Electronic Arts (NASDAQ:EA) showed solid performance yet again when it reported its fourth-quarter earnings. One important announcement during the investor conference call was management's decision to go all-in with share repurchases instead of initiating a regular dividend.
Management had previously hinted the company might start a dividend, but the explanation of why it chose not to go that route highlighted an area where it sees a lucrative opportunity to build a sizable cloud-based subscription service over the long term.
Why EA doesn't want to commit to dividends
EA already has its toes in the water in subscription services with EA Access and EA Origin Access, which both allow gamers unlimited access to the game maker's titles across PC or console. But the cloud-based service management wants to build would significantly broaden this to include third-party original content, which may require acquisitions (and, naturally, a lot of cash).
EA generated $1.6 billion in free cash flow in fiscal 2018 and has $5.3 billion of cash and investments on its balance sheet. As part of its plan to return cash to shareholders, management opted for share repurchases over dividends because, as CFO Blake Jorgensen explained, "we felt if we started a dividend it would be much harder to stop it if there was some reason to flex up to do [a large acquisition]. And that's the reason we decided to stay with the buyback."
EA is shopping for more deals
In order to bolster its content library for this new cloud-based service, EA is looking to do more acquisitions like the recent one of Respawn Entertainment for $455 million.
Here's how Jorgensen described management's thinking on the fourth-quarter conference call:
[R]unning a broad subscription service requires great content. And so we're always looking for great content and really great studios that can build that content. ... And so it's great studios and great partners that we can bring to the table in both mobile and console and PC, but also technology that will help us either in subscriptions or streaming.
Jorgensen's comment offers a broad view of the kinds of companies EA may acquire. One thing that jumps out from his remark is that the acquisition search may not be limited to games, but instead could include technology that enhances the company's streaming capability.
Keep in mind, EA doesn't have to rely solely on acquisitions to add to its content offering. For example, EA and Warner Bros. Interactive Entertainment recently announced a deal that will let members of EA Origin Access have access to six titles, including the popular Batman: Arkham series and LEGO Batman games, from the Warner Bros. catalog, as part of their subscription.
Also note that Jorgensen referenced all platforms -- mobile, PC, and console. It's clear EA wants this service to be accessible across all devices, the same way people engage with Netflix, for example.
Cloud gaming could be a multibillion-dollar revenue stream
CEO Andrew Wilson believes that a cloud-based subscription service could make up the majority of EA's total revenue in the years to come. If we take EA's fiscal 2018 revenue of $5.15 billion and assume it grows at only 5% per year over the next 10 years, that puts EA's future annual revenue at $8.3 billion. Under that scenario, Wilson is basically saying a cloud gaming service would be at least a $4 billion business.
The strategy is not about top-line growth, since a subscription service would largely replace money being spent on new games, which make up close to half of EA's revenue right now. Instead, growth in subscription revenue would be more of an opportunity to expand margins, as more of EA's revenue would come from digitally delivered content as opposed to physical goods, which still make up about 33% of EA's revenue. Plus, with EA's revenue becoming more predictable under a subscription model, it would lower the company's risk profile to investors.
EA sees cloud gaming as the future
EA executives believe the same trends that have impacted movies and music will transform how games will be played in the future. Entertainment content is increasingly getting wrapped up in subscription services, and it looks like the video game industry is next.
Subscription revenue is included in EA's live services revenue, which was the game maker's fastest-growing category in fiscal 2018, surging 31% year over year. It now makes up 43% of EA's business. Strong growth in live services is one reason EA's gross margin expanded 200 basis points to 75.2% last year.
With an opportunity to keep live services and subscriptions growing, it's understandable why management doesn't want to commit to a dividend just yet -- it has big ideas about how to grow the company.
John Ballard has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool recommends Electronic Arts. The Motley Fool has a disclosure policy.