Electronic Arts CEO Exits Leaving A Mixed Legacy
Quick Take
- Electronics Arts’ stock hit a 52 week high before CEO John Riccitiello resigned.
- Revenue growth slowed in 2012 due to console fatigue.
- The company has cut down on third party developed games allowing gross margins to expand from 45% in 2009 to 63% in 2012.
- Developers no longer earn just $60 from a video game, but also earn from after sales service and support through downloadable content.
- The revenue per title in 2011 was $107 million, increasing to $180 million in 2012.
- The disappointing sales of the Nintendo Wii U have no effect on EA which earns less than 2% of its revenues from the console.
- The eighth generation Microsoft and Sony consoles are targeted towards hardcore gamers and their performance will be crucial for EA.
Electronic Arts’ (NASDAQ:EA) CEO John Riccitiello ended his tenure on March 30, taking on the blame for the company’s long under performance. [1] While it is true that the stock lost nearly two-thirds of its market value since he took over the reigns in 2007, it must be noted that a 70% decline in the stock price was seen through the height of the financial crisis in 2008 and 2009. Since then, the stock has stabilized and even hit a 52-week high before the Riccitiello announced his resignation in March.
Recent events worked against the now former CEO – server glitches marred the launch of the popular SimCity game in March and added costs for downloadable content (DLC) related to Mass Effect 3 left several customers unhappy. Revenue growth in the calendar year of 2012 was slow at just 2%, while gross profits increased by 8%. This was largely due to console fatigue as Sony Playstation 3 and the X-Box 360 completed their eighth year of a prolonged product cycle. We believe the company is now on track for a turnaround and will benefit from the launch of the eighth-generation video game consoles in the next year.
Our price estimate for Electronic Arts’ stock is $17, in line with the current market price.
See our complete analysis of Electronic Arts stock here
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Expanding Margins
One of the key initiatives undertaken by Riccitiello was to cut down the dependence on third-party developed games. In 2009, games developed by third-party studios were the biggest revenue contributors for EA, accounting for 24% of the company’s revenues. The contribution from this stream went down to 10% in 2010 and to just 5% in 2012. The gross profit margin for third-party distribution is just 35%, compared to over 65% for in-house developed games. As a result of reduced reliance on third-party developers and growth in high margin digital revenues, EA’s gross margins expanded from 45% in 2009 to 63% in 2012.
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The advent of DLC has also been a big contributor to the increase in margins. Electronic Arts launched 36 titles in 2011, earning $107 million per title. In 2012, the company launched 22 titles, but earned nearly $180 million per title. Game developers no longer earn just $60 per game sold, they also earn 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.
The cost of revenue for physical products sold is about 51% of the net revenue, while the cost of revenue for online and digital services is just 30%. In 2011, the contribution from service revenues was just 15% but this increased to 30% in 2012. With the company planning to release just 13 titles in 2013, we can expect a more significant contribution from service revenues in the coming years. The $10 that customers had to pay for DLC for Mass Effect 3 might have upset gamers, but we believe this will be the long term trend going forward. With an increase in high margin service based revenues, we expect EA’s margins to increase to about 68% in the coming years.
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New Consoles To Bring New Life
The Nintendo Wii U was a big disappointment in 2012, the first eighth-generation console has sold just 3 million units since its release. [2] However, this has no effect on EA. The company earns less than 2% of its revenues from Nintendo consoles. The highly anticipated Sony Playstation 4 and Microsoft’s (NASDAQ:MSFT) next generation console (christened “X-Box 720” by the media) will be much more important for the company which earns about 30% of its revenues from each.
Before dismissing the eighth-generation consoles based on the Wii U’s performance, we must consider the target audience for the console. The Wii U, with its easy on the eye graphics and motion sensor controller is targeted towards casual or even family gamers. This audience has been swayed by the advent of gaming on mobiles, tablets and other portable platforms. Nintendo’s best selling games have been Mario Kart and Super Mario 3D Land [3] that are similar to those found on iPhone or Android platforms.
On the other hand, developers like EA and Activision Blizzard (NASDAQ:ATVI) focus on games for the so-called ‘hardcore gamers’. These games include first person shooters like Call of Duty and Medal of Honour, and sports franchises like FIFA and Madden. These games require cutting edge graphics and controllers which cannot quite be replicated on handheld platforms.
As we stated earlier in this article, EA has been cutting down on the number of titles released per year. Apart from the growth in DLC, we believe that the developer is waiting for the launch of the next generation consoles to expand its product line up. We expect an increase in console revenues in the coming years. You can modify the interactive charts below to gauge the effect a change in forecast would have on our price estimate.
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