After Jumping 12%, Is Electronic Arts Overvalued?

The other week, shares of Electronic Arts (NASDAQ: EA  ) jumped 11.88% following positive outlook from CRT Capital. The broker dealer initiated coverage on the video game developer with a "Buy" rating and placed a $26 price target on it. Despite noting the company's lackluster performance in recent years, particularly due to very little original intellectual property, CRT believes that its upcoming release of Titanfall could be the start of brighter days. But, is it logical to assume that one title has the potential to change the company's future, or is it more likely that Mr. Market is overreacting to this news?

Electronic Arts has a history of mediocrity
Over the past four years, results posted by Electronic Arts have been less than ideal, as shown in the table below:

Source: MSN Money. 

As we can see, Electronic Arts hasn't had much going for it lately. From 2009 through 2012, the company only managed to grow its revenue by 3.9% from $3.65 billion to $3.8 billion. In comparison, peers like Activision Blizzard (NASDAQ: ATVI  ) , Take-Two Interactive  (NASDAQ: TTWO  ) and Zynga (NASDAQ: ZNGA  ) performed much better.

Over the same timeframe, Activision saw its revenue rise 15.5% from $4.28 billion to $4.86 billion, while Take-Two saw its revenue jump 25.4% from $968.5 million to $1.21 billion. Zynga blew away the competition as revenue skyrocketed 954.6% from $121.5 million to $1.28 billion.

Based on growth alone, Zynga takes the cake. However, a company's ability to generate strong profits far outweighs its ability to grow revenue. It doesn't matter how much money you bring in if you aren't able to keep any of it. By looking at each company's net profit margin, we can get a better idea of how much money Electronic Arts and its peers can generate.

In its most recent fiscal year, Electronic Arts saw its net profit margin come in at 2.6%. What this means is that, for every dollar booked as revenue, the company earned a profit of $0.026. While this doesn't look terribly impressive, it's better than the four-year average net profit margin of negative 5.5% reported by management.

Despite these results, they are stronger than the performance reported by both Take-Two and Zynga. Take-Two saw its most recent net profit margin come in at negative 2.4% while its four-year average net profit margin was negative 6.4%. Zynga was the worst of the bunch, reporting net profit margin and a four-year average net profit margin of negative 16.3% and negative 20%, respectively.

The only impressive company in the group was Activision. Although its revenue growth rate was second to last, the company earned a 23.7% net profit margin. At 14.6%, the company's four-year average net profit margin is markedly lower than its last completed year, but still significantly higher than any of its peers.  The primary reason for this is that the two have very different cost structures: 

Source: MSN Money

While cost of revenue isn't all that different from Electronic Arts to Activision, Activision has a much lower research and development expense and a lower selling, general and administrative expense.  The disparity between the two in selling, general and administrative expenses is attributable to higher advertising by Electronic Arts.  Long-term, this could be beneficial for the company but so far the lackluster results of games like Battlefield 4 haven't pointed in that direction. 

What analysts are so pumped up over
The primary factor in CRT's report for rating Electronic Arts a "Buy" was the upcoming release of Titanfall. Even in spite of the company's poor operating history, CRT maintains that this title could provide some upside to shareholders, but I have my doubts.

For the week ending Jan. 11, 2014, Titanfall had pre-orders totaling 251,153 units (excluding the 57,350 units pre-ordered for the PC). Seeing how the game is geared solely for Microsoft's Xbox One, Xbox 360, and Microsoft Windows, it would be illogical to compare its pre-orders to other games without removing the numbers factored in for Sony's PS3 and PS4. After doing this, we can look at how other major games fared eight weeks prior to their launch and see whether it's likely that Titanfall will make much of a splash.

Source: VGChartz.

Looking at the table above, we see how anticipated Titanfall is compared to games released late last year. Of the titles provided, Take-Two's Grand Theft Auto V held the highest pre-order volume at 1.18 million units. In second place, was Activision's Call of Duty: Ghosts with nearly 731,000 units. Battlefield 4, the hottest title released by Electronic Arts, saw almost 428,000 units pre-ordered.

According to this data, it doesn't look like Titanfall will be anywhere near the size of the other big-name hits. However, things are subject to change. Despite having lower order volume prior to its release, Call of Duty: Ghosts beat out Grand Theft Auto V in terms of sales. In its first day in stores, Activision's flagship game posted revenue of $1 billion. This was higher than the $800 million earned by Grand Theft Auto V, which took three days to catch up to Call of Duty: Ghosts.

Foolish takeaway
Based on fundamentals, Electronic Arts seems to be better off than Take-Two and Zynga but is far from dominant. This is especially true when the company is compared to Activision, which beats it in terms of revenue growth and profitability. But, just as Activision struck big with its Call of Duty franchise, it's possible Titanfall could become the next big thing.

Unfortunately, whether a game will become a blockbuster or not is impossible to predict. Currently, the best indicator of a game's future performance happens to be pre-order volume. But using this metric suggests that Titanfall will be a nice release but not so large that it should warrant a $791 million single day increase in Electronic Arts market cap.

Because of the confluence of poor fundamentals and far-from-stellar expectations for its upcoming release, investors who are bullish on the company should be very cautious moving forward. This is especially true when you consider that Electronic Arts is trading at 33 times earnings, more than twice the 16 times that Activision is trading for.

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  • Report this Comment On January 28, 2014, at 11:42 AM, bigbc1631 wrote:

    Mr. Jones, do you not do any research? Call of Duty Ghosts had $1 billion "sold in" meaning on retailer shelves. In fact, they made less than the $500 million day one sales the previous installment made. Please do research before writing an article.

  • Report this Comment On January 28, 2014, at 12:00 PM, speculawyer wrote:

    The previous commenter is correct, you fell for ATVI's misleading press release.

    But I agree that Titanfall is overhyped . . . it will sell well but there are several reasons it won't be as big as many think:

    1) It is only 12 players max.

    2) It is multi-player only.

    3) It is ONLY on Microsoft consoles.

    Those 3 things will limit its success.

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