Source: EA.
Excitement over its new Star Wars: Battlefront game has helped push Electronic Arts' (EA 1.13%) shares up 60% so far in 2015, making it the second best performing stock in the S&P 500.
Disney's (DIS -0.36%) Star Wars: Episode VII film will be a worldwide theatrical and marketing phenomenon starting in December. And with what looks like a strong video game launching in November, EA should see a lift from association with this epic brand. "We're excited to be a part of one of the biggest global pop culture events of the year," the publisher's CEO Andrew Wilson said in May.
But investors shouldn't get swept up in all the movie excitement. Sure, Battlefront will add a new hit franchise to EA's slate. There are better reasons to like this stock right now, though.
Digital dominance
Take downloadable content. This includes stuff like the full game deliveries, add-ons, and expansion packs that are making video games more valuable entertainment products. Yes, digital delivery is lowering costs while cutting out the middlemen. What retailers like GameStop lose in booking sales transactions, publishers like EA and Activision Blizzard (ATVI) gain in higher profits.
But downloads are also extending a typical video game's life, which is reshaping the economics behind these properties. No one is doing a better job than EA at keeping players engaged long after a title's release through innovations like "ultimate team" for its sports franchises and "premium" title editions for shooters like Battlefield.
Management believes this digital shift should make it a fundamentally more profitable business. Operating margin recently cracked 20% and EA thinks that figure can keep climbing toward 30% of sales in the coming years.
EA Operating Margin (TTM) data by YCharts
Next-generation tailwind
The transition to next-gen gaming consoles hurt the industry last year by shifting gamer spending from (high margin) software to (low margin) hardware. The trend was most obvious in GameStop's profitability struggles as it sold relatively more console devices, at an average margin of 10%, and relatively fewer software titles — at an average margin of 40%.
The next-gen shift also pinched game publishers' results. Console bundles at one point pushed the average price paid by gamers for new AAA titles to a depressing $22 last year.
But the most painful part of this razor-razorblade sales model is over. There are more than 15 million Wii U, Xbox One and Playstation 4 consoles in U.S. homes right now. And the global installed base is expected to hit 50 million devices by the end of the year. Meanwhile, publishers don't plan to be anywhere near as generous with digital bundling in 2015.
That all suggests we're at the turning point where the console transition stops being a drag and starts lifting sales and profits. "We're very happy with the speed at which this console generation has been taken up by players," EA's Wilson told investors in May.
The Star Wars outlook
EA's official guidance calls for the Star Wars: Battlefront game to book 10 million unit sales, but Wall Street thinks that the final number will be closer to 14 million. That result would put the title on par with franchises like Battlefield and Call of Duty that enjoy a huge built-in fan base thanks to years of hit products and marketing support.
Source: EA.
Ironically, due to the hefty licensing fee that EA is paying Disney, the Star Wars game is expected to hurt the publisher's profitability this year. Royalty payments on that title alone should cut gross margin expansion to half of management's annual goal. But that's a small price to pay for help launching a new tentpole franchise.
