n/a $ 0.60 $ (0.21) $ 1.24 $ 1.23 $ 1.18
Diluted Shares 318 322 330 336 332 306

In more qualitative form, here is that thesis.

  1. EA's pre-crisis growth strategy was poorly timed and executed, but the company has worked through the bulk of legacy costs and is tested and leaner (and cheaper) as a result;
  2. EA's three key franchises (FIFA, Madden and Battlefield) provide a floor of sustainable revenues in its traditional packaged goods business, while its overall mix of top and second tier titles is largely proven and diversified;
  3. Digital products (already 40% of sales)-particularly in distribution, online content, free-to-play and mobile-offer double-digit growth and high margin opportunities, and EA has invested heavily in this area; and
  4. Cost increases and sales drag associated with the console transition are not significant long-term concerns, while post-transition sales - if history is any guide - will jump substantially.

In an even more simplified form, buy financially sound and diversified cyclical businesses at cyclical lows, particularly when that business has shown an impressive ability to adapt to and grow within the new paradigm. From a medium- to long-term risk-reward perspective, it doesn't get much better. Investors are in "show-me" mode with EA, but waiting for the show limits upside. I believe the company has shown enough.

Price Target:

In conclusion, a brief valuation hypothetical (illustrated in the table below) - assume that EA's digital growth rate is 25% in FY 14 (a conservative assumption given the last four years in the 30s and 40s). Assume that all other revenue remains at historically depressed levels (even with the almost certain launch of at least one new console), and that total gross margins tick up just 1%, to 65.6%. Meanwhile, operating expenses go up $100M to $2.3B (a record level). Non-GAAP earnings in this scenario are $484M, representing 46% growth YoY and a two-year CAGR of 31%.

Non-GAAP Annual Income Statement (FY) 2012 2013E 2014E
Net revenue 4186.0 4115.1 4531.25
Cost of revenue 1544.0 1458.2 1558.75
Gross profit 2642.0 2656.9 2972.5
Marketing and sales 827.0 742.8 742.8
General and administrative 312.0 340.0 340.0
Research and development 1106.0 1114.2 1114.2
Total operating expenses 2245.0 2197.0 2300.0
Operating income (loss) 397.0 459.9 672.5
Interest and other income (expense), net -3.0 1.0 0
Income (loss) before income taxes 394.0 460.9 672.5
Provision for (benefit from) income taxes 110.0 129.4 188.3
Non-GAAP Net income (loss) 284.0 331.5 484.2
% growth 17% 46%

How much would you be willing to pay for this performance - understanding that by May 2014 all next generation consoles will likely have launched? 10x earnings gets you to the current valuation. What about 20x, 30x (PEG ratio = 1), 40x?

All things considered, 20x seems reasonable. As such, my 12-18 month price target sits at $30 per share, upside of ~100%.

Disclosure: I am long EA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.