Description

Thesis

Electronic Arts (EA) is a Redwood City, CA based company that makes games that can be played on video game consoles, computers, and mobile devices.  The company has been publicly traded since 1989 and has long been one of the larger players in the video game business.  By platform, sales are roughly 28% Xbox, 28% Sony Playstation, 27% PC’s, and 17% mobile devices & other.

EA had an impressive financial history up through about 2005.  The driver of this performance was sales through video game consoles and PC’s.  Starting in 2006, financial performance fell off a cliff and it has not recovered.  Gross margins and sales have remained steady but operating expenses (SG&A and R&D) have increased by roughly 15-20% of sales.  The stock price has run up in the past several months, I believe in anticipation of the upcoming introduction of new consoles by Sony and Microsoft.

I think that EA is a short and is worth ~$12/share or less.

• The business is not very good and has not been since 2006.  This is a lot like the movie business, where the upside is captured by the IP owners and the game creators who are free to shop their services.
• The development of the marketplace and continual lowering of barriers to entry should result in the business worsening over time.  There are upstart competitors who are eating EA’s lunch with a much different cost structure.
• Management has been around a long time.  They have an atrocious capital allocation record.  They have a history of making optimistic comments about the business and industry that do not pan out.

Details

The business is not very good.

• As a rough cut, EA has zero retained earnings over its entire history.  Management likes to talk about how it has 8-10 valuable franchise titles, but it has had this portfolio for a long time and has not made it work.
• Management uses inflated adjusted earnings numbers.  In the past 5 years, the company has $900m stock-based compensation, $424m restructuring cost, and $75m legal/acquisition costs.  For my purposes, I add back all the expenses except I dock them fully for SBC and I add back $50m per year in normalized restructuring.  Based on that, I Get Adj EBITA for the 2011-2013 of $118m, $177m, and $153m.  I don’t think there is anything terribly distorting in those numbers.
• In the past 8 years, the company has produced $$1.4b FCF (CFO less Capex).  They have spent $2.4b on acquisitions.  They have spent $1.6b on share repurchases and sharecount is flat over that period.
• Bulls point to the pre-2006 margins and assume that EA can get back to those numbers.  I think this is unlikely to occur because the business has become structurally worse due to the rise of smartphones and casual games.
• EA doesn’t own much valuable IP.  Of their top 8 titles, only a handful are owned by the company and of those the only one with any real unique value are Sims and Simcity.  The others are ones like “Battlefield” and “Need for Speed” which are more generic and susceptible to competitive pressure.  EA’s big sports titles, the football Madden franchise and soccer FIFA franchise, all make hefty licensing payments to their partners.  In addition, the console players also extract a certain degree of leverage over EA via per game fees.
• I think this business is a lot like the movie business (or the investment banking business, for that matter) as described above.  The movie studios have never been great businesses, and the structure here is similar with the talent capturing much of the financial upside.  In addition, video games are even more susceptible to competition because at least the major movie studios have a lock on theater distribution, whereas digital video games are moving towards a direct download model.

The business is worsening.

• Over the past decade, the idea of what is a “video game” has changed a great deal with the rise of smartphones and tablets.  It has become much easier and cheaper for people to develop popular games.  In, say, 2003, it may have taken a large team of developers many years and tens of millions of dollars to produce a game and then required access to a retail distribution infrastructure to sell the game.  Current hit games can be developed in weeks or months by one or two people and then sold directly through an App store or online.  Because of this, there has been a flowering of quality games at very low prices.  While these are somewhat different than the big, complex titles that EA produces, there is increasing convergence.
• EA management points to digital as an area of rapid growth and opportunity, but I think that the increased competition will prevent this from ever being a very good business.  Witness the rise and fall of Zynga and EA’s 2011 purchase of PopCap Games for $732m that has been a flop.
• There are upstart firms which are moving upstream to compete with EA.  Valve is a hot company based in Seattle founded by an ex-Microsoft employee.  The company is considered a rising star and is valued on private markets north of $2b.  The company is run entirely by engineers.  They have developed the leading third-party PC download platform, called Steam.  EA’s competing platform, called Origin, pales in comparison and does most of its business because EA makes its titles solely available there.  I think it is fair to characterize EA as a big dumb legacy player that is being successfully attacked from below.  There are multiple other examples of smaller players coming out of nowhere to do extremely well in the smartphone game business, such as Rovio or Supercell.  See recent short writeup of Gungho as well.
• There is a lot of talk on the bull side of a new console cycle helping the company.  Microsoft and Sony are both launching next-generation consoles in late 2013/early 2014.  EA did not benefit from the last console launch in late 2005, and it is unclear that the new consoles are going to do very well at all given the competitive pressures described above.  I note that the console makers are putting a much larger emphasis on general entertainment than as game devices.

Management is not very good.

• EA has had pretty continuous management for over 20 years, so there is not a story here of a new management recently coming in and bungling things.  John Riccitiello was President and COO of the company from 1997-2004, went off to become a partner at Elevation Partners for several years, and returned as CEO in 2007.  He was recently fired.  Larry Probst was CEO from 1991-2007, remains Chairman, and stepped in as interim CEO.
• Management has made a number of large acquisitions, almost all of which have turned out poorly.  This does not even count their failed attempt to acquire Take-Two Interactive (TTWO) in early 2008 for $2.1b or $26/share in early 2008 right before TTWO crashed.  TTWO currently trades for $16/share and I think is similarly overvalued.
• Management says ridiculous stuff that causes you to question their judgment.  In addition to their constant referral to how great the business is with very selectively used numbers, they haul off and say stuff like the following:

This is from the COO in a conference call in May 2012:

“Our assets. We talked about the brands. I did skip by PopCap; but our acquisition of PopCap, this is the year I think it is going to be accretive to us. This is the year that we are going to deliver against the projections that we have made.

As we said on the call, a strong year ahead for PopCap. It is our first full year since the acquisition. The IP speaks for itself -- Plants vs. Zombies, Bejeweled, Zuma, Peggle -- all of the stuff that we feel are intellectual property assets that will still be around 20 years from now.

We think about the Pac Mans and the Tetrises, the things that we have all played over the years that have withstood the test of time.We think they have intellectual property that absolutely withstands the test of time.

Bull thesis continues to evolve

• EA has been promoted as a long by various value investors at points over the past 5 years (see Value Investor Insight October 2010, VIC writeup April 2012), but the financial results have yet to improve as decribed.  These have generally taken management’s word that they were going to successfully cull unprofitable titles, launch successful new social games, and develop hit new products like the 2012 Star Wars game, which have not come to pass.
• The Star Wars game is an instructive example.  EA started developing a massively-multiplayer online role playing game (MMORPG) based on Star Wars (for which they paid licensing fees) in 2009.  They reportedly spent over $100m on development and were talking big when they launched it in 2011.  The goal was to recreate the success of Actvision’s World of Warcraft, which is a goldmine.  The way these games work is that players pay monthly subscription fees to play and there is a big network effect if you have a hit game.  Star Wars has been a huge dud and the company recently switched it from subscription to free-to-play, which the hopes of getting increased revenues from adds and in-game sales of digital goods.  The company no longer even mentions it on conference calls.  I think something like World of Warcraft is flukey and very hard to duplicate.

Valuation

I think EA trades at a very expensive price.  Say the company earns normalized $250m Adj EBITA, which is quite a bit above recent numbers.  Taxed at 28% that is $180m Adj net income.  On 305m FDS = $0.59 Adj EPS.  At a 16x PE multiple, which I think is generous, you get $9.44/share value plus $2.86/share net cash (I hit them $280m for overseas cash) = $12/share, compared to current price of $24/share.  I do not think there is a real asset story here either.  I think that to support the current EV of $6.5b, the company needs to earn normalized $600m EBIT.  I don't see how they get there and I think stock price ultimately comes down.

Risks

• EA is able to massively cut SG&A without affecting gross profits.  EA provides little disclosure on profitability by “label” within the company or by game.  It is possible that the company has a number of titles that lose a lot of money that it will be able to cut out.  I doubt this is true, but it’s hard to know.  Flipping this, I think it is going to be hard for the company to cut costs because of the nature of the company being comprised of multiple smaller studios.
• EA is acquired by someone who believes in the cost cutting story.  I doubt this would be one of the big media players due to where they are all heading (doubling down on television and getting out of other businesses), but it’s not impossible.  Likewise, a PE firm would give it a shot.
• EA succeeds with its digital offerings, which are growing at over 15% per year (offset by packaged games shrinking over 15%), and this business proves to be structurally more profitable than the old one.  One scenario would that EA is able to successfully launch a hit casual game and sees a resulting spike in operating performance.
• The stock trades at a very high multiple and has for a long time.  There are several public comps which trade similarly (TTWO, Ubisoft in Europe).  While the stock could move up or down in the short-term on not much news (witness recent rally), I think the deterioration of the business over time will lead to a lower stock price as investor optimism fades.
• The new CFO (joined late 2012, former CFO of Levi Strauss and Yahoo) makes noise about focusing on cash and cutting costs, but it’s hard to tell whether there is much to do there.

Notes

• Sales are 48% North America, 46% Europe, and 4% Asia.
• Cash balance has greatly benefited in the past 5 years from an increase in deferred revenues due to increased subscription sales.  WC as % of sales has gone from -20% to -44%.  I give them full credit for this cash.  This is $1.4b cash and only $300m in CA in excess of CL.  If the business declines, this will unwind eventually.
• When comparing Street estimates for EPS, you should dock about $0.50/share due to stock-comp and restructuring that they do not factor.  Street EBITDA is inflated  as well for the same reason.
• There is no real story on catalog sales here as this is a hit driven business and games do not age very well.
• There are no large individual owners of the stock, although several mutual funds own large stakes, with Fidelity at 14% and top 5 mutual funds owning 46% of shares.
• The company has repurchased $349m shares in the past 12 months, or 26m shares @ $13.44/share.  The last significant repurchases prior to this was $609m @ $56/share in 2006.

Catalyst