Description

Intro

We are long shares of Electronic Arts (EA), one of the world’s premier video game publishers with highly successful franchises such as FIFA, Madden, Battlefield and Star Wars. EA’s sports franchise (FIFA, Madden, NBA Live, NHL) accounts for nearly half of revenue and provides an annuity-like recurring revenue stream as titles are released annually (with a long history going back more than twenty years). EA further increases the value of the IP with its Live Services portfolio that drives deeper engagement and monetization. Features such as Ultimate Team, where gamers can build their own teams to compete against each other (similar to fantasy sports), has been a significant driver of monetization well beyond the upfront purchase. Live Services now accounts for 43% of bookings and continues to grow. EA also benefits from a secular shift towards digitally downloaded games (~80% gross margin) from packaged games sold in retail stores (~60% gross margin) and this trend has resulted in significant margin expansion.

EA shares are down nearly 40% since July due to: (1) the delayed release of Battlefield V; (2) two consecutive quarters of lower than expected live services growth; and (3) concerns regarding the competitive environment amid Fortnite’s popularity and successful launches by Activision (Call of Duty: Black Ops 4) and Take-Two (Red Redemption 2 aka RDR2). Despite early positive indications from a public alpha test, EA decided to delay the launch of Battlefield V by one month from October 19 to November 20. Management decided to delay the release because the original launch date fell right in between the launches of Call of Duty: Black Ops 4 (October 12) and RDR2 (October 26). This decision was also made when the popularity of Fortnite seemed to be at an all-time high so EA was probably rightfully concerned. However, Fortnite did not seem to have an impact on the launches of Black Ops 4 and RDR2. Activision set a launch day record as the biggest day one digital release in its history with Black Ops 4, and Take-Two’s RDR2 sold more than $725 million during its first three days. Nevertheless, sell-side expectations for Battlefield V have come down significantly with unit sales projected to come down from 15 million units to 10-11 million. 10-11 million units would be dramatically lower than the 16 million units EA sold of the last Battlefield title, Battlefield 1, released two years ago. While the competitive dynamics are less favorable today for Battlefield V, this is well reflected in the current stock price. Given the release will occur right around Black Friday, sentiment on EA could rapidly improve if unit sales come in even a little better than expected.

EA lowered guidance for FY2019 (EA’s fiscal year ends on March 31) bookings from $5.55 billion to $5.20 billion and FCF from $1.7 billion to $1.525 billion as EA now expects some unit sales of Battlefield V to be pushed out into FY2020. At $1.525 billion of FCF, EA trades at just 16.8x FCF. On a forward basis on consensus estimates (FY2020), EA trades at just 15.8x FCF, significantly lower than TTWO (24x FY2020) and ATVI (21x CY2019). At these levels, the stock is very attractive.

Digital Penetration Driving Margin Expansion

EA benefits from two key secular trends in the video game industry: game sales transitioning from physical to digital and increase of in-game spending. Today, ~42% of EA’s unit sales are digital, vs. 36% last year, and management expects an underlying shift of around 5% a year to digital downloads. This is the early to middle innings for this transition. Improving broadband infrastructure that continues to offer faster options for consumers and large storage options on consoles will continue to drive this trend. Gross margins are significantly higher for digital downloads (80% for digital and 60% for physical) and EA has seen major gross margin expansion over the last few years (see chart below).

The other significant digital driver has been the increase of Live Services (in-game purchases and subscriptions). EA has been very successful in increasing in-game engagement and driving monetization, especially for key titles such as FIFA. Ultimate Team, which allows players to build their own teams by purchasing player cards to compete against other players, accounts for more than 50% of Live Services. Some sell-side estimates indicate that nearly 80% of FIFA players play Ultimate Team and nearly a quarter of them make a purchase.

While growth expectations from Live Services in FY2019 has been lowered (general expectations are around flat to 5% growth) as EA delayed the release of Battlefield V and player engagement in the World Cup mode has impacted FIFA Ultimate Team, Live Services will continue to grow as EA continues to find ways to increase engagement (especially in FIFA and other titles like Battlefield V that will have a battle royale mode for the first time ever) and introduce new subscriptions like Premier Access Premier that offers unlimited access to latest PC titles for $15/month or $100/year.

Overall, bookings from digital have grown from 45% in FY2014 to nearly 70% today, driving gross margins from 62% to 77% and FCF margins from 15% to 30%. As digital penetration continues to grow, the margin profile should continue to improve.

Extremely Valuable Franchises

Revenue from EA’s sports portfolio (FIFA, Madden, NHL and NBA Live) has become annuity-like with new titles being released every year, resulting in a recurring and generally predictable revenue stream. And as previously discussed, increased engagement from Live Services further enhances the value of these key titles. Also, the FIFA franchise should continue to increase in value along with the growing popularity of soccer around the world. Soccer remains the world’s most popular sport (according to Nielsen survey below).

In the recent World Cup, global viewership increased vs. the 2014 World Cup, despite a severe drop in ratings in countries like the U.S. (since the U.S. did not qualify for the 2018 World Cup). Popularity of the sport is growing in critical markets like China, where Nielsen saw interest increasing from 27% in 2013 to 32% in 2017. Soccer’s growing popularity in markets like China, the world’s largest gaming market, will be important for EA’s growth story going forward as Chinese gamers play on their phone or PC (console market is very small). More than 70% of EA’s bookings come from console.

Outside of sports, EA’s key brands are Battlefield, Star Wars and Need for Speed. Battlefield is EA’s second largest franchise and typically sells 14-17 million units in a release year. As mentioned previously, EA’s stock decline is due to lowered expectations that Battlefield V will sell 10-11 million units vs. previous expectations of 15-16 million. Given the popularity and long history (first title was released in 2002) of this brand, we think there could be tremendous upside if this title sells even slightly better than expectations. EA plans to introduce new features for Battlefield V like a Battle Royale mode, the first time ever for a Battlefield release, and this will help drive engagement and popularity for this franchise.

In February of next year, EA is introducing Anthem, a brand new IP that combines 3rd person shooter and action role-playing game elements in an open world. Management previously alluded to expectations that Anthem would probably sell about 3-4 million units but recently raised that to 6 million or more based on indications of gamers’ interests. If Anthem turns out to be a hit, that could provide upside to the stock as expectations for the title are still fairly low (sell-side models range anywhere from 4 to 6 million units).

Additional Monetization Opportunities through eSports

As one of the largest publishers and owners of valuable IP, EA stands to benefit from the growth of eSports, an industry that is expected to generate nearly $1 billion of revenue in 2018. While it’s still fairly early days for eSports and it’s not yet clear who the winners will be in this ecosystem, we think developers of the IP (like EA) are well positioned to capture a significant portion of the value that is created. EA already benefits from this trend through events like the FIFA eWorld Cup that had over 20 million players participating and over 29 million viewers, four times more than last year. To become more competitive in tournaments like the eWorld Cup, gamers buy packs of player cards (as mentioned previously), hoping to land the best professional soccer players for their teams. In addition to in-game purchases, we think eSports could lead to entirely new revenue streams like broadcast rights, sponsorship opportunities and advertising. Earlier this year, EA announced a multiyear deal with ESPN and Disney to broadcast the final rounds of a tournament for Madden 18.

Attractive Financial Profile, Valuation and Capital Allocation Opportunity

Through its strategy to drive engagement (and in-game monetization), increase the shift to digital downloads and sell new subscriptions, EA has become a highly profitable business. Gross margins expanded from 62% in FY2014 to over 75% today. We think margins still have room to increase as EA continues to focus on increasing monetization opportunities as well as benefiting from the mix shift towards digital. The improving margin profile combined with a low-to-mid single digital billings growth rate should allow EA to continue to grow FCF 10-13% annually over the next few years. EA has over $3.5 billion of net cash on the balance sheet and generates significant free cash flow. At $1.6 billion of FCF in FY2020, EA trades at just 16x FCF, significantly lower than its peers ATVI and TTWO, both trading at 21x and 24x, respectively, in the same period. If EA continues to stay at these levels, EA could be an attractive acquisition target especially as a large acquirer would benefit immediately from EA’s high margins and free cash flow.

In terms of capital allocation, EA has been actively buying back its stock ($1.9 billion left in its 2-year $2.4 buyback program) but given its unlevered balance sheet and large cash balance, it could look to meaningfully accelerate the buyback or pursue M&A opportunities.

Conclusion

While sentiment has soured on EA around near-term concerns on upcoming titles, the shares have fallen to an attractive valuation. Sentiment on video game publishers can change rapidly and at EA’s currently depressed multiple, the downside is relatively well protected (it’s hard to imagine Battlefield V sales expectations coming down again) and there are enough levers in the future (Anthem in February, Live Services growth from FIFA19, upside surprise from Battlefield V, etc.) to make investors get excited about EA again.

Catalyst

Better than expected sales of Battlefield V

Successful launch of Anthem

Reacceleration of growth from Live Services as more players transition off of FIFA 18 to FIFA 19