Leading games publisher has a track record of creating immensely-popular titles such as Fifa, The Sims and Command and Conquer. Its new business model emphasises higher margins and more predictable growth in revenue.
SINGAPORE (Jan 23): Computer gamers must know Electronic Arts (EA), investors should appreciate EA. The Nasdaq-listed company develops, publishes, and distributes games and sells related online services. Market intelligence projects a 12% CAGR in the number of gamers over the next five years, with the fastest growth from North America, which contributes 40% of EA’s revenue in the last financial year.
EA either wholly owns its gaming titles – like Battlefield and The Sims – or licenses it from others – like Fifa and Star Wars. This is a good business model to have because while Disney can take away EA’s exclusive publishing rights to publish the Star War titles, no one can take Battlefield and The Sims away from EA. In addition, Its portfolio of titles across genres give it different addressable markets to tap into as well. For example, soccer fans through Fifa, and sci-fi fans via the Star Wars franchise.
For its most recent 2QFY2020 ended Sept 30, 2019, EA’s net revenue, gross profits and operating income grew 4.8%, 8.6% and 3.9% respectively y-o-y, exceeding management’s expectations. The company’s balance sheet also strengthened, with net assets up 18.2% y-o-y. The impressive financials are a continuation of a five-year-long track record. Its CAGR for adjusted net profits, OCF and FCF were 32.1%, 19.7% and 21.4% respectively. Compared with the 13.9% CAGR in share price, there are strong reasons to suggest that EA is undervalued.
Its yields are also very attractive relative to the benchmark US risk-free-rate of 1.8%. The earnings yield, OCF yield and FCF yield of the company are 8.6%, 5.4% and 5.0% respectively. Its short-term liquidity is excellent with a current ratio of 2.8 and quick ratio of 2.7 times, comfortably above the benchmark of 1.0 times. Solvency is also not an issue, given EA’s low debt to equity ratio of 18.6% and interest coverage ratio of 22.1 times. Furthermore, compared to its regional peers, EA trades at a huge 25% discount for its P/E and EV/Ebitda, making it a very attractive pickup. The moat of the company has also grown strongly over the years, as shown in the growth of profit and cash flow margins (see Chart 1 and 2), implying stickier demand for its titles.
Expanding sales of full-game downloads
EA’s strategy for beyond 2020 will focus on optimising margins, with the aim of generating stable earnings and revenue growth. To this end, the company is investing in its in-game content (live services) such as online add-ons to enhance gameplay and aesthetics to capitalise on an industry-wide shift to digital sales. Expanding sales of full-game digital downloads, mobile and live services should create a steadier, more predictable revenue stream for EA as compared to the traditional packaged games purchased from brick-and-mortar stores. EA’s newer games feature more digital-based revenue which commands higher unit margins. The reason for the higher margins is because digital revenue has downloadable content packs, in-game micro-transactions, mobile, subscriptions, and advertising features embedded compared to physical disc game download and sales.
EA’s sports titles such as Fifa & Madden NFL should be beneficiaries of the rapidly growing e-sports industry trend; given the trend of big data value of EA growing as downloaded games, micro-payments, and subscription revenue streams grow, of which they can monetise, and translate into sustained outperformance for years to come. Another reason why this stock may be trading below its intrinsic value is the management’s tendency to underestimate earnings and performance. In the last 32 quarters, its EPS guidance exceeded actual results merely twice.
Analysts have given a target price of US$111.50 ($150.3), which is not much upside potential given the current trading price of US$109.82. The target prices range from US$95 to US$137, and we are leaning towards the higher side of this range based on in-house valuations. This is also further supported by management’s conservative estimates for the Star Wars and Apex Legends penetrating the Chinese market. We believe EA holds at least a 20% upside over the next 12 months offering not just growth but value. Further, we think EA has a very good growth trajectory for the next three to five years, hence is also a good long-term stock to hold, supported by its attractive and solid financials.
