EA Is Oversold After The Star Wars Battlefront II Fiasco

| About: Electronic Arts (EA)

Summary

EA shares have de-rated after micro-transactions backlash in upcoming Star Wars Battlefront II title.

Damage to EA's brand is significant, but effect on earnings will be less than price drop would imply.

Short term impact during holiday season limited due to live services model.

Knock-on impact to MTX in other titles not definitive due to heterogeneity among IPs.

The sharp backlash against Star Wars Battlefront II's microtransaction system has led the headlines of gaming news sites for much of November and resulted in the current slump in EA's share price. The controversy is centred around the aggressiveness of the game's MTX and accusations of a pay-to-win system, where unlocking some skills and characters requires either long hours of grinding at the game or paying real money. Key characters from the IP like Darth Vader were unavailable without being unlocked. One online user estimated that (before recent changes) it would take over 4,500 hours of gameplay to unlock all the content of the game without paying real money - notable in a title which already retails for $60. EA's stock price responded by sliding 7% during November.

While the impact on EA's brand and online popularity has been significant, it's less clear how much this will impact the company's financials. Negative online sentiment and misleading headlines about plummeting sales have left the stock oversold, and the current price is an attractive entry point. I see two main concerns stemming from the controversy: the short-term impact on earnings for the current quarter, and the longer-term question over whether the backlash will force EA to scale back lucrative MTX systems in its future titles.

Revenue impact for company Q3

EA's revenue comps for company Q3 - which includes the all-important holiday season - stand at $1,149m. Management's pre-controversy goal of 14 million unit sales in the first 5 months of Battlefront II's release now seems out of reach. But the sparse sales data that's made the headlines has been misinterpreted and led to exaggerated views of the impact on revenues. Figures from the UK made a splash by suggesting the physical sales of the game were c.50% below last year's Battlefield 1. Physical sales now make up a minority of product revenue for EA, but more importantly low physical sales have a mixed record of predicting low digital sales (see Destiny 2). While overall digital sales figures aren't public, Blake Jorgesen, the company's CFO, reiterated as of November 28th that guidance remained unchanged for company Q3. EA's management has tended to guide consensus down in the past to leave themselves with a margin of error (the company has beaten consensus on adj EPS in the past 8 quarters) so EA's internal data may indicate that whatever the impact on sales, it can be absorbed within their margin of safety without altering revenue guidance.

Additionally, product revenue (physical and digital) only made up 43% of net revenue in company Q2 - with the balance coming from services (which encompasses subscriptions, MTX, and other post-sale revenue). So might services revenue for the quarter be imperiled by the decision to temporarily halt MTX for Battlefront II? Not necessarily. The Season Pass system from Battlefront I (which subscribed the player to regular content releases) was ditched for Battlefront II in favor of the now-hated loot crate system, which EA's CEO has associated with more long-term engagement from the community. With the switch to a new model, EA likely wasn't baking in an early windfall from BF II live services into Q3 guidance to begin with (management has claimed as much when they reiterated Q3 guidance).

EA also has other titles to pick up the slack in the meantime, with Need for Speed Payback and its sporting titles largely escaping the negative publicity that's befallen Battlefront II - despite also featuring aggressive MTX themselves.

Impacts on MTX in future titles

The larger worry is that the push back over Battlefront II's aggressive MTX system will lead to reduced levels of services revenue in future titles. But the controversy in Battlefront II came from two points: one is the perceived aggressiveness of the pay-to-win aspects of transactions the perception that EA was charging to unlock parts of the Star Wars experience that players felt should have been available off the bat. But this form of monetization was partially due to limits the amount of MTX revenue that could be derived from cosmetic changes owing to the rigidity of the Star Wars IP. "You probably don't want Darth Vader in pink", Mr. Jorgesen quipped at a recent conference. With less options for charging for cosmetic alternations to characters, EA mistakenly opted to go overly-aggressive with locking key parts of the content and giving overly large competitive advantages to purchasers - hence the push back. But the company's other titles can still continue monetizing live services by hewing closer to cosmetic alternations and lessening the pay-to-win aspects that have generated so much negative sentiment. Need for Speed and the company's sports titles (see: the Ultimate Team system) have largely gotten away with their own aggressive microtransaction systems.

The decision to limit access to key characters from the IP in a title that already retails for $60 was hamfisted and has clearly damaged EA's brand. But EA is no Blizzard or Valve, it's sales aren't driven by the EA brand itself but from the brand strength of its individual titles and the company's publishing competencies. Somewhat ironically, the existing weakness of the corporate brand means the damage is less than what could have been expected if Blizzard had implemented a similarly-aggressive MTX system. Outside the scope of the current quarter, it isn't clear that earnings have been impacted - and the impact within Q3 appears less than the market is pricing in.

EA is now trading at a sharp discount to its recent historical valuation range. It's current current 27 P/E ratio is below the c.32 P/E it averaged in the three months before the BFII controversy struck. Despite it's corporate brand being lacklustre compared to shinier peers like Activision Blizzard (41 P/E), E/A has a strong roster of titles with strong product brands and loyal followings - especially in sports. Last year's earnings of $4.8b are a healthy increase from 2013's $3.7b, and EA's continued shift to services revenue and digital sales has also boosted operating income from a disappointing $121m that year to $1.2b now. The negative online sentiment that pervades online conversation about EA - however warranted - might be overshadowing some attractive fundamentals.

I expect the catalyst will be the release of Q3 earnings, which I believe will be inline with guidance of $2.15 adj EPS. EA's brand took a hit, but the financials still look solid.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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