2023-05-12 07:00:19 ET
Summary
- Electronic Arts delivered a solid quarter, primarily driven by strength in FIFA 23, which already surpassed lifetime sales of FIFA 22 in only six months.
- EA's cash flows are consistent and dependable. The company's (and industry's) shift to in-game monetization has rapidly increased both CFFO and FCF.
- Trading at 20x earnings is too expensive to recommend as a buy. However, EA is a well-run, stable business, which investors should consider if the valuation becomes more appealing.
I am excited to write about Electronic Arts ( EA ) because I am a video game player myself - I am still deciding between getting the Xbox Series X or the PS5!
Background
Electronic Arts develops, markets, publishes, and delivers games and content which can be experienced on console, PC, mobile, and tablets. The company's portfolio is robust and high quality. It consists of massive AAA titles, some owned by EA (Apex Legends, Battlefield, Sims) and some licensed (Madden, FIFA, Star Wars).
Focus of this Article
EA, being a well-established company, derives dependable cash flows from its excellent catalogue of games. I will analyze the quarterly results, but will spend more time looking at the overall valuation. For a company run this well, granularity is not of the essence. This is a big-picture, valuation article where we analyze cash flows and earnings.
Electronic Arts Q4 2023 Results
EA delivered solid financial results on the top and bottom line in the quarter. Bookings came in $200 million over expectations at $1.95 billion. The company's EPS came in at $1.78 (excluding one-time items) versus expectations of $1.34. The company's core driver was FIFA 23 (now known as, "EA Sports FC"), which produced 31% higher bookings year over year. The 2023 iteration of FIFA was a smash hit to say the least: in its sixth months of existence, it has already surpassed the lifetime sales of FIFA 22.
One comical point is the FIFA franchise has awful reviews from customers on Metacritic, where users have rated EA's latest offering at 2.2 stars. Gamers claim they hate the game, yet are buying it and paying for micro-transactions at record levels. In fact, EA set a new record for live services, primarily the result of the FIFA franchise. This dissonance is an interesting point from a psychological perspective.
Revenue Breakdown
Here is a table of EA's revenue per segment in Q4 2023. We see the highest growth rate in PC gaming, then console, with mobile bringing up the rear. These are good numbers and demonstrate the quality of titles EA delivers.
2024 Guidance
EA's midpoint guidance for FY24 for $7.5 billion in revenue with 77% gross margins compared to $7.4 billion and 76% in FY23. One of EA's weak points as it stands today is FY sales remaining stagnant from 2023 - 2024(e).
Potential Catalyst for Revenue Growth
There is an interesting development going on in the gaming community where few compelling next gen exclusive games are being released. For many years. next gen consoles have been extremely difficult to obtain and so, there is not enough of a market to make it economical to release next gen games. As a result of both the shortages and lack of compelling games, the adoption rate of next gen consoles is far behind what could have been expected if Covid never took place.
The way I see it, one of two things can happen:
- As next gen consoles make their way into gamers' homes, demand for next gen games increases, which will be a catalyst for EA's sales.
- Gamers skip this main lifecycle upgrade and opt for the update, "pro" version of it instead. For example, many PS4 users who could not obtain a PS5 (main lifecycle upgrade) after so many years, might opt to wait for the PS5 Pro (part of the same lifecycle, just updated) instead. This might delay EA's revenue growth.
FastGraphs Analysis
Let's examine EA's EPS, CFFO, FCF history, and relative valuations using FastGraphs.
EA's Historical Earnings
Over the last decade, EA's earnings have been rapid and dependable. One of the biggest boats I missed was the gaming industry's transformation from selling physical games to selling in-game consumables and upgrades, more commonly known as "in-game monetization," which took place over the past decade. I can't be blamed though; I was too young and was not an investor for most of this timespan.
During this decade, video game companies realized selling the physical game only generates $60 of revenue per copy, but selling DLC content (new skins, camos, weapons, etc.) via OTA updates, earns exponentially more money. Furthermore, these companies structure the release of DLC in such a way that you cannot outright buy it… you have to play virtual slot machines in hopes of obtaining it.
With OTA updates, game developers can speed up game release dates, despite the game not being complete, because they can just add and sell the rest of the game as DLC at a later date. This does three things: (1) it speeds up the booking run rate, which increase liquidity (2) it generates higher revenue because in essence, consumers are paying full retail price, but only receiving 80% of the game. In order to buy the remaining 20%, they have to buy virtual tokens to use on slot machines that might deliver the rest of the game, and (3) produces massive cash flows due to gamers who form gambling addictions within the game.
Note: I am genuinely surprised in-game monetization (the way it is currently practiced) is legal because it is literally gambling for kids. Also note, I did not use the 'max' timeline on the graph because I did not want to capture EA's growth years, which skews the data by raising the normal P/E metric.
EA's Historical Operating Cash Flows
Speaking of cash flows, let's take a look at EA's historical operating cash flow levels. Starting in 2013, CFFO took off on a dramatic course upwards. This was the start of widespread adoption of in-game monetization, which sent video game company profits soaring. Today, in-game monetization is well-established and standard practice so CFFO should continue rising steadily and dependably.
Free cash flow has been equally as beautiful of a graph. FCF per share is expected to be about $9/share in 2026, which represents a 30-fold increase compared to 2012 when FCF was ¢30/share.
Note: Isolating this period also coincidentally shows how powerful of a driver in-game monetization has been.
Dividend
While EA's dividend yield is barely worth mentioning at 0.61%, what you will notice from the graph above is the dividend is extremely well covered by the company's free cash flow (examine the white dotted line). EA's payout ratio is currently only 16%, which provides much room to grow so I would expect the dividend to increase over the coming years.
Forecasting
The forecasting tool enables us to predict a range of potential prices based on analyst expectations. One could argue the stock is slightly overvalued, but this is a company which trades at a premium due to its reliability of earnings. If the management team keeps executing, this stock has potential to reach $168, which represents a double-digit annual rate of return and total return in excess of 36%, including dividends. Speaking of which, if the company increases its dividend to compelling levels, it might entice a wave of new buyers which would further the support the case that EA deserves its premium valuation.
DocShah's Rating
Personally, I rate this stock as a hold. I do not consider EA's current price of $125 a good deal as it is almost 20x earnings, especially considering the softness in net bookings growth. That being said, the cash flows are a point of excellent strength. I would flip my hold to a buy rating if the following take place:
- Net bookings growth increases double digits year over year
- The P/E falls below 15
- The dividend rate increases
If all three of these possibilities occur, and all else is unchanged, I would state the price to value is in favor of the investor at that point and would be an investment worth considering.
Risks
There are numerous risks to consider in buying EA:
- EA's catalogue of games becomes less popular. Video game players are fickle and move from one hot game to the next.
- EA loses its licensing for one of its popular video games.
- The FIFA franchise is a primary driver of cash flows and any overdependence on one title is dangerous.
- EA pours money into mobile gaming, but growth lacks.
- Net bookings have briefly stagnated and might continue this trend or head downward.
- Higher interest rates prohibit the company from pursuing necessary projects.
- Stock-based compensation begins eating into cash flows.
- For the company's set of risks, please click here .
Takeaway
EA is a well-run company which has a portfolio of massively popular games. The company's in-game monetization strategy has paid off and, as a result, its cash flows are outstanding. The company delivered a solid quarter, primarily driven by the success of its FIFA franchise. The market recognizes EA's position of strength and assigned a P/E of 20 to its stock. At these levels, the valuation is too rich. However, if the company generates more revenue, increases its dividend, and falls to a more reasonable valuation, then this stock should be considered by investors. For the time being, I would simply keep an eye on this stock.
For further details see:
Electronic Arts: Great Business, But Too Expensive