Electronic Arts: A Solid Business But Shares Trade At A Rich Valuation (NASDAQ:EA)

Investment Thesis

Electronic Arts (NASDAQ:EA) is an iconic video game developer and publisher that produces some of the largest franchises in the industry, including Madden, SPORTS FC, and Battlefield.

The firm is expert at monetising their titles and remains at the forefront of creative innovation within the field. EA has developed a highly efficient production pipeline that minimises costs while ensuring their games remain popular among consumers.

Current valuations are still a little rich, with the firm trading at around a 10% discount relative to a base-case scenario that already incorporates most of the 6% growth expected in 2024 (FY25).

Therefore, I rate EA a Hold at present time and look for either a more attractive entry price or a significantly enhanced growth outlook before upgrading my rating.

Business Profile

EA is one of the largest video gamer publishers in the world. The firm is a juggernaut within the industry with leading titles such as FIFA (now “EA SPORTS FC”), Madden, Formula 1, NHL, Battlefield and The Sims all developed and published by EA.

The game developer was one of the first to apply the concepts of additional “Downloadable Content” (DLC) and microtransactions into their games so as to extract more revenue from these titles even after the sale of the initial copy to consumers.

While initially frowned upon by consumers, the practice of releasing additional content at an extra charge has become an industry standard for video games publishers.

EA continues to lead the industry when it comes to extracting revenues from games, while also producing some of the most critically acclaimed titles to date.

A focus on franchises which see new titles published each year to coincide or replicate developments in the real-world (such as F1, soccer or football) have proven massively lucrative for the firm thanks to comparatively lower development costs for these ‘new’ titles.

Andrew Wilson continues to lead EA’s 12,000-head workforce, and I believe he is a great leader for the company. Wilson’s extensive 20-year tenure within the company suggests he holds a thorough understanding of the fundamental business characteristics of the video game industry.

EA’s Economic Moat

Video games have become an essential to the lives of billions of people across the globe. The industry has accordingly developed into a massively lucrative yet competitive market environment, with thousands of new titles and games released to consumers each year.

The ever-increasing levels of market saturation and a rapidly changing consumption landscape combined with fluctuating consumer tastes and preferences has made developing a moat within the industry incredibly difficult.

Nevertheless, I believe EA’s ability to consistently generate massive sales for their core franchises while also successfully expanding their portfolio of games into new categories is evidence of a narrow economic moat generated by tangible competitive advantages for the developer.

At the very core of EA’s narrow economic moat is their set of intellectual properties. Perhaps the most iconic of EA’s games are those categorized under the “EA Sports” segment. I consider the FIFA/FC, Madden, NHL, and F1 franchises to be the four cornerstones of this category.

These massively popular games tie-in with their real-life counterparts to allow fans and gamers alike to interact more with massively popular sports franchises such as the NFL or Formula 1.

The ability for these titles to appeal even to more casual ‘gamers’ by also attracting sports fans is a massively important factor for EA, as it greatly increases the customer base potentially interested in purchasing the games.

Furthermore, each new game offered by EA in these franchises is usually a more incremental improvement of the last title instead of a brand-new video game. This allows EA to cost-effectively generate new sales while also ensuring the overall popularity of the title is not affected.

Another invaluable set of IP’s owned by EA consists of their extensive portfolio of “shooter” games. Blockbuster franchises such as Battlefield, Crisis and Star Wars Battlefront are all massively popular series which continue to attract gamers even with their latest iterations.

EA also produces a variety of mobile games and titles aimed at more causal gamers, including the massively popular “The Sims” franchise of games.

While new releases in EA’s non-sports related segments often require more investment of both capital and time so as to ensure consumers are offered an enhanced product with each new release, the segment lends itself perfectly to DLC and microtransaction implementations.

The offering of additional in-game content allows EA to extract more revenue per consumer and per existing game title, which further boosts revenues and ROIC.

Broadly speaking, I believe EA’s focus on what are called “triple A games” (AAA) has proven to be a lucrative strategy for the firm.

Such blockbuster titles require more investment of capital and time compared to smaller releases. However, I believe the overall popularity and ability for these games to appeal to a larger audience allows EA to earn outsized returns on their releases compared to smaller developers.

I also see EA benefitting from some cost-advantages compared to rivals, which arise primarily from their massive scale and industry experience. A streamlined games production process pipeline appears to allow EA to expend less capital on each game developed compared to rivals.

This largely arises from what I see as a highly efficient capital structure, along with an almost unrivalled level of experience when it comes to developing titles.

Ultimately, it is Electronic Arts’ massive portfolio of lucrative franchises, an ability to accurately appeal to consumer tastes and preferences combined with an efficient operating structure that lead me to assign the firm with a narrow economic moat rating.

The reason I cannot award a wide-rating for EA stems from the overall levels of competition within the industry along with the lack of switching costs for consumers given the firm is a third-party games developer rather than an integrated platform and developer combination such as Nintendo (OTCPK:NTDOY) or Microsoft (MSFT).

Fiscal Analysis

In my opinion, EA is a wonderfully profitable firm. Current five-year running ROA, ROE and ROICs rest at 12.00%, 19.57% and 16.55% respectively, which are healthy both from absolute and relative perspectives.

The firm’s ROIC of 16.55% tangibly outpaces their current WACC of 8.99% with EA. This implies that EA is able to generate almost 7% in excess returns on their invested capital when compared against what it costs the game’s publisher to raise said capital.

I also really like the firm’s five-year average gross, operating and net margins of 74.59%, 20.31%, and 16.44%, respectively. The elevated gross margin illustrates just how efficiently EA is able to create new games, while the still solid 20% operating margin is illustrative of strong pricing power and popularity among consumers.

The most recent Q3 FY24 results released in January saw Electronic Arts generate solid results even amidst a soft consumer demand environment.

Total net revenue for the quarter was up 3.4% YoY to $1.95 billion, thanks to a solid 1% YoY increase in net bookings to $2.366 billion. The slightly unusual term “net bookings” is utilized by the firm to illustrate revenues arising from the sale of live services and full-games along with deferred revenue from online-enabled games.

The solid growth in live services revenues illustrates just how lucrative the additional sales derived after the initial purchase of a core game really are for the firm.

This is further highlighted by EA generating 68% of total net revenues from live services and other, while just 32% is derived from full game sales.

Key franchises such as EA SPORTS FC delivered 7% net bookings growth YoY, which I believe is a testament to the quality and impact the game has among consumers.

It is also worth considering that this growth came despite the previous year being a World Cup year, while simultaneously losing the FIFA name-tag from the title.

Other key franchises within EA SPORTS along standalone series such as The Sims, Madden, Apex Legends, and Star Wars Jedi Survivor continued to generate massive profits for the firm.

A busy FY24 release schedule saw multiple new games such as NHL24, WRC23 and F1 23 being complemented by updates to existing title such as The Sims 4 and Apex Legends to bolster revenues for Q3.

While the ability for EA to continue growing both net bookings and total net revenues amidst an increasingly bearish consumer demand environment is impressive, perhaps even more impressive is the firm’s decreasing COGS.

Cost of revenues as a percentage of total net revenues fell 3% from 30% in the previous year to just 27% in Q3 FY24. This solid decrease came as the firm continues to tightly control costs through ensuring their entire operational structure remains economically efficient.

EA’s ability as an entertainment company to perfectly balance creativity and innovation with business economics is truly exceptional in my opinion.

Seeking Alpha’s Quant calculates an “A”, profitability rating for Electronic Arts, which I believe is an accurate representation of the current situation at the firm.

EA’s balance sheets reveal an exemplary capital allocation structure characterised by excellent liquidity and smart utilisation of debt.

With just $3.28 billion in total current liabilities versus total current assets of $4.35 billion (of which $2.74 billion consists of cash), EA has outstanding short-term liquidity. This leaves the firm with a quick ratio of 1.20x and a current ratio of 1.37x, which is superb.

Total liabilities amount to $6.08 billion, while the company holds $13.6 billion in total assets. EA also has $7.53 billion in shareholders equity, which leaves the firm with a wonderful debt/equity ratio of 0.26x and a financial leverage ratio of 1.85x.

Such an incredibly low debt/equity ratio illustrates just how conservatively the firm has expanded over the past decade, despite multiple acquisitions of smaller game developers and a massive growth in overall sales.

As of Q3 FY24, EA only has $1.88 billion in long-term debts. This very small portion of debentures appears to be very well financed, with a majority of senior notes maturing only after 2031.

This superbly managed debt profile once again supports my hypothesis that Electronic Arts engages in excellent capital allocation practices with a real focus on sustainable growth and long-term stability over short-term gains or astronomic growth.

Moody’s credit ratings agency affirmed a Baa1 credit rating for EA’s LT issuer rating. The outlook remains stable. Moody’s classifies “Baa1” credit ratings as being of a speculative grade due to some “speculative elements” within their analysis.

Finally, EA also pays a small dividend to investors, with Seeking Alpha’s Dividend tab informing us of a 0.58% FWD yield and a 10.28% payout ratio.

While this dividend is small, I believe it signals a desire to better reward shareholders of the company. Since the start of the dividend in 2020, EA has managed to grow it for 3 years straight which is very positive.

EA also repurchased $325 million worth of shares in Q3 FY24, which once again supports my thesis that the company is set on rewarding shareholders handsomely for their investment into the firm.

EA’s management suggests total net revenue for Q4 should be around $1.80 billion, with a diluted EPS somewhere between $0.20 and $0.68. This large range of guidance suggests to me that management is not entirely confident on the strength of the current demand environment and potentially foresees a recessionary event occurring in the U.S. economy in the coming months.

Overall, I really like Electronic Arts’ fiscal profile. The company generates solid returns on invested capital and cash flows while having excellent liquidity and strong underlying business economics.

Valuation

Seeking Alpha’s Quant calculates a “D” valuation rating for EA stock. I believe this is an excessively pessimistic letter grade which incorrectly suggests an overvaluation in shares.

The current GAAP P/E TTM ratio of 33.11x is certainly quite elevated and certainly not indicative of a deep-value opportunity. Nevertheless, the ratio is down 18.5% from 5Y means, which illustrates the drop in valuations over the past half-decade.

I also want to highlight EA’s P/CF FWD and P/S TTM ratios, which are 16.64x and 4.64x respectively. These very elevated metrics illustrate how much growth is being priced-in to the current valuation and leaves very little room for underachievement over the coming years.

Still, both of these ratios are down 13% and 19% respectively, showing how much the stock price has cooled-off relative to 5Y averages.

Over the last five years, EA shares have been soundly outperformed by the broader tech market (represented by the popular Nasdaq-100 tracking QQQ index fund (QQQ)) to the tune of almost 115%.

This underperformance came after weaker than anticipated results post COVID-19 failed to support the lofty valuations accrued during this period of intense demand for gaming.

The last six-months have seen EA stock underperform the broader markets by around 15% as even the solid quarterly results in FY24 have been unable to warrant a further appreciation in the firm’s valuations.

To gain a more objective and quantitative perspective of the value present in the stock, we can use The Value Corner’s Intrinsic Valuation Calculation.

Using the current share price of $130.69, an estimated full-year 2024 EPS of $7.15, a realistic “r” value of 0.07 (7%) and the current Moody’s Seasoned AAA Corporate Bond Yield ratio of 5.01x, I derive a base-case IV of $141.30 per share. This represents just an 8% undervaluation in current prices.

When using a bear-case CAGR value for r of 0.03 (3%) to reflect the impacts a recessionary market environment would have on the levels of disposable income among consumers, shares are only valued at around $91.10 suggesting a massive 43% overvaluation in the stock.

The massive difference in valuations between my base and bear-case scenarios illustrates how in the short term (3-12 months), essentially anything could happen to EA’s stock price.

The significant levels of growth already incorporated into the current share price leaves little room for underachievement by the firm with any negative news potentially placing real downward pressure on shares.

In the long-term (2-10 years), I think that given EA’s solid profitability, liquidity, and economic moat, it could be argued that the firm is well positioned to generate sustained long-term growth for shareholders.

A great set of franchises and an industry-leading games production pipeline bolster the firm’s ability to compete and extract revenues in what is otherwise a highly competitive market environment.

Electronic Arts’ Risk Profile

EA faces risk from competitive pressures and potential for failed execution.

Given how intensely competitive the games development and publishing industry is, it is absolutely critical for EA to continue innovating and leading the charge on new and creative ways to attract customers to their products.

While the franchise model of releasing incrementally updated games each year does generate massive profits for the firm, EA must ensure their titles do not become stale or appear as a poor value to consumers.

Equally, EA is not the only AAA developer with the likes of Microsoft, Take-Two Interactive (TTWO) (who own Rockstar Games, the developers of GTA and Red Dead Redemption) and Nintendo all competing to attract customers away from one another.

Microsoft and Nintendo are particularly fierce competitors to EA, given their wide economic moats that stem from a more closed-loop business model.

Many exclusive titles that tie in with a particular gaming console provide more switching costs and pricing power for game developers such as Microsoft. Still, much of the ultimate profitability of a title depends on its popularity among consumers, which is where EA excels.

Another source of risk arises from the potential for failed execution of new releases to tarnish either one of EA’s new titles or even franchises. While one less successful release shouldn’t hurt the company too badly, the potential for multiple commercial flops could significantly harm the firm’s topline growth and reputation.

I do not see EA being exposed to any real ESG related risks. The firm is a staunch advocate for equal pay, environmental conservation, and the protection of children online, which helps mitigate any real threats facing the firm.

Of course, both traditional and ESG related risk analysis is a highly subjective endeavor, which is why I implore you to conduct your own research into these topics should they be of concern to you.

Summary

Overall, EA is another business which I fundamentally believe is a wonderful enterprise. The firm produces high-quality games and has become experts and maximizing both the enjoyment consumers get from these titles and the sales the company is able to extract from each release.

Excessive expectations post-COVID have left shares trading sideways for most of the last five years. Nevertheless, EA continues to grow at a solid pace, with multiple releases in late Q3 most likely bolstering the firm’s total FY24 results.

Current valuations are quite pricey, however. While the growth prospects do suggest a GARP opportunity may be present in EA shares, I see most of the growth for FY25 already baked-in to the share price.

Therefore, I am forced to rate EA a Hold at the present time. I like the business, but a greater margin of safety would be required before I would feel comfortable issuing a Buy rating for the stock.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.