Is It Time to Short Electronic Arts?

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer, too. But even I have to admit some growth stories are bogus, hence this regular series.

Next up: Electronic Arts (Nasdaq: ERTS  ) . Is this video game publisher the real thing? Let's get right to the numbers.

Foolish facts

Metric

Electronic Arts

CAPS rating (5 max) **
Total ratings 2,243
Percent bulls 88.5%
Percent bears 11.5%
Bullish pitches 359 out of 414
Highest rated peers Shanda Games, Giant Interactive, Activision Blizzard (Nasdaq: ATVI  )

Data current as of Dec. 11.

Fools don't see much value in Electronic Arts compared to peers. Activision Blizzard gets four of five possible stars in CAPS versus just two for EA. Take-Two Interactive (Nasdaq: TTWO  ) , publisher of the recent hit Red Dead Redemption and megafranchise Grand Theft Auto, also rates four stars. Why the disparity? Execution issues.

"Though FIFA is doing well, between handing market share to [Take-Two] by delaying (and perhaps cancelling) NBA Live, and the poor execution behind [Medal of Honor], this next quarter's call is going to be really disappointing -- these two missteps likely cost them $200M in revenue. I believe in [Electronic Arts] long-term (they're just too big and diversified to fall apart), but $16.76 is a bad price. We'll see what happens after earnings," wrote Foolish investor mugwump67 in mid-October.

Talk about prescient. Shares of EA are down more than 5% since that call, due at least in part to a disappointing performance for Medal of Honor, which was October's third-best-selling title despite a ton of buildup.

Investors also didn't much care for the quarterly report issued in early November. Apparently, they were looking for more than market-beating results, which they got. They were also looking for higher guidance, which they didn't get.

The elements of growth

Metric

Last 12 Months

FY 2010

FY 2009

Normalized net income growth Not measurable Not measurable Not measurable
Revenue growth (7%) (13.2%) 14.9%
Gross margin 58.1% 48.9% 49.5%
Receivables growth (31.3%) 77.6% (62.1%)
Shares outstanding 332 million 329.6 million 322.8 million

Source: Capital IQ, a division of Standard & Poor's.

Does that mean EA has been the victim of an unreasonable sell-off? Don't be too sure. The company's financials aren't exactly brimming with growth. Let's review:

  • Revenue isn't declining as sharply as it once was, and net losses were lower than expected last quarter. Sure, this is good news, but only because it could've been worse.
  • In better news, cost cuts have allowed EA to make big gains in gross margin. Cost of good sold is down 28% over the past two years. Revenue is down 13% over the same period.
  • Even so, cash isn't flowing nearly as much as I'd like. In each of the past two years, EA has burned cash instead of creating it. While the trend's reversed itself over the past 12 months, the damage is already done: EA has issued shares in order to fund growth, diluting existing owners.

Competitor and peer checkup

Company

Normalized Net Income Growth (3 yrs.)

Activision Blizzard Not available
Electronic Arts Not measurable
Microsoft (Nasdaq: MSFT  ) 9.3%
Take-Two Interactive Not measurable
THQ (Nasdaq: THQI  ) Not measurable
Time Warner (NYSE: TWX  ) (10.5%)
Yahoo! 1.1%

Source: Capital IQ, a division of Standard & Poor's. Data current as of Dec. 11.

Reading this table, I can't help but smile. EA's well-known franchises haven't given it any kind of edge over most rivals in terms of normalized net income. Instead, it's Microsoft that comes across as the class act of the group.

That's unlikely to change soon. Mr. Softy has scored a big hit with the Kinect controller and has a strong franchise of its own in the Halo series for Xbox.

Grade: Unsustainable
Call me a pessimist if you must, but I don't see how EA's advantages translate into premium growth or a premium valuation. I'd be more likely to short the stock than own it, now that it's trading for more than 20 times forward earnings.

Do you agree? Disagree? Let us know what you think using the comments box below. You can also ask me to evaluate a favorite growth story by sending me an email, or replying to me on Twitter.

Interested in more info on Electronic Arts? Add it to your watchlist by clicking here.

Microsoft is a Motley Fool Inside Value pick. Take-Two Interactive is a Motley Fool Rule Breakers recommendation. Activision Blizzard and Electronic Arts are Motley Fool Stock Advisor selections. Motley Fool Options has recommended subscribers open a synthetic long position in Activision Blizzard and a diagonal call position in Microsoft. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Activision Blizzard, Microsoft, and Take-Two Interactive. The Fool is also on Twitter as @TheMotleyFool. Its disclosure policy thinks Monty Python is sustainably funny.


Read/Post Comments (11) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 15, 2010, at 4:33 PM, seanmkelly11 wrote:

    This is a great article. Activision Blizzard (ATVI) and Microsoft (MSFT) dominated gaming in November and it is definitely going to be the same story in December. Electronic Arts talks a good game but they have not been delivering like Activision and Take - Two.

  • Report this Comment On December 15, 2010, at 4:34 PM, DaveGruska wrote:

    Thanks for the informative article. I can't see owning them right now, either, for the reasons you mentioned, but I do see things improving for them.

    They are going after the casual gamer on mobile devices, which I think is a wise choice, as it seems that a lot of mobile device owners are not hard-core gamers, but still are willing to buy some of the more popular titles, many of which EA owns. They are also all over the top games sold on the iPhone.

    And at least they have no debt, which is one of Peter Lynch's main criteria for a good turn-around story.

  • Report this Comment On December 16, 2010, at 10:50 AM, oliversk wrote:

    I boldly disagree

    EA has $4.99 in cash per share, with the stock selling at less than 15.80, giving it a 3.16 price to cash ratio.

    EA has not debt.

    EA totally underperforms (compare S&P)

    EA has the best relative performance.

    EA owns AngryBirds maker Rovio

    EA games sell like crazy in Apple's appstore

    EA has awesome call/put ratio

    EA have an awesome strategy for 2011 (only big titles, less investments, social games, multiplayer games)

    EA teamed up with Facebook and Apple

    EA has the best upcoming gaming titles that will make Starcraft 2 sales numbers look like peanuts. Crysis 2, Dead Space 2, SWTOR (the biggest entertainment launch since Avatar), Mass Effect 3

    EA rocks

    ...

    longterm (12-months), possibly $25 or more, this will largely depend on the initial success of SWTOR

    I'm not the only one who disagrees. Look at the call/put ratio.

    EA might go down during the next couple weeks, but longterm EA is the way to go. There might also be a surprise headline .. "Apple buys EA" who knows?

  • Report this Comment On December 16, 2010, at 11:36 AM, oliversk wrote:

    Quote Schaeffersresearch:

    "Elsewhere, we find that short sellers are starting to unload their bearish bets. During the past month, the number of ERTS shares sold short dropped by 11% to 17.2 million. However, more than 5% of the company's total float remains sold short. A continued unwinding of these pessimistic positions could fuel a rally in the shares.

    Wall Street is somewhat split in its outlook for the game designer. According to Zacks, the stock has earned 14 "buy" ratings, 10 "holds," and two "strong sells."

    You also mentioned low Medal of Honor sales in the article. According to EA Medal of Honor sold quite well, so I don't see any problems there.

    Anyway, I'm fairly new to investing and I only invest into stocks that are have a nice growth-potential (fundamentally).. so I'd like to hear your thoughts. I think EA has a nice strategy and is currently generating more and more revenue streams .. especially apps will be really lucrative.

    Today, EA dropped to 15,40 and jumped right back to 15,75 .. looks like a nice resistance in that area.

  • Report this Comment On December 16, 2010, at 3:09 PM, BioBat wrote:

    oliversk,

    all of those things have been in play for the past 2-3 years and ERTS has done terribly.

    The problem with ERTS is they've failed to deliver. They no longer have bona fide sure hit franchises like ATVI, TTWO, and even Nintendo have.

    Quckenbush - ERTS came out and said MOH was going to rival Activisions COD in terms of sales. While MOH hasn't done terribly, COD sold more in 24 hours than MOH has sold since its release. Afterwards, they even admitted that sales were disappointing based on what they projected.

    While it's 50d moving average is a little north of 15.50, it's also dipped well into the 14s in that time. For a company that's screwed the pooch on so many new releases in the past two years, it's only a matter of time before they do it again and we see another big price drop.

    If you're going for a company in the gaming space, better to go with one that's undervalued AND selling games like hotcakes. ERTS doesn't fit that bill in any way shape or form.

    Disclosure: I owned ERTS stock for a long time and saw nothing good come of it. bad management, bad decisions, bad games.

  • Report this Comment On December 16, 2010, at 9:25 PM, oliversk wrote:

    EA has the best franchises that you can currently have. Yes, they made some bad calls in the past, but they have a great strategy for 2011.

    Some of their franchises will sell like hot cakes:

    Bulletstorm

    Crysis 2 (I predict that this will sell even better than CoD)

    Mass Effect 3 (another mega hit)

    Battlefiled Play4Free (a lot of fans are waiting for this)

    SWTOR (Star Wars has the biggest fan community in the world - this will sell like hot cakes)

    Dead Space 2

    Dragon Age 2

    AngryBirds (most sold iPhone app ever?)

    Pogo games

    Need for Speed + NFS iPhone app

    BF3

    ..

    the list goes on an on

    They are making the right decisions for 2011. When I look at Activision I see that they heavily rely on their Diablo, Starcraft and WoW games. But what if one of those games turns out to be a flop? EA is generating a lot of new revenue streams via social games and apps and decreasing investments.

  • Report this Comment On December 16, 2010, at 9:34 PM, oliversk wrote:

    2011 is a totally other story. During the past 3 years, EA did not do so well, but I'm sure it'll change in 2011.

    Latest EA news, regarding apps:

    http://www.ubergizmo.com/15/archives/2010/12/ea_releases_a_s...

    For me it's a calculated risk. They either drop to $14 again or they go up to $20 and possibly even $25 thanks to their shift in plans and mega franchises in 2011.

    It's almost a safe-haven for your money .. it's unlikely that they will drop below $14 and the chance that they will go well above $20 is there. If you think longterm, 1-2 years EA is the way to go in my opinion.

    Disclosure: I own stocks of ERTS

  • Report this Comment On December 20, 2010, at 11:06 AM, BioBat wrote:

    Oliversk,

    you have to ask yourself - is anyone rushing out to buy ERTS games. The answer is unequivocally no.

    The have some good franchises but they've managed to bungle so releases of so many franchises over the past 3-4 years (MoH, missing an NBA release, Spore, Beatles Rock Band) that I wouldn't put too much stock in their franchises going forward. Mass Effect 3 should be a huge hit, but I'm looking forward to seeing how they manage to screw up.

    Oh and Angry Birds is a great selling game but ERTS actually doesn't have any stake it in. They bought, Chillingo, the publisher but they didn't get access to the Angry Birds IP. That's retained by the developers, Rovio. So while ERTS controls the publisher of Angry Birds, they have zero stake in the best selling iPhone gaming App.

    http://www.examiner.com/technology-in-national/electronic-ar...

    And you're correct that ATVI relies heavily on 4-5 franchises but they've managed to deliver on them consistently over and over and over again, which is why gamers keep coming back and why they keep having the biggest blockbuster releases ever. They also drive a lot of revenue from WoW, with over 12 million active users paying a $15 monthly subscription fee. That's the equivalent of selling 48 million copies of a $60 game every a year and it's not going to end anytime soon, especially considering they just released an expansion pack that's the fastest selling PC game of all time.

    The only thing I agree with is that it probably can't get worse for ERTS but I just don't see it getting a whole lot better.

  • Report this Comment On December 20, 2010, at 11:35 AM, BioBat wrote:

    Edit: My math was bad (not enough coffee).

    Revenue from WoW subscriptions are equivalent to selling 36 million $60 games a year.

  • Report this Comment On December 20, 2010, at 2:05 PM, CyberMurph wrote:

    I bought EA when they announced The Old Republic, then the market promptly crashed, so I bought more.

    The Fools might be right about EA's execution issues, but they would Foolish to underestimate BioWare's (Mass Effect 3, TOR, Dragon Age 2) execution. Bioware has a commitment to quality, combined with name recognition (Star Wars) that has resulted in one of their older games, the original Star Wars: The Old Republic, still sitting on shelves six years after launch. Literally a lifetime for a sindle player game.

    My money is riding on EA, but only because of BioWare.

  • Report this Comment On December 20, 2010, at 4:58 PM, BioBat wrote:

    CyberMurph,

    I agree that BioWare is probably the only shining light in ERTS portfolio right now but I'm not sure that's enough given the amount of dead weight at ERTS. They need a management overhaul ASAP.

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