Electronic Arts Inc. (NASDAQ:EA) has delivered a huge winning streak for its investors. EA stock has soared as much as 52% year-to-date, jumping from 80 to the 110s at the end of August. Riding a string of hot releases, the stock is hitting all-time highs.
But with Electronic Arts up sixfold since 2014, and the whole industry soaring, is it time to take profits?
Certainly from a valuation perspective, it’s hard to make a case for the company here. But let’s take a closer look at the pros and cons for EA stock.
EA Stock Cons
Industry Too Hot: Electronic Arts is far from the only gaming stock that is soaring. Take Two Interactive Software Inc (NASDAQ:TTWO) has rallied from 45 last year to 96 on the strength of Grand Theft Auto. Similarly, Activision Blizzard, Inc. (NASDAQ:ATVI) has enjoyed a notable run, moving from 35 to 64 over the past year. Beaten-up social media gaming firm Zynga Inc (NASDAQ:ZNGA) has even caught a bid, moving up nearly 40% over the past year.
Unfortunately, earnings haven’t kept up with the share prices for these firms. Zynga remains unprofitable. Meanwhile, Take-Two is at 63x earnings, and Activision Blizzard sells for 44x. At 32x, EA stock might look cheap by comparison, but it’s still richly valued in an absolute sense.
The whole industry is priced for perfection. However, gamers tend to have fairly steady budgets; it’s unlikely all four of these firms will experience rising sales and profits at the same time. At least a couple of these firms will see their shares fall in coming quarters.
Hit Business Near Cyclical Peak: As EA openly describes in its annual filing, this is a “hits” business. EA publishes relatively few games each year, and relies on just a few titles to carry a huge portion of the business. That tends to work fairly well. EA’s stable of sports games, Sims-related titles and shooters are powerful intellectual properties.
Still, consumers tend to be quite fickle. There’s nothing wrong with a blockbuster-type business model. However, it’s dangerous to pay 30x or more earnings for such a business. There will inevitably be poorly designed or marketed games (EA’s near-franchise killing 2013 SimCity release for example). Investors won’t keep paying huge premiums for EA stock if the string of hit game releases doesn’t continue.
Not That Much Growth: The overall video game industry is growing at a mid-single digits rate. And Electronic Arts hasn’t done all that much better. Net income has bobbed around in the $900 million to $1.2 billion-per-year range for the past four years now.
On a top-line basis, things look worse yet. Revenues have only grown at a compounded 3% rate over the past 10 years. Yes, EA appears to have the digital transformation down, so maybe they can grow the top-line better going forward. But their track record, while fine, hardly supports the stock’s run to the stratosphere. Ultimately, this is a $36 billion market cap business that only sells $5 billion a year in product and earns about $1 billion in profits. That’s nosebleed expensive. And the company’s growth rate is hardly high enough to justify such optimism.
EA Stock Pros
Madden ’18: EA has dominated sports games for more than a decade. With the exception of basketball, EA has owned this genre and football in particular. This year is shaping up to be no exception. Madden 2018 came out recently, and it’s getting great reviews.
The game comes with a new story mode this year. The new longshot feature gives players the chance to enjoy a new-to-the-series story mode. In it, the player is a quarterback trying to get drafted and reach success in the NFL. It’s a totally new direction for Madden, which has long enjoyed great multi-player, but a rather limited single-player experience. With Madden offering a compelling new feature and scoring great reviews, this latest edition of the venerable Electronic Arts workhorse should help power a strong back-half of 2017.
The Dollar’s Struggles Are EA’s Gain: At the moment, Electronic Arts earns around 70% of its income from foreign sales. The U.S. Dollar Index has slumped from 103 to 92 since the start of this year. That more than 10% decline is the biggest drop for the greenback in seven years. The Euro in particular has spiked from 1.04 to 1.20 year-to-date.
That’s a huge boost for EA, which derives large portions of its revenues from wealthy developed markets in Europe. A 10% rise in sales, due to currency effects, would provide a huge boost to the company’s earnings. And with the dollar continuing to hit new lows lately, this tailwind appears to have legs heading into the holiday season.
Digital Transformation Going Well: For the fiscal year that ended in March 2017, EA reported more solid digital results. While revenues for the past year rose 10%, digital sales nearly doubled that, surging 19%. Overall, digital revenues are up to 59% of the company’s total.
One big positive for EA is the growth of subscription and in-game sales revenues. These types of revenue are more predictable than one-off game sales. As long as the company continues to make engaging games that appeal to players, the company will earn more predictable long-running revenues as a reward. Another plus: digital sales tend to have higher margins, thus improving the quality of EA’s earnings.
Bottom Line on Electronic Arts
I’m never going to feel comfortable paying more than 30x earnings for a hits-driven media company. Yes, signs point to another couple of good quarters for EA in the near-term. Perhaps there is more upside in EA stock heading into the holiday season.
As a longer-term investment, however, Electronic Arts is loaded with risk here. The whole gaming sector has surged recently, but the earnings just aren’t there to support these valuations. A few of these high-flying stocks will get hit once there aren’t enough gaming dollars to go around for all the developers.
You’ll likely get a chance to purchase EA stock significantly lower in coming quarters after a game or two flops.
As of this writing, Ian Bezek did not hold a position in any of the aforementioned securities. You can reach him on Twitter at @irbezek.
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