EA Rumored to Go Private

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Video game developer and publisher, Electronic Arts Inc (EA) is reportedly up for sale. According to a recent news feed from the New York Post, private equity players KKR and Providence Equity have shown keen interest in buying the video game maker. EA shares jumped 5.5% in response, closing at $13.81 on August 16, 2012.

According to the New York Post, the private-equity firms are rumored to have offered $20 a share, which is approximately a 45% premium to the closing price of $13.81. Since the discussions are at a very preliminary stage, EA has declined to provide any details.

Redwood City, California based EA is well known for its popular franchises such as Battlefield, Madden NFL, SimCity and many more. However, declining retail sales due to the ongoing transition from the physical to the digital platform and the emergence of free-to-play games has hurt EA’s top-line and profitability growth over the last couple of years.

U.S. video game retail sales declined 20.1% year over year to $548.8 million in July 2012, the eighth consecutive month of decline. Sluggish consumer spending on packaged goods has been a major factor behind this decline. According to market research firm NPD, overall consumer spending dropped 16% annually in the second quarter of 2012.

Online gaming is expected to witness growth at the expense of retail sales, given the growing popularity of digital distribution and free-to-play browser games. Consumers are increasingly spending more on smartphones and portable devices (such as the iPad) as compared to traditional devices for playing online games. 

Although EA has been steadily increasing its presence in the digital segment by offering its popular franchises online, they have not attained much success in terms of monetization to offset the significant loss from the packaged goods segment.

In the recently concluded first quarter of 2012, revenue declined 6.0% year over year despite the 55% jump in digital revenue (66% of total revenue) being fully offset by a 25% year over year decline in publishing and other (30% of total revenue) and 83.0% decline in distribution revenue (4% of total revenue).

Moreover, consumers’ reluctance to spend has compelled EA to provide most of its online games for free (in order to attract more subscribers), which has significantly hurt its profitability. EA reported an operating loss of $220.0 million in the first quarter.

EA expects that the increasing online subscriber base will boost its revenue from the sale of virtual goods going forward. The company also expects to earn significant advertising revenue over the long term.

However, we believe that EA’s online games face significant competition from social and casual game providers such as Zynga (ZNGA), Roveo (makers of Angry Birds) and many other small application developers who not only update their game content and features but also introduce new games on a regular basis.

In this regard, we believe that EA is handicapped by the limited number of new games in its portfolio. The company continues to publish digital versions of its existing franchises, but being mature, these games are naturally not doing as well as new ones from others. We believe that this is going to hurt its attempt to attract online subscribers, thereby negatively impacting revenue growth going forward.

Currently, on a year-to-date basis, EA shares are down 35.2% compared with a 10.8% increase for the S&P 500 and a 2.6% decrease for Activision’s (ATVI). EA is trading at a premium to most of its peers on a Price to Earnings, P/Sales and PEG basis. The current offer of $20.00 equates to a P/E of 31.7x, a significant premium to the current P/E multiple of 21.9x, which investors may find attractive.

We remain Neutral over the long term (6-12 months). Currently, EA has a Zacks #3 Rank, which implies a Hold rating over the short term (1-3 months).

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