EA's Q4 Earnings Surge, Revs Misses

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Electronic Arts Inc. (EA) reported earnings of $1.26 per share in the third quarter of fiscal 2014 per share, which were much better than the 57 cents reported in the year-ago quarter.

Revenues

Revenues (including change in deferred revenues) jumped 33.0% from the year-ago quarter to $1.57 billion but lagged the Zacks Consensus Estimate of $1.66 billion. Revenues also missed management’s guidance of $1.65 billion.

The miss was primarily attributed to the decline in sales of major games for old consoles such as PlayStation 3 and Xbox 360. During the quarter, both Microsoft (MSFT) and Sony (SNE) launched their next generation consoles namely, PlayStation 4 and Xbox One, respectively.

EA released 6 games for new consoles, which helped it to gain 40% segment share on the PlayStation 4 and 30% segment share on the Xbox One in the U.S.

Digital revenues jumped 27.0% year over year to $517.0 million (33.0% of revenues) in the quarter. EA’s publishing and other segment (65.0% of total revenue) revenues surged 38.0% from the year-ago quarter to $$1.03 billion. Distribution revenues declined 15.0% on a year-over-year basis to $28.0 million.

The improvement in digital revenues was driven by a 157.0% jump in full-game downloads, 26.0% increase in mobile and 15.0% growth in extra content. Smartphones and tablets (88.0% of mobile revenues) jumped 39.0% on a year-over-year basis in the reported quarter.

Region-wise, North American sales (44.0% of revenues) soared 41.0% year over year to $690.0 million, while international revenues (56.0% of total revenue) increased 27.0% from the year-ago quarter to $882.0 million.

Margins

EA’s gross margin (excluding acquisition-related expenses and change in deferred net revenue) expanded 240 basis points (bps) year over year to 68.1% in the third quarter. The solid margin expansion was primarily led by robust digital revenues.

Operating expenses (before acquisition-related contingent consideration, amortization of intangibles, restructuring and other but including stock-based compensation) as a percentage of revenues declined to 36.9% from 48.1% reported in the year-ago quarter.

The year-over-year decline was primarily attributed to lower marketing & sales expense and research & development expense, which decreased 500 bps and 600 bps, respectively. General & administrative expense declined 10 bps from the year-ago quarter.

A higher gross margin base and lower-than-expected increase in operating expenses helped operating margin (including stock-based compensation expense but excluding one-time items) to expand to 31.2% from 17.6% in the year-ago quarter.

Net income (including stock-based compensation) was $363.9 million compared with $144.1 million in the year-ago quarter.

Earnings were $1.15 per share compared with the Zacks Consensus Estimate of $1.16 in the last quarter. Earnings include stock-based compensation but exclude acquisition-related expenses, amortization of debt discount, change in deferred net revenue, gain on strategic investments, restructuring and other and related tax effect.

Balance Sheet and Cash Flow

EA exited the quarter with $1.74 billion in cash, short-term investments compared with $1.42 billion in the previous quarter.

Outlook

For the fourth quarter of fiscal 2014, EA expects to generate non-GAAP revenues of approximately $800.0 million, which is lower than the Zacks Consensus Estimate of $826.0 million. The company expects non-GAAP earnings to be 9 cents per share, much lower than the Zacks Consensus Estimate of 13 cents.

Non-GAAP gross margin is expected to be 71.0% down from 74.0% reported in the year-ago quarter. Non-GAAP operating expense is expected to be $525.0 million.

For FY14, EA expects to generate non-GAAP revenues of approximately $3.91 billion, lower than the Zacks Consensus estimate of $4.02 billion. The company upped its earnings guidance to $1.30 per share from the earlier outlook of $1.25, which is higher than the Zacks Consensus Estimate of 93 cents.

Management continues to expect gross margins of 66.0%, while operating expenses are projected to be approximately $2.04 billion (down from $2.10 billion). EA raised its operating cash flow forecast to approximately $600.0 million. Free cash flow is forecasted to be approximately $500.0 million.

Recommendation

EA’s revenue outlook fails to impress us. The company faces a number of headwinds that include significant competition from other game makers such as Activision (ATVI) and Take-Two Interactive (TTWO). Additionally, higher consumer spending on new consoles may cannibalize software sales in the near term

Nevertheless, we believe that EA’s strong digital portfolio and continuing growth in the tablet and smartphone market are key growth catalysts. EA’s strong portfolio of games will continue to boost its market share on new consoles, going forward. Moreover, the company’s efforts to optimize costs through overhead reductions will be beneficial going forward.

Currently, EA has a Zacks Rank #3 (Hold).

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