Electronic Arts: Great Business, Too Expensive (NASDAQ:EA)

Thesis

Electronic Arts (EA) is a video game company that releases major titles from brands such as FIFA, Madden, and Star Wars. The company reported poor Q1 earnings, missing their revenue target by 14 million and EPS by $0.01 (normalized). Despite these lukewarm results, we like EA’s recurring business model and ability to continuously release very popular game titles. We believe that the company will continue to post strong earnings growth driven by these two revenue streams. Overall, while we believe that EA’s business is very solid with great growth potential, their valuation is too expensive to justify an investment.

Continuous Strength In New & Existing Franchises

EA’s first quarter results highlight the continued success of their flagship franchises and strategic initiatives. Notably, EA SPORTS FIFA achieved its most significant Q1 performance to date, with FIFA Ultimate Team attracting substantial engagement and FIFA Mobile drawing over 65 million new players in Q1 alone. This impressive momentum in the FIFA ecosystem shows the great appeal of interactive soccer, positioning the company to capitalize on a robust and growing community. Star Wars Jedi: Survivor’s successful launch and expansion to PlayStation 4 and Xbox 1 illustrate the power of iconic IPs, fostering continued engagement and expanding market reach.

The transformative shift of The Sims 4 to a free-to-play model has shown impressive growth, with 4 million new players and a broadening global audience. Additionally, EA’s mobile business exceeded expectations, due to successful releases such as Star Wars: Galaxy of Heroes, The Sims FreePlay, and the new entrant Lord of the Rings: Heroes of Middle-Earth. Additionally, Apex Legends remains a core title, with roughly 18 million active monthly players and strong player retention.

As EA navigates the evolving gaming landscape, this portfolio of well-established IPs, innovative approaches, and continued commitment to community engagement, we believe the company shows a great future of strategic expansion and capital appreciation.

Upcoming Releases

EA’s future releases appear to show great promise, with EA unveiling the ambitious EA SPORTS FC 24, accompanied by advancements in FC Mobile and FC online in Asia. So far, the new release has garnered an overwhelmingly positive response, with over 2.5 million viewers over the live event, strengthening its position as a leader in authentic football experiences. EA’s newly established long-term global partnerships include collaborations with the UEFA and the Premier League, which will add extensive licensed content to FC 24, enriching the player experience with real-world content. We believe that FC 24’s release will be a crucial driver behind EA’s new game sales growth. In addition to FC 24, EA has a robust pipeline of upcoming titles like Dragon Age, skate., and EA SPORTS College Football shows the company’s dedication to sustaining fan engagement and steering towards a dynamic growth trajectory. We believe that these new titles will drive EA’s position as a market leader within the gaming industry.

Q1 Results

The company reported a strong increase in net bookings, reaching 1.58 billion, reflecting a solid 21% YoY growth attributed to the outstanding performance of FIFA and the successful launch of Star Wars Jedi: Survivor. Additionally, the diluted EPS surged by 32% YoY, driven by bolstered revenues and great expense management. However, despite substantial growth in both new and established titles, net bookings still missed expectations by 14 million, while EPS missed by $0.01, causing EA’s stock price to decline 7.2% immediately after Q1 earnings.

Despite the lukewarm earnings report, we believe that EA games is still poised to grow its earnings with newfound successes in blockbuster releases. Full game sales witnessed an impressive 143% YoY increase, fueled by the success of FIFA and Star Wars Jedi: Survivor, slightly offset by weaker performance in Apex Legends. On the other hand, live services (in-game purchases) displayed steady growth at 4% YoY. Despite the setback in stock performance, we are fans of EA having recurring live services as the core business model, as it ensures a consistent revenue stream from an established player base. Alongside the potential of upcoming releases and the ongoing strength of existing franchises, we believe EA is well positioned for sustained growth in the future.

Strong Balance Sheet Resulting In Dividends And Buybacks

With a decent leverage ratio of 0.85, assets that are more than double liabilities, and a healthy cash reserve of 2.4 billion, EA’s financial position remains impressively sound while consistently generating profits. This strong balance sheet has allowed the company to prioritize investor returns, which has been evident in their proactive approach of returning $377 million through share buybacks and dividends in Q1 alone. The cumulative impact of these efforts has led to an impressive sum of 3.2 billion in share buybacks. On the other hand, while EA’s current dividend yield is rather low at 0.62%, the company’s strong financial trajectory indicates future dividend growth. As EA continues to exhibit the strength of its financial position, the emphasis on maximizing investors through these buyback initiatives shows EA’s commitment to delivering substantial long-term shareholder returns.

Despite Lower Profitability, Bookings Have Grown Substantially

Despite not fully rebounding to pre-pandemic levels, EA’s revenue has maintained a consistent upward trajectory, with a 5 year compound annual growth rate (CAGR) of 8.3%. Notably, the absence of margin expansion is a consequence of the company’s strategic investments in new avenues, notably securing licenses for UEFA and the Premier League, alongside the revival of their college football games. These initiatives have aligned with the steady rise in research and development, marketing, and selling, general and administrative (SG&A) expenses.

However, we believe that as EA undertakes efforts to reduce expenses and these investments begin to taper, there is potential for margins to regain stability and revert to pre pandemic level. This anticipated optimization of cost structures, combined with the prospective growth of EA’s product portfolio, positions the company to enhance its profitability in the long run.

Valuation

Even with all these positives, when looking at valuation, EA appears to be too expensive. We used Graham’s Formula for valuation, with the assumption that EA will report a fairly good EPS CAGR of 9% and EPS of $6.80, which were based on consensus earnings estimates. When plugging EA into this model, it points to a downside of 24%. We believe that this was due to EA’s relatively slow earnings growth paired with a low EPS. Even though EA’s stock price has dropped 13% in the past few weeks, we believe that the company is still overvalued.

Additionally, when we look at EA from a relative valuation, their financial metrics are mixed when compared to competitors. EA’s growth figures were on-par with competitors Activision (ATVI) and NetEase (NTES), but beaten in growth figures by Take-Two (TTWO) and Roblox (RBLX). ROE, gross margin, EBITDA margin, and Debt/Equity were also approximately in-line with competitors. Finally, while EA’s EV/EBITDA was the lowest, their P/E was the highest. While EA’s valuation appears to be comparatively fair, its valuation from an independent standpoint was too high. Therefore, with this information in mind, we believe that EA is currently overvalued.

Risks

The competitive landscape poses a significant risk to EA’s business and financial performance. Intense competition within the interactive entertainment industry, ranging from established players to emerging startups, could undermine EA’s market position. The growing convergence of gaming, technology, and the entertainment sectors has led to increased competition from larger technology companies, which may divert player attention, resources, and talent. Despite EA’s efforts to create compelling products and services, the success of which hinges on resonating with consumers, there’s inherent uncertainty in predicting player preferences and market trends. The industry’s reliance on established franchises with strong brand recognition makes penetrating certain categories challenging, and the potential for competitors or other entertainment entities to capture a larger share of consumer spending or leisure time than anticipated could result in underperformance.

Another significant risk factor for Electronic Arts is the rapid pace of industry changes, potentially leading to a failure in anticipating or effectively implementing emerging technologies, successful business strategies, distribution methods, or services. The dynamic nature of the industry demands proactive anticipation of market shifts, often requiring years of advanced planning. EA’s investments in various areas such as business strategies, tools, technologies, distribution methods, products, and services might not yield the expected returns, and there is no assurance that the chosen tools, strategies, or offerings will achieve the desired financial outcomes. Additionally, the company could face challenges in seizing opportunities swiftly or keeping up with industry changes, potentially leading to loss of consumer-favored tools, technologies, product engagement methods, which could negatively impact the company’s financial performance.

Conclusion

While we believe that EA is a great company with new release opportunities and a consistent long-term revenue stream, we found that the company is simply too expensive to justify an investment in. Although our rating is a hold at current prices, we may consider starting a position in EA should the company’s stock price drop.