Description

The Qualitative Basics on ERTS

• Electronic Arts (ERTS) is the "leader" in the video game publishing industry;
• Since 1992, ERTS has grown from $160mm in sales to > $4bn on the back of continued R&D (25-30% of sales) and a variety of product successes.
• 2008/2009 have been depressed due to: 1) macro; 2) being late to the Wii; 3) higher R&D due to 3 consoles being introduced in just 2 yrs;
• ALL THREE OF THESE FACTORS SHOULD DIMINISH IN IMPACT OVER THE NEXT 12-24 MONTHS.
• Last year alone, ERTS had 31 different games that sold > 1 million copies each. ERTS is not a "one-hit" wonder.
• Market share has remained 19-21% every year this decade despite being six months late to the Wii in 2008.
• The company outspends rivals by at least 2:1 on R&D. In a "hit" business, this is important.
• Wii market share rose 10 percentage points in the last quarter to 21%; in my view, the company has fixed the "being late to the Wii" issue.
• Digital revenue was $430mm last yr, +27% YOY and now approx 10% of sales.
• ERTS was first to Asia with its digital efforts and digital downloads carry 80%+ gross margins and higher operating margins.
• Mobile revenue was $189mm last yr, +24%; same logic here as with digital;

 The Quantitative Basics on ERTS

• ERTS has $7/share of net cash on the balance sheet, thus the "real" stock price of ERTS is $11 per share.
• FCF/Sales = 8.0% since 1992; 10.2% since 2000 and 8.8% over the past 3 yrs despite higher than average R&D spend.
• Even if I haircut FCF margins to 7.5%, on $4.3bn in sales, FCF/share = $1.00.
• So P/FCF = 11x despite secular growth, a haircut in FCF margins and cyclical revenue pressure à In my view, this is why IV is significantly higher than the current quote.

 What Else Matters

• Why doesn't management use cash more effectively? Management says no large one-time dividends or large acquisitions are imminent, so it does raise the question of why ERTS won't conduct a large share repurchase program.
• I happen to think this is because the CEO and the Board come largely from the technology industry where capital efficiency is not a core competency.
• I also believe that a burgeoning cash balance makes ERTS more vulnerable from a takeout perspective and Sony, Nintendo, Microsoft could easily write $3.5bn checks. This is just an additional margin of safety and is not critical to the thesis.

Additional Items

 In FY 3/10, GAAP EPS and FCF/share are different due to the following:

 Deferred net revenue ($450-$600mm in FY 3/10);

$185mm of stock-based compensation;

$55mm of amortization of intangible assets;

$25-$35mm of non-cash restructuring charges;

$82mm-$117mm in the difference b/t GAAP and non-GAAP tax rate

 ERTS is guiding to $1.00 in non-GAAP EPS; FCF should be a bit higher (I estimate $1.15) due to higher depreciation than capex and some working capital gains (better collections according to management). 

WHY IS ELECTRONIC ARTS MISPRICED?  19 of 31 analysts rate ERTS a hold or sell and ERTS is only +27% off its 3-year lows.  This negative sentiment and recent underperformance is related to the following:

 Macro pressures; discretionary product; retailers carrying less inventory;

Modest market share losses due to a bad bet on success of Sony's PS 3 console and being late to the Nintendo Wii;

Increasing competition from Nintendo, Sony and Microsoft.

Despite these issues, ERTS' leadership positioning in the video game industry appears as strong as ever.  The video game industry is in year 3 of a 6-7 year console cycle which suggests at least stable sales for the next few years with the potential for a cyclical uptick if consumer spending recovers at all.  Even the most bearish analysts acknowledge that ERTS has recently materially improved its title quality and this should result in improved market share trends in 2010.  Longer-term, the company's subscription-based business model in Asia has been very successful and ERTS has also been investing in emerging opportunities which are more profitable and should drive margin improvement going forward.

Catalyst

Lessening macro headwinds;

Incremental market share gains on the Wii platform

Any of the company's 4-6 new big name titles being a hit in 2H/09;

Lower than expected R&D in 2010