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Is it 'game over' for Electronic Arts?
With competition mounting, the video-game maker offers a bleak outlook. And its stock remains expensive despite its decline.
By Robert Walberg
If there's been one company that has made an art out of profiting from the explosion in electronic games, it's the aptly named Electronic Arts (ERTS, news, msgs). At least until now. Last week, Electronic Arts warned that it would post a loss of between 22 and 28 cents in the current period, its fiscal first quarter. It'll be the company's first quarterly loss in almost four years. The company also sees sales dropping to $300 million to $340 million, from $432 million in the year-ago period.
The news stunned the Street, which had been expecting a first-quarter gain of 5 cents on revenues of $450 million. Investors weren't much happier with the company's outlook for fiscal 2006, which ends in March of that year. Management sees earnings of $1.55 to $1.70 a share on revenues of $3.4 billion to $3.5 billion. Prior to the news, the consensus earnings estimate was $1.73. Two months ago, the Street was even more optimistic, expecting Electronic Arts to earn $2.02. The company earned $1.71 a share on sales of $3.1 billion in fiscal 2005.
Disappointing Wall Street never does wonders for a stock, and Electronic Arts proved to be no exception. After its news on May 3, the stock quickly lost 11% of its value. Electronic Arts has rebounded a bit over the last week, as long-time fans of the company used the dip to do some buying.
But prudent investors will want to distance themselves from Electronic Arts' past successes and focus on today's grim reality. Sluggish sales, intense competition, product transitions and management missteps all point to continued weakness in the months ahead. A relatively lofty valuation and an ugly chart configuration support the near-term bearish scenario.
The center of the storm
At the center of Electronic Arts' problem is that consumer spending on games for the Nintendo and PlayStation 2 game systems has declined considerably in recent months, as gamers await new product launches from Microsoft (MSFT, news, msgs) and Sony (SNE, news, msgs) before committing their resources. (Microsoft publishes MSN Money.)
Microsoft is expected to unveil its newest version of Xbox later this month, followed quickly by Sony's introduction of PlayStation 3. Both companies hope to have their products available for retail during the upcoming holiday season. Meanwhile, Nintendo's new system, dubbed Revolution, is expected to hit the market in early 2006.
Related news and commentary on MSN Money
Once the new products hit the market, Electronic Arts' sales are likely to resume their ascent because it's the leading provider of video-game titles. Unfortunately, consumers are likely to sit on their hands for much of the next few months, exacerbating the company's sales and earnings woes.
Pricing on older games for current systems is also coming under pressure, as competitors Take-Two Interactive Software (TTWO, news, msgs), THQ (THQI, news, msgs) and Activision (ATVI, news, msgs) continue to try to steal share through aggressive pricing tactics. So Electronic Arts' industry-best margins will continue to come under pressure over the short term. Note that fourth-quarter gross margins dipped by just over four percentage points.
Shelling out more
Even as Electronic Arts experiences pricing pressures on its games, it has ramped up expenses. Marketing costs were up considerably over year-ago levels; licensing fees to the professional sports community were driven up sharply by competition; and management is raising what it spends on research and development in an effort to stay ahead of the competition. While the added R&D expenses are potentially positive over the long term, the combination of pricing pressures, declining sales and rising expenses doesn't bode well for the next six months.
Electronic Arts also was slow to see the potential in the cell-phone gaming market, a misstep that could cost the company its leadership position as the cell-phone gaming, or mobile-entertainment market, explodes.
By year-end, the global market for cell-phone games is expected to reach $2.6 billion, according to the London consulting firm of Informa Telecoms & Media. The size of the mobile-entertainment market might be dwarfed by the $20 billion video-game industry, but its growth rate of 342% over the last two years is much, much greater. Being behind the curve in such an explosive market is potentially very bad news for Electronic Arts.
If there's one positive for Electronic Arts in all of this, it's that the company sits on a mountain of cash. With nearly $3 billion, or about $10 per share, in cash and cash-like securities, Electronic Arts has the financial leverage to address its shortcomings in the cell-phone area, either through massive investment in its own games or by simply buying one or more of the smaller players. It'll probably have to overpay, but that could be a small price to pay for its earlier neglect.
By the numbers
Electronic Arts is still a good company. But it's going through a downturn now along with the rest of the video-game industry. And at five times trailing 12-month sales and 31 times estimated fiscal 2006 earnings of $1.65 (a number investors should have little confidence in, given recent events), the stock is simply too expensive to chase, even though it is down more than 27% from its 52-week high.
Given the lofty valuations, the likelihood of more bad news over the next several months and the fact that the stock is trading well below its 50- and 200-day moving averages, investors are advised to remain patient and wait for Electronic Arts to retest major support in the area of $43 or $44 a share before buying in anticipation of a rebound in fiscal 2007.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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