Live Services Are Like Taxes For Gamers

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About: Electronic Arts Inc. (EA)
by: Edgar Torres H
Summary

EA continues to receive bad press because of its Live Services growth strategy.

Nevertheless, it continues to increase revenues QoQ. Mainly because of secular growth.

I break down EA's sources of revenue and find that as Live Services increase, EA's game sales slow down.

From this relation, it looks like Live Services behaves like a gaming tax. If this segment increases, it could have a negative impact on game sales in the future.

Bad Press

Electronic Arts (NASDAQ: EA) has had much bad press after Battlefront 2. I think this is well deserved. They continue to disregard their customers' feedback, especially about their recent business model of forcing gamers to double-pay to unlock the game's full range of features.

Although this trend is not exclusive to EA, it seems like it is receiving most of the criticism. On the other hand, management shows little concern about blowback from microtransactions. All in all, I think it is hazardous for gaming companies to continue to ignore gamers' complaints.

Gaming Secular Growth

Nevertheless, it looks like EA is fine for now. Although Battlefront II had disappointing sales, overall the company did fine. EA continues to be profitable and grow revenues and profits at a decent pace year after year.

I noticed that a figure that gets quoted frequently is the gaming market projected growth from NewZoo. I'm talking about the graph below.

Source: NewZoo, November 2017.

Naturally, I think it is important to cite this graph as proof of a bullish case for EA (or any other gaming stock). However, investors should know some caveats that I do not see mentioned before committing capital to EA's stock.

First of all, most of the growth you see on that chart is coming from the mobile segment of the market. The rest of the gaming market combined is expected to grow at a much slower pace than mobile. This consideration is important because mobile accounted only 13.88% of total revenues for Electronic Arts.

Source: NewZoo, author's elaboration.

From the table above you can see that most growth is going to come from the mobile segment. The other sections in the gaming market (like PCs and consoles) are going to grow at a much slower pace.

Source: NewZoo, author's elaboration.

If you look into the compounded annual growth rate (OTCPK:CAGR) from 2016 to 2018 vis a vis the CAGR from 2018 to 2020, you will see a material drop. Mobile grew from 2016 to 2018 at almost 20% a year, while it is currently expected to "only" grow at 11.75% from now to 2020.

Source: NewZoo, author's elaboration.

Although mobile will continue to grow at a robust pace, the rest of the gaming market will not. It is worth noting that the rest of the gaming market will continue to grow an average pace for the foreseeable future. However, if gaming stocks want to provide alpha going forward, they will have to achieve additional growth by gaining market share rather than benefiting from secular growth.

Breaking Down EA's Revenues

In fact, if you look into it, EA has very little exposure to the mobile market as a percentage of total revenues. What moves the needle for EA is game sales and live services. Live services consist of advertising, subscriptions, extra content, etc.

Source: Electronic Arts - Investor Relations, author's elaboration.

The full games segment is the traditional side of gaming stocks. They develop games and sell them to the public. Here you will find sales of Battlefront II and Battlefield for example. The packaged goods and other section primarily consist of sales of games in physical form.

Between both of these segments, they roughly account for 50% of EA's annual revenues. These two segments are EA's traditional business in a way. Historically, it has grown at an average of approximately 2% Quarter over Quarter. However, the past few trimesters we have seen a slowdown in this segment.

Source: Electronic Arts - Investor Relations, author's elaboration.

Notice how the past couple of quarters seem to be an inflection point of sorts. Compare it with Live Services. It kind of looks like the traditional gaming segment of EA slowed down the most right after Live Services presented its most substantial growth.

Source: Electronic Arts - Investor Relations, author's elaboration.

The problem is that live services revenues come from precisely the type of practices that gamers seem to despise the most. This section includes microtransactions and downloadable content. Although it also has esports, but it is negligible at the moment.

Source: NewZoo, November 2017. Esports will grow fast, but it is unlikely to move the needle for EA.

The following is a pie chart of revenue by type for the last four quarters of EA.

Source: Electronic Arts - Investor Relations, author's elaboration.

From their annual report, it looks like EA plans to double down on Live Services. They think that this allows them to profit from games that have a lot of replayable value (like FIFA, Madden, Sims, Star Wars, etc.) This strategy is theoretically good for shareholders because these services enjoy better margins than the traditional side of the gaming business that I previously explained.

Source: Electronic Arts - Investor Relations, author's elaboration.

However, it is doubling down on exactly what gamers hate.

I think it is going to be interesting to see how this growth strategy works out for EA. We already see a slowdown in game sales because of these tactics. However, at the same time, their revenues increase. It is like they have become better at extracting more money from fewer gamers, at lower costs.

Still, at the end of the day, EA needs gamers. Moreover, if it continues to alienate them through Live Services, it might reach a tipping point where they sell fewer games and fewer games, and therefore extract less and less from them (despite live services growing).

Conclusion

I think about it like taxes. There's an optimal point at which you can tax your population without staving off growth. Beyond that point, you begin to receive less money even while taxing your citizens at a higher rate. In this allegory, Live Services are the tax rate for gamers. Tax them at a high enough rate and EA might run into deep (may be irreversible) trouble.

At any rate, it is just food for thought. I will be waiting for EA's upcoming earnings report to perform a valuation of the business with updated financial information.

I hope you found the article interesting and wish you good luck in your investments.

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.