Electronic Arts Beats The Industry Slump With Digital Revenue Growth

| About: Electronic Arts (EA)
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Electronic Arts' (NASDAQ:EA) stock jumped 8% as the video game developer announced better-than-expected earnings for the March quarter. Margin expansion and high digital sales were two key and interrelated points that stuck out in the company's report. The gross margin for the quarter improved by almost 10 basis points to 74%, helped by the company's cost-cutting measures and a 45% year-on-year increase in high-margin digital revenues.

EA's sales were affected by industry-wide headwinds as non-GAAP publishing packaged goods revenue fell by 25% over the prior year. The company reports non-GAAP financial measures, which exclude non-operational items like acquisition-related expenses, one-time litigation expenses, stock-based compensation, and restructuring charges. However, this decline was mitigated by the increase in digital revenues as total net revenue for the quarter was up 6% over the prior year.

The market price is now in line with our $18 price estimate for Electronic Arts' stock.

Ushering In the New Era

Extra downloadable content (DLC), which includes purchasable virtual goods and characters as well as additional map-packs, accounted for 36% of the digital revenues earned in the March quarter. Revenues from this stream were up 35% from the prior year helped by growth in "FIFA," "Star Wars: The Old Republic," and "Bejeweled Blitz." However, with the transition to the highly anticipated eighth-generation consoles, the company expects DLC revenues to remain flat in the coming year.

EA also reported a 54% year-on-year increase in subscriptions and in-game advertising revenues, which accounted for 31% of digital revenues. This was driven by the launch of the "End Game" expansion pack for "Battlefield 3." The company recognized a full year of "Battlefield 3" premium subscription revenues in fiscal 2013, and expects a 20% decline in this stream in the coming year.

Revenues from mobile-based games increased by 21% over the prior year and accounted for 17% of the company's digital revenue. This was driven by strong sales of "Real Racing 3" and "The Simpsons: Tapped Out," which was a top-five grossing iOS game during the quarter, generating over $10 million in revenue. EA plans to capitalize on the growth in mobile gaming by launching 15 mobile titles on both iOS and Android platforms in fiscal 2014. Electronic Arts expects these games to drive a 30% growth in mobile-based revenues in fiscal 2014.

Full-game downloads accounted for the rest of the digital revenues earned by EA during the three months ending March. Revenues from this stream grew by 65% over the prior year driven by PC products like "SimCity," over half the sales of which were through digital downloads. Electronic Arts plans to launch 11 major titles in fiscal 2014, including "Sims 4" and "Battlefield 4." Historically, these titles have been well received on PC platforms, which currently drive full-game downloads. EA expects revenues from full-game downloads to increase by 25% in the next year.

Growth in digital streams will allow margin expansion in the coming years. The cost of revenue for physical products sold is about 51% of the net revenue, while the cost of revenue for online and digital services is just 30%.

Gearing Up for the Launch of New Consoles

Both Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE) are expected to launch their eighth-generation consoles later this year. Electronic Arts is gearing up for these with cost reductions and title consolidation. As we mentioned before, the company is cutting down the number of titles to just 11 of its most popular franchises like "FIFA," "Battlefield," and "Madden." In contrast, the company had 85 titles in play when the seventh-generation of consoles were launched, leading to very high research and development expenses. EA also plans to reduce employee headcount by 10% to improve cost efficiency.

"FIFA" is one of EA's highest selling franchises and the soccer-based game has been a regular on the list of highest selling games across the world since the first edition launched in 1993. The latest edition, "FIFA 13," sold over 14.5 million units in fiscal 2013, 30% higher than its predecessor, "FIFA 12." The game also generated $200 million in digital revenues, an increase of 94% over "FIFA 12."

EA has extended its exclusive licensing agreement with the game governing body, Fédération Internationale de Football Association, until Dec. 31, 2022. This agreement allows EA to use player and sports team likeness and logos in its video games and gives it an edge over other soccer based franchises like "Pro Evolution Soccer."

Electronic Arts has also announced an agreement with Disney to create games based on the "Star Wars" franchise. Given the immense popularity of its titles, we expect EA to make a smooth transition to the next generation of consoles. The company expects a 7% increase in packaged goods and distribution revenues in fiscal 2014.

Disclosure: No positions.