Electronic Arts’ (NASDAQ:EA) stock has gained more than 50% since the turn of the year, with a 20% increase in stock price since the company announced earnings in May. Although the company reported a 25% year-on-year decline in packaged goods sales for the first quarter of 2013, EA’s ability to cash in on the digital revolution and announcements by console-makers have led to optimism amongst investors allowing the stock to rally. The video game publisher reported a 45% year-on-year increase in high margin digital revenues through the first three months of the year, allowing the gross margin to improve from around 65% in 2012 to 74%.
Both Sony and Microsoft (NASDAQ:MSFT) have announced that their highly-anticipated next generation consoles will be launched by the end of the year. The consoles are expected to revive video game sales, which have been largely suppressed due to console fatigue following prolonged (eight year long) product cycles of Microsoft’s Xbox 360 and Sony’s Playstation 3. This trend was particularly evident in the U.S. last year. Video game sales fell by 28% in the first half of the year and by 19% in the third quarter. 
The holiday season, which traditionally sees a rise in game sales, also proved to be quite disappointing with video game sales dropping by 22% over the prior year.  Video game sales in the country remained low through the first half of 2013, as gamers and developers wait for the next console cycle to start. The U.S. is the most important market for Electronic Arts, accounting for nearly half of the company’s revenues.
Our $18 price estimate for Electronic Arts’ stock implies a discount of 15% to the current market price.
The Digital Revolution
Although packaged goods sales have been declining, the digital video game market has been rapidly expanding over the last few years. Global digital game sales have grown from $5 billion in 2005 to $42 billion in 2012.  For EA, digital revenues can be broken down into four main streams: extra downloadable content (DLC), subscriptions and in-game advertising, mobile based games and full game downloads.
DLC includes purchasable virtual goods and characters as well as additional map-packs, and accounts for 35% of EA’s digital revenues. Revenues from this stream were up 35% from the prior year in the first quarter, helped by growth in FIFA, Star Wars: The Old Republic and Bejeweled Blitz.
In-game advertising and subscription revenues account for around 30% of the company’s digital revenues. Mobile based revenues come from games like Real Racing 3 and The Simpsons: Tapped Out, which was one of the top 5 grossing iOS game during the first quarter, generating over $10 million in revenue. Mobile revenues account for around 17% of the company’s digital revenues.
The rest of the digital revenues come from full game downloads, particularly on the PC platform. EA reported a 65% year-on-year increase in full game download revenues for the first quarter of 2013.
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%. This allows the company to earn higher margins on digital revenues. The contribution from digital revenues increased from 22% in 2011 to 30% in 2012, allowing the gross margin to expand from 60% to 65%. We expect the digital contribution to continue in the coming years, allowing for further margin expansion. The gross profit margin through the first quarter of 2013 was around 74%, we expect the figure to reach around 75% by the end of the decade.
The Complete Experience
It is critical for Electronic Arts to integrate the mobile/digital experience with its traditional platform based interface, particularly if is to capitalize on the next generation consoles. During the E3 investor presentation, the company revealed an integration plan for Battlefield 4 involving stat checks on the smartphone, quick matches on the PC, news and forums via the tablet, and an extended gaming session on the console. There are around 300 million EA registered users with over 2.5 billion game sessions per month.
According to our analysis, EA had a market share of around 14% (in terms of units sold) in the video game market across the world last year.  Battlefield 3 and Madden NFL 13 accounted for 2% of the global game sales each, while the soccer based FIFA 13 accounted for around 5% of the global game sales. In the U.S., the company had a 12% market share, with Madden NFL accounting for 4% of the total game sales and FIFA 13 accounting for around 2%.
EA has exclusive licensing agreements with NFL and FIFA, which allow it to maintain a near monopoly in the sports games domain. Apart from these, the company’s licensed intellectual property portfolio includes NBA Live, The Simpsons, UFC, Titanfall. EA has also announced an agreement with Disney, to create games based on the Star Wars franchise. Given the immense popularity of its titles, we expect EA to make a smooth transition to the next generation of consoles. The company expects a 7% increase in packaged goods and distribution revenues in fiscal 2014.Notes: