The wait for the next generation of consoles seems to be over with Sony announcing last week that the Playstation 4 will be launched during the 2013 holiday season. This will provide a much needed sales boost to major developers such as Electronic Arts (NASDAQ:EA) and Activision Blizzard (NASDAQ:ATVI). Sony consoles account for about 30% of EA’s revenues while Activision earns about 20% of its revenues from the console. Electronic Arts has been preparing itself for a smooth transition by reducing the number of titles launched. The company released 36 titles in 2011, 22 in 2012 and plans to release just 13 in 2013. In contrast, the company had more than 85 titles in play during the last console transition, which led to higher research and development expenses.
Our price estimate for Electronic Arts’ stock is $17, in-line with the current market price.
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The Big Shift
While the new console presents exciting new opportunities particularly in terms of inter-device game play, we expect a transition period of one year before the video game developers can fully capitalize on the development. This time period will be utilized for research and development and will also allow more consumers to purchase the console before exploring titles available for it.
Electronic Arts expects an increase of $100 million in research and development expenses, which was around 27% of the revenues in 2012. The company could also increase its price per title to compensate for higher expenses – though prices would likely eventually decline later in the product cycle. We expect the company’s established franchises like its popular soccer-based game, FIFA, and its first person shooter game, Battlefield, both of which are $1 billion plus businesses to help make the transition smooth.
DLC To Play A Big Role
Downloadable content (DLC) sold through micro transactions after the sale of a video game title has become a major source of revenue for developers and has helped Electronic Arts mitigate the effect of a decline in the number of titles released. The company is no longer just reliant on income through the sales of a video game but also earns revenues through time-based subscriptions and game related content that require its hosting services, particularly for online games like Star Wars: The Old Republic and FIFA.
Service-based revenues increased 73% year-on-year in the nine months ending December while product-based revenues decreased by 20%. Gross margin on service revenues is around 70% compared to 54% for product revenues. In 2011, service-based revenues accounted for just 15% of the company’s total revenues while in 2012 they accounted for 27%. This led to an rise in gross margin from 60% to 63%. With an increase in high margin service-based revenues, we expect EA’s margins to increase to about 68% in the coming years.