What Happens To EA If The Next Gen Consoles Don’t Do As Well As Expected?

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EA: Electronic Arts logo
EA
Electronic Arts

Electronic Arts’ (NASDAQ:EA) stock has nearly doubled in value since the turn of the year with investors turning increasingly bullish about the prospects of a turnaround in the gaming industry following the announcement of the release of the Xbox One and the Playstation 4 later this year. At the same time, EA’s peer Activision Blizzard (NASDAQ:ATVI) has seen a 50% increase in its stock price. At first glance, the optimism surrounding the industry seems a bit far-fetched as video game sales are down nearly 20% this year and consumer response for the Nintendo Wii U has been lukewarm at best. [1]

Despite the industry slump, EA reported a 10% increase in GAAP net income for the June quarter. This was primarily driven by a 42% y-o-y increase in higher margin digital revenues. While digital revenues seem lucrative, the growth must be taken with a hint of caution. Nearly half of EA’s digital revenues come from extra downloadable content (DLC) associated with physical games. Around 30% of the revenues come from in-game advertising and subscriptions while the rest are from full game downloads and mobile sales. These streams are directly linked to sales of video games and should the industry fail to pick up as anticipated, the digital stream might not be a sustainable option for EA.

Our $27 price estimate for Electronic Arts’ stock is in line with the current market price.

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See our complete analysis of Electronic Arts stock here

Nearly 60% of EA’s sales are through Xbox and Playstation consoles. With its flagship titles like FIFA that accounted for 5% of global game sales and Battlefield 3 and Madden NFL 13 that accounted for 2% of the global game sales each the company has been able to retain market share of nearly 12% in the U.S. [2] and 14% worldwide. However, it has been susceptible to the industry slump. EA reported a 30% year-on-year decline in publishing and packaged goods revenue last quarter.

Video game hardware and software sales grew by 60% during the Xbox 360’s first full year in the market while PS3 sales grew by 30%. Enthusiasm around the next generation consoles is high so far. GameStop (NYSE:GME) recently reported over 700,000 PowerUp Reward customers on the Microsoft (NASDAQ:MSFT) first to know list and 1.5 million on the list for Sony. However, due to the advent of casual gaming on mobile and tablets, we expect the increase to be lower this time around. We currently forecast an annual growth rate of 10% in Microsoft and Sony revenues in the coming years. Growth in new software sales should also drive digital growth with higher in-game advertising, full game downloads and sale of DLC.

However, should the consoles fail to have the desired effect with casual gaming actually overtaking the console domain, EA might not be able to generate the growth that investors currently expect. There is 10% downside to our price estimate should the growth rate in console sales be around just 2%. Our forecast for EA’s revenues could fall by as much as 15% in this case.

Even more deleterious would be the impact on margins. The cost of revenue for physical products sold is about 51% of net revenue while the cost of revenue for online and digital services is just 30%. As a result of increased contribution from these secondary streams, EA’s gross profit margin has increased from 46% in 2009 to 63% in 2012. We currently expect increased digital contribution, especially from the DLC stream, pushing margins to around 68%. However, if digital growth is not boosted by new consoles as expected, margins will remain around 60%. The downside to our price estimate is nearly 50% as our estimates for gross profits through the decade drop by nearly 30%. You can modify the interactive charts in this article to assess the effects of various scenarios on our estimate for EA’s stock.

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Notes:
  1. GameStop Management Discusses Q2 2013 … – Seeking Alpha []
  2. VGChartz []