With the shift towards digital and mobile gaming around the start of this decade, console game-developer Electronic Arts (NASDAQ:EA) was suppose to struggle. The stock though surged for one prime reason that probably isn't evident to most investors.
The stock maxed out at nearly $77 last year and now trades around $62. Though investors focus incessantly on the publishing schedule of new games, the real trend that has impacted the stock price appears maxed out no matter what game is published. For these reasons, the stock may struggle to rally in 2016.
Looking at the above chart, one might think the rally from the 2012 lows was due to surging demand for Electronic Arts games. In reality though, the game developer as seen limited revenue growth since FY12.
The combination of overdone fears on the shift of games to digital formats including mobile and the actual higher margins on the shift led to the big rally in the stock. The slide below though suggests the benefits from this shift are about maxed out.
Source: Electronic Arts FQ3'15 earnings slides
The massive shift from packaged to digital games from FY12 to FY15 brought on massive gains in the gross profit percentage. Revenues were virtually flat over those years, but the profit margin surged 790 basis points. The FY16 estimate suggests flat margin growth for the full year despite another 10% growth in digital revenues.
Digital now accounts for 55% of revenues and console games are holding up better than expected as the big multi-player games have more value on a platform. Not to mention, these games feed the Esports initiative that could extend the staying power.
At the same time that margins are peaking, Electronic Arts guided to flat revenue growth for the March quarter. Even Activision Blizzard (NASDAQ:ATVI) with a somewhat similar size to Electronic Arts is expected to produce declining revenues for the year.
Analyst forecast a general 7% revenue gain for both gaming giants in the next year. Electronic Arts though sees revenues down for the current quarter making the revenue growth for FY17 back-end loaded likely due to the new Battlefield game and the constant growth in mobile.
The stock trades at forward PE of 17x the expectations for FY17. Electronic Arts isn't too expensive at that valuation, but the assumptions required to generate 15% EPS growth next year are lofty. Not only does the company need revenue growth to accelerate over 7%, but the company will need to again expand margins.
The trends shows that Electronic Arts has seen revenues and margin expansion top out. The current price require those trends to continue expanding in FY17 in order for the stock to rally beyond the current levels.
The recommendation is to avoid the stock over the summer lull and look into possibly owning Electronic Arts into some positive game releases for the holidays.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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