EA Successfully Proves Itself As A Value Investment With Hidden Growth Opportunities

About: Electronic Arts Inc. (EA)
by: Roman Luzgin

EA has recently reported its quarterly results, beating across the board.

Despite the fierce competition and several missteps, EA managed to maintain its financial stability and deliver positive surprise to investors.

The publisher's Games-as-a-Service strategy ensures steadily growing cash flows and stable earnings.

Several promising events like a launch of Apex on mobile and in China can boost the stock significantly. The events are not modelled in the current forecasts.

This provides a valuable buying opportunity with a target price of $120 by the end of FY 2020.

(Source: EA)

At the beginning of May, Electronic Arts (EA) reported its results for FQ4 2019, significantly beating on EPS (by solid 35%) and on revenue (by about 14%). Although the stock has initially reacted with a huge jump of about 9%, the subsequent movement has not demonstrated the same level of positivity, and the price returned to the pre-earnings level. At the moment, this creates a valuable buying opportunity, and here are the reasons why.

Chart Data by YCharts

EA reported decent earnings despite concerns over its titles

The picture drawn by the financial report turned out to be significantly more positive than many analysts expected it to be. In the quarter, the revenue grew about 9% year over year, signifying positive change despite the increased competition in the market (specifically, from the likes of Epic Games' Fortnite and several titles by Activision (ATVI) and Take-Two (TTWO)) and certain missteps that we will discuss later.

The major highlight is clearly the continuing growth of Live Services. It is reported by EA that digital net bookings associated with services grew about 24%, from $679 million in Q4 2018 to $845 million in Q4 2019. In light of the trend, it can be expected that the corporation could reach about $3 billion in net digital bookings from services already this financial year. Digital bookings allow video game corporations to retain a significantly higher portion of revenue, compared to physical sales. This acts as an additional source of income growth even during the times of low market growth.

In total, "Services and other" category earned EA $3.36 billion in FY 2019, up from $2.56 billion a year ago.

(Source: FY 2019 Annual Report)

This point is important to note since EA's focus on recurring revenue, growing services, and shorter development cycles is a significant advantage for the stock, despite the fact that there can be some opposition from the gaming community (more information on the topic can be found here). This goes somewhat in contrast, for instance, to such companies as Take-Two, which are liked by players but rely on big hits with significant budgets to remain competitive.

The relevance of EA's business model is evident as it allowed the publisher to overcome the issues related to Anthem, the AAA (big budget, high quality) title launched in EA's Q4. To remind, the game experienced significant technical complications at launch, including server problems and bugs. This led to the fact that some players canceled their pre-orders or temporarily abandoned the game.

However, this did not prevent EA from growing its revenue by almost 9% in the quarter, mostly thanks to the unexpected success of the free-to-play title Apex Legends and general business diversification. Therefore, EA proved once again that having strong studios in its portfolio, coupled with an establishing a stable business model focused on cash flows, can reduce the risk of any failures.

These hidden growth drivers can boost the stock significantly by the end of 2019

It seems EA is well-positioned in the current video games market. However, what makes the stock attractive is the number of extremely valuable opportunities that can drive the stock price in the near future but are not included in the current analysts' forecasts.

The first major point here is the inevitable launch of Apex Legends on mobile, which was confirmed by the management during the earnings call.

We are in advanced negotiations to bring Apex Legends to China and to mobile, and we will update you on timeframes when those negotiations are concluded.

The platform proved to be a solid place to monetize free-to-play games, evident by the success of the aforementioned Fortnite and some other titles. Thus, Fortnite generated about $500 million in iOS revenue in less than a year after the launch on the platform.

It is clear the widespread use of smartphones makes mobile one of the crucial platforms due to the low initial price barrier. It is forecast that the number of smartphone users will top 3.8 billion by 2021, about half of the world population. This means convincing just 2% of smartphone users to try the game would result in more additional players than the current total number of 50 million registered by Respawn Entertainment, the developer.

Regarding the potential mobile revenue, it can be calculated that every 50 million users may generate about $140 million in quarterly revenue. This is based on the study that shows about 4% of users make in-app purchases with paying users spending $70.27 each on average during the 90-day period. Since EA also offers seasonal passes and can potentially include some advertising in the mobile game, the number may be higher in reality.

Notably, it seems that EA will pay more attention to the mobile platform in fiscal 2020. During the earnings call, the corporation revealed that two new mobile games are set to see soft launches in fiscal 2020.

Moreover, EA is currently negotiating the deal to get Apex to the Chinese market. According to the company's officials, this is only a matter of time, and the negotiations are going as planned. It is clear the vast number of potential players make China an attractive market for EA and finalizing a deal may result in a huge increase in the number of players.

Regarding the tensions between China and the US, it is stated no impact should be seen when it comes to the game.

We haven't heard anything or seen anything that would imply pressure based on any of the current trade talks. And our hope is that whatever is discussed is it settled in a way which it helps us even deepen our partnerships with those players in those markets.

Most of the events are not modeled in net bookings forecast for FY 2020

The current situation with EA stock is quite unique as all the aforementioned games and expansions are not modeled in the forecasts. It was stated during the earnings call:

Apex Legends is easily the fastest-growing franchise we've ever had, and we hope to build a live service that entertains players for years to come. Given the exceptional nature of the game, it is appropriate to take a cautious approach to financial modeling. Thus we are forecasting net bookings in the range of $300 million to $400 million.

Note that this assumes no contributions this year from any future mobile version, or a game in the Chinese market.

We will start early user testing for two new mobile games this year, in line with our intent to give our games more time in soft launch, and we are not modeling any net bookings from either of those games in fiscal 2020.

The company guides $5.4 billion in GAAP net revenue for 2020, with EPS reaching $8.56 (this includes a one-time tax benefit of about $5). Modeling the launch of a mobile version of Apex Legends in Q4 with around 60% margin can add about $0.2-0.3 in EPS, based on 306 million diluted shares outstanding. This alone may result in about 7% growth in stock price.

Adding here potential revenue from Apex in China and from two new mobile games the corporation plans to launch in FY 2020, the hidden upside may equal to about 10% from these events alone.

EA is a solid buy with an upside from hidden opportunities

To sum up, in Q4, EA proved to be a value investment as the company continued to generate stable recurring revenue from existing franchises and new titles. The publisher made almost $5 billion in sales, delivering a positive surprise to investors. This was achieved despite certain pitfalls such as the rough launch of Anthem and increased competition from Epic, Take-Two, and other publishers.

What makes EA stock especially attractive at the moment is the opportunities which the company will try to take advantage of in the near future and which are not modeled in the current forecasts. These include the launch of Apex Legends on the mobile platform, the launch of the game in China, and several new mobile games. Moreover, FY 2020 will see a new Star Wars game by Respawn Entertainment, a critically acclaimed studio behind Titanfall and Apex Legends, and the first full year of EA access, a game subscription service, on all platforms, including PlayStation 4.

Regarding valuation, it can be expected the stock can reach the level of around $120 by the end of FY 2020, based on a 7% upside from Apex and 12-13% organic growth modelled in the current market cap. This can be calculated with $5.11 EPS for 2021 and 21.35 potential forward P/E, which gives us an assumed future price of $109, 12.4% higher than the current level. If the mobile version of Apex or the move to China will see light earlier than Q4, the price target may be achieved faster.

(Source: Seeking Alpha)

When it comes to risks, the list of threats includes EA's potential inability to reach an agreement with China and certain dependency on the success of the upcoming Star Wars game. Importantly, the current stock price is about 50% below its recent highs, which can provide additional margin of safety.

Chart Data by YCharts

If you enjoyed this article and wish to receive updates on our latest research, click "Follow" next to my name at the top of this article.

Disclosure: I am/we are 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.