Electronic Arts (NASDAQ:EA) is expected to announce earnings for the third fiscal quarter of 2013 on Tuesday, January 28.  The video game maker had three titles on the list of NPD’s top 10 games for December in the U.S. The company could make long-term gains from strong holiday sales of the next generation Sony and Microsoft consoles.  Despite glitches reported by gamers, EA’s first person shooter (FPS) game, Battlefield 4, was the second highest selling game during the holiday month, while sports-based titles Madden NFL 25 and FIFA 14 came in fourth and ninth places, respectively.
The research firm also reported that software sales fell 17% through the holiday season, but that shouldn’t deter EA as it has been able to maintain growth in a cyclically low industry through the digital domain (NPD figures do not include digital sales). Digital streams like extra-downloadable content (DLC), full game downloads, in-game advertising and mobile and tablet games accounted for 65% of EA’s GAAP revenue in the September quarter, up 11% over the prior year. Growth in these streams allowed the company to beat its own revenue and EPS guidance for the second fiscal quarter.
EA’s stock has been on a roller-coaster ride over the last two months. The stock plummeted after the company admitted there were problems with Battlefield 4, but has since recovered on growth prospects for the highly anticipated Titanfall title, which is expected to be released in the coming months. Our $28 price estimate for Electronic Arts’ stock implies a premium of 10% to the current market price.
Electronic Arts has struggled with public relations; it was named by Consumerist as the Worst Company in America in each of the last two years.  This image has not been helped by events over the last two months. EA faces a class action lawsuit regarding materially false and misleading statements issued by the company  and has received criticism over its online marketing practices.  Vice President Jeff Brown, who handled Public Relations, recently left EA after the Battlefield 4 fiasco. 
However, we believe that these events will not have a material impact on EA’s financial results. The company has shown strong growth in the digital domain, improving margins and efficiency, and has a strong portfolio of games. Its exclusive licensing agreements with NFL and FIFA allow it to maintain a near-monopoly in the sports games domain. American football based game NFL is one of the most popular games in the U.S. and was named the third-best selling game of 2013 in the country by NPD. FIFA is more popular outside the U.S.; the soccer-based game was the fourth highest selling game in the world last year, accounting for 4% of the units sold worldwide. 
FIFA is also a big contributor to digital sales, with FIFA Online 3 driving a 35% increase in DLC revenues last quarter. Digital net revenue from the FIFA franchise in the first half of fiscal 2014 was up 25% over the previous year. The FIFA World Cup is scheduled to take place in Brazil this year, with over 500,000 fans from all over the world expected to attend the event.  Sales of the annual FIFA franchise went up 25% after the last world cup in 2010. We expect a similar trend this time, with additional gains from the DLC stream. 
Digital growth should also allow for margin expansion. The cost of revenue for physical products sold is about 50% of net revenue while the cost of revenue for online and digital services is just 30%. EA’s gross margin improved from 60.1% in the second quarter of fiscal 2012 to 61.7% in 2013. Management expects to generate over 40% of fiscal year revenues from digital streams. Going forward, we expect margins to increase to about 68% over the long term as digital contribution increases further.Notes:
- EA to Release Third Quarter Fiscal Year 2014 Results on January 28, 2014 [↩]
- NPD December: 3DS bestselling hardware of 2013, GTA 5 top game [↩]
- EA Voted Worst Company in America, Again – Forbes [↩]
- Electronic Arts Inc. : SHAREHOLDER ALERT: Pomerantz Law Firm Announces the Filing of a Class Action Against Electronic Arts, Inc. and Certain Officers – EA [↩]
- EA Issues Response On YouTube Scandal Involving Battlefield 4, Need For Speed Rivals, Gaming Blend, January 22, 2014 [↩]
- The master of zinger quotes, EA spokesman Jeff Brown skis off to GoPro, VentureBeat, January 13, 2014 [↩]
- VGChartz, 2013 Global Yearly Chart [↩]
- Brazil 2014: Four weeks of soccer that impact a lifetime, PWC [↩]
- VGChartz, 2010 Global Yearly Chart [↩]