2024-01-16 08:22:03 ET
Summary
- Electronic Arts is a well-known gaming company with popular franchises like Need for Speed and The Sims.
- Electronic Arts has a growth strategy that includes both organic growth and acquisitions, with a focus on mobile gaming and live services.
- The company has shown discipline in returning cash flow to shareholders, but my estimates suggest the company is currently trading at fair value.
Investment Thesis
Electronic Arts ( EA ) is a well-known gaming company and one of the earliest. The company is famous for its Need for Speed, Madden, NFL, Battlefield, and The Sims franchises of games. Another popular Electronic Arts game franchise, EA Sports FC, was recently rebranded from the FIFA brand name last year after it broke off its brand partnership with Fifa . With EA Sports FC being part of Electronic Arts most successful franchise of games, there was initial speculation about the adoption of the non-FIFA-branded football game, but EA Sports FC continued to see strong engagement and adoption.
The company is a machine when it comes to marketing, publishing, and distributing its video games. On the financial side, the company has shown discipline in consistently returning cash flow to its shareholders. However, with projected free cash margins of about 23%, I estimate Electronic Arts to be currently trading at fair value.
About Electronic Arts
Electronic Arts was founded way back in 1982 as a video game publisher. By “video game publisher," I mean that the company is in the business of publishing, marketing, and distributing video games and other affiliate content services for the purposes of interactive entertainment. Electronic Arts has, over time, accumulated a large catalog of games that the company either directly owns or licenses from other game publishers and gaming studios. In the gaming world, Electronic Art’s games are quite popular, with games such as Battlefield, The Sims, Legends, EA Sports FC, Madden, etc. being part of the company’s game catalog .
Through the years, the gaming industry has rapidly evolved, but Electronic Arts has demonstrated tremendous tenacity to keep up with the pace of evolution in gaming. The company was able to successfully navigate from legacy distribution models such as perpetual licenses to the more recent gaming business models of subscriptions and freemium. To adjust to newer models, Electronic Arts has shifted to distributing games via its live services platform, also known as Gaming-as-a-Service (GaaS), which is now growing faster than its overall revenue at 10% y/y and accounts for ~74% of the company’s revenue, as per its most recent FY23 10-K report .
Electronic Arts has a growth strategy that rests on its strategic organizational mix
Since Electronic Arts is decades old, the company resorts to a mix of organic growth strategies and acquisition-led strategies to continue its growth trajectories. Here is an excerpt from the company’s CFO that alludes to this while answering an analyst’s question on how growth is typically achieved in one of the previous earnings calls :
“We try to operate the business on a 5-year cadence, if not longer, and we're thinking about how we generate growth each year, both organically and through acquisitions. And I would tell you, I think we are in a better position than we've ever seen before.”
Over the years, Electronic Arts has acquired close to 43 companies to date , according to data compiled by Crunchbase. Most recently, Electronic Arts acquired four gaming startups in a post-pandemic acquisition spree, spending around $4.7 billion on all post-pandemic acquisitions. Chief among its recent acquisitions was a mobile gaming startup called Glu Mobile, which Electronic Arts acquired in 2021 for $2.4 billion. In my opinion, this acquisition was unique to Electronic Arts due to the growth potential attached to the acquisition, as can be seen below.
While Console, PC & Other platform revenue grew at a CAGR of 9.4% and 20.3% over a span of 3 years, it's really the revenue from their mobile gaming platform that grew at an impressive ~32% CAGR over the same time period. Concomitantly, revenue share from mobile game platforms increased approximately four percent from 12.8% to 16.9%. Mobile games are some of the key strategic initiatives that Electronic Arts has embarked upon to adapt to the winds of change in the gaming ecosystem. The other trend I had already talked about in the previous section is where the company has moved to a live services-based model of distributing games, which is radically different from the legacy model of selling perpetual licenses to ardent gamers, allowing the company to record subscription revenues rather than the one-and-done model of perpetual licenses. Over the last few years, moving to live services has proven to be vital in helping the company record revenue growth.
Valuation models suggest limited upside for Electronic Arts
According to its most recent quarterly report , management is projecting to grow its revenue by just 1% in FY24 at the midpoint of its guidance. Market participants are more optimistic about the company’s revenue forecast, forecasting that Electronic Arts will grow by 3%. Given that Electronic Arts had an extremely successful launch of EA Sports FC ( here , here ) last year, I will assume revenue will grow in FY24 in the high end of management’s guidance range of about 3.7% to $7.7 billion. The company has also demonstrated a history of producing strong cash flows in the past, and I will use this to estimate the fair value of Electronic Arts.
On the earnings call , management guided for capital expenditures to be at $250 million. Assuming their guidance on operating cash flows remains unchanged as per the recent quarterly report, Electronic Arts should return ~1.75 billion in free cash to shareholders at a projected free cash margin of 22.7%.
In addition to the financial data provided above, I will also note that the balance sheet of Electronic Arts does carry about $1.88 billion in debt, mostly in the form of senior notes, with a majority of the notes due for maturity in 2031 and 2051. The balance sheet also carries about $2 billion in cash. On top of the financial commitments and interest expenses born out of the Senior Notes, Electronic Arts also has unrecognized commitments in the form of payments it has to make to celebrity professionals, sports organizations, and content license companies to allow the company the ability to publish, market, and distribute their games. As of the recent earnings report, the company has about $3.8 billion in unrecognized non-financial payments to make to such entities.
Since the company has demonstrated the ability to make such payments in the past while still conducting their business in a way that returns cash flow to shareholders, I will assume a discount rate of 9% to estimate fair value using future cash flow projections. Using a reverse discounted cash flow method of valuing the company, I estimate that the market is pricing in a 7% growth rate annually in free cash flow for Electronic Arts over the next 10 years, followed by a terminal growth rate of 3% after that, when discounted at 9%. Given that the company has been focused on continually returning free cash to shareholders, I believe that the company should be able to grow its free cash flow at 5% over the next 10 years, which would mean that the stock is currently trading in the fair value range. I fear that if the company does not pull more levers to grow its business or widen its margins, it will continue to trade sideways, at best, as it has over the past 3 and a half years, as seen below.
Risks & Other Factors to consider
I had mentioned earlier that Electronic Arts is predominantly a game publisher. Companies like Electronic Arts work with game developers to publish their games on their own platform and on other platforms with whom Electronic Arts maintains publishing agreements. According to its FY23 10-K, Electronic Arts talks about the strength of its relationships with other publishers, platforms, and app ecosystems such as Microsoft ( MSFT ), Sony ( SONY ), Apple ( AAPL ), and Google ( GOOGL ). Over time, the line between platform and app ecosystems, game publishers, and game developers has blurred, leading to fierce competition. For example, in traditional game formats, Electronic Arts now faces meaningful competitive threats from Microsoft since they completed the acquisition of Activision Blizzard last year .
Moreover, I had noted earlier how mobile games have become key to Electronic Art’s revenue, especially in underserved business geographies. Unfortunately, market share in mobile games is also fiercely contested. Tencent ( TCEHY ) and NetEase ( NTES ) consistently rank among the top publishers, according to gaming intelligence company Newzoo, which has led to Electronic Arts ceding market share in important markets such as China. This is evident in revenue trends over the years, where revenue from the International segment has declined over the past five years.
In addition, Roblox (RBLX), another gaming company specializing in user-generated gaming content ((UGC)), a newer gaming format, has gained significant popularity among Gen Z gamers ( here , here , and here ), gaining market share in the younger demographic of Electronic Arts' target market.
Conclusion
To summarize, Electronic Arts is a great company with a sound history of producing cash flow. The company is constantly navigating the choppy waters of the gaming ecosystem, with fierce competition fighting for a piece of the market. Through my analysis, it is evident that the company must do more to warrant higher price targets or risk staying in its fair value range. For now, I rate this gaming giant as a hold.
For further details see:
Electronic Arts: Strong Gaming Company, But Limited Near-Term Upside