Foolish Forecast: Electronic Arts Needs a Reboot

Thursday night is game night! That's when Stock Advisor recommendation Electronic Arts (Nasdaq: ERTS  ) reports second-quarter 2008 earnings. Reset to the last earnings report, and then reboot back here to hear the rest of the story. Amazing things, these consoles.

What Fools say:
Here's how Electronic Arts' CAPS scoring rates against some of its peers and competitors:

Company

Market Cap (Billions)

Trailing P/E Ratio

CAPS Rating

Microsoft (NASDAQ:MSFT)

$343.8

24.2

**

Electronic Arts

$19.0

769.9

***

Activision (NASDAQ:ATVI)

$6.7

55.9

*****

THQ (NASDAQ:THQI)

$1.8

26.1

***

Take-Two Interactive Software (NASDAQ:TTWO)

$1.4

NM

***

Data from Motley Fool CAPS and Yahoo! Finance on 10/31/07.

Fellow Stock Advisor pick Activision gets a 97% approval rating from our players, while EA gets only a thumbs-up. Why is that?

Fans on both sides like to highlight individual games and franchises, such as Activision's Guitar Hero series and EA's major sports licenses. One CAPS All-Star bear notes that Electronic Arts' growth is slowing and says the valuation is "too high," while another high-scoring player likes Activision because it "doesn't seem to suffer from constant management missteps," unlike other game publishers, and says the company "shows far more upside potential than the conglomerate that is EA."

What management says:
Management outlined a revenue target range of $465 million to $570 million in the last earnings report. Pro forma earnings per share should land within a few pennies of $0.15, but there should also be a GAAP net loss around $0.85 per share. A few weeks ago, we were told that the results will exceed that guidance, but the company didn't say why or by how much.

What management does:
The P/E ratio above is high enough to require warning lights, lest passing airplanes crash into it. That's because GAAP net income is hovering very close to breakeven on a trailing basis. And it's not a brilliant tax-reduction strategy at work, either -- cash flows have been dwindling away at a rate comparable to net income.

Sales picked up a bit when Microsoft, Sony (NYSE: SNE  ) , and Nintendo (OTC BB: NTDOY.PK) released fresh consoles over the past couple of years, but profits have failed to follow.

Margins

3/06

6/06

9/06

12/06

3/07

6/07

Gross

60.0%

60.1%

59.7%

60.9%

60.8%

60.6%

Operating

12.2%

11.4%

10.0%

5.6%

1.8%

(0.4%)

Net

8.0%

7.1%

5.9%

2.7%

2.5%

0.8%

FCF/Revenue

16.0%

15.4%

13.5%

11.7%

7.1%

2.9%

Y-O-Y Growth

3/06

6/06

9/06

12/06

3/07

6/07

Revenue

(5.7%)

(2.1%)

2.8%

8.9%

4.7%

2.5%

Earnings

(53.2%)

(49.5%)

(51.1%)

(67.2%)

(67.8%)

(88.3%)

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
Between 2003 and 2006, EA generated at least $400 million of free cash flow every year. That haul sank to $219 million last year, and the trailing-12-month FCF total stands at just $89 million today.

The share price has just about kept pace with the S&P 500 over the past five years, albeit with great volatility. Growth is nowhere to be seen, and the spark seems long gone.

So EA is trying something new. The company plans to buy two rival studios for as much as $860 million in cash and stock. It's the largest acquisition in company history, and an injection of fresh blood and ideas. If you can't make growth happen, you can always buy it. And perhaps this is the shot in the arm this flagging operation needed.

Game on, Fool:


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