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Ole Hansen
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Article / 20 August 2012 at 8:53 GMT

Electronic Arts is for sale, but what is it worth? A lot, maybe

Equity Analyst
Denmark

Electronic Arts may be worth a lot

Electronic Arts (Nasdaq:EA) has been approached by a couple of private equity firms for a sale of the company, according to press reports. The electronic game maker is reportedly mulling a sale due to its lagging stock price, which is down more than 38% YTD before the rumors bumped up the price by 5%.

EA has been mismanaged, focusing too much on low-return social and mobile games instead of its reliable and popular brand names.  And the industry itself is in one of its periodic downturns, as game creators and consumers wait for the new consoles. 

But I believe that smart management could produce about USD 600 million of earnings per year from EA, and if the company's earnings could be valued at a price to earnings multiple of around 10-15 by the market, that would give EA a valuation of around USD 6 to 9bn, or USD 18-30 per share.  

Since according to the reports EA wants USD 20 a share - a 40% premium to the company's current stock price -  a private equity firm who bought at that price and slimmed down the company could walk away with a tidy profit.  

Some historical context

Many of the video game makers have not recovered from the studio buying spree that occurred prior to the financial crisis. This amounted to a large consolidation of the industry and has resulted in many studios overpaying for acquisitions - and being punished through poor earnings and sagging stock prices. Although Electronic Arts was not the worst, it did squander capital much like the rest of the industry.

Through the past 7 years of acquisitions, the company decreased its cash balance and its shareholder equity buying mobile and social gaming companies that have not lived up to expectations. In addition to the destruction of its balance sheet, EA also managed to reduce its earnings to nothing, driven mostly by an increase in R&D and selling and admnistrative expenses shown in the table below.

EA balance sheet deterioration

But all is not lost. The industry which is being mistakenly characterized as a 'mature industry' as consoles sales are starting to decrease year on year, is actually at the bottom of its typical 'hardware' cycle. So while EA is in difficulties, the industry is a growing one, and EA can potentially turn it around.

The electronic game industry

A lot of fear is baked in to the industry right now. As mobile and social gaming gets all the press, and typical brick and mortar sales of video games appear to be in free fall, digital sales are actually more than making up for the decrease in retail sales. The digital impact is creating new avenues for growth for traditional PC and console games by selling 'extra content' and subscription based services to gamers, which is creating a major boost to developers, and making popular game franchises even more valuable.

What is characterized as 'hardware fatigue' by the industry is simply the coming end of the seventh general hardware cycle of console makers. The industry usually goes through these 5-8 year cycles, dating back to Atari in the 80's, and this is what is currently happening. We are seeing a heavy slowdown in Xbox 360, Wii and Playstation 3 console sales.

Because the development of games is strongly driven by hardware innovation, many studios have held back from developing for the existing consoles and instead are developing for the next generation of consoles. This slowdown in game development is affecting console sales, which are then affecting game sales all over again. This is a normal part of the industry. I have included an old chart from a 2002 article from The Economist which shows the typical cyclicality of the industry. 

Cyclicality

As the bottoming of the cycle approaches, investors get spooked by the slowdown. And since rapidly growing mobile and social gaming is taking center stage, the traditional gaming industry is thought to be dying. But while mobile and social gaming has exploded in popularity through the everyday use of smartphones and tablets, it has not replaced traditional gaming at all, especially for hardcore gamers that depend on consoles such as the Xbox and Playstation for their gaming needs. Therefore what you have is an industry approaching its traditional industry bottom and appearing to be left behind by mobile gaming which leaves investors only seeing red flags, and leaving stock prices from an historical perspective, quite beaten down.

But what makes Electronic Arts so attractive?

But getting back to Electronic Arts, it does look pretty terrible from an operational perspective. This creates a good opportunity for active shareholders such as private equity firms to take over and reorganize. Years of acquisitions, 37 in 21 years to be exact, has made EA unprofitable and unfocused. But what makes this company attractive are the console games that it produces and the brands that it owns. Much like Activision-Blizzard, which is one of the best run gaming companies, the company has long-lasting and popular games that carry high loyalty, such as the EA sports franchises dominated by FIFA and Madden as well as The Sims and SimCity, the Battlefield series and Crysis, to which it licenses its Crysis engine for other developers to use. 

But with all these great games, the company has expensively acquired and created a lot of mobile, social and free to play games which have destroyed the margins of the company mainly through wasted R&D and SG&A expenses as shown in Chart 1. Although I understand that mobile and social is the new hype, EA does not make much money off these games, the company is simply chasing revenue growth which is destroying margins. Simply put, EA is completely unfocused and mismanaged.

Much of the company's capital is wasted on developing these small games which affects effectiveness of Research & Development as well as other costs. Because most of the company's games are legacy games such as the EA sports franchises, Sim games and Battlefield, the R&D requirement are much less than other games as the games can simply be improved instead of completely re-done. Once the company starts experimenting with new games, game development becomes expensive. I am assuming this is exactly what the private equity firm is looking at when they look at Electronic Arts, a strong set of brands with little R&D or marketing focus. In the chart below we can see the large effect on EA's stock price as it began to acquire mobile and social gaming companies in 2006 through 2011.

Stock performance

Why are the vultures circling?

From my own ballpark estimation, I believe that 80% of the company's revenue (Publishing and Digital) are driven by PC and console games coming from the big franchise and legacy games. Meaning that by stripping away all the 'fat'  by selling off the social and mobile games, the company should be much leaner and effective. And if we follow the Activision Blizzard model where 35-40% of sales goes to R&D and SG&A, which should be fairly accurate given that ATVI focuses on big games, EA should be able to handily increase its profit margins. As a back of the envelope calculation, I belive that EA would be able to earn about USD 600 million a year in profits on its current 4.4bn of market capitalization. This makes the company seem much more attractive and profitable at a trailing P/E of around 7.

Comparison with new operating model

But the story does not end there... EA has been leveraging its strong brands by selling extra content, a business which has grown at a 65%+ clip in the past year and accounts for 10% of EA's revenues. This will not continue indefinitely but it does paint a better picture for the prospects of the company.

The million dollar question

How much is this company worth? Well not much, if the business model doesn't change. But an activist investor could turn things around by focusing the company on the biggest brands.

Let's say the private equity firms agree to the USD 20 share price EA is reportedly demanding. With 600 million per year of earnings growing at around 5-10%, which is a rough estimation of the industry and the company's growth, the company's earnings could be valued at a price to earnings multiple of around 10-15 by the market, giving it a valuation of around USD 6 to 9bn (18-30$ per share) or a maximum increase of around 100% from the current market price.

If all goes well, a USD20 per share price for EA might turn out to be a bargain. 

 

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