Once among the highest-flying stocks in the market, shares of video game publishers Electronic Arts (NASDAQ:EA), Take Two Interactive (NASDAQ:TTWO), and Activision (NASDAQ:ATVI) have all fallen off a cliff over the past several months. All three stocks peaked in mid-to-late 2018. Since peaking, TTWO stock has dropped 20%, while both EA stock and ATVI stock have fallen a whopping 40%.
Across the board, the bull thesis looks compelling for video game stocks here. Near-term headwinds blown by disappointing back-half 2018 sales are legitimate but overstated and have been overpriced into these stocks. The much broader and more powerful multi-year trends at play here, including deeper digital adoption, a steady rise in micro-transactions, and the mainstream emergence of eSports, remain favorable.
To be sure, those near-term headwinds will inevitably phase out. They will be replaced by favorable multi-year trends. This transition will ultimately push video game stocks way higher.
This is especially true for EA stock. Electronic Arts stock has dropped 40% since July. Since then, there’s been some negative holiday sales reads regarding two of the company’s headline titles, Battlefield and FIFA. Meanwhile, there’s some concern about margins getting hit next year due to licensing fees related to a new Star Wars game.
But, again, these are all near-term headwinds. In the big picture, thanks to a robust content portfolio, the games maker has broad exposure to the three important multi-year trends in the video game industry. That broad exposure will ultimately boost EA stock the medium-to-long term as the more immediate headwinds are replaced by favorable multi-year growth trends.
Near-Term Headwinds Are Legitimate
To be sure, the headwinds weighing on EA stock are very real.
The consensus read from analysts is that gamers have not engaged with FIFA 19 ever since its debut in late 2018, despite being the number two video game sold globally in 2018. Other titles have been weak, too. A glance at the list of top video games from 2018 will show you that games from Activision and Take-Two dominated the market. Both companies had headline launches in their core franchises, Call of Duty and Red Dead Redemption, respectively.
Electronic Arts didn’t really have a big game last year. Outside of FIFA 19, EA’s showing in 2018 was relatively weak. That contributed to a down-guide in late October, and that guidance has weighed on shares ever since.
Long-Term Tailwinds Are Far More Powerful
Weak sales performance in the back half of 2018 is a very small deal in the big picture for EA stock. In that big picture, there are three multi-year trends in the video game industry that matter:
- Increased digital download adoption and the eventual birth of video game streaming.
- Continued growth in video game micro-transactions and live services.
- Mainstream emergence and widespread adoption of eSports.
Thanks to certain growth initiatives and a robust content portfolio that includes franchises like Battlefield, FIFA, Madden, Star Wars, and Sims, EA has broad and favorable exposure to all three of these growth trends. For example:
- Through Project Atlas, EA is arguably the leader in pioneering what the company calls “cloud gaming”, which is essentially video game streaming (being able to play a video game through a streaming service, not through a console).
- Many of EA’s games lend themselves to micro-transactions. These micro-transactions aren’t going anywhere anytime soon. While Battlefield V launched without micro-transactions, rumors are swirling that a premium Battlefield V currency is coming in January. The broad implication is that the era of micro-transactions will live on for EA.
- EA’s titles lend themselves well to competitive gaming. As such, EA hosts multiple eSports events, including the FIFA eWorld Cup, Madden NFL Championships, and NHL Gaming World Championships. EA is also plunging into the mobile eSports world with Command & Conquer: Rivals.
Overall, the big picture fundamentals supporting EA stock remain favorable. While there are near-term headwinds related to sales strength in the back half of 2018, those headwinds are ephemeral. They will leave just as quickly as they arrived.
As noted above, the important things will stay in the picture. EA will continue to push forward on cloud gaming and benefit from digital downloads. The company will continue to earn higher revenues and grow margins through micro-transactions. And, Electronic Arts will also continue to expand its eSports presence.
All three of those things are positive long term developments that will ultimately drive EA stock higher.
The Price Is Right
At current levels, the price is right to buy EA stock.
High margins, strong cash flows, a wide content moat with enduring demand, and favorable multi-year trends have kept EA stock trading at a 23x forward earnings multiple over the past five years. However, the past 12 months have seen the forward earnings multiple spend most of the time above 25x.
Today, EA stock’s forward earnings multiple is below 20x. That’s an unnecessarily big discount. Margins are still high. Cash flows are still strong. The content moat is still wide. And the multi-year growth trends remain favorable. Thus, a rebound to a 25x forward multiple seems reasonable. Alongside continued earnings growth, that should power big gains in Electronic Arts stock.
Bottom Line on EA Stock
EA stock has been unnecessarily beaten up on overstated near-term headwinds that will inevitably fade from the picture within the next few months. As they do, Electronic Arts stock should rebound, given strong longer-term fundamentals. This rebound will be powered by both earnings growth and multiple expansion, giving the stock double firepower to head way higher in 2019.
As of this writing, Luke Lango was long EA, TTWO, and ATVI.
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