The Real Deal on Wall Street: The Blunt Truth on Electronic Arts
For as long as I have had coverage on Electronic Arts (NASDAQ: EA), the bulls have tended to outnumber the bears.
The videogame industry is very exciting, full of splashy gamer and analyst conventions to show off the next big game or piece of technology. Therefore, I can’t blame the run of the mill analyst for being externally stimulated to the point it subconsciously impacts a keystroke in a DCF model.
Then there is the ever-growing installed base of console argument; even if hardware sales do not meet analyst estimates in a given month, units are still being carried through the door, which equates to opportunities to sell packaged goods and digital content.
I was negative on Electronic Arts pre-earnings and reiterate that position today in response to earnings. While the sell-side is trying to do a good job in sweeping under the rug poor calls on Electronic Arts for the last twelve-months (buy ratings are being maintained, price targets slashed, or neutral ratings reiterated and price targets slashed), I want to cut through all these disaster control maneuvers and strike the heart of the story on Electronic Arts. Here is the real deal:
The hotly anticipated Star Wars online game (aka an "MMO", short for massively multiplayer online), that is by Wall Street, had its subscriber count fall to 1.3 million from 1.7 million in the preceding quarter. Management attempted to send the analyst community (and queued in shareholders) off the trail of underperformance by stressing more people are paying on a sequential basis.
Umm, come on guys. What happened is that casual gamers, fans of Star Wars, and hardcore picky gamers did not fork over the credit card once their trial subscription ended, likely as the content didn’t really bite enough. Electronic Arts had to grow the subscriber count (non-paying first) to Star Wars prior to a second half of the year offering from a competitor and in the face of Street expectations, and has failed to bring that front and center.
Now, management is left to provide assurances, such as the core gaming crowd will be kept on Star Wars through new content releases for the platform and that the game only represents a mid-single digit percentage of total company profit. Remember, however, Electronic Arts dumped a ton of money into developing and marketing the game and in my view, 1.3 million paying subs does not get the job done from a returns perspective.
Bulls on Electronic Arts point to a growing digital portfolio of titles as a long-term earnings driver. Totally in agreement, I have been impressed by the transformation of the company’s digital content portfolio in the past three years.
However, I think Electronic Arts is now inclined to reinvest proceeds from its digital business in support of development for “Gen4” consoles. Consequently, earnings per share upside strikes me as contained in the medium-term.
As Electronic Arts climbs the ranks in social media and smartphone gaming, so will others that are smaller and on the ground floor of the newest trends. Therefore, one should be conservative in thinking about the long-term profit margins on EA’s digital business.
Sure the company’s large cash hoard affords it the opportunity to acquire growth (as it has done in the past), but it may not recognize the competitive threats that are stealing market share at the drop of a hat. Electronic Arts is then forced to pay exorbitant valuations to buy businesses to prevent market share loss and stay on the defensive with an industry that evolves daily.
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