My bearish stance on Electronic Arts
True, EA is arguably the most formidable competitor in the video game software market. It has the largest number of successful titles, with more than 30 of them selling more than 1 million units each, including the Madden NFL, Sims, and Need for Speed series. Indeed, its top four titles each have generated more than $1 billion in sales since their introduction. The next-largest competitor, Activision
EA is also well diversified in its exposure to the top gaming platforms. Sony
- PlayStation 2 games: 36%
- Xbox games: 13%
- Sony PSP games: 9%
- Xbox 360 games: 5%
- Nintendo GameCube games: 5%
- Games for cell phones: 1%
EA is also a very profitable company, having grown compound annual sales 17.4% over the past five years, with operating cash flow growing nearly 25% each year in the same time frame. Sounds promising so far. So why am I not a fan of the stock?
A tough industry
First off, the gaming industry is highly cyclical, not in terms of economic cycles, but rather in the busts that accompany the development of new next-generation hardware and software, and the subsequent sales booms following those products' introduction. The cycles last about five to six years, and right now we're on the cusp of the next cycle. The Xbox 360 was released late last year, while the PlayStation 3 and Nintendo's Wii are set for November release in the U.S.
The industry is as competitive as it is cyclical. Sony is currently the global leader in the struggle for hardware supremacy, but Microsoft's Xbox has made quick inroads since its introduction in 2001. As the two battle it out, software developers must develop their game plans accordingly. In the wake of Sony's numerous delays in rolling out the PlayStation 3, EA and Activision have laid off staff and cut certain game prices as they await the next ramp in the product cycle. Competition among software publishers is similarly cutthroat, as I'll expand on below.
Recent trends and valuation
The more recent past has not been as impressive for EA. Earnings have grown only about 6% on average per year over the past three years, while operating cash flow has shrunk by an average of almost 6% per year. Operating cash flow tends to come in ahead of reported net income, but tax benefits from the exercise of employee stock options accounted for 22% of operating cash flow last year, and about 10% the previous two years. Capital expenditure needs are relatively low, but after taking out these tax benefits from stock options, free cash flow runs close to reported net income, which has decreased over the past three years.
Granted, near-term results are being depressed as the company ramps up its development for next-generation consoles. Still, I'd consider EA's forward P/E of 43 quite lofty, and I think it will only come down to more reasonable levels if sales and cash flow growth following the release of the PlayStation 3 prove greatly impressive. That's hardly guaranteed.
There's no question that EA is a valuable business. But how wide is its economic moat -- its ability to fend off the competition and continue to earn returns on invested capital far beyond those of its average rival? The past three years could indicate its decreased dominance; its cash flow generation has weakened, and the video game software market is only becoming more competitive. Indeed, given its rapid expansion, EA needs an ever-increasing number of blockbusters to keep sales chugging along. That leads to higher development costs, which in turn means that the company has less room for error if it turns out an expensive flop. There has also been some backlash directed toward its complex, high-priced games. Certain developers are instead offering easier-to-play games at half the cost; their titles' increased simplicity will be a must on mobile phones.
Game over, man
Shares of EA have appreciated more than 30% since July, and they're now too pricey for my comfort level, especially given the uneven financial trends of the past few years and the uncertainty heading into the next major gaming cycle. Unfortunately, at this point, I think the stock has already priced in a very successful cycle of new game consoles and related software revenue.
EA has been incredibly successful, becoming the leading game publisher in a very competitive industry with exciting growth prospects. But at this point, I'm more partial to Microsoft overall, as it rolls out its new Vista operating system for PCs, or video game retailer GameStop
Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.